# **Executive Summary**

Currency risk remains a significant deterrent to foreign investment flows to developing and emerging economies, particularly for long-duration infrastructure investments. Given the nature of such long-term investments, that take place in non-tradable sectors for which natural hedge is unlikely, hedging instruments are frequently costly, if at all available. Thus, either government assumes the implicit foreign exposure liability by providing guarantees, or contents itself with a smaller inflow of foreign capital. Countries that are most in need of to build or modernize their infrastructure and attract foreign investment typically face balance of payment problems and a high opportunity cost of foreign exchange. For those countries, finding alternative hedging mechanisms is a policy priority.

This paper proposes an alternative approach to address currency risk in infrastructure and long-term investments. The main idea is to adjust the length of the concession in such a way that a guarantee defined ex ante as a “target function” is achieved. In this mechanism, an unfavorable (to the foreign investor) exchange rate would cause an extension of the concession period, while an appreciation of the local currency leads to a shortened length of the concession. We show that a risk-neutral government would be indifferent to the purely financial implications of providing the mechanism, even if it were not to charge for access. Moreover, considering the likely increase in foreign investors’ willingness to bid for the countries’ projects, the mechanism would in fact lead to gains on a social welfare function independent on how the government values consumer (user) surplus and efficiency of firms providing the service. This finding is intuitive to the extent that by providing hedge to suppliers of foreign capital, governments would attract a larger number of competitors willing to offer a lower tariff to consumers and/or greater revenues to government.

We initially present the government guarantee mechanism in its most general form, with a non-specific “target function” for each partner in the concession. The paper then discusses in greater detail three specific mechanisms: ensuring an exchange rate level, with the government guaranteeing a specific inflation-adjusted exchange rate; a guarantee of the net present value at the beginning of the franchise; and a guarantee of equal returns among (national and non-national) partners, while not committing to a specific return. Note that in all three instances, the mechanism is presented as an option, in principle at zero cost: at the contractual outset of the concession, the investor decides whether she wants protection or not, and what share of the project is to be insured. The mechanism is also adaptable to countries with limited regulatory resources, insofar as the tests to establish if the partner supplying capital in foreign currency should enjoy additional concession time (the “test function”) can be conducted in notional (or proxy) values, thereby reducing information requirements from the concession to the government, and thereby minimizing the probability of (bilateral) opportunistic behavior, while eventually facilitating court decisions.

Finally, empirical tests use data from a real world 25-year highway concession and exchange rates from 8 countries – Mexico, Peru, Chile, Brazil, South Africa, Mozambique, Indonesia and the Philippines – to show that the variations in concession length resulting from a hypothetical guarantee are relatively small under alternative functions. Given the baseline of 25 years, it is striking that the adjustment is less than 4 years (that is, 16% of the project’s length) for all countries. It is equally noteworthy that in six of the sixteen simulations per2