Project Appraisal and Finance

Article Review
Nature of Credit Risk in Project Finance
By Marco Sorge
(World Bank Group International Finance Corporation)

Submitted To
Anirban Ghatak
Associate Professor
Institute of Management
Christ University

Name: Sayon Das
Roll. No.: 1421328

Project Financing and Credit Risk
Project finance has been the one of the most important means for financing of project all
around the globe in various forms such as public infrastructure, defence, industrial
construction, machinery etc. In developing economies project finance has played a crucial
role in fastening the development process and building infrastructure and boosting GDP. This
has enabled developing economies to increase productivity, provide public infrastructure such
as bridges, drainage systems.
Due to financial volatility and global market fluctuations, industrial problems in the energy
sector and telecommunication sector there has been many unsuccessful project financing
scenarios which has led to delayed project, monetary losses and increase in credit risk. The
long time period of maturities is one of the reason which results in high credit risk. Big
investment projects require high capital, financial investments and investment at starting of
the project. It takes a long period of time to give back return on investment it raises the risk of
debt service coverage and cash flow as it has to be calculated as per present value. Thus,
project financing have higher maturities and risk associated than syndicated loans. The
project financing involves high leverages and long maturity debts which directly affects the
credit risk on assets and project. Financial econometric analysis of the syndicated loans infers
that financing with long maturities have higher credit risk. Apart from credit risk, long term
maturity exposes the investor to various other types of risks such as structural risks, political
risks and country risks. Ensuring guarantees with the government, banks and export credit
agencies in developing countries will help mitigate the risk.
In recent times project finance has been relying on PPP (public private partnership) by
creating a SPV with independent financing from its parent entity and relying on cash inflows
generated from the SPV for repayment of loan. In the financial crisis of 1998 investor
reinvested their portfolios in industrialised countries from emerging economies. This led to
increase of financing of project to new high. Industry risks of energy sector and
telecommunication sector and slowdown of the economy has led to decrease og financing of
project in the globe. In telecommunication sector high investment based projects such as

optical fibre, next generation bandwidth technology is yet to yield desired rate of return
around the globe.
Projects such as power sector, roads and airports have similar traits which create significant
number of challenges in term of project financing. Rising demand for energy has resulted
need for project financing in in this sector. In industries such as crude oil and petrochemicals
more than half of investments are over $1 billion which signifies that the investment is very
high and debt is of long term maturity in which risk is high. Two kinds of phases are
associated with these projects namely pre construction phase and operational phase. In pre
constructional phase risk associated are environmental and technological risk whereas in the
operational phase risks political risk, price volatility risk of cost of inputs and market risks.
An also high investment project involves number of constituent and members and it involves
a collaborative effort of all the parties to cooperate and function with a same goal. Parties
involves government, company involved in construction, banks, financers, suppliers of goods
and raw materials etc. Thus, cohesiveness in terms of functioning and distribution of cash
inflow from the project is crucial for completion and operation of the SPV.
In financing of projects various types of contractual agreements exists such as supply,
concessions, construction etc., thus, it requires to allocate various risks to different parties in
order to mitigate the risk. As large projects are very big to finance by a single company,
segmented bifurcation of debt and equity helps to diversify the risks to many investors which
creates problem at managerial level, decision making and distribution of cash generated
among investors. Syndication of loan is one method which finances big project in which debt
Is led by one bank and syndicated by other banks . This helps to distribute the risk associated
with the project among the consortium of banks and helps in avoiding collision. Also new
entity with no association with parent company will help to reduce the risk of contamination
which helps to protect the financial strength of investor’s main business. Thus, to mitigate the
risk associated with financing of project emphasis of new structures of financing are being
used such as new risk distribution models, credit protections and instruments of financial
market to widen the scope of financing.
Crossover structures of financing are being developed in which private players are involved
in development of project and operational activity and government handles the market related
risks. Also derivatives such as forward and futures, insurance of economic risks, foreign
exchange fluctuations are being introduced to reduce risk. Also securitisations of project

debts are developing class of assets of investors. This market instrument would provide
greater liquidity in financing of project.
The credit spread and the risk associated is driven by the level of leveraging a project is
utilising and value of asset of SPV at maturity. Project with long debt repayment period will
have higher risk as the future value of assets of the firm is not certain in nature. When the
leveraging is high the risk is borne by the debt holders during maturity of shorter period. The
project which is non-recourse in nature is completely dependent on cash flows generated and
relies on the construction and pre operational phase after which return can be estimated.
The credit spreads have regression on various micro economic variables such as maturity
period, guarantees made by other parties, borrowers and macro-economic variables such as
foreign exchange fluctuations, growth of GDP, inflation, foreign exchange deficit, reserves
and world market interest rates. The political risk is calculated by “corruption index
published by Transparency International”.
The findings by the article are that the credit spreads risk form an inverse parabola which
signifies the risk exposure during the time period of the project. Also political risks and
guarantees have a major impact on project finance loans and exert risk on the credit spread.
Also project financing relies on many macro and micro economic variables. Development of
the capital market for financing of project will help in credit risk for new asset classes. Thus,
careful analysis of project and efficient deployment of resources and resources over various
classes of assets will help to decrease the credit risk.
Therefore, proactive role of banking sector, government sector and private sector towards
financing of project will facilitate economic development and growth in the developing
countries and growing economies.

References: Nature of Credit Risk in Project Finance By Marco Sorge (World Bank
Group International Finance Corporation