Project Finance in Emerging Markets: a Case Study

Project finance has experienced a positive relation with the economic growth of developing countries through its unique features and capabilities to overcome problem related to an underdeveloped financial sector. It is found to be a driver of economic growth in countries where transaction costs are high and financial development and governance are weak.

The classic literature interprets the economic growth as the result of increases in innovation, human capital and physical capital. Finance development stimulates an increasing in quantity of capital that creates economic growth. Nevertheless, As Schumpeter pointed out in , finance leads growth by allocation savings better and stimulating technological innovation, thus improving the quality of the capital disagreeing with respect to the classic literature. Financial markets can enhance the quality of capital, and consequently the economic growth, because they improve resource allocation and allow easier access to capital for entrepreneurs, are pivotal in corporate governance by dealing with agency costs and informational asymmetries, facilitate pooling and sharing risks, and ease the exchange of goods and services.

Therefore, in case of emerging economies would growth while still reforming their financial sector, they should consider to import finance from abroad. International capital flows support the increasing in relatively low capital stocks, can reduce the relatively cost of capital that developing countries are faced with and can improve the risks sharing. Hence they leads benefits, but liberalization should be carefully sequenced as not all capital is equal.
According with Schumpeter, what important is the quality of capital and not the quantity of savings. The increasing in quantity of capital produce a limited effect on growth. Therefore, which is the most suitable type of capital for emerging economies when domestic financial markets are nascent and international capital flows are risky? It well known that a developing country can only receive international equity inflows if the domestic stock market is well developed, hence this problem limits the use of this type of capital. On the contrary, the FDI does not rely on the existence of a developed domestic financial market because it is in part substituted through FDI. Nevertheless, foreign direct investments for developing countries provide positive growth for an amount limited to the quantity effect, not so big, hence they are not very effective in substituting the market.

As S.Kleimer and R. Versteeg pointed out, the specific features of project finance allow it to substitute underdeveloped financial markets and emulate the desirable characteristics of a developed markets and control. If markets are underdeveloped and do not function well, then in these areas the transaction costs of capital increase. Project finance is designed to reduce these costs, which are those arising from a lack of information on possible investment and capital allocation, from insufficient monitoring and exertion of corporate governance, from diversification and risk management, and from the inability to mobilize and pool savings.

Let’s now analyzing the reasons and the ways project finance is able to cut down the transaction costs and to compensates for any lack of domestic financial development.
First of all, project finance reduces transaction costs arising from a lack of information on possible investments and inefficient capital allocation through a syndicate of banks which provide most of the funds and delegates the major screening and arranging tasks to the syndicate’s lead banks. Moreover, the SPV is separated entity form the sponsor(s), thus, only a single investment has to be evaluated, instead of the overall sponsors. The clear distinction between SPV and sponsor(s) makes the project more easy to screen, improving the transparency of investment. The screening responsibilities are assigned to the lead banks. These can be expected to have the best screening skills due to their positions in financial system as multinational banks and their project finance market knowledge.

Secondly, consider transaction costs arising from insufficient monitoring and exertion of corporate governance. The non-recourse nature and the high leverage characterizing project finance incentive lenders to monitor. The separation of SPV from sponsor(s) leads an improvement in corporate governance, the creation of specific incentives for managers and a reduction of risk of no-correct allocation of funds with respect to the initial investment. The high leverage reduces the waste of free-cash flows during operation. The contractual structure of project finance increase transparency and thus improving governance.

Thirdly, in case of capitals scarcity and investors are risk averse, these will avoid risky project with high-return in order to look for low-return assets. Hence, if investors cannot diversify cross-sectional risk, then their capitals will not flow to high return investments. Project finance is not subjected to the same constraints of the local investors, hence it flows to the growth-enhancing project with more probabilities than local savings. However, project finance does not modify the risk appetite of the local investors. Finally, project finance is designed to deal with large investments and the syndicates normally are consisted of international banks. Therefore it should be able to pool savings, and to facilitate transactions. An emerging market is not able to pool savings as well as international banks. Link them to investments can lead severe financing constraints.

The flexibility of project finance makes it highly adaptable to different economic and political environments. Its features provide it comparative advantages in underdeveloped markets over most other types of capital. This allows project finance to substitute an underdeveloped financial markets, hence to carry out functions of a developed financial sector, increasing the quality of capital as result.
Moreover, the positive relation between project finance and economic growth is provided: high-growth countries raise more funds in form of project finance than lowgrowth countries. But it is only significant contingent on the host country’s economic development (income level), in fact project finance impacts only on the low-middleincome countries. In developing countries, the size of project finance deals weight no more than 0.2% over the GNI (for comparison, FDI are typically in the range from 1% to 5%). Nevertheless, FDI is significant over all income levels for only the quantity effect, as said before, while project finance is highly significant for low-middle-income countries.

Summarizing, the project finance ability to substitute financial market. This leads an increasing in quality of capital in countries where transaction costs are high and financial development and governance are weak. Thus, project finance may be considered a driver for low-middle-income countries because, while FDI impacts without distinction in income level, project finance it is the specific variable that increase GNI of low-middle income countries.