How to deal with exchange rate risk in infrastructure and other long-lived projects

Working paper Cities

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 the government assumes the implicit foreign exposure liability by providing guarantees, or settles for a smaller inflow of foreign capital. The fact that countries which are most in need of to build or modernise their infrastructure and attract foreign investment flows typically face balance of payment problems and a high opportunity cost of foreign exchange makes the search for hedging substitutes a policy priority.

In this paper, we propose an alternative approach to address currency risk in infrastructure and long-term investments grounded on the notion that it would be more efficient for the government to provide a hedging or guarantee mechanism which adjusts the length of the concession through some publicised function defined ex-ante and dependent on the exchange rate (a "target function").

The IGC did not provide funding for this work. One of the leading authors, Claudio Frischtak, is Country Director for IGC Mozambique.