Sovereign guarantee

Sovereign guarantee is a promise given by a government to a project lender that if certain events, which have led to a substantial deterioration of the creditworthiness of the institution promoted by the government, do or do not occur, the government will compensate the project lender. It could be described as a 'standard' financial guarantee, which is distinguished by being issued by a government body, not private institutions e.g. banks. The extent of a guarantee generally depends on the unique risks of a project. Depending on a particular country and its Constitution, the right to decide about issuing a sovereign guarantee on the private sector comes down to the judgment of the President, Prime Minister, or Ruler.

The purpose of sovereign guarantees

Many governments want private firms to finance new infrastructure, in consequence, sovereign guarantees are issued to financially promote projects that are deemed to be in the public interest.. The guarantees are used as economic incentives for the capital market to finance the projects. For example, financial guarantees have in the past been used in Sweden to promote agriculture, fishing, housing construction, shipbuilding, and energy supply.

The firms, in turn, often want the government to bear some of the risks. They might ask the government to compensate them if demand falls short of forecast or to promise to repay their debts if they become insolvent. At the very least, they probably want the government to allow them to charge certain price or else compensate them accordingly.

Beginings of sovereign guarantee

According to Timothy Irwin, the earliest pieces of evidence of sovereign guarantees are:

• The Code of Hammurabi written nearly 4,000 years ago. It specified that the community should compensate the victims of unsolved thefts within its territory.
• Rome in 215 BC. It used private finance with a government guarantee to supply troops in Spain at a war with Carthage.
• The Bridge of Bordeaux in the early 19th century. The government of France would build and maintain the bridge; the concessionaire would clean it, light it at night, and, crucially, pay FF 2 million for the construction. In return, it got the right to tolls for 99 years. If annual revenue fell below FF 190.000, however, the government would make up half the shortfall, and if revenue exceeded FF 250.000, the government would get half a surplus.

Examples of Sovereign guarantee

• 'In the 1990s, the government of the Republic of Korea guaranteed 90 percent of a 20-year forecast of revenue for a privately financed road linking Seoul to a new airport at Incheon. The government didn't have to pay anything upfront and would get to keep any revenue exceeding 110 percent of the forecast. When the road opened in 2000, however, traffic revenue turned out to be less than half the forecast. As a result, the government has had to pay tens of millions of dollars every year'.
• Loan Guarantee: A sovereign guarantee is often provided to lenders in order to secure the repayment of a loan. This type of guarantee ensures that the lender will be able to receive the amount they are owed in the event the borrower is unable to make payments.
• Investment Guarantee: Sovereign guarantees may also be used to protect the interests of investors. Such guarantees can provide assurance that the government will honour the terms and conditions of the investment agreement. This can help to reduce the risk associated with investing in a foreign country, which may have less transparent economic regulations.
• Political Risk Guarantee: Governments may also issue guarantees to protect against political risks. These risks include nationalization, expropriation, and other forms of interference by the host country. Political risk guarantees can help to mitigate the risk of an investment being lost due to government intervention.
• Export Credit Guarantee: Governments may also provide an export credit guarantee in order to promote exports and support businesses that are exporting goods and services. This type of guarantee ensures that the exporter will receive payment even if the buyer is unable to make payment.

Advantages of Sovereign guarantee

Sovereign guarantees offer various advantages for project lenders, such as:

• Increased creditworthiness: Sovereign guarantees increase the creditworthiness of the project, as the government is backing the loan and thus reducing the risk of default.
• Access to cheaper funds: Sovereign guarantees can provide access to cheaper funds than those available from private lenders, as governments can typically borrow at a lower rate of interest.
• Reduced risk of political interference: Sovereign guarantees can also reduce the risk of political interference, as the government is committed to ensuring the project's completion.
• Long-term investment: Sovereign guarantees can encourage long-term investment, as the government is able to provide a more secure environment in which companies can invest.
• Reduced risk of currency fluctuations: Sovereign guarantees can help protect against currency fluctuations, as the government can provide a suitable exchange rate.
• Access to international markets: Sovereign guarantees can provide access to international markets, enabling companies to access a larger pool of potential investors.

Limitations of Sovereign guarantee

Sovereign guarantee has its limitations which include:

• Political risks: Political and legal environment of a country may limit the enforceability of the guarantee depending upon the political stability and the government's ability to honour its commitments.
• Creditworthiness: The creditworthiness of the government is a major factor in determining the efficacy of the guarantee. If the government is not creditworthy, the guarantee may not be worth the paper it is written on.
• Financial capability: The government needs to have the financial capability to honour its commitments in case a default occurs. If the government lacks financial resources, the guarantee may not be reliable.
• Currency risk: When the loan is denominated in a different currency than the government's, currency fluctuations may affect the efficacy of the guarantee.
• Time constraint: The guarantee may not be valid beyond a certain period of time, as stipulated in the agreement.
• Terms and conditions: The terms and conditions of the guarantee may have to be renegotiated in the event of a default. This may prove to be a lengthy and costly process.
• Documentation: The guarantee needs to be properly documented and the documents need to be regularly updated to ensure that the guarantee remains valid and enforceable.

Other approaches related to Sovereign guarantee

A sovereign guarantee is an important tool used to secure funding for projects that have a high degree of risk. In addition to this, there are other approaches that can be used to minimise the risk associated with such projects. These include:

• Securitisation: Securitisation is the process of pooling assets together and selling them as securities, such as bonds, to investors. This process allows lenders to spread out the risk of lending, allowing them to lend to more high-risk projects.
• Credit Enhancement: Credit enhancement is a type of financial guarantee that helps reduce the risk of default on a loan. It can be provided by a third-party such as a government or a special purpose vehicle.
• Risk Transfer: Risk transfer is the process of transferring risk from one party to another. This can be done through insurance, derivatives, or other financial instruments.
• Project Financing: Project financing is a type of debt financing that is used to fund the construction of a project. It is typically secured by the project’s assets or the revenues it generates.

In summary, a sovereign guarantee is one of the tools used to secure funding for high-risk projects. Other approaches include securitisation, credit enhancement, risk transfer, and project financing.

Footnotes

Sovereign guarantee — recommended articles

Bridge Bank — Counter guarantee — Eurocommercial Paper — International liquidity — Money emission — Bonding company — Capital Base — Negotiable certificate of deposit — Advance funding

References

• Hancock, D. (2011). Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets, Diane Publishing
• Hoffman, S. L. (2007). The Law and Business of International Project Finance: A Resource for Governments, Sponsors, Lawyers, and Project Participants, Cambridge University Press
• Irwin, T. (2007). Government Guarantees: Allocating and Valuing Risk in Privately Financed Infrastructure Projects, World Bank Publications
• LaBrosse, J. R., Olivares-Caminal, R., Singh, D. (2013). Financial Crisis Containment and Government Guarantees, Edward Elgar Publishing
• Magnusson, T. (1999). Sovereign Financial Guarantees, Unctad, undp, unitar workshop on Management of a Debt Office

Author: Małgorzata Lasota