Sovereign guarantee

Sovereign guarantee
See also
Bond Bank Currency crisis Foreign exchange reserves Development bank Negotiable certificate of deposit Monetary union Deposit rate Net Borrower Free Reserves

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.

Exaples 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'.

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