Sovereign Risk and Public-Private Partnership During the Euro Crisis

Maura Campra, Gianluca Oricchio, Eugenio Mario Braja, Paolo Esposito

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137390813
• Topic: Business
• Subtopic: Financial Risk Management
• Index: Business

This book is an examination of the sovereign risk and debt limit issues facing the Eurozone (crisis/post crisis) and the need for alternative mechanisms to fund the capital investment requirements of the region.

1

Introduction

The financial crisis in Europe has led to a sharp increase in the levels of both sovereign risk and banking risk. The high correlation between sovereign risk and banking risk has produced a negative effect on the general economic system in terms of (i) lower public expenditure, (ii) less credit to corporates and SMEs and (iii) reduced private and public investment.

Government bond issue restrictions in Euro-periphery countries have also created negative effects on the real economy. The crisis has had a strong impact on the initiation of new infrastructure and on investments on capital intensive initiatives. Direct public intervention in the economy has declined.

At the same time, the ECB’s longer-term refinancing operations (LTRO) programme has provided banks in the Euro Area with plenty of liquidity and avoided possible bank defaults. However, this liquidity has not flowed into the real economy, since the banks have invested it in either government bonds or bonds of their own (fixed income buy back).

The new Targeted Longer-Term Refinancing Operations (TLTRO) effectiveness must still be verified.

In the near future the Euro area’s main problem will be to avoid deflation. The ECB has an opportunity to follow the Federal Reserve, the Bank of Japan and the Bank of England in applying quantitative easing tools. Quantitative easing can be structured in (i) a government bond buy programme, (ii) a private bond buy programme (on SME plain vanilla Asset Backed Securities) or (iii) a modified LTRO programme linked to new loans to corporates and SMEs. It is important not to lose momentum, given the turning point in the Euro economy.

Governments cannot pursue Keynesian policies without increasing their debt. However, we believe that public-private partnerships (PPPs) would be a powerful tool (not yet fully implemented in the Euro-periphery) in order to boost real economy without any pressure on public debt and on sovereign risk.

PPPs, combined with other forms of credit mitigation or public support, would make companies creditworthy enough for banks to finance them. As a matter of fact, public-private partnerships usually have comparatively modest capital requirements, according to Basel’s current regulations. In this context, directing bank liquidity towards PPPs would produce a positive effect on the real economy and on public finance.

Through PPPs countries would fail to meet the need of creating new infrastructure or investment or the need to develop innovative sectors, for which the funds and the necessary resources would not be available or for which the cost of procurement by the state would be excessive.

Therefore, it becomes very important to implement the construction of public infrastructure in order to push bank liquidity towards investments with a lower degree of credit risk. A system of concessions to private operators, in agreement with public operators, can realize and manage the infrastructure until the concession expires. Therefore, governments achieve the construction of infrastructure without charge, relinquishing for a given period, short or long, any yields resulting from its management.

The first part of this book focuses on the analysis and assessment of sovereign and bank risks in the Eurozone and the United Kingdom (UK) and examines the relationship between PPPs and the public debt ceiling or sovereign rating in detail. Public companies wishing to receive benefit from capital markets have to show investors that they are able to afford the debt service and pay it back in accordance with the measures taken and within the due date.

A key issue in the effectiveness of PPP schemes is risk management of the timing and costs of execution. On the one hand the PPP is an excellent financing tool but, on the other hand, there is a substantial risk of requests for revision and renegotiation of agreements by the dealers. If PPPs are poorly managed the final cost to governments can be high.

In this context, the International Financial Reporting Interpretations Committee 12 (IFRIC 12) on Service Concession Arrangements has taken a fresh look at how PPP investments are represented and evaluated in the financial statements of private entities. This examination by IFRIC 12 is very important and represents a good starting point for a quantitative analysis of PPPs.

The second part of this book analyses three countries (UK, Italy and Spain) and the management of several utilities (energy, transportation and water) in order to find out how differently these countries cope with these issues and which practices prove to be the best among the ones put into action.

In the UK the Bank of England has used quantitative easing on a large scale and there is a long experience of PPP schemes. The situation is different in Spain and Italy, where there is not an extensive experience of PPP schemes and the ECB has not yet applied quantitative easing tools.

An analysis of the legislation and national regulations on the subject of concessions led us to identify a number of areas of activity covered by these aspects. For each identified sector we analysed case studies drawn from the most relevant operational realities in each country, selected as part of the companies listed on regulated markets.

Our analysis showed that the highest concentrations of PPP activities are developed in the following areas:

•Transportation management (airports, railways, highways)

•Energy management (gas, electricity, hydrocarbons, waste)

•Water management

There are other industries with a high level of PPP activity, such as the betting and gaming sector, which are not discussed this book.

We believe that in the near future the number of public-private partnerships will increase in the Euro area due to the constraints of both internal stability pacts for public finance and the fiscal compact.

Italy and Spain are two out of a group of countries that need to activate PPP schemes in order to help their economic recovery; while the UK is a country with an extensive use of PPP schemes and an economy strongly supported by the Bank of England.

Although this book has been written with the joint contribution of all the research group members, the chapters are to be attributed to the following authors: Chapter 1: Maura Campra and Gianluca Oricchio; Chapter 2: Gianluca Oricchio; Chapter 3: Paolo Esposito; Chapter 4: Maura Campra; Chapter 5: Paolo Esposito; Chapter 6: From 6.1 to 6.10: Paolo Esposito, and from 6.11 to 6.15: Eugenio Mario Braja (special acknowledgement to Lucia Taruffo for her help in researching and processing balance data in paragraph 6.11); Chapter 7: From 7.1 to 7.2 and 7.5 Paolo Esposito, and from 7.3 to 7.4 Eugenio Mario Braja; Chapter 8: Maura Campra and Gianluca Oricchio.

2

Sovereign Risk: Credit Risk Analysis and the Role of PPP Schemes

2.1 Lessons learnt from the financial crisis: the strong link between sovereign risk and bank risk

The financial crisis has brought to light a strong link between sovereign risk, bank risk and corporate risk. Initially, the crisis originated in the banking sector and then spread so quickly it acquired sovereign risk status, especially in majorly indebted countries, such as the periphery countries to the euro zone (Figure 2.1).

As in a chain reaction, no sooner had the crisis flowed from the banking system into financial markets than it instantly affected the real economy. Since then, banks have been registering an unprecedented increase in funding costs and capital absorption due to both the procyclical effects of Basel’s regulations and a non-stop growth of non-performing loans. Falling back on raising capital seemed to be much too dilutive a solution. As a consequence, the main trend was towards “crunching the credit” by restricting lending activities in the real economy, especially by reducing assets in general, or risk-weighted assets in particular. That was like adding fuel to the flames and triggered a downward economic spiral. So far, ensuing business bankruptcies, layoffs and profit decreases have reduced domestic demand and have had a negative impact on tax revenues and national budgets. Just like the banks, heavily indebted economies on the European periphery found it impossible to access financial markets in order to increase their debt. Despite uncertainties, all enterprises were nevertheless directed towards refinancing existing debt.

A link between bank credit risk and sovereign credit risk was established at once. Many banks have since stopped working correctly, thus impeding the normal functioning of transmission mechanisms of monetary policies. The relatively helpful rescue operations actually overburdened national budgets and the cost of government bonds reached (and sometimes exceeded) the margins of safety. Immediately, an upswing in government bonds yield spread (measured as the difference between the yield of a government bond and the yield of a bond offering the same duration) caused banks and companies to come to terms with rising financing costs. The European Central Bank (ECB) might have had to face a breakup of the euro zone. In accordance with Basel’s regulations, the ECB decided to rescue the euro by saving the banks in the first instance through a variety of tools aimed at expanding the monetary base. Most importantly, for three years long-term refinancing operations (LTRO) provided the banks with the liquidity necessary (rated at one per cent) to survive independently of the financial markets. As a result, banks in the euro zone periphery were easily able to pay back their obligations and give way to bond buybacks, which should have brought significant capital gains. However, rather than pouring money into the real economy, the hig...

Table of contents

• Cover
• Title
• 1  Introduction
• 2  Sovereign Risk: Credit Risk Analysis and the Role of PPP Schemes
• 3  PPP Schemes
• 4  IFRIC 12 Service Concession Arrangements
• 5  Case Studies in UK: Energy Management, Transportation Management, and Water Management
• 6  Italian Case Studies in Energy, Transport and Water Management
• 7  Case Studies in Spain (Energy, Transporation and Water Management)
• 8  Sovereign Risk and PPP Schemes: Future Directions
• Notes
• Bibliography
• Index