Political Risk, Project Finance, and Development Banks

Published in Journal of Financial Intermediation
Sustainable Banking

How should loan contracts for financing projects in countries with high political risk be designed? Looking at 4,978 project finance loans made to borrowers in 64 countries between 1996 and 2005, Stefanie Kleimeier and her co-author Christa Hainz show how non-recourse project finance lending and the participation of development banks in the loan syndicate help mitigate political risk. Based on these results, the authors derive the following suggestions for the parties involved in financing an investment. If the political risk level (e.g., risks related to expropriation or profit repatriation) is high, then the parties can utilize a project finance structure or invite development banks to participate in the loan syndicate to compensate for the high risk level. At very high levels of political risk, the participation of development banks is especially effective at reducing risk. Therefore, the results support the notion that development banks stretch their political umbrellas over projects. – While evidence on the impact of law and institutions on the loan contract is well established, we find that the influence of political risk is actually more important than that of law and institutions. Overall the findings suggest that the complexity of a project finance loan’s contractual framework can serve as a substitute for both a weak legal environment and a lack of reliable politics.

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