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

Luciano de Castro, Claudio Frischtak and Arthur Rodrigues

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: Most developing economies rely on foreign capital to finance their infrastructure needs. These projects are usually structured as long-term (25–35 years) franchises that pay in local currency. If investors evaluate their returns in terms of foreign currency, exchange rate volatility introduces risk that may reduce the level of investment below what would be socially optimal. In this article, we propose a mechanism with very general features that hedges exchange rate fluctuation by adjusting the concession period. Such mechanism does not imply additional costs to the government and could be offered as a zero-cost option to lenders and investors exposed to currency fluctuations. We illustrate the general mechanism with three alternative specifications and use data from a 25-year highway franchise to simulate how they would play out in eight different emerging economies that exhibit diverse exchange rate trajectories. Results show relatively small length adjustments, and suggest the mechanism offers a powerful policy tool to cost-effectively attract vital foreign infrastructure investment for developing countries.

Keywords: bidding for public projects; concession periods; exchange rate risk; government protection; infrastructure projects; insurance for exchange rate risk; investors risk aversion (search for similar items in EconPapers)
JEL-codes: F30 H40 H80 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2025-02-28
New Economics Papers: this item is included in nep-opm, nep-ppm and nep-rmg
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Published in Journal of Public Economic Theory, 28, February, 2025, 27(1). ISSN: 1097-3923

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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:126881

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