Huge waves covering highway | © Zastolskiy Victor, Shutterstock
My friends and I were planning a sailing trip in Croatia for later this spring. We started to worry about COVID-19-related travel disruption but felt a sense of security remembering we had travel insurance. We inquired, and the insurer pointed to two French words buried in the policy: force majeure.
Economic disruptions are cascading globally as a result of COVID-19. For infrastructure investors, the sudden evaporation of demand is colliding with cost increases, or at least cost uncertainty. Once these economic realities become balance sheet realities, a “tidal wave” will come into view that risks overwhelming the legal system with contract disputes.
Courts rely on precedent to adjudicate contract disputes. So do investors, understanding that all outcomes can never be specified in infinite detail. Force majeure clauses are catch-all buckets for big, unlikely events. The World Bank’s Model Contract Database gives one example of a definition: earthquakes, floods, fire, plague, acts of God, and other natural disasters. In many public infrastructure projects, governments indemnify senior lenders against payment disruption caused by force majeure. Where those guarantees aren't in place, we can expect legal disputes between counterparties to exacerbate systemic risk. But governments can go further to mitigate systemic risk than simply standing behind existing force majeure guarantees.
When we say the crisis is unprecedented, that isn’t a rhetorical flourish. It means, in practical terms: Courts will have a hard time figuring out what the precedent is.
So far, China has issued more than 4,000 force majeure certificates to industry. This works in their system, where most lending is underwritten by state-owned banks. Chinese firms are having a more difficult time getting international lenders to agree to activate force majeure terms, leading to disputes.
This gives a preview of the type of disputes we might see vis-a-vis international project finance lending, which would magnify the COVID-19’s economic chaos. It could delay existing project pipelines, undermine governments' efforts to enact a fiscal stimulus, and even cause financial system contagion.
Here are steps that governments can take to support infrastructure in the crisis. (But please note that most of them are most pertinent to developed country governments that can borrow unlimitedly in hard currency.)
Throw "moral hazard" out the window
Usually governments are right to worry that their interventions may create moral hazard. Right now, the risks of inaction far exceed the risks of future misallocation of resources due to moral hazard. Governments can comfort themselves that investors are unlikely to discount a global event like COVID-19 happening again.
Issue blanket financial guarantees to all infrastructure projects
Governments can immediately announce blanket financial guarantees for lenders to critical infrastructure projects. This would involve setting clear parameters for what qualifies by sector, project size, and type of financing. This would help calm lenders' nerves while the details of direct support to project owners are worked out.
For demand risk projects, make direct payments to sponsors
Government can step in and make direct payments to special purpose vehicles for projects. This can be for the delta between realized revenue and a reasonable "no-COVID" scenariodefined as the forecast , the previous year's revenue for each period, or some mixture. Direct payments to sponsors not only maintain debt service payments, they can help keep suppliers and subcontractors on the job, limiting wider economic damage. They also keep the payment chain intact, making it easier to return to normal once the need for support diminishes.
For availability payment projects, make direct payments to owner agencies
Subnational and local governments face falling revenue. A wider bailout of these governments will likely be required, which could include compensating agencies making public-private partnership availability payments for unexpected revenue shortfall. At the very least, the amount of funding made available to governments at these levels as part of any bailout should not vary with the delivery model of projects in their portfolio.
Support should have a clear time limit
One category of moral hazard risks relates to "when can we withdraw support?" One approach to this question is to ask: how much longer is economic damage likely to last than the outbreak itself? The duration of support can be linked to the duration of the health crisis. It can be a multiple – 2 or 3 times – the duration of the federal state of emergency linked to the pandemic. For example, if this state of emergency lasts for eight months, then with a multiple of 2 times, the financial support programs would last 16 months. Based on what we know, we can reasonably assume that the depth of the economic crisis will be linked to the duration of the health crisis. A "multiple" approach allows government to articulate a clear time frame up front, without knowing the crisis’ depth and duration.
A blacker swan
Nouriel Roubini famously called the 2008 financial crisis a "black swan" event. While the crisis was unexpected, it wasn't unprecedented; we’ve seen financial-led economic downturns many times before.
Likewise, epidemics and natural disasters happen all the time and have predictable economic consequences, as economists who study fragile and conflict-affected states know.
What is unprecedented, however, is an event like a natural disaster that is unfolding everywhere in the world at the same time with the same ferocity. No one should claim to know what will happen, but we should assume that conventional methods of risk mitigation are unlikely to hold up.
Lenders and investors try to insure against force majeure risks. To the extent that such risks are uninsurable, lenders may take a portfolio approach. Portfolios are constructed to include investments in diverse geographies, and across many sectors. For example, if the oil price suddenly collapses, fossil fuel investments do poorly, but airline and shipping investments do better. Right now transportation and fossil fuel sectors are collapsing together. Likewise, geographic diversification is unhelpful here.
One result of the COVID-19 crisis may be more robust methods of risk allocation and mitigation. To safely get to that point, governments will have to intervene to stop the metastasis of this pandemic into the financial system and real economy. During the 2008 crisis, policymakers used the language of preventing financial contagion to explain interventions that shored up the shadow banking system. Such metaphors are more apt than ever.
The original version of this blog appeared on Herb Ladley's LinkedIn page.
Disclaimer: The content of this blog does not necessarily reflect the views of the World Bank Group, its Board of Executive Directors, staff or the governments it represents. The World Bank Group does not guarantee the accuracy of the data, findings, or analysis in this post.
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