Risk, taxpayers, and the role of government in project finance

A perennial question has been the relative cost of public and private finance for investment projects in infrastructure. Klein argues that the apparent cheapness of sovereign funds stems from taxpayers' not being remunerated for the contingent liability they effectively assume. So the proper role for government is to reduce the cost of riskbearing for all projects by providinga stable and efficient policy framework. Klein concludes that government, through the taxsystem, cannot really do better than private financial marketsat funding infrastructure projects. All the financial advantagesof sovereign finance are due purely to coercive powers and areof no social value.

Under government finance the taxpayers would beara contingent liability that, if properly remunerated, would wipeout any cost advantage of sovereign borrowing. Governments shouldthen refrain from investing in projects or firms, whether withequity or with debt. They should not cover commercial risks.

In particular, one cannot argue that there is a tradeoffbetween the low cost of government finance and private efficiency.Private markets will do the best they can to tap lowcost fundswhile maintaining project discipline. They solve whatever tradeoffthere is. The government cannot do better by raising funds. Asa corollary, discount rates for private and public sector projectswould not be expected to differ (contrary to standard practice).

Arguing that the government cannot be expected toimprove on the outcome of free financial markets is not to arguethat all is the best in the best of all possible worlds and thatthere is no role for government. Private markets may not alwaysfind the best solutions. Market participants constantly searchfor better ways of trading risks. On average we could not expectgovernments to do better.

More important, governments can significantly reducethe cost of riskbearing by following prudent macroeconomic policies,supporting secure property rights, and deregulating and liberalizingfinancial markets so that private players can take the best advantageof lowcost funding opportunities. But it is inefficient to offsetthe risks created through bad policy by taxpayersupported funding(which would amount to stealing from investors and compensatingthem by taking from taxpayers).

Multilateral finance institutions should apply theirfinancial instruments to support the development of better governmentpolicies - for example, by granting guarantees against policyfailures where new policy regimes are not yet credible - and notsimply invest in projects or guarantee the full credit risk ofloans.

This paper - a product of the Private Participationin Infrastructure Group, Private Sector Development Department- is part of a larger effort in the department to analyze issuesrelating to private participation in infrastructure. Copies ofthe paper are available free from the World Bank, 1818 H StreetNW, Washington, DC 20433. Please contact Sandra Vivas, room G4031,telephone 2024582809, fax 2025223481, Internet address svivas@worldbank.org.(16 pages)

The full report is available on the World Bank FTP server