The love affair between project financiers and emerging markets is faltering.

Banks, which not so long ago were fighting for mandates in countries such as Indonesia and Pakistan, are now preoccupied with restructuring deals and recovering their money. Infrastructure projects in Asia have been put on hold and bond issues for Latin American petrochemicals projects cancelled.

Hubco, Pakistan's flagship private power project in which the UK's National Power has a dominant stake, is set to reschedule $500m in project finance debt, while Sincor, the Venezuelan oil developer, was forced to cancel its $1.5bn bond issue due to the turbulence in emerging markets. In Russia, even the European Bank for Reconstruction and Development is shifting its focus from long-term project finance to providing short-term pre-export capital.

Asian melt-down and the Russian devaluation, coupled with the default on its domestic debt, were responsible for an 11 per cent drop in project finance lending last year. This was the first time the growth trend has been reversed this decade.

But Geoffrey Spence, head of Project Finance for Europe, the Middle East and North Africa at Deutsche Bank, says the crises have "sorted out sheep from goats". Business, he says, is picking up in the Middle East and some African countries. Barclays Capital, for example, has managed to arrange $600m financing for the Al Tawellah power generation and water distillation project in Abu Dhabi. About 10 banks will take part in the deal including Abu Dhabi Commercial Bank and West LB.

Nonetheless, the main focus for project finance deals has shifted from emerging markets to western Europe and the US. "Since last August there has been differentiation between emerging markets and the emerged markets," says Rod Morrison, editor of Project Finance International.

Project financiers are preparing for a flurry of deals stemming from the deregulation of the power sector in the US and the country's growing need for energy. "The past year has seen the loan market's first forays into what is expected to be a flood of power assets changing hands in the US market over the next five years," says Mr Morrison.

As US utilities start to sell their power generation plants, project finance is being increasingly used for acquisition purposes, rather than for greenfield constructions, says Mr Spence. The spectacular growth of the US economy is also likely to create a need for extra power, he says, which would be funded by banks on a project finance basis.

However, liberalisation of the US power market will create new risks for banks. In the past, a project finance loan for the construction of a power generator was secured by a 30-year contract to sell electricity to a particular utility. Now electricity will be sold on a merchant basis, in the same way as oil or any other commodity, the price of which is determined by the market.

This means banks will have to take the view on where the electricity prices will be in 10 years' time, says Mr Spence. "This is a completely new situation for us."

Bankers also hope to benefit from the proliferation of private finance initiative (PFI) projects in Europe. Governments across southern Europe need to cut public spending and can no longer afford to subsidise infrastructure projects. As a result they are building on the UK experience of private-public partnership to fund and operate infrastructure projects.

The Italian government, which has one of the highest levels of debt as a percentage of GDP in the euro-zone, has declared its commitment to use private finance for public infrastructure projects such as roads, bridges and water developments. The government estimates that E63bn of infrastructure spending is needed in southern Italy over the next 10 years, says Mr Spence. Deutsche Bank has recently signed a co-operation agreement with Banco di Napoli in preparation.

The birth of the euro also had a serious impact on project finance by spawning high-yield bond markets. Banks, eager to earn a healthy margin by lending money to projects, are facing competition from the capital markets. "There is a lot of potential for using capital markets for project finance in western Europe," says Paul Jeffery, a managing director at Barclays Capital.

In the UK, where PFI projects are more developed, domestic bonds are already providing a source of financing for some projects. Catalyst Healthcare issued a $97.1m bond earlier this year to finance the new 452-bed private hospital in Worcester, while Sterling Water raised $79.2m from an ultra-long bond offering.

"With the development of the euro-zone capital market and with investors looking for higher yields, it is only a matter of time before projects in the euro-zone start being financed by international bond issues," says Mr Spence. Telecoms companies which have traditionally funded themselves through bank loans have so far been the biggest beneficiaries of the junk bond markets.

However, project finance bonds are still an expensive way of funding projects, particularly as growing competition and falling interest rates in Europe are driving the cost of bank loans down. "The tightening of profit margins caused by increasing competition means that some banks are prepared to lend money for over 30 years at under 100 basis points over Libor," says Mr Morrison.

But as bank shareholders increase pressure on the banks to free up their balance sheets, observers say an increasing number will themselves be looking to securitise their project finance portfolios.


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