Perspectives 2020-2021 Public Sector

Citi Perspectives for the Public Sector 32 33 A solutions toolkit to head off a solvency crisis While markets remain sanguine at present about the risk of an emerging markets solvency crisis, the potential for markets to shut rapidly in the event of a renewed shock is significant. How could central banks and MDBs respond to such a closure? 1. Use of central bank liquidity facilities: Developed market central banks could provide cheap liquidity to a special purpose vehicle (SPV), which would allow EM debt investors to repo a combination of secondary and new issue bonds. This would avoid the need to liquidate bonds in the event of market stress. Investors would be subject to daily margin calls on the repo (a commercial bank administering the structure would take the investor counterparty risk). The central bank’s exposure would be to the commercial bank and investors – only in extreme circumstances would they be exposed to the EM bonds. In order to improve the repo haircut, an MDB could provide a first loss to the SPV. This equity, added to the cheap funding, would be passed on to the EM country via the lower cost of the new bonds issued to the structure. 2. MDB envelope deployment into secondary market purchases: Should an EM bond reach distressed prices (60% of face value or less), an MDB could purchase bonds in the secondary market (in coordination with the issuer) to help support prices. If the market returns, the bonds could be re-sold in the secondary market. If it does not, the money invested could be counted against other disbursements that the MDB has made to the country. Retiring debt at a discount would imply less funding for other uses, but would help to capture the discount on behalf of the issuer (and represent a crystalized loss to the private sector), improving the efficiency of the market. 3. More efficient use of MDB guarantees: Partial Risk Guarantees (PRGs) are inefficient in terms of the pricing benefits they confer. An alternative solution would be for MDBs to charge private sector market prices for guarantees and enable market transactions – such as an SPV that allows tranching and new debt to flow to EM issuers, or supply chain finance – to be structured around them. The cost of the structures would not be concessionary (as with a PRG), but it would attract private sector capital to EM debt at times of stress. Alternatively, MDBs could distribute PRG loans and bonds into the market through a standardized note issuance platform (like a Medium Term Notes program) that is able to accommodate and maximize investor appetite with regard to currency, tenor, fixed/floating rate and proportion of PRG. This approach would help recycle PRG bonds and loans for a multiplier effect, unlock investor appetitive and scale MDB capacity. 4. Effective standstill for near-term distressed sovereign debt: Distressed sovereigns should have at their disposal a market- friendly mechanism that postpones principal and interest payments in a way that is orderly, avoids default and is systemically scalable. Instead of making cash interest and amortization payments to existing investors, the sovereign would issue single series, zero-coupon interest promissory notes and principal promissory notes to holders of record on the respective interest payment date or maturity date. This would allow them to re-direct current cash away from private sector creditors and toward crisis response until market normalcy returns and classic reprofiling and restructuring (Sovereign Liability Management) techniques can be implemented. Avoiding sovereign disorderly defaults will benefit all issuers and investors by reducing the risk of panic redemptions and severe EM contagion effects. 5. Blended fund with MDB first loss layer: EM sovereigns, MDBs and private institutional investors, with input from rating agencies, could jointly create a Blended Fund with risk- absorbing tranches that aggregates financing requests from EM countries, leverages grant monies and lifts complicated and cumbersome project-by-project blending to the Fund level. The Fund would be guaranteed at a defined loss level by grant funding from MDBs or other partners to achieve investment grade-rated issuance, thereby attracting private institutional investor capital at appropriate risk-return levels. An immediate call to action The suggestions above and other innovative ideas should be discussed in a formal forum that brings together the official and private sectors to create a crisis response framework and gives momentum to proposed solutions. There is no time to lose, given the still looming uncertainty and the potential risk of a new sudden stop to economic activity. Countries should use this relatively benign market window to design and implement an arsenal of solutions that are ready to be deployed when a crisis hits, rather than waiting and then finding themselves in the difficult position of having to create solutions in an ad hoc and sub-optimal way while in the middle of the battle. If in the end no immediate crisis emerges, countries will be left with a toolkit that will be accretive to resource mobilization and market stability. One way or another, these efforts will have contributed to economic development and sound debt management policy. Preparing for a Potential Emerging Markets Debt Crisis: A Response Toolkit Countries should use this relatively benign market window to design and implement an arsenal of solutions that are ready to be deployed when a crisis hits, rather than waiting and then finding themselves in the difficult position of having to create solutions in an ad hoc and sub-optimal way while in the middle of the battle.