Perspectives 2020-2021 Public Sector

Citi Perspectives for the Public Sector 40 41 What have we learned about de-risking and currency composition during the pandemic? 1. Many emerging markets borrowers need to prioritize liquidity, funding and addressing the health and human aspects of the pandemic. 2. However, market volatility is expected to continue. Therefore, de-risking – which is a proven strategy with significant benefits – should also be a priority, focusing on a range of simple strategies. 3. During the initial stages of the COVID-19 crisis, most emerging market currencies devalued against USD, raising borrowers’ costs. Hedging can protect against rising interest rates and further currency devaluation. 4. Debt to GDP ratios tend to increase at an accelerated rate when sovereigns with a high share of foreign currency debt face currency depreciation. 5. No borrower can be completely protected from systemic shocks and it is difficult to predict when the next one will come. Therefore, it makes sense to hedge risks while it is possible. What do we see happening in the market? • Interest rates, especially USD, are now at historic lows as central banks have been swift to loosen monetary policy during the COVID-19 pandemic. • Emerging market currencies have devalued 10%-20% since the onset of the crisis. • While borrowing in hard currency is viable when exchange rates are constant, it can be problematic during times of volatility. As the dollar’s value increases, so do debt servicing costs, which, in turn, can worsen a country’s finances and lead to a deteriorating credit rating, further raising borrowing costs. • In local currency debt markets that lack sufficient liquidity, a conversion to local currency is a viable strategy as it allows the borrower to hedge a portion of its debt. What are the driving forces behind the loan conversions? Loan portfolios carry a number of risks including interest rate and refinancing risk. However, borrowers cite foreign exchange risk as the single most significant risk. Dian Black, Principal Director Debt Management and Acting Deputy Financial Secretary in the Government of Jamaica’s Ministry of Finance, says that de-risking transactions are critical to the country’s debt management strategy. With foreign currency debt representing approximately 61% of its portfolio and a volatile foreign exchange rate, the government began to implement a de-risking strategy two years ago. Black intends to continue with this strategy, which has yielded significant savings. In Costa Rica, a middle income country that has enjoyed steady economic growth over the past 25 years, one state-owned enterprise, Instituto Costarricense de Electricidad (ICE) borrowed in foreign currency to fund electricity generation projects during an aggressive period of development. The large-scale projects required liquidity greater than the local market could provide, prompting ICE to access the international capital markets in USD, as well as lending from bilateral and multilateral banks. Borrowing in the international markets, especially from bilateral or multilateral development banks, was also cheaper than from local commercial banks. Now, ICE has developed a strategy to reduce foreign currency exposure risk and begun to hedge using financial derivatives directly or indirectly – by executing a conversion clause in loan contracts from its multilateral development bank lender that allows a portion of foreign currency debt to be converted to local currency. These efforts are the beginning of a more global strategy that aims to reduce debt payment outlays attributable to the depreciation of the local currency and decrease volatility of the income and expenses statement. In an increasingly challenging and uncertain global economic environment, prudent and proactive sovereign debt risk management remains essential. Herman Kamil, Head of Sovereign Debt Management in the Ministry of Economy and Finance of Uruguay, shared that a cornerstone of Uruguay´s debt management strategy is to increase the share of local currency in its sovereign debt portfolio, thus mitigating fiscal exposure to currency volatility and underpinning the country`s credit quality. Transforming Debt: Re-Focusing in the COVID-19 Era Emerging Market Currencies Devaluation Major EM Currencies Devaluation at the Onset of Global COVID-19 Pandemic USD Rates 5Y, 10Y, and 30Y USD Swap Rate Historical Dynamics (2000 — Present)