Perspectives 2020-2021 Public Sector

Citi Perspectives for the Public Sector 42 43 Kamil highlighted that one way is to accomplish this is by increasing its funding in local currency in both domestic and global markets, with a particular focus on enhancing liquidity and diversifying its investor base for their internationally-issued peso bonds. Having access to local currency funding at competitive rates and from a wide array of investors offers an important source of financing flexibility and helps mitigate the impact of sudden movements in the exchange rate on debt ratios. Uruguay also sees strategic value in de-risking its sovereign debt portfolio by continuing to execute currency conversion clauses on outstanding dollar loans into local currency with multilateral development banks. Given that multilaterals, in turn, hedge their currency exposure through USD-pesos swaps with market dealers, these transactions help market development by deepening liquidity across the local currency yield curve and benefiting price discovery. Another borrower, the Ministry of Finance of one of the largest economies in Southeast Asia, has developed a strategy to diversify foreign currency borrowing in its debt portfolio by adding to USD a mix of EUR and JPY over the medium term. This diversification strategy was executed by re-denominating of a portion of their USD supranational debt to JPY and EUR, whereby the supranational then executed the JPY and EUR hedging swaps in the market. The Ministry of Finance has reduced the expected volatility of their hard-currency debt when measured in local currency, while also reducing the interest rate. The Ministry is now analyzing the benefits of de-dollarization to its local currency. In an uncertain global environment, the de- risking of debt has ensured certainty of short, medium and long-term flows. It has also resulted in a more stable balance sheet that is progressively less exposed to exchange rate variations. These changes have been welcomed by the rating agencies. What are the best examples of de-risking transactions that are deepening the market? The current systemic crisis has proven that de- risking emerging and especially frontier market debt should be a strategic priority. Both the Central Governments of Jamaica, Costa Rica and Uruguay have been leaders in Latin American frontier markets, adapting IDB de-risking strategies for their loan portfolios and aligning with credit agencies’ guidelines regarding FX composition of public debt. In the largest frontier currency inflation linked swap in the history of Latin America, Uruguay successfully converted $150 million of Inter- American Development Bank debt to Uruguayan peso inflation index (“UI”) in June, 2020. In the longest tenor frontier markets currency swap in the Caribbean region, Jamaica converted a portion of 20-year Inter-American Development Bank USD debt to Jamaican dollar in June, 2020. These trades resulted from IDB’s focused efforts to help their sovereign borrowers to de-risk and improve their debt profile, while also achieving one of its strategic priorities. The carefully executed conversions over the last few years not only helped Jamaica and Uruguay de- risk their hard-currency debt, but also to do so at competitive local currency interest rates and for a long tenor, often expanding or deepening liquidity at long-ends of the local curve. It is important to note that the frontier currency conversions almost exclusively occur by re- denominating the loan to local currency, while keeping USD as the settlement currency. From an economic and accounting standpoint, this results in local currency debt as the borrower owes less USD in the event that the local currency devalues – but also provides for an easy execution of the conversion and ability to execute larger sizes. 1 Conclusion Black swan events remind us of the importance of being prepared. However, in a crisis such as COVID-19, perfection is the enemy of effectiveness. Those countries that actively managed their debt composition – to any extent – benefited from greater protection and more effective risk management. While challenges exist, such as the limited number of international and domestic investors focused on emerging market currencies, multilateral development banks continue to respond to borrowers’ needs by partnering with international banks to facilitate loan conversions that de-risk emerging market debt and deepen market in local currencies. The frontier markets continue to present the biggest de-risking challenge, given the illiquidity of their capital and derivatives markets. Partial debt conversions, hard currency diversification (to EUR, JPY or CHF) as well as a proxy portfolio or basket of currencies are all strategies that have gained popularity in recent times. While such strategies do not attain the full hedge to local currency, they statistically reduce the volatility of a single hard-currency debt portfolio and may be executed with optionality that limits the downside currency scenarios. We intend to explore such option-based de-risking strategies during our next proprietary roundtable on this exciting and increasingly important topic of modern finance. 1 Ability to settle the converted debt in USD leads to the multilateral development bank lender’s ability to hedge the conversion in the international markets, benefitting from potentially wider range of dealers and investors in local currency. Transforming Debt: Re-Focusing in the COVID-19 Era Cascade Approach 1 2 3 4 Local (Frontier) Currency Conversion Partial Conversion to Local Currency Hard Currency (EUR, JPY) Debt Portfolio Diversification Proxy Approach (Currency Basket, Commodity, Correlated Currency)