2024 Public Sector Perspectives

Cost reducing strategies While de-dollarizing debt via a loan conversion is practical for borrowers, the mechanism does not address some other challenges when hedging against EM currency devaluation. The most important of these are the increase in interest costs – as a consequence of higher EM interest rates – and limited liquidity (especially for hedging frontier markets). Fortunately, there are a number of alternative strategies that borrowers can pursue to achieve meaningful protection against the types of adverse market events that have occurred in the past few years. While these strategies – which are ordered by the amount of protection they offer – may not eliminate risk entirely, any hedge is much better than not hedging at all. Hedging cost-reducing strategies Level of FX Protection Low High Carry Cost Low High Conversion of a portion of USD debt to another hard currency (CHF, JPY, EUR…); Rationale: diversification, systemic risk hedge, interest cost reduction . Conversion of USD debt to a low-interest basket of currencies, correlated with local currency; Rationale: diversification, systemic risk hedge, interest cost reduction. Conversion of selected fraction of USD debt to local currency; Rationale: partial hedge and reduction in interest compared to a full hedge (also benefitting shape of local currency curve). Conversion of USD debt to local currency, whereby in event of sovereign default, the loan converts to the original USD amount; Rationale: reduction in interest cost when confident about sovereign risk. Conversion of USD debt to local currency where local currency interest rate has step-up profile (1st periods lower, later higher); Rationale: reduction of short-term interest cost (to cope w fiscal pressures). Conversion of USD debt fixed previously at low USD interest rates, to below- market local currency interest; Rationale: Monetize gain embedded in fixed rate USD loans to convert to low local currency rates. HardCurrency (JPY, CHF…) Debt Portfolio Diversification Proxy Basket/ Index Approach Partial Hedging Strategies Extinguishing (Credit-Contingent) Hedge Step-Up Interest Rate Solution Blend-and- Convert 1. Blend and convert Blend and convert – where borrowers that have previously borrowed at low interest rates in USD (or other hard currencies) convert to local currency – has become increasingly popular as USD interest rates have risen recently. This strategy enables borrowers to achieve a significantly lower local currency interest rate than the current market rate, effectively monetizing the gain they achieved by fixing dollar rates at an advantageous time. 2. Step-up interest rate approach For borrowers facing fiscal pressures or unexpected expenses in the current year, a step-up interest rate approach could represent an attractive hedging solution. The loan can be converted so that the interest rate for the first few years is very low or near zero to reduce the financial burden for the borrower in times of distress. In later years – when the borrower anticipates an improvement in the fiscal situation – the local interest rate is commensurately higher. Local currency step-up hedge Comparison of LCY interest rates in traditional vs step-up de-risking 0% 2% 4% 6% 8% 10% 2026 2025 2024 2023 2022 Traditional LCY Hedge Step-Up Hedge 3. Partial local currency hedging Where borrowers have very long tenor MDB loans and their local currency market is illiquid and/or has steep local currency yield curves, partial loan conversion is a practical strategy to reduce hedging costs and address local market illiquidity. The borrower can choose to convert only interest and/or amortization payments for the first few years into local currency, while keeping the long end of the loan in USD. Thus the borrower achieves payment certainty in the near term as well as valuable currency protection at an attractive rate. Over time, as the tenor of the loan shortens, the strategy can be replicated to capture upcoming flows. As an alternative, borrowers might choose to hedge either coupons or principal in order to reduce the cost of hedging. Where borrowers have very long tenor MDB loans and their local currency market is illiquid and/or has steep local currency yield curves, partial loan conversion is a practical strategy to reduce hedging costs and address local market illiquidity. Citi Perspectives for the Public Sector 61 60 De-Risking Emerging Market Hard Currency Debt