2024 Public Sector Perspectives

Partial local currency hedging strategies Costa Rica Colon 10-YR amortizing loan example: Cost comparison of full vs various partial hedging strategies A. Full 10-YR Hedge: (all coupons + amortizations) B. Partial Hedge Variation: Only first 5-yr coupons, amortizations + final principal (“balloon”) C. Partial Hedge Variation: Only first 5-yr Interest + amortizations D. Partial Hedge Variation: Full 10-YR Coupons only Resulting Costa Rica Colon Interest Rate 7.25 % p.a. 6.79 % p.a. (0.46% saving) 5.12% p.a (2.38% saving) 4.82% p.a (2.43 % saving) 4. Credit-extinguisher local currency hedge Credit-extinguisher currency hedges, also known as credit-contingent hedges, are a relatively low-cost way of achieving a full local currency hedge. A borrower converts a USD loan to local currency via a hedge that is contingent on the default of a related party, usually the local sovereign credit: upon sovereign default, the loan reverts back to the original USD amount (less any transpired amortizations). Any default by the sovereign is likely to result in significant local currency depreciation. So while a credit-extinguisher currency hedge offers a full local currency hedge during the lifetime of the hedge, it still carries some risk. Hence, a credit-extinguisher hedging strategy is best deployed when a borrower seeks a full local currency hedge at a reduced interest rate and is confident about the sovereign credit risk outlook. Credit-extinguishing savings are typically positively correlated with the local currency interest rate, tenor and sovereign credit default swap. Indicative 15Y vanilla swap vs extinguisher swap levels BRL COP IDR INR MXN PEN PHP ZAR Vanilla Rate 10.42% 10.90% 6.34% 7.22% 9.95% 6.11% 5.72% 9.96% Extinguishing Rate 9.32% 9.94% 5.87% 6.91% 9.30% 5.76% 5.29% 8.70% Savings (bps) 1.10% 0.96% 0.47% 0.31% 0.65% 0.35% 0.43% 1.26% 5. Proxy hedging strategy In cases when the borrower’s currency is high-yielding and the underlying need for hedging is large, a proxy hedging strategy that uses a correlated portfolio of lower yielding currencies can be deployed. Citi has developed a proprietary model that utilizes the efficient frontier approach to determine the appropriate portfolio for borrowers. Based on historical performance and using simulation, the model approach identifies the optimal proxy hedge, providing the lowest risk (volatility) for a given interest cost, and the lowest interest cost for given risk (volatility). Implementing a proxy strategy is statistically expected to reduce the volatility of USD debt, as measured in local currency, and may increase resilience to systemic risk, as the proxy portfolio is likely to move in the same direction as the local currency. It also reduces the carry cost compared to the local currency. Finally, the approach would also enable borrowers to hedge a significantly larger notional amount (exceeding several billion USD) than would typically be available for a single EM, especially frontier, currency. 6. Hard currency diversification USD is the principal currency for MDB borrowing and lending. However, borrowing in a single currency necessarily creates risk, especially during a systemic event when the majority of currencies depreciate against USD during a so-called “flight to safety”.Diversifying to other hard currencies (such as CHF or JPY) is therefore statistically beneficial in terms of risk mitigation and can be a valuable de-risking strategy when local currency hedging options are unavailable or too costly. Moreover, borrowing in low yielding currencies, such as CHF or JPY (which have interest rates close to zero), can significantly reduce the interest cost that a borrower carries on their debt. Of course, borrowing in a non-USD hard currency does not provide full protection against local currency devaluation. However, it does offer potential protection against a systematic risk event such as war, a financial crisis or other global shocks, whichwould ordinarily result in amajority of world’s currencies (and other financial assets) depreciating against the dollar. Efficient frontier simplified illustration Comparing full hedge, zero hedge and proxy hedge Resulting Debt Interest Cost 100% Hedge to Local Currency (0% volatility, “high” interest cost) 100% of Debt in USD (no hedge) Efficient Point – Hedge via Proxy Portfolio of 6 Currencies: • lowest interest cost, for given volatility; • lowest volatility for given interest cost. Risk (expected volatility of debt portfolio measured in local currency) Conclusion: It’s time to act There are a wide range of hedging strategies available for borrowers accessing funds fromMDBs and other development finance institutions. Moreover, these strategies are not just suitable for central and local government and state-owned enterprise borrowers. They can be helpful for any other entities borrowing fromMDBs, including cities and municipalities, infrastructure projects and local corporate and financial sector entities. Not all de-risking and hedging strategies will be available to all borrowers in all circumstances. Furthermore, borrowers need to carefully consider the most appropriate option given the market environment and their circumstances. Nevertheless, there are numerous full and partial hedge options or other de-risking approaches that can accommodate borrowers’ needs and their cost considerations. In addition, the market continues to evolve as new strategies are deployed and opportunities constantly emerge. The need for effective de-risking strategies continues to grow. The market environment and geopolitical situation remains uncertain and fluid. Development finance institutions active in the debt market – as well as the public and private sector entities that they lend to – in all jurisdictions should seek support and guidance to help them identify the most appropriate de-risking strategy when borrowing in hard currencies. Indeed, MDBs should work to help educate their clients to understand the benefits of risk management and the options available. Choosing the right strategy can have a tangible impact on borrowing costs and significantly mitigate risk for their clients, helping MDBs and other development finance institutions to more effectively achieve sustainable growth and other objectives. Citi Perspectives for the Public Sector 63 62 De-Risking Emerging Market Hard Currency Debt