2024 Public Sector Perspectives

The expansion of local markets has also helped to build trust in local currencies among domestic and international investors. This is highlighted in the remarkable advances that local currency-issuances have made over the past 3 decades. Maturities have become longer dated, which reduces refinancing risk and reflects investor trust in locally issued government securities. Average maturity on internal debt (Years, 2010 vs 2022) Source: Inter-American Development Bank Standardized Public Debt Database Note: *Costa Rica average maturity reflects 2009 The region’s debt currency switch has also helped countries increase their sovereign credit worthiness. Recent improvements to the sovereign ratings of several Latin American countries have coincided with significant increases in their local currency debt relative to foreign. For example, Uruguay, Peru, and Colombia each had reached 40 to 50 percent or more local currency debt as a percent of total debt when they were upgraded to investment grade between 2008 and 2013. While other factors played a role in reaching this milestone, the development of local markets, increased financing flexibility, and reduced external vulnerability risks were key for helping to improve these sovereigns’ credit profiles. Furthermore, the exhibit below highlights that there exists a correlation between higher levels of local currency debt (relative to total) and better sovereign ratings, which can result in benefits such as improved financing costs and more access to funding sources. Latin America’s sovereign debt composition (2023, % total GG debt) Source: Moody’s Investor Service Note: Data excludes Caribbean sovereigns; ‘AAA to A-‘ rating group only includes Chile; ‘SD’ rating group only includes Argentina The development of local currency instruments and enhanced financial stability The expansion of domestic capital markets has been pivotal for providing governments with greater financing flexibility and reducing currency mismatch risks. The IMF has found there is a positive correlation between the expansion of local debt markets and financial stability in Latin America. Therefore, sovereigns seeking to reduce exposure to external adverse shocks and improve fiscal resilience against FX volatility have several strategies available to achieve these goals, including: issuing government securities in the local market, de-dollarizing multilateral debt, using Global Depository Notes or issuing local currency- linked external bonds. As countries are increasingly embarking on the journey towards de-dollarization, derivatives strategies have emerged as a powerful tool, helping countries to effectively manage currency exposures and navigate the complexities of de-dollarization. A recent report by the International Monetary Fund (IMF) found that the use of derivatives for de-dollarization has increased significantly in recent years 3 , with the average share of derivatives used for these transactions doubling from 10% in 2010 to 20% in 2021. Derivatives, particularly currency swaps, options and futures provide a valuable mechanism for hedging against currency risks. By employing these instruments, countries are protecting their economies from the impact of currency volatility. In cases where countries are de-dollarizing their debt by utilizing conversion clause with MDBs, they don’t need to execute derivatives themselves, thus avoiding the complexities of derivatives but enjoying their full benefits. These transactions can also help to strengthen local debt markets by increasing the demand for local currency-denominated debt. When a country borrows in its own currency, risks associated with foreign exchange volatility are minimized. This canmake the country’s debt more attractive to investors and can contribute to a reduction in borrowing costs. Presently, de-dollarization transactions withmultilateral agencies such as the IADB, theWorld Bank, and regional development banks play a crucial role in facilitating transactions and can also affect the currency composition of countries’ debt balances by providing an alternative source of financing. Another solution used by governments is the issuance of international local currency-linked bonds. This solution has increased in the past year and its expanded use has provided issuers several benefits including larger investor pools, higher liquidity in local debt and reduced currency mismatch risks. Local linked Eurobond benefits Sovereigns seeking to modify their debt composition and reduce foreign currency funding could use these bonds as an alternative. However, in order to issue local currency-linked bonds, sovereigns must first take certain steps, including working with a bank and legal counsel to consider the below criteria. Although local currency-linked bonds may be more expensive than foreign currency bonds, sovereigns that have issued these bonds note that the benefits can supersede the costs in the short to medium term, especially in the event of adverse external shocks. 3 IMF. 2022. “The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies”. Citi Perspectives for the Public Sector 79 78 The Currency Switch: How the Expansion of Local Debt Markets Has Provided Greater Financial Stability to Latin America