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Citi Perspectives for the Public Sector |
2014
37
Since then, EM borrowers and lenders alike have
benefited from the development of the swap
market on EM currencies. Borrowers gained
the ability to synthetically convert their US
dollar debt to local currencies, while multilateral
institutions, such as the World Bank, gained the
ability to lend in local currencies. A multilateral,
for instance, typically gets funding in US dollars
from its traditional sources, lends local currency
to its clients, and hedges the local currency
and interest rate risk via a cross-currency swap
with a bank such as Citi. Recent swap market
dynamics have also made these synthetic local
currency loans a cheaper funding solution than
local funding alternatives.
Notwithstanding advances in currency risk
management, the balance sheets of many EM
governments continue to harbor currency
exposures, along with interest rate or
commodity exposures that could potentially
harm GDP growth or cause inflation, among
other troubles. Such governments typically
abstain from using derivatives for a number
of reasons, including lack of risk management
expertise and proper derivative infrastructure.
These shortcomings may be further
compounded by an aversion to margining and
jitters about new regulations, such as Dodd
Frank’s new reporting rules.
Overcoming these weaknesses is where global
banks such as Citi and multilateral institutions
such as the World Bank come in – often
alongside each other. These institutions can
provide technical- and ministerial-level advice
and training that lead to sound and politically-
vetted approaches to risk-management and
requisite derivatives infrastructures.
In practice, a multilateral’s support for
a hedging strategy provides an almost
instant “vetting” at the political level. At the
transaction level, multilateral involvement
also yields more efficient and cost-effective
transactions and the extension of local
currency yield curves.
Multilaterals, with their high credit ratings,
play an important role in transforming the
credit risk of invariably lower-rated EM swap
counterparties to credit risk such multilaterals.
Being able to trade a swap with a AAA-rated
multilateral that in turn lends local currency to
the EM borrower, makes the transaction less
costly and more efficient by driving down the
derivative’s credit value adjustment (CVA), a
cost premium tacked on to derivatives based
on counterparty risk.
Multilaterals, and institutions such as Citi,
bring to the table a wealth of experience
and expertise that can help public sector
entities take advantage of opportunities in
the EM derivatives. Citi’s resume includes a
number of milestones in the development
of EM derivatives markets, many achieved
in concert with multilateral institutions, and
numerous cross-currency derivative solutions
that involve currencies from Mexican pesos to
Chinese renmimbi.
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