2018 - 2019 Edition of Citi Perspectives for the Public Sector

Citi Perspectives for the Public Sector |  2018-2019 35 Mitigating Risk By Modifying Multilateral Development Bank Loans Valentina Antill Head of Strategic Risk Solutions for the Americas, Citi John Finnigan Head of Development Organizations, Public Sector, Citi 1 Due to the small size of the local debt market and/or lack of appetite for its local currency from international investors. 2 The legal and regulatory requirements around derivatives, as well their Basel III/IV regulatory capital costs, all became onerous following the global financial crisis. M ultilateral development bank loan modification can play an important role in helping emerging market countries to manage risk — especially for economies exposed to volatile commodity prices. To some extent, it can also help insulate countries from global events that threaten their ability to attain budgetary and sustainable development goals. This article explains the concept of loan modification, focusing primarily on local currency conversion and its advantages for both the multilateral development bank and its borrowers. Emerging market (EM) economies are often characterized by a significant amount of foreign currency (i.e., USD or EUR) debt which creates balance sheet risk as the revenues to repay the debt are largely denominated in local currency. Although macroeconomic conditions have improved over the last decade in some markets, the use of foreign currency funding persists. Moreover, many developing market economies are heavily dependent on commodity exports or imports, bringing exposure to volatile commodity prices. Risk management can improve and stabilize a government’s fiscal position and protect the countries against the global systemic shocks and their pernicious impact on economies and societies. The traditional tools for shielding against local currency devaluations are predicated on the use of local currency debt. Alternatively, for countries with liquid currency derivatives markets, “synthetic” risk management solutions, in which the hard-currency debt is effectively converted to local currency via a derivative, can be used. When a country’s ability to satisfy local currency funding needs via local currency debt issuance is limited, the local currency derivatives market can be used as a risk management tool. 1 Nevertheless, the two predicaments (i.e., the inability to issue a sufficient amount of local currency debt and the lack of a local currency derivatives market) usually go together — especially in so-called “frontier jurisdictions.” In addition, execution of a derivative requires an especially notable amount of infrastructure for the borrower, as well as the capital cost charged by dealer for the counterparty credit risk. 2