2018 - 2019 Edition of Citi Perspectives for the Public Sector

36 Mitigating Risk By Modifying Multilateral Development Bank Loans Modification of multilateral development bank (MDB) loans by embedding exposure management solutions, including local currency conversion, is an effective way to facilitate risk management for sovereign and private sector borrowers. It overcomes the limitations of local currency bond markets, as well as the costs and the inconveniences associated with an outright derivatives execution. It is important to note that MDB’s structured finance and treasury client solutions teams play key roles in tailoring programs to their borrowers and providing much needed support in facilitating EM public sector risk management practices. The concept of loan modification involves the following (simultaneous) steps: • Conversion of an outstanding MDB debt — partially or in its entirety — from USD to local currency. In our experience, the most efficient way of performing the conversion is via a so-called “currency indexation” mechanism, whereby the loan principal and interest are redenominated in local currency, yet the loan settlements remain in USD. 3 This method — avoiding a physical delivery of local currency — also simplifies the next step, described in continuation; 4 • MDB hedges the newly re-denominated local currency loan — which remains funded in USD via a non-delivery cross-currency swap, paying local currency to the dealer and receiving USD. 5 The most salient benefits of the loan modification solution as a risk management tool are: • Executional simplicity for the borrower —— the existing loan is simply redenominated to local currency and there is no derivative execution by the borrower —— no ISDA/Credit Support Annex Documentation —— no margining —— no mark-to-market of “embedded” derivative by the borrower —— simple accounting, whereby the borrower — in lieu of a previously USD accrual liability — now has a local currency accrual liability —— the borrower does not have to face multiple banks (nor have multiple ISDAs) in the execution 6 3 The vast majority of MDB loans have provisions allowing for precisely such currency conversions. 4 To date, most emerging markets currencies are not fully convertible, nor deliverable outside the host jurisdiction. 5 USD-settlement of the cross-currency swap provides a perfect hedge to the MDB’s USD-settled local currency loan. 6 The borrower continues to face the MDB, under the existing loans, while it is the MDB which may line up multiple banks in competition for the hedging swap, in an effort to provide the best conversion price to the borrower. How does MDB loan modification work? DEALER OFF-SHORE ON-SHORE (EM) Hedging of Embedded Derivative (Currency Interest Rate, Commodity) USD Loan MINISTRY OF FINANCE (SOE, Private Sector) Local Currency, Interest Rate, or Commodity-indexed payment (settled in USD) MDB