2018 - 2019 Edition of Citi Perspectives for the Public Sector

38 Mitigating Risk By Modifying Multilateral Development Bank Loans here is “partial de-dollarization”, whereby only the interest portion of the MDB loan is redenominated to local currency. Alternatively, for example, only the first ten years of a 20-year loan may be de-dollarized. Both approaches also reduce the local currency interest rate on such newly de-dollarized debt, which also has its own benefits, as some borrowers may be averse to replacing low interest rate hard currency debt with high(er) interest rate local currency debt. 11 Another way of reducing the currency risk of a frontier jurisdiction is conversion of the MDB loan to a proxy, i.e. correlated, more liquid currency. Many EM currencies move in tandem, for a variety of reasons, and this phenomenon is not limited to liquid benchmark EM currencies. For example, Dominican Republic peso (DOP) has an 85% correlation 12 with the more liquid Mexican peso (MXN). Hence, indexing an (unhedgeable) portion of Dominican Republic USD debt to MXN would reduce the volatility of USD debt. Likewise, Kazakhstani tenge (KZT) has 94% correlation 13 with the more liquid Russian ruble (RUB) and the RUB/USD swap market can be used to index Kazakhstani USD debt to RUB, in lieu of leaving it unhedged. 14 Finally, in the absence of a proxy currency that can be used as a hedge, the conversion of USD debt to another hard-currency, such as JPY or EUR, is also likely to reduce volatility of a USD debt portfolio as measured in local currency, while also delivering the benefits of lower interest rates. 15 11 For example, while the current 10-year USD swap rate hovers around 3%, those of Honduran lempira, Kazakhstani tenge and Vietnamese dong are 10.50%, 7.40% and 6.50% respectively. 12 Measured over a 24-year period. 13 Measured over a 24-year period. 14 While the proxy concept is very intuitive and firmly justified by historical data, this risk management concept more likely than not encounters a push-back, likely because of its “out-of-the-box” nature. 15 EUR 0.72% and JPY -0.17% 10-year swap rates are well below that in USD (3%). Kazakhstani Tenge Exchange Rate Evolution Against USD and RUB 1994 — Present 900 600 300 0 1994 2003 2012 KZT / USD KZT / RUB