Perspectives 2019 2020 Public Sector

14 Transforming Debt in Frontier Markets The default approach for emerging and especially frontier market countries has been to source capital from other deep monetary systems, such as G10 countries, and particularly US dollars. Emerging and frontier market sovereign debt issuance has soared since the financial crisis and is at record highs. Sovereign debt levels in emerging markets have risen from a low of 34% in 2008 to 49.7% at the end of 2018, according to the Institute of International Finance. 1 Availability of credit to emerging market governments is likely to continue rising in the near term as lenders and bondholders chase yield. However, it is questionable how long investors will remain this hungry. Moreover, while borrowing in hard currency is viable when exchange rates are constant, it can present problems during times of volatility. If the dollar’s value increases, then so do debt servicing costs, which, in turn, can worsen the country’s finances and lead to a deteriorating credit rating, further raising borrowing costs. Analysis shows that USD is the riskiest currency for most frontier countries to borrow in, as USD consistently strengthens during EM crises. As public debt levels across the emerging markets approach 50% of annual output for the first time, rising interest costs and frontier market currency weakness represent a significant potential threat. Frontier Market De-risking strategies for USD or EUR Debt In April 2019, Citi hosted the fifth in a series of roundtables that bring together the public, private and third sectors to collaborate on strategies that crowd in private capital to finance emerging and frontier market infrastructure by addressing key risks such as currency. Particular focus has been paid to the frontier markets, not only due to their most pressing need for infrastructure funding, but severe underdevelopment of the capital or derivative markets in their local currency. The most recent roundtable focused on innovative approaches to managing risk associated with USD and other reserve currencies, interest rates and commodity exposures. During the roundtable, Citi outlined various options for debt risk management, including re-denomination of USD debt to the local frontier currency, or, absent the market to convert debt to local currency, diversifying to another hard currency, using a proxy currency, or leveraging a currency basket strategy in an effort to de-risk on a much larger scale. The paradigm permeating the series of de-risking roundtables was de-risking by converting Development Bank loans, whereby a Development Bank loan to a frontier borrower is indexed to a local or proxy currency or commodity, leaving the Development Bank, instead of the borrower, to close the derivative. Given its superior economics and numerous conveniences for the borrower such as no ISDA or margining, this arrangement has gained notable interest in the frontier markets community. Below we focus on two groups of strategies that have the potential to de-risk and transform frontier market debt — when hedging is unavailable in local currency — and open the way to more sustainable financing of the SDGs for frontier market countries. De-Risking with a proxy (correlated) currency, index or a commodity Citi has developed three potential solutions that involve converting existing or indexing new loan payment amounts to calibrated proxies. Under the Development Bank loan conversion structure, such payout linkage can then be hedged with the market by the Development Bank lender. Each of these solutions addresses a different component of a frontier currency risk (as described in continuation) and can be tailored, or even combined, to accommodate the borrower’s specific circumstances. 1. De-risk the EM-wide component of frontier currency risk using an EM local currency index One component of frontier currency risk, which is beyond the control of an individual country, often correlates with EM wide or regional asset classes. Most currencies, including illiquid ones, sell off to various degrees in line with broader, liquid local currency indices. Converting USD \loan payments to the appropriate EM liquid local currency index can therefore mitigate the volatility driven by this component. 1 https://www.ft.com/content/7cd60938-6cd2-11e9-80c7-60ee53e6681d