Perspectives 2019 2020 Public Sector

16 Transforming Debt in Frontier Markets Currency basket strategy A second innovative approach to de-risking frontier market debt is the use of a currency basket. The basket approach could limit single currency exposure by diversifying a sovereign debt portfolio away from U.S. dollar exposure and mitigating downside interest rate risk. In addition, swapping to a basket could reduce principal devaluation risk through its correlation with the local currency. The currency basket is selected by optimizing a mix of currencies across global regions based on carry, risk and correlation considerations. The key objectives of basket currency selection should satisfy several risk mitigation attributes: 1) high correlation with local currency; 2) low interest rate volatility (risk) when translating to local currency; and 3) low carry. The selected currencies need to balance across these three objectives and, after combining them, could provide meaningful risk reduction and diversification to the existing debt portfolio. With respect to correlation benefits, those currencies which could sustain higher co-movements during downside or stress periods should be preferred. After defining the objectives, Citi selects currencies across global regions (LatAm, NAM, Europe, APAC) with sufficient market capacity and the above- mentioned criteria. We apply a portfolio optimization approach to determine the optimal mix of the currency basket. The identified currency mix minimizes carry and maximizes correlation at each given level of risk. Lastly, we back test the currency basket performance over historical periods to examine its robustness throughout various market conditions, including financial crises. The final step of the currency basket approach is to assess its risk reduction effectiveness by incorporating it into the sovereign’s existing debt portfolio. We construct a Monte-Carlo simulation- based, country-specific “efficient frontier” to evaluate the risk-return tradeoff of various debt portfolio alternatives. For example, we apply this framework to a Latam government with substantial U.S. dollar debt exposure (more than 50%). We examine the risk reduction impact from swapping 20% of its U.S. dollar debt to the basket and find that the basket meaningfully reduces both expected and worst-case interest costs, and also significantly decreases the currency risk of principal devaluation by about 11%. While swapping U.S. dollar debt to other low-carry hard currencies (e.g. EUR or JPY) could also reduce interest cost, it tends to be less effective in managing principal devaluation risk. Our analysis indicates that the currency basket approach could be very impactful as a de-risking strategy for sovereigns with high U.S. dollar debt exposure and limited local market capacity. Carry Correlation Risk 09’ = 100 ‘09 ‘11 ‘13 ‘15 ‘17 Currency Movements Principal Interest Cost Downside Expected Current 10 yrs Downside Cost Expected Cost Alt 1 Alt 2 Basket