Perspectives 2019 2020 Public Sector

24 Structural Penalties in Sovereign Credit Ratings Citi is exceptional among banks in the extent of our geographic footprint and product offering. We offer to governments globally a wide range of solutions to address and sustainably resolve public finance challenges. Virtual accounts and procurement cards enhance budgetary control and transparency in government departments; our top-ranked debt capital markets and worldwide syndicate teams compress bond spreads to limit interest burdens; and our investment banking platform leads public sector clients through the process of monetizing state assets for greater fiscal resources, to name just a select few of Citi’s capabilities relating to common rating agency concerns. From the ratings agency perspective, individual transactions and targeted programs over time aggregate into a strong track record to support a sovereign ratings upgrade. Returning again to the size penalty, the specific concern about economically and geographically small sovereigns arises in part from the concentration of assets either in industry supply chains or in the path of natural disasters. Over the long term, the best solution is to grow, diversify and strengthen the economy, for which Citi is a committed partner; in the short and medium terms, Citi offers solutions to mitigate the fiscal risks of a downside shock. Where the economic concentration is in commodities, a well-designed hedging program can efficiently lock in prices and provide budgetary predictability. In Mexico — a large country and economy — Citi partners with the central government to insulate the budget from temporary falls in oil-linked revenues. In basic terms, the hedge (a rolling put option) places a floor under Mexico’s oil price sales, acting as a form of insurance. Thus in the event of a downside shock, the government’s fiscal resources are better protected and more available to deploy against other challenges. Catastrophe bonds are another form of insurance and are of particular value for countries exposed to storm and earthquake risk — and the range of covered disaster risks is always expanding. In a “cat bond” structure, a sovereign pays a premium to international investors to make liquidity rapidly available in the event of a natural disaster event exceeding agreed parameters. For example, in May 2019, an 8.0Mw earthquake in Peru triggered a $60mm payout of Peru’s outstanding cat bond, making these funds available more quickly than traditional insurance or donor assistance would do and allowing Peru to begin recovery. This instrument is part of the Pacific Alliance $1.36bn program, the largest-ever sovereign cat bond, for which Citi collaborated closely with the World Bank’s IBRD and insurance industry partners. Although a cat bond program alone is unlikely to result in a ratings upgrade, it can be an important part of a responsible fiscal and debt management — with rating benefits. Jamaica has historically suffered from fiscal deficits and high debt, both of which can be exacerbated by disaster-related expenditures. To address this risk and as part of its current IMF program, the country has developed a natural disaster resilience framework including cat bonds. 22 As the framework demonstrates over time its ability to shield Jamaica’s fiscal resources as well as the country’s improved governance, it should reinforce the evolving views of Jamaica that led Fitch to upgrade the country one notch in January 2019 and S&P to upgrade its outlook in September 2018. 23 Citi is in conversations with countries across the ratings spectrum — Aaa to B3 — about using cat bonds to insure against negative surprises. Where relevant, we are also discussing them as one part of a larger program to compensate for the structural, hard-to-change rating variables that might hold back a sovereign rating. 22 Patterson, C. (2019), “Gov’t Building Financial Resilience Against Disasters,” Jamaica Information Service, https://jis.gov.jm . 23 Fitch (2019), “Fitch Upgrades Jamaica to ‘B+’; Outlook Stable”; S&P (2018), “Research Update: Jamaica ‘B/B’ Rating Affirmed; Outlook Revised To Positive From Stable On Improved External Position.” Paull Randt Global Public Sector, Citi Anna Corcuera Global Public Sector, Citi