External Debt Risk Management

1. External Debt & Risk Management National Workshop on Capacity-Building For External Debt Management in The Era of Rapid Globalization August 30 -31, 2005

2. External Debt & Risk Management RISK-DEFINED CLASSIFICATION OF EXTERNAL DEBT

3. WHY DO COUNTRIES BORROW EXTERNALLY? to fill the gap between desired expenditure and domestically available resources.

4. WHY DO COUNTRIES BORROW EXTERNALLY? The large foreign currency exposure of emerging markets can be explained by a number of factors, including:

5. WHY DO COUNTRIES BORROW EXTERNALLY? Low domestic saving rates; Lack of domestic borrowing instruments; The high proportion of official financing (multilateral and bilateral), which tends to be denominated in donor countries� currencies.

6. WHY DO COUNTRIES BORROW EXTERNALLY? Governments also issue debt in foreign currencies to signal their commitment to a policy of stable exchange rates or prices; To maintain a presence in international bond markets, even though it may not need the funds. If there were no reliable measure of country risk government foreign debt issues can usefully establish benchmarks. Regular small issues can maintain access to the market, which may be helpful in the event of a sudden need for heavier borrowing.

7. WHY DO COUNTRIES BORROW EXTERNALLY? As emerging markets have regained access to international debt markets, the choice of currencies and maturity structures of their external borrowings have often been driven by a desire to reap the immediate fiscal benefits of borrowing in currencies with low coupon rates.

8. WHY DO COUNTRIES BORROW EXTERNALLY? Such debt strategies underestimate the risks associated with un-hedged foreign currency borrowing for several reasons. Many developing countries that have borrowed heavily in foreign currencies are now faced with the challenge of how to manage the currency, interest rate, and maturity risks associated with these debts.

9. The Choice Between Domestic And Foreign Borrowing Four important factors: Crowding-out effect political choices debt service costs balance sheet effect

10. The Choice Between Domestic And Foreign Borrowing borrowing in the short term is that government borrowing locally pushes up domestic interest rates, and so crowds out private sector borrowing. In the short term, foreign borrowing tends to avoid this crowding-out effect.

11. The Choice Between Domestic And Foreign Borrowing The manner of financing deficits affects political considerations about their size. Ensuring that the unpleasant consequences of heavy government borrowing are felt immediately (i.e. through higher domestic interest rates) may be more conducive to realistic policymaking.

12. The Choice Between Domestic And Foreign Borrowing A key incentive for governments to make heavy use of foreign currency debt is that it minimizes current interest costs. But leaves the country vulnerable to �contagion� and other risks, as the bonds may become hard to re-finance if there is a crisis affecting the country or in a neighboring or �similar� countries.

13. The Choice Between Domestic And Foreign Borrowing The nature of the liabilities chosen depends on the nature of assets on the asset side of the balance sheet.

14. DEFINITION OF RISK Risk is the volatility of debt servicing costs, relative to the budget. It results from the possibility that actual debt servicing costs will exceed expectations. Foreign-currency-denominated debts are exposed to various risks, particularly currency and interest rate movements. Frequent commodity price fluctuations add further risk to the economies that depend on commodity exports by affecting their ability to service the debt.

15. TYPES OF RISK Re-Financing Risk: the possibility that debt market cannot be accessed or funds cannot be raised at an acceptable cost. Liquidity Risk: the possibility that market conditions might shift in such a way as to not allow for quick or cost-effective liquidation of securities or positions. Market Risk: is the possibility that, once debt has been issued, adverse changes in interest rates or foreign currency exchange rates could cause either debt service costs to increase directly or cause the opportunity to reduce debt service costs to be missed.

16. Market Risk Interest Rate Risk refers to the volatility of Debt Servicing Cost, due to unexpected interest rate movements. (Interest Rate Risk is controlled by: Setting a duration target, �smoothing� the maturity profile - whereby, a constant proportion of debt is redeemed each year - as well as setting an appropriate fixed-rate share)

17. Market Risk Currency Risk is the volatility of debt servicing due to unexpected fx movements. (Indicators of exposure to foreign exchange risk include the degree of currency mismatch and the share of foreign currency within the total debt.)

18. HISTORICAL PERSPECTIVES Debt crises of the early 1980s; recent common elements include: Oil price hikes leading to a surge in the import bill of non-oil producing countries, Rising interest rates Global recession eroding export earnings, Appreciation of the US dollar, adding to the burden of repayment on dollar loans. Predominance of short-maturity debt contracted at variable interest rates. These factors placed pressure on developing countries, affecting their debt servicing abilities negatively. In the event of a currency crisis, short-maturity foreign exchange borrowings add currency risks to the liquidity problems.

19. HISTORICAL PERSPECTIVES Several Asian countries saw significant increases in their debt burdens in the early 90s because of their large, unhedged exposures to Japanese yen. A third of the increase in the dollar value of Indonesia�s external debt between 1993 and 1995, attributable to cross-currency movements, particularly the steep appreciation of the yen. Sometimes there is over-lending to governments (e.g. Mexico in the late 70s and early 80s and Argentina in the 90s) and sometimes there is over-lending to the private sector (e.g. Asian countries in the 90s, especially banks). When the government accumulates too much debt it has an incentive to default. Increasing expectations of default trigger the crisis. Similar considerations apply to the private sector: when the investors start to doubt about the possibility of recovering their loans, they ask for the repayment and trigger the crisis.

20. OTHER COUNTRY PERSPECTIVES Risks associated with a large net currency exposure and the existence of deep and liquid domestic capital markets are the main reasons why the governments of most industrial countries have limited their issuance of foreign currency debt. Among advanced economies, few, if any, issue foreign currency debt, a number of smaller, advanced economies, including Belgium, Denmark, and New Zealand, have stopped issuing foreign currency debt, except to replenish their foreign currency reserves. In Ireland, gross foreign currency borrowing is limited to the level of maturing foreign currency debt. Spain and Sweden issue foreign currency debt but hedge their currency risk through swaps or swap options.

21. OTHER COUNTRY PERSPECTIVES In developing countries, however, governments still often need to access international debt markets to offset a shortage of domestic savings, lengthen the maturity of their debt, diversify their interest rate risk exposure across various asset markets, accumulate foreign exchange reserves, or develop benchmark instruments, to enable domestic private entities to issue abroad.

22. Major Causes of International Lending & Financial Crises Over-lending and over-borrowing Exogenous negative international shocks Excessive exposure to exchange rate risks Volatile international short-term lending Global contagion

23. NEED FOR A STRATEGY Heightened awareness among governments of the importance of sovereign debt management, particularly in an environment of increasingly mobile and volatile capital flows and integrated international capital markets. Recognition that objective of debt management is to minimize the costs of borrowing within acceptable and pre-determined risk limits and to finance the government�s budget deficit at the minimum possible long-term cost.

24. NEED FOR A STRATEGY Debt managers, subject to approval of policy-makers, establish separate benchmark portfolios for domestic and foreign currency debt and permitted deviations from the benchmarks. Within these broad guidelines, the debt office manages the currency allocation, maturity structure, and market risk of the debt portfolio. E.g.: �identify a low risk portfolio of net liabilities consistent with the government to acceptable levels of risk, having regard for the expected costs of reducing risk, and to transact in an efficient manner to achieve and maintain that portfolio.� Main objective is to fund maturing government debt and annual borrowing requirements at a lower cost than that of the benchmark portfolio, while containing the volatility of annual fiscal debt-service costs as well as exchange rate, liquidity, and interest rate risks.. Deviations of the actual portfolio from the benchmark should be minimal.

25. NEED FOR A STRATEGY The sound management of sovereign liabilities is an important element in safeguarding a country�s economic stability, in a world of large and volatile capital flows and integrated international capital markets,. As a first step toward reducing their exposure to external shocks, countries should aim to improve the management of their net foreign exchange exposure. The choice of the currency denomination of external debt should not be driven by the level of nominal interest rates�instead, borrowing costs should be calculated on a risk adjusted basis.

26. NEED FOR A STRATEGY Limiting the currency risk exposure of emerging markets� sovereign debt and lengthening the maturity profile should be viewed as a medium-term strategy and a gradual process.

27. OTHER APPROACHES TO RISK MANAGEMENT Coordination of reserve and debt management It is considered that a degree of coordination between the management of reserves and debt can, at least in principle, reduce risk exposures.

28. OTHER APPROACHES TO RISK MANAGEMENT Asset liability management approach To minimize its net risk exposure, debt managers may try to match the duration and currency profile of the government�s liabilities with those of its assets, including the present (discounted) value of future tax revenue and social expenditures. Generally, as the average duration of government assets tend to be quite long, longer-dated debt should be issued.

29. Asset Liability Management Approach Since the asset side tends to be mostly insensitive to exchange rate movements, then, most debt should be in domestic currency. Can cover all national assets and liabilities

30. Derivatives When derivative markets in the domestic currency are available, governments can hedge their foreign currency borrowing, thereby limiting their exposure to foreign exchange and interest rate movements. E.g., the foreign currency can be swapped into the domestic currency, or, into a currency that is closely correlated to the domestic currency and for which liquid derivative markets exist. Issuing currency-hedged foreign debt would preclude a borrowing strategy targeted solely at reducing interest rates and softening internal budget constraints. As the international derivative markets have grown in sophistication, the possibilities of hedging the risks associated with borrowing in foreign currencies have greatly expanded.

31. WHY IMPLEMENT A RISK MANAGEMENT FRAMEWORK? The capacity of governments to generate foreign currency revenues to repay their obligations is generally limited, as government assets consist predominantly of the discounted value of future taxes denominated in local currency.

32. WHY IMPLEMENT A RISK MANAGEMENT FRAMEWORK? It is hardly ever the case that all of the actual costs�in terms of output, welfare, and reputation�that a developing country may incur in the event of an adverse external shock are fully taken into account in emerging markets� external borrowing strategies. Although the likelihood of crises is small, their potential disruption to an economy is substantial.

33. WHY IMPLEMENT A RISK MANAGEMENT FRAMEWORK? Net foreign exchange exposure exacerbates the economic impact of external shocks and limits the policy options available during a financial crisis Depreciation of the currency would worsen the country�s indebtedness and risk profile and magnify the financial crisis. In the event of a real exchange rate shock, a government may be faced simultaneously with the escalation of its external debt-servicing costs and a decline in the foreign currency value of its revenues. Its ability to access international markets to refinance its maturing debt is likely to be hindered.

34. WHY IMPLEMENT A RISK MANAGEMENT FRAMEWORK? The lower cost of foreign currency debt in contrast to domestic currency debt reflects not only the creditworthiness of sovereign borrowers but also implies that their claims have implicit seniority over domestic claims. �Cross default� clauses may make it impossible for a sovereign borrower to restructure obligations such as short-term notes� that are falling due, without causing the due dates of most other short- and long-term issues to be advanced.

35. WHY IMPLEMENT A RISK MANAGEMENT FRAMEWORK? In view of all the risks associated with foreign currency borrowings, policy makers in developing countries need to adopt appropriate risk management techniques.

36. CONCLUSION Developing economies tend to have: high levels of external debt more instability on the asset side of the balance sheet less diversified economies, vulnerable to external shocks less well-established public and private institutions shallower financial sectors & limited access to international capital, insurance and derivatives markets

37. CONCLUSION This means fewer policy options and limited resources in dealing with complex risk management issues A risk management framework provides the basis for a coherent, objective and generally quantifiable basis for performance reporting Forces the debt manager to recognize the full range of financial risks involved across all debt management operations, including: funding, market, credit, liquidity and operational risks, etc. Makes it clearer that risks are not independent and provides a basis for selecting efficiently from among different risks so as to minimize risk overall

38. THANK YOU