Local Currency Financing Initiative Ajay Sagar Asian Development Bank March 2005
Outline • Background • Concept • Development Impact • Issues and Challenges • Swap vs Bond Issue – Determining Factors • Local Currency Swaps - Schematic Diagram • Peso Swap and Financing Project • Benefits • Role of ADB
Background • Heightened risk perception of unhedged foreign currency borrowing as a result of Asian financial crisis. • Weak macro economic climate affecting FDI and infrastructure projects. • Weak banking sector • Under developed capital markets • Emerging market currencies considered volatile and susceptible to devaluation. • Modified accounting standards providing for transparent treatment of currency fluctuations (Developing countries need billions of dollars and their local currency equivalent to build a strong infrastructure to spark an investment boom. They also need to strengthen their financial sector.)
Accounting treatment of devaluation losses Old Standard New Standard BALANCE SHEET P&L Account Assets Liabilities 1997 Assets 2,600 1997 Liabilities 2,600 Charge Pesos 3000 to P&L Account in the year devaluation loss is incurred. Impact on earnings Transparent treatment 2004 Assets 5,600 2004 Liabilities 5,600 P3,000 devaluation losses were capitalized having no impact on P&L account Philippine example: 1997 USD1 = P 26, 2004 USD 1 = P56 Loan of USD 100 for asset purchase 7
Background (cont’d) • Significant impact of local currency devaluation on balance sheet of borrowers. Project viability threatened. • Banks carry both maturity and currency mismatch risks • Lending banks traded currency risk for a credit risk. • Devaluation pass through in tariffs faced stiff resistance from consumers of “user to pay” projects. • Borrowers in emerging markets have a strong preference for local currency denominated borrowing. (While developing countries need to attract capital, investors prefer local currency alternatives due to volatile patterns.)
Bank A AAA Bank B AA Bank C A Bank D BB Unrated FI Background — Impact of Maturity Lender Consortium • Spread represents compensation to cover credit (commercial and political) risks. • Consortium participants assumed continued access to $ funding for life of loan at LIBOR disregarding their own long-term credit ratings. • Injection of long term funding will strengthen banking sector and spur investment. Interest=6 month LIBOR + spread say 300 bps Emerging Market Project Borrower $ 300 mln – 15 years Amortized Principal Repayments
Concept • Provide local currency denominated lending through structured and straightforward alternatives ** developing and accessing local capital markets. ** local currency swaps. ** local currency guarantees. • Applicable in countries where local currency is freely convertible at least on trade account. • Dictated by market based pricing mechanisms. • Direct linkage to solvency of banking system (ADB’s local currency initiative is under its private sector window. ADB will use only private sector banks as financial intermediaries without requiring sovereign guarantees.)
Development Impact • Economic growth and gain to consumers through greater availability of goods and services. • Development of local capital markets providing depth and extended maturities. • Provides natural hedge to borrowers where currency of borrowing = currency of revenue. • Spurs foreign direct investment. Currency risk hedged by capital intensive infrastructure projects (The expectation is that this new funding approach will attract fresh capital to emerging countries as risks associated with short term lending in the nature of refinancing, interest rate, volatility, maturity mismatch are removed.)
Development Impact (cont’d) • Retention of FDI through participation of foreign banks. • Strengthened banking sector. • Improved financial intermediation and reduced probability of default. • Market based intervention gives a strong demonstrational effect • Wider recognition of local benchmarks • Impact on money supply (By seeking ways to fund in local currency, external lenders would contribute to the creation of an efficient and strengthened financial system.)
Issues and Challenges • Lack of market depth for local currency. • Underdeveloped legal, political, and institutional infrastructure for local capital markets. • Underdeveloped local currency swap markets. • Lack of acceptable swap counterparties. • Short tenors in local markets. • Risk protection and capital allocation. • Willingness of host sovereign as it may affect their own borrowing programs. (Capital markets in developing countries are in their infancy. They do not only comprise of bond markets but also include equity and derivative markets.)
Swap vs. Bond Issue Determining Factors • Adequacy of foreign currency reserves. • Maturity profile of foreign currency borrowing. • Balance of payment position. • Internal savings rate. • Balance of trade. • Fixed or floating exchange rate. • Depreciating nature of local currency. • Conflict with sovereign borrowing. (Individual developing country markets, macro economic situation and regulatory environment will dictate the modality of intervention.)
A. Initial Principal Exchange Dollars Participating Institutions Local Borrowers ADB DMC Local Currency Loan Local Currency B. Swap/Interest Payments Dollars Participating Institutions Local Borrowers DMC ADB Local Currency Local Currency C. Final Principal Exchange Dollars Participating Institutions Local Borrowers DMC ADB Local Currency Local Currency Schematic Diagram Local Currency swap and Financing ADB=Asian Development Bank, DMC=Developing Member Country.
Impact of Swap – Change in Currency Composition of Reserves Current After Swap At Maturity Local Currency X – local currency leg of swap Local Currency X Local Currency X Foreign Currency Y + dollar leg of swap Foreign Currency Y Foreign Currency Y A Cross Currency Swap is not a borrowing by a developing member country and is undertaken at market based pricing principles 7
Current Local Currency X Foreign Currency Y Funds to be generated for meeting repayment obligations at prevailing exchange rate Impact of Borrowing After Borrowing At Maturity Local Currency X Local Currency X Foreign Currency Y Foreign Currency Y + Additional funding requirement to cover devaluation impact. To be quantified at maturity Amount borrowed (Govt. Borrowing) – Proceeds utilized for payments & projects Exchange rate risk as foreign currency is purchased at rate at the time of maturity 7
Accounting Treatment Item Creates a contractual obligation to meet swap counter party commitment Cross Currency Swap Creates a debt obligation Offshore Sovereign Borrowing Form of Documentation ISDA Loan Agreement Front end costs Generally not associated Generally associated in the form of arrangement fee, underwriting fee and commitment fee. Availability of additional cash No. A swap simply changes the currency composition of the cash held by a DMC government. Yes Swap vs Borrowing
Macroeconomic Stability Item Promotes macroeconomic stability Cross Currency Swap May not promote macroeconomic stability Offshore Sovereign Borrowing Counter party risk Creates a counter party risk. In case of swaps with ADB, a DMC will be taking the counter party risk of a AAA rated multilateral institution. Not created. In stead a borrower and a lender relationship is created. Balance sheet size Does not increase. Increases with the amount of borrowing. Number of legs Comprises of two independent legs namely a hard currency leg and a local currency leg Comprises of one leg denominated in hard currency. Swap vs Borrowing
Peso Swap and Financing-Target Sectors • Infrastructure, transport, manufacturing, SMEs, housing, environmental improvement expenditure, lease and non bank finance companies, non performing loan resolution, retailing, securitization, and bond market development. • ADB can approve other sectors at its discretion. • Ineligible sectors include narcotics, tobacco, spirits, defence, environmental hazardous and radioactive materials. (ADB carefully selects the target sectors that have a direct linkage to economic growth and job creation).
Peso Swap and Financing-Salient Features • ADB’s credit exposure comprises of a swap and lending to banks without sovereign guarantee • ADB will undertake a swap on back to back basis with lending transaction. • No crowding out - competition with banks • Tenors 5-15 years, Amortizing • Participating banks selected on an acceptable international credit rating criteria • A private sector alternative to a two step loan to a government owned DFI backed by sovereign guarantee. (ADB intervention will facilitate private sector financing in targeted sectors without sovereign guarantee to stimulate private sector confidence in developing, structuring, and engineering the financing of investment projects).
} • Infrastructure • Manufacturing • SME • Financial Services Local Currency Multilateral Financial Institution Development Bank Government • Owned, managed, or influenced by Government Local Currency Local Currency US$ Local Currency Currency Swap Benefits Traditional Two-step Loan Structure Swap and Loan Facility } • Infrastructure • Manufacturing • SME • Financial Services Multilateral Financial Institution Commercial Banks Government • Rating criteria • Int’l rating agency • S&P BBB for int’l banks • S&P BB- for local banks Government’s role is that of a Facilitator by undertaking a swap. ADB lends without sovereign guarantee.
Asset Asset Borrowing Borrowing Result Result Currency Amount Ps 10 million Ps Ps 10 million Ps No currency risk Matched funding Currency Tenor 15 years Ps Ps 15 years No maturity / refinancing risk; repayment ability matches with project’s payback period No currency risk Term 5 years 5 years No maturity mismatch/ refinancing risk Interest rate Fixed under tariff/ arrangements Fixed No interest rate risk Interest rate Fixed Fixed No interest rate/ swap counterparty risk Benefits To the Banking Sector To the Borrowers / Projects Ps = Peso.
Select Aspects of ALM Category • Cost of Carry • Liquidity investments • Interest Rate Risk • Tenor mismatch risk BOND • Staggered loan disbursements and amortized nature of lending could create challenges especially in countries with underdeveloped capital markets.. • Significant challenges such as conflict of interest (investment in government bonds), moral hazard and competition with public sector mandate of ADB • Yes. Challenges associated for converting fixed rate liabilities to floating rate liabilities due to underdeveloped local interest rate swap markets. • Possible due to amortized nature of lending and bullet borrowing. SWAP • Not expected as swap and lending are on a back-to-back basis. • Not required as swap is on a back to back basis • None. Common benchmarks are used in lending and swap. • Not applicable as swap and lending are on a back-to-back basis.
Select Aspects of ALM Categories • Prepayment flexibility without penalties • Duration risk • Disbursements • Basis risk BOND • Under developed local capital markets pose challenges. • Possible. Lending tenors significantly limited based on tenor for bonds. Could also expose to interest rate risk. • Generally convenient for one-off disbursements. • Possible as borrowing and lending benchmarks may be different due to local market practice and under developed local capital markets. SWAP • Under developed local capital markets could pose challenges. Penalties include swap breakage cost subject to market conditions. • None. Tenor on both lending and swap is on matched basis. • Provides flexibility for staggered disbursements in suitable tranche sizes. • Common benchmarks applied for swap and lending.
Role of ADB • ADB’s local currency lending initiative would ** strengthen long term domestic debt/capital markets. ** provide depth for extended tenors to investors. ** strengthen banking sector ** improve financial intermediation ** develop local currency swap markets. ** facilitate access to financing of institutions. • Assist DMCs in development of a regulatory framework. • ADB involvement would send an important message to private sector. (ADB is taking a leadership role for development of local markets in its developing member countries.)
Role of ADB (cont’d) • ADB’s participation is intended to catalyze financing from local and foreign sources, and not to compete with them. • Capacity creation. • Promote private sector development. • Support strategic objective of its developing member countries in attracting private capital. • Promote partnerships, transparency, corporate governance, and corporate social responsibility. (ADB’s dual capability of having public and private sector operations under one roof offers important synergies. This combination enables ADB to deliver a comprehensive development solution).
SWAP AND FINANCING PROJECT Macroeconomic Implications - Spillover benefits Maturity transformation in domestic currency Capacity creation through foreign lenders Spurs foreign direct investment Market based mechanism Improved financial intermediation No conflict with sovereign borrowing Private Sector led Financial Intermediation Strengthening of banking sector Positive impact on FX reserves Capital market development No capital injection required from host sovereign No Sovereign borrowing or guarantee Certainty in Projects Foreign Investment led economic growth Currency Risk Management No Crowding out of Private Sector Benefit to Consumer 7
ADB looks for alternatives that are best suited for individual circumstances but the idea is to inject long term local currency financing. It is ADB’s hope to be able to provide long-term, local currency funding in all of the countries in which the Bank works. Moving forward ADB will seek ways to collaborate on this important initiative by working together with other bilateral and multilateral agencies in order to create capacity.