Ajay SagarAjay SagarAsian Development BankAsian Development Bank

March 2005March 2005

Local Currency Local Currency Financing InitiativeFinancing Initiative

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 (Developing countries need billions of dollars and their local currency equivalent to build a strong infrastructure to spark an investment boom. equivalent to build a strong infrastructure to spark an investment boom. They also need to strengthen their financial sector.)They also need to strengthen their financial sector.)

Accounting treatment of devaluation losses

7

Old StandardBALANCE SHEET

Assets Liabilities

P3,000 devaluation losses were capitalized having no impact on P&L

account

New StandardP&L Account

Charge Pesos 3000 to P&L Account in the year

devaluation loss is incurred.

Impact on earnings

Transparent treatment

Philippine example: 1997 USD1 = P 26, 2004 USD 1 = P56

Loan of USD 100 for asset purchase

1997 Assets

2,600

1997 Liabilities

2,600

2004 Assets

5,600

2004Liabilities

5,600

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 While developing countries need to attract capital, investors prefer local currency alternatives due to volatile patterns.)currency alternatives due to volatile patterns.)

Background — Impact of Maturity

• 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.

Lender Consortium

Amortized Principal Repayments

Interest=6 month LIBOR + spread say 300 bps

Bank AAAA

Bank BAA

Bank CA

Bank DBB

Unrated FI

Emerging Market Project

Borrower

$ 300 mln – 15 years

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 (ADB’s local currency initiative is under its private sector window. ADB will use only private sector banks as financial intermediaries without requiring sovereign only private sector banks as financial intermediaries without requiring sovereign guarantees.)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 (The expectation is that this new funding approach will attract fresh capital to emerging countries as risks associated with short term lending in the to emerging countries as risks associated with short term lending in the nature of refinancing, interest rate, volatility, maturity mismatch are nature of refinancing, interest rate, volatility, maturity mismatch are removed.)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 (By seeking ways to fund in local currency, external lenders would contribute to the creation of an efficient and strengthened financial system.)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 (Capital markets in developing countries are in their infancy. They do not only comprise of bond markets but also include equity and derivative only comprise of bond markets but also include equity and derivative markets.)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 (Individual developing country markets, macro economic situation and regulatory environment will dictate the modality of intervention.)and regulatory environment will dictate the modality of intervention.)

Schematic Diagram Local Currency swap and Financing

C. Final Principal Exchange

Local Borrowers

Participating Institutions ADB DMC

Dollars

Local Currency

Local Currency

ADB=Asian Development Bank, DMC=Developing Member Country.

A. Initial Principal Exchange

Local Borrowers

Participating Institutions ADB DMC

Dollars

Local Currency

Local Currency Loan

B. Swap/Interest Payments

Local Borrowers

Participating Institutions ADB DMC

Dollars

Local Currency

Local Currency

Impact of Swap – Change in Currency Composition of Reserves

7

A Cross Currency Swap is not a borrowing by a developing member country and is undertaken at market based pricing

principles

Foreign Currency

Y

Local Currency X

Foreign Currency Y + dollar leg of

swap

Local Currency X – local currency leg

of swap

Current After Swap

Foreign Currency

Y

Local Currency X

At Maturity

Impact of Borrowing

7

Foreign Currency

Y

Local Currency

X

Current

Foreign Currency Y +

After Borrowing

Local Currency X

Local Currency X

Exchange rate risk as foreign currency is purchased at rate at

the time of maturity

At Maturity

Foreign Currency Y

Additional funding requirement to cover

devaluation impact. To be quantified at maturity

Proceeds utilized for payments &

projects

Amount borrowed (Govt. Borrowing)

–

Funds to be generated for meeting repayment

obligations at prevailing exchange rate

Swap vs Borrowing

Accounting Treatment

Creates a contractual obligation to meet swap

counter party commitment

Creates a debt obligation

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

Item Cross Currency Swap Offshore Sovereign Borrowing

Swap vs Borrowing

Macroeconomic Stability

Promotes macroeconomic stability

May not promote macroeconomic stability

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.

Item Cross Currency Swap Offshore Sovereign 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 (ADB carefully selects the target sectors that have a direct linkage to economic growth and job creation).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 (ADB intervention will facilitate private sector financing in targeted sectors without sovereign guarantee to stimulate private sector confidence in without sovereign guarantee to stimulate private sector confidence in developing, structuring, and engineering the financing of investment projects).developing, structuring, and engineering the financing of investment projects).

• Infrastructure• Manufacturing

•SME• Financial

Services

}

Development Bank Government

Multilateral Financial Institution

Local Currency

Local Currency

US$• Owned, managed, or influenced by Government

Traditional Two-step Loan StructureTraditional Two-step Loan Structure

Swap and Loan FacilitySwap and Loan Facility

• Infrastructure• Manufacturing

•SME• Financial Services

}

Commercial Banks Governmen

t

Multilateral Financial Institution

Local Currency

Currency Swap

• Rating criteria• Int’l rating agency• S&P BBB for int’l banks• S&P BB- for local banks

Local Currency

Government’s role is that of a Facilitator by undertaking a swap. ADB lends without sovereign guarantee.

Benefits

To the Banking SectorTo the Banking Sector

To the Borrowers / ProjectsTo the Borrowers / Projects

  Asset   Borrowing   Result

Amount Ps 10 million Ps 10 million Matched funding

Currency Ps Ps No currency risk

Term 5 years 5 years No maturity mismatch/ refinancing risk

Interest rate Fixed Fixed No interest rate/ swap counterparty risk

  Asset   Borrowing   Result

Currency Ps Ps No currency risk

Tenor 15 years 15 years No maturity / refinancing risk; repayment ability matches with project’s payback period

Interest rate

Fixed under tariff/ arrangements

Fixed No interest rate risk

Ps = Peso.

Benefits

Select Aspects of ALMSWAP

• 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.

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.

Select Aspects of ALMSWAP

• 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.

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.

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 (ADB is taking a leadership role for development of local markets in its developing member countries.)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 (ADB’s dual capability of having public and private sector operations under one roof offers important synergies. This combination enables under one roof offers important synergies. This combination enables ADB to deliver a comprehensive development solution).ADB to deliver a comprehensive development solution).

Macroeconomic Implications - Spillover benefits

7

SWAP AND FINANCING

PROJECT

Market based

mechanism

Strengthening of

banking sector

NoSovereign

borrowing or guarantee

No Crowding out of Private

Sector

Private Sector led Financial Intermediatio

n

Capital market

development

Currency Risk Management Benefit to

Consumer

Certainty in Projects Foreign

Investment led economic

growth

Positive impact on FX

reserves

Maturity transformation in domestic

currency

Capacity creation through foreign lenders

Spurs foreign direct

investment

Improved financial

intermediation

No conflict with

sovereign borrowing

No capital injection

required from host sovereign

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.