1. Ajay Sagar Asian Development Bank March 2005 Local Currency Financing Initiative

2. 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

3. 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.)

4. Accounting treatment of devaluation losses 7 Old Standard BALANCE SHEET Assets Liabilities P3,000 devaluation losses were capitalized having no impact on P&L account New Standard P&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 2004 Liabilities 5,600

5. 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.)

6. 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 A AAA Bank B AA Bank C A Bank D BB Unrated FI Emerging Market Project Borrower $ 300 mln – 15 years

7. 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.)

8. 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.)

9. 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.)

10. 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.)

11. 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.)

12. Schematic Diagram Local Currency swap and Financing C. Final Principal Exchange Local Borrowers Participating Institutions ADB DMC Dollars Local Currency ADB=Asian Development Bank, DMC=Developing Member Country. A. Initial Principal Exchange Local Borrowers Participating Institutions ADB DMC Dollars Local Currency Local Currenc y Loan B. Swap/Interest Payments Local Borrowers Participating Institutions ADB DMC Dollars Local Currency

13. 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 CurrentAfter Swap Foreign Currency Y Local Currency X At Maturity

14. 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

15. Swap vs Borrowing Accounting Treatment Creates a contractual obligation to meet swap counter party commitment Creates a debt obligation Form of Documentation ISDALoan Agreement Front end costsGenerally not associatedGenerally 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 ItemCross Currency SwapOffshore Sovereign Borrowing

16. Swap vs Borrowing Macroeconomic Stability Promotes macroeconomic stability May not promote macroeconomic stability Counter party riskCreates 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 sizeDoes not increase.Increases with the amount of borrowing. Number of legsComprises of two independent legs namely a hard currency leg and a local currency leg Comprises of one leg denominated in hard currency. ItemCross Currency SwapOffshore Sovereign Borrowing

17. 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).

18. 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).

19. Infrastructure Manufacturing SME Financial Services } Developmen t Bank Government Multilateral Financial Institution Local Currency US$ Owned, managed, or influenced by Government Traditional Two-step Loan Structure Traditional Two-step Loan Structure Swap and Loan Facility Swap and Loan Facility Infrastructure Manufacturing SME Financial Services } Commercial Banks Government 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

20. To the Banking Sector To the Borrowers / Projects Asset Borrowing Result AmountPs 10 million   Matched funding CurrencyPs   No currency risk Term5 years   No maturity mismatch/ refinancing risk Interest rateFixed   No interest rate/ swap counterparty risk Asset Borrowing Result CurrencyPs   No currency risk Tenor15 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

21. Select Aspects of ALM 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. 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.

22. Select Aspects of ALM 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. 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.

23. 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.)

24. 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).

25. Macroeconomic Implications - Spillover benefits 7 SWAP AND FINANCING PROJECT Market based mechanism Strengtheni ng of banking sector No Sovereign borrowing or guarantee No Crowding out of Private Sector Private Sector led Financial Intermediation Capital market development Currency Risk Management Benefit to Consumer Certainty in Projects Foreign Investment led economic growth Positive impact on FX reserves Maturity transformatio n 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

26. 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.