The financial crisis of the 1980s and 1990s in Latin America has resulted in an increasing sophistication on the part of governments in the management of their monetary assets in the 21st century.
This in turn has led to a growing interest by government financial leaders in diversifying their debt structure to reduce the risk of foreign exchange mismatches and an increasing preference for assuming a greater part of debt in national currencies as opposed to foreign currencies, usually U.S. dollars. A widely held view is that a more balanced and diversified debt structure may avoid some of the difficulties in acquiring foreign currency resources during periods of financial stress that affected many of the countries of the region during the 1980s and 1990s.
Responding to the demand from its clients and recognizing their strategic objectives, IDB has adopted a new policy framework that will enable the Bank to significantly expand lending in local currencies to its borrowing member countries in the region under attractive terms. Because of national laws restricting the use of foreign currency in certain types of transactions, the new IDB policy also creates greater financing opportunities for subnational borrowers, such as provinces and municipalities, and the private sector.
The new policy, adopted by the Bank’s Board of Executive Directors on April 1, 2008, authorizes the IDB to denominate loans in local currency from the inception of an operation. A previous limit on the number of local currency operations has been lifted, and surcharges on local currency financing have been removed.
Under the old policy, which had been in effect since 2005, the Bank in a pilot program offered up to five local currency transactions a year that were restricted to the conversion of foreign currency loans at the time of disbursement, direct currency swaps against existing Bank debt, and the conversion of U.S. dollar obligations into called guarantees. A risk premium was placed on the transactions.
One of the steps in developing the new policy was incorporating the lessons learned from existing and potential local-currency clients in understanding their needs and viewing their critique of the pilot program. Their answer was simple: they wanted more local currency financing on more favorable terms.
Instead of applying generic, administratively determined fees on local currency transactions, the Bank now charges interest rates that reflect the cost of funding in each local currency market plus the same spread and fees applicable to sovereign or non-sovereign foreign-currency denominated loans, whichever the case.
“We are applying a client-driven approach that applies cutting-edge financial instruments and places the Bank in the forefront of international institutions,” says Edward Bartholomew, IDB chief financial officer and manager of the Finance Department. “This service was made possible by the Bank’s recent institutional realignment, which mobilizes human resources with special skills to meet customer needs more efficiently in areas that require specialized expertise.”
Market limitations remain. The Bank will eliminate currency risk in the transaction through currency swaps that will serve as a hedging mechanism. For such a transaction to take place, a swap market in the local currency needs to be available. Now adequate swap markets exist only in countries with more stable and open economies.
For countries with less developed capital markets, access to local currency financing from the IDB may be obtained to a limited extent by using the hedging services of The Currency Exchange (TCX), a recently created public-private partnership that can serve as a swap counterplay.
The local currency financing will be monitored by the Bank’s Asset Liability Management Committee (ALCO) and the Office of Risk Management, which was organized during the 2007 institutional realignment.
The Bank’s local currency financing activity is expected to evolve as Latin America’s capital markets also evolve.
A country that has only limited access to local currency financing today may be in a position to take on more local currency debt in the future if it develops a swap market of sufficient depth. In addition, as an alternative to U.S. dollars in a country whose own local currency market is limited, the borrower could choose to take out a credit in another local currency, say Mexican pesos, if the borrower has natural hedges due to trade flows with Mexico. This is an additional benefit of the Bank’s local currency financing instrument.
“What the new policy does is give us a platform to move in any currency in any country as markets evolve,” says Bartholomew. “This is a dynamic process. As the markets expand, our local currency financing will expand.”
For more information on IDB local currency lending, contact the Finance Department at (202) 623-2863.