Multilateral development banks with big annual funding programmes to fill must constantly search for innovative ways to unlock new sources of cash. Local currency bond markets are an important niche for these borrowers — but they remain just that, a niche. However, some treasurers are hoping to change that.
Funding outside the core markets of dollars, euros and sterling has traditionally meant compromising on size. And with volatile global markets, it often feels to treasurers and funding heads as though there are only scant windows available in which they can issue to meet their ambitious annual funding targets.
Local currency bond markets will never be able to compete for scale with the almost infinite appetites of core markets. And, even if a supranational could raise a full benchmark-sized bond in a local currency, it might not be the most prudent move. Supranationals must be careful not to flood the local market, soaking up too much cash that could otherwise be invested in local issuers. A triple-A credit printing the equivalent of $500m in a local currency could easily swamp the market and leave little appetite for the nation’s sovereign bonds.
With limited size and liquidity available, some investors are put off from participating. But Jingdong Hua, treasurer of the World Bank, thinks he has a solution. He wants to offer big investors exposure to the performance offered in small size by local currency markets.
When Hua worked as the treasurer of the International Financing Corporation (IFC), he was part of the team that developed the Managed Co-lending Portfolio Programme (MCPP) — a syndicated loan platform that offered global investors exposure to a variety of emerging market loans products.
The product raised $8bn from eight investors, including $3bn from the People’s Bank of China. The scale of investments involved would normally rule out exposure to the size of instruments available from emerging markets borrowers. “Trillion dollar investors simply don’t want to play in really small sizes,” says Hua. “The MCPP is a way of solving that problem. Investors don’t need to look at individual project risk, but at the portfolio level.”
Hua believes the same thing can work in the bond market. He envisages issuing a whole series of local currency bonds, in perhaps 50 different currencies, then constructing a basket product providing exposure to the performance of the whole series of bonds as a single product.
The World Bank’s triple-A rating gives investors the confidence that they will get their capital back and, while investing in a single niche currency leaves investors’ exposed to the vicissitudes of a small and vulnerable economy, with a basket of 50 assets, that risk is diffused through the portfolio.
And, while the dollar has gone from strength to strength against many emerging market currencies this year, even a depreciation across the whole portfolio will not necessarily spell disaster for investors.
As with many of World Bank’s local currency bonds, the basket could carry a far more generous yield than investors would receive on World Bank core currency bonds. While this yield is meant to compensate investors for lending in a currency that could depreciate, Hua feels it is a risk worth taking. “You might buy a five year World Bank local currency bond with an 800bp pick-up over our dollar curve. Even if the currency depreciates by 40% over the life of the bond, you’d still get the same return as if you’d bought a dollar bond, as there is no credit risk with World Bank’s triple-A ratings,” Hua points out.
The concept, if successful, would unlock funding from the bulge bracket investment funds, offering them exposure to World Bank local currency bonds. Many such funds are constrained by their mandate from venturing outside core currencies, or would simply be put off by the size and illiquidity of such products on an individual basis.
With rates creeping down ever lower in developed markets, investors may soon be forced to look at opportunities outside core markets.
Global retail bonds?
At the other end of the spectrum are retail investors. Individual savings are a resource almost completely untapped by multilateral development bank bonds.
Hua envisions global retail bonds: bonds available to retail investors all over the world in any one of a hundred or so currencies. The world, as Hua points out, is full of diasporas. Many people in the developed world whose families hail from developing nations would jump at the chance to finance development projects in their ‘home’ currency.
Millennials as a generation care deeply about development finance — their savings are growing and, as yet, almost untapped. The equivalent of a thousand dollars from a few million millennials around the globe could form a huge part of the World Bank’s funding needs, should the idea become a reality.
This idea is something of a dream project for Hua. By his own admission, bringing it to reality would require fundamental changes to market infrastructure, not to mention the regulatory approvals required.
But the rewards for the World Bank of creating such a tool would be superb. While core markets are at present unmatched for the ease with which they provide high volumes of funding, the clients of multilateral development banks want to receive funds in currencies they can use.
That leaves supranationals with two options. Firstly, they can borrow money in core markets and then use the FX or cross-currency basis swap markets to obtain a cashflow in the target currency, which they can lend to their clients. Or secondly, they can raise the money directly in the local currency, in which case the cost of funds does not matter, because the funds are on-lent at a spread.
Neither method is entirely simple. Relying on the swap market to find local currency funds can be tricky. “It can be difficult to find quotes in the swap market when you need them,” says Nathalie De Weert, head of funding — public markets, at the European Investment Bank (EIB). “Getting the swap of the right tenor when you need it could be a challenge when the swap market isn’t deep enough. In that case, having access to the local market for issuance is an advantage. That’s the reason why we have developed benchmark issuance in Polish zloty, a currency in which EIB has a lending activity.”
Isabelle Laurent, head of funding at the EBRD, agrees: “We don’t take currency risk in our loans, so we have to borrow in the currency or hedge. The latter is not always possible.”
Under such circumstances, supranationals traditionally turn to the local market.
However, Hua’s global retail bond idea could provide a huge source of funding denominated in the currencies in which it would be lent.
The approach is an extension of the classic supranational approach to local currency markets: enticing international investors to buy high quality multilateral development bank paper in a local currency. “Many low income countries, particularly in sub-Saharan Africa, have limited domestic savings,” says Hua. “Banks take the savings and buy government treasury paper when its coupon rate is double digits, so there’s little lending to the private sector. We don’t want to come in and make that worse. We like to issue on the local market eventually, but the first step is to bring in international investors.”
International investors enticed into local currency supranational paper often go on to participate in the local markets themselves.
Another potential problem when sourcing local bonds is the mismatch in appetite for maturity. Loans from development banks tend to be long term. Development projects require long term investment and those buying local currency bonds, whether domestic or international investors, typically prefer to invest on a short term basis.
Building up a curve requires sustained engagement over a long period. The IFC’s Masala bond programme is a typical example. “We had to start somewhere,” says Jingdong Hua, referring to his time as IFC treasurer. “It took several years to create, but now that market has bonds from three years all the way out to 15 years.”
The EIB’s relationship with the Polish zloty market is another example where a supranational has raised funds for local lending but, by doing so, has kickstarted a local capital market, which now contributes to Polish economic development.
Much of the funding conducted by supranationals outside of their core markets is not lent on in the currency, but is swapped back to their home currency. At certain times, issuers will be able to swap local currency funding back into dollars or euros inside their curves but at other times, the balance will have shifted and that door will be closed.
“When we look at the higher middle income countries — Brazil, Mexico, India, Chile et cetera — these have pretty robust capital markets,” says Hua. “It’s useful for us to issue there because it offers a different source of funds, and it’s helpful for the market to have a range of top quality credits.”
Local currency funding is valuable beyond its use as a means for issuers to get hold of cheap dollars. Hua calls that kind of funding “a nice to have”, but says that it doesn’t “fundamentally change anything in the market”.
Hua would like supranationals to take a more ambitious approach to their local currency funding. Of course, swapping proceeds back to core currency inside a funding curve will always be an attractive option.
But borrowing money in the currency in which it will be lent offers the chance not just to save on funding costs but to make borrowing as well as lending part of the development effort.
“For investors above a certain size — the global asset owners with trillions under management — generating alpha ahead of the market is essentially impossible,” says Hua. “Their opportunity to really generate large scale returns can only come from the world systematically developing. When I left China in 1990, there was no real bond market. Today, it’s over $13tr. Africa as a continent is similar in size to China. Could that be another $13tr of investible assets? It behoves international investors to be looking for these opportunities and for ways to bring them about.”