Rational pricing in local currency non-sovereign lending

Appropriate instruments, additionality, and no market distortion

In sovereign operations, because sovereigns can print money, appropriate MDB instruments are foreign currency (FCY) loans. Therefore, loans are usually extended in euros (EUR), Japanese yen (JPY), pound sterling (GBP), or United States dollars (USD), and they are concessional in nature.³ Due to preferred creditor treatment (PCT)⁴, which is related to concessionality and countercyclicality⁵, defaults are extremely rare and relatively inexpensive⁶.

In non-sovereign operations, appropriate DFI and MDB instruments are those that do not create unwarranted currency risk: if a project generates FCY revenue, financing the project in FCY is appropriate; alternatively, if a project generates LCY revenue, financing the project in LCY is appropriate.⁷ In either case, the financing should be additional⁸ and should not distort markets⁹. The “additionality principle” says that the private sector is not to be crowded out; thus, a development challenge or a market failure must be addressed. The “no market distortion principle” says that the normal functioning of markets is not to be disrupted; hence, concessionality, if any, must be minimized.

After-swap pricing and market segmentation

DFIs and MDBs may extend loans only in approved lending currencies. CCS can be attached to loans in order to manage currency risk, and CCS may be transacted only with approved swap counterparties.

DFIs and MDBs use CCS in their funding operations. Specifically, DFIs and MDBs that are interested in USD after-swap borrowing cost issue bonds denominated in EUR, GBP, and JPY, among other currencies, and use EUR-USD, GBP-USD, and JPY-USD CCS, respectively, to convert the exposures to USD. Because only the USD after-swap borrowing cost matters, the EUR, GPB, and JPY borrowing cost is basically irrelevant.¹⁰

A similar situation arises in some sovereign operations. Upon extending FCY loans, MDBs may use CCS to convert the exposures to LCY on behalf of their borrowers.¹¹ MDBs offer this risk management service to their shareholders upon request and charge fees¹², and MDBs can offer the service only when adequate CCS are available¹³. Because the underlying loans are concessional and because the CCS are executed by the MDBs on behalf of their borrowers, the LCY after-swap lending rates do not necessarily reflect the LCY credit profiles of the borrowers.

The situation in non-sovereign operations is only slightly different. Although they do not tend to extend FCY loans and then use CCS to convert the exposures to LCY, DFIs and MDBs price in FCY and use CCS to obtain LCY pricing.¹⁴ Because FCY and LCY markets are segmented and because the CCS are executed by the DFIs and MDBs, the resulting LCY lending rates do not necessarily reflect market, or fair, LCY pricing.¹⁵

Like FCY and LCY markets, deliverable and non-deliverable CCS markets are segmented.¹⁶ Deliverable CCS are not really necessary to manage currency risk, and non-deliverable CCS have the advantage of not requiring access to LCY. For this reason, with sovereign support, several DFIs and MDBs established The Currency Exchange Fund (TCX) in 2007.¹⁷ TCX’s primary function is to transact non-deliverable CCS, converting FCY pricing—predominantly EUR pricing and USD pricing—into LCY pricing whenever LCY loans are the appropriate instruments.

Converting FCY pricing into LCY pricing may be questionable for yet another reason. Given that they reduce risk, appropriate instruments ought to reduce return. Therefore, when an LCY loan is the appropriate instrument, the FCY pricing of the loan when extended in FCY should be worse than the FCY pricing of the loan when extended in LCY through a CCS that converts FCY pricing into LCY pricing.

Lastly, if offering appropriate instruments is a developmental objective, it is unclear why a borrower would be given the option between an FCY loan and an LCY loan. Since LCY rates are higher than FCY rates, if given the option, a borrower may prefer an FCY loan to an LCY loan even when an LCY loan is the appropriate instrument.

Rational LCY pricing

Shareholders of DFIs and MDBs can decide whether offering appropriate non-sovereign instruments is a development objective. Also, shareholders can explore, potentially subject to the development objective of offering appropriate instruments, whether additionality in FCY loans can be different from additionality in LCY loans. However, shareholders have already accepted the “no market distortion principle,” so LCY pricing must be rational.

LCY pricing is rational if it reflects LCY risk associated with similar credit quality and identical financing terms and conditions. This means that LCY loans should be priced in LCY; then, whenever desired, LCY pricing can be converted into FCY pricing, such as EUR pricing and USD pricing, through CCS. In particular, the LCY lending rates offered by DFIs and MDBs should not depend on how LCY is sourced.¹⁸ When pricing is rational, the LCY lending rate for a non-sovereign operation does not depend on whether LCY is sourced through CCS or through LCY bonds. This is a key concept in Finance: the cost of capital associated with an investment depends on the riskiness of the investment. It is the use—not the source—of the funds that matters.¹⁹

In effect, DFIs and MDBs should treat all lending currencies equally, maintaining, or modeling, zero curves for various credit qualities in each lending currency. Correspondingly, TCX’s function should be to convert LCY pricing into FCY pricing.

Importantly, if they believe that TCX’s model—which is to be short USD and long LCY while relying primarily on LCY diversification—is financially sound, TCX’s shareholders should be willing to implement the model within their institutions.²⁰ Since diversification is key, TCX’s shareholders could explore non-sovereign exposure exchanges similar to those executed by MDBs in the sovereign space.²¹