Developing the Derivatives Market can Mitigate Foreign Currency Risks of Eurobonds

By Malindi Msoni and Shebo Nalishebo

The Zambian government has to-date issued three Eurobonds: one worth US$750 million in 2012, another for US$1 billion in 2014 and for US$1.25 billion this year (2015). While Eurobond issuances present several potential benefits for the country, notably increased financing for infrastructure development, they also expose the country to significant risks. Because they are denominated in US Dollars, Eurobonds are susceptible to losses resulting from adverse fluctuations in the exchange rate, commonly known as currency risks.

The Kwacha has continued to depreciate against the US Dollar, falling by more than two-thirds since January. This has among other things, increased the debt servicing costs of the Eurobonds in Kwacha terms. Managing the risks arising from the Kwacha depreciation is crucial especially that experts expect the currency to remain under pressure, against the background of growing domestic demand for the US Dollar, a strengthening US Dollar trend, falling copper prices and a slow-down in the Chinese economy. One way in which the Zambian Government can manage currency risks is through derivatives.

Derivatives markets offer important opportunities for Governments to reduce the losses resulting from negative movements in exchange rates. As its name suggests, a derivative is a financial instrument that derives its value from the value of an underlying asset, such as equities, foreign currencies and commodities. The value of a derivative instrument is then determined from the corresponding equity prices, exchange rates or commodity prices. Derivatives allow investors to protect their investments against currency risks – this is what is known as ‘hedging’.

There are several derivative instruments that public debt managers can use to reduce the currency risk exposure of Government portfolios. However, long-term foreign currency debt such as Eurobonds should be hedged using what are called “options” or “swaps”. Currency options give the holder the right, but not the obligation, to buy or sell a particular amount of currency at a predetermined exchange rate at a specified future date. Currency swaps are financial operations during which two parties agree to exchange a certain amount of currencies for a stated period of time. Emerging countries such as Brazil, India, Mexico and Argentina use derivative instruments to hedge currency risks.

With the recently issued Eurobond, Government will now have to pay annual interest in excess of US$240 million. Annual interest payments on the first two Eurobonds are made in two instalments; US$21.1 million on 20 March and 20 September, and US$42.5 million on 14 April and 14 October. Government will also make two interest payments on the third Eurobond annually.
To illustrate the impact of currency risks, the 20 September annual interest payment on the US$750 million Eurobond cost the government K111.4 million in 2013 and K130.6 million in 2014 when the Kwacha was trading at K5.28/US$ and K6.19/US$, respectively. However, a similar payment cost the Government K211 million on 20 September 2015, when the Kwacha was trading at K10.00/US$. This amounts to currency losses of about K100 million between 2013 and 2015, on the US$750 million Eurobond alone.

Exposure to currency risks in Zambia is worsened by the country’s heavy reliance on copper exports for foreign exchange, notwithstanding other sources of external vulnerabilities such as US monetary policies. Copper accounts for two-thirds of Zambia’s total exports. In the absence of policy intervention by the authorities, it is likely that the Kwacha largely responds to international prices of copper which, although higher than historical levels, have been falling in the last few years. Copper prices have fallen by more than 20% since January, reaching a record low of US$4960.00 per tonne on 28 September 2015. This saw the Kwacha falling to a record low of US$11.61.

While borrowing on the sovereign bond market is agreeably cheaper than borrowing domestically, ultimately, it is likely that the cost of Eurobond repayment will depend largely on the evolution of the exchange rate over the life of the three bonds. Unmanaged, the weakening currency could greatly increase future external debt servicing costs. Also, currency risks may add pressure for the Government to increase taxes or to borrow domestically to service the Eurobonds. With a much weaker Kwacha, interest payments on Eurobonds become relatively more expensive than repaying domestic debt. Domestic borrowing risks putting upward pressure on interest rates and crowding out the private sector. Eventually, Eurobond borrowing could stifle the very growth it was meant to foster.

Moreover, currency risks are historically a dominant cause of debt crises. In the early 1980s, the debt-servicing burdens of some Latin American, Southeast Asian and African countries were severely hurt by the dollar appreciation, rising international interest rates and falling commodity prices. For example, the deterioration of the Peso against the US dollar meant that Argentina owed huge quantities in Peso terms. Faced with this, a widening fiscal deficit, and rising interest rates, Argentina accumulated unsustainable levels of debt which eventually led to an unprecedented default.

In view of the risks associated with foreign currency exposure, Government should consider using derivatives to reduce its exposure to currency risks. Currency options in particular are more ideal for developing countries, as they provide cover against currency risks without giving up the benefits of an exchange rate appreciation. However, reducing Government’s exposure to currency risks is a gradual one as it relies on the development of hedging instruments. Currently, the derivatives market in Zambia only trades futures contracts. Nevertheless, in the short-term, Government should continue to support efforts to make institutional arrangements that provide appropriate incentive structures for debt management as well as technical expertise and systems. Government’s efforts to set up a sinking fund are commendable in this regard.

Zambia has a difficult history of debt and it would be prudent to avoid a repeat of past debt crises. Eurobonds have possibly brought benefits to Zambia, but there are risks, such as those associated with the depreciating Kwacha. Continued enjoyment of these benefits relies on what measures we take now to reduce these challenges.

The authors are researchers at the Zambia Institute for Policy Analysis and Research (ZIPAR).
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