An innovative technique to broaden the scope and reduce the cost of borrowing
Christine I. Wallich
The World Bank finances the bulk of its loans to developing countries through its borrowing operations. Last fiscal year, 1983, it borrowed the equivalent of $10.3 billion to support a total lending program of $11.3 billion. The Bank’s need for funds is thus vast. It has, in recent years, sought to broaden the scope of its borrowing to reduce its dependence on any one market in various ways. The new technique of currency swaps, which has been used with success, has enabled it to carry out its large borrowing program at low cost by increasing its access to diversified funds.
In the past decade, the Bank borrowed through public issues and private placements in Austria, Belgium, Canada, France, the Federal Republic of Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom, the United States, Venezuela, and the OPEC countries, among others, as well as in the Eurobond markets. In most of these countries, the Bank is the largest nonresident borrower. It sells its securities in two main ways: by placing its notes or bonds directly with governments, agencies, and central banks, or by offering them through private or public issues via its network of investment banks. Borrowings from governments and central banks represented about 17 percent of the total in 1983—evidence of their support for the Bank’s activities as well as their confidence in the institution’s financial strength. In fiscal year 1983, $2.146 billion was privately placed or was lent directly to the Bank, and $4,847 billion was raised via public issues. In addition, $1.5 billion was generated through short-term borrowings in the U.S. market; the accompanying article by Thomas Hoopengardner and Ines Garcia-Thoumi discusses these in more detail.
Need for swaps
In its borrowings, the Bank seeks to achieve the lowest possible borrowing costs for its members (which are charged the nominal borrowing cost plus a spread of 1/2 percent to cover administrative costs). In fiscal year 1983 the average cost to the Bank of borrowed funds was 8.72 percent; without currency swaps, the average cost would have been 10 percent. The Bank’s low nominal costs were achieved because of its overall access to currencies such as deutsche mark, Swiss francs, and yen that had low nominal interest costs compared to the dollar.
The Bank’s estimates indicate that the developing countries have been well served by the Bank borrowing, say, Swiss francs at 6 percent, rather than U.S. dollars at 12 percent. Projected movements in exchange rates over the life of the liability are not likely, in the Bank’s estimation, to offset the interest rate differential. In the above case, the Swiss franc would have to appreciate some 36 percent to offset the benefits of the lower Swiss franc borrowing rate and to make dollar borrowing less costly. If the Bank considered such an appreciation likely, it would, of course, borrow dollars. Over the last six years the weighted average cost of Bank borrowings in deutsche mark, yen, and Swiss francs averaged 7.36 percent, compared to the alternative cost of dollar borrowing of 11.54 percent. The “effective” cost of borrowing—that is, the nominal interest cost plus the exchange rate appreciation or depreciation—has been even lower, due to exchange rate changes vis-à-vis the U.S. dollar since the date of each issue, producing an effective cost of borrowing deutsche mark, yen, and Swiss francs of 5.57 percent in dollar terms.
Because of the cost advantages, the Bank has sought to borrow a high proportion of its total requirements in these currencies, but its ability to borrow in many nondollar currencies is less than the desired borrowing volume. One reason has been official constraints on borrowing; because of capital outflows and domestic budget deficits, governments have sought to curtail access to domestic savings for all but priority borrowers in order to maintain domestic interest rates consistent with domestic objectives. The Bank also competes with a growing number of other nonresident borrowers for scarce nondollar funds (such as sovereign creditors; institutions like the European Economic Community and the European Investment Bank; and the other multilateral development banks—such as the Asian Development Bank and the Inter-American Development Bank). Savers’ portfolio preferences may also constrain the volume and frequency of Bank borrowing in a given market. The Bank must always be careful to avoid market saturation when it brings new issues, since in all markets it is already the largest nonresident borrower.
But even if the Bank had faced no official or “market-determined” access limits, its borrowing would have been below its desired level, for the environment for medium- and long-term fixed-rate borrowing generally has not been strong in the last ten years. The search is thus always on for new means and sources of borrowing, at acceptable terms and costs. To take advantage of the vast pool of liquidity in the short-term U.S. market, the Bank’s discount notes were introduced in fiscal year 1982. Offered at maturities of up to 360 days, these notes provide to the investor liquidity and a competitive yield, while for the Bank they represent an additional source of funds at a cost well below that of longer-term dollar borrowings. In the new Central Bank Borrowing Facility, which began operations in 1984, the Bank has developed an instrument which seeks to meet the needs of central banks in a way that meets its own requirements for further sources of funds. This Facility aims to tap directly the foreign exchange reserves of central banks, offering an instrument to meet their need for an attractively priced, liquid, and low-risk financial instrument for their U.S. dollar reserve holdings. The deposit Facility has a fixed maturity of one year and offers a variable yield related to the return calculated monthly on one-year U.S. Treasury bills. Liquidity would be guaranteed by the right to withdraw funds at par at a few days’ notice. On the nondollar side, the primary vehicle for enhanced long-term borrowing has been the currency swap.
Currency swapsare a technique whereby a borrower such as the World Bank can use its access to the U.S. dollar market to obtain a liability which it prefers, such as Swiss francs.
The technique of borrowing with a currency swap is straightforward. The World Bank borrows funds in one currency, simultaneously converting the proceeds of its borrowing into another currency. It then enters into forward exchange contracts to recover the currency borrowed and needed to meet debt-servicing payments.
To illustrate, assume there are two currencies (Swiss francs and U.S. dollars) with an exchange rate relationship of 2:1. These two currencies have interest rates of 7 percent and 14 percent, respectively. Assume a borrower has major access to dollars and constrained access to Swiss francs, although francs are the preferred liability. Finally, assume that the borrowing will be for $50 million at par, for five-year maturity with annual coupons. This leaves the borrower with an annual commitment to pay $7 million of interest for four years and $57 million for final interest and principal repayment at maturity to the bondholders. Under a currency swap, one borrower would borrow $50 million in the capital market at the prevailing yield of 14 percent, exchanging the $50 million for Sw F 100 million through the foreign exchange market. Simultaneously, the borrower executes a long-term forward exchange contract through which the borrower receives exactly the funds required to meet this dollar liability, providing in exchange a stream of Swiss francs in the future. In other words, the borrower signs a forward contract to receive $7 million annually on coupon dates in exchange for an agreed amount of Swiss francs, and $57 million on the maturity date in exchange for another agreed amount of Swiss francs. The borrower has in effect borrowed indirectly at the effective cost of 7 percent, using his access to the U.S. dollar market.
Through currency swaps the Bank aims to increase its access to its preferred low-cost currencies. The program was started when the Bank was borrowing close to its official access limits in nondollar currencies, and real and nominal rates of interest in U.S. dollars were at historic highs. It was not in the interests of the Bank or its borrowers to continue to borrow U.S. dollars at rates of 14 percent to 16 percent when interest rates on other currencies were around 7 percent.
The Bank has chosen to obtain some 30 percent of its preferred low-cost nondollar currencies via currency swaps, rather than through direct borrowings, and this has been a major factor in its ability to lower its lending rates to developing countries. From the date the program started in August 1981 until June 1983, the Bank raised through swaps the equivalent of approximately $2.5 billion in Swiss francs, deutsche mark, Dutch guilders, and Austrian schillings. Currency swaps represented one seventh of the Bank’s total medium- and long-term borrowings over this period, and one fifth of its borrowings in nondollar currencies. As mentioned earlier, currency swaps lowered the average cost of the Bank’s borrowing in fiscal year 1983 significantly. The majority of currency swaps—about two thirds—have been in Swiss francs.
The rapid development of the currency swap market was spurred by the volatility of interest and exchange rates (and hence the need for new ways of hedging the risks of cross-border and trade transactions) and by the rapid internationalization of capital markets that opened up new investment opportunities and increased the need for hedging assets and liabilities.
A typical currency swap
In the diagram, the World Bank and its Swiss counterparty, a Swiss corporation, have each borrowed funds and wish to swap them. Spot purchases of the desired currencies are made and forward contracts concluded. These contracts call for “bullet” repayments to the counterparty, meaning that interest only is paid in years one through four, and that principal and the final interest payment is paid in year five; there is no sinking fund or interim amortization. The Bank’s Swiss franc payments to the counterparty are used to repay the counterparty’s Swiss franc obligation; likewise, the Bank’s forward purchases of dollars from the counterparty are used to meet the Bank’s dollar liabilities.
A typical currency swap at fixed interest rates
The following is a typical swap scenario:
Day 1. The Bank has just completed a $200 million five-year bond issue in the Eurodollar market. It carries a coupon of 12 percent payable annually and is priced at par, that is, 100 percent, to yield 12 percent, 50 basis points over five-year U.S. Treasury notes. The cost to the Bank, including fees and other charges, is 12.5 percent.
Late in the morning the Bank receives a call from a Swiss corporation that wants to finance expansion of a manufacturing facility in the United States. The corporation would prefer to raise the necessary funds directly in the U.S. market, for example through a dollar bond issue, but its credit standing will not enable it to obtain the best rate, and the cost would be too high. In Switzerland, on the other hand, the company has a triple-A credit rating with substantial liquidity. The firm could finance the plant by using its existing Swiss franc liquidity either to buy dollars or to float a Swiss franc bond issue and convert the proceeds into dollars. However, the firm is concerned that a later appreciation of the Swiss franc could have a substantial and unpredictable adverse impact on its ability to service its Swiss franc-denominated debt from its dollar cash flow.
To hedge the dollar flows expected from its expanded U.S. facility against exchange rate risk, the firm proposes to sell these dollar revenues forward, entering a long-term forward exchange contract with the Bank that provides for a series of annual forward sales and purchases on dates coinciding with the debt-servicing obligation of the Bank in U.S. dollars.
The forward contract would enable the firm to convert the dollar revenues from its expanded U.S. facility into a Swiss franc flow at known rates of exchange. Such a contract obligates the Bank to pay a flow of Swiss francs to the counterparty. The contract is priced to cost the equivalent of the debt service on a Swiss franc borrowing at an all-in cost of 6.2 percent. The company, at the same time, is obliged to supply a periodic dollar flow to the Bank, equivalent to what the debt service would have been, had it borrowed at an all-in cost of 12.5 percent to finance its plant. The attraction of this offer to the Bank is that the 6.2 percent is lower than the cost to it of a direct Swiss franc borrowing. Likewise, to the counterparty, 12.5 percent is less than the cost of a direct dollar borrowing in its own name. The Bank considers the offer overnight.
Day 2. After further discussions, the Bank and the counterparty agree on the final terms:
|Spot exchange contract||0||$ 49,581,0461||Sw F 99,162,091|
|Forward contract||1||Sw F 6,000,000||$6,057,567|
Exchange rate at time of swap agreement is $1 = Sw F 2.
Exchange rate at time of swap agreement is $1 = Sw F 2.
An exchange of telexes and payment instructions confirms the transaction.
Day 6. The Bank purchases Sw F 99,162,091 for $49,581,046 in the spot foreign exchange market.
Day 10. Representatives of the Bank and the counterparties sign the contract.
For the Bank, the opportunity for currency swaps arose initially because a number of highly rated U.S. corporate borrowers wished to hedge or cover themselves against future changes in exchange rates, given their long-term exposure in foreign currencies resulting from earlier market borrowings. The borrowers preferred to take on dollar liabilities at 14 percent to 16 percent instead of maintaining their nondollar exposure. Using the currency swap technique, the Bank could acquire Swiss francs and other nondollar currencies directly from the counterparty without having to draw upon the domestic capital markets of Switzerland or Germany—the technique thus allowed the Bank to take advantage of its more extensive access to U.S. dollars and still end up with its preferred liability in Swiss francs or deutsche mark.
The currencies obtained through swaps become part of the Bank’s overall lending resources. Swap transactions vary as to the nature and business purposes of the counterparties, the currencies supplied to the Bank, and the detailed arrangements worked out to accommodate the participants. However, all transactions follow a common pattern: in each, the Bank borrows U.S. dollars, sterling, ECUs, or Canadian dollars (either in the Euromarket or domestically), subsequently selling them in the spot foreign exchange market and buying the preferred currency spot. Or it may exchange the borrowed currency directly with the swap counterparty. Assume it borrowed U.S. dollars initially. At this point, the Bank has a currency risk: it no longer holds U.S. dollars but foreign currency cash assets. However, the Bank’s liability remains a commitment to pay annual interest and principal at maturity on its dollar borrowing. To hedge this risk, the second and simultaneous step in a swap transaction is for the Bank to cover the future liability in dollars by executing a forward exchange contract—whereby it contracts to receive U.S. dollars at some future date in exchange for funds in its preferred currency. (The box gives a brief account of a typical swap.) Unlike a direct market borrowing, currency swaps in principle entail some degree of default risk for the Bank: should the counterparty default on its obligation, the Bank would be left with an open position in a currency, having an asset on its books (its loans) in the swapped currency, but faced with the continuing obligation to service its liability (the original dollar borrowing) in dollars. The Bank would also have a profit or loss, depending on exchange rate movements in the interim. The Bank estimates this risk to be very small. Nonetheless, to minimize it, the Bank restricts tightly the counterparties with which it deals to institutions of the highest credit ratings.
Advantages of swaps
As the program has developed, the types of counterparties involved in swap transactions have expanded. Previously limited to multinational corporations, they now include commercial banks and a wide variety of financial institutions. To date, about 80 percent of all swaps have been with the latter two entities; the remainder have been with industrial companies. The rapid growth of recent swap activity largely reflects the perceived advantages of this technique; very substantial potential exists for expanding this market, as financial managers become aware of the effectiveness of swaps as risk management tools.
The main advantage of swaps for the Bank’s counterparties is that they meet the need for long-term hedging cover against exchange rate risk by adding liquidity and contributing to the development of the long-term forward market in the major trading currencies. For hedging against risks inherent in short-term transactions, such as trade finance, the FOREX (foreign exchange) market in the most important currencies is highly efficient. It is very large and highly liquid, and arbitrage of interest rate and forward exchange rate differentials is often near-perfect. (Arbitrage involves the simultaneous buying and selling of the same currency or security in two different markets for the purpose of profiting from price or spread differentials prevailing because of conditions in each market. In the case of covered interest arbitrage the result is a tendency for interest rate differentials between markets to approximate the annualized exchange rate differentials, the definition of an efficient market.) The short-term FOREX market has thus become a highly efficient mechanism for dealing with the risks inherent in a floating exchange rate regime (that is, bid-offer spreads—or the differences between prices bid by buyers and those offered by sellers of a currency—are narrow).
Beyond maturities of about one year, however, the FOREX markets are thin or nonexistent. An importer or exporter with unhedged foreign currency payables or receivables could finance them by borrowing offshore in the foreign market or hedging exchange rate risks by varying the timing of payments through leads and lags, or by using the FOREX markets. But the longer term of currency swaps and their broader reach make them both more certain and less costly than any of these alternatives. For the enterprise funding offshore investments in its domestic currency, or seeking offshore financing for its domestic operations, swaps alleviate the exposure inherent in a currency mismatch, without potentially expensive and uncertain foreign borrowing or investment. (These activities are outlined in the table.)
|Hedging needs||Hedging alternatives|
|Exporter has stream of dollar receipts in excess of dollar payments to be made.*|
Importer has dollar payments to make but no receipts.
|Lead or lag payments.|
Hedge on an ongoing basis through short-term FOREX.
Hedge through swap on long-term basis.
Finance offshore in dollars.
|Long-term contracts/export financing|
|Exporter has long-term flow of dollar receipts in excess of dollar obligations.*|
Exporter has long-term dollar-denominated contract, costs of production in other currencies.*
Importer has long-term payments to make.
|Finance offshore in dollars.|
Hedge through swap or long-term forward contract.
|Company has offshore dollar assets (fixed investment) which were financed domestically in local currency.*|
Company has offshore dollar portfolio assets which were financed domestically.*
Company has local currency assets, financed offshore.
|Remain exposed by keeping mismatched position.|
Hedge through long-term swap or long-term forward contract.
Finance assets offshore in dollars (obtaining counterliability).
Hedge by obtaining matching asset for the offshore liability.
Asterisk indicates potential counterparty for the World Bank.
Asterisk indicates potential counterparty for the World Bank.
Another important motivation behind currency swaps is to take advantage of arbitrage opportunities that exist because of capital market inefficiencies. In the Bank’s own currency swap program, the most frequent arbitrage opportunity underlying a swap occurs because “scarcity value” plays a large role in pricing new issues. The Bank is one of a limited number of entities that are willing to borrow in any currency, while domestic investors based in those currencies strongly desire to diversify their portfolios internationally. The result is that, depending on the relative volume of their respective borrowings, borrowers of the same credit quality can pay markedly different rates of interest. In the Swiss capital market, for example, where the Bank has been a major issuer for many years, some U.S. corporations can borrow at rates below what the Bank can achieve, even though the latter remains one of the most highly regarded nonresident names in that market. The Bank, on the other hand, achieves very fine pricing in the U.S. domestic and Eurodollar markets. The different perceptions each market has of the creditworthiness of the Bank and its counterparties make swapping of their respective liabilities mutually attractive, as it enables each party to borrow more cheaply in a given currency than would otherwise be possible.
The funding activities of nondollar-based commercial banks promise significant potential for additional arbitrage-related swap transactions. These institutions generally lack sources of dollars, and they are constantly searching for lower-cost ways of obtaining them, mostly at floating rates for their offshore lending businesses. Recently, foreign banks have taken advantage of their relatively superior ability to raise fixed-rate deutsche mark and Swiss francs to obtain the floating-rate dollars they prefer through swaps. Indeed, the Bank has been the “third leg” of such transactions, providing fixed-rate dollars in exchange for, for example, Swiss francs to a commercial bank counterparty, which simultaneously swaps the fixed-rate dollars for long-term floating-rate dollars. Because of the Bank’s comparative advantage in raising floating-rate dollars, a logical expansion of its swap program would be to provide floating-rate dollars directly to such institutions in exchange for preferred currencies at fixed rates.
There are, however, natural limits to the flows that can take place at rates attractive to both parties. A common misunderstanding of the economies of swaps is that they are driven by interest rate differentials between markets. They are not. Swaps are based on creditworthiness differentials within markets, not differentials between markets, as noted earlier. Covered investment flows that occur through swaps leave each party with an interest cost in the swapped currency. So the swap will induce demand for borrowings in the swapped currency (e.g., Swiss francs) only as long as its cost is lower than that of a direct borrowing. That is, swaps will induce flows only to the point where this “creditworthiness” differential is narrowed or eliminated, as the borrower taps the markets with greater frequency. On the other hand, the overall interest rate differential between markets is narrowed by capital flows on an uncovered basis—for a net capital outflow to take place, there must always be a party willing to accept an exposed position in some currency.
Since the inception of its program, the Bank has priced swap transactions to obtain a cost saving over a direct market borrowing. In setting cost guidelines, both sides of the swap are “marked to market,” that is, the dollar cost offered to the counterparty is linked to the Bank’s cost in replacing the dollars being swapped rather than to their actual cost. Likewise, the cost of potential borrowings in the nondollar market fixes a ceiling on the cost of the nondollar currency to the Bank. In many instances, the Bank can borrow through the swap market at an all-in cost well below that of a direct market borrowing. Savings have been as large as 1 percent or more; more commonly, they are in the range of 0.25–0.35 percent.
Unlike a direct market borrowing, currency swaps, in principle, entail some degree of risk for the Bank, as mentioned earlier. That is, in a swap, the Bank simultaneously creates a foreign currency exposure (by selling dollars borrowed in the market) and covers it (through the swap contract). Should the counterparty not meet its obligation, the Bank will be left with an open position in a currency. This would need to be closed by another forward contract, by the immediate reconversion of the currency held into U.S. dollars, or by an offsetting borrowing that might not be to the Bank’s advantage at the time. For this reason, another guiding principle has been that the Bank should sign forward contracts only with the highest credit ratings in the markets. This effectively restricts swap counterparties to banks or other financial institutions with triple A—the highest possible rating given by bond-rating agencies in the United States—or comparable credit ratings. The Bank monitors its exposure to these counterparties on an ongoing basis.
The World Bank offers employment opportunities to qualified men and women at its Headquarters in Washington, D.C., for the following positions:
Investment Officers: Participate in the day-to-day management of the Bank’s investment portfolio, which includes bonds, bills, certificates of deposits, and other money market instruments; maintain close contacts with dealers and commercial banks in several major money markets and monitor fundamental and technical position in these markets; and participate in the development of research in money and capital markets analysis, portfolio management techniques, risk analysis and performance measurements, contributing to the overall investment decision-making process. A graduate degree in finance, economics, or equivalent is essential. Candidates should have experience in management of diversified fixed-income portfolio, especially in government securities and money markets; a strong background in finance and the ability to work independently and to make decisions under pressure. Experience in computer systems and financial model-building, mathematics, and statistics would be useful and desirable.
Financial Analysts: To work in the Bank’s agricultural, energy and water supply lending sectors. Successful candidates will be responsible for analyzing and evaluating the organization, management, staffing, operating and accounting procedures, and financial policies and performance of prospective borrowers. Candidates should have a university degree in corporate or public finance, accounting or business administration, as well as over five years of financial experience at senior levels in entities related to the sector, i.e., public utilities, agencies or organizations dealing with agriculture and/or livestock, or related industries. Candidates should possess a good command of written and spoken English; candidates with additional knowledge of French especially needed.
The World Bank offers a competitive salary and benefits package. Please send a detailed curriculum vitae, quoting reference No. 44-USA-8201 to:
The World Bank Staffing Division
1818 H. Street, N.W., Washington, D.C. 20433 U.S.A.