By using market-based risk management techniques, developing countries can protect themselves from external volatility
For the past two decades, developing countries have been contending with highly volatile international prices—exchange rates, interest rates, and commodity prices. For developing countries, especially those that had borrowed heavily in world capital markets, this has meant greater uncertainty and, in many cases, unfavorable price movements have contributed to the rapid buildup of debt. Traditional methods for coping with external exposures to price risks, such as general borrowing, contingent finance, domestic and international commodity price stabilization schemes, and export diversification have proven to be limited. Hence, new arrangements and creative strategies for managing risk have been sought.
In light of the positive experience of many corporations in industrial countries, central banks, and major companies throughout the developing world have begun to experiment with various risk management instruments. These techniques, most notably futures, options, and swaps, are designed to transfer and reallocate some of the associated external risks. More specifically, risk management involves the structuring of financial arrangements to produce gains (or losses) that offset or counterbalance, at least in part, the losses (or gains) arising from price volatility.
Glossary of financial instruments
Futures/Forwards. Agreements to purchase or sell a given asset at a future date at a preset price. Futures transactions are traded in formal exchanges through clearinghouse systems; forwards are offered (usually by banks) on an over-the-counter basis. Futures and forwards contracts differ in their handling of credit risk: Futures involve collateral with (daily) adjustments to reduce credit risk, while forwards involve no collateral.
Options. Contracts that give its owner the right to buy (if it is a call option) or sell (if it is a put option) a fixed quantity of a currency or a commodity, or establish an interest rate at a fixed price before or at a designated future date. Options provide price insurance by guaranteeing a minimum price received (for commodity exports by buying put options) or a maximum price paid (for currencies by buying call options).
Swaps. An agreement to exchange specified cash flows at fixed intervals. Swaps involve a series of forward contracts, extending to long-dated maturities. Both parties to the contract incur credit risk because, depending on the prevailing market price being above or below the predetermined price, one party owes or is due the net amount.
Commodity-linked loans. A loan in which interest and/or repayment amount are linked to the market price of a certain commodity.
This article describes the various available financial instruments, with a focus on how some developing countries are using them. It must be noted, however, that although risk management instruments hold considerable promise, their use remains limited and, often, at an experimental stage.
Financial tools are attractive …
Risk management provides insurance against adverse fluctuations in external prices without either requiring substantial resources (e.g., subsidies, reserves, or financing), or introducing price distortions. It transfers the risks associated with price volatility to international financial markets at terms that are attractive to developing countries. Although risk management means giving up the chance of unexpected gains, as well as the risk of loss, developing countries are typically not well equipped to profit from speculation, which is best left to international markets.
Risk management instruments have evolved over the past decade in breadth and sophistication. Essentially, they include both short-dated (roughly 1-year maturity) and long-dated (up to 20-years maturity) instruments (see glossary).
Short-dated instruments. Some developing countries are discovering how comforting short-dated instruments, such as futures and options, can be. Typically, transaction costs (brokerage fees, bid/ask spreads, and the costs of providing margin) amount to no more than a fraction of 1 percent of the contract value (about one eighth to one half of 1 percent); and risk premia—the return that hedgers have to pay to other agents for bearing the risk of price movements over the life of the contract—are generally low. Chile hedged part of its floating interest rate debt in 1989 and 1990, and Mexico hedged a significant part of its oil export earnings in late 1990 and the first half of 1991 (see boxes above). In some cases, risk management in the short-dated forwards markets has been routinely undertaken for many years. For instance, Ghana and Cote d’lvoire have consistently sold forward a large portion of their subsequent year’s cocoa crop at a fixed price. Simulations have shown that by using futures, 80-90 percent of price risk can be eliminated for most commodities.
Mexico’s oil-hedging strategy
In late 1990 and during the first half of 1991, Mexico used financial risk management tools to protect its crude oil export earnings (which average about 1.3 million barrels a day) against a price fall. Mexico bought put options at different strike prices (i.e., the price at which the option-holder can sell), engaged in selling of oil futures, and used short-dated (up to one year maturity) oil swaps to hedge its oil price risk. Mexico’s overall strategy was to ensure that it received at least $17 a barrel, the price used as the basis for its 1991 budget. By using these contracts, Mexico effectively ensured a minimum price for its chief export over the near term. As oil prices fell sharply following the end of the recent Middle East crisis, it is likely that, compared with going unprotected, Mexico achieved a higher price by engaging in risk management. Mexico also used this period of higher prices to establish a special contingency fund to protect against a medium-term decline in oil prices. As explained by the finance ministry, participation in the futures markets served to reassure investors that regardless of oil price movements, the country’s economic program and the budget would be maintained.
Chile’s hedging operations with Eurodollars
To manage the risk of its variable interest rate debt with commercial banks in 1988, Chile’s central bank carried out short-term hedging operations with Eurodollar futures contracts. As of December 1987, about 83 percent of Chile’s total $18 billion medium- and long-term debt consisted of variable-rate loans, mostly tied to the six-month LIBOR. After the October 1987 stock market crash, interest rate developments were particularly uncertain. To reduce this risk, Chile hedged about $1.5 billion of debt against interest rates. In March and June 1983, Chile sold 3-month Eurodollar futures contracts. The sale of futures contracts was spread over more than three weeks and the effective LIBOR achieved was 7.3 percent. The LIBOR would have been as high as 7.8 percent without the hedge. The central bank is said to have carried out similar hedging operations in 1990.
Long-dated instruments. The search for long-term and more comprehensive risk management techniques has produced longdated instruments, including currency, interest, and commodity swaps; long-dated options; and commodity-linked bonds. These nonstandard, tailor-made instruments trade in the “over-the-counter” markets provided by commercial banks and other financial institutions. These instruments are essentially composed of two building blocks—swap and option features—that can be combined with loans and bonds in a variety of ways.
Currency and interest swaps. Currency and interest rate swaps are typically used in two ways. One is to hedge an existing risk by contracting a swap in such a way that the timing of cash flows in a swap matches the payment dates on an existing asset or liability (see accompanying box). A second is to obtain a desirable liability structure by contracting new debt and a swap at the same time, yielding a loan that is effectively denominated in another currency or with another interest rate. This flexibility makes it possible for participants to take advantage of favorable borrowing opportunities in certain markets without incurring undesired currency or interest rate risk.
Thailand has used swaps in both of these strategies. For instance, the ministry of finance in Thailand has arranged with US money center banks and Japanese banks to exchange floating for fixed interest payments (or fixed for floating interest payments). In March 1988, finance ministry officials invited several US commercial banks to bid for two (seven-year) US dollar fixed/floating interest swaps of about $70 million. Although Thailand does not disclose the details of its swap transactions, the country is known in the international financial community for this type of transaction.
Commodity-linked instruments. The longdated commodity-linked instruments market developed in the late 1980s. These instruments are now being used on a regular basis in the mineral and energy sectors in industrial countries. Investments in gold mining in developed and developing countries are often financed with loans denominated in ounces of gold. Exporters in developing countries, most notably in Chile, Ghana, Mexico, and Papua New Guinea have often combined trade finance with commodity swaps. By locking in their export receipts at a fixed price through a one- to two-year commodity swap, exporters have achieved a better match between export receipts and debt service obligations, allowing them to secure more favorable terms on their trade finance. An example of a copper swap associated with new financing is the Mexicana de Cobre transaction described in the box.
Dual currency loans. Another use of longdated risk management instruments is dual currency loans. The Central Bank of Turkey frequently uses DM-US dollar dual currency loans, since Turkey can expect ample revenue in deutsche marks from workers’ remittances from Germany. Turkey agreed to a $100 million dual-currency syndicated loan in March 1988. The loan included the sale by Turkey of a DM option on the principal. The premium from the sale of the DM option was used to reduce the cost of funding. As a result, the loan carried a floating interest rate of 0.015 percent over the London Interbank Offered Rate (LIBOR). If it had been a conventional loan, the central bank would have paid about 1.25 percent over LIBOR.
Indonesia used a type of dual currency loan in which the borrower chooses the currency in which the funds are disbursed. In October 1988, Indonesia contracted a 40 billion yen revolving credit facility for three years. In this facility, Indonesia could draw up to 40 billion yen or its dollar equivalent for three years. Once the loan was disbursed, it became a conventional (yen or dollar) loan, with an 8-year maturity and a 5-year grace period, with a floating interest rate of 0.5 percent over LIBOR for the first three years and 0.625 percent over LIBOR thereafter. The fee required at the time of entering the loan contract was 0.5 percent of the principal. This arrangement allowed Indonesia to manage its debt by giving it the right to choose the currency denomination of the debt over three years.
How do currency swaps work?
Suppose a country has access to yen financing but would not like to increase the amount of its yen obligations. Assume that the borrower has secured a loan for ¥10 billion, on which the interest rate is 5 percent, resulting in annual interest payments of ¥500 million. The country could now arrange a swap with its bank in which it essentially acquires a yen asset in exchange for accepting a dollar liability. The original yen loan will be retained. The yen asset will pay exactly the interest due on the original yen loan, ¥500 million, and as a result, the country will have offsetting yen assets and liabilities. The net result is to create a “synthetic” dollar borrowing. If the exchange rate is ¥125 per dollar and the dollar interest rate is 10 percent, annual interest obligations on the newly accepted dollar obligation would be $8 million. This swap requires, of course, a partner that prefers a yen-denominated liability to a dollar-denominated liability.
Mexicana de Cobre financing using a copper swap
Mexicana de Cobre (MdC), a copper mining subsidiary of Grupo Mexico, obtained some innovative financing in 1989. In addition to a conventional loan of $210 million syndicated for MdC, a copper swap was arranged with the same maturity and payment dates as the loan to hedge MdC’s export earnings to a European purchaser. As a result of the swap, MdC was able to assure creditors it had sufficient funds to service and repay the loan, regardless of fluctuations in the price of copper over the loan life. As copper prices have declined since 1989, MdC most likely benefited from having locked in a fixed price. Further security was provided by an “offshore” escrow account (i.e., located outside of Mexico), into which the European purchaser of copper deposited payments according to its purchase contract with MdC. The first charges on the escrow account were the net payments under the debt service on the loan and the swap, ahead of any remittances to MdC. The elimination of the copper price risks through the swap and the security afforded by the escrow account were the basis of financing at an interest rate favorable to MdC. Effectively, MdC shifted financing costs from periods of low copper prices to periods of high copper prices and thus increased its creditworthiness.
… but some factors limit their use
Despite advances in new and flexible instruments, developing countries face barriers—some formidable—to embracing these techniques. These include:
• High up-front premiums. The use of some financial techniques, such as buying options, can require high premiums to be paid up front. This may be difficult for countries that have limited access to foreign exchange.
• Low credit standing. For many developing countries, access to some risk management instruments is limited by creditworthiness considerations. This is particularly the case with long-dated instruments where the longer the length of the contract, the larger the potential range of price movements and the higher the credit risk. Credit risk is less of a barrier in the case of short-dated instruments where margin requirements at the outset of the contract minimize the credit risk.
• Strict domestic rules. Domestic legal and regulatory barriers affect, in particular, the private sector’s capacity to hedge abroad. Exchange controls, for example, may prevent the purchase of collateral for engaging in the futures market or laws may prohibit domestic access to such instruments.
• Weak incentives. Often, several parties in developing countries incur external price risks in a complex and not so transparent manner, with the result that no single party has the incentive to engage in risk management. In Costa Rica, for instance, coffee price risk is incurred by exporters, intermediaries, and final producers. The producer, who is least able to engage in risk management, incurs most of the risk, while the exporter, who is most able to engage in risk management, has the least incentive to do so. Appropriate changes, including measures to assure a liberalized domestic financial and marketing system, could expand use of these risk management instruments (by the private sector).
• Limited expertise. Risk management is a complex operation requiring the knowledge of market instruments and their strategic use. Too often, developing countries lack technical and management expertise, as well as the institutional framework within which to carry out these operations. While it is clear that improved external risk management can assist developing countries in their economic management, it is important to realize that risk management can only be performed effectively when certain key conditions are fulfilled. These financial techniques, when used inappropriately, can be very costly. Therefore, it is important to introduce an institutional framework that ensures adequate reporting, recording, monitoring, and evaluating mechanisms, and to establish internal control procedures that avoid and protect against speculative transactions.
Still, they hold promise
Developing countries’ exposures to external price risks are large and the impact of adverse shocks can be severe. In such circumstances, obtaining some degree of insurance against price volatility through the use of market-based risk management tools can make an important contribution to a country’s adjustment effort. Although developing countries have been severely constrained in their use of these techniques—particularly long-dated instruments—they have started to make use of risk management opportunities in financial markets. Removing domestic, legal, and institutional barriers on access to international markets is the first step in furthering the use of these instruments.