Swaps IV: Protection for Third World Central Banks

By Schap, Keith | Futures (Cedar Falls, IA), November 1990 | Go to article overview

Swaps IV: Protection for Third World Central Banks


Schap, Keith, Futures (Cedar Falls, IA)


Swaps IV: Protection for Third World central banks

For the central banks of developing countries, forward strip hedges using Eurodollar futures - often called synthetic swaps - can help control the cost of debt.

U.S. banks' problems with "Third World debt" have become financial legend. But concern for the lending banks should not obscure the problems of the borrowers.

When London Interbank Offered Rates (LIBOR) rose 3% in 1988, Latin American debtors faced an additional $12 billion in payments.

"That skyrocketing debt service affects standards of living for those people," points out Ed Rombach, a vice president at Emcor Risk Management Consulting in New York.

The recent World Bank annual report notes that in 1989 developing countries transferred record resources to the industrialized world. Obviously, the more of a country's output going to debt service, the less it has to develop programs to improve its standard of living.

And, as commercial banks write down huge Third World debts, they grow less willing to make new loans. Even the recent euphoria over Eastern European political changes has not overcome that reluctance.

Even as developing country debt service has trended up, disbursements of new funding have tapered. In the aggregate, Third World countries paid out $42.9 billion more than they received in new loans in 1989.

To stave off the devastating potential of that situation, says Marcus Fedder of the World Bank, the bank "advises Third World countries to explore the use of futures in hedging risk, though it cannot recommend specific exchanges or instruments."

Following the lead of Chile's central bank, which began using futures in 1987, several nations have explored futures-based hedging. Besides limiting exposure to unfavorable rate changes, it makes it easier for them to find willing lenders.

As John Haseltine of the Institute for International Finance said, when banks see a nation has a risk management program, they know it is trying to improve its economic lot.

Central bank hedgers can choose among several approaches.

But in choosing, Fedder says, the main point is to think in terms of the risk-reward question. Often, veteran hedgers know, the choice of tactics involves deciding which is more acceptable given different risks, balancing costs and possible gains.

To a country short of cash, doing nothing may seem attractive. Falling rates could make that seem right, but it's hard to predict rates. Doing nothing is accepting rate risk. As 1988 suggests, this can easily be a painful choice - unless the borrower is willing, in polite phrase, to suspend payments as some countries have done.

To protect against rising rates, borrowers can engage in over-the-counter (OTC) swaps or caps or hedge their positions with futures.

Though effective against rate risk, swaps and caps involve salty transaction costs. Short-term swaps currently trade on a four to six basis point bid-ask spread, in contrast to the one-tick spreads of the major financial futures markets.

Also, swaps introduce significant counterparty credit risk. Many commercial banks that deal swaps have been major lenders to the Third World. These swap-dealing banks, recalling troubled loans, may be loath to take swap positions.

Interestingly, the efforts of Chile, Mexico and Hungary to put their economic affairs on sounder footings have been changing that somewhat.

Still, in terms of cost and credit risk, hedging in futures markets, especially the Eurodollar contracts, may be the best tactics for developing countries to manage rate risk.

Much Third World debt is indexed to LIBOR rates. Because Eurodollar futures also price off LIBOR, loan rates move in tandem with them, making "Euros" a natural hedge vehicle. Also, Euros enjoy immense liquidity. Even back months out to three or four years can absorb large positions quickly and inexpensively.

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