ENHANCING THE LIQUIDITY OF EXISTING AND FUTURE AFRICAN SOVEREIGNS EUROBONDS
How will the LSF support the liquidity of African Sovereigns Eurobonds?
According to the Journal of African Trade, studies have shown that interest rates on emerging market sovereign bonds are 2.9 per cent higher than comparable bonds issued by sovereigns with similar credit ratings and economic fundamentals.
Engagement by counterparties such as the LSF can compress yields by strengthening the demand and consequently, the price of eligible sovereign bonds. Demand would be enhanced by improving the liquidity of such instruments through a more robust and liquid repo market and by requiring sovereign bonds as collateral for development financing at competitive rates.
Central banks, the International Capital Market Association, and large international asset management groups all confirmed the importance of a functioning repo market in compressing liquidity premiums and improving sovereign access to international bond markets.
Are repo markets the most effective mechanism for improving the liquidity of bond markets?
Repo markets play a key role in facilitating the flow of cash and securities around the financial system, with benefits to both financial and non-financial firms. A well-functioning repo market also supports liquidity in other markets, thus contributing to the efficient allocation of capital in the real economy.” Bank for International Settlements
Repo markets have been created specifically and successfully to improve the liquidity of financing instruments such as government bonds. Developed countries have long enjoyed the existence of large repo markets for their government bonds, facilitating the creation of stable and additional funding sources. The Term As- set-Backed Securities Loan Facility program initiated by the Federal Reserve of the United States in November 2008 provides a useful precedent.
Central banks, the International Capital Market Association, and large international asset management groups all confirm the importance of a functioning repo market in compressing liquidity premiums and improving sovereign access to international bond markets.
In the case of Africa, a well-functioning repo market could improve the liquidity of sovereign bonds by providing a mechanism for bondholders to refinance their positions. This reduces the liquidity premia. While repo markets alone will not solve Africa’s credit risk challenges, they can contribute to reducing interest rates by compressing the liquidity premium, reducing the debt vulnerabilities of African sovereigns and expanding the fiscal space for investments in critical trade-enabling infrastructure. In effect, compressing Africa’s liquidity risk premium is good for trade and the related opportunities offered by the African Continental Free Trade Area. And, collectively, these impacts can reduce credit risks and improve perceptions.
Can a self-sustaining repo market arise if the underlying structural challenges of African bond markets remain?
The “kickstart” effect of similar publicly funded initiatives is well established. The LSF aims to contribute to strengthening the African bond market by attracting to it a wider range of international investors. The focus will be on international investors because the domestic investor base in African countries is limited. This explains the focus on euro-bond markets rather than domestic markets.
Will improvement in the liquidity of African bonds result in a significant compression of yields?
In November 2021 the LSF and its partners estimated that African governments could save up to USD 11 billion over the next five years on their borrowing costs thanks to the LSF, thereby significantly improving debt sustainability for low and middle income countries and reversing what constitutes a regressive income transfer due to excessive risk premiums.
Can the LSF further facilitate other forms of innovative financing such as debt swaps?
For countries with market access that are concerned about taking on additional commercial debt, debt-for-adaptation swaps may be a viable alternative to be pursued. Debt swaps are made viable through a number of means, for example through swapping foreign-currency-denominated debt for local currency debt to reduce balance-of-payment pressures, through a reduction in interest rates by creditors, or through a partial write off. The opportunity to undertake debt swaps through new issuances becomes more viable as well, since the LSF aims to reduce the interest rate and improve the attractiveness of African Sovereign bonds, thereby either eliminating or reducing the need for credit enhancement.
How will the LSF be funded?
The LSF was incorporated in 2021 and its establishment announced by the UNECA at the COP 26 in Glasgow in November of that year.
The LSF operates an Asset and Liability Management policy with a funding plan for credit and repo lines of various terms matching its transactions, established with a diversified pool of financial institutions representative of the multiple LSF stakeholders, globally as well as in Africa. It includes central banks, MDBs and IFI, private and commercial banks. The optimal funding capacity is expected at USD 30 Bn over the medium term. To that effect, the LSF is actively engaging with the IMF and G20 on the on-lending of their unused-SDRs.
GEOGRAPHICAL COVERAGE AND INVESTOR BASE
What countries and what type of investors will the LSF target?
The LSF initially targets African economies with access to capital markets and with sound economic fundamentals. Currently, there are at least 22 African countries with access to capital markets.
The LSF engages with counterparties established in recognized jurisdictions and of the highest quality and reputation such as insurance companies, banks, pension funds, asset management firms, and public and private investment funds.
Could the LSF have a tendency to select the least risky eligible countries and exclude the most vulnerable?
The LSF looks to engage in relation to African Sovereign Eurobonds generally and determines its engagement with private investors as long as they fit the LSF risk management criteria i.e. transact Eurobonds of African countries that have access to capital markets and deal solely with counterparties of high credit quality and with full recourse.
The LSF organizes regular reviews of the universe of eligible bonds it accepts as collateral to ensure the high quality of its risk management framework over time.
How will the LSF deal with situations where the value of the posted collateral falls below the face value of the loan?
Repo lending is structured in such a way that eligible investors are required to post collateral in excess of the loan value (i.e., maintain a margin), and should there be a decrease in value of the posted collateral, the LSF would issue a margin call and require the investor to advance more bonds or cash to compensate for the loss in value.
Target investors likely to participate in the LSF being insurance companies, pension funds, asset managers, public and private investment funds and commercial banks, any scenario where the private investor fails to repay the LSF would constitute a default event for the counterparty in question, which has been a very rare occurrence historically.
Could the LSF risk incentivizing excessive borrowing by Sovereigns if it succeeds in lowering the costs of commercial credit?
An objective of the LSF is to support the access of African Sovereigns to capital markets. This may indeed result in volume expansion for countries that investors are willing to fund. Governance and sound financial management are therefore crucial to ensure prudence in investment choices and transparency and accountability in the use of funds.
Could the structure of the LSF exacerbate adverse market reactions to shocks by providing high levels of cheap “mark-to-market” leverage to private-sector investors?
On the contrary, in the event of tightening markets, the LSF would provide investors with the option of holding to their positions while generating any cash necessary to sustain their investment policies in the short term. From that perspective, the LSF doesn’t contribute to the downward pressure that can be felt in such situation.
It must also be noted that the LSF is not a mechanism to backstop central banks or local markets. Its focus is to engage in the repo market relating to Eurobonds issued in hard currencies by middle-income and low-middle-income countries. As such, it has no impact on local monetary policies.
If the LSF leads to a significant expansion of “market” borrowing at the expense of concessional official borrowing, could this undermine debt sustainability?
This will depend in part on African Sovereigns’ adhesion to sound financial management. However, we believe that diversifying the potential sources of funding for African sovereigns is positive. Furthermore, since eligibility for participation is based on sound economic fundamentals, the risk of elevated debt vulnerability is mitigated.
Could there be a risk of public bailout of private investors in case of defaults?
On the contrary, should a counterparty defaults, which has been a very rare occurrence historically for market participants such as insurance companies, pension funds, asset managers, public and private investment funds and commercial banks, the LSF would seek bankruptcy proceedings in accordance with applicable laws. In addition, the sovereign bonds serve as collateral which can be sold to pay off creditors.
USAGE OF SPECIAL DRAWING RIGHTS (SDRs)
How confident are you developed countries will lend their SDR to the LSF? What would be their interest in doing so?
For the G7 to reach its target pledge of $100Bn a year by rich countries to help poorer countries cut carbon emissions and cope with global warming it needs practical and actionable solutions such as the LSF, which is endorsed by the largest economies in Africa. Further, the challenges the LSF aims to contribute to alleviate such as the pandemic and climate change are both global in nature. In such environment, cooperation is the best way forward to tackle these challenges as no country on its own can address these problems in a sustainable way. We believe the LSF presents a unique opportunity not only to alleviate Africa’s pressing issues and transform the continent’s development path, but also to contribute to the establishment of long-lasting solutions to some of the world’s most pressing issues which would benefit all parties.
How SDR on-lending countries will be compensated for any associated costs?
The LSF would charge a spread above prevailing interest rates on every repo transaction. The spread level will be a function of the current market conditions and the specificities of each transaction (credit, maturity, quality of the collateral, etc.). The spread plus the full interest rate received from the repo counterparties are expected to cover and pay for all costs incurred by all parties involved.
The LSF aims to provide improved terms for Green and SDG Linked Bonds to foster green finance in Africa, still the overall spread received would remain higher than SDR on-lending costs.
Have you considered other funding options such as the IBRD's Flexible Loan, ICF, and borrowing from developed countries?
Yes, these options have been explored however they do not address compressing yields on sovereign bonds. The LSF seeks to strengthen the relevant capital markets and help address liquidity risks by engaging as a counterparty in market mechanisms.
About The Liquidity and Sustainability Facility
The LSF was designed by the United Nations Economic Commission for Africa, in collaboration with Afreximbank, with the dual objective of supporting the liquidity of African Sovereigns Eurobonds and incentivizing SDG-related investments such as SDG and green bonds on the African continent.