Sovereign risk manager of the year: Senegal’s Ministry of Finance and Budget

Risk Awards 2020: ADB guarantee cuts swap costs by 500bp, opening the door for a $1.4b forex hedge

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Babacar Cissé

When Senegal’s Ministry of Finance and Budget wanted to raise funds for a series of agriculture, energy and infrastructure projects, it did what it had always done before: issue dollar-denominated bonds.

The country has good access to the international financing markets, borrowing $1.6 billion over two issues in 2011 and 2017, with the latter maturing in 2033. It bought back $200 million of the 2011 issue this year, but was still exposed to foreign exchange risk on the remaining $1.4 billion.

Senegal therefore needed a long-dated forex hedge. The country uses the West African CFA franc, which is pegged to the euro, so swapping the debt into euros would dampen the impact of currency fluctuations on debt repayments.

But while the country has a respectable sovereign credit rating, it wasn’t willing to post any collateral, as it would create a situation that led to a default.

“Senegal has limited market access, and therefore margin calls – should they occur while capital markets are closed – could potentially trigger a default,” says Thibaud Fourcade, a director in the sovereign advisory group at Rothschild & Co, which was Senegal’s financial adviser for the transaction.

“A collateralised trade was deemed toxic because of this, so we had to conduct an un-collateralised trade instead,” adds Fourcade.

However, uncollateralised trades attract higher charges from banks to cover accounting and capital requirements for counterparty credit risk, known as credit valuation adjustment (CVA). When Senegal first started asking banks for a price on a 16-year forex swap in 2017, the quotes were eye-watering, coming in at north of 600 basis points.

“This indicative bank pricing was purely theoretical,” says Babacar Cissé, head of public debt directorate within the Senegalese Ministry of Finance and Budget. “No bank would ever have granted us credit lines on a forex derivative with a 16-year maturity, even with such punitive CVA charges.”

That left Senegal with one remaining option: finding a guarantor for the transaction to cover some of the negative mark-to-market on the swap should the sovereign default. Senegal had previously used the Multilateral Investment Guarantee Agency – part of the World Bank – as a guarantor for a bond it issued in 2015. But that route was no longer an option, as the country was no longer eligible under MIGA’s credit support policy.

In addition, MIGA guarantees come with burdensome environmental requirements. For example, in 2015, when Senegal issued a bond to cover road construction, it had to provide an environmental report on the road twice a year – something Senegal could ill-afford.

Senegal has limited market access, and therefore margin calls – should they occur while capital markets are closed – could potentially trigger a default
Thibaud Fourcade, Rothschild & Co

Senegal’s guarantor eventually came in the form of the African Development Bank (ADB), which is able to act as a guarantor for derivatives transactions for the 54 regional member countries who fall within the bank’s remit – that is, if such states meet certain eligibility criteria.

If the state in question has a per capita income above $1,165 and is able to reach concessional funding, then it’s classified as an ADB country and can benefit from full credit guarantees. States that don’t meet this criteria are classified as African Development Fund (ADF) countries instead, which is unable to provide guarantees for derivatives transactions.

The ADB had only served as a guarantor once before, when in 2015 it provided a €500 million partial credit guarantee to help Cameroon hedge its €1.15 billion bond.

After a process that took 18 months to complete, Senegal was eventually able to secure a €470 million partial guarantee for the $1.4 billion forex hedge – allowing the West African state to save more than 500 basis points on the derivatives valuation adjustment charges attached to the trade.  

Due to Senegal’s improved macroeconomic performance and sustainable debt profile, the country had recently been re-classified to a ‘blend country’ under the Bank Group’s country classification. The ‘blend’ status enables Senegal to benefit from both the ADB and ADF financing windows of the bank, hence the ability for ADB to support Senegal on this transaction.

However, ADB’s support came with some unusual features. Rather than hedging banks being able to immediately terminate the transaction, activate the guarantee and exit the trade if Senegal defaults, instead banks are committed to staying in the trade for up to two and a half years.

Negotiating this point with the banks was somewhat challenging, given that this was not a familiar structure for a transaction
Eghosa Giwa-Osagie, African Development Bank

“This avoids a potentially painful situation where Senegal defaults while the mark-to-market for the country is negative, meaning it must face an additional cash outflow in a time of stress. With this mechanism, if Senegal defaults then the hedges stay in place for a certain period of time, allowing us to keep our hedges alive while we may restructure and reprofile our underlying exposures,” says Cissé.

If Senegal defaults, banks can only withdraw from the trade if the mark-to-market reaches a certain threshold, compared to the amount of remaining guarantee.

Senegal is currently at a low risk of default based on current analysis by the International Monetary Fund (IMF), and faces low levels of debt distress risk. Nevertheless, the 13 banks interested in the transaction were hesitant to agree to such terms, resulting in five months of painstaking discussions. Indeed, while there was little pushback on provisions such as the minimum credit rating of the banks involved or currency direction, 10 of the 13 banks interested in the transaction pushed back on the length of the standstill agreement in the event that Senegal defaults – pushing heavily for a standstill agreement of only 12 months.
 
“Negotiating this point with the banks was somewhat challenging, given that this was not a familiar structure for a transaction. The 2.5 years that was agreed upon was a further negotiation from the initial three-year standstill period which was introduced. This feature was included to avoid the swap banks terminating the swap immediately if there was a default, in order to give the Republic a chance to redeem their obligations without the guarantee being called under certain circumstances,” says Eghosa Giwa-Osagie of the ADB’s syndications, co-financing and client solutions department.

Senegal essentially managed to create a soft amortisation profile and lengthen its external debt through hedging derivatives
Thibaud Fourcade, Rothschild & Co

The sheer number of banks involved also created a challenge, with the ADB and Senegal having to ensure every bank’s different internal processes and risk procedures were properly adhered to and that everyone was comfortable with how the derivatives documentation was negotiated. Eventually, the transaction was executed in July, with four of the 13 banks that had originally submitted firm pricing bids. But the fact that so many banks were interested was a big plus.

“Cameroon’s FX swap involved a shorter tenor of 10 years, so it was easier to find counterparties with an appetite for the transaction. To our surprise though, Senegal’s transaction actually attracted more international banks and also closed with more banks than Cameroon’s, who closed with three banks,” says Giwa-Osagie.

But that wasn’t all. Of the $1.4 billion of bonds, there was $300 million in bullet format set to mature in 2021, creating a large repayment obligation in two years’ time. This risk was specifically flagged by the IMF’s 2017 debt sustainability analysis.

“The debt sustainability analysis from the IMF considers a number of categories, one of which is debt service compared to government revenues. Due to the bullet repayment profile of the bond, we expected an overshoot on this ratio in 2021, meaning we were at risk of being de-notched under the IMF’s debt sustainability analysis,” says Cissé.

In order to tackle the risk and avoid one big repayment of $300 million for the Eurobond in 2021, the bond was synthetically re-profiled so that Senegal would receive 100% of the bond repayment amount from the hedging banks in 2021 in order to repay the bond.

On the other leg of the transaction, Senegal repays the banks 10% of principal repayment in 2020, 50% in 2021 and 40% in 2022. The 13 banks interested in Senegal’s forex swap were also interested in the reprofiling, with the transaction eventually closing with four banks.

“Senegal essentially managed to create a soft amortisation profile and lengthen its external debt through hedging derivatives – banks are making a loan to Senegal, starting forward in 2021 through the use of derivatives,” says Rothschild’s Fourcade.

Cissé says that as a result of this reprofiling, they’ve made some debt servicing gains and have managed to retain a good rating from the IMF: “We intend to build on our relationship with private international investors to further fuel Senegal’s development with carefully selected transactions in international markets, while maintaining a strong focus on risk management, as per our cautious debt strategy.”

“Our transaction involves slightly more complex elements than Cameroon’s. It’s a real extension of what can be done through ADB guarantees,” adds Cissé.

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