Sunday, April 2, 2006

A Primer on Sovereign Debt Buybacks and Swaps

According to Medeiros, Polan and Ramlogan, the surge in emerging market debt buyback in 2006 reflected, in particular, liability management operations by Brazil and Russia to decrease debt service and sovereign risk. Though sovereign debt buyback is an important topic, there is little literature on the theme.

Here we summarize a few important aspects of the paper:

1. Sovereign debt buybacks are related to the broader theme of debt management and hence has to be done in tandem with fiscal policy and monetary policy;
2. The main reasons as to why emerging countries have been engaging in debt buyback are: to reduce debt service; to minimize sovereign risk and foster domestic capital markets;
3. The above reasons require trade-offs. This is so because an increase in the debt maturity usually raises its costs if long term interest rates are higher than short-term. Another trade-off, debt managers face is the increase in the cost of debt, when a country switch part of its debt from foreign currency to domestic currency due to higher domestic interest rates (or higher risk premium). Finally, the authors explain the trade-off is the one between FX risk and rollover risk, when countries switch from foreign to domestic debt. Usually, it happens because domestic capital markets are not well developed and hence they tend to offer short-term and floating rate debt.

The paper shows that the complementarities and the costs associated with debt buybacks. In other words, capital market development usually leads to a reduction in liquidity and rollover risk in the long run. In brief, as explained by the authors:
“The crux of buyback and swap evaluation is to determine the combination of cost, risk, and capital market attributes that is associated with the buyback or swap, and whether this combination is superior to the one existing without the buyback or swap, or to the combination that is associated with any other buyback or swap operation that could be undertaken for the same purpose.”

No comments:

Post a Comment