EMERGING MARKETS AND DEVELOPMENT RANKING

In the eyes of many, development banking and emerging markets, which are often referred to as developing markets, are closely linked. This is certainly true and, for our specific purposes, in more ways than commonly thought.

As we have said before (and will explore in greater detail later), development institutions lend to underdeveloped or developing countries roughly in two ways: by using funds given by donors (this term is used with a certain freedom) or by using funds raised in the capital markets, that is, by using the tools of investment banking. As we shall see in the following sections, in the former situation they are in contact with emerging countries only through lending, in the latter also through borrowing.

Borrowing

We can observe in Figure 4.2 the outstanding principal amounts of bonds issued by the International Bank for Reconstruction and Development (part of the World Bank Group), the European Investment Bank, and the Asian Development Bank in emerging market currencies. The range of currencies is extremely varied. We shall see later how a treasury business works, but the first question one would probably ask is, why would a development institution issue debt in an emerging market currency? The reasons are twofold, the first applying to any treasury operation and the second being relevant only in the case of development banking.

One could say that the goal of a treasury desk is to borrow at the cheapest possible rate. In order to do so they must issue bonds that attract the

TABLE 4.2 Principal outstanding of bonds issued in emerging market currencies by selected development institutions as of September 13, 2011 (in millions of local currency).

highest level of interest in order to sell the bond at the highest price (the details on how this takes place are left vague on purpose and are left for future chapters).

Bonds in emerging markets' currencies issued by development banks are particularly attractive to investors for several reasons. They offer diversification by being only as risky as the issuing institution they offer exposure to a currency and its rates that would be otherwise much riskier; it is an attractive way to invest funds gained within a certain country (e.g., a manufacturer needing to invest profits in local currency). These reasons could be the same as those of any financial institution looking for investors.

One usually considers the commitment to development as being purely expressed through favorable lending terms; however, this is an incomplete picture. If a developed financial market is believed to be important for the overall development of a country, then issuing good quality debt in that currency is a fundamental step. Let us imagine that a country with currency X has practically a nonexistent financial market except for deposits which are short dated, illiquid, and accessible mainly to locals (although we are not assuming that the currency is controlled).

Let us imagine that a development bank issues a two-year bond in currency X: the bond pays a semiannual fixed coupon in X. An investor buying this bond will receive four fixed amounts of X and might want to hedge this exposure; another market participant agrees to enter into an agreement with the investor to exchange these amounts into USD at an agreed price, in practice creating an X/USD FX forwards market. The market participant is now in possession of X, which he might want to invest. He can do this either in the economy itself (which, under the point of view of development, is a positive consequence) or by investing in proper government bonds, which, by now, due to the presence of new investors, might have started being issued.

When confidence and liquidity grows, interest rate swaps and floating- rate bonds would eventually follow. The initial issue of debt in currency X by an institution with good credit can therefore create a virtuous circle to the benefit of the development of a financial market.