TCX regularly welcomes interns to work on a certain project or analyze a certain question. Toph Cottle, a master’s student at Johns Hopkins SAIS and University of London SOAS, analyzed for TCX the benefits, if any, of increasing the share of local-currency denominated debt in sovereign debt portfolios. In his own words:

“Increasing debt management capacity for sovereigns is a crucial development challenge. The COVID-19 economic shutdown caused a massive increase in debt, but also in currency risk held by governments, resulting in dozens of sovereigns credit downgrades.

Moreover, nations need further financing for SDGs and climate pledges. One important focus of debt management is to minimize long-term costs of financing, while protecting debt sustainability.

In my paper, I examine one critical cost element of debt: the credit spread. To be concrete: I compare the credit spreads of debts denominated in local currencies versus debts denominated in foreign currencies (essentially USD).”

The result of Toph’s work is very interesting: there seem to be clear advantages to holding and increasing sovereign debt in local currency. Funding in local currencies not only reduces the FX risk exposure, but LC credit spreads are also lower than FC credit spreads in 20 of 21 analyzed countries. Furthermore, local-currency credit spreads are more resistant to changes in global volatility than foreign-currency credit spreads.

Please read his full paper here. Highly recommended!