Finally, authorities also consider the financing costs compared to USD. When considering tapping a non-USD market, the DMO always computes the equivalent cost of funding in USD using a CCS. Last year, this factor went against the funding in EUR, but cost considerations were overridden by the benefits brought by the other three factors.<sup>29</sup> While currently, the funding in EUR may be relatively expensive, the spread to the USD funding should gradually narrow as investors get familiar with the issuer. In this context, the Chileans see the move towards the EUR as a strategic one.

# **An important funding alternative for a large issuer: The case of Mexico**

The key driver of Mexico’s debt management strategy since the Tequila crisis in 1994 has been the development of the domestic debt market. Mexico has modified the composition of the government debt portfolio to the point where four-fifths are denominated in local currency. The Congress even discussed the possibility of ruling out the use of FX debt, but the Ministry of Finance defended the need to have alternative funding sources to provide flexibility to the government and avenues to reduce funding costs.

There is no explicit benchmark for the currency composition of the FX debt, but there are internal targets derived from the cost-risk analysis. At the time of writing this note, 73% of marketable FX debt was denominated in USD and this share increases to 80% when non-marketable debt is included. This currency composition is based on a Cost-at-Risk (CaR) model where risk is driven by the volatility of exchange and interest rates. Exchange rates are the main drivers of risk and the recent depreciation of the MXP close to 20% versus the USD has increased the debt stock by 2% of GDP.<sup>30</sup> Over time, the government debt management strategy has allowed the reduction of both exposures by increasing the share of the local currency, reducing the share of floating rate loans and reducing short-term debt.

The CaR model quantifies the cost-risk trade-off with cost modeled as expected cost and risk as the volatility of that cost. The model finds value in the diversification brought by EUR and JPY whose exchange rates versus the MXP have a negative correlation with the USD/MXP rate. These negative correlations have helped contain the increase in debt service since 2015 when the MXP started falling versus the USD. According to the model, the share of the EUR in the FX debt portfolio could be as high as 20%.<sup>31</sup> While funding in EUR has been at times relatively expensive, the authorities are willing to incur in the extra cost to access the benefits of entering the market in EUR. Based on the CCS, issuing

> 29 For Chile, the EUR market was relatively expensive as illustrated by the recent issue priced at +110 over midswaps compared to +65 of Poland that had a lower credit rating. According to the authorities, this was due to investors being less familiar with Chile and possibly too concerned with the sovereign dependence on copper and the gloomy perspectives for commodities in general. However, in the same placement Chile tapped simultaneously EUR and USD markets and the book building went better for the EUR tranche (lower premium of 5-8 bps for EUR vs 15-20 bps for USD).

> 30 Exposure to interest rates is lower because of the smooth redemption profile and the small share of variable rate debt (limited to the loans contracted with multi/bilaterals).

> 31 According to the authorities, the FX portfolio included 16% EUR, 7% JPY and 4% GBP and the model indicated there was room to increase the share of the EUR at the expense of the USD.

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