The Mexican peso financing of US$108 million equivalent for the Decentralized Infrastructure Reform and Development Project was the first IBRD loan conversion into local currency. The transaction eliminated currency risk for the sub- national government, the domestic development bank, and the federal government. federal government. These issues and constraints all contributed to an unattractive pricing structure for Providing financing to Mexican sub-national IBRD loans to sub-sovereigns in Mexico and an governments was challenging due to various inefficient allocation of foreign exchange exposure market conditions and regulations. First, specific for the government. constitutional provisions required the states to borrow exclusively in local currency and from local financial institutions. Secondly, the spread charged IBRD’s objective was to devise a mechanism to over the IBRD cost of funds by the local financial efficiently provide local currency financing to intermediary (state-owned development bank, Mexican sub-national governments at a competitive BANOBRAS) to states and municipalities resulted cost while, simultaneously, reducing the currency in an uncompetitive overall cost. and interest rate risks to BANOBRAS and the Lastly, the financial intermediaries had traditionally guarantor (the Government of Mexico). hedged against foreign currency exposure through a foreign exchange trust fund established by the Ministry of Finance, effectively concentrating all IBRD was able to efficiently provide Mexican peso foreign exchange risk relating to foreign currency financing to sub-nationals using the well-developed borrowing by sub-nationals in the hands of the Mexican peso swap market. The transaction worked as follows:  Borrower submits request to withdraw funds. Amount IBRD executes swap transactions with an US$108 million international financial intermediary matching the Approval Date conditions of the disbursement. June 8, 2004  An initial exchange of US dollars into pesos Maturity 18 years with 3-year takes place under the swap transaction. grace period  The peso amount is disbursed to BANOBRAS, Lending Instrument Investment Loan which has to service and repay that disbursed amount in pesos. Lending Terms Fixed Spread Loan  Pricing is dependent on the price IBRD gets from the market. Figure 1: Financial Structure of Mexico’s Foreign  BANOBRAS adds its own lending spread and Currency Management via the Swap Market passes the cost on to the final beneficiary. The sub-national government was able to obtain IBRD local currency financing at a very attractive cost through the proper combination of financial products. For practical purposes, IBRD’s local currency financing resembles a line of credit denominated in US dollars that is disbursed, serviced, and repaid in pesos. This financing structure transfers foreign currency risk from the borrower to the market. As a consequence, the currency and interest rate risks to the borrower, the guarantor, and the final beneficiary are drastically reduced. Miguel Navarro-Martin, Head of Banking Products, mnavarromartin@worldbank.org, +1 (202) 458 4722 Photo Credits Front: Curt Carnemark / World Bank