Download New currency hedging possibilities in Cambodia`s

DERIVATIVES
New currency hedging
possibilities in Cambodia’s
growing market
A benchmark derivative deal has shown how
Cambodian institutions can manage their currency
risks. Here are the factors to consider
L
ast year saw one of the first
currency derivative transactions
between
a
Cambodian
microfinance institution (MFI)
and an offshore counterparty. This involved:
the Currency Exchange Fund or TCX (the
market maker); Angkor Mikroheranhvatho
Kampuchea or AMK (the counterparty that
hedged its currency risk) and the authors of
this article.
The CEO of AMK said the deal “secured
a source of long-term hedging in KHR
[Khmer Riel]” and “diversif[ied] our access
to the sole commercial bank offering
currency solutions in Cambodia”.
Besides diversifying AMK’s counterparty
risk with an institution rated A- by S&P,
the open line offered to AMK to hedge its
currency risk is an effective way to enable
MFIs to better match their assets and
liabilities, as TCX provides pricing for
long-term Non-deliverable forwards
(NDF) and cross currency swaps (CCS) are
not available in the market. The idea of
getting out of so-called wrong way risk is
another concept particularly relevant to
financial institutions and local players. If
the KHR were to depreciate unexpectedly,
the counterparty risk of the local bank
offering a hedge would also deteriorate, due
to the high correlation between the local
currency and local counterparty providing
the hedge.
“
AMK’s treasurer explained that although
TCX requests its clients to post collateral
and respond to collateral calls, which had
to be factored in the decision to hedge its
risk with the Dutch-based fund, the pricing
was competitive. The higher interest rate to
pay was modest enough to extend the
maturity of the hedge and avoid rolling
over the shorter hedging facility with its
local partner. Another interesting aspect of
the transaction was AMK’s willingness to
institutionalise its risk management
practices by trading with TCX based on
international standard documentation
(International Swaps and Derivatives
Association (ISDA)/Credit Support Annex)
which it may use to hedge its risk with
other banks of international tenure
whenever the market develops.
Cambodia’s investment and
growth story to continue
The economic situation in Cambodia
continues to be stable. Real growth will
remain strong at around seven percent,
supported by recovering foreign demand
and foreign direct investment. Overall,
Cambodia is considered one of the brightest
frontier growth stories in Asia. Its open
attitude towards foreign investment is
expected to spur further growth in 2013 and
beyond. Further, foreign investors are
anticipated to benefit from the opening up
By enabling international lenders to
offer long-term debt in local currency, an
important source of risk is removed for
local enterprises
1 IFLR/October 2013
of the Association of Southeast Asian
Nations (ASEAN) as a single market, which
is expected to launch at the end of
Cambodia has healthy growth potential in
manufacturing, tourism, and agriculture.
Labour intensive industries will keep
benefitting from cheap labour as production
facilities relocate to the country, mainly
from the manufacturing hub of China. This
would allow Cambodia to continue its seven
percent growth rate of for the next two years,
strongly supported by foreign direct
investment. However, the country is not
reaching its full potential due to stillsubdued demand in Cambodia’s main
export markets – the US and the eurozone.
A complete recovery in foreign demand,
combined with the launch of hydrocarbon
extraction, will drive growth beyond seven
percent from 2016 onwards according to the
independent research arm of the fund
Mantis.
Based on a stable commodity price
outlook, only moderate domestic demand,
and slow recovery in the US and the
eurozone, inflation will remain stable,
slowly approaching five percent in 2015.
Although inflationary pressures will
reappear once the economic recovery
gathers pace, this will not threaten
Cambodia’s stability. Inflation will stay
below six percent beyond 2016. Overall
macroeconomic stability, combined with
continuously growing foreign exchange
reserves of the National Bank of Cambodia
which stand at almost 5.8 months of
imports at the end of 2012, provide
sufficient grounds for making a de-facto
peg of the riel to the dollar sustainable in
the long term.
Cambodia’s credit growth is still strong,
and as such, remains the main risk to
Mantis’s forecast. The country’s credit-toGDP ratio of 40% is significantly higher
than the median for low-income countries,
which is 25%. This has sparked worries
that it might become excessive, resulting in
pressure on asset prices and the creation of
a bubble. Nevertheless, Cambodia’s creditto-GDP ratio of below 50% is still very low
in a regional context, especially when
compared with Thailand and Vietnam’s
ratios, which are higher than 100%.
Cambodia’s need for hedging
The majority of lending into Cambodia
consists of USD-denominated facilities
made available by at least 33 offshore
lenders. In 2012, the 17 largest financial
institutions recorded an outstanding loan
portfolio $1.95Bn. That number follows
years of credit growth and was 20% upon
2011 levels, and does not include foreign
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DERIVATIVES
“
Government agencies have indicated
that they do not consider the activities
of offshore hedge providers to fall under
their supervision
direct investment into infrastructure and
other nonfinancial institutions.
However, as in other largely so-called
dollarised economies, Cambodia has not
spurred financial innovations domestically
to offer a way-out to the market to hedge
its currency risk. By enabling international
lenders to offer long-term debt in local
currency, an important source of risk is
removed for local enterprises. This
contributes directly to their viability, by
reducing their cost of capital. TCX helps
reduce the excessive reliance on short-term
debt that characterises lending in frontier
markets. This lowers the probability of selffuelling liquidity crises, supports long-term
financial
inflows
(mainly
from
development
finance
institutions),
contributes to an overall strengthening of
the balance sheets of corporate and
financial institutions, and enhances the
resilience and growth potential of emerging
economies. Helping these markets to
acquire the capacity to borrow long-term
both locally and abroad in their own
currencies should be a priority for officials
striving to make the world a safer financial
place, and seeking to quicken the pace,
sustainability and resilience of growth.
Borrowers with long-term assets must
often choose between two equally risky and
unattractive alternatives: short-term debt in
local currency raised through, for instance,
deposits; or, (ii) longterm debt in hard
currency, sourced from international
markets. The first alternative creates a
maturity mismatch, the second a currency
mismatch. These mismatches can cause
serious financial distress in case of severe
interest rate or currency movements, which
are frequently occurring events in emerging
economies.
TCX was established to absorb the
foreign exchange and interest rate risks
associated with long-term funding. These
risks are transferred to the fund means of
swap and forward agreements. It provides
hedging products that are not effectively
covered by commercial banks in Cambodia
for maturities up to 5 years.
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Legal challenges and solutions
The ISDA documentation provides a robust
structure for trading currency derivatives in
more developed markets, but significant fine
tuning was required to reflect Cambodian
law and practice and to give the comfort
needed to an international swap dealer to
hedge a Cambodian MFI.
Licensing requirements / authority
Cambodian law is silent on which licensing
requirements, if any, apply to offshore hedge
providers. However, as a matter of practice
the relevant government agencies (the
National Bank of Cambodia and the
Securities Exchange Commission of
Cambodia) have indicated that they do not
consider the activities of offshore hedge
providers to fall under their supervision.
In terms of onshore counterparties,
article 2 of the Prakas on the Licensing of
Microfinance Institutions dated January 11
2000, provides that MFIs are prohibited
from entering into ‘derivative transactions’.
However, when read in the context of
article 2 as a whole, this prohibition would
appear to be intended to apply only to a
Cambodian MFI that provides hedging to
others; not to an MFI that enters into a
derivative transaction for the purpose of
hedging its own risk.
Transparency issues and enforceability of
foreign judgments
Bringing legal proceedings in a Cambodian
court may not be convenient for an offshore
hedge provider due to:
a. the language of the proceedings being
in Khmer;
b. any documentary evidence being
required to be translated into Khmer to
be admissible;
c. the unwillingness/inability of the court
to apply a foreign governing law; and
d. transparency issues.
In addition, enforcing a judgment of a
foreign court in Cambodia is not
technically possible.
However, Cambodia is a signatory to the
1958 New York Convention on the
Recognition and Enforcement of Foreign
Arbitral Awards and has enacted the Law
on Commercial Arbitration and the Law on
Civil Procedure. Read together, these
require that arbitral awards be recognised,
upheld and enforced by the courts of
Cambodia without re-trying the case or
otherwise examining the merits subject to
limited exceptions.
Governing law
Although Cambodian laws do not impose
any restriction on the choice of law
governing an agreement, prevailing judicial
practice indicates that Cambodian courts
may be unwilling or unable to recognise or
give effect to the laws of any other
jurisdiction. This issue is mitigated by
selecting arbitration as the dispute resolution
mechanism.
Counterparty sophistication
Pursuant to article 529 of the Civil Code
(2011) a ‘seller’ (which is likely to capture a
hedge provider) must explain the essential
terms of a transaction to the ‘buyer’
(counterparty). This is somewhat wider in
scope than the usual representation given by
counterparties to the effect that they have
received independent advice and understand
the risks of the transaction. Further, article
346 of the Civil Code allows a party to avoid
an agreement on the basis that it made a
mistake with regards to the terms. It is
therefore prudent to document the process
by which a derivative transaction and the
risks associated with it are explained to
counterparties.
Insolvency of banks and other ‘Covered
Entities’
The general provisions applicable to
insolvencies and contained in the Insolvency
Law (2007) do not apply to banks and other
entities, such as microfinance institutions,
which are collectively referred to as ‘Covered
Entities’. Instead, the Law on Banks and
Financial Institutions contains provisions
regarding the insolvency of those entities.
These cover, in the following sequence:
a. a failure of the Covered Entity to
comply with solvency thresholds;
b. a failure of the Covered Entity’s
‘influential shareholder(s)’ to inject
further capital; and
c. administration of the Covered Entity
(these provisions are far less detailed
than those contained in the Insolvency
Law and it is likely that a court would
apply the provisions of the Insolvency
Law (to the extent not inconsistent
with the LBFI) at the stage of
administration of a Covered Entity).
Careful consideration needs to be given
IFLR/October 2013 2
DERIVATIVES
to the Bankruptcy Event of Default,
Automatic Early Termination provisions
and section 6.
Close-out netting
The enforceability of the close-out netting
provisions under section 6(e) of the ISDA
Master Agreement is unclear. As such, it is
possible that an insolvency official will be
able to cherry-pick the (in-the-money)
transactions they wish to affirm. However,
cherry-picking is not permitted where the
obligations of the parties under the relevant
agreement have been ‘fully performed’. It is
more likely that such obligations will be
considered as having been fully performed if
a form of ‘Automatic Early Termination’
applies.
Securities-linked derivatives
The core legislation dealing with derivatives
in Cambodia is the Law on Banks and
Financial Institutions (1999) and its
implementation falls within the authority of
the National Bank of Cambodia. However,
the more recently enacted Law on the
Issuance of and Trading of Non-
Government Securities (2007), the
implementation of which is the
responsibility of the Securities and Exchange
Commission
of
Cambodia,
treats
“securities” as including derivatives that are
linked to equity securities, debt securities
and interests in managed investment
schemes. It is not unusual for supervision of
derivatives to be split between different
governmental authorities but the line
between the responsibility of the National
Bank of Cambodia and the Securities
Exchange Commission of Cambodia
remains unclear and care must be taken to
ensure compliance with both the banking
law and the securities law.
Recording of telephone conversations
Parties typically include provisions in the
schedule to their ISDA Master Agreements
providing that they may record telephone
conversations and submit these as evidence
in court. There is no restriction on including
such a provision, but it is unlikely that a
court would admit such recordings as
evidence, particularly if they are not in
Khmer. It is therefore appropriate to keep
“
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records
of
Credit support
As Cambodia’s derivatives market is in its
infancy, counterparties have not yet started
taking advantage of the standard ISDA-form
credit support documentation. However, it
is not uncommon for hedge providers to
take security over accounts or third-party
guarantees. In relation to guarantees, special
care needs to be taken to ensure that it
complies with the formal requirements of
the Civil Code.
Third Party Rights
Article 379 of the Civil Code (provides that
a third party beneficiary of an obligation
may enforce compliance with it. It is unclear
whether this provision may be ousted by the
parties, but the better view appears to be
that it may be.
Interest withholding tax
Cambodia is not a signatory to any bilateral
or multilateral tax treaties. As such, a
resident taxpayer carrying on business who
makes payment of interest or certain other
types of payments, such as fees, to a nonresident taxpayer is required to withhold and
pay as tax a flat rate of 14% of the amount
paid. Consideration of an appropriate grossup is therefore key and the standard payer
representations and payee representations
made under sections 3(e) and 3(f ) of the
ISDA Master Agreement will require
amendment.
By DFDL Legal and Tax’s Patrick Smith in
Phnom Penh and TCX’s Jerome Pirouz in
Amsterdam
“
“
“
As Cambodia’s derivatives market is in
its infancy, counterparties have not yet
started taking advantage of the
standard ISDA-form credit support
documentation
contemporaneous written
telephone conversations.
IFLR provides an opportunity to describe for
lawyers and others throughout the world matters
of domestic or multinational law that affect
lawyers in various parts of the world.
David Bernstein, corporate partner, K&L Gates
What I find particularly intriguing about IFLR is
its ability to stay on top on developments and
trends, always one step ahead of and different
from any competitor.
Peter L Brechan, partner, Haavind Vislie
3 IFLR/October 2013
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