Emerging markets are a strategic priority for Toyota Motors Corporation. Its captive finance arm, Toyota Financial Services, is expected to support Toyota’s sales efforts in these markets whenever possible. Access to diversified, cost-effective sources of term liquidity is therefore critical to Toyota Financial Services’ success in maintaining its competitive position in markets such as Brazil.
But even when attractive offshore funding opportunities arise, internal risk management policies related to emerging market sovereign risk exposure must be respected. What are some of the options and possibilities available to treasurers wanting to mitigate the sovereign risk associated with cross-border funding? This article will discuss Toyota Financial Services’ evolution and approach towards managing its exposure to Brazilian sovereign risk.
Background and Funding Opportunity
Banco Toyota do Brasil (BTB) is Toyota Financial Services’ affiliate in Brazil. BTB was established in 1999 to provide consumer retail, lease, dealer financing and insurance products to Toyota/Lexus dealers and their customers in Brazil. BTB’s US$1bn balance sheet has benefited from the strong Brazilian economy and growth in the domestic automotive market. BTB funds itself primarily through the Brazilian interbank market and issues certificates of deposit (CDs) and finance bills supported by a brAAA, standalone, domestic credit rating from Standard & Poor’s (S&P).
Strong capital inflows to Brazil over the past few years have created pricing disparities between the Brazilian real (BRL) onshore and offshore swap markets. Periodically, companies located in Brazil that borrow foreign currency from offshore sources are able to swap and hedge the proceeds in BRL onshore at significant savings compared to domestic alternatives. BTB wished to take full advantage of such opportunities, and Toyota Financial Services’ global banking relationships were engaged.
Mitigating Sovereign Risk When Funding from Offshore Banks
Several banks were prepared to provide BTB with US dollar (USD) denominated term loans from their US offices, and the economics were compelling. However, a key risk was BTB’s inability to pay its lenders, which in turn triggered an event of default under its loan agreements. The issue was not BTB’s inability to pay because of its creditworthiness but, rather, its inability to pay due to a Brazilian sovereign event. Specifically, BTB would be exposed if the Brazilian government took actions that resulted in the BRL becoming inconvertible and/or if funds were non-transferable outside of Brazil. In other words, if BTB couldn’t swap BRL into USD or remit funds back to its offshore lenders, then it would be in technical default. And irrespective of the probability (or improbability) of a Brazilian sovereign event actually occurring, Toyota Financial Services’ global policies forbade exposure of its debt to emerging market sovereign risk. Unless the risk could be properly mitigated, BTB would lose its offshore funding opportunity.
The solution was to restructure BTB’s loan agreements. If BTB was unable to pay due to a sovereign event, then the loan agreement would now allow BTB to pay the equivalent USD amount in BRL to an account in Brazil as specified by the lender. This in turn fulfilled BTB’s USD loan payment obligations under the agreement. The ability of BTB to substitute its cross-border payment obligation with an in-country payment in its local currency effectively extinguished its exposure. In short, the sovereign risk was shifted from BTB to the banks.
The banks’ reactions were mixed. Some were concerned with the revised language, while others were comfortable with their existing exposure levels to Brazilian risk. And it was clear that some would simply price the sovereign risk into the loans’ cost of funds. Either way, the end result left BTB in a position to opportunistically execute USD term loans and benefit from the swap arbitrage, while simultaneously complying with corporate risk management policies.
Sovereign Risk and Cross-border Intercompany Funding in a Time of Crisis
BTB has drawn a number of offshore bank loans since 2007, and this funding source and the indirect method of managing sovereign risk served BTB well for several years. As the global financial crisis continued to deteriorate, however, many international banks either began to deleverage from emerging markets, or capital constraints made their loan pricing uneconomical. Although the arbitrage opportunities for Brazilian borrowers that could still fund offshore persisted, BTB couldn’t effectively access the global capital markets to tap foreign currency debt. However, BTB’s sister company, Toyota Motors Credit Corporation (TMCC), could. And with a global credit rating of AA-/Aa3, TMCC can source liquidity through its global funding platforms more cost effectively than most international banks or other captive finance competitors.
TMCC is Toyota Financial Services’ US affiliate. TMCC’s team of 45 treasury professionals located in Torrance, California, co-ordinate Toyota Financial Services’ global capital market funding activities (US$20.5bn of debt securities issued in the US last year). It manages over US$20bn of direct issuance commercial paper and oversees the treasury activities of its Americas region affiliates. TMCC is already an intercompany funding provider to multiple affiliates and has the capabilities to easily source and manage term funding for BTB. But even though a compelling economic case was made, TMCC management was unprepared at that time to assume any Brazilian cross-border risk, particularly given the on-going precarious European sovereign environment.
TMCC’s treasury team explored different risk management possibilities such as the purchase of Brazilian credit default swaps (CDS) or the execution offsetting derivative structures. However, all were imperfect hedges that were either cost prohibitive or would leave TMCC exposed to risk. For example, a CDS would be ineffective against a currency inconvertibility event if the Brazilian government continued to make payments on its sovereign bonds. And with offsetting derivatives structures, one must make strong assumptions with respect to the behavior of the BRL onshore/offshore swap markets following a sovereign event. After further evaluation, treasury ultimately chose political risk insurance to protect its intercompany lending activities.
Political Risk Insurance
Political risk insurance (PRI) functions much like any other insurance policy, whereby a policy is underwritten to protect a policyholder against certain risks during the policy’s life. PRI is generally meant to protect the policyholder against loss from expropriation, political violence, or currency inconvertibility/transferability events. Loss from expropriation or political violence is not a material risk applicable to Toyota Financial Services’ business. However, loss from inconvertibility/transferability events related to cross-border lending to emerging market affiliates is indeed a material risk. A policy to address this sole risk could be written for TMCC.
TMCC approached a broker who specialised in PRI. The broker solicited underwriters’ interest in insuring TMCC’s potential lending activities with BTB. TMCC then provided a forecast of its portfolio including loan amounts, tenures, disbursement dates, forecast interest rates, and the loans’ amortisation schedule (quarterly loan amortisation versus bullet repayment was chosen to reduce the policy’s premium). The underwriters quoted an annual premium based on the portfolio’s outstanding balance each year (note that the premium’s cost is clearly driven by the probability of the risk event occurring: e.g. sovereign risk for Brazil is much cheaper to insure today than, say, for Argentina or Venezuela). At the end of each premium period, a ‘true up’ would occur between the forecasted loans’ cash flows and the drawn loans’ cash flows, with the premium difference added or subtracted to the following year’s premium.
TMCC may make a claim after proving loss from non-payment due to the risk events defined in the policy. Particular to PRI is a negotiable ‘waiting period’ of anywhere between 3-12 months before compensation for the claim is paid. The waiting period provides time for the sovereign event to potentially reverse or correct, allowing the borrower to then resume payments or make ‘catch-up’ payments to the insured during this period.
TMCC executed a US$150m, seven-year policy in 2011 to protect TMCC against losses on a basket of Brazilian intercompany loans. To date, loans totaling US$125m with tenures of 6-7 years have been disbursed. BTB was able to capitalise on the swap arbitrage opportunities and will enjoy risk-adjusted interest expense savings of US$16m over the life of these loans compared to domestic alternatives. Furthermore, BTB is well-positioned to continue offering competitive automotive financing to Toyota dealers and their customers, particularly when production of small-sized vehicles in Toyota’s new Brazilian factory commences later this year in 2012.
Additionally, the evolution of TMCC treasury’s efforts to deliver effective risk mitigation solutions has provided the company’s management with an enhanced understanding of emerging market sovereign risk and related risk management strategies.
All of the affiliates’ existing offshore funding arrangements have now been reviewed to determine if proper risk mitigation structures are in place, and global risk management policies and guidelines have since been modified. Consequently, TMCC’s intercompany funding capabilities can be leveraged and opportunistic funding structures for other affiliates in emerging markets are under evaluation.
Political risk insurance may not be the most suitable or appropriate choice in all cases for treasurers wanting to manage cross-border risk. For TMCC to support its intercompany lending opportunities and meet its global policy requirements, however, PRI was chosen as the simpler, better correlated and more cost-effective solution to manage its exposure to Brazilian sovereign risk.
- This case study is based upon an entry into the gtnews Awards for Global Corporate Treasury 2012, sponsored by Bank of America Merrill Lynch (BofA Merrill). The winners of this year’s annual awards, now in its third staging, were only revealed at a gala dinner on 24 May at the Sofitel Grand Hotel in Amsterdam, the Netherlands, after the opening of the two-day gtnews Forum for Global Corporate Treasury conference. This winning Toyota entry is shared here from the risk management category as a best practice guideline and commentary on Brazilian operations. To see a full report on all the Awards winners and the gala dinner on 24 May please click here.
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