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External and domestic financing in Latin America: developments, sustainability and financial stability implications

“Debt finance and emerging issues in financial integration”

United Nations

New York – April 8-9 2008

The views expressed here do not necessarilly reflect those of the BIS.

Jose Antonio Ocampo

Columbia University

Camilo E Tovar

Bank for International Settlements

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Background

The financing of Latin American economies has experienced a major transformation in the past 10 to 15 years. Two remarkable developments:– Shift from cross-border towards domestic financing.– Shift from bank to bond financing

As a result, capital markets have expanded, deepened and diversified, creating a promising financing alternative.

Such developments help mitigate risks and sources of vulnerability (eg currency mismatches) and should help provide an alternative source of financing when banking sectors are weakened.

Nonetheless, their rapid development pose risks that need to be taken into account.

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Main issues

It is still an open question whether i) reduced reliance on external financing and ii) alternative financing markets in the region are permanent features.

As the pillars supporting the favourable global conditions began to erode, these new domestic markets will have to prove their resilience and the extent to which they offer room of manoeuvre for counter-cyclical policies (in particular, if exchange rate appreciation trends reverse).

Progress in reducing currency mismatches are positive. Nonetheless, local currency debt markets still have a strong

short-term bias and remain highly illiquid. Furthermore, progress in developing corporate bond markets

are an unfulfilled promise, which will raise new risks.

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Outline

Macroeconomic environment

Shifts in financing patterns

Development of local currency bond markets

Sustainability and financial stability considerations

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Macroeconomic environment

In recent years, Latin America has at last witnessed high growth rates (similar to those of the 1960s-1970s). This has been possible due to exceptional international conditions:

– Strong commodity prices

– Exceptional external financing conditions

– Large remittances by migrant workers to the region

Two features are notorious of the current regional situation:

– Growth while generating current account surpluses

– Large accumulation of international reserves

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Current account surpluses

The large CA surpluses are unprecedented in the region’s history, and are mainly associated with the improvement in terms of trade.

Terms of trade

effect in 2007: 3.4%

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Reserve accumulation

A new development policy has been the frequency and scale of intervention in foreign exchange markets. Therefore, several LA countries are operating “dirty” floats.

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Scale of international reserve accumulation

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Reserve accumulation involves costs

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Shifts in financing patterns

Against the background of rapid growth with current account surpluses and reserve accumulation, the region has experienced a shift in financing needs.

In contrast with the past, capital flows are no longer needed to finance current account deficits.

New elements of the dynamics of capital flows and international investment positions:

– Large gross FDI and portfolio inflows

– Incipient but growing gross capital outflows

– Reduced reliance on external financing in net terms

– Reduction in external liabilities positions

– Improved external balance sheets

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Gross and net capital flows

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Changes in cross-border holdings

Debt reduction

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The development of local currency bond markets

An important counterpart of the region’s shift improvement of its net international position is the development of domestic bond markets.

In fact, domestic financing has expanded significantly vis-à-vis external financing.

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Main features of domestic bond markets in Latin America

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Domestic bond markets vary widely in size

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Public sector issuers dominate domestic markets

= USD 808 billion

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Fixed rate debt now accounts for a significant share of domestic government securities in some countries.

Dollar-linked debt has been phased out in some countries (eg

Brazil and Mexico).

However, short-term, floating-rate and inflation-indexed securities continue to be significant across the region.

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The maturity structure of government debt in local currency has expanded

Notwithstanding this progress, the amount of long-term fixed rate securities remains limited, as reflected by the weighted

average maturity of new issues.

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Nominal yield curves have began to emerge

The wider availability of longer-dated bonds is beginning to provide a useful representation of the term structure of interest

rates.

However, the information content

of yield curves remains an issue.

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Only few countries enjoy reasonably strong liquidity

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Sustainability and financial stability considerations

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Is the development of domestic bond markets temporary or permanent?

Some progress at the domestic level appear to be of a permanent nature (eg debt management, better macro policies).

But much seems to depend on the sustainability of the global process of portfolio diversification.

Interestingly, despite the financial turmoil in developed economies capital continues to flow to the region.

Nonetheless, the extent to which domestic bond market will continue to be a dependable source of funding remains to be truly tested.

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Diversification benefits offered by LA domestic bond markets relative to other asset classes

(US dollar-based investors)

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Financial stability considerations

The region has seen an improvement in currency exposures.

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Financial stability considerations

Indirect (and direct evidence for government debt) suggest an improvement in maturity mismatches

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Risks associate to the development of domestic bond markets

As any new financial development, local currency bond market may involve hidden risks. These can be associated with:

– Local currency bond markets may have swapped currency risk for interest refinancing risk.

– Lack of liquidity. This is a concern because:

• Limits the capacity to manage exposures, and

• Constrains the possibility of making rapid adjustments of portfolios without a significant disruption of the market.

– The type of investors (eg domestic vs. foreign). The lack of an appropriate infrastructure to deal with these markets.

– The intrinsic characteristics of the new instruments (ABSs, derivatives, corporate debt, etc…)

– The type of issuer

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Challenges

Improve liquidity:

– Consolidate various forms of public sector debt under a single obligor

– Concentrate government issuance in a limited number of benchmarks, reopening issues where necessary.

– Central banks can use government and other high-grade securities as collateral for their lending operations (Repos).

– Widen the investor base (eg changes in regulations)

– Regional funds (ABF-2) Reduce vulnerability of debt structures to interest rate and

refinancing risk. Increase the issuance by the corporate sector. Spread the risk of bond investment ie expand the investor base.

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Resiliency of local currency bond markets