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

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External and domestic financing in Latin America
developments, sustainability and financial
stability implications
Jose Antonio Ocampo Columbia University Camilo E Tovar Bank for International Settlements

• 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.
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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
  regions 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 regions 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
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