1

San JoseSan JoseFebruary 9, 2007February 9, 2007

Eduardo BorenszteinEduardo Borensztein

San JoseSan JoseFebruary 9, 2007February 9, 2007

Eduardo BorenszteinEduardo Borensztein

2

Why Now?Why Now?(when we have no crises)(when we have no crises)

• Precisely. Crises can be prevented (at least some)

• Favorable Markets. Possibility of improving debt management (local currency, new instruments)

• Role of the IFIs is being reconsidered. New ideas to make global finance safer

3

OutlineOutline

•Stylized Facts• International Borrowing•Domestic Borrowing•Towards Safer Debt

4

OutlineOutline

• Stylized FactsStylized Facts• International BorrowingInternational Borrowing• Domestic BorrowingDomestic Borrowing• Towards Safer DebtTowards Safer Debt

5

Public debt is not going Public debt is not going away…away…

Public Debt in Latin America and the Caribbean

0

20

40

60

80

100

120

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 20050

10

20

30

40

50

60

70

80Weighted average (right axis)

Average (left axis)

Median (right axis)

Weighted average excluding Argentina (right axis)

Source: Authors' calculations based on Cowan et al. (2006).Note: Countries included: Argentina, Bahamas, Barbados, Belize, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Guyana, Haiti, Honduras, Jamaica, Mexico, Nicaragua, Panama, Paraguay, Peru, Trinidad and Tobago, Uruguay, and Venezuela.

6

..and domestic debt is ..and domestic debt is increasingincreasing

Composition of Public Debt in Emerging Latin American Countries

0

10

20

30

40

50

60

70

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Domestic debtExternal due to private creditorsExternal due to official creditors

Source : Authors' calculations based on Cowan et al. (2006).Note : Countries included: Argentina, Brazil, Chile, Colombia, Ecuador, El Salvador, Mexico, Panama, Peru, Uruguay, and Venezuela.

7

Domestic Debt is also Domestic Debt is also growing in the smaller growing in the smaller

marketsmarkets

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

Domestic

External due to Private Creditors

External due to Official Creditors

Countries Included: Barbados, Belize, Bolivia, Costa Rica, Guatemala, Honduras, Jamaica, Nicaragua, Paraguay.

8

Official borrowing Official borrowing remains important…remains important…

Composition of Public External Debt in Latin American and Caribbean Countries

with Limited Market Access

0

10

20

30

40

50

60

70

80

90

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Bank loans

Bonded debt

Other external

Bilateral

Multilaterals

IMF

Source : Authors' calculations based on Cowan et al. (2006).Note : Countries included: Belize, Bolivia, Costa Rica, Guatemala, Guyana, Honduras, Jamaica, Nicaragua, and Paraguay.

9

LAC debt levels are not LAC debt levels are not very high…very high…

Public Debt around the World (weighted averages)

0 10 20 30 40 50 60 70 80 90

EAP

ECA

LAC

SSA

IND

MNA

SAS

2001–2005

1996–2000

1991–1995

Source: Authors' calculations based on Jaimovich and Panizza (2006).

10

……but debt structure but debt structure matters more than debt matters more than debt

levellevel Public Debt and Sovereign Rating (1995–2005)

Italy

Jamaica

Japan

Israel

Belgium

Ghana

Jordan

Saudi Arabia

Pakistan

Egypt

MongoliaSenegal

Morocco

Grenada

Argentina

Barbados

Bolivia

Panama

Indonesia

Bulgaria

Portugal

Cyprus

Hungary

Sweden

Philippines

Papua New Guinea

Austria

Tunisia

Malta

Denmark

Ecuador

India

Benin

CanadaFinland

Qatar

Netherlands

SpainFrance

Uruguay

Russian Federation

Venezuela

United Kingdom

PeruCroatia

Brazil

Poland

South Africa

Ireland

Malaysia

Trinidad and Tobago

United States

Iceland

Belize

Turkey

Costa Rica

Ukraine

El SalvadorColombia

Bahamas

New Zealand

Paraguay

Germany

Slovak RepublicMexico

Switzerland

Lithuania

Bahrain

Slovenia

Norway

OmanChinaThailand

Kazakhstan

Guatemala

KoreaCzech RepublicChile

Australia

Latvia

Botswana

Estonia

Luxembourg

0 10 20 30 40 50 60 70 80 90 100 110

Public debt (percentage of GDP)

Sta

ndar

d &

Poo

r's s

over

eign

rat

ing

AAA

B

BB?

BBB

A?

AA?

Source : Jaimovich and Panizza (2006) and Standard & Poor's.

Investment grade line

11

Composition of Sovereign Debt, 2000-Composition of Sovereign Debt, 2000-0404

Domestic debt in local currency Domestic debt in foreign currency External debt

.

Costa Rica 1

0 10 20 30 40 50 60

2000 2001 2002 2003 2004

Dominican Republic 2

0 10 20 30 40 50 60

2000 2001 2002 2003 2004

Guatemala 4

0 5

10 15 20 25 30

2000 2001 2002 2003 2004 4 Central government.

El Salvador 3

0 10 20 30 40 50 60

2000 2001 2002 2003 2004 3 Nonfinancial public sector.

Panama 7

0 10 20 30 40 50 60 70 80

2000 2001 2002 2003 2004 7 General government.

Honduras 5

0 10 20 30 40 50 60 70 80

2000 2001 2002 2003 2004 5 Nonfinancial public sector.

Nicaragua 6

0 20 40 60 80

100 120 140 160 180 200

2000 2001 2002 2003 2004

1 Public sector. 2

Nonfinancial public sector and central bank.

6 Public sector and central bank.

(in percent of GDP)

Source: Faria and Tolosa, forthcoming IMF Occasional Paper

12

Structure of External DebtStructure of External Debt 2001–04 2001–04

,

GROUP ITotal PPG debt Total PPG debt Privately-held PPG debt

GROUP IITotal PPG debt Total PPG debt Privately-held PPG debt

Group I consists of Costa Rica, Dominican Republic, El Salvador, Guatemala, and Panama. Group II includes Honduras and Nicaragua.

Concessional

Private

Official Concessional

Nonconcessional

Private

OfficialNonconcessional

Bonds

OtherBank loans

Other

Bank loans

Source: Faria and Tolosa, forthcoming IMF Occasional Paper

13

Debt and DeficitsDebt and Deficits

• Discussions on how to control the growth public debt focus on the fiscal deficit

• This is not surprising as: DEBT GROWTH = DEFICIT + SF

• We expect SF (stock-flow reconciliation) to be a small adjustment

• But this is not the case

14

SF around the worldSF around the worldThe Stock- Flow Adjustment

(percentage of GDP)

0 1 2 3 4 5 6 7 8 9 10

Advanced economies

South Asia

East Asia and Pacific

Eastern Europe and Central Asia

All Countries

Middle East and North Africa

Latin America and the Caribbean

Sub-Saharan Africa

All observations

Excluding outliers

Source : Campos, Jaimovich, and Panizza (2006).

15

SF around the worldSF around the world

Decomposition of Debt Growth in Different Regions of the World

-15

0

15

IND SAS Caribbean EAP ECA MNA LA SSA

Per

cent

age

of G

DP Inflation

GDP growth

PrimarybalanceInterestexpenditureStock flowadjustment

Source: Campos, Jaimovich, and Panizza (2006).

16

OutlineOutline

• Facts Facts • International BorrowingInternational Borrowing• Domestic BorrowingDomestic Borrowing• Towards Safer DebtTowards Safer Debt

17

The emerging bond The emerging bond market todaymarket today

• Private international lending revived in the 1970s in the form of syndicated bank loans

• This new wave of sovereign lending ended with the debt crisis of the 1980s

• The Brady deals restarted the market for emerging market bonds and gave birth to a new asset class

18

The International The International Market: Large but Market: Large but

Volatile… Volatile…

• Capital flows to emerging markets tend to be volatile and procyclical

• External factors explain a large share of this volatility

• External debt is almost all in foreign currency

19

Mark Twain on procyclicality

A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain.

20

Sudden Stops and Sudden Stops and ContagionContagion

• Episodes of “market closure” and jump in spreads that reverse within 2 years

• Spreads closely connected with global risk appetite

• Effects extend to countries with little economic link to the original event

• Uninformed investors may herd and/or chase an index

21

The international market The international market is large but volatileis large but volatile

Emerging Markets and Latin American Spreads

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

Ap

r-9

3

Fe

b-9

4

De

c-9

4

Oct

-95

Au

g-9

6

Jun

-97

Ap

r-9

8

Fe

b-9

9

De

c-9

9

Oct

-00

Au

g-0

1

Jun

-02

Ap

r-0

3

Fe

b-0

4

De

c-0

4

Oct

-05

Au

g-0

6

Ba

sis

po

ints

Composite Latin AmericaSource: Authors' calculations based on JPMorgan (2006) from Bloomberg (2006). Spreads are a combination of EMBI and EMBI plus indices. The Latin America index comprises the four largest debtors: Argentina, Brazil, Mexico, and Venezuela. Weights are adjusted to consider the structural break resulting from the Argentine default.

Tequilacrisis

Russian crisis

September11 attacks

Brazil elections and

22

Has volatility abated?Has volatility abated?

• Spreads are at record low levels; investors show appetite for local currency bonds

• Weak or no contagion from Brazil’s election anxiety and Argentina’s and Turkey’s crises

• Less cross correlation among EMBI assets

23

Has Contagion Has Contagion Disappeared?Disappeared?

Average Correlations among Sovereign Emerging Market Bonds and Industrial Sector Indices of US High Yield Bonds

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Jul-94 Oct-95 Jan-97 Apr-98 Jul-99 Oct-00 Jan-02 Apr-03 Jul-04 Oct-05

JP Morgan EMBI Plus Index Merrill Lynch U.S. High Yield Index

Note: Figure plots the average six-month correlation in 78 country pairs of the JPMorgan EMBI plus index and 465 sector pairs of the Merrill Lynch U.S. High Yield Index. Correlation coefficients are based on daily returns of indices.

Tequilacrisis Russian crisis

Source: Authors' calculations based on JPMorgan (2006) and Merril Lynch (2006) from Bloomberg (2006).

24

A new phase? A new phase?

• Policies are stronger: fiscal surpluses, reserve accumulation, current account surpluses

• Debt structure changing to local currency

• Investor base widening; EM assets more mainstream

• Or, in fact, are spreads too low?

25

Will the good times last?Will the good times last?

0

200

400

600

800

1000

1200

1400

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Predicted Spreads Actual Spreads

Spreads are lower than predicted

26

0

200

400

600

800

1000

1200

1400

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Spread for average External Conditions Actual Spreads

Predicted Spreads would be Predicted Spreads would be lower with average external lower with average external conditionsconditions

27

Possibly important Possibly important changes in global changes in global

marketsmarkets

• Impact of the growth of hedge funds

• Impact of the growth of credit derivatives

• Is the appetite for local currency instruments permanent?

28

OutlineOutline

• Facts Facts • International BorrowingInternational Borrowing• Domestic BorrowingDomestic Borrowing• Towards Safer DebtTowards Safer Debt

29

The Domestic Markets: The Domestic Markets: More Stable but Still More Stable but Still

SmallSmall

• Natural habitat of local currency instruments

• “Spare tire” for the banking system• High volatility in LA makes bank finance

a very short-run proposition• “Captive audience” of domestic

institutional investors (pension funds, banks)

30

Domestic bond markets in Domestic bond markets in LAC are growing but are LAC are growing but are

still smallstill small

0

20

40

60

80

100

120

140

Latin America 1994 Latin America 2004 East Asia 1994

East Asia 2004

Advanced 1994

Advanced 2004

Corporate issuers

Financial institutions

Governments

Percentage of GDP, simple average

31

But in fact it is the whole But in fact it is the whole financial sector that is financial sector that is

smallsmall

0

10

20

30

40

50

60

70

80

Latin America 1994 Latin America 2004 East Asia 1994 East Asia 2004 Advanced 1994 Advanced 2004

Corporate issuers

Financial institutions

Governments

Bond Markets relative to Domestic Bank Credit

32

Plausible Determinants of Plausible Determinants of Bond Market DevelopmentBond Market Development

• Scale of the market, in turn related to size of the economy and saving rates

• Scale of firms that are potential issuers

• Market liquidity• Institutional strength: creditor rights,

transparency, etc.• Market microstructure

33

Other Important Factors with Other Important Factors with Less Definite EffectLess Definite Effect

• Large domestic government debt: market development or crowding out?

• Well established banking system: competitor or complement?

34

Scale of the MarketsScale of the Markets Corporate bond market as a function of country size

ARG

BRA

CHL

COLMEXPER

CHN

HKG

IDN

KOR

MYS

PHL

SGP

THA

TWN

0.1

.2.3

.4T

ota

l C

orp

. S

ec.

over

GD

P

2 4 6 8 10Ln GDP

35

Scale of the Markets Scale of the Markets Market capitalization as a function of saving rates

ARG

BRA

CHL

COL

MEX

PER

CHNHKG

KOR

MYS

PHL

SGP

THA

TWN

0.2

.4.6

.81

Tota

l D

om

. S

ec. ove

r G

DP

0 .2 .4 .6Domestic Savings over GDP

36

ARG

BRA

CHL

COL

MEXPER

CHN HKGIDN

KOR

PHL

SGP

THA

0.1

.2.3

.4T

ota

l C

orp

. S

ec. o

ver

M2

-.05 0 .05 .1Adjusted Firm Size

Scale of Firms Scale of Firms Corporate Bond Market as a Function of Firm

Size

37

0 1 2 3 4 5 6 7 8 9

Argentina

Colombia

LAC AV

Thailand

Mexico

Brazil

India

EM AV

Chile

ASIA AV

Korea

Malaysia

G3 AV

Source: IMF, Global Financial Stability Report (2005)

Investor ProtectionInvestor Protection

38

Effects of Large Effects of Large Government DebtGovernment Debt

• Government bonds provide a reference yield curve

• Larger markets are needed for an efficient microstructure

• Crowding out?

39

Interaction between Interaction between government and private government and private

bond marketbond marketDomestic Government Bonds and Corporate Bonds

-0.04

-0.03

-0.02

-0.01

0

0.01

0.02

0.03

0.04

-0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4

Share of domestic government bonds in total public debtSha

re o

f co

rpor

ate

bond

s in

tota

l dom

esti

c cr

edit

to p

riva

te s

ecto

r

Latin AmericaOther emerging marketsFitted values

40

Investor Surveys in Argentina, Investor Surveys in Argentina, Brazil and MexicoBrazil and Mexico

Do you agree or disagree with the following statements? (1 = strongly agree,…, 5 = strongly disagree)

0 1 2 3 4

Government and corporate bonds aresubstitutes in your portfolio

If the yield on government bonds w ere toincrease signif icantly and that of private bonds

remained constant I w ould sell private bonds

A large stock of public sector bonds isimportant for the development of the corporate

bond market

The yield curve provided by public bonds iscrucial for pricing corporate bonds

Argentina Brazil Mexico

\

41

Banks vs. BondsBanks vs. Bonds

• Conventional sequence: 1) Banks

2) Bond Markets3) Equity Markets

• But interest groups can affect this evolution, e.g. Banks can prevent markets from developing (Rajan-Zingales)

42

Banks and Bonds: Banks and Bonds: Substitutes or Substitutes or Complements?Complements?

• Banks contribute to market infrastructure: bridge finance, distribution channels, primary dealer network.

• Banks contribute to secondary-market liquidity • Banks often are major issuers of domestic bonds

and structured securities

• Rather than being a political force against markets, banks and bonds seem to be held back by the same reasons in Latin America

43

GGoing Forward: oing Forward: New Investors, New New Investors, New

InstrumentsInstruments

• New investors needed. Savings are low and markets are small

• Institutional investors, especially pension funds, are starting to provide volume (but not liquidity).

• Foreign investors provide more liquidity (but also volatility). Less averse to long-term nominal instruments (see Mexico, Brazil). Capital account restrictions must be removed.

44

Institutional InvestorsInstitutional Investors

• Institutional investors have been growing and they can play a key role in developing a stable demand for local currency bonds

• But they could become victim of their own success, especially at times of crisis

45

Institutional InvestorsInstitutional Investors

Assets of Mutual Funds and Pension Funds

(percentage of GDP)

0

5

10

15

20

25

30

35

40

45

50

1997 1998 1999 2000 2001 2002 20030

20

40

60

80

100

120

140Emerging markets (left axis)

Latin America (left axis)

Advanced economies (right axis)

46

Institutional InvestorsInstitutional Investors

Government Bonds as a Share of Pension Fund Assets

0 10 20 30 40 50 60 70 80 90 100

GermanyUnited States

United KingdomCanada

SpainNetherlands

ItalyAustria

Thailand Korea

EstoniaSlovenia

Czech RepublicBulgaria

PolandHungary

SingaporeBrazilChilePeru

ColombiaUruguay

ArgentinaMexico

IND

Oth

er E

ML

AC

47

Institutional InvestorsInstitutional Investors

Banks' Exposure to Public Sector, 2003–2005

(percentage of total domestic credit)

0 10 20 30 40 50 60

Chile

Uruguay

Peru

Colombia

Brazil

Mexico

Argentina

United States

Euro area

Lat

in A

mer

ican

cou

ntr

ies

Mat

ure

mar

ket

s

48

International InvestorsInternational Investors

• Saving is low in Latin America and this affects the size of bond markets

• Institutional investors like pension funds do not provide liquidity

• Foreign investors display less aversion to long-term local currency instruments. But less stability. Need to open capital accounts to some extent.

• In Mexico, foreign investors hold more than 50% of the ten-year bond and more than 80% of the 20-year bond.

49

0 5 10 15 20 25 30 35 40 45 50 55

Bulgaria

Korea

Indonesia

Peru

Thailand

Brazil

Japan

Malaysia

Argentina

Turkey

Mexico

Poland

Hungary

Uruguay

USA

Percent of Foreign Percent of Foreign Holdings of Domestic Holdings of Domestic

BondsBonds

Sources: FMI (GFSR, 2005) y Takeuchi (“Study of Impediments…” 2005, asianbondsonline.adb.org)

50

Going Forward: Going Forward: New Instruments New Instruments

• New Instruments: Asset Backed Securities (mortgages, receivables, consumer loans, commercial paper)

• Less complicated enforcement of creditor rights (by recourse to collateral)

• Can overcome firms’ small scale problem • Strong growth in Mexico, Brazil, Chile, Argentina,

but from a very small base• Successful securitizations for working capital to

SMEs Can structured instruments also help SMEs get long-term, investment finance?

51

OutlineOutline

• FactsFacts• International BorrowingInternational Borrowing• Domestic BorrowingDomestic Borrowing• Towards Safer DebtTowards Safer Debt

52

Debt sustainabilityDebt sustainability

Traditional approach: Debt to GDP ratio to stay constant

s = (r – g) d

The primary surplus must be enough to cover interest (adjusted by growth) on the Debt to GDP ratio

53

Actual and “Required” Actual and “Required” Primary SurplusesPrimary Surpluses

7

2004 Real interest rates

Belize

Brazil

Colombia

Costa RicaDominican RepublicEcuador

El SalvadorGuatemala

Jamaica

Mexico

Panama

ParaguayPeru Trinidad and Tobago

Uruguay

Venezuela

-2

-1

0

1

2

3

4

5

6

7

-2 -1 0 1 2 3 4 5 6

Actual primary surplus

R

equ

ired

pri

ma

ry s

urp

lus

1992-2004 Median real interest rates

Argentina Pre

Argentina Post

Belize

Brazil

Chile

Colombia

Costa RicaDominican Republic

EcuadorEl Salvador

Guatemala

Jamaica

MexicoPanama

Paraguay

Peru

Uruguay

Venezuela

Trinidad and Tobago

-2

0

2

4

6

8

10

12

-2 0 2 4 6 8 10 12

Actual primary surplus

R

equ

ired

pri

ma

ry s

urp

lus

54

Sustainability Analysis Sustainability Analysis under Uncertaintyunder Uncertainty

• Variables that enter debt projections have large variance: interest rate, exchange rate, growth, primary surplus.

• The more volatile these variables are, the lower the Debt/GDP ratio that is sustainable “for sure” (95% statistical confidence, for example)

55

Required Primary Surpluses Required Primary Surpluses and Credit Ratingsand Credit Ratings

Venezuela

Uruguay

Trinidad and Tobago El Salvador

Peru

Paraguay

Panama

Mexico

Jamaica

Guatemala

Ecuador

Dominican Republic

Costa Rica

Colombia

Brazil

Belize

y = ?0.087x + 8.6707 (0.7689)

R2 = 0.0064

0

2

4

6

8

10

12

14

-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4Required minus observed primary surplus (percentage points of GDP)

Cre

dit

rat

ing

56

Sustainability Analysis Sustainability Analysis under Uncertaintyunder Uncertainty

• Many sources of risk– GDP volatility– Terms of trade shocks– Natural disasters

• A better debt structure can reduce risks

57

Debt Management can Debt Management can reduce the risk of reduce the risk of sovereign financesovereign finance

Debt-to-GDP Ratio Distribution

0.2

0.3

0.4

0.5

0.6

0.7

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Deb

t-to

-GD

P r

atio

Foreign currency

Foreign currency–local currency

Foreign currency–local currency–linked to GDP

58

Lowering the risks of Lowering the risks of sovereign financesovereign finance

• Should countries avoid government debt altogether?

• Useful purposes: investment in infrastructure and human capital, coping with natural disasters, crises

• But there are political economy distortions and market failures

59

Lowering the risks of Lowering the risks of sovereign financesovereign finance

• Controlling the flow of debt

• Managing the inherited stock of debt

• Improving the international financial architecture

60

Controlling the flow of Controlling the flow of debtdebt

• Fiscal rules– Structural balance target– Debt/GDP target

• Budget institutions– Hierarchical rules – Transparency Rules

61

Managing the inherited Managing the inherited stock of debtstock of debt

• Self-insurance policies– Stabilization funds– International reserves

• Contingent contracts– Cat bonds, commodities, GDP-linked

• Develop the domestic bond market– More use of local currency debt

62

Debt and Debt and Monetary/Exchange Monetary/Exchange

Rate SystemsRate Systems

• Exchange Rate System => Debt Structure– Fixed rates may promote foreign currency debt– Higher inflation discourages long duration, local

currency instruments– There is no “local currency” instrument in dollarized

economies (except inflation-linked bonds)

• Debt Structure => Exchange Rate System– Harder to use exchange rate flexibility in partially

dollarized economies– Do inflation-linked bonds discourage inflation?

Debt Structure

63

Depreciation and Debt Depreciation and Debt SustainabilitySustainability

• Depreciations are important source of large unexpected increases in Debt/GDP ratios (SFs)

• But the effect of depreciation is not necessarily negative. It depends on:– Net effect of the exchange rate on taxes

and spending (including indirect effects)– Size of Debt/GDP ratio– Currency composition of Debt

64

Debt Management in Debt Management in (fully) Dollarized (fully) Dollarized

EconomiesEconomies

• Use contingencies! • Contingencies: natural disasters, oil

prices, economic growth, domestic inflation

• It can be achieved through derivatives or insurance policies (cat bonds) and use payoffs to service debt.

65

Improving the Improving the international financial international financial

architecturearchitecture

• Rollover risk. Create a “Country Insurance” facility. Support pooling of reserves

• Contagion risk. “Emerging Market Fund”

• Currency and real economy risks. Help develop local currency and contingent debt instruments. “De-dollarize” multilateral lending

66

……and much moreand much more

• Latin American sovereign debt in 1820-1913

• The political economy of public debt• Public debt and public investment in

human and physical capital• Debt relief, has it worked?• The cost of default