WSJ Editorial. Latin America Needs a Bond Market
September 4, 1998
By MICHAEL PETTIS
The aftershocks from the Russian ruble collapse have battered local Latin
American capital markets. Venezuela, abandoned by investors, has seen
interest rates shoot up to 80%, more than twice the expected inflation rate.
In Brazil, interest rates have risen to 40%, while one-year rates in Mexico,
also at 40%, have soared from 19% in April.
Compounding the burden on the local markets is the fact that rising interest
rates are increasing local government borrowing costs at a time when the
markets are demanding fiscal discipline. In Brazil, for example, higher
interest costs are putting added pressure on an already strained fiscal
budget, pushing public sector borrowing up to 7% of gross domestic
product.
Unfortunately, no Latin American nation issues fixed-rate treasury notes in
local currency beyond one year, and until the treasury leads the way, the
corporate markets are not likely to follow. One result is that when
exogenous shocks hit the region, governments and other borrowers
simultaneously see dramatic increases in their borrowing costs. Developing
a fixed-rate treasury market that extends beyond one year may be among
the more important components of a program to reduce vulnerability to
external events.
Emerging economies are by definition extremely volatile, partly because of
their commodity-dominated export sectors and partly because of their
sensitivity to international capital inflows. With so much implicit volatility,
Latin American entities should ideally access capital in such a way that
repayments are correlated with economic performance. Borrowers, should
borrow in such a way that they end up paying more when things are going
well and less when things are going badly.
However, neither external nor domestic capital structures in emerging
markets are designed this way. Local financial markets, for example, usually
consist only of short-term or floating-rate instruments. Changes in local
expectations, consequently, are immediately reflected in debt servicing
costs.
As a result, when things are going well and inflation is under control,
borrowing costs decline commensurately and immediately, and the
borrower's financial position improves. When things go badly, however, the
reverse occurs. At the extreme, during a crisis, interest rates shoot up so
much faster than inflation that the real cost of servicing debt can become
unbearable for the borrower--usually at a time of deteriorating economic
conditions when the borrower is least able to absorb the higher costs.
The end result is that the inefficient structure of the local capital markets
ensures that a financial crisis is exacerbated by the collapse of purchasing
power and investment at precisely the wrong time. The dangers of this were
dramatically demonstrated by Mexico following the December 1994 peso
crisis, when inflation fears and capital flight caused peso interest rates to
shoot up. Mexican homeowners found their mortgage payments rising much
faster than their wages, virtually eliminating their purchasing power.
Corporations that had borrowed for investment purposes found themselves
unable to service debt, and were often denied the ability to roll over existing
maturities. Many Mexican homeowners and corporate borrowers were
forced to default on their obligations, and this helped destroy the already
precarious banking system, pushing interest rates even higher, ultimately to
over 100%, as the crisis spiraled out of control.
There are two reasons that this would not have happened with longer- term
fixed-rate obligations. First, longer-term debt reduces refinancing risk.
Second, and more importantly, because inflation generally surges after a
currency crisis, the cost of fixed-rate debt, instead of shooting up to
unmanageable levels, actually declines in real terms during the crisis, thus
providing some relief for producers and improving their capital structure.
The real reduction in debt servicing reduces pressure on the economy
during a currency crisis instead of reinforcing it.
Over the past five years the major Latin American countries could easily
have developed long-term local markets. Except during crisis periods, there
has been strong interest on the part of investors to lock in long-term local
currency interest rates, either because investors believed rates would
decline in the future or because some investors, like local pension funds and
insurance companies, needed to be able to predict cash inflows with
certainty.
Most Latin American governments however have not taken advantage of
these market opportunities. During stable times many governments,
convinced that a continuation of their policies would lead to lower inflation
and lower interest rates, believed that by borrowing long term they were
locking in excessively high borrowing costs. During less stable times, on the
other hand, government finance officials refused to borrow long term, or
borrowed only on a dollar-indexed basis, because they wanted to signal to
the market their confidence in their own improving condition. Doubling up
the risk was seen as a way of encouraging confidence.
But both beliefs are misguided. Capital structures are a crucial transmission
mechanism for external shocks, and a high risk premium is the cost of
safety. Because investors know this, local interest rates will decline largely
as a consequence of improving credibility. Ironically, a short-term capital
structure can often signal the reverse of what government officials intend and
can increase the very risk premium that is judged to be too high--choosing a
risky term structure is not the right way to signal a credible policy mix.
The process of developing a sophisticated local capital market is a slow and
deliberate one that can nonetheless have tremendous risk management
benefits. Above all, fixed-rate treasuries are an efficient and much-needed
way to transfer financial risk from producers to domestic and foreign
investors. Without such a mechanism, the structure of the economy tends to
reinforce both improvement and deterioration in external conditions.
Mexico has announced its intention to extend the domestic Treasury market
to three years, but only Argentina so far has moved forward, furthering the
perception among many investors that it is the country with the most
sophisticated liability-management strategy in the emerging markets.
Although this past July adverse market conditions forced Argentina to
postpone its first issue of 5-year fixed-rate Treasury notes, as soon as
market conditions will allow it, it should proceed with the issue. Other Latin
American countries, and indeed other emerging market countries, should
follow these two countries' lead.
Mr. Pettis is a managing director at Bear Stearns.
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