Bond Markets in Latin America: Comments on Recent Proposals

Alejandro Werner

April, 2003

The proposals discussed in the previous panel addressed three different problems in EM financing:

1) Reducing the volatility of the Debt/GDP ratio by

indexing to GDP.

2) Smoothing capital flows through contingent

contracts.

3) Dealing with default through CAC’s, SDRM’s, etc.

The recent discussion has focused too much on restructuring and too little on:

1) How to deal with “sudden stops.”

2) How to handle other shocks.

1) Policy response.

2) The response of IFI’s.

3) Design of financial instruments.

The policy package to address these issues should focus on:

Index Bonds: sources of risk to Debt/GDP.

• Interest rate risk (in domestic and foreign currency)

• Exchange rate risk

• Growth risk

• Fiscal risk

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ptt SRER

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In Mexico, after 1995, the currency/maturity structure of public debt was re-established according to the following strategy:

External External Debt in F.C. Debt in F.C. (maturity=1 (maturity=1 to 5 years to 5 years with some with some

sweeteners)sweeteners)

Increasing Increasing Maturity of Maturity of E.D. and of E.D. and of

D.B. by D.B. by indexingindexing

D.D. D.D. indexed to indexed to C.P.I. and C.P.I. and short-term short-term

ratesrates

Nominal Nominal D.D. at D.D. at

long long maturities maturities 3, 5, 7 and 3, 5, 7 and 10 years10 years

Gross Public Sector Debt (% of GDP)

26.7

20.2 21.717.5

14.0 12.3 12.4

6.6

7.79.0

10.1

11.612.7 13.8

0

5

10

15

20

25

30

35

1996 1997 1998 1999 2000 2001 2002

External Debt Internal Debt

33.33.33

27.27.99

30.30.77 27.27.

66 25.625.6 25.025.0 26.226.2

SOURCE: SHCP SOURCE: SHCP

Public debt/GDP has been decreasing and it’s composition has changed in favor of internal (peso, CPI) financing.

During this period, the domestic debt market has grown consistently. This growth has been primarily based on the demand of domestic investors.

Domestic Participation in Government Debt Market (Billions of Pesos Dec. 2000)

Value of Outstanding Domestic Government Debt / GDP

0%

5%

10%

15%

20%

25%

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

0

100

200

300

400

500

600

700

800

900

1000

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

Foreign Investors

Domestic Investors

• In recent years, macroeconomic stability and the development of institutional investors have created the conditions for the public and private sectors to issue long term debt in the Mexican market.

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0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

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19931997Sep-02

Government Debt Composition by Maturity

306 292 297383

421

561 538

748816

0

100

200

300

400

500

600

700

800

900

1994 1995 1996 1997 1998 1999 2000 2001 2002

Weighted life term of government securities (in days)

Share of Public Debt Held by Institutional Investors

Assets Managed by Institutional Investors

0

100

200

300

400

500

600

700

1998 1999 2000 2001

Mutual Funds

Insurance Companies andPension FundsSiefores

0

10

20

30

40

50

60

1998 1999 2000 2001

Pe

rce

nt

The expansion of the domestic debt market has been possible due to the growth of institutional investors.

Comments on indexing to GDP

• Maybe not the most important source of risk.

• If the country faces a quasi-permanent shock, as the

bonds are re-negotiated g* changes, so the benefits are

lower than those calculated in the paper.

• Due to “home bias” the risk premium might be larger.

• How would the political economy of adjusting be

affected?

• A lot of the capital inflows of the post 95 era are GDP

indexed through FDI.

Insuring E.M. against sudden stops:

1) Different from stabilization funds.

2) Very close to contingent credit lines.

3) However, the argument that they could be re-

packaged by CDO’s is powerful.

4) The hedging argument against private CCL is not

insurmountable.

Creating new markets faces several free rider problems:

• Role for G-7 to set benchmarks.

• For for IFI’s to “subsidize” the emergence of new

markets.

• However, a key question is how to strengthen

governments to adjust. If not, these financial

gimmicks will only help to postpone crises and make

them bigger.