Some Latin American countries are returning to global capital markets. An early assessment
After a prolonged and almost total reliance on debt reschedulings, some Latin American countries—notably Chile, Mexico, and Venezuela—have recently begun to attract voluntary financing from international capital markets. This provides them with a wider and more flexible range of financing instruments to fund productive activities, given the narrow, albeit expanding, domestic capital markets. It also signals to agents in other international and domestic markets that the risks associated with investing in these countries have been sharply reduced—a crucial step in encouraging other private inflows, such as foreign direct investment and the repatriation of flight capital.
Although the process of market re-entry is still at an early stage—so far, only three countries have made significant inroads, and the numbers involved are quite small compared with the overall size of these markets—it has nevertheless attracted considerable attention. This article draws upon the recent experience of these countries to provide an overview of the difficult task of regaining access to voluntary capital market financing.
Re-entering the market
International capital markets were a major source of external financing for developing countries in the 1970s and early 1980s. Medium and long-term international bank credit commitments totaled some $225 billion in 1976-82. In 1982 alone, such commitments amounted to $42 billion, with Latin American borrowers accounting for $23 billion. On the bond side, developing country issues reached $27 billion in 1976-82, with $4 billion of that in 1982—half of which was accounted for by Latin American borrowers.
The article is based on a paper presented at the America Economia seminar on “Latin America: Raising Capital on the International Voluntary Markets,” held in Chile on June 18-19,1991. The paper was subsequently published in the IMF Working Paper series (WP/91/74). A more detailed analysis of the Mexican experience is contained in “Mexico’s External Debt and the Return to Voluntary Capital Market Financing,” IMF Working Paper WP/91/83. Both papers are available from the author.
But with the outbreak of the debt crisis in late 1982, when Mexico, followed by several other countries, announced its inability to meet fully scheduled debt servicing, the picture changed sharply. All sources of voluntary private financing to the region, with the exception of short-term trade facilities, virtually dried up. As a result, the total amount of medium- and long-term bank and bond fi-nancing over 1983-88 dropped to an estimated $7 billion—less than a third of the amount committed in the first three quarters of 1982 alone. Almost overnight, “concerted” financing became the major source of private external credit for the region.
Since mid-1989, however, a few countries in Latin America have managed to regain access to voluntary sources of private financing. The process so far has been dominated by borrowers in Mexico and, to a lesser extent, Chile and Venezuela; some limited operations have also been undertaken by Argentinian and Brazilian entities. The return to voluntary financing has taken the form of international bond issues on US and European markets, attracting primarily institutional investor funding and residents’ capital held abroad. Total bond issuance is estimated at some $3 billion in the 18-month period to December 1990. Market data point to stepped up borrowing in the first half of 1991, with over $2 billion being mobilized by Mexican entities alone.
At the same time, there has been a modest revival in voluntary bank lending to these countries, primarily in the form of trade and project financing and short-term interbank facilities. Moreover, several Latin American corporations have recently completed equity offerings in industrial country markets, thereby complementing the impact of a growing number of country funds. These were the first significant Latin American foreign stock offerings since the 1960s, reflecting in part a stepped up effort by some governments to privatize. Along that line, the $2 billion Mexican telephone company (TELMEX) issue is reported to be the sixth largest placement of shares in the world (nominal values) to date and the biggest ever for any Latin American country (see “Accessing the International Capital Markets” by Kumiko Yoshinari in Finance & Development, September 1991).
However, the large syndicated bank credits, which dominated private flows to developing countries in the 1970s and early 1980s have not resurfaced. Besides concerns about the higher rescheduling risk associated with such lending, this reflects the more difficult financial circumstances of banks in several financial centers, along with tighter regulatory requirements in some cases.
Terms on voluntary financing. The renewed availability of voluntary foreign financing has been accompanied by an improvement in market terms, as evidenced in the sharp drop in yields on Mexican and Venezuelan bonds (see chart). The first unsecured voluntary bond issue by a Mexican public enterprise since 1982 (Bancomext in June 1989) carried an initial yield of some 17 percent, implying a spread (or “risk premium”) of about 820 basis points over US government bonds. But by the third quarter of 1990, the weighted average spread for new Mexican bond issues had declined to an estimated 320 basis points. Although it increased somewhat in the final quarter—reflecting the general market tightening associated with the Middle East crisis—the average spread fell again in the first half of 1991. For example, the April 1991 Bancomext issue carried an initial yield of under 10 percent (implying a spread of only 200 basis points), and a 300 million deutsche mark Mexican central government issue in February (used as a “benchmark” for tracking other bonds in that market) was marketed at an estimated spread of under 200 basis points over comparable German government bonds.
But a word of caution is in order, as these measures of creditworthiness are affected by the changing composition of borrowers and structures of bonds (particularly, the degree of credit enhancements, such as payments guarantees). To help correct for this, one can track the performance of an individual borrower’s debt instrument, albeit at the cost of limiting the coverage of the analysis. For example, the yield on the Mexican oil company (PEMEX) issue fell from 14 percent in mid-1989 to under 10 ½ percent by end-May 1991, the yield on the Bancomext June 1989 issue dropped from 17 percent to around 10 percent, and the yield on the 1989 Venezuelan (11 ⅛ percent benchmark) bond decreased from 18.5 percent to 10.4 percent. These movements reflected a significant fall in risk premia, which was compounded by lower international interest rates.
Reform pays off
Source: International Financing Review.
1Weighted average reported yield on floating rate notes Issued in 1988-89 and maturing in 1993. 1994, 1995. and from September 1990) 1998.
Other private external inflows. In recent years, there has also been a resurgence in nondebt-creating private capital inflows-such as foreign direct investment and capital repatriation—providing additional resources to help support comprehensive economic adjustment and reform policies. In Mexico, for example, foreign direct investment in 1989- 90 was twice the level reached in 1987 88, with the pipeline of new investments yet to be disbursed growing to over $5 billion. Similar developments were recorded in Chile and, to a lesser extent, Venezuela.
The magnitude of capital repatriation, however, is more difficult to quantify with any precision, although the majority of indicators point to a significant turnaround in the last two years. These include a recent study by Chartered West LB that estimates net total inflows of $14.1 billion for Chile, Mexico, and Venezuela in 1989-90, compared with an estimated outflow of $4.5 billion for 1987-88—a difference of almost S20 billion.
Why re-entry was possible
Implementing sound economic policies. Just as inappropriate economic policies, together with adverse exogenous developments, contributed greatly to the emergence of debt problems, the sustained implementation of sound macroeconomic and structural reform programs has done the most to restore access to voluntary financing. While these programs, which have been supported by the IMF and the World Bank, have varied from country to country, several common elements can be identified:
reducing domestic financial imbalances through improved budgetary performance and prudent monetary policies. This involves reinforcing the fiscal revenue effort, containing expenditures, and allowing domestic interest rates to reflect fully the cost of compensating savers for the considerable risk premia in lending domestically;
enhancing the supply response of the economy through appropriate pricing policies, such as promoting the tradable sector by maintaining a competitive exchange rate; and
improving economic efficiency through fundamental structural reforms. This includes liberalizing the trade regime, reforming the tax system, divesting public sector enterprises, liberalizing the financial sector, improving legal and other procedures governing foreign investment, and deregulating domestic activities.
Comprehensive restructuring of existing indebtedness. The experience of Latin American countries in the 1980s suggests that in some cases, the positive effects from the implementation of sound policies may not be fully realized due to high risk aversion on the part of the private sector on account of existing indebtedness. This aversion, which undercuts incentives to undertake productive investment activities, reflects concerns about expected financial returns, given the uncertainty about the country’s ability to meet contractual debt obligations without further increases in effective taxation. Such adverse effects can become more pronounced if, as has been increasingly the case, the process of securing concerted new money loans from banks is subject to protracted negotiations that raise the risk of creditor/debtor confrontations.
Against this background, Chile, Mexico, and Venezuela managed to reduce the burden of their bank debt in recent years through market-based debt and debt-service reduction operations. Chile cut back its stock of restruc-turablc bank obligations by over 70 percent in four years (to some $4 billion) through a series of voluntary market-based conversions, supplemented by direct cash buybacks. Mexico and Venezuela adopted a different approach within the framework of the “Brady Initiative” that involved an agreement with bank creditors on a comprehensive restructuring package, incorporating debt and debt-service reduction options. For Mexico, the 1990 package resulted in an effective gross bank debt reduction of around $15 billion, or 31 percent of eligible debt (see “Mexico’s Commercial Bank Financing Package” by the author in Finance & Development, September 1990).
Venezuela’s 1990 bank agreement involved an effective gross bank debt reduction of some $5 billion. This was achieved through a menu of five options, including a buyback of debt at a discount of 55 percent and conversions of claims into partially collateralized discount bonds (at 70 percent of face value), reduced interest rate (6 ¾ percent, fixed) par bonds, and bonds with below-market, but gradually increasing, interest rates in the first five years.
Reducing market transaction costs. There has also been a reduction in the transaction costs for accessing international capital markets, largely because of regulatory changes in industrial country capital markets and more widespread market information on borrowers’ creditworthiness.
Important regulatory changes have occurred in the US market; other countries, such as Japan, have also taken steps to facilitate developing country access to their capital markets. Before April 1990, the average costs of meeting US bond registration and disclosure requirements for first time developing country issuers were estimated at roughly $500,000700,000, prompting many is-suers to go outside the public market and try the route of private placements instead. But these placements carried costs of their own, including those associated with buyers being required to hold the issues for at least two years after the initial offering.
With the passage of Regulation S and Rule 144A in April 1990, however, it has become much easier for developing countries to tap US investors. Regulation S has facilitated the sale of Euro-issues to US citizens by clarifying what exactly constitutes the sale of a Euro-issue in the United States—these issues involve relatively fewer transaction costs. Rule 144A has reduced the loss of liquidity associated with private placements by relaxing the two-year holding period, provided that the sale of the financial instrument is to “qualified institutional buyers.” Such buyers are defined as entities managing and owning at least $100 million in securities and, in the case of banks, with a net worth of at least $25 million. There are about 5,000 qualified institutional buyers in the United States—mainly insurance companies, commercial banks, and money managers.
These changes have accompanied the greater use of the American depository receipts (ADR) program, under which developing countries may access equity markets without meeting the full costs of offerings and listings on these markets. Under this program, each American depository share traded in the United States represents a specified batch of the company’s trading shares in the local market. This route has been used by a number of Latin American corporate re-entrants, including Chile’s telephone company, and Mexico’s TELMEX and Vitro (a private glass manufacturer).
US dollar-denominated equity-based instruments backed by a trust containing stocks of non-US companies. ADRs may be traded directly among US investors, with clearance and settlement handled by the custodian bank in the United States.
The repurchase for cash of debt often at a discount.
These exchanges have tended to involve the conversion at a discount (either on the face value or contractual interest rates) of bank loans into longer-term bonds, the principal and/or part of the interest on which is guaranteed through the use of “risk-free” instruments (e.g., US Treasury zero coupon bonds for principal collateralization).
Proportional increases in commercial bank exposure, coordinated by advisory committees negotiating, on behalf of creditors.
These funds allow investors in industrial countries to pool their resources and invest them in specific emerging capital markets.
Attributes of financial instruments that improve the underlying value of these instruments. They include collateralization (on the basis of existing assets or an expected stream of income), early redemption possibilities, and preferential treatment in the case of privatization.
Ratings, issued by established market agencies, that seek to measure the degree of credit and transfer risks. For example, Moody’s Investor Service assigns ratings of Aaa, Aa, A, and Baa for investment grade; Ba and B for non-investment grade; and Caa, Ca, C and D for default grade. In addition, numbers from 1 to 3 are often attached to differentiate borrowers within a given grade, with 1 being the highest Similar classifications are used by other rating agencies, such as Standard & Poor’s.
Risk associated with the possibility that the other party to a financial contract (the counterparty) will be unwilling or unable to fulfill the terms of the contract. This type of risk is to be distinguished from transfer risk, which arises from the possibility that foreign exchange may not be available to the counterparty to meet its obligations.
The contractual right, but not the obligation, to buy or sell a specified amount of a given commodity or financial instrument at a fixed price before or at a designated future date.
Formal deferment of principal obligations, with new maturities applying to the deferred amounts.
A financial credit involving several bank lenders who are linked through various legal clauses governing both the distribution of payments made by the debtor and the conditions for changing the terms of the credit.
Increased interest among international investors in bond issues by re-entering Latin American entities has led to, and been rein-forced by, the provision of market-credible credit ratings, thereby reducing some of the costs investors face in compiling investment information. In December 1990, for example, Mexico received its first credit rating by Moody’s Investors Service—the ceiling rating for Mexican debt (excluding the debt restructuring bonds) was set at Ba2, just below investment grade. In July 1991, Moody’s upgraded the credit rating on outstanding Venezuelan bonds to Bal from Ba3.
Customizing financial instruments. In an environment of still significant—albeit declining—perceptions of credit and transfer risks, borrowers must pay particular attention to customizing their debt instruments to meet market requirements. This becomes particularly important when there is a general tightening of market conditions, as occurred temporarily during 1990.
In several of their bond issues, some Latin American re-entrants have attempted to make the instruments more attractive by providing explicit credit enhancements. This has been done, most often, through collateralization on the basis of existing assets or an expected stream of receivables. But other options have also been used, including preferential treatment in the case of privatization or early redemption clauses.
In addition to the intrinsic value in relation to the face value of debt, the attractiveness to investors of the collateral, and thus the extent to which it improves market terms, depends on the collateral’s location, and the costs involved in taking possession and disposing of it, should the need arise. Several borrowers have provided collateral in the form of assets and receivables located, or generated, outside the country, thereby enabling them to address investors’ concern about both credit and transfer risks. TELMEX, for example, provided investors protection in the form of a claim on payments due from AT&T on account of international communications. Accordingly, investors’ exposure to TELMEX credit and Mexican transfer risks was effectively transformed into an exposure to AT&T credit and US transfer risks. Other forms of collateralization have included bank deposits, electricity payments, and credit card receivables.
But the use of collateralization also involves actual and potential costs for the borrowing entities. In effect, by pledging existing assets or future receipts, borrowers may lose future financial flexibility, as well as lower the seniority of creditors with unsecured debt. Moreover, other re-entrants may find themselves similarly having to pay higher borrowing costs, a development that would be of concern to government officials.
Finally, in customizing borrowing instruments, a relatively small number of entities have also resorted to the wider range of financial risk management techniques that are now more feasible thanks to the entities’ improved creditworthiness. These include interest rate and commodity hedging mechanisms, which allow borrowers to reduce their exposure to price volatility. By limiting their “open positions” (contracts not fully offset by futures transactions or fulfilled by delivery), borrowing entities thus minimize the risk of adverse price developments being translated into their international obligations and receipts. Such an approach may also be used by country authorities, as illustrated in the case of Chile (relatively widespread use of interest rate hedging) and Mexico (commodity hedging through the sale of future oil contracts consistent with the price assumed in the government budget).
The years ahead
The success achieved so far by some Latin American countries in regaining international capital market access, while still limited, is a welcome development. But further progress will depend largely on the sustained implementation of sound economic and financial policies. This needs to be supported by continued efforts to avoid excessive new indebtedness and to reduce exposure to adverse developments in exogenous prices (e.g., through greater use of market-based risk management techniques). This should be accompanied by a careful use of collateralization and other credit enhancements, with an eye to maintaining an appropriate balance between the immediate gains of lower borrowing costs and potentially adverse longer-term implications for liquidity management.
Industrial creditor countries can also contribute to the process by helping to expand the pool of investors that may be tapped by developing countries and opening up their markets for developing country goods and services. With mutually reinforcing actions in both developing and industrial countries, entities with solid financial prospects will be increasingly able to complement their access to domestic sources by taking advantage of the broader opportunities offered on international capital markets.
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