Chapter

Annex IV Developments in Private Market Financing for Developing Countries

Author(s):
International Monetary Fund
Published Date:
January 1994
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Private financing to developing countries increased substantially in 1993; it was associated with a further improvement in the terms of borrowing and strong increases in equity prices in many local stock markets. Developing country borrowers issued almost $60 billion of bonds in 1993, by far their most widely used financing instrument. Much of this inflow represented net financing, because most bonds issued so far have bullet repayments that have not yet fallen due. A large share of these bond flows went to borrowers in about six to eight countries in Asia, Europe, and Latin America, but the range of countries accessing this market continued to expand in 1993. In contrast, international equity placements by developing country issuers rose only moderately from $9 billion in 1992 to $12 billion in 1993, with an important share of these issues made through American Depository Receipts (ADRs) or Global Depository Receipts (GDRs). This estimate of equity placements, however, misses direct purchases of equity in the local stock markets, which reportedly grew significantly in 1993. Banks continued to provide financing primarily through short-term trade credits, although their medium- and long-term lending to most developing countries picked up somewhat in 1993.

In the first quarter of 1994, the increase in U.S. interest rates, inter alia, helped spark a drop in demand for emerging markets assets (relative to their peaks in the fourth quarter of 1993), as financing to developing countries tapered off, together with strong declines in bond and equity prices. Developing country bond issuance had accelerated throughout 1993 to $24 billion in the fourth quarter and then fell off to $18 billion in the first quarter of 1994. A similar pattern occurred with international equity placements, which had reached over $5 billion in the fourth quarter of 1993 before declining to $4 billion in the first quarter of 1994.

The first part of this section reviews the recent experience with securitized capital flows (international bonds, short-term debt instruments, and equities) and with bank lending. The second part discusses two aspects of the development of the market in 1993. First, it explains the broadening of the investor base and the reasons behind the expansion. Second, it discusses the factors behind the assessment of risk.

Recent Experience

International Bonds

Issuance by developing country borrowers in international bond markets continued to show impressive growth, as bond placements more than doubled to $59 billion in 1993 following a doubling in the volume of bond issues in each year since 1990 (Table A10). During the course of the year, total bond issues accelerated from $10 billion in the first quarter to over $23 billion in the fourth quarter. The average size of bonds issued increased to $135 million in 1993, somewhat higher than the average of $110 million in 1992. In May, Cementos Mexicanos (Cemex), Mexico’s largest cement producer, successfully placed a $1 billion issue, the largest Eurobond issued by a Latin American borrower to that date. In December, the Republic of Argentina launched the first global bond issue by an emerging markets issuer, a $1 billion bond payable in ten years. The share of developing countries in total bond issuance in international markets rose further to 12 percent in 1993, three times the share of 4 percent in 1991; and this share more than doubled from 7 percent in the first quarter of 1993 to 20 percent by the fourth quarter.

Bond issuance in 1993 was concentrated in three regions. Borrowers in the Western Hemisphere raised some $27 billion, with Mexico once again emerging as the leading borrower, raising over $10 billion. Besides the issue by Cemex, a wide range of Mexican corporations, such as Petroleos Mexicanos (Pemex) and several banks, placed sizable bond issues. Argentine issuers quadrupled their access to bond markets to $6 billion, which included several large issues by Telecomunicaciones. International bond offerings by Brazilian and Venezuelan entities also rose considerably, in spite of continued uncertainty about the course of economic policies and restrictions on the maturity of Brazilian bond issues. One of the Venezuelan issues was launched simultaneously in Colombia and outside Latin America, the first intra-regional bond issue in Latin America. Chile, Trinidad and Tobago, and Uruguay maintained their presence in these markets through a moderate amount of borrowing, and Colombia, Guatemala, and Peru tapped the market for the first time in many years.

Asian borrowers more than tripled their borrowing in international bond markets to $20 billion, reflecting in large part a sixfold increase in bonds issued by China and Hong Kong.1 Borrowers in Korea and Thailand sharply increased their presence in international bond markets. Both the Philippines and Malaysia entered the market for the first time in many years, with the Philippines raising over $1 billion. India also returned to the market after being absent in 1992, with a sharp pickup in issuance in the fourth quarter of 1993.

Among European developing countries, Hungary stepped up its bond issues to the equivalent of $4.8 billion in 1993, in an effort to cover its present and future large external financing needs, while Turkey borrowed $3.9 billion on international bond markets. Other regions were relatively inactive in international bond markets in 1993, with the exception of the Middle East, where Israel floated $2 billion of bonds in 1993 as part of a loan-guarantee program granted by the United States.

All types of borrowers took part in the surge in bond financing in 1993. Private sector issuers more than doubled their bond issuance from $10 billion in 1992 to $27 billion in 1993, which accounted for 46 percent of total bond issues by developing countries. Almost three fourths of the private sector bond issues were placed by issuers in four countries or regions (Hong Kong and Mexico with about $6 billion each, followed by Brazil with $4.8 billion and Argentina with $3.8 billion). Sovereign borrowers roughly tripled their bond placements between 1992 and 1993, accounting for $16 billion, or 28 percent of bonds issued in 1993. Hungary and Turkey led sovereign bond issuers with $4.5 billion and $3.7 billion of bond placements, respectively, in 1993. Other public sector borrowers issued roughly the same amount of bonds in 1993 as the sovereign borrowers.

Terms on primary issues improved for many developing country borrowers during the year. The average yield spread against comparable U.S. Treasury securities at launch for all borrowers fell from 288 basis points in the first quarter of 1993 to 241 basis points by the fourth quarter of 1993. The average yield spread for sovereigns, however, actually increased slightly, reflecting the entrance of sovereign borrowing by the Philippines, the Slovak Republic, and Venezuela at spreads of over 300 basis points. For countries with a track record in the markets, sovereign yield spreads came down. In 1993, average yield spreads for other public sector borrowers were below the spread on sovereign issues for the first time, reflecting the experience of Mexico, the Philippines, and Thailand. There was a strong variation in yield spreads across countries, with the lowest spreads for Asian borrowers, such as China, Korea, and Thailand (all below 100 basis points), while the private sector in Latin America typically paid a spread of 300 to 500 basis points. The average maturity of bond issues continued to lengthen in 1993 to about 6½ years. Maturities were shortest in the private sector. Some sovereign borrowers pursued a strategy of lengthening the maturity structure of their country’s debt; Hungary placed a 20-year bond issue, while a number of countries such as Argentina and Mexico placed 10-year bond issues.

Bond issues continued to be concentrated in three currency sectors, with the share of issues denominated in U.S. dollars, deutsche mark, or Japanese yen amounting to 95 percent of the total. The U.S. dollar sector continued to be the major funding source for developing country borrowers, even for non-U.S. investors. Most investors reportedly hedge their currency exposure and it is easier to hedge instruments denominated in U.S. dollars. German investors exhibit a strong home currency preference and tend to buy deutsche mark-denominated issues to avoid any exposure to exchange rate risk. Other reasons for the predominance of these three currencies would include their widespread use in international payments and the ease of settlement. While most borrowers—especially those in the Western Hemisphere—placed dollar-denominated bond issues, a number of countries—particularly in Europe—continued to try to diversify the currencies of denomination of their borrowings, as a means of broadening their investor base and in an effort to match the currency composition of their external assets and liabilities. Mexico has issued bonds in nine different currencies, and is followed by Hungary with bonds issued in eight currencies, including its first Matador bond and a forint medium-term note facility.2

Enhancement techniques continued to be employed by developing country issuers in 1993 to help reduce borrowing costs, and as in past years the pattern of enhancements differed among regions. Asian borrowers enhanced roughly $6 billion (35 percent) of their bond issues, relying principally on equity conversion options, while Western Hemisphere borrowers enhanced only $3 billion (12 percent) of their bond issues, mainly through put options or collateralization.

The bond market began to taper off somewhat in January and early February 1994, but experienced a more pronounced setback after U.S. interest rates were increased starting in early February. For the quarter as a whole, a decline in bond issuance compared with the last quarter of 1993 took place in all regions, and the fall-off was substantial for Hungary, Turkey, and several other major borrowers. Nonetheless, certain countries, such as China, Thailand, and Mexico, actually increased their bond issuance. Sovereign borrowers increased their level of bond issuance, while other public sector and private sector issuers registered sizable declines. The average maturity of the bonds became shorter in the first quarter, and a growing share of bonds relied on floating interest rates. Yield spreads at launch continued to improve, suggesting that lower quality borrowers lost access to the market, while the secondary market spreads rose for some countries but declined for others.

International Equity Placements

The market for international equity placements grew sevenfold between 1990 and 1992, reflecting in part the wave of privatization in several countries. In contrast to bonds, this expansion of the equity market moderated in 1993, as international equity placements reached $11.9 billion, up from $9.3 billion in 1992 (Table A11). In 1993, developing countries accounted for only 23 percent of all international equity placements, well below their share of 41 percent in 1992. Since 1990, companies from developing countries have raised over $28 billion through the international equity markets.

Latin American and Asian companies accounted for almost all of the international equity placements in 1993. In Mexico, share prices and issuance activity were subdued in the first three quarters because of uncertainty about the passage of the North American Free Trade Agreement (NAFTA), but following the passage of the Agreement in the last quarter, Mexican corporations raised $1.7 billion in international equities, while local share prices rose rapidly (Chart 8). The shares sold by Mexican corporations in the fourth quarter were placed through ADR/ GDR programs, with Grupo Televisa offering the largest GDR issue ever at $822 million (Table 18). For the year, Mexican firms issued $2.5 billion in international equities, down from the $3 billion issued in 1992. International equity issues from Argentina rose sharply in 1993 to $2.8 billion, reflecting a strong increase in share prices and the $2 billion privatization of Yacimientos Petroleros Fiscales in the second quarter. China and Hong Kong accounted for over half the equity issues from Asia.

Chart 8.Share Price Indices for Selected Emerging Markets1

(In U.S. dollar terms, December 1988 = 100)

Source: International Finance Corporation, Emerging Markets Data Base.

1 IFC weekly investable price indices.

2Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela.

3India, Indonesia, Korea, Malaysia, Pakistan, the Philippines, Taiwan Province of China, and Thailand.

Table 18International Equity Issues by Developing Countries: Depository Receipts and Other Issues(In billions of U.S. dollars)
1990199119921993
Developing countries1,2625,4369,25911,865
Africa1432708
Depository receipts
Other1432708
Asia1,0401,0224,7325,673
Depository receipts12001,056937
Other1,0398223,6764,736
Europe1249167202
Depository receipts10105
Other124915797
Middle East60127257
Depository receipts188
Other6012769
Western Hemisphere984,1204,0635,725
Depository receipts982,1661,7815,246
Other1,9542,282479
Sources: Euroweek; and International Financing Review.
Sources: Euroweek; and International Financing Review.

For a number of developing countries, cross-border equity inflows have occurred through direct purchases on local exchanges. Although comprehensive statistics across countries are not available, recent estimates suggest that secondary market purchases in emerging markets by international investors amounted to some $14 billion in 1992, and many market participants believe that these flows increased substantially in 1993, with one source reporting an amount of $40 billion.3 For India, direct purchases of equity amounted to an estimated $1.4 billion in 1993, following no purchases in 1992, while in Mexico these inflows are estimated to have held steady at about $6 billion in 1992 and 1993.

In the first quarter of 1994, international equity issues declined to $4 billion, but accounted for about one third of total international equity issues, up from roughly one fifth for 1993. Enterprises in both Asia and the Western Hemisphere issued less equity, except for India which experienced about a sevenfold increase in the volume of equity placements.

Bank Lending

Banks began to show a renewed interest in lending to developing countries in 1993, although bank activity remained subdued in comparison with the financing through bonds. To limit their risk exposure, banks restricted new lending to short-term credits (typically trade credits), project finance, and loans structured using a variety of risk-mitigating techniques, including asset securitization. Medium-and long-term bank loan commitments to capital importing developing countries rose from $14.1 billion in 1992 to $18.5 billion in 1993 (Table 19).

Table 19Bank Credit Commitments by Country or Region of Destination(In billions of local currency)
1990199119921993
Developing countries121.027.017.018.7
Capital importing developing countries120.916.714.118.5
Africa0.60.20.60.3
Algeria0.1
Angola0.3
Côte d’Ivoire
Ghana0.10.10.1
Morocco0.1
Nigeria
South Africa
Tunisia0.10.1
Zimbabwe0.10.1
Other0.40.1
Asia12.013.610.513.4
China1.52.32.73.8
India0.70.2
Indonesia3.95.01.82.0
Korea2.03.51.82.1
Malaysia0.50.21.21.4
Pakistan0.40.1
Papua New Guinea0.10.3
Philippines0.7
Taiwan Province of China0.80.70.80.8
Thailand1.31.62.03.3
Viet Nam
Other0.1
Europe4.91.92.12.3
Bulgaria
Czech Republic0.2
Hungary0.10.20.1
Slovak Republic0.1
Turkey1.81.61.81.9
Former U.S.S.R.3.0
Other0.10.20.1
Middle East0.10.1
Egypt
Jordan
Other0.10.1
Western Hemisphere3.31.00.92.4
Argentina0.4
Brazil0.20.3
Chile0.30.40.3
Colombia0.20.1
Mexico1.60.60.20.4
Uruguay0.1
Venezuela1.40.20.8
Other0.10.1
Other developing countries0.110.02.90.2
Kuwait5.5
Saudi Arabia0.14.52.90.2
Offshore banking centers3.71.51.53.6
International organizations and unallocated4.46.67.14.8
Total124.5116.0117.9138.3
Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.

Excluding offshore banking centers.

Source: Organization for Economic Cooperation and Development, Financial Statistics Monthly.

Excluding offshore banking centers.

Most notable was the increase in loan commitments to Latin America, which rose from $0.9 billion in 1992 to $2.4 billion in 1993. Each of the major restructuring countries (Argentina, Brazil, Mexico, and Venezuela) received loans ranging from $0.3 billion to $0.8 billion. Asian borrowers continued to account for three fourths of new syndicated bank credit commitments to capital importing countries, with China borrowing $3.8 billion, followed by Thailand ($3.3 billion), Korea ($2.1 billion), and Indonesia ($2.0 billion). In Europe, Turkey obtained close to $2 billion in bank loan commitments in 1993, while European countries in transition had little access to nonguaranteed medium- and long-term bank lending. Bank lending to the Middle East (including Kuwait and Saudi Arabia) fell to virtually nothing in 1993, down sharply from the historical high of $10 billion in 1991. Bank lending activity to Africa continued to be very low.

This pickup in bank lending to developing countries in 1993 was associated with a widening of the average spread on voluntary loans to these countries to 106 basis points and a fall in the average maturity to 5.6 years in 1993, compared with 6.7 years in the previous year. The spreads differed widely according to the credit quality of the borrowing country, with spreads ranging from 57 basis points on loans to Malaysia to over 200 basis points on loans to India and Venezuela.

In contrast to the primary market for bank loans, the secondary market for bank claims on developing countries was very active. In October 1993, the Emerging Markets Traders Association issued the results of the first Trading Volume Survey. This report revealed that total trading volumes in the secondary market for developing country instruments exceeded $730 billion in 1992. Latin American instruments represented more than 80 percent of the volume, led by $209 billion for Brazil, $189 billion for Mexico, and $156 billion for Argentina. It is believed that the trading volume in 1993 was on the order of $1 trillion. By the end of 1993, securitized bank debt in developing countries had increased to some $90 billion, which includes about $25 billion of bonds issued in Argentina’s 1993 debt restructuring.

Issues in Market Access

Broadening of the Investor Base

The rapid growth in private financing to developing countries in 1993 reflected a considerable broadening of the investor base. Prior to 1993, the investor base in this market displayed a regional specialization. Asian countries that maintained access to the international markets continued to attract a moderate level of investment from the mainstream institutional investors such as pension funds and insurance companies from industrial countries, especially the United States and the United Kingdom. In contrast, Latin American countries, which began to regain market access in 1989, received inflows primarily from flight capital investors—who in many cases were repatriating money to their home countries—and from wealthy individuals. Hedge funds and other highly leveraged speculators have generally remained on the sidelines of this market, but have entered for short periods when they have perceived a good profit opportunity.

Starting in late 1992, some U.S. pension funds, such as ARCO and GTE, began to purchase investments, including Brady bonds, in Latin America.4 According to market participants, U.S. mutual funds significantly increased their participation in all segments of this market in mid-1993 and were followed by another round of buying by pension funds and insurance companies. At the end of 1993, U.S. mutual funds held about 2 percent of their assets (roughly $30 billion) in emerging markets, principally in the form of equity.5 The 200 largest pension funds in the United States increased the share of their portfolio placed in investments outside the country from 5.2 percent at the end of September 1992 to 7 percent at the end of September 1993, with slightly over one half of this increase due to new cash investments and with the remainder deriving from appreciation in the market value of the assets.6 U.S. pension funds engaging in international investment tended to be defined benefit plans and included public as well as private pension plans. There is little evidence on the investments of U.S. insurance companies in emerging markets in 1993, but they probably allocated an even smaller share than pension funds to foreign assets. European institutional investors also increased their participation in this market, although more moderately, perhaps taking a cue from the heightened interest of the U.S. institutions. While the shares of the international investments allocated to emerging markets are difficult to obtain, a recent survey of institutional fund managers reports that these managers allocated 13 percent of their international portfolios in 1993 to emerging markets assets, up from 10 percent in 1992 and 2.5 percent in 1989.7 The major institutions manage very sizable portfolios. The portfolios of U.S. mutual funds amount to $2 trillion.8 U.S. pension funds and insurance companies manage almost $6 trillion, while the assets of these institutional investors in France, Germany, Japan, and the United Kingdom amounted to $5.7 trillion at the end of 1991.9

Investor preferences continue to vary widely across countries. U.S. investors continue to play the largest role and purchase debt and equity principally from Latin American and Asian issuers. U.K. investors are also active in this market and tend to buy assets in Asia and to a lesser extent in Latin America. German investors focus principally on Eastern Europe, although their interest in Latin American instruments is picking up, and they prefer deutsche mark-denominated bond issues to avoid any exchange rate risk. Japanese investors have invested a small share of their assets in securities issued by the fast-growing economies of East and Southeast Asia and by other developing countries that maintained a good debt-servicing record during the 1980s. Investors outside these four countries have largely stayed on the sidelines of this market, although they have shown modest interest, mostly for opportunities in Asia.

Factors Behind the Expansion of the Investor Base

Starting in 1989, a number of developing countries proved they could sustain a program of sound macroeconomic policies and structural reforms (especially privatization), which helped open up investment opportunities with rates of return sufficiently high to attract international investors. In addition, several of the developing countries, including China and Mexico, began to improve financial reporting and the supervision of their financial markets, which helped boost investor confidence further. The reputation of the strong performing countries rubbed off on neighboring countries that embarked on a reform path later and made investors more willing to invest at an earlier stage in the reform process.

In 1993, high returns in emerging markets relative to those in industrial countries put pressure on some institutional investors, who face short-term performance goals, to enter these markets. The dollar return on equity investments in emerging markets reached 80 percent in 1993, ten times higher than the 8 percent return on U.S. equities and almost three times the gain in other industrial country stock markets (Table 20). In 1990–92, emerging market equity returns only matched those of the U.S. stock market after a strong relative performance in 1989. In addition, the equities in a number of emerging markets have price-earnings and price-book value ratios that are low in relation to the rest of the world (Table A12); and although a great deal of caution is needed in interpreting these indicators, these may lead investors to view emerging markets equities as undervalued. The average return for equities in all emerging markets, however, masks the strong variation in returns across countries as well as the volatility over time of returns in each country (Table 20). Similar to the returns on emerging market equity, the total return on Latin American bonds rose from about 10 percent in 1992 to 18 percent in 1993.10 Total returns on bonds appear to show a much greater degree of stability than emerging market equity returns.

Table 20Total Return on Equity in Selected Emerging Markets(In percent)
19891990199119921993
IFC composite61.5-2.239.53.379.2
Latin America76.29.1139.23.460.2
Of which:
Argentina204.4-42.5444.9-25.776.7
Brazil23.0-69.5285.11.094.2
Mexico129.827.2113.916.754.8
Venezuela56.9-50.750.7
Asia54.1-19.212.418.597.6
Of which:
China49.8
India26.0
Malaysia47.4-9.410.324.1110.0
Thailand105.8-24.420.638.5114.0
Europe, Middle East, and Africa75.813.9-29.2-32.7122.4
Of which:
Turkey2.5-45.8-50.7230.7
United States S&P 50031.6-3.130.47.67.5
Europe, Australia, and Far East10.8-23.212.5-11.930.5
Source: International Finance Corporation.
Source: International Finance Corporation.

The high rate of return compensates the investors for the fact that the returns on emerging markets equities have been considerably more volatile than those in industrial countries. Investors may also be attracted by diversification arguments since returns in emerging markets tend to be relatively uncorrelated with returns in developed countries.11

Institutional Issues

The investment decisions of insurance companies and pension funds in industrial countries are also affected by a variety of prudential limits on their ability to invest in foreign assets. Nonetheless, it is important to stress that these constraints do not appear to have been binding so far for most of these institutional investors. A recent World Bank study reviewed these restrictions in five major industrial countries and found the intensity of these restrictions varied across countries and differed for insurance companies as opposed to pension funds.12 Of these five countries, Germany imposes the strictest limits on both insurance companies and pension funds, setting a maximum portfolio share of 5 percent for foreign investments and prohibiting net exposure in any foreign currency (Table A13). In the other four countries, pension funds are treated differently from the insurance companies. In the United States, private pension funds are free from mandatory ceilings on holdings of foreign assets, but are subject to a “prudent man” rule and review by their boards or shareholders.13 Public pension funds in the United States are often subject to binding limits. In the United Kingdom, there are no limits, while in Japan there is a limit of 30 percent. Canada sets a ceiling that will reach 20 percent in 1994 on the foreign asset share of pension funds. Insurance companies in Canada, Japan, and the United Kingdom are free from any mandatory ceilings on their holdings of foreign assets, while the ceilings in the United States are set by state insurance regulators. Not surprisingly, insurance companies and pension funds in all five countries must meet certain minimum standards on the credit quality of their assets, which are often self-imposed, and in several countries these funds are subject to a prudent man rule.

The expansion of the investor base for emerging markets assets has been facilitated by the development of an infrastructure of the market. In recent years, many emerging market countries have improved the information that is available about their markets and have established investor safeguards, such as tougher laws against insider trading. Nonetheless, investments in these markets are affected by the host country’s macroeconomic policies as well as its regulations, taxes and settlement, and custodial procedures. As a result, pension funds and insurance companies tend to rely on specialized fund managers to select investments in emerging markets. Almost four fifths of the U.S. pension funds decide on an allocation for international investments and let a specialized manager place these funds as they see fit among non-U.S. investments.14

One common way to invest in emerging markets is to purchase shares in a country fund, a mutual fund that invests in a variety of emerging markets or in just a single country. The first country fund—the Mexico Fund—was launched in 1981, and by the end of 1993 there were nearly 500 country funds listed in a number of major financial centers. There is a wide variety of country funds, ranging from global funds that may invest in any emerging market, to funds dedicated to a specific region, to funds that specialize in a single country. Country funds require relatively low minimum investment and offer more liquidity than directly investing in the local market of the developing country, because the funds are traded in major financial markets. Also, a number of emerging market countries restrict portfolio capital inflows, and country funds may be the only vehicle for investing in such countries. Multi-country funds lower the cost of diversifying across emerging markets.

Many country funds are closed-end mutual funds in which a fixed number of shares are issued and shares may be sold only if another investor is willing to buy them, meaning that there are no net redemptions on the fund. In 1993, these funds invested $4 billion in emerging markets, bringing the combined portfolio of all emerging market closed-end funds to $33 billion at the end of 1993 (Table A14). The structure of a single-country closed-end fund protects the country from sudden swings in capital flows, because the shares invested in the country remain relatively stable. This also frees the fund from the risk of large net redemptions, allowing the manager to invest in less liquid assets. With a fixed number of shares, the market price of the share may trade at a discount or a premium from the net asset value of the fund, which is the total value of the assets divided by the number of shares. A discount or premium can persist for several reasons, including restrictions on the access of nonresidents to domestic capital markets of the issuing countries. At the end of 1993, closed-end equity funds on average had a discount of 11 percent.

Depository receipts are another instrument that facilitates investment in emerging markets. These instruments offer several advantages: they are denominated in and pay interest or dividends in U.S. dollars; settlement occurs in five days in the United States, which may be faster than in the issuer’s home market; tax payments on the underlying asset may be simpler, particularly when the host country has a withholding requirement; and the investor avoids global custodian safekeeping charges. Companies from many countries, both developing and industrial, rely on this mechanism to raise capital, and the number of depository receipts currently trading exceeds 900.

There are three levels of depository receipt programs, which differ in the degree of disclosure required.15 A level I program must obtain an exemption from the SEC’s registration and periodic reporting requirements, which allows it to trade these instruments only on the OTC market. This type of program is useful to get investors accustomed to trading in a particular stock, and most depository receipts use a level I program. A level II program is subject to a fairly complete registration and reporting requirement and is used mainly by issuers wishing to sell new shares through ADRs on NASDAQ or an exchange. A level III program requires full compliance with disclosure requirements of the SEC and is for foreign firms issuing new shares through a public offering.

Investors may also purchase a private placement of shares issued by a non-U.S. firm, and this private placement may take place through an ADR program. A private placement may qualify for an exemption from SEC reporting requirements if it meets a certain number of conditions, such as whether the potential investors have access to the kind of information that would be available in a registered public offering and whether they are sufficiently sophisticated. Rule 144a was adopted in 1990 to make securities privately placed under this exemption more liquid. Rule 144a permits holders of these securities to sell them freely to qualified institutional buyers (QIBs) under certain conditions without being subject to the two-year minimum holding period. Rule 144a does not apply to securities that are of the same class as “listed securities,” that is, securities that are listed on NASDAQ or an exchange. Although not necessarily required by U.S. securities law, non-U.S. companies selling newly issued stock or debt securities under Rule 144a have typically prepared extensive placement memoranda or offering circulars, and the amount of disclosure contained in such material is not much less than that required for complete disclosure under the U.S. Securities Act.

Assessment and Pricing of Risk

The nature of the credit risk associated with developing country debt instruments makes risk assessment and pricing more complex than for bonds issued in industrial countries. The likelihood of repayment for a developing country sovereign bond issue is affected by the country’s macro-economic policies and in particular by the government’s ability to service its debt obligations. The political situation also matters because of its impact on a country’s ability to sustain sound fiscal and other economic policies. Other factors also count, such as the market for the product of the issuer, the financial structure of the issuer, and the domestic legal and regulatory environment of the issuer. These factors are of course relevant for assessing risk more generally. But the recent wide-ranging structural changes in a number of these countries diminish the value of historical information about an issuer. Also, transfer risk—the possibility of restrictions on a corporation’s access to foreign exchange—can be important for many developing country bonds. Because the bond market for developing countries has expanded so quickly, investors, especially those who entered the market in 1993, are still learning to understand the available information. Likewise, many corporate issuers are new to the market and are just becoming acquainted with the needs of their investor base.

The market measures the degree of risk of a particular bond in terms of the spread over the comparable U.S. Treasury obligations—that is, the difference between the yields to maturity on the bond and on the U.S. Treasury instrument with the same maturity.16 Bond issues are sold initially at a particular spread, which may subsequently change over time through secondary market transactions. Because of the complexities associated with processing and evaluating the information, the market looks for certain benchmarks and arrives at a spread through a process of trial and error. Mexico, as the first debt-restructuring country to regain access to voluntary financing in recent years, has come to serve as the benchmark for measuring the risk of new sovereign debt issues from other developing countries in Latin America and in other regions, particularly for those with subinvestment grade ratings. In 1989, Mexico placed a bond at a spread of about 800 basis points over the comparable U.S. Treasury instrument. Mexico’s economic performance improved steadily since 1989, and over time the market was willing to accept a larger stock of Mexican sovereign bonds at spreads that declined to around 200 basis points by late 1993.

Some analysts suggest that investors evaluate developing country bonds by reference to U.S. corporate bonds with comparable credit ratings. According to Moody’s Investor Service, a U.S. Aaa corporate bond trades at a yield to maturity about 60 basis points above the yield on a long-term U.S. Treasury instrument, although this spread has at times reached 100 basis points.17 A U.S. Baa corporate bond—the lowest investment grade category—pays a spread of about 75 basis points above the Aaa bond, or 135 basis points above long-term U.S. Treasury instruments. Like the spreads on developing country bonds, these spreads are determined by market forces. But because the U.S. corporate bond market is stable and established, bond investors have access to financial information about the borrower that meets the investors’ standards, and the spreads can more accurately reflect the costs associated with delinquent payments or outright defaults. Bond default rates for different classes of U.S. borrowers are known by the market. It has been estimated, for example, that AAA bonds experienced a default rate of 0.21 percent in the ten years after issuance, while the ten-year default rate for the lowest investment grade bonds was 2.1 percent. Default was much more common in subinvestment grade issues, with 10.7 percent of BB bonds and 30.9 percent of B bonds defaulting in the ten years after issuance.18

In January, the market was anticipating that Standard and Poor’s would upgrade Mexico from the highest subinvestment grade rating, which for a U.S. corporate bond reportedly trades at a spread of about 200 basis points, to the lowest investment grade rating, which in the U.S. market would trade at a spread of about 130 basis points. As a result, the spread on Mexican sovereign issues fell to about 150 basis points, before the current market correction pushed the spread back up to about 200 basis points.

Argentina’s debt trades at a spread about 50 to 100 basis points above Mexico’s. Argentina is perceived as having made substantial progress in controlling inflation and implementing structural reforms, but is regarded as being at an earlier stage in the reform process and as having not yet resolved doubts about its external competitiveness. The market clearly regards both Brazil and Venezuela as much greater risks, and these countries’ bonds trade at spreads of about 200 to 300 basis points above Mexico’s. With regard to Eastern Europe, bonds of the Czech Republic currently obtain spreads below Mexico’s, mainly because of the Czech Republic’s investment grade rating, while Hungary’s spread has risen above Mexico’s because of the former’s high and increasing external debt. China’s $1 billion global bond issue was priced at a spread of about 80 basis points, in part because China received an investment grade rating and has relatively little external debt compared with Mexico and other countries.

Since 1989, Mexico has consistently paid the lowest spread of the major Latin American borrowers; the spread fell to below 200 basis points after NAFTA was approved in November 1993. The spread on Argentine bonds peaked at over 400 basis points in early 1993, but has hovered around 300 basis points since the completion of its bank debt restructuring in April 1993. The spread on Venezuelan bond issues has been the most volatile, rising from less than Argentina’s spread in early 1992 to more than Brazil’s spread of about 500 basis points by mid-1993. Brazilian bonds have generally paid the highest spread in Latin America.

The bonds of many countries that avoided debt restructurings in the 1980s generally have paid lower spreads compared with the Latin American borrowers other than Mexico (Chart 9). Korea has consistently paid a spread of less than 100 basis points. Turkey’s spread was 250 basis points at the end of 1993, but fluctuated considerably in early 1994, reaching 900 basis points. In the wake of the uncertainties surrounding the dissolution of Czechoslovakia, spreads on the bond of the Czech Republic reached almost 500 basis points in late 1992, even though its external debt was relatively low, but its spreads have fallen sharply since then to about 150 basis points.

Chart 9.Yield Spreads at Launch for Selected Developing Countries1

(In basis points)

Sources: International Financing Review and Financial Times.

1 Yield spread measured as the difference between the bond yield of U.S. dollar-denominated bonds and the corresponding U.S. Treasury security. Figures are weighted averages for sovereign and other public issuers.

2Argentina, Brazil, Mexico, and Venezuela.

3Czech Republic, Hungary, and Turkey.

4Korea, Malaysia, and Thailand.

These spreads are linked to the secondary market prices for Brady bonds and other bank claims on developing countries. The market arbitrages away differences between the yields to maturities on new issue and Brady bonds, but the arbitrage possibilities are often complicated by the different characteristics of these two types of instruments. For example, Brady bonds are typically collateralized, while new issues usually carry no collateral and instead may feature different types of credit enhancements, such as put options. Brady bonds also have much longer maturities than the new issues. Some market participants use Mexico and other countries that have completed Brady operations as a benchmark for setting the price of claims on countries (such as Peru and Russia) still to complete bank debt restructurings.

Sovereign bond issues in each country serve as a benchmark for the bond issues by other borrowers in that country. Mexico pursued a deliberate strategy of issuing sovereign bonds at different points along the yield curve to facilitate the pricing of bonds issued by Mexican public and private enterprises.19 In 1990, private bond issues paid spreads of 400 to 500 basis points above sovereigns, but by 1993, this margin had come down to 100 to 150 basis points.

For a description of China’s external borrowing strategy, see Annex V of this report.

A Matador bond is a bond issued in Spain by a nonresident.

See Pensions and Investments, January 25, 1993.

Information provided by Morningstar and is based on its data base of about 3,500 U.S. open-end mutual funds. These data exclude closed-end funds. Information for before 1993 is not available.

See Pensions and Investments, January 24, 1994, p. 17.

Board of Governors of the Federal Reserve System (1993). The information on mutual funds includes open-end and closed-end funds and money market mutual funds.

J.P. Morgan, Latin American Eurobond Index.

Under this type of rule, a regulator requires a pension fund or an insurance company to exercise prudence—which is not defined precisely—in their investment decisions.

Pensions and Investments, January 24, 1994.

There are also unsponsored depository receipts, but these are now obsolete. This discussion of depository receipts and private placements is based on Bank of New York (1993) and Quale (1993).

A U.S. dollar interest rate is presented here for illustrative purposes. For bonds denominated in other currencies, the appropriate comparison would be with a government instrument denominated in the same currency.

Moody’s Bond Survey, March 7, 1994, p. 6838.

This strategy is explained in more detail in Loser and Kalter (1992) and Collyns and others (1993), Section V.

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