Abstract

Although emerging market issuance of international bonds, equities, and syndicated loans rose in 2000 to the highest level since 1997, access to the international capital markets was characterized by an “on-off” nature. Increased asset price volatility in mature markets and the prospects of a slowdown in global growth combined with market turbulence in key emerging markets to make it difficult for many emerging markets to achieve sustained access. Indeed, the “on-off” nature of market access for emerging markets so evident during the 1990s is now viewed by many market participants as a key characteristic of international financial markets.

Although emerging market issuance of international bonds, equities, and syndicated loans rose in 2000 to the highest level since 1997, access to the international capital markets was characterized by an “on-off” nature. Increased asset price volatility in mature markets and the prospects of a slowdown in global growth combined with market turbulence in key emerging markets to make it difficult for many emerging markets to achieve sustained access. Indeed, the “on-off” nature of market access for emerging markets so evident during the 1990s is now viewed by many market participants as a key characteristic of international financial markets.

The terms and conditions of access to international markets for emerging markets are naturally influenced by events in both mature and emerging markets. However, developments in mature markets (particularly increased asset price volatility and the prospect of slower growth) have been especially important in the year ending May 2001. In the Asian and Russian crises, mature market financial conditions (particularly interest rate differentials) contributed to the buildup of external debt by emerging market private and public sector entities, but the abrupt losses of market access experienced during these crises were associated with the emergence of exchange rate and banking crises in key emerging markets and the ensuing contagion. In the past year, however, there were periods, especially in the fourth quarter of 2000, where developments in mature markets (such as the closing of U.S. high-yield markets and the collapse of equity prices on the Nasdaq) effectively eliminated emerging markets’ access to international capital markets. The crises in countries such as Argentina and Turkey clearly resulted in an immediate loss of market access for these countries; but there were limited spillover effects to other countries, in part reflecting the view that fundamentals in many emerging markets had continued to improve (with sovereign credit rating upgrades outnumbering downgrades by four to one in 2000).

In 2000, there was also a sharp break in the high positive correlation between gross and net capital flows to emerging markets that had existed throughout the 1990s. Although gross issuance of international bonds, equities, and syndicated loans rose by 32 percent (to reach $216.4 billion), net capital flows fell by 55 percent (to $32.2 billion). This divergence primarily reflects the experience of the fuel-exporting emerging markets, however. Due to a rise in oil prices, the current account surpluses of the fuel-exporting countries increased sharply and this led to the accumulation of both official foreign exchange reserves and claims (mainly deposits) on international banks, thereby generating a large net private capital outflow ($44 billion).

The nature of the current investor base for emerging market assets has been one of the key channels for transmitting the effects of developments in mature markets to emerging markets, as well as for affecting the “on-off” nature of recent market access.1 The holdings of emerging market assets by “dedicated” emerging market investors remain relatively limited, and market participants argue that the activities of highly leveraged institutions (such as hedge funds) with regard to emerging markets are now much more limited than during the Asian and Russian crises. This latter development reflects the closing of several large macro hedge funds, the orientation of other hedge funds toward mature market investments, and reductions in the capital allocated to support the activities of proprietary trading desks of investment banks. Nonetheless, it remains difficult to gauge the activities of hedge funds because of the limited disclosure of their investment activities. As a result, the current investor base is dominated largely by “crossover” investors who make most of their investments in mature markets but will devote a small proportion of their investment funds to emerging market investments if they are expected to offer an attractive return. However, since the benchmarks used to evaluate the performance of the portfolio managers of crossover investors typically do not encompass emerging market assets, these investors can reduce or eliminate their holdings of emerging market assets if the outlook for emerging markets deteriorates, more attractive investment opportunities become available in mature markets, or if managers become more risk averse and seek to lower the overall level of volatility of their holdings. (This contrasts sharply with the situation for dedicated investors, who necessarily are judged against emerging market benchmarks.) Such portfolio adjustments by crossover investors can lead to an abrupt expansion or contraction of market access for emerging markets that can be unrelated to changes in emerging market fundamentals. Unless the dedicated emerging market investor base expands significantly (which is regarded by market participants as unlikely), this on-off market access is likely to be a regular feature of the international financial system.

Emerging market borrowers have recently shown deftness in adapting to the on-off nature of market access. In part, this has involved turning to the syndicated loan market when access to bond markets has been restricted. In addition, they have attempted to develop access to the retail and institutional bond markets denominated in euros and yen when the U.S. dollar bond market has been closed. Moreover, they have employed staff in debt management agencies with extensive investment banking and trading experience, exploited “windows of opportunity” to pre-fund their yearly financing requirement, engaged in debt exchanges to extend the maturity of their external debt and avoid a bunching of maturities, and made greater use of local debt markets.

Developments in Aggregate Net Private Capital Flows to Emerging Markets

In contrast to the relatively high, positive correlation between net and gross private capital flows to emerging markets that has existed throughout the 1990s (Figure 3.1), net capital flows declined substantially in 2000 (Table 3.1) whereas gross issuance of international bonds, equities, and syndicated loans by emerging markets was buoyant (as discussed below). However, the $39 billion decline in net capital flows between 1999 and 2000 encompassed sharply divergent experiences for fuel and nonfuel emerging market exporters. As oil prices rose from an average of $18 per barrel in 1999 to $28 per barrel in 2000, the current account surpluses of fuel-exporting emerging markets rose from $10 billion to $94 billion, leading to a sharp buildup in claims on international banks and a substantial net capital outflow. In contrast, net private capital flows to non fuel-exporting emerging markets fell by only $5 billion.

Figure 3.1.
Figure 3.1.

Net Private Capital Flows and Gross Private Issuance to Emerging Markets

(In billions of U.S. dollars)

Sources: Capital Data; and IMF, World Economic Outlook.
Table 3.1.

Net Private Capital Flows to Emerging Markets

(In billions of U.S. dollars)

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Sources: IMF, International Financial Statistics; and IMF, World Economic Outlook.

Fuel exporters are defined (as in World Economic Outlook, October 2000) as countries for which oil exports constitute at least 20 percent of exports in the base period (1995–97): Algeria, Angola, Bahrain, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Oman, Qatar, Republic of Congo, Saudi Arabia, Trinidad and Tobago, United Arab Emirates, and Venezuela.

Despite the strengthening of aggregate emerging market current account positions in 2000, the decline in net private flows resulted in a somewhat slower buildup of foreign exchange reserves. However, there was again a sharp distinction between the experiences of the fuel-and nonfuel-exporting countries. The fuel-exporting emerging markets experienced a sharp increase in their current account surplus, which was accompanied by an increase in both official foreign exchange holdings (which had declined in both 1998 and 1999) and private claims (mainly deposits) on international banks. This was a pattern reminiscent of the accumulation of “petro-dollar” deposits in the 1970s. As a result, net bank exposures to fuel exporters declined by $40 billion (Table 3.1). In contrast, the current account surpluses and accumulated foreign exchange reserves of the non fuel-exporting countries declined. Moreover, the slower accumulation of foreign exchange reserves primarily reflected a slowdown in the rapid accumulation of reserve assets in Asia; accumulation of reserves accelerated in all other regions.

The decline of net private capital flows reflects, for the first time since 1990, a slowdown in foreign direct investment (FDI) as well as a continuing cutback in net bank claims on emerging markets. FDI nonetheless remains the largest single source of private capital in all regions. For the first time since 1997, however, new FDI flows did not offset the decline in bank exposures. The slowdown in FDI was largest in Asia and the Western Hemisphere, reflecting the winding down of mergers and acquisitions activity (M&A) in Asia and of privatization-related FDI in Latin America. Analysts have attributed the continuing slowdown in FDI flows to a number of factors: a decline in M&A activity in Asia after an initial spurt following the Asian crisis; the completion of many large-scale privatizations in Latin America; weakening earnings growth for multinational corporations, which reduced their capacity to acquire or build new assets; and a shift by multinationals from expansion to consolidation as global growth has slowed.

The sharp decline in net bank claims on emerging markets ($172 billion in 2000) represents a continuation of a trend that has been evident since the onset of the Asian crisis in 1997.2 In contrast to both 1998 and 1999, however, the contraction in net bank claims in 2000 represented a surge of deposits into international banks rather than a decline in bank lending to emerging markets (Table 3.2). While loan repayments had exceeded new credits by a large margin between 1997 and 1999, gross bank claims on emerging markets (that is, gross of liabilities) remained relatively stable during the first three quarters of 2000. Although the placement of deposits by residents of the fuel-exporting countries seems reminiscent of the 1970s, it notably has not been accompanied by large increases in cross-border bank exposures to other emerging markets as had occurred in the earlier period. Although it is true that banks have increased their exposures to some countries in Europe and Latin America, this has been offset by reduced exposures to Asian emerging markets. The repayments in Asia were dominated largely by reduced claims on Thai and Indonesian entities, due in part to a shift by domestic banks and corporations to local currency funding as a result of relatively low domestic interest rates (and possibly a desire to reduce vulnerability to cross-currency exposures).

Table 3.2.

Changes in Net Assets of BIS-Reporting Banks in Selected Countries and Regions

(In billions of U.S. dollars)

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Source: Bank for International Settlements.

Mainly deposits.

Fuel exporters are defined (as in World Economic Outlook, October 2000) as countries for which oil exports constitute at least 20 percent of exports in the base period (1995–97): Algeria, Angola, Bahrain, Equatorial, Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Oman, Oalar, Republic of Congo, Saudi Arabia, Trinidad and Tobago, United Arab Emirates, and Venezuela.

One factor cushioning the impact of the decline in net private flows to nonfuel-exporting emerging markets, as well as the on-off nature of access to international markets, has been the greater reliance of sovereign and high-quality corporates on local funding sources, particularly local bond markets in both Asia and Latin America (Figure 3.2). The recent growth of emerging bond markets can be attributed in part to the bank and corporate restructuring in the aftermath of the Asian crisis. During the financial restructuring exercises, the national authorities have issued large amounts of domestic bonds to fund purchases of nonperforming loans and the recapitalization of local banks. In addition, corporate bond issuance has risen sharply in some countries. For instance, between 1997 and 2000, the outstanding stocks of local currency-denominated, long-term bonds in Malaysia, the Republic of Korea, Thailand, Indonesia, and the Philippines more than doubled from a total of $181 billion to $422 billion (see Annex II for a discussion of the development of local bond markets in Asia and Latin America).

Figure 3.2.
Figure 3.2.

Emerging Market Domestic Debt and External Debt

(In billions of U.S. dollars)

Source: Merrill Lynch.

Argentina provides one example of the greater reliance on domestic markets when the prospect for raising funds in the international capital markets has weakened. The share of domestic debt in Argentina’s total public debt increased from about 28 percent at end-1997 to 36 percent at end-2000. These figures underestimate residents’ holdings of government debt, however, since Argentina’s financial institutions hold a substantial portion of the country’s U.S. dollar-denominated external debt (see Annex II). Moreover, in 2000, the Argentine authorities intended to fulfill about 78 percent of their financing program by tapping local investors. Of the $17.5 billion earmarked for local investors, $4.3 billion was expected to come from private pension funds, $6 billion from banks, and $3 billion from insurance companies and other investors.

Developments in the Bond, Equity, and Syndicated Loan Markets

Total emerging market issuance of international bonds, equity, and syndicated loans grew by 32 percent in 2000, and there was a further surge in issuance early in the first quarter of 2001 (Table 3.3).3 However, issuance activity during this period aptly illustrated the on-off nature of market access experienced by emerging markets, with both the expansion and contraction of market access often triggered by events in mature markets (Annex III). In the first quarter of 2000, total issuance reached $60.4 billion, the highest quarterly rate since the third quarter of 1997. However, issuance moderated subsequently as equity prices fell sharply on the U.S. Nasdaq market and concerns grew about the extent and duration of the tightening of U.S. monetary policy. Although equity prices, especially in the technology, media, and telecoms (TMT) sector, continued to decline in the third quarter as earnings prospects were reevaluated, perceptions that the U.S. economy was slowing alleviated concerns about higher U.S. interest rates. In this environment, higher bond issuance partially offset declines in equity placements and syndicated loans. As a result, this was the best third quarterly issuance level in three years, with gross issuance through the first three quarters of 2000 exceeding the annual amounts raised in 1998 and 1999.

Table 3.3.

Gross Private Market Financing to Emerging Markets, by Region, Financing Type, and Borrower Type1

(In billions of U.S. dollars)

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Sources: Capital Data: and IMF staff calculations.

Bond data include only the new money component of bord exchanges.

Fuel exporters are defined (as in World Economic Outlook October 2000) as countries for which oil exports constitute at least 20 percent of exports in the base period (1995–97) Algeria, Angola Bahrain. Equatorial Guinea. Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Oman, Oatar, Republic of Conga, Saudi Arabia, Trinidad and Tobago, United Arab Emirates, and Venezuela.

Heightened concerns about a slowdown of the U.S. economy, a further downgrading in the earning prospects of the global TMT sector, and a deterioration in U.S. credit markets (especially in the high-yield sector) all took their toll on emerging bond and equity markets in the last quarter of 2000. Emerging market interest rate spreads widened in line with those in the U.S. high-yield market, and concerns about developments in Argentina and Turkey led to an almost complete drying up of emerging market bond issuance. Nonetheless, overall issuance was sustained during the period by large equity issues by Chinese entities and continued syndicated lending. Overall, issuance in 2000 thus reached the highest level since 1997.

All emerging market regions experienced significant percentage increases in gross inflows in 2000, except the Middle East. In Asia, nearly half the increase came in the form of the equity issues already noted and increased syndicated bank loans accounted for the remainder—especially loans to northern Asian countries or regions, notably Hong Kong SAR and Taiwan Province of China. In the Western Hemisphere, emerging market economies also increased both equity and loan issuance, notably new bank lending to Mexican corporates. In emerging Europe, bank lending increased significantly to Central European economies and Slovenia. And the rise in flows to Africa was mainly accounted for by bank lending to South African corporates.

Following the announcement of multilateral financial packages for Argentina and Turkey in December, and especially after the surprise cut in U.S. interest rates in early January 2001, conditions in global bond and equity markets improved. A number of emerging market borrowers quickly came to the market with new bond issues and equity market prices rallied strongly. Many emerging market sovereigns successfully prefunded much of their financing needs for 2001. In February and March, however, the rallies on the secondary markets for bonds and equities dissipated on continuing evidence of a U.S. economic slowdown and poor corporate earnings reports that more than offset the effects of lower U.S. short-term interest rates. Moreover, international bond markets were essentially closed for emerging market borrowers as investor concerns about emerging market fundamentals grew. Turkey experienced a major crisis and was forced to float the exchange rate, and doubts about the sustainability of Argentina’s debt position came to the fore. For the first quarter 2001 as a whole, the record bond issuance in January was offset by drops in international equity placement and syndicated lending, leaving the quarterly total well below the average quarterly issuance levels in 2000.

Notably, the abrupt changes in market access experienced during this period were not associated with sharp changes in market perceptions about emerging market fundamentals as a whole. During 2000, average emerging market credit quality continued the improvement that had been evident since the Russian crisis of 1998 (Figure 3.3). Although there were concerns about fiscal developments in Argentina in May and October 2000, it was not until January 2001 that concerns about Argentina and Turkey (which resulted in credit rating downgrades), and about the likely effects of deteriorating global growth on emerging markets, led to declines in the average level of emerging market credit ratings. Moreover, market participants continued to project sustained growth for emerging markets typically until the third quarter of 2000, when anticipated growth fell off rapidly during the remainder of the year (Figure 3.4). If changing market views on emerging market fundamentals were relatively stable or evolved slowly, this raises the issue of what factors contributed to the on-off pattern of market access so evident during 2000 and early 2001. These factors can best be illustrated by examining the experience with primary bond issuance and secondary bond market developments.

Figure 3.3.
Figure 3.3.

Average Credit Ratings in Emerging Markets1

Sources: IMF staff calculations based on data from Moody’s, Standard and Poor’s, and Capital Data.1Includes all major emerging markets with credit ratings as of December 1996.
Figure 3.4.
Figure 3.4.

Real GDP Growth Consensus Forecast

(Year-on-year percent change)

Source: Consensus Forecasts.

Bond Market Developments

Primary Market Issues

Although the first quarter of 2000 saw the largest quarterly issuance of emerging market bonds since the third quarter of 1997, total issuance declined by 2 percent between 1999 and 2000 (Table 3.3). Western Hemisphere borrowers accounted for almost half of total issuance in 2000, a slight reduction over prior year levels. Asian issuance was flat in 2000, but low interest rate spreads for high-grade corporate issuers stimulated new issuance among corporates and banks in a number of Asian countries in the first half of 2001. Issuance in Europe, Africa, and the Middle East was roughly unchanged, and continued to be heavily weighted toward sovereigns. Only Turkish issuance increased sizably, by some 30 percent to $8.5 billion in 2000, although not surprisingly the issuance came to a halt in the fourth quarter.

As already noted, issuance of bonds surged in January 2001 following the unexpected cut in U.S. interest rates and efforts by emerging market sovereigns to prefund their 2001 financing requirements. However, the market turbulence in Turkey (in February) and in Argentina (in March) caused issuance to taper off quickly. In particular, issuance by Argentina and Turkey in the first quarter of 2001 dropped by $8 billion in comparison to the corresponding figure in the first quarter of 2000. Total bond issues by emerging markets in the first quarter nonetheless reached $26.3 billion, which compared favorably with average quarterly issues of around $20 billion during 1998–2000. Latin America was again the largest issuer (accounting for 46 percent) in the first quarter, and Mexico exceeded its bond financing program for 2001 with two Eurobond issues totaling $2.2 billion. High-grade Mexican corporates followed, with Telmex and Pemex each issuing $1 billion deals. Asian borrowers accounted for 35 percent of total bond issues in the quarter, which was dominated by Hong Kong SAR corporate Hutchison Whampoa’s issue of both a $2.5 billion convertible bond and a $1.5 billion plain vanilla Eurobond.

One of the characteristics of emerging debt markets over the course of 2000–01 has been repeated market closures. There are a number of potential definitions of market closures, but one simple standard is to look at weeks where issuance falls short of 20 percent of the prior year’s weekly average issuance (excluding the holidays at end-December and in early January when issuance is always low). Under this definition, U.S. dollar emerging bond markets were closed for 16 weeks during 2000–01 (see Annex III for more details). In addition, market participants argued that December 2000 issuance had been limited, even after taking into account seasonality. These market closures typically occurred at times of great uncertainty, reflected in upturns in Emerging Markets Bond Index (EMBI) spreads. This, in turn, caused both issuers and investors to become reluctant to participate in primary issuance.4 It is interesting to note that the euro and yen markets were open at times that the U.S. dollar segment was closed (Figure 3.5). An example of this is the multiple small tranches offered in the euro market by the Argentine sovereign, during May 2000, after the dollar market closed to emerging market issuers. Similarly, in the fourth quarter of 2000, Brazil and Turkey issued in the relatively receptive Samurai market. Indeed, the overall market for emerging market debt was closed less than half the time that the U.S. dollar segment was.5

Figure 3.5.
Figure 3.5.

Currency Composition of Emerging Market Bond Issues

(In millions of U.S. dollars)

Sources: Capital Data; and IMF staff calculations.

Excluding bond exchanges (see below), sovereign borrowers continued to account for the majority (53 percent) of emerging market bond issues in 2000. Other public sector issuers accounted for a further 15 percent of total issues. Corporate issues were strong in the early part of the third quarter of 2000, amid improving market conditions in the United States and after the main emerging market sovereign borrowers had completed their financing programs for the year. Some of the top-rated corporates that maintained access nevertheless preferred to borrow locally because of lower domestic interest rates. In early 2001, there were sizable issues by corporates (in particular from Asia), given the room left by the light issuance calendar of sovereigns in 2001 and the reopening of the U.S. high-yield market in the first quarter. Latin American corporates suffered from developments in Argentina over the period and were able to issue only minimally from the fourth quarter of 2000 onward.

After a large drop in the share of U.S. dollar-denominated bonds between 1998 and 1999 (from 74 percent to 61 percent), there was relatively little change from 2000 to the early part of 2001, with the dollar share declining from 60 percent to 59 percent of total bond issuance (Figure 3.5). Issues denominated in Japanese yen took on a more important role in 2000, rising from 3 percent of total issues in 1999 to 10 percent in 2000. Euro-denominated issues declined to some 27 percent in 2000 from 32 percent in 1999. The reemergence of Samurai issuance by emerging market sovereigns is related to the growth of both institutional and retail demand, and reflects the low-yield investment opportunities available in Japan at a time when there was a large-scale maturing of Japanese postal savings deposits (Box 3.1). Euro-denominated bond issuance has been supported by a retail market attracted by high coupon bonds and the development of the European institutional investor base (Box 3.2). The slower issuance in euro-denominated emerging market bonds in 2000 and in early 2001 can be attributed, in part, to disruptions in the infant euro high-yield market, which is dominated by telecoms, cable, and media issuers, whose stocks fell out of favor. Another cause of slower issuance in this segment was the strength of the U.S. dollar, which rose against the euro in the early months of 2001, resulting in reduced investor appetite for euro-denominated instruments. Both yen and euro-denominated markets were tapped opportunistically in 2000–01, when U.S. dollar issuance weakened (Figure 3.5).

In 2000 and the first quarter of 2001, emerging market sovereigns (mostly in Latin America) continued to undertake external debt liability management transactions, designed to lengthen the maturity of their external liabilities and reduce their outstanding stock of Brady bonds. For example, Mexico added $500 million to its 10-year global bond issue in January 2000 and reopened its $1 billion global bond (with an 8-year maturity, paying 8.625 percent) for $500 million in March 2000 to buy back Brady bonds. In March 2000, Brazil reopened its 30-year global bond for $600 million and also used the proceeds to buy back Bradys. In August 2000, Brazil issued a $5.16 billion, 40-year (callable on or after 2015) global bond in exchange for Brady bonds.

In early 2001, Brazil exchanged $2.2 billion in four Brady bonds—Par, Discount, Capitalization (C), and Debt Conversion (DCB) bonds—for a new global bond maturing in 2024. Moreover, Brazil decreased its Brady debt by paying the final principal payment of the amortizing Brazil Interest Due and Unpaid (IDU) bond, its shortest Brady bond. This marked the first time a Brady bond had actually matured. Argentina reduced its Bradys by exchanging Floating Rate Bonds (FRBs), Bontes, and Bocones for $2.1 billion in 11- and 30-year global bonds and paying about $650 million in principal on the amortizing FRBs, offsetting $1.4 billion bonds that matured. Since the first exchange by Argentina in 1995, emerging market sovereigns have reduced the stock of outstanding Brady debt by $80 billion (Brazil, -$29.2 billion; Argentina, -$15.5 billion; and Mexico, -$15.1 billion—see Table 3.4) through exchanges, buybacks, calls, warrant exercises, default and subsequent restructuring (Ecuador), amortization, and (most recently) exchanges including cash payments. As a result, only 47 percent of the original face value of Brady debt ($153.7 billion) remained outstanding as of the end of the first quarter of 2001. At the same time, issuance of Eurobonds grew substantially and emerging market sovereign debt now consists of 70 percent Eurobonds versus 30 percent Brady debt.6

Table 3.4.

Decline of Brady Debt1

(In billions of U.S. dollars)

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Sources: Merrill Lynch; and IMF staff calculations.

Reduction in the stock of Brady debt.

Emerging Market Sovereigns Return to the Euroyen Market

A notable development in 2000 was the return of emerging market sovereigns to the euroyen market. After being squeezed out for a two-year period following the Asian crisis, emerging market sovereigns have tapped the euroyen market during the 18 months to May 2001 for about 12 percent of their international bond issues (see the first figure). The recent turbulence in emerging markets does not appear to have precluded countries such as Argentina, Brazil, Colombia, Mexico, and Turkey from issuing bonds in the euroyen market at spreads that are significantly lower than in the dollar market (see the second figure). For instance, Turkey launched a three-year, ¥50 billion samurai bond in October 2000 at a spread of just 219 basis points over the yen-swap rate. Additionally, Tunisia launched a five-year, ¥35 billion global samurai bond in March 2001 aimed at both the domestic yen and the U.S. investor bases, with a spread of only 163 basis points over the yen-swap rate. The distinction between euroyen and samurai bonds is not entirely clear-cut: the former are sold internationally and the latter domestically in Japan. Euroyen issues may, therefore, have a significant domestic tranche, and ownership is further dispersed in secondary market trading.1 Market participants expect the euroyen market for emerging market sovereign issues to deepen in the year ahead (accompanied by a growing dispersion and heterogeneity of the emerging market investor base). Emerging market corporates, however, have accessed this market only to a limited extent and are not expected to make significant inroads in the near term—hence, the exclusive focus on sovereigns.

uch03fig01

Emerging Market Sovereign and Public Sector Euroyen Bond Issuance

Sources: Capital Data; and IMF staff estimates.

The recent revival of the euroyen market, however, needs to be viewed in perspective. A sizable chunk of gross issues by emerging market sovereigns in the year to May 2001 in this market has been for rolling over maturing bonds (see the third figure). The maturity profile of recent issues has been for a shorter duration than was the case in 1995–97, and noninvestment grade ratings have constituted a relatively smaller portion of recent issues than before. Nevertheless, given that there were literally no rollovers during 1997–99—a period characterized by significant maturity clustering—the recent reactivation of the euroyen market constitutes an important development in international capital markets.

uch03fig02

Emerging Market Sovereign and Public Sector Weighted Spreads

(By currency of issuance)

Sources: Capital Data; and IMF staff estimates.
uch03fig03

Emerging Market Sovereign Euroyen Bond Issuance

(In millions of U.S. dollars)

Source: Capital Data.

What accounts for the revival of the euroyen market for emerging market sovereign bonds? The primary driving force, as argued below, is a clustering in recent years of economic and policy developments in Japan that have favored the samurai market. Emerging market sovereigns have been nimble in understanding and using this window of opportunity to widen their funding base.

Developments in Japan

The search for yield intensified when the Bank of Japan (BoJ) introduced its zero interest rate policy in February 1999. Both the corporate and household sectors in Japan have been flush with liquidity in recent years—BoJ estimates indicate that cash and deposits held by the household sector alone are almost 140 percent of GDP. Moreover, the cash position of households is being enhanced by the wave of maturing 10-year postal savings deposits amounting to a cumulative ¥106 trillion during fiscal years 2000 and 2001. The search for yield, however, has not been transformed into an appetite for equities—risk aversion among households is strong, given past experience with investing in stocks. Alternatives to holding cash, other than to invest in Japanese government bonds (JGBs), have been limited in recent years. High-grade corporates in Japan, faced with a combination of favorable cash flow positions and dwindling incentives for expanding operations domestically, have responded by cutting back on bond issues—the supply of corporate bonds was down by about 40 percent in 2000 from the previous year. Unlike in the United States, Japan does not have a deep high-yield domestic bond market.

With limited options for securing higher yields in the domestic bond market, both institutional and retail investors in Japan have been eyeing the euroyen market for possibilities—with the former investors focusing mainly on the global euroyen market, and the latter primarily on the samurai market. Although institutional investors have exhibited a preference for euro-yen bonds issued by foreign corporates, retail investors have an overwhelming preference for emerging market sovereign over corporate debt instruments. Retail investors—a category that includes middle-class salary earners, rich individuals, small companies, and private endowments—have been significant buyers of samurai bonds issued by emerging market sovereigns during the 18 months to May 2001. According to market participants, the purchase of emerging market samurais by retail investors appears to be driven by their gut feeling that while countries do not go out of existence, companies can and do so periodically.

Regional banks in Japan are also significant holders of emerging market sovereign samurais. However, they have recently adopted a more cautious attitude to this category of debt instruments because of the introduction of mark-to-market accounting from April 2001. While regional banks, like retail investors, tend to hold emerging market samurais to maturity, and hence are less concerned in practice with price volatility, mark-to-market accounting nevertheless introduces a new element of balance sheet risk. Consequently, they have focused mainly on shorter duration emerging market sovereign samurais in recent months to minimize risks to balance sheets.

Duration mismatches in the bond market have had positive spillovers for emerging market sovereign euroyen issues. First, there has been a relative paucity of debt instruments of shorter duration in Japan—JGBs tend to be concentrated mainly in the 10-year range. While the Ministry of Finance has recently done a good job of spreading the issues across the yield curve, this still has not fully alleviated the relative shortage of debt instruments in the two- to five-year range. While JGBs and emerging market sovereign euroyen bonds are not perfect substitutes, issuers of the latter category of debt instruments have used the window of opportunity created by the duration mismatch in yen instruments to focus on the shorter end of the yield curve, and increase their placements of bonds in the two- to five-year range.

Technical features

Listed below are some of the main defining characteristics of the emerging market sovereign euroyen bond market.

  • There is no technical secondary market for emerging market samurais—that is, a market in which bid-ask prices for these instruments are quoted on a daily basis. Since emerging market sovereign samurais are generally held to maturity, the absence of a secondary market has not crimped demand for these instruments. Furthermore, market-makers try to fill the gap left by the absence of a proper secondary market by offering to buy back the samurais in order to maintain an ongoing relationship with their clients. However, the prices at which such sales and purchases of emerging market sovereign samurais take place between the market-maker and the client are not public knowledge, so that it effectively functions as an over-the-counter market, presumably to the advantage of the market-maker.

  • Market-makers sell emerging market samurais directly to retail investors—these can be purchased in denominations as small as $1,000 equivalents. There is very little bundling of emerging market debt into bond funds for the retail market. Listings in the global euroyen market are in much larger denominations to meet the needs of institutional clients. The recent launch of the Tunisian euroyen bond, for instance, was structured to take account of the different issuing requirements of the samurai and global euroyen markets.

  • Institutional investors in Japan tend to depend primarily on risk assessments provided by international credit rating agencies in deciding how large a spread to demand on emerging market sovereign issues. While retail investors also make use of assessments provided by Japanese credit rating agencies, they tend to take the lead mainly from the international credit rating agencies in cases where there is a difference of opinion between the local and the foreign rating agencies.

  • Japanese retail investors make a distinction between Asian and non-Asian sovereign debt. In general, they appear to be more negative on debts issued by the Asian countries—memories of the Asian crisis still appear to be fresh. While the “Miyazawa Plan” opened the door to Japanese guarantees of Asian samurai issues, there has been little use made so far of these guarantees, except by the Philippines, and much of the recent samurai issuance has been by South American sovereigns.

  • Asian sovereigns, in general, prefer to keep their yen exposure, and do not swap into dollars. Non-Asian sovereigns prefer to swap some of their yen exposure to dollars, and do so.

1

Samurai bonds are listed in Japan and have to conform with local securities regulations, which tends to make the retail investor comfortable about the legal status of these bonds. Bonds listed in the global euroyen format, in contrast, conform to Securities and Exchange Commission (SEC) regulations. Arbitrage opportunities between the global and samurai markets tend to be somewhat stymied by regulations that restrict who can trade in which market.

The European Investor Base for Emerging Market Debt

One of the major structural changes in international financial markets over the past three years has been the growth of the European investor base for emerging market debt. In 1997, new bond issues denominated in the 12 predecessor (national) currencies of the euro accounted for 13 percent of total emerging market bond issues, compared to 73 percent for U.S. dollar-denominated issues. The share of euro-denominated issues rose to around 30 percent in 1999 and remained at that level in 2000; for dollar-denominated issues, the figures fell to 61 percent in 1999 and 60 percent in 2000. These bond issuing trends remained similar in the first two months of 2001 (see the table).

Following the introduction of the euro in January 1999, the market for euro-denominated emerging market debt expanded rapidly, with issues in 2000 amounting to some €26 billion, compared to U.S. dollar issues of $44 billion. At end-February 2001, outstanding debt in euros (and its component currencies) was €60 billion compared to $250 billion for the U.S. dollar sector. Of the euro issues, €34.6 billion, equal to 58 percent of the total, was issued by sovereign and public sector borrowers, and the remainder by private sector borrowers.

The main structural factors driving growth of the European investor base have been the creation of a pan-European debt market since the inception of the euro and the growth of European pension funds.

The appearance of the euro has been accompanied by a strong move by European investors, primarily institutional and, to a lesser degree, retail, out of individual country fixed-income and equity markets into internationally traded, euro-denominated fixed-income (not only emerging market, but also high-yield and investment-grade). Although both individual country and international bonds are denominated in euro, the latter are more liquid instruments because of the scale of issuance (both of single bonds and in aggregate). By contrast, European Economic and Monetary Union (EMU) convergence criteria have reduced not only the amounts of individual country bonds available, but also the yields on offer. Thus, the creation of the euro has released funds for crossborder investment that were previously prohibited by rules forbidding cross-currency investment, and the funds have flowed to the international market because of its better liquidity.

Emerging Market Debt Issues by Currency

(Percentage of total)

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Source: Capital Data Bondware.Note: The euro sector includes issues denominated in the 12 legacy (component) currencies.

In addition, demand for liquid, euro-denominated assets has been driven by rapid growth in the European pension fund industry; most of this demand has come from firms setting up funded employee schemes, and also from individuals building up pension savings through mutual funds and other means.

As a result of these developments, the main investors in euro-denominated emerging markets have been euro-area residents. Market participants argue that about 60 percent of the investors are bank-managed funds and newly created mutual funds; pension funds and private banking (that is, managed funds for wealthy individuals) account for a little less than 10 percent each; direct retail investors are a very small percentage; and the remainder, about 20 percent, is accounted for by asset managers representing a variety of funds, both euro-area and non-euro-area.

The euro-area investors are located mainly in Germany, Italy, the Netherlands, and Spain (the latter country being dominated by bank funds), which account for roughly three-fourths of transactions, according to market participants. Investors from France, Portugal, and (through bank funds) Austria are also active. To date, diversification by U.S. and other non-euro-area investors appears to have been a minor factor in market development.

Emerging market issuers in the euro market have been the traditional borrowers from Latin America and Europe. In 2000, borrowers (sovereigns, corporates, and banks) from Argentina, Brazil, Mexico, and Turkey accounted for 59 percent of new issues, similar to the figure for 1999. Additional borrowers have been accessing this market, however. For example, in early 2001, Venezuela, Colombia, and Jamaica were able to access the market. In addition, South Africa, with an investment-grade rating of BBB-, issued €500 million at a 7-year maturity; Croatia, also with a rating of BBB-, was able to issue €500 million at a 10-year maturity; and Poland was able to access funds at E+28 basis points (E denoting EURIBOR, the interbank offered rate in euro). Turkey was able to borrow €750 million at three years in February 2001, just prior to the float of the Turkish lira, thanks to the strength of its traditional retail investor base. Indeed, one motivation for borrowers to issue euro-denominated bonds has been the perception that the investor base is stable and, therefore, a reliable source of funds.

The main market characteristics for emerging market euro debt, compared to dollar-denominated debt, are less depth and liquidity (that is, ability to trade in size), but also less price volatility. Also, the euro market is shorter in duration, without the range of 20- to 30-year bonds that have become common offerings in U.S. dollars in recent years. The depth of the market is improving, nevertheless, as shown by its ability to comfortably absorb new issues of €1 billion, without the previously used backstop of a 144A tranche (which permitted private placement with investors in the United States if the issue faced difficulties).

Market participants have noted that the euro market has been much less volatile than the dollar market but has also offered a lower total return. For example, from January 1999 (inception of the euro) to end February 2001, the annual standard deviation of prices has averaged just under 10 percent for U.S. dollar bonds, and just under 3 percent for euro bonds. Over the same period, the euro market returned substantially less, thanks largely to the depreciation of the euro against the dollar, but also because of tighter spreads to corresponding government bonds. The low volatility of prices to some extent is seen to be reflecting the role of retail investors who trade very little, preferring to buy and hold.

Prices of euro-denominated emerging market debt are closely linked to euro investment-grade and high-yield debt, through crossover investors. Unlike dollar-denominated debt, however, high-yield debt is comparatively unimportant, and investment grade is the dominant influence because it is overwhelmingly the bigger market. In 2000, new issues in the euro investment-grade market amounted to €472 billion (compared to $546 billion in the U.S. dollar market), whereas in the euro high-yield market it was less than €7 billion (compared to $42 billion in the U.S. dollar market, down from $100 billion in 1999).

One feature common to the euro-denominated debt markets has been the use of the swap curve, rather than a government securities yield curve, as the benchmark for pricing. The relatively good liquidity in the interest rate swap market out to 10-year maturities, in comparison with illiquid and heterogeneous individual country government bonds (of differing size, rating, and liquidity), has led to pricing in terms of swap rates and implied spreads over EURIBOR.

In addition to the issuance of long-dated debt to retire Bradys, emerging market sovereigns issued about $24 billion of bonds with maturities greater than or equal to 10 years (about one-fifth of gross issuance). Argentina, Brazil, and Turkey—and also Qatar and the Central Bank of Tunisia—were able to issue 30-year bonds.

Secondary Market Developments

Emerging debt markets were the best performing asset class in 2000, as the total return of the asset class reached 14.4 percent (based on the EMBI global), althou