Public Debt Markets in Central America, Panama, and the Dominican Republic
Author:
Andreas Jobst
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Ms. Laura Valderrama
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https://orcid.org/0000-0001-5968-6092
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Mr. Ivan S Guerra
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Mr. Hemant Shah
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Contributor Notes

Author’s E-Mail Address: hshah@imf.org; ajobst@imf.org; lvalderramaferrando@imf.org; iguerra@imf.org
Publication Date:
01 Jun 2007
eISBN:
9781451867114
Language:
English
Keywords:
WP; global bond; secondary market; short term; capital market; investment funds; short-term debt; commercial paper; finance ministry; coupon rate; debt issuance
Download PDF (650.1 KB)

This paper-consisting of a regional study and seven country studies-reviews the state of domestic public debt markets in Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, and Panama as at end-2005. Although they account for the lion's share of capital markets, regional public debt markets remain underdeveloped for a variety of reasons. The problems of small scale, dollarization, and weak public finances in many countries are compounded by poor structure and composition of debt (with sizeable nonstandard and non-tradable components), fragmentation of public debt between central banks and the sovereigns and across instruments, poor debt management practices, weaknesses in securities market, and small investor bases all of which result in high transaction costs and a lack of liquid benchmarks. The paper also briefly discusses efforts towards and impediments to regional integration of public debt markets. The authorities recognize these problems and the paper takes note of the regional efforts to harmonize debt standards and improve issuance practices. It offers several recommendations to improve strategic debt management, issuance mechanics, and secondary trading.

Abstract

This paper-consisting of a regional study and seven country studies-reviews the state of domestic public debt markets in Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, and Panama as at end-2005. Although they account for the lion's share of capital markets, regional public debt markets remain underdeveloped for a variety of reasons. The problems of small scale, dollarization, and weak public finances in many countries are compounded by poor structure and composition of debt (with sizeable nonstandard and non-tradable components), fragmentation of public debt between central banks and the sovereigns and across instruments, poor debt management practices, weaknesses in securities market, and small investor bases all of which result in high transaction costs and a lack of liquid benchmarks. The paper also briefly discusses efforts towards and impediments to regional integration of public debt markets. The authorities recognize these problems and the paper takes note of the regional efforts to harmonize debt standards and improve issuance practices. It offers several recommendations to improve strategic debt management, issuance mechanics, and secondary trading.

I. Public Debt Markets in Central America, Panama and the Dominican Republic1

1. This paper2 examines the strategic context of public debt management and the functioning of primary and secondary markets for domestic public debt. It proposes measures to improve the functioning of these markets and promote a more efficient regional market in public debt.3 The main text focuses on the functioning of domestic debt markets in Central America from a regional perspective, based on the seven country studies that follow.4

2. Development of Central American public debt markets is critically important to the overall development of regional capital markets. As with many emerging markets, the Central American capital markets are somewhat, underdeveloped. Problems in public debt management and underdevelopment of capital markets are related. The underdevelopment of capital markets particularly, institutional investors limits the amount and maturity of funding available to the government locally and can substantially increase the rollover and currency risks in managing public debt. At the same time, weak debt management practices which result in fragmented issuance and a lack of a liquid benchmark yield curve makes it difficult for all borrowers (including corporate and home loan borrowers) to obtain long-term funding, and for institutional investors to undertake appropriate risk management. The broader development of capital markets is a complex and multifaceted problem that also needs to be addressed, but given the dominance of public debt in capital markets in the Central American countries, improving the public debt market is their logical first priority.

3. Even for the relatively small Central American economies, developing local public debt markets is important. Sovereign issuers in smaller economies suffer from many problems in terms of a limited local investor base, higher transaction costs, limited trading, and economies of scale. El Salvador and Panama are dollarized and several other countries have a significant amount of de facto dollarization. A high degree of domestic dollarization may force issuers—including sovereign—to rely on foreign currency funding for a significant part of their financing requirement, and create some preference for doing so from the more developed external markets and investors.5 A country with current account deficits may also need to rely on external capital flows to close the balance of payments. However, external debt financing in foreign currency cannot be obtained without incurring some risks of currency mismatch and sudden capital outflows. Recognizing this, virtually all sovereigns in the region have already undertaken domestic issuance programs and from a sovereign debt management perspective, it would be appropriate to strengthen rather than abandon them, even if external debt issuance has to continue.

4. Development of a more integrated regional capital market, including that in public debt entails complex benefits and difficulties that require further study. Given the small size of the Central American economies, a more integrated financial market may seem to offer substantial benefits to investors and issuers alike. For investors, it might mean more efficient capital allocation and risk diversification. For issuers, it might imply greater and more liquid access to regional savings. However, despite the relative openness of regional capital accounts and the substantial presence of regional financial groups,4 sovereign debt markets (and, more generally, capital markets) remain divided in important respects by currency, creditworthiness, regulation, restrictions on domestic institutional investors, and the absence of a regional exchange. To advance towards a regional sovereign debt market requires significant convergence and cooperation in terms of economic policies and regulation of financial markets, and potentially creation of regional exchange or at least regional trading platforms. A full examination of such issues is worthwhile but beyond the scope of this study, which focuses on the more pressing task of improving individual sovereign debt markets. Of course, several aspects of development of national debt markets discussed here, and in particular standardization of issues will facilitate a more active regional debt market.

5. While developing an integrated regional market remains a longer term goal, substantial progress is being made under a project to harmonize public debt market standards. Under a project of the Central American Monetary Council, supported by the Inter American Development Bank, the authorities of the seven countries have signed a resolution to advance adoption of common standards in public debt issuance across the region in November 2003.6 The effort involves promotion of common standards and good practices in such areas as organizing the primary market, public debt management, money markets and monetary policy operations, wholesale secondary market in public debt, payment and settlement systems, and conventions in calculations relating to public debt, regulation of collective investments and secondary markets in public debt, and developing a regional wholesale/OTC market in public debt. The program has led to important advancements in establishing common market conventions and calculation standards, adoption of standardized securities in new issuance, building consensus towards analytical approaches and solutions to common problems, and offering training to debt managers. Further progress in implementing the 2003 resolution would depend on substantial additional technical and political support.

A. Financial Sector in Central America

6. The financial sector in Central America is dominated by banks which are the largest financial intermediaries throughout the region (Table 1). The Dominican Republic and Guatemala have somewhat, low levels of financial penetration in terms of a bank-assets-to-GDP ratio of around 35 to 40 percent. The numbers for Costa Rica, El Salvador, Honduras, and Nicaragua range from 50 to 90 percent and compared well with other emerging or developing markets. Panama, with a dollarized and open economy has very high levels of financial penetration (250 percent), reflecting its offshore activities. Deposit levels are typically about 60–80 percent of total assets, except in Costa Rica where they are only a third of the assets. Private credit generally accounts for about half of the assets.

Table 1.

Central America: Structure of the Financial System

(As of December 2005, except for *, which indicates December 2004)

article image
Source: IMF estimates based on official sources.

7. By contrast, capital markets are underdeveloped throughout the region. Except for Panama, the number of equity and corporate bond listings are generally in the single digits and market-capitalization-to-GDP ratios are quite low. While complete data are unavailable, institutional investors (pension funds, mutual funds, and insurance companies) also are underdeveloped. In some countries, the enabling laws and regulation for important sectors such as pension and mutual funds need to be significantly upgraded or remain to be implemented altogether. In all cases, these institutions intermediate a relatively small share of national savings. Thus, the principal investors in government securities are commercial banks and public sector entities such as pension funds.

8. Issuance of corporate securities is stymied by a variety of factors. Leading Central American businesses are often family-owned, and their reluctance to share even minority control or to comply with extensive transparency and disclosure requirements seems to be the principal hurdle. Anecdotal evidence suggests that the large majority of local businesses needing financing of under $10 million find it cheaper to seek bank financing while the larger companies seeking from $25 million to $50 million source it overseas. Thus, domestic bond markets are approached for a relatively narrow range of financing needs. Bank loans are preferred because they have fewer information disclosure requirements and those requirements are private rather than public. At times, this situation has been compounded by cyclical excess liquidity in the banking system that lowers bank lending rates. In some cases, brokerage and exchange fees and procedural requirements of the exchange are also deterrents to corporate debt or equity issuance. Mortgage- or asset-backed securities have yet to emerge in these markets. While the private financial sector has issued some bonds, this activity is also limited in light of the relatively liquid condition of many regional banking systems.

9. Thus, public debt issues dominate Central American capital markets. The capital markets of Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua consist almost entirely of public debt instruments and public debt also dominates capital markets in Panama. Despite this, problems of fragmented domestic debt issuance and the large stock of nontradeable public debt mean that there is insufficient trading and liquidity in domestic public debt markets.

B. Structure and Composition of Public Debt

10. Public debt levels in Central America remained fairly high at end-2005. They exceeded 40 percent of GDP in all countries, except Guatemala and the Dominican Republic (Figures 1 and 2, Table 2). The Dominican Republic restructured its debt with the Paris Club in 2004, its sovereign debt in 2005, and most of the debt falling due with commercial banks during 2005. Since end-2005, Honduras and Nicaragua have benefited from debt reduction under the Multilateral Debt Relieve Initiative, which has resulted in a marked fall in their levels of public debt.

Figure 1:
Figure 1:

Public Debt Composition in Central America, 2005

(Millions of US dollars)

Citation: IMF Working Papers 2007, 147; 10.5089/9781451867114.001.A001

Figure 2.
Figure 2.

Outstanding Public Debt in Central America, 2005

(In percent of GDP)

Citation: IMF Working Papers 2007, 147; 10.5089/9781451867114.001.A001

Table 2.

Central America: Public Debt Composition

(As of December 2005, except for *, which indicates September 2005)

article image
Sources: Central banks and ministries of finance.

11. In the region, a substantial share of public debt is held by non-residents. In five countries, external debt accounts for 60 to 80 percent of total public debt (central government and central bank combined). Only Guatemala (12 percent of GDP) and Costa Rica (26 percent) have moderate levels of external debt levels with most of their debt provided by domestic markets (Figure 1). However, the level and type of access to external debt varies considerably. While Costa Rica, the Dominican Republic (after restructuring), El Salvador, Guatemala, and Panama are able to secure external commercial funding, including through bonds, other countries (notably Honduras and Nicaragua) rely primarily on concessional loans from international financial institutions.

12. Government debt is primarily, but not exclusively, issued in the form of securities. The central bank debt is always issued in the form of securities. As Figure 3 shows, the bulk of government debt has been issued in the form of securities in Guatemala, Costa Rica, El Salvador, and Honduras, but not in Nicaragua, Dominican Republic, and Panama. The nonsecuritized debt is not tradable. Moreover, as discussed later, a significant part of the securities issued by some governments is also not tradable, particularly those issued to the central bank, to public at large for compensation for properties taken over by the state, or to suppliers for past arrears.

Figure 3:
Figure 3:

Domestic Debt Issued as Securities, 2005

(Percent of total issuance)

Citation: IMF Working Papers 2007, 147; 10.5089/9781451867114.001.A001

C. Organization of Public Debt Management

13. None of the countries in the region has yet developed a clear debt management strategy that articulates the long-term role of domestic markets, domestic currency, and resident investors in funding public debt. Many countries depend heavily on external sources of funding or on foreign currency funding, and lack clarity regarding the strategic role of local currency and resident investors in funding public debt, goals regarding the amount of domestic currency issuance, and the preferred tenor up to which the sovereign desires building a yield curve. In the absence of a well-developed strategy, domestic debt issuance decisions are taken in a somewhat ad hoc fashion. There is little systematic dialog between issuers and investors concerning the medium-term goals of the former or the problems facing the latter.

14. The capacity of the Central American countries’ debt management units needs to be substantially strengthened. Most units have grown out of traditional back-office operations. They typically have a weak front office and lack a clearly identifiable middle office charged with risk management. They do not generally have a regular investor relations program that involves meetings with key investors and institutions to incorporate market views or resolve problems relating to public debt issuance. That said, debt management unit staff are aware of the need to standardize debt issuance, facilitate secondary market trading, extend yield curve. They also meet regularly at the regional level to discuss these issues as part of the Central America Monetary Council’s harmonization program.

15. By and large, debt management does not adequately aim to manage the stock of existing debt. Except for Panama and, to some extent, Costa Rica, debt managers focus primarily on securing current funding needs, and secondarily on standardizing future issuance or extending the maturity of the yield curve. Most debt management units have limited capacity to undertake the more complex management of the overall stock of existing domestic debt. This is particularly important given the high debt-to-GDP ratio in many countries and the sizable nonstandard and nontradable domestic debt that requires restructuring.

16. Coordinating debt issuance of the sovereign and the central bank is an important challenge. In many ways, the debt management problems of the smaller Central American economies are more complex than those of the larger emerging markets. One problem is the sizable debt issuance by the central banks (see Section D below) that requires considerable coordination with the ministry of finance. While some coordination is the norm, it is typically confined to operational issues such as the issuance calendar, standardization of instruments, and auction logistics.

17. In several countries there are some problems in the structure of authority and responsibility between the legislature and administration. First, debt managers sometimes have only limited clarity or authority for conduct of debt management operations. In the Dominican Republic, Honduras, and, to a lesser extent, Nicaragua, issuance is authorized under somewhat restrictive laws that define the operational terms but can clash with current market conditions, leaving debt managers limited discretion.7 Second, in most countries debt managers lack the authority to conduct overall liability management operations that go beyond the financing of current cash flow needs. Third, as much of the nonstandard debt has been issued under provisions of specific laws, restructuring of that debt is likely to require more than general authority to finance the government or conduct liability management operations. Finally, the transfer of central bank losses to the sovereign is not routine and involves significant intervention by the legislature.

18. These problems are reflected in the differences between domestic and external market access. Several countries have access to external bond markets, and thus to advice from international underwriters and advisors. Their successes in the external markets often stand in sharp contrast to their efforts in domestic markets. For example, Panama has possibly the best developed domestic financial sector in the region, with considerable success in issuing Eurobonds globally and in arranging a $980 million global bond swap in January 2006, issuing a 30-year bond in the process. At the same time, Panama is actually curtailing its domestic medium-term issuance program. Similarly, the Dominican Republic successfully issued a 20-year $300 million Eurobond in March 2006, attracting the lowest coupon in the country’s history and an oversubscription of 3.3 times. However, the Dominican Republic has not made a single “regular” debt issue in the domestic market.

D. Dual Sovereign Issuers: Government and the Central Bank

19. Public debt issuance is complicated by the simultaneous and often competing presence of the sovereign and the central bank as issuers of public debt. Ideally, public debt should be issued by the sovereign alone, with the central bank using a stock of sovereign public debt instruments to conduct open-market operations for monetary policy purposes.

With the exception of Panama, the central banks in all five countries (Costa Rica, the Dominican Republic, El Salvador, Honduras, and Nicaragua) have sizable accumulated deficits arising from previous financial crises, financial system bailouts, and even just from normal central bank operations. This makes the central bank a frequent issuer of debt in its own name. For example, in the Dominican Republic, the stock of central bank domestic debt is about 4.5 times as large as that of the government (Figure 4). Moreover, as bulk of government debt is not issued in the form of securities, the outstanding stock of central bank securities is about 17 times as large as the stock of government securities. In both Honduras and Nicaragua, the central bank is a far larger issuer, while in El Salvador and Costa Rica, central bank issuance is between a quarter and half that of the sovereign. Such large issuances by central banks, coupled with the frequency of issuance and a concentration in short-term tenors by both issuers, creates a number of problems.

Figure 4:
Figure 4:

Domestic Central Bank Debt/Domestic Government Debt, 2005

(In percent)

Citation: IMF Working Papers 2007, 147; 10.5089/9781451867114.001.A001

20. First and foremost, debt issuance by a central bank to finance its own operations compromises monetary policy operations. The continuous need for the central bank to issue debt to finance its own operations or to roll over maturing debt may cause doubts in the markets about the bank’s ability to conduct monetary policy consistent with the objectives of price stability and the proper choice of instruments and interest rate paths.8 While this paper does not focus on such monetary policy issues, this is perhaps the most important reason to recapitalize the central bank to a point that it can have a stock of suitable public debt instruments with which to conduct open market operations.

21. The substantial and simultaneous issuance by central banks also forces a significant burden of coordinating issuance of public debt. While all the countries of the region seem to have the will to cooperate effectively, the need for extensive coordination on a calendar of issues, demarcation of maturities, issuance terms, eligible issuers, issuance/trading platforms, and the manner in which auctions are conducted adds many layers of complexity relative to a situation in which the sovereign is the sole issuer and the central bank at best a fiscal agent. In many countries, there are gaps in technical sophistication, familiarity with market conventions, and in some cases pay scales between central bank and finance ministry staff that deal with debt issuance, with the latter usually lagging behind. Often there are differences in the issuance practices of the two issuers, and the sensible need to harmonize them, even when addressed, nonetheless slows down the adoption of desirable innovations. For example, in Guatemala, while the ministry of finance can issue standard instruments (carrying a common coupon), such issuance has been delayed until the somewhat greater legal difficulties in issuance of similar standard instruments by the central bank can be resolved.

22. The sizable issuance of central bank debt creates a potentially large rollover risk and a short-term orientation toward public debt in the market. For monetary operations, Central banks have a preference for issuing short-term debt. This bias tends to be carried over in financing of central banks’ quasi-fiscal deficits that are not quickly or fully compensated by the sovereign (which is the root cause of central bank debt issuance in Central America). Such decapitalized central banks are generally resource-constrained and loath to issue longer-term debt that, all else being equal, entails higher interest rates and thus larger deficits. The sovereign authorities also are generally wary of issuance by the central banks at longer maturities, as they themselves intend to tap these maturities and prefer not to have competing paper from the central bank.

23. Resolution of a central bank’s accumulated losses is typically delayed and inefficient. In many countries, the authorities do recognize the need to recapitalize the central bank, and, in turn, transfer the central bank losses to the fiscal accounts. However, this is not an easy process given the politics involved, the level of public deficits, and legislative complexities. Thus, such transfers—if they occur at all—are delayed. In some cases, they are still ad hoc—in the Dominican Republic, for example, the first such issuance of the recapitalization bond was authorized for 2005, but its terms are not yet determined. Even in countries where transfers are now more routine (e.g., Costa Rica, Guatemala, and Honduras) and losses are supposed to be transferred annually, the accounting and legislative process of determining the actual central bank losses and authorizing the issuance of government bonds nonetheless takes one to two years. As recapitalization entails a considerable legislative effort, a partial recapitalization that does not eliminate future operational losses allows a difficult problem to persist.

24. When it does occur, recapitalization of central banks is more often apparent than real. Typically, recapitalization bonds have unusually long tenors of the order of 25 to 100 years, with zero or below-market interest rates. In present value terms, this results in an effective recapitalization well short of the face value of the bond. For instance, in Guatemala, a recapitalization bond issued in 2005 to cover losses incurred in 2003 had a 30-year maturity and a 3.87 percent coupon rate, well below the 9.6 percent rate on the 10-year bonds issued during the same period. Another bond expected to cover central bank losses for 1982–2002 is expected to have even more off-market terms: a maturity of 100 years and a zero interest rate, resulting in a bond with a present value of approximately 1 percent of the face value. In Honduras, central bank losses in 2003 were covered with a 50-year bond with zero interest rate, while 2004 losses were covered with a 25-year bond, paying a market interest rate only on one-tenth of the bond issued.

25. Partial recapitalization with deep discount bonds may actually inflate the nominal level of public debt, while creating weak incentives to check future public deficits. Positive capitalization of a central bank is desirable to ensure full recognition of its losses by the sovereign and to preserve the central bank’s independence.9 The current practice of recapitalizing central banks with zero coupon or deep discount bonds not only fails to adequately reduce future central bank losses, but also overstates the widely followed nominal debt-to-GDP ratios than would have been the case with bonds paying current market interest rates.10 The resulting reduction in future interest bills also probably weakens fiscal discipline.

26. The issuance of deep discount debt to the central bank has created a sizable stock of nonstandard and nontradable debt that reduces the liquidity of public bonds. Such debt is rarely traded due to its unusually long maturity, absence of liquid yield benchmarks at such maturities, and, above all, the central bank’s incentives to not recognize the large capital losses if it were to sell such debt.

27. The division of sovereign debt issuance between the two issuers hinders development of larger benchmark issues and lowers liquidity. Central American sovereign debt markets are small, and the market for longer tenors has yet to develop adequately. Liquidity of most bonds is related to the size of individual tradable issues and aggregate tradable stock. The division of issuance between the two sovereigns and the nontradable nature of debt issued to the central banks prevents most issues from reaching volumes needed to become liquid benchmarks and reduces liquidity. These factors are also generally detrimental to development of a long term yield curve and widening the investor base, particularly to foreign investors in local issues.

E. Primary Issuance of Public Debt

28. The primary debt issuance process throughout Central America suffers from several problems. Despite the progress made under the harmonization project, many problems remain in the form of poor issuance mechanisms, issuance of nonstandard debt; fragmentation of issuance; and weak auction practices.

Issuance Mechanisms

29. Several countries use multiple issuance mechanisms, thus draining volume, liquidity, and competitiveness from auctions. In addition to regular auctions, several issuers (Costa Rica, the Dominican Republic, Guatemala) also rely on post-auction windows (Table 3) offered by the central bank or the ministry of finance.11 The presence of such windows, for extended periods of time, drains liquidity from auctions themselves, and complicates the bidding and acceptance strategies for investors and issuers, respectively. In the Dominican Republic, the window creates a further segmentation of the market, as the fixed interest rates offered in the window are only loosely guided by the preceding auction or current secondary prices, the window is open only to retail investors, and longer tenor maturities are offered through the window than are auctioned. Securities issued through these windows are typically nonstandard and nontradable. Interestingly, in Costa Rica, the finance ministry takes advantage of the statutory restrictions on nonfinancial public sector entities by issuing public debt outside the competitive auction process at “negotiated” below-market yields and tenors, creating an additional source of nonstandard debt.

Table 3.

Central America: Securities Issued by the Ministry of Finance and the Central Bank

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Sources: Central banks and ministries of finance.

30. There are no primary dealer systems in Central America, although issuers often rely on brokers and exchanges to conduct primary auctions. None of the countries employ a true primary dealer system with clear market-making obligations. Nor are broker or dealers capable of many of the functions performed by the primary dealers in larger government securities markets. However, reflecting the traditional dominance of exchange brokers (the largest of whom are typically affiliated with major banks), many countries employ a somewhat unusual process for public debt issuance by relying on brokers and exchanges to conduct the auction. These arrangements vary widely. In Panama, all auctions must be conducted through exchange brokers. In Costa Rica, banks can participate directly in an auction, while other investors must submit their bids through brokers and pay related commissions. In El Salvador, ministry of finance auctions are open not only to brokers but to other approved investors, including domestic and foreign banks, whereas central bank auctions are only open to brokers. As a general rule, it is difficult to make the case for value added by brokers during the primary auction process, particularly for institutional investors. As the banks typically have in-house brokers, as a group they tend to be neutral about the exclusive rights of the brokers and the fees charged by them, with the pension funds objecting most to such a monopoly.

Issuance on Nonstandard Debt

31. The issuance of “nonstandard” debt without suitable characteristics that facilitate trading has been diminished, but not eliminated. In addition to issuance in irregular transactions (such as compensation for properties taken over by the state, arrears to suppliers, and issuance to central banks at off-market terms), several countries issue debt carrying amounts and interest rates specific to each holder (such as bank term deposits) rather than through standardized debt instruments; and/or issue debt in physical (not dematerialized) form. The last two problems are directly addressed by the Central America Monetary Council’s harmonization project. While all countries have agreed to start issuing standardized securities, the Dominican Republic, Costa Rica, El Salvador, Guatemala, and Nicaragua continue as of this writing to regularly issue some nonstandard securities. In addition, all recapitalization bonds issued or planned for issuance by the sovereign to the central banks in the Dominican Republic, Costa Rica, Guatemala, Honduras, and Nicaragua remain nonstandard.

Fragmentation of Public Debt Issuance

32. Despite the relatively small volume of domestic issuance, public debt is issued in an extremely fragmented fashion across Central America for a variety of reasons (Table 4). First, as discussed earlier, debt issuance is undertaken by the sovereign and the central bank in five countries. Second, there is a high frequency of issuance—all countries schedule auctions on a weekly or biweekly basis, except for Panama, which conducts auctions monthly (see Figures 5 and 6).

Figure 5:
Figure 5:

Central America: Potential Debt Auctions per year

(number)

Citation: IMF Working Papers 2007, 147; 10.5089/9781451867114.001.A001

Figure 6:
Figure 6:

Central America: Actual Debt Auctions per year

(number)

Citation: IMF Working Papers 2007, 147; 10.5089/9781451867114.001.A001

Table 4.

Central America: Auction Mechanisms for Public Debt Securities

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Sources: Central banks and ministries of finance.

The auction of BEMs in Costa Rica is competitive for zero cupon and fixed rate BEMs denominated in local currency, and non-competitive for variable rate BEMs denominated in U.S. dollars.

BPIs in Nicaragua are partially standardized.

33. While many issues are re-opened and consolidated, their eventual total size is unclear. Third, Central American public issuers attempt to issue a large number of maturities relative to their total domestic issuance. Fourth, some of the nondollarized issuers (e.g., Nicaragua) are unable to issue all of their financing requirements in local currency, and while attempting to develop a local currency market, have to divide their local issuance in different currencies. Finally, issuance of nonstandard debt with different interest rates to winning bidders (rather than different prices) obviously creates extreme fragmentation.

Conduct of Auctions

34. Investors throughout the region complain of gaps in information regarding primary auctions. As part of the harmonization initiative, in all countries, there is now a pre-announced calendar of issues from both issuers. However, the overall annual calendar announcement is rather generic, and the amount offered is typically announced only about a week before the actual auction. There are considerable uncertainties about the actual issuance volume, as in some countries (e.g. Costa Rica and Honduras), the government and central bank often issue the same paper jointly. Allocation rules are not always fully formalized, and at times are perceived as murky by both investors and issuers. Investors are not always assured which issuer’s securities will be awarded to them, which is a nontrivial problem in markets where the prices differ, or of the eventual size of a particular bond issue.

35. Fragmented and frequent issuance of a small quantity of debt appears to be partly driven by the desire of issuers to systematically capture the most aggressive bids or beat down the yields. Issuers routinely complain that the market is not sufficiently competitive, and that domestic investors, particularly those in the private sector, “overcharge” the government. There is thus a widespread reluctance on the part of the issuers to offer larger auction volumes, or commit to issue the announced volume when auctions are fully subscribed. Some of the most aggressive bids often come from banks that temporarily are very liquid, or from pension funds that, for regulatory reasons, must heavily invest in government paper. From time to time, this results in bids that other market participants regard as unrepresentative for the full spectrum of investors. Debt managers with weak authority and lacking a clear strategy to develop domestic markets and investor base find it easier to defend small issuances or large rejections, than a higher interest rate.

36. While there may be some validity to these concerns, they ignore the fact that investors will eventually factor in such defensive behavior of the issuers and adjust their bids accordingly. Smaller volumes can be placed at seemingly lower yields from time to time. But unless the overall volume of sovereign and domestic issuance is reduced, smaller issuance in individual auctions itself cannot reduce interest rate in the long run. Moreover, as smaller issues are less liquid, the market is likely to charge a premium for such issues. As the domestic rates in both primary auctions and secondary markets are generally higher than the yields for comparable Eurobonds, where they exist, small and fragmented local issues ultimately appear to carry a higher cost.

37. This widespread lack of agreement on “market clearing prices” between issuers and investors results in frequent auction failures or rejections. Auctions are often undersubscribed and at times are “deserted” (especially in Nicaragua)—that is, they receive no bids at all. Neither is it uncommon for the issuers to reject many bids in a fully or oversubscribed auction, while not filling the entire amount offered (e.g., in Panama). Apart from the uncertainties they imply in public financing, such auction failures or rejections signal market-wide disequilibria that should best be avoided.

38. There are also concerns about the role of dominant public sector investors. There is some consensus that public sector investors should be excluded from competitive bidding, as they could be influenced by the issuers and may result in an unrepresentative market-clearing interest rate or at least the perception thereof. However, the Central American experience indicates that there may not be a simple solution to this situation. In Panama, public sector bidders are allowed to participate only through noncompetitive bids, whereas elsewhere they are allowed to participate with competitive bids as well (e.g., in Costa Rica). Frequent and sizable participation of public sector investors through noncompetitive bids is likely to influence the issuer’s acceptance of competitive bids, and, in turn, the competitive bids by the private bidders. There thus may be a need to frankly discuss the role of the public sector vis-à-vis the private sector, provide public sector investors enough regulatory leeway and operational autonomy to bid as much on an arms-length basis as possible, and encourage the largest possible participation in competitive bids.

F. Secondary Markets

39. Public debt securities account for the lion’s share of secondary market trading throughout Central America. Given the relative underdevelopment of corporate securities markets, trading in public securities dominate the overall trading in regional exchanges (Table 5).

Table 5.

Central America: Secondary Trading of Fixed Income Domestic Securities

(In millions of U.S. dollars, 2005)

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Source: National Stock Exchanges.

40. However, the bulk of domestic issuance in Central America is in short-term paper, and most of the domestic trading is in repo transactions, resulting in a lack of liquid, long-term secondary market yield curve. Few of the issuers (barring Panama and Guatemala) have managed to issue domestic debt for longer than a few years. This failure contrasts with the issuance of up to 30 years in the Eurobond markets by Costa Rica, the Dominican Republic, El Salvador, Guatemala, and Panama. Moreover, bulk of the trading is in repo transactions of a few days. Thus, despite accounting for 90 percent or more of local exchange trading, government securities do not provide a meaningful benchmark yield curve, and even for the short durations involved, secondary prices and yields are not sufficiently current.

41. Transaction costs in the smaller local securities exchanges—including brokerage and exchange fees involved in trading public bonds—as a rule, are extremely high. On an annualized basis, they amount to 1 to 3 percentage points in the Dominican Republic, 1 to 2.5 percent in Nicaragua for an outright transaction and 1.25 percent for a repo transaction, and 0.1 to 1 percent in Guatemala.12 Transaction costs are somewhat lower in Costa Rica, Guatemala, and Panama. High brokerage and bolsa fees may be justified by the low trading volumes and the small size of many issues, but they create a chicken-and-egg problem. More importantly, low liquidity eventually must raise the market clearing interest rates demanded by investors.

42. Central American brokerages and exchanges face an uncertain future given their limited viability and difficulties in terms of consolidation. It should be kept in mind, of course, that brokers and exchanges may have played an important role historically in raising the transparency of government securities trading and, to a limited extent, popularizing investment in public securities by retail investors. In an environment of extremely limited private sector security issuance, exchanges may not have developed without some support from public issuers. Nonetheless, continued support of Central American exchanges and brokerages through higher charges and fees on public debt issuance and trading may have questionable value, especially considering the ownership of many brokerages by banks. The low trading income, the opposition of institutional investors to paying fees, and the growing reluctance of public issuers to pay issuance fees may make consolidation both necessary and desirable. There is a need to examine the consolidation of the brokerage industry within the region and encourage well-capitalized foreign brokerage houses, cross-listings across countries, and, eventually, consolidation of the trading platforms themselves. Consolidation of domestic exchanges is also worth considering in Guatemala, where there are two competing exchanges within a small market. However, cross-border consolidation entails many important challenges (see Section G below) within countries without a common currency or regulatory bodies. While these issues need to be examined in detail, the global impetus toward consolidation of smaller bourses needs to be recognized and harmonization of listing and trading practices within the region needs to be speeded up.

G. Investor Universe and Regulation of Investments in Public Debt

43. A preliminary examination of the regulation of principal institutional investors in public debt markets finds three broad problems: inadequacies in the regulatory framework for the securities markets themselves, limitations on the institutional investors, and limitations on their investment portfolios.

44. The enabling framework for securities issuance, markets and regulation of markets themselves is either lacking or in need of upgrading in many countries. In Nicaragua, a draft securities market law pending congressional approval for some years would allow the dematerialization of securities and the issuance of asset-backed instruments, thereby widening the set of available securities and facilitating development of a liquid secondary market. In cases such as Guatemala, weak institutions (e.g., a securities registry) act as a temporary substitute for a proper securities regulator.13 The absence of a superintendency of securities has also seriously hindered the creation of a central depository of securities.

45. Throughout the region there are also gaps in the legal and regulatory framework for institutional investors. In turn, these gaps affect development of local government securities markets. In particular, the regulation of private pension funds and mutual funds is inadequately developed in most countries. In Nicaragua, design of a law to regulate creation of private pension funds was abandoned in 2003 following a vigorous debate in Congress. In the Dominican Republic, pension funds are not permitted to invest in government or central bank securities, mainly because of opposition from other investors who fear losing a lucrative investment opportunity. In the absence of well developed mutual funds, brokers in many countries are offering less well-regulated variations such as participations in the so-called “investment portfolios.” Investors are not always aware of the liquidity and pricing of such investments, and at times bank deposit clients are drawn into such investments (e.g., in Costa Rica) without fully realizing the possibility of capital losses or illiquidity of such products. Introduction of well-developed mutual fund laws, together with sound governance, pricing, and mark-to-market practices would help develop investor base for government securities in the long run.

H. The Challenge of Creating a Regional Market

46. Despite trade and political links, Central America’s regional public debt markets and capital markets more generally are not well integrated. There are many benefits of greater regional integration of financial markets, but getting there involves addressing several important challenges and complex issues. The paragraphs that follow sketch some of the issues involved in the context of sovereign debt.

47. Smaller economies such as those in Central America appear to have much to gain from regional financial integration. Small financial markets suffer from high transaction costs, small volumes, a small investor base, and a small universe of investment products and instruments. For issuers of securities, including the sovereign, small domestic markets may limit the size and tenor of issues, competitive pricing, or the speed of execution. For investors as well as financial intermediaries, the limited investment universe may result in suboptimal diversification and risk concentration. Brokers and markets, particularly security exchanges, may find it difficult to survive or grow without a critical mass of trading. Smaller economies can partly offset these well-known problems by integrating within a common financial space. Within Central America, these benefits are relatively easy to obtain given the geographical proximity, shared language, common time zones, relatively free trade and capital movements, presence of several regional financial groups, and political will to promote regional ties.

48. But in the absence of further economic and regulatory convergence, significant problems hamper further integration of regional capital markets in general and the sovereign debt markets in particular. Central America remains divided by currencies. Macroeconomic policies, debt burdens, sovereign ratings, and debt sustainability are materially different across countries. Thus, sovereign debt issued by different countries remain securities with very different risk characteristics. Eurobonds issued by the regional sovereigns can be easily invested in and traded by regional investors. But underwriting and over-the-counter trading of such issues will remain located largely in global financial centers, given the advantages of the large global investor universe, speed of execution, competitiveness, and low cost they offer. Thus, it is more meaningful to think of regional integration within sovereign debt markets in terms of a common market and investor base for sovereign debt issued in regional currencies. As the situation currently stands, further integration of the regional currency debt is likely to be hampered by two important factors, the separation of regional security exchanges, and the restrictions on institutional investors such as banks, insurers, and pension funds.

49. First, tradable domestic debt of each issuer is typically listed only in local bourses and often in local currencies. In the absence of any centralized links between regional exchanges themselves, and absence of regional brokerage firms, nonresident transactions in such locally listed securities typically entail working through a local broker. Such transactions generally are less efficient than the purchase of Eurobonds through a broker based in Miami or New York. Listing of government securities across regional exchanges is often cumbersome, as the exchanges do not have completely common listing standards. While some bilateral arrangements to overcome these problems have been undertaken,14 they fall short of a regional securities exchange, coupled with a regional custodian and clearing and settlement systems. The latter is a major initiative that would require substantial effort, study, and cooperation by the private sector participants.

50. Second, institutional investors face substantial restrictions on the purchase of regional foreign government securities that cannot be readily harmonized. Pension funds, and sometimes banks, are subject to prohibitions or tight limits on purchase of foreign government securities. In all cases, banks face higher capital adequacy requirements on foreign than domestic government securities, which carry zero risk weighting. In Nicaragua, the 1995 regulatory framework on the investment portfolio of commercial banks requires the prior authorization of the bank regulator to acquire sovereign securities (with the exception of Nicaraguan and U.S. instruments). Similarly, the 2005 bill regulating the investment portfolio of insurance and reinsurance companies requires the prior authorization of the regulator for the acquisition of all foreign sovereign securities. In a nutshell, prudential restrictions on foreign government securities are tight. Capital adequacy standards cannot be readily harmonized given the substantial differences in sovereign credit ratings, as well as implications for currency risk. As for pension fund investments, most countries would have to carefully balance the cost and benefits of foreign investments and consider the interests of the fund beneficiaries rather than sovereign debt issuers. While Eurobond issues may be readily sold to a global investor base, local currency issues cannot be so seamlessly sold to the regional investor base.

I. Key Problems and Recommendations

51. Central American countries face many important challenges in developing local public debt markets and establishing ready sovereign access to domestic funding and a liquid and efficient domestic secondary market are at best medium-term goals. This section highlights the key problems in public debt management and steps needed to resolve them.15 While the problems are not unknown to the regional officials, significant political, legal, and fiscal constraints have prevented more effective resolution thus far. Thus, it is worth emphasizing at the outset that successful implementation of the recommended measures would require strong macroeconomic performance, political stability, a clear political consensus for the desired reforms between the legislative and executive branches, and substantial technical capacity and/or technical assistance.16 The measures recommended below are grouped thematically, and while certain key actions are singled out as particularly important, further detailed work must be done to identify a more precise country-specific action plan and timing for implementation. While full implementation of these measures may well take 2–3 years, it is important to establish a clear, ambitious and unambiguous goal leading to restoration of ready sovereign access to domestic markets at a reasonable cost, and efficient functioning of the secondary markets.

52. The most critical and strategic steps for improving public debt management in virtually all the countries in the region involve (1) developing a medium-term debt management strategy and formally defining and building capacity for debt management units; (2) eliminating the central bank’s quasi-sovereign deficit; (3) converting a large stock of nontradable and nonstandard domestic debt through liability management operations; and (4) eliminating future issuance of nonstandard debt. These four steps need to be undertaken as an integral and well-coordinated package that can be labeled “strategic debt management.” A variety of other measures are also needed to simplify and improve primary market issuance, make price discovery more efficient, and improve secondary market trading. But without the four strategic debt management measures, additional measures would only make a marginal contribution to solving the larger problems at hand.

Strategic Debt Management

53. It is important for all countries to develop a formal, medium-term debt management strategy, as advocated by the Fund as part of a debt sustainability framework. Several Central American countries have large debt problems relative to their economic aggregates. Moreover, their debt problems are exceedingly complex. The present approach of managing these problems through routine issuance decisions with inadequate debt management units does not fully recognize the gravity of the problem. The inability of virtually all countries to place in local markets, say, issues of the order of $100 million for five years with a reasonable assurance of full subscription, is a strategic limitation. It also stands in sharp contrast to improvements in domestic market access by some other highly-indebted countries (e.g., Jamaica and Uruguay) and to the considerable successes of Panama, Guatemala, El Salvador, and the Dominican Republic themselves in accessing Eurobond markets. Again, while highly desirable and feasible, the task of developing an adequate medium-term strategy cannot be underestimated. It would need substantial country-specific technical assistance, with an important role again for the international financial institutions.

54. The overall capacity for debt management needs to be significantly strengthened in all Central American countries. While this paper has not focused much on institutional aspects, it is generally clear that the regional debt management units within the ministries of finance suffer important weaknesses in terms of mandate, skills, staff size, and resources. Strengthening these entities requires adequate formal recognition of them as debt management units, definition of their mandate and accountability requirements, and adequate staffing and budget support. Such units need not require large staff; most offices may not need more than five employees. But staffing with the right personnel is critical.

55. The five countries with significant accumulated central bank debt or continuing central bank deficits—Costa Rica, the Dominican Republic, El Salvador, Honduras, and Nicaragua—need to consider full recapitalization of central banks at market terms, so as to eliminate or substantially reduce central bank debt issuance in a phased manner.17 While the sustainability of overall public finances is an important macroeconomic challenge beyond the scope of this paper, recognition of central bank debt is more of a political, legal, and technical problem. While such problems ought not to be minimized, recapitalization of the central bank should be addressed as part of a comprehensive strategy to eliminate future central bank losses and integrate the fragmented sovereign debt market. Most countries have already taken important first steps in recognizing such losses and establishing precedents for recapitalization. It is now desirable to speed up this process, issuing marketable bonds in future recapitalizations, and replacing existing recapitalization bonds with marketable instruments. Both new issuance at market terms and conversion may need to be suitably phased to accommodate certain fiscal and legal constraints. But the goal should be to clearly restore the central bank’s solvency and future profitability, and eliminate the perpetual problem of dual sovereign issuers in medium term. Designing appropriate options, assessing the related evolution of central bank profit and capital and of sovereign debt, and reconciling the latter with the current program targets of international financial institutions may require substantial technical assistance. IFIs, including the IMF, can play an important role in supporting this effort.

56. Where needed, central banks could be provided tradable government securities for open market operations. In some cases, recapitalization of the central bank (i.e., transfer of losses) may not leave it with a sufficient stock of public debt with which to carry out monetary policy operations effectively. In these circumstances, consideration could also be given to issuing a stock of “sequestered” government securities to the central bank for such purposes, in lieu of additional capital injection or issuance of central bank securities. Important details (including the appropriate treatment for fiscal accounting, public debt statistics, and debt issuance authority) would need to be customized and fleshed out for individual country situations. But the broad outline of such an operation would entail issuance of standard government securities to the central bank, with the central bank maintaining “contra” accounts in its books. The latter would reflect both the acquisition of government securities as assets as well a corresponding liability to repay the government with identical interest and amortization terms. The transactions between the central bank and the government would thus not entail any net cash flow. The central bank could then use these special government securities, which would be identical to other public debt, for open market operations or repos.18

57. Conversion of existing nonstandard debt issued to the central bank and other creditors is another highly promising but technically challenging effort that warrants high priority. In addition to the nonstandard debt issued to the central bank, virtually all countries have a substantial stock of nonstandard and nontradable debt issued to private holders in lieu of arrears, confiscation of property, and other measures. In the rare instances that such debt trades, it carries huge discounts. Trading benefits primarily the few market intermediaries, typically at the expense of the often unsophisticated holders of such debt. While conversion of such debt into marketable debt is not easy, several recent examples of complex domestic debt transformations by Brazil, Colombia, and Mexico, and of external debt by the Dominican Republic, and Panama, suggest the fundamental feasibility of such transactions. Conversion of current nonmarketable also holds major benefits for the sovereign. First, most conversion has the potential for significant reduction in the nominal value of public debt, thus reducing the well-published level of debt. Second, conversions could be particularly useful to introduce new longer term maturities in the domestic market and extend the current yield curve gradually.19 Fleshing out such internal debt restructuring may also require substantial country-specific technical assistance for designing appropriate options and implementing the same.

Issuance Process and Auction Mechanisms

58. In countries that continue to issue securities under a discriminatory price auction, the practice of issuing nonstandard securities with different rates of interest (rather than at different prices) should be stopped forthwith. Technically, this change is easily accommodated in the existing auction arrangements, and market participants would be able to adapt to it easily. Internal procedural rules or laws could be modified—with interim decrees, where needed—to expedite the transition.

59. Concurrent issuance of government and central bank paper in a single series and auction should be phased out. While central bank issuance in its own name should be eliminated altogether, if it does have to be continued, the two issuers should not seek to force a single auction upon investors. Such commingled auctions, such as those in Costa Rica, are more likely to raise the cost of funding for both issuers and cannot prevent secondary market prices from diverging. That said, in several countries, at present, the sovereign faces a considerably more difficult access to the market than the central bank, and this transition would take time (perhaps a few years) to improve market access. However, there needs to be a recognition that improved sovereign access to the market must come about from fundamental improvements in debt sustainability, developing a strict culture of honoring debt-service payments, and more generally all sovereign payment obligations, rather than “association” with the central bank in a joint auction.

60. Throughout the region, the issuers should slowly develop a commitment to accepting market discipline. Regional sovereign issuers should naturally retain the legal right to reject bids they consider inconsistent with market rate. There are also concerns in many markets that the bidders, both from public and private sector, could exercise oligopolistic power, and raise interest rates payable by the sovereign. However, the issuers’ behavior at auctions must also be guided by a long term commitment to open and transparent auctions as the principal mechanism to raise funding domestically. Most sovereigns also have a compelling financing need that requires them to re-enter the auction market in a matter of days after undersubscribed or even deserted auctions. Thus, all considered, there seems to be a stronger case for issuers to phase in greater acceptance of market bids, developing a long term and steady investor base, and developing a convergence about appropriate level of interest rates. In particular, once an auction amount is announced and is covered (i.e., bids cover the amount offered), rejection of competitive bids short of the offered volume (minus any noncompetitive bids) should be an exception rather than the rule. To avoid excessive uncertainty and costs for competitive market participants20 and the resulting long term loss of investor interest, convergence of interest rate expectations of issuer and investors should be encouraged through several measures (as discussed below). These include developing a more liquid secondary market that would provide continuous quotations on current interest rates, a regular dialog with market participants, especially concerning new maturities, widening investor pool by developing domestic institutional investors, and attracting regional and foreign investors. Where rejections are considered necessary, an effort should be made to explain the issuers’ stance and provide guidance to the market for future auctions. Again, while such commitment to market discipline would be an appropriate medium term goal for most countries, the pace of transition would need to be carefully analyzed and implemented in a country-specific manner.

61. Multiple avenues of noncompetitive bids should be closed, while encouraging all noncompetitive bidders to participate in the announced auctions. As a rule, the reliance on separate post-auction windows should be stopped. At times, issuers justify such windows on the ground that auctions are insufficiently competitive, and such specialized windows21 (say, to retail investors or public sector investors) enable issuers to fulfill financing needs at more reasonable interest rates. However, when it is a routine practice, such windows eventually drain interest and competitiveness from the “mainstream” auctions, reduce the volume of securities issued in large, competitive and publicly announced auctions, and signal the unwillingness of issuers to accept market rates in competitive auctions. While noncompetitive bids per se can be allowed, noncompetitive bidders should be encouraged to participate in the same auction. This should also apply to the forced placement of government paper with public sector enterprises, as in Costa Rica.

62. Consideration should also be given to allowing competitive bids by public sector borrowers. The standard advice to keep public sector investors out of competitive bids, and thus prevent them from influencing market clearing prices, has validity in certain situations. However, in the specific context of the region, and Panama in particular, it appears not to serve a useful purpose, as the participation of such bidders is large and indirectly affects the cutoffs set at competitive auction as well. Accordingly, it appears preferable to allow all public sector investors—including banks and pension funds—to participate in competitive bids, but with enough operational autonomy for them to set their own bids without “guidance” from the government.

63. Countries that use discriminatory price auctions—Costa Rica, El Salvador, Honduras, and Panama—could consider adopting uniform price auctions. While there is enough precedent for both auctions globally, there is a stronger theoretical justification on balance to adopt uniform price auctions. While discriminatory price auctions need not involve nonstandard issuance, adoption of uniform price auctions would allow a faster transition away from nonstandard issuance. Again, it is important to recognize the variation in convergence on market rates across the region, take measures to educate and consult with market participants, and phase in the adoption of such changes at a pace appropriate to specific country circumstances.

64. Several steps are needed to eliminate fragmentation of current securities issuance and extend yield curves. As discussed, an important step would be the recapitalization of central banks with the issuance of longer-term, standardized, and tradable bonds, and the elimination of short-term central bank issuance for its own financing purposes. Second, conversion of the large stock of existing nontradable securities would enable most governments to jumpstart the creation of medium- to long-term securities of up to 10 years, which would start generating secondary market quotes and a benchmark yield curve. Subsequent medium- to long-term placements could be considered through the re-opening of these issues. Issuance calendars could be consolidated, particularly for longer-term securities. As sovereigns become the principal issuers of long-term debt, they need to commit to issuance in minimum volumes, which is one of the key goals of the Monetary Council of Central America’s harmonization project. For the region, a minimum domestic issuance size of $100 million equivalent would seem an appropriate target.

Secondary Market Trading

65. Brokerage fees need to be reduced in most countries. The simultaneous solution to the chicken-and-egg problem of low trading volume and high transaction costs requires a multi-pronged approach including (1) reduction of exchange and brokerage fees; (2) equal access to all institutional investors in primary auctions with uniform participation rules for government and central bank auctions; and (3) other measures outlined above for extension of the yield curve and conversion of nonstandard government debt into more standardized and tradable instruments. Using stock exchanges and brokers for primary auctions of sovereign or central bank debt is of somewhat dubious value. While the still-limited stage of development of local securities exchanges must be kept in mind, it would be preferable to shift attention to promoting secondary market trading through the measures discussed above.

66. Certain institutional problems in specific markets need to be resolved expediently, perhaps with some gentle public encouragement. There may be merit in encouraging the various parties involved in Guatemala to consider uniting the two exchanges. Authorities in the Dominican Republic need to facilitate a solution to the dispute between the two competing custodial agencies. Issuance of dematerialized securities needs to become the norm in countries that do not yet issue them in this manner.

Other Measures

67. There is a need to expedite the passage of broader securities market legislation in several countries. Across the region, there are bills to improve the regulatory framework for the securities market, replace ad hoc presidential decrees, create interbank trading platforms, dematerialize securities, introduce asset-backed securities, and facilitate the formation and regulation of institutional investors. These measures would have profound beneficial effects on the depth and efficiency of public debt markets.

68. In the Dominican Republic, the authorities must remove the current restrictions on pension fund investment in public securities. The present restriction on pension fund investment in government securities is far from the best practice and needs to be expeditiously removed, if necessary by executive power.

J. Conclusions

69. The countries of Central America face substantial challenges in managing their public debt burden and ensuring debt sustainability. Development of domestic public debt markets is of crucial importance for developing capital markets. While macroeconomic and fiscal discipline are of fundamental importance, regional public debt managers also face several important technical problems in achieving reliable access to domestic financing and creating wider, more liquid public debt markets. The most important responses include developing and implementing a medium-term debt management strategy, building the technical capacity of debt management units, transferring the quasi-fiscal debt of central banks to the government, restructuring nonstandard and nontradable debt, and taking a series of steps to promote capital markets generally and pension and mutual funds in particular. While such a comprehensive reform must be implemented carefully, over the medium term, and at a pace consistent with the particularities of individual markets, a clear vision and political commitment at the highest levels are needed in most countries. Taking action on the measures that have been proposed may require substantial technical assistance to individual countries and sustained political will. Developing an efficient regional public debt market that overcomes the limitations of size and scale is an important long term goal. Development of a more solid domestic debt market would provide the foundation on which to such an integrated regional market could be built in the future.

II. The Public Debt Market in Costa Rica22

70. Costa Rica has recorded robust average annual economic growth of about 4.4 percent since 1990. The contributing factors have been a stable social and political environment, fiscal prudence, trade liberalization, and a probusiness environment that has boosted investment and total factor productivity (TFP). After a deep recession in 1982, economic recovery was slow, and inflation has remained at comparatively high levels. Growth has picked up significantly during the past decade, averaging 2.5 percent per annum in per capita terms, and peaked at 6.5 percent in 2003 before tapering off to 4.1 percent in 2005. Although the crawling peg exchange rate regime has helped anchor inflationary expectations, inflation climbed 14 percent in 2005 (up from 10.3 percent in 2000). The consolidated public sector deficit was approximately 3.5 percent of GDP in 2005, while the debt-to-GDP ratio stood at 51.2 percent. The external current account deficit was estimated at 4.7 percent of GDP in 2005, and has remained stable over the past five years (up from 4.5 percent in 2000). At the same time, foreign reserves reached a record $2.3 billion at end-2005.

A. Financial Sector

71. Costa Rica’s financial sector is more developed than in other Central American countries and ranks second only to Panama; however, it is still fragmented and centered on banking intermediation. Commercial banks are the most important financial institutions, accounting for more than 80 percent of financial sector assets, followed by savings and loan associations (Table 6).23 Commercial banks are generally organized in financial groups that often include, in addition to an onshore bank, an offshore bank, a stock broker, an investment fund, an insurance commercialization firm, a pension fund, and a mortgage company. Since 1996, the growth of the banking sector has outstripped GDP growth. Gross assets of banks reached 66.7 percent of GDP in 2005 (up from 48.2 percent in 2000), which is high by Latin American standards. Investment funds have slowly regained market share since the mutual fund crisis in 2004 that slowed what had been rapid growth of both mutual funds and pension funds.24 While banks have increasingly directed lending to the private sector, investment funds have concentrated almost exclusively in government debt securities for lack of a significant private debt market.

Table 6.

Costa Rica: Structure of the Financial System

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Sources: Ministry of Finance, Central Bank, Financial Supervisory Agency (SUGFEF), and IMF staff calculations.

Costa Rica has a state-run insurance sector. However, the U.S. Central America-Dominican Republic Free Trade Agreement (CAFTA-DR) is expected to bring about a substantial opening of the insurance sector in 2008.

AUM denotes assets under management.

This figure includes both primary and secondary exchange-based trading.

72. Five public banks dominate the financial sector. The three largest public banks—Banco Nacional (BN), Banco de Costa Rica (BCR), and Banco Popular y de Desarrollo Comunal (BP)—alone accounted for 49 percent of total banking assets in 2004. They are state-owned public banks and benefit from state guarantees of deposits, while the two remaining public banks, Banco Hipotecario de la Vivienda and Banco Crédito Agrícola de Cartago (Bancrédito),25 are special commercial banks incorporated under public sector law. BP receives indirect state subsidies via mandatory deposits raised in the form of a 1.5 percent deduction from gross wage income in Costa Rica. These “social charge” deposits earn low interest and have a minimum holding period of 18 months, which gives BP a large deposit base at low cost. Despite their mandate to engage in development activities, public banks generally allocate credit on market terms. Roughly 80 percent of public bank assets are private sector credits and 95 percent of their security investments are in government debt.

73. The strong market position of public banks reflects the legacy of four decades of a state-controlled banking system, even though there have been substantial reforms over the past 10 years. The banking sector was a state monopoly until the mid-1970s. Since the 1980s, the system has undergone major structural changes and has been deregulated in an effort to improve efficiency in the provision of financial services.26 In 1996, a new bank law (Ley Orgánica del Sistema Bancario Nacional, LOSBN) and a new central bank law (Ley Orgánica del Banco Central de Costa Rica, LOBCCR) were enacted as independent initiatives to reorganize the supervision of financial institutions, pension funds, and the securities market as well as monetary policy. According to the LOBCCR, the principal objectives of monetary policy are to contain the growth of monetary aggregates to levels consistent with the central bank’s targeted inflation-based crawling peg rate policy and to foster a stronger net international reserve position.

74. LOSBN also revoked the exclusive rights of the public banks to hold savings and current account deposits27 and allowed private banks to expand their range of services and investment instruments offered to the public. Nonetheless, public banks still capture most of the local deposits and control roughly 70 percent of the banking system’s domestic assets.

75. Profound financial sector reforms have fostered more efficient financial intermediation. The growth of credit to the private sector from 23.1 percent of GDP in 2000 to 34.7 percent in 2005 testifies to the increased accessibility of the private sector to financial services as a result of the financial reforms. Nonetheless, credit to the private sector and deposit volume in the banking system are among the lowest in Central America,28 while the annual lending increase slowed from 44.1 percent in 1999 to 16.2 percent in 2004. In 2005, there were 17 commercial banks, including three public banks, two specialized banks and nine private domestic banks,29 28 savings cooperatives, and 53 investment funds and financial holding institutions, which are largely foreign owned. An increase in minimum capital requirements and a policy of attracting foreign capital have stimulated the consolidation of financial groups since 1996.

76. Despite the dominance of public banks, offshore banking has helped private banks gain a significant market share over the last 15 years. Private banks are growing in importance and now hold more than 35 percent of total bank assets (up from 12 percent in 1990) and about one-third of all bank deposits (up from 7 percent in 1990) in the domestic banking system. The growth of private banks is driven mostly by offshore deposits (mainly from domestic depositors).

77. Offshore banking in Costa Rica is unusually large,30 having grown rapidly in the initial stages of private banking in the 1970s in response to excessive regulation in the form of high unremunerated reserve requirements, and as part of efforts by private banks to find a competitive edge against public banks. Initial financial sector reforms in the middle of the 1980s, such as the Structural Adjustment Programs (Programas de Ajuste Estructural, PAE), were insufficient to reverse the trend towards arbitrage-based offshore banking. Since the 1990s, however, the relative importance of offshore banks has declined as regulatory distortions to the domestic financial system have been corrected, and in light of efforts by the national financial supervisory agency (Superintendencia General de Entidades Financieras, SUGEF)31 to expand its supervisory role to foreign investors in Costa Rica. The decline followed a substantial reduction in reserve requirements (to 9 percent at end-2001), concerns about the negative connotations of offshore banking, and aggressive competition in the dollar funding market by mutual funds and public banks. However, offshore banking in Costa Rica remains significant and roughly matches domestic credit origination and deposit-taking by private banks. Today, offshore banks still account for more than 20 percent of total banking system assets.

B. Structure and Composition of Public Debt

78. The public debt structure has moved toward more standardization, increased funding from the private sector and reduced external borrowing by the central bank. In 2005, Costa Rica recorded a total public debt of $10,006 million, of which more than 70 percent was held domestically. Of the domestic debt, two-thirds was denominated in local currency, of which 80 percent was issued by the government and the rest by the central bank. The remaining one-third was mostly in U.S. dollars, of which 52 percent was central bank debt and the rest government debt. Of the external debt, almost 94 percent has been issued by the government. The external government debt amounted to $2,367 million at end-2005 (12.1 percent of GDP), down from $2,287 million at end-2004, of which 80 percent (9.7 percent of GDP) was U.S. dollar-denominated and carried low rollover risk. The government’s debt structure is weighted toward privately-held bonds, with domestic lenders holding roughly two-thirds, or $4,822 million. Total outstanding government debt at end-2005 was $7,189 million, roughly unchanged from 2004 (Tables 7 and 8). Due to recently implemented austerity measures, the consolidated fiscal deficit was projected to drop slightly from 4.3 percent of GDP in 2004 to 3 percent in 2005.

Table 7.

Costa Rica: Local Government Debt

(In millions of U.S. dollars)

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Sources: Ministry of Finance and Central Bank.
Table 8.

Costa Rica: External Government Debt

(In millions of U.S. dollars)

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Sources: Ministry of Finance and Central Bank.

79. As in many Central American countries, the central bank carries a significant quasi-fiscal deficit and is undercapitalized. Central bank debt has increased consistently over the years and climbed by more than 20 percent to more than $2.7 billion in 2005 due to a large local issuance of medium-term bonds. At end-2005, the domestic component, $2.55 billion, comprised mainly short- and medium term debt (Table 9), while the external component, $169 million, has been issued at long maturities (Table 10). In 2005, the total outstanding stock of central bank debt amounted to 13.9 percent of GDP, up from 9.0 percent in 2000.

Table 9.

Costa Rica: Local Central Bank Debt

(In millions of U.S. dollars)

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Sources: Ministry of Finance and Central Bank.
Table 10.

Costa Rica: External Central Bank Debt (In millions of U.S. dollars)

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Sources: Ministry of Finance and Central Bank.

80. The Ministry of Finance (Ministerio de Hacienda) is planning to recapitalize the central bank, whose debt amounts to approximately one third of domestic public debt. As a first step toward a more long-term solution, the finance ministry assumed $500 million of central bank debt in 2004. A full recapitalization of the central bank through the issuance of finance ministry bonds (three, five, and seven years) is expected in 2007 in accordance with the new public debt restructuring regulation (Reglamento a la Ley de Reestructuración de la Deuda Pública No. 30803-H). However, both public and private sectors appear to agree that this is only feasible if the planned fiscal reform is approved in 2006

81. The large stock of public debt highlights the urgency of comprehensive fiscal reform to curb further increases of public debt and to improve payments capacity. Interest payments on the public debt have absorbed an average of 4 percent of GDP over the past four years despite a policy aimed at reducing the debt service by improving the maturity profile of public debt. The planned fiscal reform seeks to broaden the tax base by applying value-added tax (VAT) to products and services that are currently exempt and by introducing universal income taxation. However, the reform process has suffered lengthy delays and was recently turned down by the constitutional court. Notwithstanding the broad political consensus for recapitalization of the central bank and restructuring of public debt, uncertainties remain about the prospects for fiscal reform.

C. Primary Issuance

82. There is a need to develop a structured and integrated strategy for comprehensive debt management and for deepening the local debt market. The primary market is fragmented due to an excessive frequency of issuance, nonstandardization,32 and continuous issuance through a post-auction window. Both the finance ministry and the central bank issue similar debt securities and compete in the same maturity spectrum. Despite efforts to coordinate their debt issuance through the joint auction of some short-term instruments, the process of reconciling the fiscal funding needs of the finance ministry with the liquidity needs of the central bank is weakly formalized and lacks an integrated debt management strategy.

83. But the overlapping primary issuance of public debt by both the finance ministry and the central bank also reflects a deeper problem of decapitalization and losses of the central bank. Generally, the administration of liquidity operations by a decapitalized central bank creates substantial problems of rollover risk (if debt is issued at short maturity) or competition with government debt (if central bank paper is issued at longer maturity). Because of its negative capital and ongoing deficits, the central bank is compelled either to extend the maturity profile of its debt beyond one year or roll over a large volume of short-term debt. At the moment, the central bank issues more than one-third of its debt at maturities of more than one year (Table 11), while the finance ministry also issues government debt at short-term maturities and recognizes annual losses of the central bank through the issuance of nonstandardized bonds.

Table 11.

Costa Rica: Outstanding Government and Central Bank Debt Securities, 2005

(In millions of U.S. dollars)

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Sources: Ministry of Finance, Central Bank, and IMF staff calculations.

84. The finance ministry and the central bank issue most public debt securities through a joint auction process. Since the adoption of LOSBN in 1996,33 the finance ministry and the central bank have jointly sponsored a biweekly discriminatory price auction of short-term, zero-coupon certificates, denominated in local currency,34 and medium-term, amortizing fixed-rate bonds, denominated in either local currency or U.S. dollars (Table 12).35 This competitive auction is open to both exchange brokers (puestos de bolsa) as well as financial intermediaries. The national stock exchange, Bolsa Nacional de Valores (BNV), operates the electronic trading platform for public debt securities with a payment and settlement cycle of T+2. After auctions close, a joint auction committee36 of officials from both institutions decides on the distribution of successful bids between the finance ministry and the central bank; however, this process is administered without clearly specified rules.37

Table 12.

Costa Rica: Securities Issued by the Ministry of Finance and the Central Bank

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Sources: Ministry of Finance and Central Bank.

85. Almost all public debt instruments issued by the finance ministry and the central bank are similar in substance (Appendix Table 1.7). The finance ministry issues (1) títulos de propiedad cero cupón (TPCER) (short-term, zero-coupon debt denominated in local currency); (2) títulos de propiedad interés fijo colones (TUDEB/TUDEM)38 (medium-term, fixed-rate, denominated in local currency); and (3) títulos de propiedad interés fijo dólares (TP$) (medium-term, fixed-rate, denominated in U.S. dollars). The central bank issues (1) bonos de estabilización monetaria colones (BEM) (short-term, zero-coupon debt, denominated in local currency); (2) bonos de estabilización monetaria interés fijo colones (BEM) (medium-term, fixed-rate debt, denominated in local currency);39 and (3) certificados de depósito a plazo en dólares (CDP) (medium-term, fixed-rate debt, denominated in U.S. dollars). The central bank securities are reopenings of existing series and represent the only standardized public debt issues in Costa Rica besides dollar-denominated zero-coupon certificates (TPCER) issued by the Finance Ministry.

86. Both the finance ministry and the central bank also seek funding outside the joint auction. Other government-issued securities are (1) very short-term, local-currency-denominated treasury bills (pagarés del tesoro) issued to public authorities and financial institutions;40 (2) variable interest rate, medium-term bonds denominated in both U.S. dollars and local currency (títulos de propiedad, interés variable dólares and títulos de tasa básica, interés variable colones); (3) inflation-indexed development bonds (títulos de propiedad en unidades de desarrollo, TUDES), which are offered to nonfinancial public sector entities; and (4) dollar-denominated títulos propiedad cero cupón (TPCER) (short-term, zero-coupon finance ministry debt). Only the last government debt security is offered via a competitive auction, whereas treasury bills, bonds with variable interest, and TUDES are individually negotiated. The central bank also offers two other types of debt securities: short-term certificates (inversiones de corto plazo), which are denominated in local currency; and fixed rate bonos de estabilización monetaria interés variable dólares (BEM), denominated in local currency and issued at variable maturity terms.

87. In addition to the competitive auction, the finance ministry operates a noncompetitive auction window and separate issuance arrangements with nonfinancial institution as alternative channels of government funding. During the period between two competitive auctions, the finance ministry occasionally offers the same instrument noncompetitively to both private and public financial entities through an electronic window at a uniform price with a spread level of approximately 20 basis points lower than the secondary market rates.41 This auction picks up an average of 30 percent of available public debt that has not been accommodated in the competitive auction process.42 Furthermore, the finance ministry routinely offers nonstandardized, inflation-indexed development bonds (TUDES) to nonfinancial public entities via the Caja Única de la Seguridad Social, which is a general fund in charge of administering the demand of state agencies and public sector entities for medium- and long-term government debt. Private pension funds, whose investments are mostly buy-and-hold, also frequently negotiate the purchase of nonstandardized, long-term, inflation-indexed bonds from the government. The spreads of these bilaterally negotiated, nontradable instruments are approximately 100 basis points lower than the secondary market rates. They are not subject to specific regulations, vary greatly in terms and conditions, and add to the stock of nonstandardized public debt ($2,002 million or 10.2 percent of GDP).

88. The auction results of medium-term debt issued by the finance ministry and the central bank indicate that both issuers pay a substantial risk premium over other benchmark interest rates. The central bank raises funds more cheaply at shorter maturities, while debt securities issued by the finance ministry at longer maturities attract a lower risk premium (Table 13). Both sovereign issuers also paid significant inflation-adjusted premia (230–450 basis points) over comparable U.S. government securities. In 2005, short-term BEMs (with a maturity term of 15 months) were issued at a mean spread of 240 basis points over the bank deposit rate at the time of the primary market auction, while títulos de propiedad of the finance ministry were auctioned at spreads of around 290 basis points.

Table 13.

Costa Rica: Comparative Rates of Return of Public Debt Issues in 2005

(In percent)

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Source: IMF staff calculations.

We also have taken account of the inflation rate differential between Costa Rica and the United States, which amounted to 7.85 percent on average in 2005.

89. The liquidity premium for medium-term issues varies between 100 basis points (in the case of central bank debt) and 200 basis points (in the case of government debt) for public debt at a maturity term of five years. A closer inspection of primary market auction results reveals a small dispersion of offered interest rates by successful bidders. However, this high degree of convergence to a uniform price is not due to efficient price discovery, but reflects price concentration at low allocation rates. Moreover, these findings do not indicate a scarcity of public debt, which might otherwise spawn lower spreads in response to large demand from institutional investors.43

90. The ability of the central bank to administer monetary transmission continues to be plagued by structural deficiencies. Comprehensive financial reforms in the 1990s strengthened monetary policy to support a sustainable inflation-based crawling peg rate policy. However, the central bank has been almost exclusively a seller of securities due to the funding requirements of its quasi-fiscal deficit. Moreover, the large deposit base of the three public banks, which comprise 75 percent of participation in the money markets, and the fragmentation of the money market into repos,44 interbank OTC, and exchange-based trading of BEMs, makes it difficult for the central bank to transmit its monetary policy to the market.

D. Secondary Markets for Public Debt

91. Following a merger of two stock exchanges in 1999, the BNV became the sole stock exchange in Costa Rica. It is the largest exchange in Central America in terms of market capitalization, although small by international standards. Almost all capital market transactions are executed using the trading facilities of the stock exchange. According to Article 23 of the Ley Reguladora del Mercado Valores (LMV), No. 7732 (August 11, 1997)45 all publicly offered securities (including repos) must be traded exclusively via registered brokers.46

92. BNV operates a dedicated trading platform for public debt securities. The LMV requires all publicly traded securities to be exchange-listed within the interbank electronic clearing and payment system, the Sistema Interbancario de Negociación y Pagos Electrónicos (SINPE).47 The trading platform for the primary auction trades not only public securities every 14 days (according to the public auction schedule), but also short-term securities (e.g., certificates of deposit) issued by financial institutions on a daily basis. Settlement takes place in Box 1.

Electronic Trading Platforms in Costa Rica

The BNV operates different electronic trading platforms for stock exchange transactions. Besides the trading platform (subasta primaria) for public debt securities and short-term securities issued by financial institutions, the BNV also operates a separate trading platform for stocks and standardized debt securities (with a settlement cycle of T+3 for stocks and T+1 for standardized debt securities, e.g., international bonds, mainly U.S. dollar-denominated Eurobonds issued domestically).

For money markets, the BNV administers two trading systems that have experienced significant increases in total traded value in recent years. Spot and forward transactions as well as repos are executed via the TEBEL system (with a settlement cycle of T+1). Overnight repos with the finance ministry and the central bank securities trade in the Mercado de Liquidez (which operates from 11.30 a.m. to 12.30 p.m. and settles in T). Moreover, the Instituto Centroamericano de Finanzas y Mercado de Capitales (ICAF), which in turn is owned by the BNV, operates the Interbank Money Market (Mercado Interbancario de Dinero, MIB). Participation is restricted to banks and the central bank, which trade without intermediation of a broker/dealer and subject to terms and conditions stipulated by the central bank for ICAF activities. Repos and outright loans with a maximum maturity of 30 days may be traded in this system. Settlement is gross, in real time, and takes place through the reserve accounts the banks maintain at the central bank.

Up until November 1998, the BNV also operated a foreign exchange trading platform (MONED), which was used for real-time gross settlement (RTGS) on a payment versus payment (DVP) basis before transactions were settled through the SINPE. The central bank regulates and controls the clearance and settlement system of foreign exchange trading.

93. Secondary market trading is dominated by repo and outright transactions in public securities. Secondary trading (without exchange-based primary issuance) at the BNV has increased steadily from $23.8 billion to $29.4 billion over the last five years (Table 14). In 2005, debt securities issued by the finance ministry and the central bank represented almost 87 percent of the total value traded in outright and repo transactions. Repo transactions (on both private and public debt securities) constitute the largest money market48 and amount to about 67 percent of the total trading volume. Given the large share of repo operations of maturities up to seven days in recent years, much of the secondary market trading seems to be liquidity-driven.

Table 14.

Costa Rica: Secondary Trading of Domestic Securities in 2005

(In millions of U.S. dollars)

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Sources: Ministry of Finance, Central Bank, Stock Exchange Superintendency (SUGEVAL), National Stock Exchange (BNV), and IMF staff calculations.

94. Partly due to the small size of the country and concentrated ownership patterns, the market for private securities is undeveloped. The lack of a long-term public debt yield curve makes it difficult to obtain long-term, capital market-based financing, allowing banks to dominate both medium and long-term lending and secondary market activity through their own brokerage houses. Long-term capital market finance for corporate investment is also largely absent, as local corporations seem to prefer the more limited information disclosure needed for private bank lending. There is only a handful of private debt securities, mainly issued by the financial sector, with limited trading. Corporate bonds and equities are almost absent in the secondary market and represent merely 0.2 and 0.1 percent of the total trading volume. Besides some conventional capital market-based debt finance, the secondary market activity involves money market transactions only.49

95. Fragmented and volatile primary issuance of public debt, a short-term sovereign yield curve, and a very liquid public banking sector hinder secondary market deepening. Both the finance ministry and the central bank issue public debt securities in small amounts, at high frequency and short maturities within a joint auction process, which is dominated by public banks. Additionally, fluctuations of public debt supply in the primary market precludes sufficient market volume of the same issue type for secondary trading. Issuance through post-auction windows in the primary market creates nonstandardized issues, which exacerbate the problem. Moreover, the small volume of retail investment in capital markets restricts the lending width.

E. Investor Universe and Regulation of Investments in Public Debt

96. Nonfinancial investors and banks are the most important investors in public debt. Nonfinancial private and public investors hold 35.6 percent (or $1,786 million) and 24.7 percent (or $1,241 million), respectively, of locally issued, bonded public debt (Table 15), followed by banks and quasi-banks, which hold 24 percent (or $1,206 million). Banks capture about 80 to 85 percent of the primary market issuance,50 which constitutes roughly 90 to 95 percent of their security investments. Private banks receive a far smaller allocation of public debt in the primary market than their share in the banking system. Other important institutional investors are pension funds, which hold 5.3 percent of the total amount of outstanding debt. Following a severe mutual funds crisis in 2004 (which also affected investment in pension funds),51 investment funds in Costa Rica have been gradually regaining depositor confidence.52

Table 15.

Costa Rica: Investor Breakdown of Public Debt (2000–05)

(In millions of U.S. dollars)

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Sources: Ministry of Finance, Central Bank, Stock Exchange Superintendency (SUGEVAL), National Stock Exchange (BNV), IMF staff calculations.