This Selected Issues paper considers the “informal sector” in Mexico. In Mexico and many other countries, the informal sector represents a large share of total employment. The paper reviews the literature on informality, with special focus on findings for Mexico, and develops a theoretical model that highlights the importance of externalities and the distortion associated with the informal sector. The analysis provides insight into the kinds of policy measures that might sustainably reduce the size of the informal sector. The paper analyzes financial saving in Mexico.

Abstract

This Selected Issues paper considers the “informal sector” in Mexico. In Mexico and many other countries, the informal sector represents a large share of total employment. The paper reviews the literature on informality, with special focus on findings for Mexico, and develops a theoretical model that highlights the importance of externalities and the distortion associated with the informal sector. The analysis provides insight into the kinds of policy measures that might sustainably reduce the size of the informal sector. The paper analyzes financial saving in Mexico.

V. Development of Government Securities and Local Capital Markets in Mexico1

Abstract

This chapter examines the significant steps Mexico has taken to develop its government securities market in the context of broadening and deepening its local capital market. The chapter presents a framework of how Mexico has approached this task through building up both the demand and the supply for these securities, while simultaneously strengthening the necessary infrastructure. The chapter focuses on the legal, regulatory and institutional aspects of the Mexican experience, and outlines its implications as well as pending areas for broader capital market development. Issues that may be of particular interest going forward, such as the benefits and risks associated with foreign participation in the local market, and the factors affecting the asset allocation of the AFORES, are also discussed.

A. Introduction

1. A well-developed government securities market can play a crucial role in macroeconomic and financial stability. A government securities market facilitates the domestic funding of public sector financing needs, thereby reducing the need for direct monetary financing or the build-up of foreign currency-denominated debt. As a result, and coupled with sound debt management, it reduces exposure to global interest rate and currency fluctuations.

2. An advanced government securities market can also establish the conditions for the development of non-bank financing for the private sector, facilitating the diversification of financial intermediation. An optimal capital market structure is likely to be one with balance among various channels of intermediation, thereby enabling the various channels of financial intermediation to compensate for each other during times of stress.2

3. By contributing to the conditions needed for a well-functioning financial system, a deep and liquid government securities market can also contribute to more efficient intermediation and hence economic growth. A well-developed securities market enables the development of financial products, including money market instruments, repurchase agreements (repos) or secured lending in general, structured finance, and derivatives, all of which can improve risk management. These financial instruments play a crucial role in promoting an efficient allocation of capital, and can contribute to productivity growth by improving management and transfer of risk. Risk transfer is essential as it helps facilitate the type of entrepreneurial activity that generates new technologies and new ways of doing business.3

4. The development of Mexico’s government securities markets, and its positive impact on the rest of the financial sector, has been rapid in recent years. The country boasts an extended yield curve in the local government debt market, with maturities up to 20 years issued at a fixed rate (see Figure). Although the size of the local bond market is still smaller (in relation to GDP) than in some other emerging markets, the liquidity of the debt market (public and private), as indicated by a high turnover ratio (695 percent in 2004, see Table), also reflects the important role these instruments play in the functioning of the Mexican financial market, as opposed to a much lower turnover in countries where they act mainly as a safe investment vehicle for the local banks.

Selected Emerging Markets Economies Bond Market Size and Turnover

(End-2004)

article image
Source: BIS.
uA05fig01

Selected Emerging Markets Local Yield Curves

(July 2005)

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: Bloomberg.

5. The development of the government securities market in Mexico was the product of concerted efforts. The initial efforts started in 1978 (see below), as the government attempted to move from central bank financing of its deficit to direct market financing. Subsequently, the experience of 1994–95 crisis had profound implications for the government’s approach to deficit financing and debt management, since the fact that most of the debt had to be issued at a floating rate or as dollar-indexed debt was a central aspect of that crisis. Since then, the authorities have taken advantage of the opening of the financial sector under NAFTA, which was phased in gradually to maintain a balance between the benefits of increased access to global financial markets and the need to guard against potential threats to financial stability, with significant effort devoted to developing the government securities market (G-20 Conference, Mexico Case Study (2003)).

6. This chapter reviews the experience of Mexico in developing the government securities market, outlines its impact on the economy, and discusses some issues going forward. Section B reviews the main factors that have helped develop the demand for government securities, outlines their impact, and discusses some issues going forward. Section C reviews the main factors that have shaped the supply of these securities, outlines their impact, and discusses some issues going forward. Section D reviews the measures that have improved the supporting financial infrastructure. Section E discusses the impacts of the development of the government debt market on the broader capital market, including the corporate bond market, the stock market, and derivative markets (including securitized products). Section F concludes.

B. The Demand Side

Financial liberalization

7. Financial liberalization in Mexico, aimed at removing legal and regulatory impediments and widening investment opportunities, has had important implications for the development of the demand for local debt instruments. The Mexican authorities have defined four phases of institution building in the financial sector, spanning the last three decades (G-20 Mexico Case Study (2003)): (i) early reforms4 (the early 1970s to 1988); (ii) fortifying financial institutions (1988–1994); (iii) revamping the financial sector in the aftermath of the crisis (1995–2000); and (iv) recent institutional reforms (2001–2003).

8. The second of these phases was characterized by a radical transformation of the financial sector. In this context, significant reform measures were taken. These actions included freeing deposit interest rates, abolishing reserve requirements, removing credit controls and lending restrictions, privatizing (again) the banking system, starting to dismantle restrictions on foreign investment in Mexican financial and non-financial assets, and granting autonomy to the central bank. In the context of financial liberalization and deregulation, emphasis on prudential supervision also began to increase. During this period, several actions were of great importance in terms of their impact on the demand for local securities:

  • Deregulation of the financial sector: in 1988, banks were allowed to invest freely subject to maintaining a liquidity ratio of 30 percent in the form of government debt instruments and interest-bearing deposits at the BoM. Banks were also authorized to participate in CETES auctions, bidding either on their own account or on behalf of third parties. Indeed, banks’ holdings of CETES played an important role in the early development of the yield curve, particularly at the shorter end of the curve. The 30 percent liquidity coefficient was eliminated in September 1991.

  • Internationalization of the financial sector: in 1990, the restrictions on the purchase by non-residents of fixed income securities, especially on government securities5, were abolished.

Financial deepening

9. Following the 1994–95 crisis, the Mexican authorities initiated actions to deepen the financial liberalization process. A main objective was to develop a diverse investor base as a way to reduce the cost of borrowing and promote market stability and efficiency. A diversified investor base was crucial to enhance the liquidity of the local securities market and ensure a stable demand for fixed-income securities. In this light, the authorities’ efforts focused on creating the conditions for greater participation of both domestic institutional investors and foreign investors in the government securities market, especially at the long-end of the curve. The participation of foreign investors was viewed as critical not only to promote financial innovation, but also to contribute to the liquidity and maturity extension of government securities.

10. In this context, Mexico took a number of far-reaching measures. In so doing, Mexico made efforts both to provide incentives to different investors to buy, hold and trade government securities, and to put in place structural reforms designed to attract different investors. These included:

  • Pension sector reforms: in 1992, a private pension system based on an individual capitalization scheme began operating, though at first the individual accounts were placed at the central bank. Since 1997, the contributions made by employees, employers, and the government have been deposited and registered in personal accounts owned by the employees, but administered by financial entities called Administrators of Retirement Funds (AFORES). In 2002, amendments and additions to the retirement savings system law opened the possibility for more workers to access the benefits of the new pension system. The amendments also eliminated the restrictions to invest in foreign securities, allowing retirement fund managers to invest up to 20 percent of their total assets in these instruments.

  • Bankruptcy procedures: in 2000, the bankruptcy and security lending legislation was passed. The new law permitted holders of repo collateral to terminate in advance their repo operations by netting their rights and obligations with the defaulting counterparty.6 This was necessary to provide more certainty for counterparties’ operations in case of bank defaults, as repos were not protected by IPAB, the deposit insurance agency.

  • Mutual fund reforms: the mutual fund law of 2001 required that management of mutual fund firms be independent. This law has led to the establishment of new entities, which has broadened the field of domestic institutional investors. As credit institutions and brokerage houses can no longer operate directly as mutual fund managers, they had to create independent subsidiaries with independent staff. Mutual fund management firms are, in effect, compelled to operate as independent business units with the sole purpose of managing and distributing mutual funds.

Implications of demand policies

11. Financial liberalization, coupled with broadening of the investor base, has allowed Mexico to open up its economy while reducing its vulnerability to external shocks. In particular:

  • Financial intermediation has been enhanced. In contrast to the earlier periods, total domestic financial savings as measured by M2 have increased, from 41 percent of GDP in 1995 to 53 percent of GDP in 2004. In comparison with the rest of the world, Mexico’s level of M2/GDP at end-2004 seems to be broadly in line with its GDP per capita (in US$ at market prices), though there is room for further improvement (see Figure).

  • Public sector financing has become stable, with a reduced risk of funding problems. The investor base in the government debt market is much more diversified. Different types of investors, including foreign investors, with different time horizons, risk preferences and trading motives buy, hold or trade all government securities, facilitating public sector financing (see Table).

  • The yield curve has been extended, and has shifted lower (see Figure). The extension of the yield curve has been made possible as domestic institutional investors (and foreign investors, more recently) began to participate more actively in the domestic debt markets. Greater competition within a larger pool of investors has contributed to reducing the cost of borrowing.

uA05fig02

World Domestic Financial Savings and GDP Per Capita

(End-2004)

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: WEO.

Mexico: Actual Portfolio Composition of Institutional Investors by Type of Instrument

(in percent, end-2004)

article image
Footnotes:

‘Government and CB debt’.

‘Corporate bonds’ include bonds (but not commercial paper) issued by non-financial firms and in some cases, asset-backed securities;

‘Other’ includes commercial paper, bank deposits and investments in local mutual funds; “n.a.” - not applicable/not allowed;“…”- no information

Sources: CNBV, CNSF, CONSAR
uA05fig03

Domestic Yield Curves

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: Bloomberg.
Foreign participation

12. Foreign participation in local currency issues has been encouraged by many countries seeking to diversify their investor base and foster the development of their local capital markets. Countries have sought to achieve this objective in various ways (see Box 1). Flows have been concentrated in the most liquid local-currency markets, including government bonds in Brazil, Mexico, Poland and Turkey. The proportion of government bonds held by foreign investors in these markets doubled over the past year, and ranges from a still small 4 percent in Brazil to one-fifth of the market in Poland (see Figure).

An Alternative Foreign Exposure to Local Currency Bonds

Allowing foreign investor participation in local-currency bond markets provides an opportunity for a government to reduce its exposure to FX risk (so-called “original sin”) while helping to diversify the investor base and foster the development of their capital markets. Different countries have sought to achieve this objective in different ways: some, like Mexico, have encouraged foreign participation in the local bond market, while others have taken the approach of issuing international bonds in local currency.

Some sovereign (and private) issuers have ventured recently to issue international bonds in local currency. Such issues have an ambiguous effect on local capital market development. On one hand, the international local currency issuance attracts foreign investment that might have otherwise bought the bond in the local market, thus depriving the latter of a source of liquidity. On the other hand, the international issues may help deepen the local market development by attracting investors that would not have invested in local bonds because of fears of convertibility or default risk.1/ These issues also extend the investor base to investors that are interested in local currency, but unwilling to undergo the complicated procedures required to buy local securities in some countries.

So far, the international bonds issued by EMs in their own local currencies have accounted for a small fraction of their total international bond issues. From 1995–2005, the ratios of local currency bonds issued internationally to total international issues were only 0.8 percent (US$1.2 billion) in Emerging Asia, 0.2 percent (US$249 million) in Emerging Europe and 0.7 percent (US$ 2.2 billion) in Latin America. However, such issuance is widening, as recently some EMs have issued international bonds in their own currencies for the first time. For example, the Colombian government issued a US$375 million equivalent of 6-year international bonds denominated in local currency in November 2004, followed by another such issuance, in January 2005, for US$124 million.

1/ The investor will be protected against convertibility risk (in case the government imposed exchange controls), as interest and principal payments are payable in dollars at the spot exchange rate prevailing around the day when the payment falls due. In addition, because the bond is a global bond, investors may find the legal statutes that govern the bond more favorable than local laws in case of default.
uA05fig04

Foreign Participation Rates in Local Markets

(In percent)

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Sources: Central bank data.

13. Several factors have facilitated the higher participation of foreign investors in local markets. The introduction of derivative instruments to hedge foreign exchange risk was a key factor. Another was the inclusion of local market bonds in global benchmark indices that are used by a wide range of investors. For instance, local currency bonds of selected investment grade emerging market countries (Chile, Czech Republic, Hungary, Mexico, Poland, Slovenia and South Africa) were recently included in the Lehman Global Aggregate Index. This has made it easier for investors that manage such benchmarks to add emerging market local-currency bonds to their portfolios, thus adding longer-term investors to the investor base.

14. For investors, local-currency debt may also offer an opportunity for diversification. This is especially true for debt from low-yielding investment grade countries such as Poland and Mexico, where the correlation between external and domestic debt returns has been low in 2004 (see Figure). For higher-yielding credits such as Brazil and Turkey, the country/credit risk premium is high and changes in the premium affect yields on dollar debt, the exchange rate, and yields on domestic debt at the same time, resulting in high correlations among the return on these assets, particularly in times of stress.

uA05fig05

Correlations Between Local and External Debt

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: Citibank.

15. The implications of higher foreign participation in local government securities market for financial stability, however, may not be as clear cut. Mexico’s avoidance of double taxation and other tax and regulatory complexities7 has encouraged foreign investors to participate in the local bond markets. This participation has potential benefits, but also could pose certain risks:

  • Foreign investors can bring several significant benefits to the local bond market. They can play an important role in diversifying the investor base. Through their participation in the local bond market, arbitrage activities and diversification of portfolios, foreign investors can contribute to increasing the liquidity of the local bond market. In the context of macroeconomic stability, these activities may facilitate the extension of the maturity of bonds issued in the local bond market. This seems to be the case in Mexico, which extended its yield curve in 2003 by issuing a 20-year peso-denominated bond (see section C); as of early 2005, holding of this bond is thought to be dominated by foreign investors. Another example is Turkey, which issued a fixed rate three-year lira bond for the first time in October 2004, with strong interest from foreign investors. Foreign investors can also help speed up the pace of financial innovation, particularly through the use of both technology and services already available in international capital markets, giving rise to efficiency gains.

  • The participation of foreign investors in the local bond market, however, may not be a source of stability in all circumstances. In principle, reducing exposure to external shocks is one of the main benefits of developing an efficient government bond market. However, some market participants have suggested that attracting foreign investment in a local securities market could end up importing the volatility that developing the domestic market tried to avoid (El-Erian (2005)). Foreign investors’ views on the exchange rate will affect the way they value these securities, and they might be more prone to using them as a short-term speculative tool. A further consideration is that recently the demand for local currency government bonds has been whetted by the unprecedented decline of yields on all hard-currency-denominated credit instruments, including emerging market external bonds, which has pushed international investors to search for higher returns in local currency-denominated assets. For example, yields on a 2-year dollar-denominated Mexican global bond were recently (early 2005) only 30 bps above the comparable US treasury yields, while the equivalent peso-denominated bond was yielding 565 bps over US treasuries. An increase in mature markets interest rates might hence affect the appeal of these securities.

AFORES asset allocation

16. The implications of a more developed local debt market are also relevant to the investment strategy of the AFORES. While reforms in the pension fund industry have helped create a class of investors that may be interested in long-term fixed income instruments (long duration), it seems that recently the AFORES have not been investing significantly in longer-term government securities.

17. Recent moves by the AFORES into shorter-term government chapter have raised some concern about the appropriateness of their portfolio decisions as pension funds. Foreign investors stepped in at the long-end of the market, heading off what otherwise could have been an upward adjustment in rates at the long-end of the yield curve. Still, the AFORES’ move underlined the powerful market impact their collective investment behavior could have. As of 1Q 2005, and despite recent liberalization of the investment regime (see Table below), AFORES hold 85 percent of their assets in government and quasi-government chapter (see pie charts). They hold 50 percent of their assets in one instrument, Bondes, the 7-year floating rate government bond, and much of the rest is in relatively short-term government debt. AFORES hold only 11 percent of their assets in fixed rate government securities (Bonos with maturities of 3, 5, 7, 10, and 20 years).

uA05fig06

Afores Asset Allocation by Sector

(March 2005)

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: CONSAR.
uA05fig07

Afores Asset Allocation by Instrument

(March 2005)

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: CONSAR.

18. A number of factors could have driven AFORESasset allocation decisions and perhaps biased them against risk-taking. AFORES derive the bulk of their income from fees on employers contributions, which are automatically deducted every two months from workers’ payroll. The other fee, calculated as a percent of the value of assets under management, accounts for a much smaller portion of AFORES’ income. Thus AFORES’ income depends directly only on the number of contributors they enroll; returns on portfolio matter only insofar as they might induce contributors to switch AFORES. This system may have created a tendency among AFORES to mimic each other’s investment allocation,8 trying to avoid large deviations that could trigger moves by contributors.9 Other regulatory issues might also have played a role in restraining risk taking, including high penalties on deviations from value-at-risk (VAR)-based restrictions.10

19. Recently, consideration of how best to adjust AFORES’ incentives to be closer in line with pension beneficiaries’ long-term interests has led to a proposal of pension fund “benchmarking”. Under this proposal, AFORES would announce their model portfolio for a certain period (set initially at one year, but with intentions to extend it later). The model portfolio would spell the investment strategy of the Siefores, detailing the allocations among various sectors and instruments and, hence, producing a benchmark against which the performance of the Siefores could be measured and published. The idea is that benchmarking would help develop the risk culture, encouraging beneficiaries to choose AFORES according to their risk preferences, and providing incentives to AFORES to focus more on generating returns and meeting or beating their benchmark performance. Box 2 discusses the several factors driving the asset allocation of pension fund in OECD countries.

Mexico: Investment Restrictions for Pension Funds

(AFOREs)

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Sources: CONSAR

Factors Affecting Pension Fund Asset Allocation in OECD Countries1

Several factors influence the asset allocation of pension funds. These include market characteristics, regulation, accounting, and implication of risk transfer to beneficiary.

For several pension funds in OECD countries, the relative shortages of long-term and index-linked bonds have been an important constraint. In fact, in most if not all mature markets, such long-term instruments remain small compared with the size of pension fund portfolios. Policy actions have been taken in many OECD countries to develop further the market for these instruments, partly through the development of securitization and structured credit markets, and through incentives for capital-intensive industries, such as utilities, financial services and housing to issue longer-dated instruments.

Regulators, through setting minimum funding requirements and restricting certain investments or asset holdings, tend to influence investment behavior. A very important factor is the choice of the discount rate for minimum funding requirement, which heavily influences pension fund asset allocation strategies. Pension fund managers wishing to limit the volatility of their regulatory funding ratio may hold a larger a larger allocation of assets with a high correlation to the discount rate used for liabilities.

Accounting considerations are frequently cited as the most important factor affecting pension fund management, and the shift from defined benefits (DB) to defined contribution (DC) or hybrid schemes. How pension assets and obligations are measured could potentially introduce volatility in the financial statement of the sponsor company or the pension fund. Indeed, many industry observers consider that a move to market-based, fair value accounting principles (mark-to-market) would not only increase the shift away from DB pension plans (as it inflates the present value of benefits), but also encourage short-term trading and investment styles.

Educating households about the various investment strategies and how these should change according to the time horizon is becoming more important with the growing shift to DC plans and the transfer of risk from sponsor to beneficiary. Financial consultants in OECD have been significantly more involved than in the past in providing this guidance. For instance, they typically advise individuals to hold relatively large allocations of higher risk instruments, such as equities, in pension savings when they are young, and gradually switch to assets with more stable values, such as bonds, as they approach retirement.

1 The discussion is based on Groome et. al., “Risk Management and the Pension Fund Industry”, Chapter III of the September 2004 Global Financial Stability Report.

C. The Supply Side

20. Mexico has sought to develop its government securities market not only to lower the cost and improve the structure of the public debt, but also to promote the development of private sector debt and derivatives markets. To this end, Mexico has pursued supply-oriented policies, focusing on the consolidation of a benchmark yield curve to promote a deeper, more liquid government securities market and, therefore, to lower the cost of the public debt. The consolidation of the yield curve has also aimed at facilitating the pricing of financial instruments issued by states, and public and private companies across a wide maturity span, a key element underpinning the actions of both borrowers and investors and the development of the local securities market. Mexico has also sought to improve transparency and predictability of its issuance program as a way to support the development of the local securities market, and reduce the information risk of investors.

Consolidation of a benchmark yield curve

21. Mexico has sought to develop its government securities market through a continuous extension of the range of securities on offer. The initial step was taken in 1978, when a peso-denominated fixed rate security, or Cetes, was issued. The first issue of a one-year zero coupon bonds took place in 1990. For many years subsequently, the government’s domestic funding came from placing short-term zero coupon bills, floating rate notes, inflation-indexed, oil-indexed, and dollar-indexed bonds. Ten-year inflation-indexed bonds were issued for the first time in October 1999. Three-year fixed coupon bonds were introduced in January 2000, five-year fixed-coupon bonds were introduced in May 2000, ten-year fixed-coupon bonds were introduced in July 2001, and twenty-year fixed coupon bonds were introduced in October 2003. The two tables below show (1) the categories and amounts of the auctions in recent quarters, and (2) the total outstanding debt stock and its composition.

Government Security Auctions For the Last Year Amounts Offered on Each Auction

(Millions of Pesos)

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Inflation-linked bonds, 1 udi= 3.5 pesos aprox.

Source: SHCP.

Federal Government Domestic Debt Securities Billions of pesos, March 2005

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Source: SHCP, BM and Staff estimates.

22. A consistent macroeconomic framework and more stable macroeconomic conditions have set the conditions for the authorities to expand further the range of securities on offer. A record of fiscal prudence11 has been key to lessen investors’ perceptions of market and default risk and, therefore, has helped the government build credibility in its ability to honor its obligations—as reflected in credit rating upgrades and lower spreads on global bonds, for example. Overall debt service cost has declined as a result (see Figure). Meanwhile, the achievement of low and fairly stable inflation also has greatly facilitated the extension of the maturity profile of the domestic debt, as well as the increased issuance of peso-denominated fixed-coupon bonds (see Figure).12

uA05fig08

Public Sector Deficit and Real Interest Rates

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: IMF.
uA05fig09

Inflation and Average Maturity of Federal Government Domestic Debt

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: Banco de Mexico.

23. Developing the government securities market has required, however, more than a supportive macro framework. Mexico has taken several steps, at the legal,13 institutional, regulatory and market levels, to develop the stable supply of government securities. The following steps were particularly important:

  • Central bank autonomy: in 1993, Congress granted autonomy to the central bank, the Bank of Mexico (BoM). This ended direct BoM financing of deficits, and underlined the government’s commitment, among other things, to finance itself solely from market sources at market interest rates.

  • Commercial bank restructuring in the wake of 1994–95 crisis: IPAB became operational in 1999. Its mandate included, among other things, managing the restructuring programs for banks that received official support. This in turn, required increased government borrowing and issuance.

  • Introduction of new instruments: in June 2001, changes to the securities law have allowed the introduction of the new instruments, the “Certificados Bursátiles” (CB’s) that can be issued by the private and public sectors, and are versatile, combining the speed and ease of issuance characteristics of Medium-Term Notes,14 (Mtns) with the flexible amortization schedules of debentures, which makes them very attractive. Moreover, CB’s can include covenants and legal restrictions, which is not possible with Mtns.

Transparency and predictability

24. To provide more certainty to market participants, Mexico recently has changed the way it announces the debt management strategy and the auction system. In 2004, Mexico made a commitment to announce a detailed and comprehensive domestic debt strategy for the entire year, as opposed to the previous quarterly basis. In line with the strategy in place since 2001, the authorities announce the type of securities to be auctioned, the minimum amount to be tendered, and the maximum nominal value of the total placement; since April 2004, target issuance amounts for particular securities are also announced.15 The commitment to provide this information reflected a conscious decision by the authorities to forego discretion to “time” access to the market and potentially (and opportunistically) get better terms.

25. The government’s commitment to a published debt issuance plan and to finance itself at market prices even during periods of stress has been essential to developing the primary market. On the last point, the government has only very rarely made use of its right to reject bids at the primary auction. The last times bid results were rejected were in early 1995 during the Mexican crisis and in September 1998 at the peak of the Russian crisis.

26. Mexico has also changed the auction schedule recently. The objective of this change has been to allow market participants to rebalance their portfolios of government securities after the auction results are published, but before the market closes.

Implications of supply policies

27. The supply policies have played an important role in reducing both vulnerabilities and financing costs of the public debt. The supply policies have contributed to (i) improve the debt amortization profile; (ii) reduce financing costs; (iii) reduce the vulnerability of the public debt to exchange rate and interest rate shocks; and (iv) lessen the effects of changes in international capital flows (IMF, 2004). In this context:

  • The development of long-term, fixed-rate instruments and the lengthening of debt maturity of other instruments have resulted in smoothing of future amortizations, particularly of IPAB securities in 2005-06.

  • The debt structure has improved because of the greater use of long-term fixed rate debt by the federal government (see Table above). The share of medium and long-term, fixed rate debt in the total debt of the federal government rose from nearly zero in 1998 to around 41 percent at 1Q 2005. This has allowed IPAB and FARAC16 to focus on other instruments, with IPAB issuing 3 and 5-year Bondes (floating rate bonds adjusted every 28 and 91 days respectively), and FARAC issuing twenty and thirty year inflation-linked bonds.

  • The average maturity of the domestic securities of the federal government more than doubled between 1998 and 2004, to 2.6 years. This relied to an important extent on the use of debt indexed to short-term rates initially, and fixed-rate bonds subsequently. Even though short-term debt measured on a residual maturity remains substantial and the average maturity of public debt remains less than three years.

  • The achievement has been especially impressive in reducing the government’s balance sheet exposure to the risk of peso depreciation, as the share of gross external debt has fallen from over 80 percent of total public debt in 1995 to around 40 percent of total public debt in 2004 (see Figure). Indeed, the government has now reached position in which its FX-denominated earnings (mainly related to oil income) exceed its FX-denominated interest payments.

  • In turn, the government’s ongoing effort to gradually reduce its external indebtedness may have helped facilitate Mexican firms’ access to external debt markets on favorable terms.

uA05fig10

Gross Public Debt Composition

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: IMF.

D. The Infrastructure

28. A government securities market cannot play a role in developing the broader capital markets unless it is supported by a solid and efficient infrastructure. This infrastructure is essential to ensuring the liquidity of secondary market, the availability and dissemination of market-determined prices and yields, and safe clearing and settlement of transactions.

Secondary market liquidity

29. A liquid secondary market is of great importance to generating appetite for these securities and developing the broader domestic capital markets. The Mexican authorities have taken several steps to improve liquidity in secondary market trading, including:

  • Market makers: in 2000, the government introduced primary dealers or “market-makers,” with the objective of enhancing further liquidity in the secondary markets by making continuous bid-ask offers in exchange for certain privileges, such as bidding for additional securities at the auction average price results once they are known. This has increased liquidity and facilitated the participation of additional investors in the market.

  • Reopening policy: the authorities must strike a difficult balance between issuing different maturities to provide the market with a benchmark yield curve, and issuing amounts of single maturities large enough to attract investors concerned with liquidity. Mexico has taken steps to promote the liquidity of the benchmark issues. In particular, Mexico has put in place a more aggressive reopening policy of benchmark issues. The objective of this policy has been to reduce the number of issues outstanding, increase the size of each of these issues, and allow Mexico to achieve the desirable size and the life cycle for benchmark issues, thereby promoting the liquidity in the secondary market. In this context, the government announced in its 2005 debt strategy that the issuance of fixed nominal interest rate bonds with maturities of 3, 5, 7, 10, and 20 years will be implemented by reopening existing securities instead of by issuing new ones. This policy will increase the liquidity of existing securities at the long end of the yield curve and reduce the number of benchmarks in the yield curve. Specifically, the strategy would aim at reopening regularly the 3 and 5 year bonds maturing in 2007 and 2009, which were issued originally as 5 and 7 year bonds in 2003. Additionally, new 7, 10, and 20-year bonds will be issued in 2005, and will be reopened regularly throughout the year (Ministry of Finance Report).

  • STRIPS market: the government has initiated efforts to develop long-term zero coupon government securities (STRIPS). A STRIP market will allow institutions to purchase a stream of cash flow that matches liabilities, hence creating more demand for government securities.

  • Repo/securities lending: the government is working on improving the regulatory framework of the repo and securities lending markets. In this context, BoM issued in 2003 a new regulation which among other things: (i) allows corporate bonds to be traded in the repo market; (ii) allows foreign participants to finance their positions in the repo market; (iii) requires standard contracts to be used and margin calls to be considered. In addition, repo regulation will be complemented with the new regulation for securities lending, which will integrate both markets with participation of institutional investors that are not allowed to offer their bonds in the repo market.

Availability of market prices

  • BoM, through joint efforts with the Banking Commission and industry representative, led to the creation of “price vendors” in 2003. These entities are in charge of compiling information from inter-market brokers and selling it to market participants. Currently, banks, brokerage houses, mutual funds, pension funds and insurance companies are required to obtain the services of a price vendor.

  • Since 1999, BoM has also published on a daily basis information on government securities prices on its website, serving as a benchmark to evaluate the performance of price vendors.

Payment, clearance, and settlement

30. These efforts have been coupled with steps taken to ensure an efficient and safe financial infrastructure through reforms targeting the payment, settlement and clearance systems. These reforms, listed below, strived to strike a balance between the objectives of reducing risks in the system and maintaining an adequate operational efficiency in financial markets.

  • In 1994 the BoM initiated a comprehensive reform of its payment systems in order to achieve a high degree of operational security and reliability. A major component of this reform was the design and development of new payment systems with more stringent risk controls and real-time settlement procedures. The BoM first developed the Extended Electronic Payments System (SPEUA) to facilitate the settlement of payments transactions made by banks clients and also the Interactive System for Securities Deposits (SIDV) to support securities transactions through a delivery-versus-payment mechanism.

  • The new Securities Market Law of June 2001 enabled the creation of central counterparties for securities market transactions, with the purpose of eliminating the risk of settlement default. Central counterparties have to determine and apply a strict system of financial safeguards to assure fulfillment of their obligations.

  • Efforts since 2001 have also focused on revamping the legal framework in order to ensure payment finality and to improve the execution of collateral and the oversight powers of BoM. In line with its objectives of complying with the BIS Core Principles for Systemically Important Payment Systems, the BoM announced a sequence of measures that would be implemented within the following three years. The main measure, implemented in 2002, requires that any overdraft in the large value electronic payments system be settled in the same day by using bilateral credit lines provided by other banks.

E. Implications for the Development of the Local Market

Financial products

31. The development of the government securities market is likely to have improved intermediation. The availability of a benchmark has helped the pricing of credit and therefore facilitated the lending activity of the commercial banks. It has also enabled the development of financial products, including repurchase agreement (repos), derivatives, and securitized products.

32. Asset securitizations and structured finance have increased in recent years. In particular securitizations of tax revenues, construction bridge loans, residential and commercial mortgages, existing receivables, and future flows have taken off. Credit enhancements, such as full or partial “wraps” provided by banks or insurance companies, have been increasingly used by lower credit or less known issuers as means to push the rating of the issue higher. As a result, in 2004 there were 52 securitized bond offerings in Mexican domestic market totaling over US$4 billion (Ilyina (2005)). Large recent securitizations included GMAC’s and Ford’s credit securitizations, and Banorte’s mortgage securitization.17 In addition, a recent report by S&P showed that the impressive growth in Mexico’s structured finance established the country’s as the leading market in Latin America (see Figure).

uA05fig11

Structured Finance Development

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: S&P.

33. Derivatives products have also flourished. Over the counter (OTC) market in interest rate swaps (IRS) and forward agreements (FRAs) have grown steadily and are currently as liquid as the underlying bond market. The exchange-traded interest-rate derivatives markets, which was almost non-existent prior to 2001, has picked up sharply, especially the TIIE-2818 future contracts. In addition, foreign exchange (FX) derivatives markets are very liquid. According to market participants, in the past five to seven years most of FX trading activity was undertaken off-shore, with foreigners mainly using them to bet on their views on the exchange rate and interest rates. This however has been changing recently as MexDer (the local derivatives exchange) gained market share.

Corporate bonds

34. In light of the success in the development of the government bond market, Mexico has made significant strides in the development of the corporate bond market. The possibility of the corporate sector to finance itself through the issuance of bonds has potentially important benefits as it can (i) reduce stress on the banking sector by diversifying credit risk across the economy; (ii) supply funds for long-term investment needs;19 and (iii) lead to the creation of financial products that meet the needs of both borrowers in the corporate sector and investors (World Bank and IMF (2001)).

35. Mexico has taken a number of steps to bring about the development of a critical mass of investors, funds, and securities. Not surprisingly, this process has benefited from the development of the government bond market itself. Steps to seek the diversification of the investor base in the government bond market, including mutual funds and AFORES, have served to develop an investor base the corporate bond market, as a great number of investors, who buy, trade and hold government bonds, and carry out the same activities with corporate bonds. Efforts to encourage the development of specialized financial intermediaries have also made it possible to build up and strengthen the institutional and operational infrastructure for the corporate bond market. In addition, as indicated above, the development of the benchmark yield curve has been critical for the pricing of corporate bonds across the yield curve in both the primary and secondary markets. Currently 62 percent of outstanding corporate bonds are floating rate, with future cash flows based on the CETES rate or the TIIE rate.

36. Mexico has adopted other measures to promote the development of the corporate bond market. To promote the investor base and debt instruments with characteristics that matched the needs of borrowers and investors, Congress approved changes to the Securities Market Law and the Mutual Fund Law in 2001. These changes aimed at promoting the development of the corporate bond market by giving greater emphasis to transparency, efficiency, and liquidity. In particular, these changes called for increased transparency through an improved provision of timely information, and introduced additional protection for investors through the requirement of better corporate governance practices and establishment of explicit rights for minority stockholders. These changes also opened the way for the key introduction of “Certificados Bursátiles,” (see above). In addition, these changes were intended to help promote the growth and development of mutual funds, while requiring transparency in their operations and dissemination of information and providing for incentives of small investors to buy a broad range of savings instruments.

37. In this context, the corporate bond market has shown promise (Ilyina (2005)):

  • The diversification of the investor base has been critical for the development of the corporate bond market, with AFORES, mutual funds, and insurance companies buying, holding, and trading the bulk of corporate bonds. Of all outstanding bonds as of end 2004, AFORES held approximately 35 percent, mutual funds 20–30 percent, and insurance companies 15–28 percent (see Table). Meanwhile, participation of local banks and retail investors was limited, and participation by foreign investors is all but non-existent, which is partly due to withholding tax on foreign holders of corporate bonds.

  • The specialized financial intermediaries have played an important role in the issuance of bonds. More than 24 different entities, including brokerage house that are subsidiaries of local commercial banks, foreign commercial banks, and international investment banks, lead or co-lead corporate bond issues.

  • Corporates are allocating bond offerings through a Dutch auction in light of past questions about the fairness in the distribution of corporate bonds through underwriting. This auction allows corporates to allocate the bonds at the cut-off price for the amount they want to allocate. In this context, investment banking fees have fallen significantly (to below 25 basis points for 5–10 year bonds and zero basis points for some issues.

  • Efforts to introduce a new financial instrument have succeeded as the Certificados Bursátiles now account for 90 percent of all outstanding private bonds.

  • In this environment, corporate spreads have declined markedly, with high-quality corporates, such as PEMEX, issuing at a spread close to or equal to the spreads on sovereign bonds. Even a troubled credit such as GMAC (rated “AA” locally) has been able to issue at a 150 basis points spread in the Mexican market, while a comparable spread in the US domestic market would have been in the range of 500–600 basis points).

Mexico: Local Institutional Investor Base for Corporate Bonds

(in billions of US dollars, unless indicated otherwise)

article image
Footnotes:

including securitizations;

not including the banking sector.

Sources: CNBV, CNSF and Staff Estimates

38. The corporate bond market could benefit, however, from further development (Ilyina (2005)):

  • Most of the corporate issuers are quasi-sovereigns, and small and medium-size firms (SMEs) are absent from the market. The biggest bond issuers are quasi-sovereign entities (PEMEX, CEF and Apoyo Vivienda) and large banks (Banorte and Banamex). The outstanding bonds issued by the largest private non-financial companies, CEMEX, America Móvil, Ford, Coca-Cola Femsa, and GMAC, account each for 3–4 percent of the total stock of private debt. Meanwhile, according to the BoM Credit Survey of end-2004, “other liabilities” accounted for less than 1 percent of total liabilities of SMEs, compared with 4 percent for large firms and 6.3 percent for the “AAA”-rated firms (see below).

  • The corporate bond market, despite its very fast growth in the last several years, is still relatively small. As of end 2004, the bond issued by the corporates was US$ 12 billion (or 1.8 percent of GDP), which is relatively small in international comparison. The further growth of this sector may well require the entry of new firms. The new Securities Law under consideration in Congress aims to promote the entry of small- and medium-sized enterprises.

  • Most issuers are investment grade. While there are around 80 listed issuers, the number of “regular” issuers is close to 10. At end-March 2005, AAA rated bonds comprised 65.5 percent of all outstanding issues, AA+, AA, AA- rated bonds comprised 28.7 percent, A+, A, A- rated bonds comprised 3 percent while the rest 2.3 percent. An increase in institutional investors’ demand for lower rated instruments may require some relaxation of investment restrictions. At present, institutional investors are not allowed to invest in bonds that are rated below A, which limits the investable universe to 20–30 large firms with strong credit fundamentals.

  • As in many other countries (both industrial and emerging), the secondary market for corporate bonds is still illiquid. Trading in fixed income securities takes place in the OTC market through electronic screens, but the pricing information is not publicly available. Financial institutions also have limited incentives to make markets in corporate bonds because of the lack of hedging opportunities. To address these problems, Mexico is making use of the so-called “price vendors,” who provide daily quotes for all securities, including those that are illiquid and not traded at all. However, according to the leading price vendor, only about 20 percent of corporate debt instruments tend to have either the last transactions price or a bid-ask spread on any given day. Mexico has also put in place a number of regulations aimed at promoting the market for STRIPS and security lending.

Stock market development

39. Despite registering strong growth in recent years, Mexico’s stock market remains relatively small and illiquid. The stock market’s capitalization is little more than half the market capitalization of Brazil’s stock market, and, relative to GDP is it still significantly below the market capitalization to GDP of Brazil or Chile (see Table). A notable trend over the past year has been the strong growth of foreign participation in the domestic stock market, though this remains well below levels in Brazil, for example.

Stock Exchange Indicators in Selected Latin American Countries

article image

End-2004.

Sources: WEO, BMV, Banco de Mexico, BOVESPA, Bolsa de Valores de Santiago, and Fund staff calculations.

40. A handful of companies account for the bulk of trades included in the stock exchange price index (IPC). The transport and communications listings account for close to 40 percent of market capitalization and are dominated by two communications stocks: Teléfonos de México (Telmex) and América Móvil. According to Bank of Mexico data, the face value of the outstanding stock of domestically issued private-sector debt instruments grew by 21 percent in 2004, to around 5.2 percent of GDP. Short-term instruments, in the form of short term commercial chapter, promissory notes and stock certificates, account for a little over 10 percent of the debt market.

Mexico: Selected Stock Market Indicators

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Sources: WEO, Banco de Mexico, and Fund staff calculations

41. Trading activity in the Stock Exchange is expected to deepen in the near future following recent amendments in the Siefores’ (private pension fund administrators) investment regulation, which allows up to 15 percent of their assets to be invested in equities. In addition, a new stock market law, currently being discussed in congress, contains provisions to ease access to medium-sized enterprises which are expected to increase stock market capitalization and the share of domestically issued securities (see Box 3).

Proposed Reforms to Mexico’s Stock Market Law

In the fall of 2005, the Mexican congress has resumed consideration of a proposed new stock exchange law. The new law, designed following closely the Sarbanes-Oxley law of the U.S. 1/, is directed primarily to three main areas not considered in the reforms of 2001: (i) strengthening rights of minority shareholders, for example by requiring an executive board of directors and not allowing single administrators; (ii) increasing transparency of issuing entities so as to improve corporate governance practices (as in the SO); and (iii) facilitating access to the stock market by medium-sized enterprises by selectively easing certain regulatory constraints which, for example generate a high level of fees and costs required for the listing. For this last purpose, the proposed law creates a new type of entity, the “investment promotion company,” through which medium-sized enterprises will be able to list their shares.

In addition, the new law is designed to strengthen and modernize the legal framework of agents participating in the stock market, in particular that of investment companies, by defining their organization, responsibilities, and structures, and also that of stock brokerage companies and participating financial institutions, by introducing greater flexibility in current regulations.

The new law also re-defines the functions and the powers of the different supervisory authorities in the financial markets, so as to avoid duplication in the processes of authorization, regulation and supervision of all entities participating in stock market operations. This is expected to reduce regulatory costs, and would leave the Ministry of the Economy in charge of coordination of the supervisory agencies and the Stock Market Supervisory Commission (CNVB) in charge of the operational aspects.

Many observers consider that the new law will adjust Mexico’s stock market legislation to international standards and, thus, provide a basis for greater foreign participation in the Mexico Stock Exchange.

1/ The United States’ Sarbanes-Oxley Act of 2002 followed a wave of large corporate financial scandals. Effective in 2004, all publicly-traded companies are required by this law to submit an annual report of the effectiveness of their internal accounting controls to the U.S. Securities and Exchange Commission. The major provisions of the Sarbanes-Oxley Act include: (i) criminal and civil penalties for noncompliance violations; (ii) certification of internal auditing by external auditors; and (iii) increased disclosure regarding all financial statements.

F. Conclusion

42. The Mexican experience illustrates lessons to other countries wishing to use the government securities market as a catalyst for the development of the broader capital market. In particular, it underlines the importance of a stable and consistent macro framework, key legal, institutional, and regulatory reforms, and safe and efficient financial infrastructure.

43. Mexico indeed has come a long way in developing both its government securities market and the broader local capital market. An extended, and moderately liquid and efficient, yield curve has helped the country achieve significant macro and micro benefits. In particular, the public debt now costs less, has a longer average maturity, and is less vulnerable to exchange rate and interest rate fluctuations. Meanwhile, financial intermediation improved as domestic financial savings, measured as M2 to GDP, have increased. The local capital markets broadened, with the introduction of new players, especially institutional investors, and deepened as new instruments and financial products blossomed (see Figure).

uA05fig12

Financial System Assets Distribution

(March 2005)

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: CNBV.

44. Banks still dominate the system, and while commercial banking loans remain a relatively low 14 percent of GDP as banks recover from the 1995 crisis, the role of debt capital markets is increasing (see Figure). This has been possible as institutional investors, fostered, through their large pool of assets under management, companies’ ability to issue directly in the debt markets. Meanwhile, the deepening of the derivatives market and the growth of securitization and structured finance are providing key support for companies in debt capital markets financing.

uA05fig13

Private Sector Lending (December 2004)

Citation: IMF Staff Country Reports 2005, 428; 10.5089/9781451825657.002.A005

Source: CNBV.

45. Mexico has consolidated these achievements and is now looking forward to further reforms and the further natural development of the capital market. The issuance of 10- and 20-year fixed rate bonds is a significant achievement, but such instruments are a relatively minor share of public debt, and there is still considerable room for shifting the distribution of total public debt into maturities of 5 years and longer. Greater volumes at such maturities would promote liquidity. In addition, as the development of the local debt market, in both its public and private side, was supported in part by regulations that had the effect of fostering a domestic investor base, the challenge will be to maintain this development while some relevant regulations are relaxed. In this context, changes to the legal and regulatory frameworks are now aimed at boosting liquidity, facilitating the participation of SMEs, and granting more flexibility to institutional investors.

References

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1

Prepared by Mazen Soueid (ICM). The author is indebted to the Mexican authorities at the Bank of Mexico and Ministry of Finance for valuable suggestions on an earlier draft of this paper.

2

Various episodes in financial history attest to this. The United States bond market helped substitute for bank intermediation in the credit crunch of the late 1980s. Also, the banking system played the back-up role when the bond market weakened in the wake of the LTCM crisis of 1998. Another example is the Korean bond market, which played a vital role in carrying on financial intermediation after the 1997 financial crisis, which had impaired the banks. In contrast, the less developed bond markets in other countries in East Asia failed to provide this backup function.

3

This is evident for instance in the increasing role of venture capital in developed capital markets, notably the United States.

4

A significant action taken by the authorities during this period was the adoption in 1977 of a single reserve requirement ratio for the liabilities in domestic currency of banks. The introduction of Treasury Certificates (CETES) in 1978 complemented measures adopted on legal reserve requirements.

5

Foreign investors who are residents of countries with which Mexico has double taxation agreements are exempted from any withholding tax on their investment in government securities.

6

Prior bankruptcy laws required market participants to first settle their obligations and then collect their rights out of bankruptcy proceeds.

7

As opposed to Brazil, for instance, where there are requirements to appoint a legal and tax representative in the country to conduct transactions, to register with the Brazilian Securities and Exchange Commission, to pay 15 percent income tax on capital gains and other income, to pay a tax of investments unwound less than 30 days after inception (at the rate of 1 percent per day less than 30 days), and a financial transaction tax of 0.38 percent on entering and exiting the country.

8

AFORES reportedly shared among themselves their own investment allocations plans.

9

Mobility of contributors across AFORES remains low, with only 1 million contributors recording any move since the system began.

10

This factor is significantly less important given that most AFORES are operating at VAR levels way below their limits.

11

The augmented fiscal deficit has declined since the late 1990s, and moreover has been adequate to contain the level of public debt (in relation to GDP).

12

A volatile inflation rate would restrict the government’s ability to extend the yield curve beyond very short maturities and render the nominal yield curve uninformative about the real cost of borrowing. While these difficulties could be partly overcome by the development of the market for inflation-linked bonds, few countries have used these instruments, for various reasons. In fact, inflation volatility in Brazil in 1999 and in Argentina in 2000/2001 was a major impediment to yield curve extension and the further development of local financial markets (del Valle (2002)).

13

The 1975 a Securities Market Act established the legal framework for the expansion of securities operations. It also substantially strengthened the regulatory role of the National Securities Commission (CNV).

14

Mtns are an instrument that can be issued in tenors from 1 to 7 years, in nominal pesos or inflation-linked. The main inconvenience of Mtns is that they can only be repaid at maturity (bullet payment) and cannot include covenants.

15

The exact nominal amount and other technical characteristics of the instrument to be tendered are normally announced two working days prior to the auction.

16

FARAC is a government trust fund which was created to rescue private toll road operating companies after the 1994–95 financial crisis. As a result of the rescue operation, the trust fund acquired both the assets and the liabilities of the toll road operating companies.

17

Recent securitization took advantage of the flexible trustee structure of the CB’s, which have a trustee structure in which a bank (typically) acts as the fiduciary on behalf of bondholders. Fiduciary requirements include making interest and amortization payments to bondholders and organizing meetings to decide on indenture modifications or other types of restructuring. CB’s can be modified relatively easily, with two-thirds votes needed to modify indenture initially, and a 50 percent vote the second time an issue comes before bondholders.

18

The standard floating peso reference rate is TIIE, “Tasa de Interes Interbancaria de Equilibrio,” which is the average inter-bank rate.

19

Financing through bank loans tends to be cost effective for short-term, small-scale, and recurring financing, while financing by issuing bonds is cost effective for long-term, large-scale, and opportunistic financing by companies, particularly those with a high credit rating.

Mexico: Selected Issues
Author: International Monetary Fund