Loan and Bond Financing

International capital markets were a major source of external financing for developing countries in the 1970s and early 1980s. Medium- and long-term publicized international bank credit commitments totaled some $225 billion in 1976–82. In 1982 alone, such commitments amounted to $42 billion, with Latin American countries accounting for $23 billion. For bond financing, publicized developing country issues amounted to $27 billion in 1976-82. Of this amount, $4 billion was issued in 1982, with Latin American borrowers accounting for $2 billion.

These estimates are in stark contrast to those for the following six years. The outbreak of severe debt-servicing problems in several Latin

American countries in 1982 was associated with a virtual drying up of all sources of voluntary financing, with the exception of short-term trade facilities. As a result, the total amount of voluntary loan and bond financing flows to Latin American countries during the 1983-88 period was considerably smaller than that for 1982 alone. Specifically, financial flows to Latin America in the form of voluntary medium- and long-term bank credits and bonds totaled only $7 billion in 1983-88. Concerted financing became the main source of private international financial support. Restructured medium- and long-term bank debt amounted to some $310 billion during this period,¹ with the associated cash flow relief being supplemented by new money facilities.

Several developments indicate that the quantitative international credit rationing facing some Latin American countries in the 1980s has been gradually relaxed in the last two years. Although still limited, the process of market re-entry is gaining momentum and is affecting a growing number of countries. Two groups of Latin American countries may be distinguished. The countries in the first group—which includes Chile, Mexico, and Venezuela—have established relatively solid footholds in the markets. The countries in the second group—comprising Argentina and Brazil—are at an earlier stage, having just recently been able to place selected voluntary issues at terms (interest rates and maturities) that are considerably less favorable than those obtained by the first group of countries. Although it has implications for the prospects of this latter group of countries, the present analysis is concerned primarily with the experience of the first group.²

An important source of voluntary financing (in value terms) has been international bond markets. Mexico and, to a lesser extent, Venezuela and Chile, are reported to have issued some $3.4 billion of bonds in the two-year period ended December 1990 (Figure l).³ The majority of these were placed on markets in the United States and Germany, and mobilized investor funding from specialized institutions and residents’ capital held abroad. On the borrowers’ side, they tended to involve corporations with established international reputations and sound export history and prospects. The process intensified in the course of 1991, and these countries are estimated to have issued a total of $2.8 billion in the first nine months of the year. The increased volume was accompanied by a widening in the investment base to include a broader range of institutional and retail investors in a larger group of industrial countries.

Bond Issues by Chile. Mexico, and Venezuela

(In millions of U.S. dollars)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Sources: International Financing Review and the Financial Times.

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Bond Issues by Chile. Mexico, and Venezuela

(In millions of U.S. dollars)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Sources: International Financing Review and the Financial Times.

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Bond Issues by Chile. Mexico, and Venezuela

(In millions of U.S. dollars)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Sources: International Financing Review and the Financial Times.

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The renewed access to international bond markets has been accompanied by some—albeit relatively limited—relaxation in the constraints on voluntary commercial bank borrowing. These borrowings have taken the form of trade and project financing, with Chile using such financing as its main source of voluntary external funding.⁴ Overall, however—and in sharp contrast to developments in other segments of international capital markets—banks have remained reluctant to extend new voluntary medium-term credits to developing countries with recent debt-servicing problems.

The difference in risk attitudes between bank and bond lending reflects several factors, including banks’ more difficult overall balance sheet situations, as well as past debt-servicing policies of countries that gave seniority to the relatively small stock of outstanding bonds compared to bank loans.⁵ The impact of these factors has, in some cases, been compounded by regulatory considerations, including new capital-adequacy standards and required provisions for loan loss. Thus, under the agreement on risk-weighted, capital-asset ratios, banks, in adhering to regulatory jurisdictions and seeking to maintain the same level of risk-weighted capital, will be required to increase their capital by a minimum of $8 for every $100 increase in exposure to developing countries.⁶ This requirement could act as a disincentive on bank lending to developing countries, especially if the lender is unable to raise the incremental capital on terms that are more favorable than those on the prospective loan. The cost of making loans to developing country borrowers is increased further to the extent that banks are also required to set up new loan-loss reserves against the increase in exposure. A distortionary impact may result if the regulatory requirements, which in some cases tend to lag developments in borrowers’ creditworthiness, inadequately reflect the transfer and credit risks implicit in the lending activity.⁷

The relaxation in credit rationing has been accompanied by an improvement in market terms. This is most apparent in the sharp drop in yields on Mexican bonds—both on new issues and in the secondary market. The first unsecured voluntary bond issue by a Mexican public enterprise since 1982 (Bancomext in June 1989) carried an initial yield that implied a spread (or risk premium) of about 820 basis points over U.S. Government bonds. By the third quarter of 1990, the weighted average spread for new Mexican bond issues had declined to an estimated 320 basis points.⁸ The spread increased somewhat in the final quarter due to a tightening in general market conditions, particularly investors’ “flight to quality” reflecting uncertainties associated with the Middle East crisis,⁹ but it was reversed in 1991. Thus, by the third quarter of the year, the yield spread at time of issue had declined to some 225 basis points—half the average level for 1990 as a whole.

These measures of improved creditworthiness are subject to bias, however, on account of the changing composition of borrowers and structures of bonds (particularly, the degree of credit enhancements). This bias may be overcome by tracking the secondary market yields on an individual bond issue—albeit at the cost of limiting the coverage of the analysis. As illustrated in Figure 2, the yield on the PEMEX long-dated issue reportedly fell from 14 percent in mid-1989 to about 9 percent by end-November 1991, implying a reduction in the risk premium indicator from over 500 basis points to about 200 basis points during this period. Over the same period, the yield on the Bancomext June 1989 issue fell to under 10 percent. As demonstrated in the figure, similar developments occurred with sovereign Venezuelan bond issues.

The improvement in interest rate terms was accompanied by a lengthening of maturities. This is most clearly illustrated in the case of Mexico where successive issues by PEMEX and NAFINSA in September–October 1991 involved maturity terms of seven and ten years, respectively. These were the longest dated voluntary debt instruments since the early 1980s issued by a developing country that had experienced debt-servicing problems.

Developments in Secondary Market Yields

(In percent)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Sources: International Financing Review, Latin Finance, and International Financial Statistics.

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Developments in Secondary Market Yields

(In percent)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Sources: International Financing Review, Latin Finance, and International Financial Statistics.

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Developments in Secondary Market Yields

(In percent)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Sources: International Financing Review, Latin Finance, and International Financial Statistics.

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In contrast to bond financing, the terms on bank lending to developing countries worsened. This deterioration occurred in the context of an overall tightening of bank lending terms, including for borrowers from industrial countries. For developing countries as a whole (no consolidated data are readily available for the Latin American re-entrants), the average spread on voluntary loans increased by some 14 basis points in the first eight months of 1991, compared to the same period in 1990, while average maturity terms lengthened by two years and two months (Organization for Economic Cooperation and Development (1991)).

Equity Financing

A number of Latin American corporations—including, but not limited to, Mexico’s TELMEX (public telephone company), Cemex (private cement company), and Vitro (glass manufacturer), and Chile’s Compania de Telefonos—have also completed equity offerings in industrial country markets; these offerings have complemented the impact of a growing number of country funds channeling resources to emerging capital markets in the region.¹⁰ The equity placements were the first significant Latin American foreign stock offerings since the 1960s; in the 1970s borrowers found it easier to resort to debt financing in the form of bank loans, and in the 1980s equity markets were effectively closed to Latin American borrowers partly as a result of the heightened perceptions of country transfer risk.

The TELMEX privatization, completed on May 20,1991, involved the issuance of some $2.3 billion of equities on several capital markets including in Canada, France, Germany, Japan, Switzerland, the United Kingdom, and the United States, including the over-allotment provision of 15 percent (from the residual government share) to meet larger-than-anticipated investor demand. This equity offering is reported to be the sixth largest placement of shares in the world (nominal values) and the largest for any Latin American country. Cemex mobilized $140 million in May 1991, while Vitro raised a total of $73 million in April 1991 through the sale of 4 million shares. The latter issue was oversubscribed despite having been increased from an initial offering of $50 million. The earlier (July 1990) offering of the Chilean telephone company of 6.5 million shares raised some $90 million.

Other Capital Inflows

The above developments have been reinforced by substantial capital inflows in the form of foreign direct investment and capital repatriation. In Mexico, for example, registered foreign direct investment inflows in 1989-90 were twice the level recorded in 1987-88, with the pipeline of new investment registration growing to over $5 billion. Similar developments were recorded in Chile.

The magnitude of capital repatriation is more difficult to specify with confidence. Most available indicators point to a significant turnaround in the last two years in the capital flight that has plagued several countries in the region. These indicators include a recent study by Chartered WestLB, which estimates net total inflows of $14.1 billion for Chile, Mexico, and Venezuela in 1989-90; this compares to an estimated outflow of $4.5 billion in 1987-88, implying a turnaround of almost $20 billion (Chartered WestLB (1991)).

Economic Policy Implementation

Just as inappropriate economic policies, together with adverse exogenous developments, were major contributors to the emergence of debt problems, the sustained implementation of adjustment policies has been the critical factor in the restoration of voluntary access. In effect, appropriate macroeconomic and structural reform policies have reduced perceptions of country transfer risk.

Although the economic and financial programs have varied in the countries under consideration, including entailing different policy trade-offs, it is possible to identify several key elements. First, domestic financial imbalances have been reduced due to improved budgetary performance and prudent monetary policies. These policies have involved reinforcing the fiscal revenue effort, rationalizing expenditures, and allowing domestic interest rates to reflect fully the cost of compensating savers for the considerable initial risk premia. Second, the supply responsiveness of the economy has been enhanced through appropriate pricing policy, including promoting the competitiveness of the tradables sector. Third, economic efficiency has been improved through fundamental structural reforms. These reforms have included liberalization of the trade regime, reform of the taxation system, divestiture of public sector enterprises, financial liberalization, rationalization of legal and other procedures governing foreign investment, and deregulation of domestic activities.

The implementation of these programs must be sustained if they are to be translated into a lasting reduction in country transfer risk. Indeed, the experience of several other developing countries suggests that policy slippages can quickly negate the economic and financial benefits of these programs. This is particularly important, given that many Latin American economies remain vulnerable to sudden and large reversals of private capital flows in response to such slippages. Indeed, for some of these countries whose economies have become much more integrated into the international financial system, the potential for more rapid transmission of shocks from the financial to the goods markets is greatly enhanced. The effectiveness of the economic policy package will also depend on the availability of appropriate financial support. This involves the provision of financial inflows that not only meet the immediate cash flow requirements of the adjustment program, but also contribute to a debt stock consistent with medium-term viability—an issue addressed in the next section.

Restructuring of Existing Indebtedness

Although sustained implementation of appropriate economic and financial policies is a necessary condition for market re-entry, it may not be sufficient in all cases. The experience of some Latin American countries in the 1980s suggests that, in some cases, the implementation of sound policies may be undermined by continued high risk aversion on the part of the private sector because of the country’s outstanding contractual debt obligations—the so-called debt overhang effects.

Growth in indebtedness increases concerns among economic agents about the country’s ability to service its debt fully in a sustained manner¹¹ Specifically, investor sentiment deteriorates as questions arise about the authorities’ ability to meet contractual payments without further increases in effective taxation. The latter lowers the expected return on domestic investment activities, thereby discouraging inflows of foreign direct investment and stimulating capital flight and the diversion of resources to consumption. Agents’ concerns mount further if the process of securing sufficient concerted financing is subject to protracted negotiations, with uncertainties about the timing and nature of the outcome. This increases the risk of confrontation between creditor and debtor, with adverse implications for other forms of capital inflows.

Debt overhang effects require that the debt problems in some countries be addressed through contractual debt and debt-service reduction operations, rather than through the refinancing and rescheduling of obligations falling due. By lowering perceptions of country risk, the reduction in contractual obligations would trigger an investment response in excess of the one that would result solely from the larger domestic availability of resources associated with lower debt-servicing payments. Debt and debt-service reduction operations may also improve the willingness and ability of the authorities to implement adjustment policies; this willingness is linked to perceptions that foreign creditors will not secure an “undue” share of the benefits of adjustment.

After the outbreak of debt-servicing problems and until 1987-88, most Latin American countries were involved in a process of repeated and often protracted debt renegotiations. Centered on the provision of liquidity support through principal rescheduling and concerted new money, the process resulted in an increase in contractual debt obligations. Specifically, despite some improvements in the performance of the non-interest current account, the region’s external debt rose from $331 billion (271 percent of exports of goods and services) in 1982 to $421 billion (over 340 percent of exports of goods and services) in 1987 (International Monetary Fund (1991c)).

It is in this context that Chile, Mexico, and Venezuela took steps to reduce the burden of bank contractual indebtedness through market-based debt and debt-service reduction operations. The Chilean authorities reduced the country’s total debt to banks by more than half in four years, from $14.5 billion at end-1985 to $6.7 billion in 1990 (the stock of restructurable bank debt declined to about $4 billion) through a series of voluntary market-based debt conversions. Mechanisms for these conversions were introduced in mid-1985 and supplemented by direct cash buybacks in 1988–89. These buybacks extinguished some $440 million of bank debt at a cost of $250 million, involving an average discount of 43.5 percent.

In contrast to Chile, Mexico and Venezuela reduced their indebtedness through comprehensive bank restructuring packages. The 1990 Mexican package covered some $48 billion of bank claims,¹² resulting in an effective reduction of gross bank debt of about $15 billion through conversions into partially collateralized discount bonds (65 percent of face value) and reduced interest (6¼ percent, fixed) par bonds. An additional $3 billion of claims will be extinguished if the conversion rights awarded under the new debt-equity program are fully exercised.

Venezuela’s 1990 bank agreement involved an effective reduction of gross bank debt of $4.6 billion. This was achieved through a menu of five options, including an “indirect buyback” (discount of 55 percent) and conversions of claims into partially collateralized discount bonds (70 percent of face value), reduced interest (6¾ percent) par bonds, and front-loaded bonds with provisions for temporary interest reduction (5 percent for the first two years, 6 percent for the third and fourth years, 7 percent for the fifth year, and LIBOR plus ⅞ percent thereafter).

Preliminary indicators suggest that, together with appropriate economic policies, the debt and debt-service reduction operations have reduced debt overhang concerns. This is most evident in the case of Mexico where the announcement of the bank financing package was followed by a sharp improvement in country risk indicators. Real ex post domestic interest rates fell by 20 percentage points to about 10 percent a year following the announcement—a decline that was sustained thereafter. The yield on Mexican external traded bonds also fell sharply (by 75 to 230 basis points). Finally, the secondary market price for bank claims on Mexico generally improved, with its ratio to other Baker 15 countries rising from 1.20 before the package to 1.34 by end-1990.

The secondary market prices for bank claims on Chile and Venezuela also recovered strongly.¹³ By end-November 1991, the prices for bank claims on all three countries were at their highest relative levels since comprehensive reporting of such data was initiated in the mid-1980s (see Figure 3). Moreover, in the case of Chile, the secondary market discount fell to only 10 percent, consistent with the discounts for several developing countries that had retained voluntary market access throughout the 1980s.

Reduced Transaction Costs

The improvement in country fundamentals (that is, lower transfer risk) has been accompanied by a reduction in the transactions costs for accessing international capital markets. This has resulted, among other things, from regulatory changes in industrial country capital markets and increased market-credible information regarding borrowers’ creditworthiness.

The most important regulatory changes have occurred in the U.S. markets. Specifically, the 1990 approval of “Regulation S” and “Rule 144A” reduced the transactions costs and liquidity problems facing developing countries in tapping U.S. capital markets.

Before April 1990, the average costs of meeting bond registration and disclosure requirements for first-time developing country issuers were estimated at about $500,000-$700,000. Avoidance of some of these costs through private placements was possible but involved reducing the liquidity of the instruments. Thus, the prevailing Securities Act required buyers of securities not offered publicly to hold them for at least two years after the initial offering. At the same time, the Act imposed heavy penalties on issuers that adopted the public offering route but were not able to meet fully all the registration requirements. Indeed, under the Act, a purchaser of a security could choose at any time to rescind a transaction that has not been properly registered.

By clarifying the definition of what constitutes a sale and offer of a security in the United States, Regulation S facilitated the sale of Euro-issues to U.S. citizens. It exempts securities from registration requirements, provided the buyer is outside the United States; if the buyer is within the United States, the exemption conditions relate to the marketing of the securities. Concurrent with the reduction in transactions costs, the adoption of Rule 144A reduced the loss of liquidity associated with private placements. The changes relaxed the requirement of a two-year holding period, provided the sale of the financial instrument was to “qualified institutional buyers.” Such buyers are defined as entities managing and owning at least $100 million in securities and, in the case of banks, having a net worth of at least $25 million.¹⁴ On this basis, it is estimated that there are about 5,000 qualified institutional buyers in the United States—mainly insurance companies, commercial banks, and money managers.

Secondary Market Prices for Developing Country Loans

(In percent of face value)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Source: Salomon Brothers.

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Secondary Market Prices for Developing Country Loans

(In percent of face value)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Source: Salomon Brothers.

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Secondary Market Prices for Developing Country Loans

(In percent of face value)

Citation: IMF Staff Papers 1992, 001; 10.5089/9781451956948.024.A007

Source: Salomon Brothers.

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The changes cited above have reinforced the possibilities offered by the American Depository Receipts (ADR) program, under which developing countries may access equity markets without meeting the full costs of offerings and listings on these markets. Under this program, each American Depository Share (ADS) traded in the United States represents a batch of shares in the local market. This route was used by a number of Latin American corporate re-entrants, including Chile’s telephone company in mid-1990 for an offering of 6.5 million shares. These ADSs correspond to more than 110 million shares of Series A Common Stock on the Santiago exchange, or 13.5 percent of the company’s equity. In the case of the TELMEX privatization, the 65 million ADSs correspond to 1.3 billion shares.

There have been several other recent regulatory changes in industrial countries that have the potential of facilitating developing country access. In Japan, for example, in June 1991 the authorities lowered the minimum credit rating standards for public bond issues on the Samurai market (from single A to triple B). In Switzerland the regulatory authorities took steps in January 1991 to abolish the minimum credit rating requirements (previously set at triple B) for foreign bond issues. Consideration is also being given to removing other quantitative barriers to entry, such as the requirements relating to the minimum size of the issues and capitalization of debtor firms.

Increased interest among international investors in bond issues by re-entering Latin American entities has led to, and been reinforced by, the establishment of market-credible credit ratings, thereby reducing some of the costs investors face in compiling purchase information. In December 1990 Mexico received its first credit rating by Moody’s Investors Service. The ceiling rating for Mexican debt was set at Ba2 (equivalent to double B plus)—just below investment grade—with Brady bonds receiving a Ba3 rating as a result of the perception of greater restructuring risk based on historical experience. In July 1991 Venezuela was upgraded to Bal from Ba3.

The specification of credit ratings allows for developing country issues to be targeted explicitly to meet specific portfolio allocation segments along the risk-return spectrum of the prospective investors. Moreover, the potential existence of investment grade paper would, other things being equal, open new segments of the international capital markets to Latin American re-entrants; these segments include areas where regulatory credit rating requirements apply and cases where certain investors (for example, pension funds and other institutional investors) are subject to internal quantitative risk level cut-offs.

Customizing Financial Instruments

In an environment of still significant—if declining—perceptions of credit and transfer risks, borrowers must be prepared to customize their borrowing instruments to the requirements of the market. This requirement becomes more important when there is a general tightening of market conditions, as was the case during 1990.

In several of the initial bond issues by Latin American re-entrants, borrowers have attempted to differentiate the instruments by providing explicit credit enhancements. Most of these have been in the form of collateralization (on the basis of existing assets or an expected stream of receivables), but various put options have also been offered, including preferential treatment for privatization and early redemption possibilities.

The credibility of collateralization, and therefore the extent to which it improves market terms, has depended on the form of the collateral, its location, and the costs involved in taking possession and disposing of it, should the need arise. Several borrowers have provided collaterals in the form of assets/receivables generated outside the country, thereby allowing them to address investors’ concerns about both transfer and credit risks. TELMEX, for example, provided investors protection in the form of a claim on payments due from AT&T on account of international communications. Accordingly, investors’ exposure to TELMEX credit and Mexican transfer risks was effectively transformed into an exposure to AT&T credit and U.S. transfer risks. The resulting reduction in perceptions of risk was reflected in the spreads paid by TELMEX. Specifically, the risk premia on the collateralized October 1989 and March 1990 bond issues averaged some 200 basis points, compared to a premium of 450 basis points for the noncollateralized July 1990 issue.

Other forms of collateralization used by Latin American re-entrants have included bank deposits and electricity accounts, suppliers, and credit card receivables.