Politics, Business & Culture in the Americas

Public Debt Markets: Sin and Redemption

Latin America has made significant strides in shoring up its public debt. Previously constrained by what financial experts consider the “original sin”—relying on foreign currency borrowing to finance domestic projects, which inevitably leads to a currency mismatch—the region is now heading toward a more balanced currency composition of government debt. This reached a milestone in August 2010 when the average ratio of local currency-denominated debt to total public debt reached a historic high of 65 percent in the region’s seven largest economies.

The new composition of public debt has allowed governments to smooth the effects of capital flight and currency devaluations on debt sustainability, which exacerbated the last two financial crises in Asia and Latin America.

Similarly, the deepening of domestic bond markets has offered crucial funding alternatives during the global credit crunch. Asian governments and corporations have reaped the greatest benefits. At the end of 2009, Asia accounted for 65 percent of local-currency-denominated bonds in emerging markets, three times the 22 percent share of Latin America.

This year in Latin America, the largest shares of local currency debt were registered in Chile (92 percent), Brazil (89 percent), Colombia (77 percent), and Mexico (75 percent). Five years of strong growth, balanced budgets, reduced public debt, stable inflation, and increased foreign exchange reserves helped these economies weather the global financial crisis. The progress achieved through this policy mix also boosted investor confidence and left these governments well-positioned to transform their public debt portfolios. Not surprisingly, Chile, Mexico, Brazil, and Colombia are also among the highest-rated sovereigns in the region and the pioneers in attracting a broader pool of institutional investors from their domestic pension, insurance and mutual fund industries.

In July 2010, Colombia effectively overcame the original sin by raising $1.3 billion in peso-denominated global bonds. The transactions met robust demand from international investors, allowing the government to offer a low-price concession for instruments with a relatively long, 10-year maturity. Chile soon followed suit, successfully tapping international capital markets for $520 million worth of peso-denominated bonds. Both transactions took place soon after Moody’s upgraded Chile’s sovereign debt to Aa3 and S&P brought Colombia’s ratings closer to investment-grade status.

But the impressive growth of local bond markets and their positive spillovers are neither risk-free nor shielded from policy reversals. Investors have a low tolerance for macroeconomic slippage and will closely watch policy continuity.

The challenge is to maintain a deep and diversified investor base. In the long term, market incentives will triumph over regulatory tricks or moral suasion. In Asia, for instance, the combination of high savings and market infrastructure reforms helped bond markets thrive during the 2008 financial crisis. In contrast, attempts to link pension reform and domestic capital market development in some Latin American countries—particularly by requiring banks and pension funds to maintain a minimum allocation of government bonds in their portfolios—have actually crowded out private creditors and resulted in disappointing returns.

A broad investor base can reduce vulnerability to the increasing volatility of global financial markets. Brazil has led the region in attracting institutional investors looking to assume more stable positions. By the end of 2009, 39 percent of Brazil’s government debt was held by banks, 33 percent by investment funds, 16 percent by pension funds, and 8 percent by foreign investors. This diversity has allowed short-term investors to enter and exit bond markets without exacerbating volatility or sparking herding behavior. In Colombia and Peru, private pension funds played a critical stabilizing role during the crisis. They absorbed the excess supply of long-term government bonds and helped contain sell-off pressures from foreign investors.

From a cost perspective, the shift to local currency debt mitigates foreign exchange vulnerabilities but increases interest rates. Latin American governments still pay a high credibility premium for past mistakes and the lack of liquidity in their local markets. The result has been an increased exposure to floating rates and short maturities in most public debt portfolios. This combination makes government debt sensitive to changes in interest rates and liquidity conditions in a region with with a history of price volatility and financial stress. Countries are increasingly seizing opportunities to conduct successful buybacks, bond exchanges and prefinancing operations, but there is a long way to go.

Debt management might be a highly technical profession, but it is not isolated from the political process. Latin America has resisted temptations of fiscal profligacy and public mismanagement. Hopefully this time the change is irreversible.

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Any opinions expressed in this piece do not necessarily reflect those of Americas Quarterly or its publishers.
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