IADB- XXII Meeting - LA Network of
Central Banks and Finance Ministries
Local Currency Issuance: Fad or Trend?
October 21, 2005
Gustavo Cañonero
Chief Economist Latin America
Gustavo.Canonero@db.com
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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE BODY OF THIS RESEARCH.
Reference (apr02)
Local Currency Issuance: Fad or Trend?
Overview
•
Under normal circumstances issuers would try to match their liability
structure with their revenues/cash flows. Therefore, starting from high
concentration of foreign currency debt in the 90s, LA governments are
inclined to borrow in local currency, if possible long maturity and fixed rate.
•
Ergo, the recent trend in debt composition mostly reflects significant
reduction in borrowing costs in long dated local currency debt.
•
By decomposing the determinants of local currency rates, we show recent
trends and rationalize them through fundamental positive changes in the
countries external and public financing situation.
•
We however acknowledge pending risks of current fast growth amid a high
liquidity environment that exacerbates the search for yields overall as well as
the positive side of the economic cycle for the region.
•
We conclude that, in our view, local currency issuance is more a trend than a
fad, but recognize that further development in local capital markets may well
be a rocky road, with ocassional setbacks that could be sizeable.
Page 2
Local Currency Issuance: Fad or Trend?
Valuation: Fair Local Risky from External Risky Yields
Market prices of
External Debt
UST
zero curve
F2X
Or the way FI investors
evaluate the relative
return/risk of local
assets
Risky US$
zero curve
+
External Debt
Credit Spread
Expected FX
Devaluation
Correlation and
volatilities of credit
spread and FX
Break-even FX
devaluation
FX risk
premium
Volatilities,
correlations, skew and
kurtosis of FX returns
Risk free
local curve
+
Risky local
yield curve
Source: DB Global Markets Research
Page 3
Local debt
Credit Spread
Fair prices of
local bonds
Local Currency Issuance: Fad or Trend?
Valuation-Adjustment1: Expected FX Depreciation
 Short and long term real exchange rate equilibria are obtained from our “Fundamentals
to Exchange Rates” (F2X) Model and “Regression (RESRM) Model”
AR
BR
MX
CL
CO
TR
ZA
Cumulative Real FX % Depreciation
1Y
3Y
-10.0
-17.5
0.0
0.0
2.0
4.0
1.0
2.0
1.0
6.0
4.0
12.0
2.3
3.2
Source: DB Global Markets Research
 Important variables: Current account balance, USD debt service, GDP growth, etc.
 Real expected FX depreciation is transformed into nominal expected depreciation
using forecasted Inflation differentials.
Page 4
Local Currency Issuance: Fad or Trend?
Valuation- Expected REER Depreciation and Volatility
REER (1.0=Jan 1994)
Appreciation is the new regional trend and
volatility has been relatively contained
1.20
14.0%
1.10
12.0%
10.0%
1.00
8.0%
0.90
6.0%
0.80
4.0%
Avg StDev (RHS)
REER (12m MA)
0.70
0.60
Ja
n9
Ju 6
lJ a 96
n9
Ju 7
lJa 97
n9
Ju 8
lJa 98
n9
Ju 9
lJa 99
n0
Ju 0
lJa 00
n0
Ju 1
lJa 01
n0
Ju 2
lJ a 02
n0
Ju 3
lJ a 03
n0
Ju 4
lJ a 04
n0
Ju 5
l-0
5
0.0%
Source: DB Global Markets Research
Page 5
2.0%
Local Currency Issuance: Fad or Trend?
Valuation-Adjustment2: FX Risk Premium
FX _ Pr em   s ,ED
 Classical Linear CAPM leads to
Where
s
ED _ spread
 ED
 s ,ED  Correlation between FX changes and external debt spread changes
 s  FX volatility
and
 ED  External debt spread volatility
Large correlation, smaller diversification: larger FX risk premium.
Large volatility ratio makes local assets unattractive.
Unfortunatelly, overall small premiums and fails to capture tail risk.
 We use a non-Linear CAPM, which leads to a more complex formula that
captures negative tail risk (skew) and yields a more reasonable risk
premium estimate.
 Important variables: Correlation between FX and credit spreads, volatilities, skews (the
most important variable) and kurtosis.
Page 6
Local Currency Issuance: Fad or Trend?
Valuation-Adjustment 3: Credit Adjustment
• Assumming positive correlation between credit and FX risks, spreads in local currency
debt are smaller than USD credit spreads.
• The reason is the assymetry in the payoffs of local currency debt:
 If there is no default, sizeable extra return from FX appreciation can be expected;
 in case of default, there is only a small extra FX loss over the recovery value.
• Please see our previous Jan 2005 research piece “On the Pricing of EM Currency Linked
Offshore Notes” for a detailed analysis.
• It just partially offsets the FX RP when skew is considered.
• Important variable: correlation between FX and credit spreads.
Page 7
Local Currency Issuance: Fad or Trend?
Valuation – The Negative Relation REER/SPREAD
Source: DB Global Markets Research
Page 8
Local Currency Issuance: Fad or Trend?
Valuation - Estimated Values for the FX Risk Premiums
Linear CAPM
ARG
1Y
2Y
3Y
5Y
10Y
30Y
0.59
0.18
COP
0.04
0.09
0.15
0.18
0.31
0.39
0.43
ZAR
TRY
0.05
0.1
0.17
0.29
0.4
0.45
0.29
0.2
0.35
0.51
0.75
0.98
1.09
0.57
0.07
0.13
0.18
0.28
0.5
0.63
0.33
1Y
2Y
3Y
5Y
10Y
30Y
0.3
0.43
0.59
0.81
1.05
1.17
0.89
1.56
2.24
3.21
4.13
4.6
0.26
0.28
0.3
0.36
0.46
0.52
0.41
0.5
0.64
0.69
0.97
1.16
0.3
0.43
0.57
0.86
1.14
1.29
0.47
0.69
0.92
1.28
1.62
1.8
0.54
0.65
0.75
0.95
1.38
1.65
1Y
2Y
3Y
5Y
10Y
30Y
0.22
0.28
0.35
0.45
0.57
0.63
0.56
0.82
1.1
1.51
1.93
2.15
0.24
0.25
0.27
0.3
0.36
0.4
0.36
0.41
0.48
0.51
0.66
0.77
0.26
0.32
0.41
0.57
0.74
0.84
0.27
0.33
0.41
0.53
0.64
0.71
0.47
0.52
0.57
0.66
0.88
1.03
Source: DB Global Markets Research
Page 9
CLP
0.02
0.03
0.04
0.06
0.1
0.12
with Hist Correl
0.3
MXN
0.33
0.74
1.14
1.69
2.2
2.45
with Zero Correl
Non linear CAPM
Non linear CAPM
correl level
BRZ
0.08
0.16
0.24
0.36
0.48
0.53
Local Currency Issuance: Fad or Trend?
Valuation-Some Applied Results
•
•
•
•
Brazil: cheap across the curve
Mexico: some value in the belly and long tenors
Colombia: fair valued but slightly expensive on the long end
Argentina: cheap on the short end but expensive on the long end
AR
BR
MX
CO
TR
ZA
Local Yields: Market versus Model
Market
2Y
5Y
20Y
-0.11
2.57
5.83
17.29
14.88
N/A
8.36
8.39
8.45
6.87
8.97
9.86
14.80
13.00
N/A
7.43
7.80
7.70
2Y
5Y
20Y
-1.97
3.31
7.37
9.18
10.53
12.77
8.52
7.69
7.71
7.00
8.54
10.69
11.84
10.87
10.67
9.85
8.83
8.74
Difference
2Y
5Y
20Y
+1.86
-0.74
-1.54
+8.11
+4.35
N/A
-0.16
+0.70
+0.74
-0.12
+0.43
-0.83
+2.96
+2.13
N/A
-2.42
-1.03
-1.04
Model
Source: DB Global Markets Research
Page 10
Local Currency Issuance: Fad or Trend?
Valuation- Currency Risk Premium In Retrospective
•Floating exchange rate regimes with monetary discipline (Inflation Targeting)
•Significant improvement in external and fiscal accounts
•…..Fundamentals!
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Average
Source: DB Global Markets Research
Page 11
Sup Lim
Inf Lim
5/2/2005
3/2/2005
12/30/2004
10/28/2004
8/30/2004
6/30/2004
4/30/2004
3/2/2004
12/30/2003
10/28/2003
8/27/2003
5/30/2003
3/31/2003
1/31/2003
11/29/2002
9/30/2002
7/31/2002
-5.00%
160.00
140.00
100.00
80.00
Page 12
6
60.00
20.00
0.00
SD
REER
Source: DB Global Markets Research
Ja
n9
Ju 4
lJa 94
n9
Ju 5
l-9
Ja 5
n9
Ju 6
lJa 96
n9
Ju 7
lJa 97
n9
Ju 8
lJa 98
n9
Ju 9
l-9
Ja 9
n0
Ju 0
lJa 00
n0
Ju 1
lJa 01
n0
Ju 2
l-0
Ja 2
n0
Ju 3
lJa 03
n0
Ju 4
lJa 04
n0
Ju 5
l-0
5
REER
120.00
35
160.00
100.00
30
140.00
25
120.00
80.00
100.00
40.00
10
12
10
8
80.00
60.00
20.00
5
20.00
0.00
0
0.00
REER
40.00
2
4
40.00
2
20.00
0
0.00
15
Colombia
SD
120.00
120.00
80.00
60.00
10
8
6
4
0
SD
REER
Std. Dev.
Argentina
Std. Dev.
SD
Std. Dev.
15
REER
REER
60.00
Std. Dev.
Ja
n9
Ju 4
l-9
Ja 4
n9
Ju 5
lJa 95
n9
Ju 6
lJa 96
n9
Ju 7
lJa 97
n9
Ju 8
l-9
Ja 8
n9
Ju 9
lJa 99
n0
Ju 0
lJa 00
n0
Ju 1
lJa 01
n0
Ju 2
l-0
Ja 2
n0
Ju 3
lJa 03
n0
Ju 4
lJa 04
n0
Ju 5
l-0
5
20
Ja
n9
Ju 4
lJa 94
n9
Ju 5
lJa 95
n9
Ju 6
l-9
Ja 6
n9
Ju 7
lJa 97
n9
Ju 8
lJa 98
n9
Ju 9
l-9
Ja 9
n0
Ju 0
lJa 00
n0
Ju 1
lJa 01
n0
Ju 2
lJa 02
n0
Ju 3
l-0
Ja 3
n0
Ju 4
lJa 04
n0
Ju 5
l-0
5
Ja
n9
Ju 4
l-9
Ja 4
n9
Ju 5
lJa 9 5
n9
Ju 6
l-9
Ja 6
n9
Ju 7
lJa 9 7
n9
Ju 8
lJa 9 8
n9
Ju 9
lJa 9 9
n0
Ju 0
lJa 0 0
n0
Ju 1
l-0
Ja 1
n0
Ju 2
lJa 0 2
n0
Ju 3
lJa 0 3
n0
Ju 4
lJa 0 4
n0
Ju 5
l-0
5
REER
Local Currency Issuance: Fad or Trend?
Fundamentals – Equilibrium Real Exchange Rates
With apparent room to strengthen with the only reinforcing
volatility being added by the Central Banks!
Brazil
30
25
20
40.00
10
5
0
REER
Mexico
18
100.00
16
14
12
Local Currency Issuance: Fad or Trend?
Fundamentals – A Radical Change in External Financing
Finally net export-led growth????????
Source: DB Global Markets Research
Page 13
Local Currency Issuance: Fad or Trend?
Fundamentals – As Well as Fiscal Financing Position
That among other things enhances monetary prudence credibility
Source: DB Global Markets Research
Page 14
Page 15
Average
Source: DB Global Markets Research
+ Std Dev
- Std Dev
2005 - Aug
2005 - Mar
2004 - Oct
2004 - May
2003 - Dec
2003 - Jul
2003 - Feb
2002 - Sep
2002 - Apr
2001 - Nov
2001 - Jun
2001 - Jan
2000 - Aug
2000 - Mar
1999 - Oct
1999 - May
1998 - Dec
1998 - Jul
1998 - Feb
1997 - Sep
1997 - Apr
1996 - Nov
1996 - Jun
1996 - Jan
Local Currency Issuance: Fad or Trend?
Fundamentals – Inflation Convergence
A revealed preference growingly institutionalized
48
42
36
30
24
18
12
6
0
Local Currency Issuance: Fad or Trend?
Risks – Liquidity/Commodity/Growth/US Imbalances (1)
Historically Correlated with High
Commodity Prices
Historically Low US Real Rates
330
18 %
Real 10-yr treasury yield*
15
S&P500 1yr forward E/P Ratio
Global liquidty growth
40-week forward, (rhs, % yoy)
% 18
12
15
24
290
16
250
8
12
Forecast
9
9
6
6
3
3
0
1983
0
210
1988
1993
1998
2003
Source: DB Global Markets Research
Page 16
0
CRB index (lhs)
170
1993
-8
1995
1997
1999
2001
2003
2005
Local Currency Issuance: Fad or Trend?
Risks – Liquidity/Commodity/Growth/US Imbalances (2)
Strong Commodities is Associated with
Better EM Credits
The Commodity Shock is Perceived as
Partly Permanent
Rolling 12-mth % of upgrades (rel. to total rating changes)
CRB Index
70
NYMEX WTI Sw ap Cal'10 (USD/barrel)
100%
350
90%
330
80%
310
70%
290
60%
270
50%
250
45
40%
230
40
30%
210
65
NYMEX WTI Sw ap M01 (USD/barrel)
60
55
Upgrade ratio
CRB
20%
30
170
0%
150
96
97
98
99
00
01
02
03
04
05
Source: DB Global Markets Research
Page 17
35
190
10%
95
50
06
25
Jan-04 Mar-04 May-04 Jul-04
Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05
Local Currency Issuance: Fad or Trend?
Risks – Excessive (?) Foreign Participation
Brazil BRL Market
Mexico Bonos Market
USD bn
USD bn
12
60
Local Inst Inv
10
Afores
Forgn Inst Inv
Total
Foreigners
Other domestic
50
Banks
8
40
6
30
4
2
20
0
10
-2
0
-4
Aug 04
Dec-05
Nov 04
Feb 05
May 05
Aug 05
Source: DB Global Markets Research
Page 18
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-23
Dec-24
Local Currency Issuance: Fad or Trend?
Risks – (Mitigated) – Normal EM Exposure?
Cross Over
EM Dedicated (% of US GDP)
380
0.80
360
0.75
0.30%
USD30bn
0.25%
340
0.70
320
0.65
300
0.60
280
0.55
0.20%
0.15%
0.10%
260
0.50
EMBI+ Total Return Index
US Crossover Exposure to EM
240
0.45
Mar-03
Jul-03
Oct-03
Jan-04
May-04
Aug-04
Nov-04
Feb-05
Jun-05
Sep-05
Source: DB Global Markets Research
Page 19
0.05%
USD9bn
0.00%
2003 - Q1 2003 - Q2 2003 - Q3 2003 - Q4 2004 - Q1 2004 - Q2 2004 - Q3 2004 - Q4 2005 - Q1 2005 - Q2
Local Currency Issuance: Fad or Trend?
Appendix: Formula for non linear CAPM
 Recently developped Non-Linear CAPM (Campbell Harvey, Journal of
Finance 2000), gives us the more complex formula
Forex _ Pr emT 
 s ,RM  Norm _ Skew 
1 Norm _ Skew 2


2
s , RM
2
s , RM

 Norm _ Skew  s ,RM
1 Norm _ Skew 2

s
E RM ,T 
 RM

E RM ,T 2
s
 RM
Kurt

 RM
• We have the 3 extra parameters:
1.
2.
3.

2
s , RM
= correlation between fx and square market returns (co-skew),
Norm _ Skew 
Kurt 


E rM  e  rM
E rM  e  rM
 RM 4
 RM 
4 
3 
always between -1 and +1, by Cauchy Swartz inequality
2
RM
> 3 for fat tail distributions
• 2 and 3 can be estimated from implied vol smile. Skew from slope, kurt from convxt.
• Skew and co-skew are the big drivers. If they are set to zero, we get Linear CAPM.
Page 20
Local Currency Issuance: Fad or Trend?
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recommendation or view in this report. Gustavo Cañonero
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