External and domestic financing in Latin America: Jose Antonio Ocampo

External and domestic financing in Latin America:
developments, sustainability and financial stability implications
Jose Antonio Ocampo
Camilo E Tovar
Columbia University
Bank for International
“Debt finance and emerging issues in financial integration”
United Nations
New York – April 8-9 2008
The views expressed here do not necessarilly reflect those of the BIS.
 The financing of Latin American economies has experienced
a major transformation in the past 10 to 15 years. Two
remarkable developments:
– Shift from cross-border towards domestic financing.
– Shift from bank to bond financing
 As a result, capital markets have expanded, deepened and
diversified, creating a promising financing alternative.
 Such developments help mitigate risks and sources of
vulnerability (eg currency mismatches) and should help
provide an alternative source of financing when banking
sectors are weakened.
 Nonetheless, their rapid development pose risks that need to
be taken into account.
Main issues
 It is still an open question whether i) reduced reliance on
external financing and ii) alternative financing markets in the
region are permanent features.
As the pillars supporting the favourable global conditions
began to erode, these new domestic markets will have to
prove their resilience and the extent to which they offer room
of manoeuvre for counter-cyclical policies (in particular, if
exchange rate appreciation trends reverse).
Progress in reducing currency mismatches are positive.
Nonetheless, local currency debt markets still have a strong
short-term bias and remain highly illiquid.
Furthermore, progress in developing corporate bond markets
are an unfulfilled promise, which will raise new risks.
 Macroeconomic environment
 Shifts in financing patterns
 Development of local currency bond markets
 Sustainability and financial stability considerations
Macroeconomic environment
 In recent years, Latin America has at last witnessed high
growth rates (similar to those of the 1960s-1970s). This has
been possible due to exceptional international conditions:
– Strong commodity prices
– Exceptional external financing conditions
– Large remittances by migrant workers to the region
 Two features are notorious of the current regional situation:
– Growth while generating current account surpluses
– Large accumulation of international reserves
Current account surpluses
 The large CA surpluses are unprecedented in the region’s
history, and are mainly associated with the improvement in
terms of trade.
Terms of
effect in
Reserve accumulation
 A new development policy has been the frequency and scale
of intervention in foreign exchange markets. Therefore,
several LA countries are operating “dirty” floats.
Scale of international reserve accumulation
Reserve accumulation involves costs
Shifts in financing patterns
 Against the background of rapid growth with current account
surpluses and reserve accumulation, the region has
experienced a shift in financing needs.
 In contrast with the past, capital flows are no longer needed
to finance current account deficits.
 New elements of the dynamics of capital flows and
international investment positions:
– Large gross FDI and portfolio inflows
– Incipient but growing gross capital outflows
– Reduced reliance on external financing in net terms
– Reduction in external liabilities positions
– Improved external balance sheets
Gross and net capital flows
Changes in cross-border holdings
Debt reduction
The development of local currency bond markets
 An important counterpart of the region’s shift improvement of
its net international position is the development of domestic
bond markets.
 In fact, domestic financing has expanded significantly vis-à-
vis external financing.
Main features of domestic bond markets
in Latin America
Domestic bond markets vary widely in size
Public sector issuers dominate domestic markets
= USD 808 billion
Fixed rate debt now accounts for a significant share of domestic
government securities in some countries.
 Dollar-linked
debt has been
phased out in some countries (eg
Brazil and Mexico).
 However, short-term, floating-rate
and inflation-indexed securities
continue to be significant across
the region.
The maturity structure of government debt in local currency has
 Notwithstanding
this progress,
the amount of long-term fixed
rate securities remains limited, as
average maturity of new issues.
Nominal yield curves have began to emerge
 The wider availability of longer-
dated bonds is beginning to
provide a useful representation of
the term structure of interest
 However, the information content
of yield curves remains an issue.
Only few countries enjoy reasonably strong liquidity
Sustainability and financial stability
Is the development of domestic bond markets temporary or
 Some progress at the domestic level appear to be of a
permanent nature (eg debt management, better macro
 But much seems to depend on the sustainability of the global
process of portfolio diversification.
 Interestingly, despite the financial turmoil in developed
economies capital continues to flow to the region.
 Nonetheless, the extent to which domestic bond market will
continue to be a dependable source of funding remains to be
truly tested.
Diversification benefits offered by LA domestic bond
markets relative to other asset classes
(US dollar-based investors)
Financial stability considerations
 The region has seen an improvement in currency exposures.
Financial stability considerations
 Indirect (and direct evidence for government debt) suggest
an improvement in maturity mismatches
Risks associate to the development of domestic bond markets
 As any new financial development, local currency bond market may
involve hidden risks. These can be associated with:
– Local currency bond markets may have swapped currency risk
for interest refinancing risk.
– Lack of liquidity. This is a concern because:
• Limits the capacity to manage exposures, and
• Constrains the possibility of making rapid adjustments of
portfolios without a significant disruption of the market.
– The type of investors (eg domestic vs. foreign). The lack of an
appropriate infrastructure to deal with these markets.
– The intrinsic characteristics of the new instruments (ABSs,
derivatives, corporate debt, etc…)
– The type of issuer
 Improve liquidity:
– Consolidate various forms of public sector debt under a single
– Concentrate government issuance in a limited number of
benchmarks, reopening issues where necessary.
– Central banks can use government and other high-grade
securities as collateral for their lending operations (Repos).
– Widen the investor base (eg changes in regulations)
– Regional funds (ABF-2)
 Reduce vulnerability of debt structures to interest rate and
refinancing risk.
 Increase the issuance by the corporate sector.
 Spread the risk of bond investment ie expand the investor base.
Resiliency of local currency bond markets