The State of Latin American Bond Markets Barry Eichengreen Rio, August 11, 2006

Joint work with Eduardo Borensztein and Ugo Panizza of the Interamerican Development Bank. Intended as a synthetic overview of the state of the markets. Also provides a review of progress on policy reform to date and an agenda for the future. –Methodological innovation is to provide a systematic comparison of East Asia and Latin America, which I don’t think has been done before. I hope you will find this interesting.

Why it Matters Bond market development is widely regarded as important for financial development and stability alike. –Better diversified financial systems are more efficient. Banks and bond markets are good at different things. –Eliminating excessive reliance on banks may also help to lengthen tenors and promote financial stability. There has been considerable progress in recent years. –Market cap has grown. Foreign participation has grown. –But this remains almost entirely foreign participation in government bond markets. The important question is how much of this progress is permanent? –Institutional reform may have permanently augmented domestic and, in particular, foreign investor appetite. –But recent trends may also heavily reflect favorable global liquidity conditions. Retrenchment in the last two quarters, associated with global monetary tightening, is consistent with this latter view. But the fact that some countries, including Brazil, have been heavily if not entirely insulated from this pull-back suggests that at least some of this progress might be properly regarded as permanent.

Bond markets in Latin America have grown (more LAC countries are above the diagonal than below)

Same is true of corporate bonds (most countries are above the diagonal, though disturbingly close to the origin)

While this is progress, Latin markets continue to lag along a number of dimensions. They are still small by advanced-country standards. With a few exceptions, turnover rates remain low. Markets are disproportionately dominated by government bonds. The duration of issues remains relatively short. –The next two figures provide views of this.

Share of Short-Term Bonds (residual maturity < 1 year): LA is still an outlier

Share of Medium & Long-Term Bonds (in purple): LA is still an outlier

Interestingly, this differential in the growth of local markets is less pronounced when capitalization is scaled by the size of the financial sector (by M2 or, even more clearly, by the stock of domestic credit). Another way of putting the fact that Latin American bond markets are small relative to GDP but not relative to the financial sector is that it is Latin American financial sectors and not merely the bond market that is underdeveloped. The fact that these markets seem to grow together suggests that bond market development is a corollary of the larger process of financial development. –The next two slides point up the contrast.

Here: scaled by GDP

But here: scaled by domestic credit

The role of banks The fact that bond markets grow in tandem with the rest of the financial system, which generally means in tandem with the banking system, suggests that banks and bond markets are complements rather than substitutes. –Banks provide underwriting services for prospective domestic issuers, advising the issuer on the terms and timing of the offer. –They provide bridge finance in the period when the marketing of bonds is still underway. –They provide distribution channels for government bonds and form an important part of the primary dealer network. –Their institutional support may also be conducive to secondary-market liquidity. –Finally, and most directly, banks owing to their relatively large size can be major issuers of domestic bonds themselves. This perspective is rather different from the “pecking order model” of financial development, in which bank finance develops first, because the information and contracting environments are highly imperfect, and in which the bond market develops only later.

But an imperfectly competitive banking system may be an obstacle. Banks with market power may collude to discourage the development of alternative channels for intermediation. –In Chile, the Latin American country with the most active corporate bond market, fully 26 investment banks have been active in underwriting and helping to place domestic debt securities. –In Mexico three large banks dominate the underwriting and sell side of the domestic market. –Is Brazil an intermediate case? (Brazil has 20 different commercial and investment banks that act as lead underwriters. But how many are really players?)

To be sure, all of the preceding are generalizations Bond markets in Brazil and Chile are an order of magnitude larger than those of Argentina and Peru, even scaled by GDP. In addition, those markets are very different in composition: in Brazil corporate bond issuance is very small compared to government bonds, whereas in Chile they represent a significant share of market capitalization. Variation is also evident in maturity. And again in terms of turnover. –The next three slides illustrate these points.

Total market cap by country

Maturity by country

Turnover by country

What are some of the determinants of these variations? In the paper you have before you, we take market capitalization as our dependent variable, if only because data are most comprehensive. And we do not limit our cross country comparisons to LAC. We present the data both visually and in the form of multiple regressions. –First visually…

Country size (and minimum efficient scale) plausibly matter (this figure illustrating the role of country size is for corp bonds)

In addition, countries with higher savings rates evidently have a leg up

Size of firms also matters for corporate bond market capitalization

Institutional investors matter Countries with better development of institutional investors (privatized pension funds, insurance companies, mutual funds) also have a leg up (although IIs buy and hold, adding little to liquidity). There are some data on this in the paper, but these are fragmentary. For example, In Mexico and Chile, institutional investors hold upward of 90 per cent of corporate bonds; in Peru they hold more than 70 per cent. –Pension funds hold a very significant fraction of government bonds in Chile, Colombia, and Mexico, where the reform of pension systems was relatively early to get underway. –In Brazil, the mutual fund industry is the most important holder of government securities (along with the banking system and BNDES). –On the other hand, the role of insurance companies is smaller in Latin America than in Asia – with the exception of Chile, where insurance company assets under management approach 20 per cent of GDP.

Foreign investor participation can help to relax constraints on market size and liquidity This includes both: –Issuance by nonresidents –Investment by nonresidents However… …

LAC lags in nonresident issuance

Depending on country, LAC compares better on nonresident investment

Policy measures LAC has made progress but still has a way to go in terms of: –Investor protection –Creditor rights –Compliance with international accounting standards

Finally, we provide some statistical analysis of the determinants of market cap Annual data from the BIS (through 2004) Estimates by GLS Focus here on the corporate bond market –There are too many results to summarize. But a sweeping overview would emphasize:

Summary of results A limited number of variables explain the vast majority of differences in bond market development, so measured, across regions. –These include GDP per capita, country size, development of the financial system (and efficiency of the banking system), exchange rate stability, openness, investor protection (cost of contract enforcement), presence or absence of capital controls. Thus, more stable policies and stronger investor protections would make a difference.

Results (continued) In addition, however, a quarter of the difference in bond market capitalization between industrial countries and Latin America is due to country size (measured by aggregate GDP) and the level of development (measured by GDP per capita). –Level of development can be changed, but market size? Does this mean that attempting to develop bond markets in small countries is a losing fight? In addition, about 15 percent of difference is attributable to the development of the financial system (measured by bank credit to the private sector). These variables are not easy to change in short order. Another 15 percent is related to historical and geographical factors (like the origin of the legal code and other measures of institutional inheritance). Can these be changed at all?

Results (continued) The only policy variables easily controlled in the short run that seem to be play an important role are macroeconomic stability (proxied by the volatility of the exchange rate), openness, and the only institutional variables with a first order effect are investor protection and the cost of enforcing a contract. But these can explain at most 1/4 of the difference between the Latin America and the industrial countries. Policy variables like the exchange rate regime, the presence or lack of capital controls, the level of public debt, bank concentration, and banking spreads are all statistically significant in the empirical analysis but play a very small role in explaining the difference between the development of the bond market of industrial countries and that of Latin America.

Bottom line Clearly, one should not conclude that policies and institutions do not matter. –Still, the fact that many of the obvious policy variables have only a modest effect on bond market development suggests that there are unlikely to be convenient short-cuts. Bond market development is a long hard slog. –By implication, the same policies that are necessary for economic development in general are also necessary for the development of domestic bond markets. But, in addition, the importance of country size and firm size raises questions about the feasibility of “bond market development in one country.” –Does this mean that LAC should follow Asia in attempting to develop bond markets at the regional level?

Extra-national initiatives Asia has sought to integrate national markets regionally in order to overcome handicap of small market size. –ABF1 &2. –Regional indices and passively managed funds. –Asian Bond Markets Initiative. Latin America has not gone down this road. –In contrast to Asia, it has sought to enhance the access of its corporates to international markets. –This has included, most recently, efforts to issue government debt in local currency in New York and other centers, in the hope that corporates will be able to follow. At least, this is what is suggested by the following slide:

LA relies more on international markets (Private Sector Bonds/GDP) Left panel is LA, right panel is EA Blue is domestic, red is external

Costs and benefits of the two strategies Spreads are often lower on international markets, especially for LAC borrowers (reflecting, inter alia, weak creditor rights at home). –Thus, in the case of Colombia’s November 2004 domestic currency issue, where we can make a direct comparison, primary spreads were 20 to 50 basis points below those on comparable domestic bonds. –We see the same thing when we look at large corporates, which can often borrow more cheaply on international markets. –Thus, the LAC strategy is the obvious short-run cost-minimizing one. But does encouraging corporates to borrow on foreign markets slow the development of local market liquidity? –We find that spreads also decline with domestic market capitalization. –So the Asian strategy may be the long-run cost-minimizing one.