November, 2002 Currency and Maturity Matchmaking: Redeeming Debt from Original Sin Alejandro Werner

2 “Under a predetermined exchange rate regime firms will not fully internalize their exchange rate risk and they will be more likely to engage in balance sheet mismatches than under a floating regime” (Martínez and Werner, 2002). Therefore the fixed exchange rate regime and the history of macroeconomic instability left the Mexican government and corporate sector with two problems: 1.Original Sin 2.Balance Sheet Mismatches Motivation

3 Martínez and Werner (2002) “The Exchange Rate Regime and the Currency Composition of Corporate Debt: The Mexican Experience” To test the hypothesis that the exchange rate regime affects the perception of the exchange rate risk we used an extension of the model developed by Holmstrom and Tirole (1997) allowing for the possibility of currency mismatches. From the model we derived the optimal foreign debt ratio will be given by: The Exchange Rate Regime and Balance Sheet Mismatches           DebtTotal Pbc DebtTotal SalesDomesticNet E E r P DebtTotal Exports r P TotalDebt DollarDebt t tHH /)( * *   

4 1 3 *   t tH E E r P  * 2 r P H  t iiii t i t i t i t i t i T i CDMEHADRSizeDSXUSDD 

5 Rolling coefficient of cash flows I it /K it-1 = a 0 + a 1 (CF it /K it-1 ) + a 2 (Investment Opportunities)+ v it Sometime ADR Never ADR

6 The main conclusion of these results is that flexible exchange rate regime helps solving the problem of balance sheet mismatches. However, there is still the need of domestic debt markets to finance the non-exporting sectors. … HOW? Motivation

7 There are two main risks of peso debt: 1.Nominal or the risk of a nominal devaluation and it is faced by every investor. 2.Real exchange rate devaluation risk, that is only faced by foreign investors. This risk could be in principle diversifiable by holding a portfolio with instruments denominated in different currencies. Under this conditions it is important to take in the advantage of having domestic investors. The rest of the presentation will present the development of the long term debt market in Mexico and how it has been achieved. The Development of Peso Long Term Market in Mexico

8 Even though the “Original Sin” problem has declined in Mexico it is still present, both for the government and the corporate sector Outstanding Corporate Dollar Debt / Long Term Corporate Debt * New Issuance of Corporate Debt with Maturity Longer than 1 Year in USD, Government New Issuances with Maturity Longer than 1 Year (USD Debt / Total)

9 Regarding bank credit, we don’t observe a significant improvement and Mexican banks have not really given new credit. * Does not include credit in restructuring programs Outstanding Bank Credit (Millions of 94 Pesos)*

10 The Mexican fixed income market has improved thanks to five actions. 1.In 1995 the government started issuing inflation indexed debt and then in 2000 a 3 year bond with a fixed yield in pesos. Average Maturity of Government Debt (Days)Government Debt Composition by Maturity

11 Yield Curve by Maturity (days)Traded Volume by Maturity (Millions of 1996 Pesos) 1.(cont) In May 2000 the Mexican Government issued a 5 year bond and in July 2001 a 10 year one, both with a fixed yield in pesos.

12 1.(cont) The corporate sector followed the government fixed income market. Inflation indexed corporate debt started in 95, but it started to gain importance in 99. Issuance of Corporate Long Term Debt

13 2.The figure of market makers was introduced in the domestic fixed income market during 2000, since then the liquidity increased significantly. But more importantly these participants were crucial for the introduction of longer term instruments. Average Weekly Traded Volume Before and After the Figure of Market Makers by Maturity (Millioms of Pesos)

14 3.A more flexible instrument for corporate debt was created in 2001, the Certificado Bursátil (Stock Market Certificate, SMC). This certificate combines an easy issuing process with the possibility of including any type of covenant to protect the bond holder. It represented 13% of total corporate debt issuance in 2001 despite it started to operate in August. By November 2002 the issuance has reached more than 3 billion USD with low yields and long matutiry. Characteristics of SMC Issuance

15 4.The macroeconomic stability èInflation rate decreased from 51.97% in 1995 to 4.9% in èThe nominal interest rate decreased from 48.54% in 1995 to 12.19% in 2001, while the ex ante real interest rate declined from 8.60% to 4.98% in the same period. èRegarding economic growth it improved from –6.17% in 95 to – 0.31% in 2001, despite the negative international environment in this last year. 5.The developement of the derivatives market. è Institutional investors have supported the development of long term warrants. In 1997 there were very few products and the spreads were very high. è In 2000 the spread for the three year exchange rate forward was 10 bp thanks to the liquidity conditions on the three year bond in pesos. This year, despite the international volatility, the spread has been close to 6 bp. è There are interest rates swaps in pesos, where the spread for the 3 and 7 years is less than 15 and 20 bp respectively. è There are TIIE- Libor swaps up to five years with an spread of 10 bp.

16 But also, and very importantly, for the developement of the Mexican pension funds, Share of Public Debt Held by Institutional Investors Assets Managed by Institutional Investors

17... which explains the decline in the importance of foreign participants in the Mexican fixed income markets. Domestic Participation in Government Debt Market (Billions of Pesos Dec. 2000)