1 External and domestic financing in Latin America: developments, sustainability and financial stability implications “Debt finance and emerging issues in financial integration” United Nations New York – April The views expressed here do not necessarilly reflect those of the BIS. Jose Antonio Ocampo Columbia University Camilo E Tovar Bank for International Settlements

2 Background 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.

3 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.

4 Outline Macroeconomic environment Shifts in financing patterns Development of local currency bond markets Sustainability and financial stability considerations

5 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

6 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 trade effect in 2007: 3.4%

7 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.

8 Scale of international reserve accumulation

9 Reserve accumulation involves costs

10 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

11 Gross and net capital flows

12 Changes in cross-border holdings Debt reduction

13 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.

14 Main features of domestic bond markets in Latin America

15 Domestic bond markets vary widely in size

16 Public sector issuers dominate domestic markets = USD 808 billion

17 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.

18 The maturity structure of government debt in local currency has expanded Notwithstanding this progress, the amount of long-term fixed rate securities remains limited, as reflected by the weighted average maturity of new issues.

19 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 rates. However, the information content of yield curves remains an issue.

20 Only few countries enjoy reasonably strong liquidity

21 Sustainability and financial stability considerations

22 Is the development of domestic bond markets temporary or permanent? Some progress at the domestic level appear to be of a permanent nature (eg debt management, better macro policies). 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.

23 Diversification benefits offered by LA domestic bond markets relative to other asset classes (US dollar-based investors)

24 Financial stability considerations The region has seen an improvement in currency exposures.

25 Financial stability considerations Indirect (and direct evidence for government debt) suggest an improvement in maturity mismatches

26 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

27 Challenges Improve liquidity: –Consolidate various forms of public sector debt under a single obligor –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.

28 Resiliency of local currency bond markets