Bond Markets in Latin America: Comments on Recent Proposals Alejandro Werner April, 2003

The proposals discussed in the previous panel addressed three different problems in EM financing: 1) 1)Reducing the volatility of the Debt/GDP ratio by indexing to GDP. 2) 2)Smoothing capital flows through contingent contracts. 3) 3)Dealing with default through CAC’s, SDRM’s, etc.

The recent discussion has focused too much on restructuring and too little on: 1) 1)How to deal with “sudden stops.” 2) 2)How to handle other shocks. 1) 1)Policy response. 2) 2)The response of IFI’s. 3) 3)Design of financial instruments. The policy package to address these issues should focus on:

Index Bonds: sources of risk to Debt/GDP. Interest rate risk (in domestic and foreign currency) Exchange rate risk Growth risk Fiscal risk

In Mexico, after 1995, the currency/maturity structure of public debt was re-established according to the following strategy: External Debt in F.C. (maturity=1 to 5 years with some sweeteners) Increasing Maturity of E.D. and of D.B. by indexing D.D. indexed to C.P.I. and short-term rates Nominal D.D. at long maturities 3, 5, 7 and 10 years

Gross Public Sector Debt (% of GDP) SOURCE: SHCP Public debt/GDP has been decreasing and it’s composition has changed in favor of internal (peso, CPI) financing.

During this period, the domestic debt market has grown consistently. This growth has been primarily based on the demand of domestic investors. Domestic Participation in Government Debt Market (Billions of Pesos Dec. 2000) Value of Outstanding Domestic Government Debt / GDP 0% 5% 10% 15% 20% 25% Foreign Investors Domestic Investors

In recent years, macroeconomic stability and the development of institutional investors have created the conditions for the public and private sectors to issue long term debt in the Mexican market. 3 Years or More, Year or Less Indexed to Inflation Floating Rate 3 Years or More Fixed Yield in Pesos Sep-02 Government Debt Composition by Maturity Weighted life term of government securities (in days)

Share of Public Debt Held by Institutional Investors Assets Managed by Institutional Investors Mutual Funds Insurance Companies and Pension Funds Siefores Percent The expansion of the domestic debt market has been possible due to the growth of institutional investors.

Comments on indexing to GDP Maybe not the most important source of risk. If the country faces a quasi-permanent shock, as the bonds are re-negotiated g* changes, so the benefits are lower than those calculated in the paper. Due to “home bias” the risk premium might be larger. How would the political economy of adjusting be affected? A lot of the capital inflows of the post 95 era are GDP indexed through FDI.

Insuring E.M. against sudden stops: 1) 1)Different from stabilization funds. 2) 2)Very close to contingent credit lines. 3) 3)However, the argument that they could be re- packaged by CDO’s is powerful. 4) 4)The hedging argument against private CCL is not insurmountable.

Creating new markets faces several free rider problems: Role for G-7 to set benchmarks. For for IFI’s to “subsidize” the emergence of new markets. However, a key question is how to strengthen governments to adjust. If not, these financial gimmicks will only help to postpone crises and make them bigger.