Bond Markets in Latin America: On the Verge of a Big Bang? Eduardo Borensztein IMF Santiago de Chile, April 2007

Based on IDB Research Network project “The Development of Bond Markets in Latin America” directed by E. Borensztein, K. Cowan, B. Eichengreen and U. Panizza “On the Verge of a Big Bang? Building Bond Markets in Latin America” MIT Press, forthcoming See also: “Living with Debt” IDB’s IPES (flagship research publication) 2007

Plan Why do we need bond markets? The state of Latin American bond markets Determinants of bond market development. Survey results Latin American issues: large government debt, pension system privatizations, banks vs. bonds, asset-backed securities

Why Do We Want a Bond Market in Latin America? “Spare tire” function Natural habitat for local currency instruments Broader range of options for corporate financing. ABSs can broaden access for consumers High volatility in LA can limit bank finance to short-run loans

The State of the Markets Small capitalization, not just compared with advanced economies but also East Asia Dominated by government securities; recent shift from global market to local market

Domestic bond markets in LAC are growing but are still small Percentage of GDP, simple average

The State of the Markets But it’s financial markets overall that are small in Latin America (and bond markets are not disproportionately small)

Bond Capitalization Relative to Bank Domestic Credit Latin America 1994Latin America 2004East Asia 1994East Asia 2004 Advanced 1994Advanced 2004 Corporate issuers Financial institutions Government

Development is Uneven

Size of Private Bond Market

Corporate Bonds Denomination In Argentina and Uruguay, in dollars; in Brazil and Colombia, floating rates; in Chile, inflation-adjusted; in Mexico, moving from floating rates to fixed rate Scale Average size of issuance ranges from $20 m in Colombia and Uruguay to over $100 m in Mexico and Argentina. International issues are over $200 m in average size. Only large firms issue bonds.

Determinants of Bond Market Development (Ch. 9) Macroeconomic factors –Price stability, monetary credibility, default risk Institutional factors –Creditor rights, transparency, rule of law –Market microstructure (trading platforms, settlement systems, market makers, brokers, investment banks, etc.) Structural factors –Scale of the market, in turn related to size of the economy and saving rates; scale of firms that are potential issuers –Institutional investors (private pension funds)

Surveys of Firms. What are the obstacles to issuing bonds? In all countries: Large issuance costs, high underwriting fees, lengthy processes Disclosure and accounting costs (Argentina), minimum size requirement (Brazil, Colombia), other regulatory requirements (Brazil) Small market size (all), no “junk bond” market (Brazil, Colombia, Uruguay),

Surveys of Investors. What are the shortcomings of bonds markets? In all countries: Low liquidity, low market capitalization No yield curve (all but Mexico, Uruguay) no benchmark index (Colombia, Argentina, Chile) Poor creditor rights (Argentina, Uruguay, Brazil), poor information on issuers (Mexico, Argentina, Uruguay), high default risk (Uruguay) Unfavorable tax treatment (Chile), low returns (Chile), excessive regulations (Mexico)

Effects of Large Government Debt Government bonds provide a reference yield curve Larger markets are needed for an efficient microstructure Spillover of denomination and maturity Crowding out? Sovereign ceiling in international markets.

Survey of Investors. Interaction between Government Bonds and Private Bonds

Institutional Investors and Foreign Investors New Investors needed. Savings are low and markets are small Institutional investors, especially pension funds, are starting to provide volume (but not liquidity). Restrictions on investment can be abused by the government Foreign investors provide more liquidity (but also volatility). Less averse to long-term nominal instruments (see Mexico, Brazil). Capital account restrictions must be removed.

The Role of Private Pension Funds

Banks vs. Bonds Conventional sequence: 1) Banks 2) Bond Markets 3) Equity Markets But interest groups can affect this evolution, e.g. Banks can prevent markets from developing (Rajan-Zingales)

Banks: Substitutes or Complements? The fact that bond markets grow in tandem with the rest of the financial Banks contribute to market infrastructure: bridge finance, distribution channels, primary dealer network. Banks contribute to secondary-market liquidity Banks often are major issuers of domestic bonds and structured securities Rather than being a political force against markets, banks and bonds seem to be held back by the same reasons in Latin America

Firm Surveys. Bonds vs. Bank Loans Bonds dominate in maturity, interest rate (except Chile), guarantee requirements (Colombia and Uruguay) Bank loans dominate in speed of access, information requirements, minimum size (except Chile), guarantee requirements (Argentina and Brazil)

Going Forward: New Instruments Asset Backed Securities (mortgages, receivables, consumer loans, commercial paper) Strong growth in Mexico, Brazil, Chile, Argentina, but from a very small base Less complicated enforcement of creditor rights (by recourse to collateral) Could overcome firms’ small scale problem Some successful securitizations for working capital to SMEs Can structured instruments also help SMEs get long-term, investment finance?

Thank you