1. 1 San Jose February 9, 2007 Eduardo Borensztein

2. 2 Why Now? (when we have no crises) Precisely. Crises can be prevented (at least some) Favorable Markets. Possibility of improving debt management (local currency, new instruments) Role of the IFIs is being reconsidered. New ideas to make global finance safer

3. 3 Outline Stylized Facts International Borrowing Domestic Borrowing Towards Safer Debt

4. 4 Outline Stylized FactsStylized Facts International BorrowingInternational Borrowing Domestic BorrowingDomestic Borrowing Towards Safer DebtTowards Safer Debt

5. 5 Public debt is not going away… Public Debt in Latin America and the Caribbean 0 20 40 60 80 100 120 199119921993199419951996199719981999200020012002200320042005 0 10 20 30 40 50 60 70 80 Weighted average (right axis) Average (left axis) Median (right axis) Weighted average excluding Argentina (right axis) Source : Authors' calculations based on Cowan et al. (2006). Note: Countries included: Argentina, Bahamas, Barbados, Belize, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Guyana, Haiti, Honduras, Jamaica, Mexico, Nicaragua, Panama, Paraguay, Peru, Trinidad and Tobago, Uruguay, and Venezuela.

6. 6..and domestic debt is increasing Composition of Public Debt in Emerging Latin American Countries 0 10 20 30 40 50 60 70 19911992199319941995199619971998199920002001200220032004 Domestic debt External due to private creditors External due to official creditors Source : Authors' calculations based on Cowan et al. (2006). Note: Countries included: Argentina, Brazil, Chile, Colombia, Ecuador, El Salvador, Mexico, Panama, Peru, Uruguay, and Venezuela.

7. 7 Domestic Debt is also growing in the smaller markets

8. 8 Official borrowing remains important… Composition of Public External Debt in Latin American and Caribbean Countries with Limited Market Access 0 10 20 30 40 50 60 70 80 90 1983198419851986198719881989199019911992199319941995199619971998199920002001200220032004 Bank loans Bonded debt Other external Bilateral Multilaterals IMF Source : Authors' calculations based on Cowan et al. (2006). Note : Countries included: Belize, Bolivia, Costa Rica, Guatemala, Guyana, Honduras, Jamaica, Nicaragua, and Paraguay.

9. 9 LAC debt levels are not very high… Public Debt around the World (weighted averages) 0102030405060708090 EAP ECA LAC SSA IND MNA SAS 2001–2005 1996–2000 1991–1995 Source : Authors' calculations based on Jaimovich and Panizza (2006).

10. 10 …but debt structure matters more than debt level Public Debt and Sovereign Rating (1995–2005) Italy Jamaica Japan Israel Belgium Ghana Jordan Saudi Arabia Pakistan Egypt Mongolia Senegal Morocco Grenada Argentina Barbados Bolivia Panama Indonesia Bulgaria Portugal Cyprus Hungary Sweden Philippines Papua New Guinea Austria Tunisia Malta Denmark Ecuador India Benin Canada Finland Qatar Netherlands Spain France Uruguay Russian Federation Venezuela United Kingdom Peru Croatia Brazil Poland South Africa Ireland Malaysia Trinidad and Tobago United States Iceland Belize Turkey Costa Rica Ukraine El Salvador Colombia Bahamas New Zealand Paraguay Germany Slovak Republic Mexico Switzerland Lithuania Bahrain Slovenia Norway Oman ChinaThailand Kazakhstan Guatemala Korea Czech Republic Chile Australia Latvia Botswana Estonia Luxembourg 0102030405060708090100110 Public debt (percentage of GDP) Standard & Poor's sovereign rating AAA B BB? BBB A? AA? Source : Jaimovich and Panizza (2006) and Standard & Poor's. Investment grade line

11. 11 Composition of Sovereign Debt, 2000-04 (in percent of GDP) Source: Faria and Tolosa, forthcoming IMF Occasional Paper

12. 12 Structure of External Debt 2001–04, GROUP I Total PPG debt Privately-held PPG debt GROUP II Total PPG debt Privately-held PPG debt Group I consists of Costa Rica, Dominican Republic, El Salvador, Guatemala, and Panama. Group II includes Honduras and Nicaragua. Concessional Private Official Concessional Nonconcessional Private Official Nonconcessional Bonds OtherBank loans Other Bank loans Source: Faria and Tolosa, forthcoming IMF Occasional Paper

13. 13 Debt and Deficits Discussions on how to control the growth public debt focus on the fiscal deficit This is not surprising as: DEBT GROWTH = DEFICIT + SF We expect SF (stock-flow reconciliation) to be a small adjustment But this is not the case

14. 14 SF around the world The Stock- Flow Adjustment (percentage of GDP) 012345678910 Advanced economies South Asia East Asia and Pacific Eastern Europe and Central Asia All Countries Middle East and North Africa Latin America and the Caribbean Sub-Saharan Africa All observations Excluding outliers Source : Campos, Jaimovich, and Panizza (2006).

15. 15 SF around the world Decomposition of Debt Growth in Different Regions of the World -15 0 15 IND SAS Caribbean EAP ECAMNALASSA Percentage of GDP Inflation GDP growth Primary balance Interest expenditure Stock flow adjustment Source : Campos, Jaimovich, and Panizza (2006).

16. 16 Outline FactsFacts International BorrowingInternational Borrowing Domestic BorrowingDomestic Borrowing Towards Safer DebtTowards Safer Debt

17. 17 The emerging bond market today Private international lending revived in the 1970s in the form of syndicated bank loans This new wave of sovereign lending ended with the debt crisis of the 1980s The Brady deals restarted the market for emerging market bonds and gave birth to a new asset class

18. 18 The International Market: Large but Volatile… Capital flows to emerging markets tend to be volatile and procyclical External factors explain a large share of this volatility External debt is almost all in foreign currency

19. 19 Mark Twain on procyclicality A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain.

20. 20 Sudden Stops and Contagion Episodes of “market closure” and jump in spreads that reverse within 2 years Spreads closely connected with global risk appetite Effects extend to countries with little economic link to the original event Uninformed investors may herd and/or chase an index

21. 21 The international market is large but volatile Emerging Markets and Latin American Spreads

22. 22 Has volatility abated? Spreads are at record low levels; investors show appetite for local currency bonds Weak or no contagion from Brazil’s election anxiety and Argentina’s and Turkey’s crises Less cross correlation among EMBI assets

23. 23 Has Contagion Disappeared? Average Correlations among Sovereign Emerging Market Bonds and Industrial Sector Indices of US High Yield Bonds

24. 24 A new phase? Policies are stronger: fiscal surpluses, reserve accumulation, current account surpluses Debt structure changing to local currency Investor base widening; EM assets more mainstream Or, in fact, are spreads too low?

25. 25 Will the good times last? 0 200 400 600 800 1000 1200 1400 1993199419951996199719981999200020012002200320042005 Predicted SpreadsActual Spreads Spreads are lower than predicted

26. 26 0 200 400 600 800 1000 1200 1400 1993199419951996199719981999200020012002200320042005 Spread for average External ConditionsActual Spreads Predicted Spreads would be lower with average external conditions

27. 27 Possibly important changes in global markets Impact of the growth of hedge funds Impact of the growth of credit derivatives Is the appetite for local currency instruments permanent?

28. 28 Outline FactsFacts International BorrowingInternational Borrowing Domestic BorrowingDomestic Borrowing Towards Safer DebtTowards Safer Debt

29. 29 The Domestic Markets: More Stable but Still Small Natural habitat of local currency instruments “Spare tire” for the banking system High volatility in LA makes bank finance a very short-run proposition “Captive audience” of domestic institutional investors (pension funds, banks)

30. 30 Domestic bond markets in LAC are growing but are still small Percentage of GDP, simple average

31. 31 But in fact it is the whole financial sector that is small 0 10 20 30 40 50 60 70 80 Latin America 1994Latin America 2004East Asia 1994East Asia 2004 Advanced 1994Advanced 2004 Corporate issuers Financial institutions Governments Bond Markets relative to Domestic Bank Credit

32. 32 Plausible Determinants of Bond Market Development Scale of the market, in turn related to size of the economy and saving rates Scale of firms that are potential issuers Market liquidity Institutional strength: creditor rights, transparency, etc. Market microstructure

33. 33 Other Important Factors with Less Definite Effect Large domestic government debt: market development or crowding out? Well established banking system: competitor or complement?

34. 34 Scale of the Markets Scale of the Markets Corporate bond market as a function of country size

35. 35 Scale of the Markets Scale of the Markets Market capitalization as a function of saving rates

36. 36 Scale of Firms Scale of Firms Corporate Bond Market as a Function of Firm Size

37. 37 Source: IMF, Global Financial Stability Report (2005) Investor Protection

38. 38 Effects of Large Government Debt Government bonds provide a reference yield curve Larger markets are needed for an efficient microstructure Crowding out?

39. 39 Interaction between government and private bond market Domestic Government Bonds and Corporate Bonds -0.04 -0.03 -0.02 -0.01 0 0.01 0.02 0.03 0.04 -0.4-0.3-0.2-0.100.10.20.30.4 Share of domestic government bonds in total public debt Share of corporate bonds in total domestic credit to private sector Latin America Other emerging markets Fitted values

40. 40 Investor Surveys in Argentina, Brazil and Mexico Do you agree or disagree with the following statements? (1 = strongly agree,…, 5 = strongly disagree)

41. 41 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)

42. 42 Banks and Bonds: Substitutes or Complements? 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

43. 43 Going Forward: New Investors, New Instruments New investors needed. Savings are low and markets are small Institutional investors, especially pension funds, are starting to provide volume (but not liquidity). Foreign investors provide more liquidity (but also volatility). Less averse to long-term nominal instruments (see Mexico, Brazil). Capital account restrictions must be removed.

44. 44 Institutional Investors Institutional investors have been growing and they can play a key role in developing a stable demand for local currency bonds But they could become victim of their own success, especially at times of crisis

45. 45 Institutional Investors Assets of Mutual Funds and Pension Funds (percentage of GDP) 0 5 10 15 20 25 30 35 40 45 50 1997199819992000200120022003 0 20 40 60 80 100 120 140 Emerging markets (left axis) Latin America (left axis) Advanced economies (right axis)

46. 46 Institutional Investors Government Bonds as a Share of Pension Fund Assets 0102030405060708090100 Germany United States United Kingdom Canada Spain Netherlands Italy Austria Thailand Korea Estonia Slovenia Czech Republic Bulgaria Poland Hungary Singapore Brazil Chile Peru Colombia Uruguay Argentina Mexico IND Other EM LAC

47. 47 Institutional Investors Banks' Exposure to Public Sector, 2003–2005 (percentage of total domestic credit) 0102030405060 Chile Uruguay Peru Colombia Brazil Mexico Argentina United States Euro area Latin American countries Mature markets

48. 48 International Investors Saving is low in Latin America and this affects the size of bond markets Institutional investors like pension funds do not provide liquidity Foreign investors display less aversion to long-term local currency instruments. But less stability. Need to open capital accounts to some extent. In Mexico, foreign investors hold more than 50% of the ten-year bond and more than 80% of the 20-year bond.

49. 49 0510152025303540455055 Bulgaria Korea Indonesia Peru Thailand Brazil Japan Malaysia Argentina Turkey Mexico Poland Hungary Uruguay USA Percent of Foreign Holdings of Domestic Bonds Sources: FMI (GFSR, 2005) y Takeuchi (“Study of Impediments…” 2005, asianbondsonline.adb.org)

50. 50 Going Forward: New Instruments New Instruments: Asset Backed Securities (mortgages, receivables, consumer loans, commercial paper) Less complicated enforcement of creditor rights (by recourse to collateral) Can overcome firms’ small scale problem Strong growth in Mexico, Brazil, Chile, Argentina, but from a very small base Successful securitizations for working capital to SMEs Can structured instruments also help SMEs get long- term, investment finance?

51. 51 Outline FactsFacts International BorrowingInternational Borrowing Domestic BorrowingDomestic Borrowing Towards Safer DebtTowards Safer Debt

52. 52 Debt sustainability Traditional approach: Debt to GDP ratio to stay constant s = (r – g) d The primary surplus must be enough to cover interest (adjusted by growth) on the Debt to GDP ratio

53. 53 Actual and “Required” Primary Surpluses 7 2004 Real interest rates Belize Brazil Colombia Costa Rica Dominican Republic Ecuador El Salvador Guatemala Jamaica Mexico Panama Paraguay Peru Trinidad and Tobago Uruguay Venezuela -2 0 1 2 3 4 5 6 7 -20123456 Actual primary surplus Required primary surplus 1992-2004 Median real interest rates Argentina Pre Argentina Post Belize Brazil Chile Colombia Costa Rica Dominican Republic Ecuador El Salvador Guatemala Jamaica Mexico Panama Paraguay Peru Uruguay Venezuela Trinidad and Tobago -2 0 2 4 6 8 10 12 -2024681012 Actual primary surplus Required primary surplus

54. 54 Sustainability Analysis under Uncertainty Variables that enter debt projections have large variance: interest rate, exchange rate, growth, primary surplus. The more volatile these variables are, the lower the Debt/GDP ratio that is sustainable “for sure” (95% statistical confidence, for example)

55. 55 Required Primary Surpluses and Credit Ratings Venezuela Uruguay Trinidad and TobagoEl Salvador Peru Paraguay Panama Mexico Jamaica Guatemala Ecuador Dominican Republic Costa Rica Colombia Brazil Belize y = ?0.087x + 8.6707 (0.7689) R 2 = 0.0064 0 2 4 6 8 10 12 14 -7-6-5-4-3-201234 Required minus observed primary surplus (percentage points of GDP) Credit rating

56. 56 Sustainability Analysis under Uncertainty Many sources of risk – –GDP volatility – –Terms of trade shocks – –Natural disasters A better debt structure can reduce risks

57. 57 Debt Management can reduce the risk of sovereign finance Debt-to-GDP Ratio Distribution 0.2 0.3 0.4 0.5 0.6 0.7 20002001200220032004200520062007200820092010 Debt-to-GDP ratio Foreign currency Foreign currency –local currency Foreign currency– local currency–linked to GDP

58. 58 Lowering the risks of sovereign finance Should countries avoid government debt altogether? Useful purposes: investment in infrastructure and human capital, coping with natural disasters, crises But there are political economy distortions and market failures

59. 59 Lowering the risks of sovereign finance Controlling the flow of debt Managing the inherited stock of debt Improving the international financial architecture

60. 60 Controlling the flow of debt Fiscal rules – –Structural balance target – –Debt/GDP target Budget institutions – –Hierarchical rules – –Transparency Rules

61. 61 Managing the inherited stock of debt Self-insurance policies – –Stabilization funds – –International reserves Contingent contracts – –Cat bonds, commodities, GDP-linked Develop the domestic bond market – –More use of local currency debt

62. 62 Debt and Monetary/Exchange Rate Systems Exchange Rate System => Debt Structure – –Fixed rates may promote foreign currency debt – –Higher inflation discourages long duration, local currency instruments – –There is no “local currency” instrument in dollarized economies (except inflation-linked bonds) Debt Structure => Exchange Rate System – –Harder to use exchange rate flexibility in partially dollarized economies – –Do inflation-linked bonds discourage inflation? Debt Structure

63. 63 Depreciation and Debt Sustainability Depreciations are important source of large unexpected increases in Debt/GDP ratios (SFs) But the effect of depreciation is not necessarily negative. It depends on: – –Net effect of the exchange rate on taxes and spending (including indirect effects) – –Size of Debt/GDP ratio – –Currency composition of Debt

64. 64 Debt Management in (fully) Dollarized Economies Use contingencies! Contingencies: natural disasters, oil prices, economic growth, domestic inflation It can be achieved through derivatives or insurance policies (cat bonds) and use payoffs to service debt.

65. 65 Improving the international financial architecture Rollover risk. Create a “Country Insurance” facility. Support pooling of reserves Contagion risk. “Emerging Market Fund” Currency and real economy risks. Help develop local currency and contingent debt instruments. “De-dollarize” multilateral lending

66. 66 …and much more Latin American sovereign debt in 1820-1913 The political economy of public debt Public debt and public investment in human and physical capital Debt relief, has it worked? The cost of default