Bond Markets in Latin America: On the Verge of a Big

Bang? Eduardo Borensztein

IMFSantiago 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 http://www.iadb.org/res/network_study.cfm?st_id=84

• “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

0

20

40

60

80

100

120

140

Latin America 1994 Latin America 2004 East Asia 1994

East Asia 2004

Advanced 1994

Advanced 2004

Corporate issuers

Financial institutions

Governments

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

0

10

20

30

40

50

60

70

80

Latin America 1994 Latin America 2004 East Asia 1994 East Asia 2004 Advanced 1994 Advanced 2004

Corporate issuers

Financial institutions

Government

Development is Uneven

Argentina Brazil Chile Colombia Mexico Peru

Private 9.8 12.6 23.3 0.6 3.4 4.5

Financial 3.4 12.0 11.1 0.0 0.8 1.3

Corporate 6.3 0.7 12.2 0.6 2.6 3.2

Government 23.6 48.9 21.3 30.4 22.4 5.8

Total 33.4 61.5 44.5 31.0 25.7 10.4

Share of long term corporate bonds 25.7 21.9 93.0 40.7 4.1 91.6

Turnover of locally issued bonds

(% of stock of bonds)108.6 123.4 56.7 75.0 463.4 4.8

Sources: Authors' calculations based on BIS data, EMWARE data and 2005 EMTA surveys.

Size of Private Bond Market Private Domestic Bond Issuances

(percentage of GDP)

0

2

4

6

8

10

12

14

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

0

1

2

3

4

5

Argentina (left axis)

Brazil (left axis)

Chile (left axis)

Colombia (right axis)

Mexico (right axis)

Uruguay (right axis)

Corporate Bonds

• DenominationIn Argentina and Uruguay, in dollars; in Brazil and Colombia, floating rates; in Chile, inflation-adjusted; in Mexico, moving from floating rates to fixed rate

• ScaleAverage 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

YearPublic debt holdings of PPF over total public

debt

Public debt holdings of PPF over total domestic

public debt

Public debt holdings of PPF over total

1994 1 3 98

1994 1999 6 23 46

2004 5 14 59

1994 1 2 4

1999 1 2 6

2004 2 3 11

1994 18 22 40

1981 1999 28 30 35

2004 25 28 19

1994 0 0

1999 1999 3 6 45

2004 15 27 83

1994 0 0

1996 1999 5 9 95

2004 14 20 85

1994 0 0

1996 1999 4 9 60

2004 9 36 79

Source: AIOS and ABRAPP

Chile

Colombia

Mexico

Uruguay

No Pension Reform

Composition of Assets of PPF (%)

CountryYear of implementation of the pension reform

Argentina

Brazil

Banks vs. Bonds

• Conventional sequence: 1) Banks

2) Bond Markets3) 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