Debt management in Latin America: How safe is the new debt composition?

Eduardo Cavallo

24 February 2010

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Latin American public debt levels as a share of GDP declined substantially during the five years leading up to the global financial crisis. Data available for the largest seven countries in the region (LAC-7)1 show that the ratio of total public debt to GDP fell from 53% of GDP in 2003 to 32% in 2008, reaching the lowest level since the late 1990s, when the Asian and Russian financial crises wreaked havoc on financial stability in many parts of the emerging world, including Latin America. This declining trend was partially reversed during the peak of the crisis, however. In 2009, average ratios of public debt to GDP in the region reached 36%, approximately the same level as in 1998 (Figure 1).

Figure 1. LAC-7 public debt as a percentage of GDP

Source: Latin Macro Watch Database (LMW) and data from national public sources. Figures for 2009 are provisional.

Despite the increase in public debt ratios during 2009, debt composition has continued to shift towards domestic debt. Since the late 1990s, there has been a steady increase in the share of domestic compared with external debt. Domestic debt refers to the liabilities issued under national law and subject to domestic courts’ jurisdiction. External debt is issued in a foreign country and subject to that country’s court jurisdiction. The difference between the two types of debt has narrowed considerably in recent year, as the holders of bonds issued in domestic markets may be international investors and domestic investors may hold bonds issued in international markets. Figure 2 shows that domestic debt now accounts for approximately 63% of total public debt in seven largest countries in Latin America (LAC-7) is almost 13 percentage points higher than in 2000.

Figure 2. LAC-7 domestic debt as a percentage of total debt

Source: Latin Macro Watch Database (LMW) and data from national public sources. Figures for 2009 are provisional.

This change in turn has implications for the currency composition of debt. Unlike external debt, which is issued predominantly in foreign currencies, domestic debt includes a greater share of local currency (IDB 2007). Consequently, as shown in Figure 3, the ratio of foreign currency debt as a share of total public debt has decreased steadily from 64% in 1997 to 37% in 2009.

Furthermore, the ratio for 2009 is the same as in 2008. This suggests that not even the cheap financing in US dollars available amid the unprecedented injection of dollar liquidity into financial markets by the Fed since the outbreak of the global financial crisis seems to have persuaded debt managers in the region to increase borrowing in foreign currencies. The unchanged ratio further suggests that much of the increase in the financing needs observed during 2009 has been satisfied through domestic-currency issuances in local markets.

Figure 3. LAC-7 foreign currency debt as a percentage of total debt

Source: Latin Macro Watch Database (LMW) and data from national public sources. Figures for 2009 are provisional.

Implications of the change in debt composition

The shift in the composition of public debt in recent years has led some observers to conclude that Latin American countries are gradually reducing their balance-sheet vulnerabilities. This is because the new debt structures (based on domestic debt with a higher percentage of domestic currency) are less sensitive to an external credit crunch than structures based on foreign currency-denominated external debt – that, until recently, was far more prevalent. Seen through the lenses of the crises of the 1990s, this change represents a step in the direction of “safer” debt composition. When foreign currency external debt represents a lower share of total debt, the effects of the typical combo shock of “sudden stop-cum-real exchange rate depreciation” on countries’ solvency are likely to be reduced. Despite this, the current debt structure poses risks and policy challenges that should not be overlooked.

A paradigm shift?

Before the beginning of the global financial crisis of 2008 and 2009, it could be argued that Latin America’s improved debt composition resulted in part from the highly favorable external environment that the region faced during the preceding expansion phase of 2002 to 2007 (see IDB 2008) – it is easier to issue debt at longer terms and fixed rates when interest rates are expected to fall, and to issue in domestic currency when the currency is expected to appreciate. Nevertheless, if expectations regarding the direction of interest rates and the exchange rate changed, adjustments in debt composition across the abovementioned dimensions could tilt towards riskier debt very quickly.

Those expectations did change as the financial crisis intensified in the last quarter of 2008. The collapse of Lehman Brothers in September 2008 marked the beginning of a phase in the global crisis in which international and financial conditions suffered a severe deterioration. For the region it marked an abrupt end to the expansionary cycle (IDB 2009). The good news is that the debt composition did not change significantly during the global financial crisis. This is remarkable, as experience with past episodes of global financial duress suggests that debt composition can very quickly mutate into more precarious structures (see for example, Mexico in 1994 and Brazil in 1998 as discussed in IDB 2008). However, part of this success must be attributed to the fact that the duration of the crisis – at least the financial stress felt in the region – was relatively short-lived.

The financial stress began to recede in the second quarter of 2009, and by the end of the year the financial markets appeared to have recovered a sense of normality. If the effects of the global credit crunch had turned out to be more persistent for the region, the story could have been different and we may have seen a reversion of debt structures towards more risky compositions (Cavallo 2010). The trade-offs debt managers face, moreover, are often very complex. For example, maintaining high shares of domestic currency debt amid a protracted crisis might require employing short-term maturities. In contrast, “re-dollarising” debts to lower interest rates and extending maturities may prove to be harmful if exchange rates depreciate later. Inflation-indexed instruments provide an alternative that can help improve the terms of the trade-off between currency denomination and maturity of the debt, as it may be possible to issue long-term inflation-indexed instruments at moderate costs, because investors are protected from the risk of unexpected inflation (IDB 2007). Up to a few years ago, only Chile had made extensive use of price indexation of nominal debt. More recently, other countries in the region have begun to experience success in using this tool proactively. Still, this approach will continue to be feasible only if the integrity and credibility of the underlying indices are maintained despite momentary temptations of short-term gain. To the extent that the price index is measured with long lags or mismeasured, it will not fully protect investors from the underlying risk, and the cost of issuing indexed instruments will consequently soar.

How “safe” is the new debt composition?

The shift in the composition of public debt portfolios in recent years has led some observers to conclude that Latin American countries are gradually reducing their vulnerabilities in relation to the composition of debt. Often overlooked in these debates, however, is the fact that there does not yet exist a large investor base in the region for debt denominated in domestic currency at fixed nominal rates and reasonably long maturities (IDB 2007). This implies that the increase in the share of domestic debt issued in local currencies in recent years was in part possible through an increase in the presence of foreign investors in local securities markets. In the case of Brazil, for example, Borensztein and Loungani (2009) report that the net asset value of the total holdings of local securities by foreign investors increased from approximately $50 billion in the 1990s to $250 billion by mid-2008, a development that can increase liquidity pressures during a protracted sudden stop. With the current situation, attempts to liquidate positions by foreign investors may trigger a sell-off of the domestic currency equal to the size of the total investment position of foreigners in domestic markets (albeit devalued by the crash in asset prices that is likely to take place).

Going forward, this suggests that the strategy for gaining access to long-term, fixed-rate, domestic-currency denominated debt hinges on the development of local bond markets that are underpinned by a stable local investor base rather than frugal foreign investors (IDB 2007). Domestic institutional investors such as pension funds are increasingly forming the core of that investor base in many countries. In that respect, attempts by some governments to capture the resources of institutional investors through regulation, moral suasion or outright confiscation defy the effectiveness of any policy aimed at encouraging the development of domestic bond markets. Without a stable investor base, Latin America will remain vulnerable to swings in global financial markets.

As the share of domestic debt in total debt continues to grow, its evolution should be placed in historical perspective. Reinhart and Rogoff (2008) show that the issuance boom of domestic government debt in recent years is not something new or entirely different from past experiences. Furthermore, they argue that when overt default on domestic debt does occur, it appears to occur under situations of greater distress than pure external defaults – both in terms of an output collapse and a marked escalation of inflation.

Altogether, the evidence suggests that recent improvements in debt composition – and the stability shown during the global credit crunch – should not be taken for granted. Governments need to remain alert in pursuing prudent debt management strategies (including debt reduction!) that prevent a repetition of past debt distress episodes while being alert to the potential fragilities of the new debt composition.

Note: The views and interpretations in this column are those of the author and should not be attributed to the Inter-American Development Bank, or to any individual acting on its behalf.

Footnotes

1 LAC-7 consists of the seven largest countries in the region, namely, Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, which account for 90% of Latin America’s GDP.

References

Borensztein, Eduardo, and Prakash Loungani (2009), “Financial Integration in Asia”. Washington, DC, United States: International Monetary Fund, Mimeographed document.

Cavallo, Eduardo (2010), “Debt Management in Latin America: How Safe Is the New Debt Composition?” Policy Brief #109. Washington, DC, United States: Inter-American Development Bank.

Inter-American Development Bank (IDB) (2007), “Living With Debt: How to Limit the Risks of Sovereign Finance”, Economic and Social Progress in Latin America Report, Washington, DC.

Inter-American Development Bank (IDB) (2008), “All that Glitters May Not be Gold”, Washington, DC.

Inter-American Development Bank (IDB) (2009), “Policy Trade-offs for Unprecedented Times: Confronting the Global Crisis in Latin America”, Washington, DC.

Reinhart, Carmen and Kenneth Rogoff ( 2008), “The Forgotten History of Domestic Debt” NBER Working Paper 13946. Cambridge.

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Topics:  Financial markets Global crisis

Tags:  financial markets, Currency crises, Latin American debt

Lead Economist, Research Department, Inter-American Development Bank

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