From the Debt Crisis to the New Bond Market

The two world wars, the Great Depression, and the end of the first era of globalization witnessed a long hiatus in private international lending to developing countries. When such lending resumed in the 1970s, the traditional bond instrument was replaced by syndicated loans from international banks. With the advent of the Eurodollar market, “money center” banks created syndicates to make international loans to middle-income countries. This activity received a big impetus when the surpluses of the oil-exporting countries started to increase liquidity among the banks. At the same time, developing countries’ demand for external financing was growing in step with their trade deficit, and international financial institutions and policymakers from the largest industrial countries seemed to encourage recycling of oil surpluses to allow an easier adjustment to the oil price shock in the global economy.

The syndicated bank loans of the 1970s were mostly short or medium term, at variable interest rates, and denominated in U.S. dollars. It was a period of high inflation and low, even negative ex post real interest rates, in the context of high export prices and strong global demand for the products of most developing countries. But the nature of the loans meant that borrowing countries were assuming essentially all the risks if the conditions prevailing at the time of the loans changed. Indeed, when real interest rates turned highly positive and the world economy slowed down at the end of the decade, borrowing countries began to face serious debt sustainability problems, especially those that had been more profligate during the period of abundant liquidity in international markets.

The public statement by the finance minister of Mexico, in August 1982, that Mexico was unable to service its debts marked the end of a wave of capital inflows. In the following months and years, most other large borrowers followed suit and defaulted on their debt obligations in one way or another. The debt crisis that ensued had serious economic consequences. In the borrowing countries, it created the need to make huge adjustments to budget deficits and external current accounts; in many countries the difficulty of implementing these adjustments resulted in high inflation or hyperinflation. Domestic economies fell into deep recessions, while private investment collapsed and remained depressed for years under the weight of a “debt overhang” that would persist for years. (Chapter 10 describes the debt overhang problem.)[1]

The debt crisis of the 1980s also had a substantial impact in the financial markets of the advanced economies. Some of the largest banks in the United States and other developed countries were holding sizable amounts of the defaulted debt, and heavy losses on developing country debt threatened their financial soundness. At least four of the largest U.S. banks had exposures on loans to Latin American countries that exceeded their total capital. Although the situation was a little less extreme, several major banks in the United Kingdom, Canada, and Japan were likely to become insolvent if claims on Latin American sovereigns had become worthless.

In that environment, the solution to the debt crisis became difficult and protracted. It involved bilateral negotiations between debtor governments and creditor committees representing the main banks, but it was strongly influenced by the policies and initiatives of the international financial institutions and the governments of the advanced economies. In the end, a new strategy was announced by U.S. Secretary of the Treasury Nicholas Brady in March 1989 that provided official incentives, through IMF and World Bank loans, for agreements to restructure debts into bonds with significant write-downs of the claims. The objective—which the strategy proved successful at achieving—was to bring debtor countries back into sustainable positions without causing destabilizing financial losses to the creditor commercial banks.

The Rise of the Emerging Market Asset Class

The restructuring of sovereign debts of developing countries under the Brady Plan marked the return to bond financing for Latin America and emerging markets more generally. The first operation was the Mexican debt restructuring in 1990, and it was followed by similar operations in 20 other countries in the following years. The deals exchanged new Brady bonds for defaulted syndicated bank loans. Some of the bonds preserved the value of the principal but carried significantly discounted coupons (“par” bonds), while others carried coupons more in line with market interest rates but discounted the face value (“discount” bonds). Many of the bonds also had some form of enhancements in the form of partial guarantees or “value recovery rights” (VRRs) which offered extra payments if certain economic conditions were met. (Box 5.1 discusses the VRRs included in these deals.) The guarantees typically consisted of collateral in the form of zero-coupon U.S. Treasury bonds which would cover part of the payments in case of default on the Brady bonds (see Box 10.2).

By the early 1990s, an active market for the new Brady bonds was in full swing. Supported by strong—if sometimes fickle—investor appetite, sovereigns in Latin America and other emerging markets began to issue Eurobonds and global bonds in the 1990s, which started to displace the original Bradys and now dominate the markets.[2] In fact, most countries preferred to replace their Brady bonds with bonds of other types because they felt that the origin of the Bradys in the restructuring of defaulted loans was a reminder of a tainted past, and certain features—such as partial guarantees—that were introduced to facilitate an agreement with creditor banks were proving unattractive to current bond investors. Of the total global volume of $175 billion in Brady bonds that was issued, just over $10 billion remain in circulation now, after buybacks (including some ongoing operations), amortizations, and some new defaults and restructurings that have occurred in the past few years. Latin American countries have been the most active in buying back or exchanging their Brady debt, and their share of these instruments has fallen sharply (Table 5.1).

The retirement of the Bradys is in fact a sign of the strength of the emerging economies’ sovereign bond market, which has grown to significant proportions in global capital markets. According to Bank for International Settlements figures, total outstanding international sovereign emerging debt reached about $450 billion in 2005, of which Latin American debt accounted for about $240 billion. The emerging economies total represents almost one-third of the global supply of international government bonds (Table 5.2). The international debt securities of corporations and financial institutions in emerging economies are fast approaching the level of government bonds and reached almost $390 billion in 2005. Nonetheless, Latin America accounts for a much lower share of private borrowing than of government borrowing in international markets. The share of emerging markets in world private bonds is also lower but still amounts to 9 percent. Emerging markets have a much smaller share of the market for bonds issued by financial institutions (Table 5.3).

The global market is active and liquid for the sovereign bonds of most Latin American countries. EMTA (the Trade Association for the Emerging Markets, an industry association based in New York with broad membership among market participants) has been surveying its members and compiling data on secondary market trading of emerging market bonds since 1993. Trading in such bonds was relatively light in the early years when the instruments were still new and the investor base was starting to develop. Subsequently, trading reached frantic levels during 1997–1998, in the context of a series of financial crises and unsettled conditions in many financial markets (Figure 5.1). Turnover in Latin American issues tends to be higher than that in issues from other regions, reflecting in part large holdings of Latin American, and in particular Mexican, paper by international investors who are members of EMTA.

In assessing the volume of emerging market debt in global markets, it is noteworthy that the distinction between international and domestic debt has become increasingly blurred. Not all holders of international bonds are international investors, nor are all the holders of domestic debt residents of the country issuing the debt. In fact, residents of countries that are emerging markets tend to be active participants in the global debt markets of their countries, acquiring securities either in domestic exchanges or through international accounts. And international investors are increasingly entering domestic debt markets (see Chapter 7). Although there are no reliable data for estimating a breakdown of bondholders by residence, there is broad anecdotal evidence that holdings of emerging market government bonds by residents of the issuing country are indeed significant. For example, surveys conducted in connection with the 2005 Argentine debt restructuring suggested that institutional and individual residents of Argentina held as much as 75 percent of the country’s outstanding global sovereign debt in 2001–2002.[3]

Sudden Stops and Contagion

Although the renewed access to the global financial market since the 1990s has contributed to investment and budget smoothing for the public sector, the availability of financing and the spreads paid on emerging markets’ bonds have displayed a high degree of volatility, as was the case in the previous golden era of bond financing (1870–1914) described in Chapter 4.[4] High volatility may be a pervasive feature of these instruments, and the reason for this may be that the fundamental economic factors that underlie the creditworthiness of sovereigns in emerging economies are themselves highly volatile. For example, in many cases, government revenues are highly dependent on commodity export prices and economic growth, which are subject to large swings over time. If government debt is largely denominated in foreign currencies, the volatility of the exchange rate will also result in large changes in the relative value of debts and the creditworthiness of the sovereign. In addition, investors face a more difficult challenge in trying to assess the creditworthiness of a sovereign than that of a private firm. In the latter case, equity prices and debt-to-equity ratios provide precise information that helps to make the valuation of debt more precise. There are no comparable market instruments to help in the valuation of sovereign debt. Moreover, should a default occur, the recovery value of government bonds is harder to predict, because the framework for sovereign debt restructuring is less well defined than is the case with private borrowers.

The structure of the market and the cost of obtaining and updating information have been contributing factors to market volatility as well. When debt instruments of a given country represent a small share of an investor’s portfolio, there will be a tendency to rely on general information (like current market trends) and to pay less attention to the subtle details of the current economic conditions in that country, especially when information is costly to acquire and changes frequently. Calvo and Mendoza (2005) show that in this situation, a slight change in expectations may bring about a sharp and unexpected portfolio repositioning, sudden stops in capital flows, contagion to seemingly unrelated countries, and generally higher market volatility.

Thus, frequent sudden stop episodes have been the distinctive element of the modern international bond market for emerging economies (Calvo, 1998). Sudden stops are periods of market panic in which the valuation of bonds seems to be well below economic fundamentals. For example, a spread of 1,500 basis points would imply a probability of default of almost 66 percent within one year, and almost 90 percent within three years, in a typical 10-year bond configuration.[5] These seem to be excessively pessimistic prospects. Sudden stops may be associated with a global event or with a financial crisis breaking out in one of the emerging economies, but they have the tendency to result in virtual market closures and significant jumps in spreads for several or all emerging countries. A plot of the spreads implicit in JPMorgan’s Emerging Market Bond Index Global (EMBIG) starkly highlights four major sudden stop episodes: the Tequila crisis, the Russian–Long-Term Capital Management (LTCM) crisis, the aftermath of the September 11 terrorist attacks in the United States, and the uncertainty associated with the election of President Luiz Inácio Lula da Silva in Brazil and with the Enron and other corporate fraud cases in the United States (Figure 5.2).[6]

Another sign of the intense turbulence that has affected emerging economies’ debt markets is the high degree of correlation among different countries. It is also telling that this correlation has increased sharply during periods of distress (or sudden stops). This “contagion” effect was particularly strong during the Tequila and the Russian-LTCM crises and generated considerable debate over the extent to which it was justified by fundamental economic conditions or was purely the result of runs by irrational speculators (see, for example, Forbes and Rigobón, 2000). It is true that the underlying risks that affect emerging economies are somewhat related, in part because economies in the same region tend to maintain close trade and investment linkages with one another. Intraregional trade is more important in East Asia, where it accounts for close to one-half of total trade, than in Latin America, where it amounts to roughly 15 percent. The trade linkages are also indirect. For example, Mexico and some East Asian economies are competitors as exporters to the same third markets. Thus a crisis in East Asia, for example, that results in large currency depreciations would make the East Asian economies more competitive and have a negative effect on Mexico.

It is perhaps telling that for the sudden stop event in which contagion was the strongest, the Russian devaluation and domestic debt default of 1998, it is impossible to identify important linkages to Latin America running through trade, investment, or any other fundamental factor in the real economy. The direct and indirect relation of Russia with Latin American economies is insignificant. The overall share of Russia in the global economy is very small. And yet the Russian event triggered a large spike in emerging market bond spreads (see Figure 5.2). This event, and the contagion phenomenon more generally, raised considerable concern within the international community because, if crises are easily transmitted within and between regions, the ability of official international financial institutions to respond by providing liquidity support diminishes significantly. In fact, the consequences of the Russian crisis were so widespread that they reached some of the advanced markets themselves, with the most notorious casualty being LTCM.

There is broad consensus that the Russian contagion operated through financial markets. The financial channels of contagion are varied and subtle. The most obvious possibility is a direct connection, that is, residents of one country holding large amounts of sovereign debt or other financial assets in another country. Direct financial links, however, tend not to be very important among emerging economies. One notable exception may be the links involving Argentina and Uruguay, which resulted in a massive propagation of the Argentine financial crisis of 2001–2002 to its neighbor. A more common channel is through “common creditors” such as banks or international investors that hold claims in different emerging markets. Banks, for example, can react to losses in one emerging market economy by adopting a more conservative strategy and reducing their exposure in other emerging market economies where they have loans or investments. There may also be a more mechanical effect triggered by declines in asset prices. Leveraged investors face margin calls when their asset prices fall, which may force them to reduce their positions in other markets. Mutual funds may benchmark their returns against an emerging market bond index comprising bonds from many countries and may not want to deviate much from the index composition, or they may be constrained by their investment mandates from doing so. This means that they need to sell the whole emerging markets asset class when they want to reduce their exposure to one country.

The structure of information that is behind investors’ decisions is a more subtle way in which problems in one country can be transmitted to others. Monitoring and understanding economic and political developments in each individual emerging economy involve significant costs. They may require consulting experts, and with conditions changing rapidly, the consultations would have to be frequent. At the same time, an individual emerging country may represent only a small part of a particular investor’s portfolio, especially for a class of investors who are not dedicated to the emerging economies segment of the market. Under these conditions, two types of investors are likely to emerge: informed investors, who are specialists in emerging economies, and uninformed investors, who prefer to follow the actions of informed investors, as can be read from signals such as price changes and market developments. The resulting information structure is likely to generate overreaction of market prices and contagion to other emerging markets (see Calvo, 2005a, and Calvo and Mendoza, 2005). The propagation of the sellout can be further magnified when compensation of fund managers implies stiff penalties for underperforming relative to the market average; in such a case, managers have strong incentives to “herd” together. It becomes quite risky to deviate from the trends that other investors are following (see Rajan, 2005b).

The tendency toward contagion seems to have abated recently. In particular, the Argentine default of 2001 and market concerns about the outcome of the Brazilian presidential election in 2002 did not generate widespread spillovers to other borrowers. In fact, the correlations among sovereign bonds are now broadly the same as the correlations among the high-yield borrowers from different industrial sectors of the U.S. economy. Figure 5.3 calculates the average six-month correlation between all the pairs of indices of high-yield debt corresponding to 30 economic sectors, as well as the average correlation between pairs of emerging market sovereigns. As the figure shows, although correlations between emerging markets were much higher until 1999—and especially during the Tequila and the Russian-LTCM crises—they are now broadly the same as those between high-yield bonds of different industries in the United States.

The durability of the recent decline in contagion does not seem to be assured, however. In recent years, liquidity in international financial markets has been high, and this may account for across-the-board strong performance of assets. If conditions change, with the rise in interest rates in advanced markets, for example, there may be a selling off of emerging market securities and a reappearance of the contagion phenomenon. Although there is very partial and fragmented information about the positions of different classes of investors, there is no reason to believe that the structure of financial links among countries has changed substantially from what they were during past contagion episodes. In Latin America, there appear to be increases in the share of domestic institutional investors among holders of sovereign debt. Domestic institutional investors are believed to provide a stable source of demand, either by choice or to comply with existing regulations. Among international investors, highly leveraged participants like hedge funds are gaining market share, as are less specialized investment funds—the so-called crossover investors. At a more fundamental level, the low level of contagion in the most recent crises and market runs may have been a response to the fact that they had been well anticipated (Didier, Mauro, and Schmukler, 2006). Crisis episodes in Argentina and Turkey in the past few years developed gradually, and indicators such as forward exchange rates showed clear signs of anticipation months before the crises came about. Gradually developing, broadly expected crises are well understood even by the least-informed groups of investors and are not likely to generate unexpected margin calls for highly leveraged investors. This means that the requisite conditions for contagion were not prominent in recent episodes.[7]

Global Financial Markets and Self-Fulfilling Crises

The above characterization of the modern international sovereign bond market implies that global financial conditions are a substantial determinant of the borrowing costs of emerging economies. Investors’ risk appetite is of course unobservable per se, but the evolution of some financial variables can provide a rough indicator of market sentiment. One variable that is commonly associated with the market attitude towards risk is the Chicago Board Options Exchange Volatility Index (VIX), which is an index of the volatility of the U.S. stock market implicit in the prices of various option contracts. Loosely speaking, higher values of the VIX imply that these options are more expensive. Because options are contracts that permit investors to hedge against large changes in the underlying asset (the U.S. stock market in this case), investors are willing to pay higher prices to obtain such protection in periods when expected volatility is higher. Figure 5.4 depicts the VIX and the Emerging Market Bond Index (EMBI) and illustrates their high correlation with one another, especially since the 1998 global financial turmoil. A similar picture obtains if one uses the spread on high-yield—or “junk”—bonds in U.S. markets as a proxy for risk aversion.

In this vein, several empirical studies have measured the importance of the risk appetite of fixed income investors and liquidity conditions in U.S. markets for the spreads of Latin American and other emerging markets over risk-free interest rates. Risk appetite is typically measured as the VIX or a high-yield index. Market liquidity is measured by the U.S. Treasury bond yield; a lower yield indicates an easier monetary stance by the Federal Reserve Board and thus more abundant liquidity in financial markets. A recent study (González Rozada and Levy Yeyati, 2006) puts the combined effect of these two global factors at about 30 percent of the total variability of emerging market spreads throughout the 1990s and at over 50 percent for the period 2000–2005. In addition to these two external factors, the contagion effect arising from events like the Mexican and Russian crises, which are controlled for separately, add considerable weight to the impact of global factors during periods of international turmoil. The effect of global financial conditions does not dissipate when longer time horizons are considered for their relationship with sovereign spreads, and in fact, it becomes stronger. This means that improving creditworthiness, for example, by reducing deficits and introducing needed reforms, has a somewhat limited effect on the risk premium that must be paid, even if global conditions are free from any major financial crisis.[8]

The temporary nature of changes in the level of financial variables can be measured by calculating their level of “mean reversion.” Mean reversion measures the tendency of financial returns that are temporarily very high or low to return to average levels rather than continue to be high or low. Mean reversion would characterize a market in which bubbles, that is, divergences between market and fundamental values, often emerge, but beyond some limit they are eliminated by market forces (Poterba and Summers, 1988). Most studies of mean reversion have focused on looking for the presence of bubbles in the stock market. Given that bonds have a maturity date and a well-defined principal value at that point, it is not possible to have a rational bubble. Just before maturity, the price of the bond cannot deviate from its principal (discounted by a small time factor), and since that value is known, so is the price of the bond a little before that, etc. Because of this, a rational bubble can never get started, in contrast to the case of open-ended securities like equity. Mean reversion in EMBI spreads would be consistent with the story that panics or sudden stops drive spreads well above fundamental values and that periods of euphoria or exuberance tend to narrow spreads excessively.

In fact, the EMBI tends to return fully to previous levels within 24 months of any sudden stop. This feature seems to be exclusive to emerging bond markets, as it is largely absent from other bond markets in the United States and is much lower in equity markets. For example, U.S. equities, as measured by the Standard & Poor’s 500 index, have been found to display a certain degree of mean reversion, but this is 10 times smaller in magnitude than the EMBI’s mean reversion. High-yield (junk) bonds in the United States show virtually zero mean reversion. The magnitude of the mean reversion found in the EMBI using various specifications of the length and nature of the statistical procedures is quite high—about 10 times the level found in studies of the U.S. stock market—and takes place over periods which are significantly shorter (see Borensztein and Valenzuela, 2006).

As documented in various studies, the dynamics of the emerging bond market seem to be quite different during tranquil periods and during periods of market distress. When this feature is allowed for in calculating mean reversion, a strong contrast emerges. Periods of tranquility tend to persist, while periods of turbulence show a much stronger tendency to be reversed. The same is true when the technique is applied to other bond indices such as those for high-yield bonds. Interestingly, the periods of tranquility and turbulence that the model identifies for these different indices do not always coincide, as shown in Table 5.4. The Tequila effect in 1994–1995 and the Asian crisis in 1997 did not affect high-yield markets in the United States, but the Russian crisis of 1998 did. Similarly, the NASDAQ crash in 2000 did spread to the emerging bond market (in addition to its impact in U.S. markets) but did not very significantly affect many Latin American countries on an individual basis.

Volatility and contagion are a reason for concern because they may become a bigger problem than temporary high spreads and liquidity shortages. It is possible for negative expectations to become “self-fulfilling,” and what started as a more or less unwarranted market run may create a dislocation in a country’s domestic economy that seriously impairs the country’s repayment ability. This may happen because the international market “closure” may trigger high domestic interest rates and sharp exchange rate depreciations, especially if the country’s debt is short term and international reserves are not plentiful. These may have a large negative impact on the domestic economy, especially when the banking system is vulnerable to such shocks. Sometimes, the policy response may result in deeper crises, such as when the government resorts to general deposit freezes to protect the weakest institutions, with devastating effects on economic activity. The result is that the creditworthiness of the country will be severely impaired, as the recession hurts government revenues and the burden of debt soars with the cost of bank rescue operations and the effect of the exchange rate depreciation. An initially unwarranted panic has thus resulted in a real insolvency problem (see Calvo, Izquierdo, and Talvi, 2005, and the discussion in Chapter 11).

Credit Ratings

Low credit ratings can be an important determinant of high cost and unreliable access to international bond markets. There is a fairly close relationship between the credit rating assigned to a bond by the main rating agencies and the spread over U.S. Treasury bonds that the issue pays in the markets. Although, as will be shown below, the direction of influence may run both ways—namely, an increase in spreads may sometimes prompt the rating agencies to downgrade a sovereign—there is no doubt that a bond’s credit rating is an important factor in the consideration of most investors. Moreover, the rating determines the asset class in which a security is included, and this determines the group of investors that may consider including it in their portfolios. Typically, an “investment grade” rating—with which the agencies signal a security that has a low risk of going into default—qualifies an asset to be part of the portfolio of many institutional investors like insurance companies and pension funds. Some of these investors are required by regulations or their own charters or policies to restrict their holdings to investment grade issues. Thus, a sovereign that obtains an investment grade rating gains not only more favorable spreads but also a broader and more stable investor base and market access.

Emerging market economies started to seek credit ratings in the 1990s, when they started to issue bonds in the global markets once again. Before the 1990s, Standard & Poor’s rated only a dozen sovereigns, almost all of them in the top (AAA) rating category. Similarly, Moody’s had rated only 11 countries up to 1980, and all of them were in the investment grade range.[9] This means that there is a fairly short experience with sovereign ratings for use in observing their evolution, especially compared with the century-long corporate ratings (Moody’s, 2003).

Although the ratings of some Latin American sovereigns have improved steadily in recent years, most countries still have not achieved good ratings. In fact, the broad distribution of credit ratings, shown in Table 5.5, has hardly improved since mid-2000, which is the point at which the emerging market asset class had recovered from the Russian-LTCM turbulence and had not yet been hit by another major global shock. As of June 2006, only two countries in Latin America enjoyed an investment grade rating: Chile and Mexico.

One reason why credit ratings are important is that there is a close relationship between credit ratings and spreads. Figure 5.5 displays that relationship for sovereigns, U.S. firms, and firms in emerging economies on September 1, 2005. The steeper slope of the sovereign spreads curve tends to hold regularly. It may perhaps reflect, at the low credit ratings end, the expectation of a longer and more uncertain recovery process in the case of sovereign defaults. The figure suggests that sovereign ratings have a sizable impact on the cost of borrowing. At lower rating levels, a single-notch downgrade may represent 50 basis points in spread.

Although the rating agencies claim that their success in predicting sovereign defaults is comparable to that in predicting corporate defaults (Moody’s, 2003), there have been some conspicuous cases of misjudgment. In the Asian crises, the rating agencies were criticized for reacting too late (Adams et al., 1998), and later for overreacting, most notably in the case of Korea (Reisen and von Maltzan, 1999; Huhne, 1998). Famously, Uruguay maintained an investment grade rating until early 2002, even after a financial crisis had already erupted in Argentina and even in Uruguay itself. Only months later, Uruguay had no option but to restructure its sovereign debt. In determining sovereign ratings, the credit-rating agencies look at a five-year horizon, evaluate a number of economic and political factors, and make a qualitative and quantitative assessment of the government’s financial prospects. Yet Cantor and Packer (1996) find that eight variables explain more than 90 percent of the variance in sovereign ratings assigned by both Moody’s and Standard & Poor’s: per capita income, GDP growth, inflation, fiscal balance, current account balance, debt-to-export ratio, an indicator variable of advanced economy, and an indicator variable of default since 1970. And in fact, one variable (GDP per capita) explains 80 percent of the cross-country variance in credit ratings.

There is, however, no consensus among researchers on the failings of the rating agencies. Some studies have claimed that the agencies aggravate financial crises by being excessively procyclical in their ratings (Ferri, Liu, and Stiglitz, 1999). More recent research, however, concludes that ratings are in fact too sticky rather than excessively procyclical (Mora, 2004). Although cases such as Uruguay in 2002 are extreme, precipitous declines in the agencies’ estimation of countries’ creditworthiness are not rare. Table 5.6 shows that rating agencies’ perceptions of sovereign creditworthiness can change quickly. Leaving aside the case of Venezuela, the top panel of the table displays 13 cases of defaults. In almost half of these cases (six), the rating was closer to investment grade than to default just one year before the default.[10] The Institutional Investor ratings of the 1980s, displayed in the bottom panel of the table, give an even starker picture. One year prior to the occurrence of default, over 90 percent of the ratings were closer to investment grade than to default. In fact, in almost 40 percent of the cases, the rating was the equivalent of investment grade in the rating agencies’ scales.

There is some evidence that changes in ratings are themselves influenced to some degree by movements in spreads. Event studies show that spreads start to widen weeks before the announcement of a downgrade in ratings (Figure 5.6). In fact, there seems to be no change in spreads in the days following the announcement. In the case of upgrades, spreads also tighten weeks before the announcement, but the effect is smaller than in the case of downgrades. In part this may result from the agencies’ reacting more slowly to the same news as the market, which could be expected to be the case. It is also possible that the movement in spreads reflects to some extent the market expectation of a downgrade or upgrade by the credit-rating agencies. However, the same anticipation of spreads holds in the case of announcements of changes in the credit outlook for a country. This type of announcement indicates that the rating agencies are studying a possible change in rating, a sort of early warning to limit the element of surprise if eventually the agencies decide to change the rating of a borrower. Thus, outlook changes should be more difficult to predict from the market than changes in rating, yet spreads tend to move just as much before changes in rating outlook as well. This suggests that the ratings actions of the agencies are themselves influenced by the market prices of a sovereign’s debt as well (see González Rozada and Levy Yeyati, 2006)

Another important cost of a low sovereign credit rating arises from its significant influence on the ratings achieved by private companies and banks in the country in their international borrowing. Up to 1997, the rating agencies applied a “sovereign ceiling” to the ratings assigned to private borrowers, which meant that no firm in a particular country could obtain a rating higher than that of the sovereign. Although the policy has been progressively relaxed, sovereign credit risk continues to be a key consideration in the assessment of the credit standing of banks and corporations. The main argument is that governments facing a situation of financial distress or default may force private sector defaults by imposing exchange controls and other restrictive measures. Although, post-1997, the sovereign rating is no longer an absolute ceiling, the influence of the sovereign rating is still significant. Borensztein, Cowan, and Valenzuela (2006) show that over the past 10 years, 79 percent of emerging market corporations received a rating lower than the sovereign, 15 percent received the same rating as the sovereign, and only 5 percent received a rating higher than the sovereign. In banks, 88 percent of the sample received a rating lower than the sovereign, 10 percent received the same rating as the sovereign, and just 2 percent received a rating higher than the sovereign. The study concludes that, after indicators of creditworthiness of the firms and macroeconomic conditions in the country are controlled for, sovereign ratings are a significant factor affecting private ratings and can imply an onerous burden for private borrowers in emerging markets. On average, a two-notch slip in sovereign rating implies roughly a one-notch decrease in private ratings. For banks, the effect is even larger. For a prime corporation operating in the average emerging market economy, this effect can add 100–200 basis points to the cost of borrowing. The effect varies across countries and time, as there is a stronger effect in developing countries and prior to 1998. It is also asymmetrical: sovereign downgrades have a somewhat stronger impact than upgrades, while the impact of changes in sovereign rating on private ratings is stronger if the private rating was approaching the sovereign ceiling in the previous period.

Has Volatility Abated?

Emerging market spreads have been on a downward trend in the past few years. As of May 2006, the EMBI was at an all-time low since its inception in the 1990s. With modest financing needs—thanks to strong fiscal positions—governments have an easy time finding willing investors for their new placements. Under these favorable conditions, governments have been able to begin improving the profile of their obligations and increasing the share of domestic-currency-denominated instruments, which for the first time are also attracting the interest of international investors. Private corporations and banks in Latin America are also coming to international debt markets in record numbers. Although market volatility and spreads increased in May 2006 under the perception that U.S. interest rates were going to be raised more than previously expected, the increase in emerging market spreads was modest compared to that in previous similar episodes. Has market dysfunctionality been cured, or is this only another temporary period of calm before the next storm breaks?

Whether the current favorable trends will constitute a durable change depends on the nature of the forces supporting the current environment. Has there been a change towards a more stable investor base for emerging markets? Is the increase in investors’ appetite for local currency instruments a reflection of a desire for portfolio diversification or merely the response to a temporary profit opportunity? Have fiscal policies and debt management policies in Latin America benefited from the lessons of the turbulent 1990s, and have critical vulnerabilities been reduced?

There are some signs that the environment has changed so as not to be conducive to sudden stops. Policies have strengthened in the Latin American countries, indicating that the experience of past crises has not been in vain. Against the backdrop of strong economic performance, primary surpluses have increased significantly in many countries, supporting a reduction in debt-to-GDP ratios and improving solvency positions. Countries hold much larger reserves than a decade ago and less short-term debt, which reduces their external financing needs and allows them to be better prepared to face unexpected shocks. The region is also taking advantage of favorable terms of trade and strong foreign demand and showing a steady improvement in current account balances (Figure 5.7). Argentina, Brazil, and especially Venezuela are enjoying large current account surpluses. (Venezuela is excluded from the calculations underlying the figure because its current account surplus of 20 percent of GDP makes it a significant outlier.) Although many firms and economic sectors may still be dependent on foreign financing, a current account surplus in a country implies, in principle, that the country as an aggregate could satisfy all of its financial needs domestically.

There is also some evidence of a progressive process of learning in which investors are increasingly able to better assess risks on the basis of fundamentals and differentiate countries on a firmer basis. It should be recalled that when the emerging bond market came into existence in the 1990s, economic information was harder to come by and often less accurate. Some of the most important currency crises of the 1990s came as complete surprises, in part owing to the lack of information—or the presence of inaccurate information—on the level of international reserves. Today, much more economic and financial information is available about each country, and governments make an effort to disseminate it through investor relations offices and other means of communication. This helps investors better assess risks and differentiate among countries.

The increasing sophistication of investors is also reflected in their demand for local currency instruments, inflation-linked bonds, and the recently issued Argentine GDP-linked unit. Since 2003 three Latin American countries (Brazil, Colombia, and Uruguay) have placed domestic-currency-denominated government bonds on foreign markets for the first time. In the private sector, several Brazilian and Mexican banks and corporations, among others, have been able to float bonds denominated in domestic currency abroad as well (see Box 2.4). These bonds are in local currency, as noted, and are reasonably long term (they mature between 2010 and 2016). These are very important first steps toward creating a more resilient profile of external debt. The question is whether they can be followed with further issues and at costs that do not make them prohibitive. Entrenched expectations of inflation and weak creditor rights (a combination of weak contract enforcement and the presence or expectation of capital controls) have often resulted in high risk premiums on domestic-currency-denominated debt, and governments have often turned to foreign currency borrowing because of the high cost of borrowing in domestic currency.

Attracting international investors to domestic currency instruments may provide the opportunity to lower the steep cost of such instruments and extend their maturity. In Colombia’s November 2004 issue, primary spreads were 20 to 50 basis points below those on comparable domestic bonds (Tovar, 2005).[11] In Brazil’s case, the international bond was a 10-year-maturity, fixed rate instrument, and the government simply does not have recourse to this kind of financing in the domestic market on a reliable basis. Domestically placed Brazilian reais bonds are typically floating rate instruments that adjust with the overnight rate; the yield on Brazil’s international bond was 13 percent, while the overnight interest rate has fluctuated between 16 and 20 percent in Brazil, over the past two years. International investors may find reais bonds issued under New York governing law and settled in U.S. dollars more attractive as a result of their lower risk of being subject to capital controls and other taxes (Amato, 2006).

There are also increasing opportunities for countries to issue new types of instruments that provide a measure of insurance against various risks that affect their economies. The active market that is developing on the Argentine GDP-linked unit is one indicator of such opportunities. Small amounts of this type of instrument were issued before, most notably in many Brady deals, but generally failed to attract any trading interest. But investor interest in this type of instrument seems to be on the rise, as also shown by some more exotic instruments. Recently, the World Food Program, a UN agency, sold futures on Ethiopian rains, effectively obtaining an insurance policy that pays the agency a sum of money in case of drought. In this way, the agency has access to liquid funds to distribute among farmers faster than is possible through traditional aid channels.[12] In another interesting example, pension funds in England have sold “longevity bonds” that insure them against an increase in their liabilities arising from demographic changes. And Mexico has issued “catastrophe” bonds that provide coverage in case of earthquakes of large magnitude in the most affected areas. It should be noted, however, that investor willingness is only half of the requirement for developing country insurance instruments. Political problems and the relative complexity of the operations tend to be serious obstacles. Commodity prices, for example, have a major impact on the economies of many emerging countries; although futures markets are fairly available at certain maturities, countries have nonetheless made little use of them (Chapter 14 discusses these issues).

It is believed that the investor base in emerging market bonds has been widening since 2003 to include a broader group of dedicated investors, such as retail investors from Asia and Middle Easterners with “petrodollars.” Investors such as pension funds and insurance companies have also been in a process of broadening their portfolios by incorporating new asset classes, and now it seems to be the turn of emerging market debt. These “strategic accounts” are believed to follow a buy-and-hold policy and thus provide a more stable source of demand. These developments may contribute to reducing market volatility for two reasons. First, a more diverse investor base would contribute to stability, because investors who follow similar strategies tend to react in the same way to news of economic shocks. Second, investors with a longer horizon are more likely to focus on the economic fundamentals in the borrowing countries rather than chasing current trends.

But there are also reasons to be cautious in interpreting the current situation too favorably. For starters, the improvement in fundamentals, while noticeable, is quite difficult to characterize empirically. In particular, while economic fundamentals are undoubtedly stronger throughout the region, their strength is in great measure due to external factors, such as terms-of-trade improvement and growth in the global economy, as well as abundant liquidity and relatively high investor risk appetite. Indeed, a large fraction of the decline in spreads (and yields) can be attributed to these positively correlated global drivers rather than to more robust improvements in economic fundamentals.

In fact, the current level of the EMBI spreads appears to be lower than could be predicted based on current conditions, applying a fairly standard model to explain spreads (Figure 5.8). Using a set of standard variables measuring macroeconomic conditions in the borrowing country and a few variables that characterize the situation of global financial markets, the model predicts spreads as indicated by the shaded area in the figure.[13] Actual spreads have been significantly lower than predicted over the past three years, by as much as 200 basis points. Furthermore, if one assumes that favorable global conditions will not prevail and that global variables will have values equal to their sample average instead of current values, the discrepancy is even larger (Figure 5.9). While the model used for this exercise has not been tested extensively and no claim is made about its predictive accuracy, it does represent a fairly standard approach to explaining spreads. A similar exercise that was conducted in 1996 also found that spreads were “excessively” low, and this was just months before the Asian crises (Cline and Barnes, 1997).

In this context, some question whether the policy framework has improved to take full advantage of favorable external conditions. If the current confluence of high export prices, strong demand in the global economy, and low interest rates were to alter for the worse, there would be no guarantee that Latin American economies could meet such a challenge without difficulty.

As for the widening of the international investor base, it has been noted that, in addition to strategic investors, hedge funds—whose assets have grown exponentially in recent years—seem to be gaining in importance in emerging market debt markets. Hedge funds pursue investment strategies to take advantage of market anomalies and in the process contribute to making such anomalies smaller, which should be considered a positive factor for market stability. But hedge funds usually hold highly leveraged positions. This implies that, in a downturn, they may need to liquidate their holdings immediately, which may turn a market downturn into a full-fledged crisis. Memories of the impact of LTCM’s collapse in the altered markets of the post-Asian and Russian crises certainly suggest caution in regard to large hedge fund activity.

More generally, there may be doubts as to whether international investors’ current appetite for local currency instruments is permanent and whether corporations will follow where governments lead. Ample liquidity has made for unusually favorable conditions for emerging economies on global markets; if central banks continue to raise interest rates and drain that liquidity and there is a flight to quality on the part of investors, it is not clear that an appetite for Latin American bonds will in fact survive.

The massive growth in credit derivatives has introduced a new element that can change the nature of bond markets in ways that are still not fully understood. Credit default swaps (CDSs), for example—securities that insure against the event of default in an underlying bond—have grown to the point that, although direct data do not exist, such credit derivatives have been estimated to amount to about 50 percent of the face value of emerging markets’ international debt securities.[14] The purchaser of CDSs pays an annual premium to the seller and, in the case of default, can sell the underlying bond and receive the full face value from the insurance provider. But the buyer of the CDS does not need to own the bond, and thus this derivative instrument provides a simple, low-cost method of “shorting” a bond. If an investor has a negative view of the debt of a certain borrower, he or she can purchase CDSs on the underlying bond. If the investor’s expectations prove correct, the spreads on the underlying bond will widen, and the annual rate on the CDS will likewise increase. The investor can sell the position for a profit at that point or enter an offsetting CDS transaction, assuming the opposite side this time. This means that the volume of credit derivatives could increase out of proportion to the existing underlying bonds and that tracking who is assuming what risks may become very difficult for a financial markets regulator. At the other end, the seller of insurance can take a highly leveraged position by obtaining a rate of return comparable to that of the underlying bond but without needing to disburse the money that would have been necessary to buy the bond.

The sharp growth in the CDS market could be a positive development in providing for a better risk distribution and more complete markets. Institutions like banks or other investors can more easily adjust the degree of exposure that they wish to have against certain credit risks. But with a relatively new and complex instrument—the CDS market on U.S. corporate debt, for example, did not take off until the late 1990s—there is always the risk that some investors will take large positions without understanding them very well and that a shock may cause the market to unravel. A scenario could arise in which conditions turn unexpectedly for the worse in the underlying country, and institutions that have taken highly leveraged positions will incur large losses that they may be unable to absorb.