The growing role of Latin American currencies

When the sovereign debts of both Brazil and Peru were upgraded to investment levels by international rating agencies in the first quarter of 2008, the two nations joined an exclusive club of financial winners whose other two Latin American members were Mexico and Chile. Mexico’s debt became investment grade in 2000, while Chile’s achieved that status in 1992.

A common denominator of policymakers in the four countries was a sustained effort to diversify their national debt structure and convert a greater portion of it into national currencies as opposed to U.S. dollars. An international investment grade debt rating is desirable, because it helps drive down interest rates and attract investors, contributing to economic growth and stability.

As the debt ratings of other countries approach investment grade, national currency has steadily assumed a greater position in their debt structure while the foreign monetary component has simultaneously fallen. According to a study by the IDB Research Department, the foreign currency composition of the public debt of the seven largest economies of Latin America fell from 65 percent in 1998 to 38 percent in 2007.

Underlying the growing role of local currency in debt composition is a concern that what is a bargain today – relatively cheap dollars – could become prohibitively expensive in the future. Moving more debt into national currency is a  hedge to prevent monetary mismatches and a repeat of the financial shocks that hit  many emerging economies during the 1980s and 1990s. Countries that assumed a heavy debt in dollars when the dollar was cheap found themselves pushed into financial crises later down the road when they were forced to devalue because of capital market pressures.

The hedging strategy survived its first test of the 21st Century. During the recent U.S. mortgage crisis and resulting financial stress, Latin America’s financial systems proved to be surprisingly resilient and emerged intact, helped by a favorable international liquidity environment.  In decades past, a financial crisis of that magnitude in the United States could have produced severe economic reversals in the entire hemisphere.

International rating agencies offer concrete incentives for countries to maintain a well hedged debt structure. They see a strong local currency component of a national debt as one of many signals of monetary stability and an improved national investment climate.

Debt ratings go up

A country with a responsibly managed debt burden can expect its investment rating to “go up one or two notches” if the proportion of local currency in its debt structure grows significantly,  says Samuel Fox, a senior director of Fitch ratings. “This is a general trend, not a hard-and-fast rule,” he says. If a multinational company in Brazil receives it revenue in dollars, “then we don’t mind its debt being in dollars. We look at the relative size of the debt.”

Juan P. de Mollein, managing director of Latin America/Emerging Markets Structured Finance at Standard & Poor’s, notes that “having local currency financing opportunities available not only expands opportunities for firms, but in the long run it may also reduce the cost of doing business.”

Claudia Calich, a portfolio manager for Invesco of New York, says an emerging economy that resists the temptation to take out excessive dollar debt when dollars are cheap has a better chance of becoming more resistant to boom and bust economic cycles.  Slow and steady growth is better for a country than volatility, she adds, and “at the end of the day, what is good for the country is good for investors.”

What proportion of a national debt should be in national currency as opposed to dollars or another foreign currency? Here debt managers differ.

In Peru, where both the U.S. dollar and the national currency circulate freely, the government’s strategy is to gradually move more debt into the national currency – a strategy that paid off in April of 2008, which Fitch Rating awarded Peru’s debt an investment grade. Peru’s debt composition moved from 6.3 percent in local currency in 2000 to more than 36 percent in 2008. At the same time, notes Fernando Vasquez, deputy manager of economic policy at Peru’s Central Bank, the sol, the national currency, gained strength in the banking system. In 2000 the dollar accounted for 70 percent of the country’s monetary liquidity, while in 2008 it accounted for 40 percent, says Vasquez.

In Brazil, local currency accounted for about 92 percent of the country’s sovereign debt in 2008 compared with 60 percent in 2000. The government is comfortable with the current debt composition, which took decades of effort and policy experience to achieve, says Otavio Ladeira de Medeiros, head of the Strategic Public Debt Planning for Brazil’s National Treasury. He says policymakers need an “understanding of the debt and its relationship to assets and liabilities, revenues and expenditures.” It is also important to “move in the direction of predictability” and to convince national and international investors “to believe in our currencies,” he adds

Resistance to dollarization

Multilateral institutions, such as the World Bank and the IDB, are encouraging Latin American countries to structure their national debts with a greater proportion of local currency. As part of this policy, these institutions in recent years began issuing bonds in Latin American currencies and offering countries financing in their local currency under certain conditions.

IDB economist Alejandro Izquierdo observes that Latin American debt managers were successful in aggressively changing the currency composition of their debt portfolios.  Nevertheless, he cautions against being lulled into a false sense of security, because this change in currency composition took place in the context of expectations of currency appreciation that made the restructuring easier.  However those expectations could change, and this will affect the willingness of investors to hold domestic currency securities, according to Izquierdo. He notes that in 1993 only five percent of Mexico’s debt was indexed to foreign currency on the eve of a financial crisis. Once the nation’s financial system experienced a shock, investors demanded that debt rollovers be denominated in dollars. Within a year after the crisis, the foreign currency composition of Mexico’s debt increased to 67 percent. Following many years of financial recovery, that debt structure was transformed once again. Now more than 80 percent of Mexico’s debt is in local currency.

The lesson from the Mexican crisis of 1994, says Izquierdo, is that Latin America’s debt managers must not only aggressively build up the presence of national currency in the national debt structure, but they must also "be prepared to deal with a trend toward dollarization when bad times come."

To help build stronger and more resilient national debt structures, debt specialists from 26 nations in Latin America and the Caribbean launched the LAC Debt Group in 2005 to exchange ideas and experiences and to strengthen national finances. The IDB serves as executive secretary of the group.