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Sovereign debt: Fork in the road

Sep 1, 2013

Latin America’s economies are on increasingly divergent paths. Bond investors must now make tough choices between the likely winners and losers. By Mariana Santibáñez

When Mexican finance minister Pedro Aspe met Nicholas Brady in 1988 to discuss Mexico’s problems during the Latin America debt crisis, what he sought was a smaller debt burden for his country.

While Brady sympathized, the former US Treasury Secretary said his government’s role was simply to help facilitate the process: it wasn’t a bank; and since Mexico had borrowed money from private lenders, it needed to strike a deal to roll over its debt through more financing.

"There are a lot of lessons we learned, some of them the hard way by not being careful with our debt," says Aspe, now co-chairman of Evercore Partners, an independent investment advisory firm.

Aspe’s single most important lesson from the 1980s Latin America debt crisis was simple: no debt plan can be a substitute for sound economic policy.

In the years following Mexico’s $48 billion Brady debt rescheduling, the country’s fiscal discipline and reform momentum has given the country greater credibility. Today, it holds a coveted status as one of the most sophisticated borrowers in Latin America.

"Every country would like to be Mexico," says James Craige, head of emerging markets debt at Stone Harbor Investment Partners. "Mexico has a fully developed yield curve in dollars and pesos and only issues in dollars to keep that curve intact. They have a strong and functional local market and are a poster boy for all EM countries."

While many Latin American countries have cut their debt-to-GDP ratios, implemented structural reforms, introduced independent central banks and liberalized labor laws, others have not. The result is a widening gap between the creditworthiness of countries in the region.

"There will be continued differentiation in the market between the winners and losers," says Paul DeNoon, director of emerging market debt at Alliance Bernstein.

Alliance, which takes a bottom-up approach on picking securities, is optimistic over Mexico’s outlook, spurred by energy reforms planned for the second half of 2013. DeNoon describes Mexico as a country that has set the stage for more sustainable growth.

Market growth

Since Latin sovereigns rescheduled their way out of overbearing debt loads in the late 1980s and early 1990s under the Brady plan, their ability overall to raise cash in the bond market has improved.

This magazine cheered an impressive year for sovereigns in the international markets in 1991, celebrating particularly a $300 million Eurobond sold by Argentina. Lauded by LatinFinance as Deal of the Year in 1992, Argentina’s offering was particularly spectacular for coming before the country signed a Brady Bond agreement. Earlier that year Mexico had raised a $202 million five-year bond.

By 1993, a busy month meant Latin borrowers were selling close to $3 billion of Eurobonds. That dropped sharply 1994, though, when soaring US interest rates sent shockwaves through emerging markets.

All the same, those deal sizes look tame today. Now the best-rated sovereigns can easily raise $1 billion in a day. The progress is due to a number of factors. Local markets have developed and currencies, especially the Mexican peso and Brazilian real, have become increasingly liquid.

But the progress is as much about political decisions as it is about market depth. "It is not a story of debt and debt management but a broader story of macroeconomic policy," says Gerardo Rodríguez former undersecretary of finance and public credit in Mexico and now managing director at investment firm BlackRock. "Mexico has been a front runner in innovation and experimenting with the non-obvious in Latin American and EM debt markets."

Since Chile took the first Latin investment grade rating in 1992, the region has evolved from a predominantly sub-investment grade market to one where around three-quarters are rated triple-B or higher. Freer markets and stronger rule of law were also critical in paving the way for capital markets for both debt and equity to develop, says Roberto D’Avola, head of LatAm DCM at JPMorgan.

That is not to say that only the strongest countries can tap debt markets: single-B rated Honduras sold its debut dollar bond in March, a couple of months after double-B Paraguay pulled a similar trick. Nevertheless, volatile economic policies and debt management strategies in countries such as Argentina, Ecuador, Bolivia, Belize, and Venezuela generate worries among some international investors looking at Latin America.

Ecuador, for example, was stymied by a history of default – in 1999, it called for renegotiations on its Brady Bond debt only to default again in 2008 – when in mid-2013 it considered a bond market return. And Argentina has spent more than a decade wrangling with global investors after stopping payment on $144 billion of debt in 2001.

"This can lead to the perception the entire region is a political mess," Craige says. "The reality is these countries are outliers. Argentina will continue to blame others for their problems 20 years from now, but for every Argentina we have Peru, Panama, Colombia and a host of others that took the responsibility upon themselves to address their debt overhang, high inflation and sub-par growth to become investment grade. They will continue to prosper as a result."

Penelope Foley, co-manager of the TCW EM Fund which has $130 billion of assets under management says: "The big change from the last 10 years, and for the next 10, is the recognition that emerging markets as a class will not lock-step together as a unit."

Two giants

As the emerging market investor base deepens, portfolio managers are taking a closer look at the differentiating factors between Latin America’s sovereign borrowers. The region’s two largest economies, Mexico and Brazil, are examples of countries heading in different directions.

"Mexico began a very strong reform momentum," says Marcela Meirelles at TCW. "Brazil unfortunately is going through ad hoc measures focused on boosting consumption and has more underlying obstacles for higher growth rates. These are two different extremes on how proactive the governments have been."

Commodity exports to China have supported a number of economies over the past decade. Those countries – such as Brazil – are likely to feel the effects of lower demand as China’s growth moderates.

"Some countries have been lucky. And other countries have been working hard to improve fundamentals," says Michael Chamberlin, executive director of the Emerging Markets Trade Association, and a former partner at law firm Shearman & Sterling, where he worked on Mexico’s Brady bond debt rescheduling.

But those that did the best were also those that worked hard at reforming their economies and legal infrastructure.

"It is important to look at what Latin American countries have done to improve fundamentals," says Uruguay’s debt management head Azucena Arbeleche.

"We have been favored by a lot of liquidity, but some countries have done reforms and have improved their fundamentals," she says.

"LatAm countries can offer good quality paper. At the same time LatAm investors increasingly demand assets in which to allocate their pensions fund savings. We have already seen an increase in cross-border investment from pension funds and insurance companies in LatAm."

Sovereign funding has moved from bank loans to bonds over the last quarter century. With that, new frameworks for crisis resolution are emerging, Arbeleche says. She highlights renewed focus on the role collective action clauses (CACs) could play in resolving sovereign debt problems.

The most important of these is the majority-restructuring clause, by which a qualified majority of bondholders can vote to alter the payment terms of the bond and make these changes binding even for dissenting bondholders.

Aspe says reform is a process that takes decades and is ultimately influenced by the politics and culture of the country in question. His advice to Latin America’s emerging markets: patience and consistency. "There will be fruit, but the harvest will not come tomorrow. Sometimes it comes five to 10 years [after planting the seeds]." LF



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