Capital market reforms have enhanced liquidity but more change is needed
March 27, 2019 |
Markets have experienced sweeping change. But further regional integration and investment diversification are needed
When the subprime bug infected the US in 2008, European and Asian countries were soon affected. Then, as experts anxiously waited for the fragile economies in Latin America to follow suit as emerging markets had in previous crises, something unusual happened. Some of the biggest economies in the region, such as Brazil, Colombia and Chile, emerged relatively unscathed.
The resilience displayed by Latin American economies at the beginning of the global financial crisis can be traced to several factors. But none is more important than the evolution of regional capital markets. Once addicted to the US dollar, Latin American economies took measures to create domestic demand for financial assets that enabled governments to fund their activities and companies to raise capital—all with local currency. This prevented the kind of capital flight that occurred in the 1980s and 1990s. Today, Brazil and Mexico rank among the most liquid and widely traded emerging markets, while Chile is often cited for its healthy investment environment.
Pension fund reform was key in the transformation of markets in the region. Chile was the first to introduce a radical reform in 1981. Peru followed in 1992, while Mexico and Brazil approved changes in 1997 and 2001, respectively. Subsequent reforms eliminated many of the antiquated restrictions that placed severe limits on fund investments. These not only constrained fund performance but prevented market access to the biggest source of liquidity in the region.
AFPs, Afores and Fundos de Pensão have since become major players in domestic capital markets. In Brazil, pension funds had BRL873bn ($237bn) in assets under management as of September 2018, according to Previc, the industry regulator. This money has traditionally flowed mostly to government bonds, helping the Brazilian state to fund itself without borrowing too many dollars. According to the Brazilian Treasury, in 2004, almost one-third of the federal government’s debt was denominated in dollars. Currently, the ratio hovers around 4%.
“It is necessary to develop local markets through a curve of government securities. Brazil has done it, and it was no small feat,” said Jonatan Plavnik, a managing director at Oaktree Capital Management.
Latin American markets have experienced a remarkable expansion in size and liquidity. The value of tradeable debt in the region grew from $300 billion to $3.5 trillion in the last 15 years, according to UBS, citing data from the Bank for International Settlements (BIS). On the equity side, the World Federation of Exchanges estimates that the market capitalization of companies listed on Latin American exchanges went from $500 billion to $2.3 trillion in the same period. “LatAm assets are becoming harder to ignore for global investors,” says Alex Czerwonko, the director of emerging markets investment strategy at UBS in New York.
Further pension fund investment diversification remains a challenge. The funds have been pressing regulators, with some degree of success, to allow them to allocate a higher share of their portfolios to international markets. Still, investment officers at pension funds in markets like Brazil still find it hard to pursue strategies that go beyond government debt.
Looking ahead, investors say they expect to see more activity in corporate debt and initial public offerings in response to demand and enhanced market practices. “Initiatives like Novo Mercado in Brazil have been a big step forward,” says Ian Simmons, portfolio adviser for Fiera Capital’s Latin America strategy. Companies that list on the exchange voluntarily adopt corporate governance practices. “Several big companies, like Vale, have gotten rid of dual share class structures and replaced them with single share class ones, which are always preferred by investors.”
In markets, such as Brazil, Mexico, Chile and Peru, minority shareholders are beginning to have their voices heard, the rights of bondholders have been strengthened and many issuers have upped their governance standards as a reaction to new investment attitudes that have trickled down from developed markets.
“Companies have become much more responsive to us when it comes to environmental, social and governance issues,” Simmons adds. “And the region now offers diversification in areas like healthcare, insurance and education that did not exist 20 years ago.”
Latin American markets are also demonstrating innovation in project finance in a quest to solve the conundrum of investing in much-needed infrastructure projects in times of tight budgets. Plavnik points to the experience of Peru, which introduced the noughties debt instruments backed by payment obligations from the government and helped attract private investors to public-private partnerships. “It is a successful experience that has created a new asset class and has inspired similar initiatives in Colombia, with the 4G road plan, and Argentina, with the new PPP program,” says Plavnik.
Mexico’s CKD is another example. A structured equity security, this investment vehicle allows institutional money to flow into infrastructure, technology, real estate and other sectors. Brazil, for its part, created in 2011 a kind of debenture dedicated exclusively to infrastructure projects which offers tax advantages for individual investors. The volume of issuance in the first 11 months of 2018 was 147% higher than in the whole of 2017, according to the Finance Ministry, and the tax incentives are expected to be soon extended to institutional investors as well.
Despite the progress made in the past two decades, sharing best market practices and promoting more investment diversification remain works in progress. More regional integration could help, says Jan Dehn, the global head of research at Ashmore in London. He cites the MILA marketplace of the Pacific Alliance, which combines the stock exchanges of the four countries. Institutional investors in the countries participating in the MILA project have easier access to a broader pool of securities, helping them to diversify their portfolios.
Although the development of capital markets still has a long way to go in Latin America, Dehn is upbeat about the outlook for capital markets. “If Latin America has been able to survive the last 10 years without defaulting, then it is extremely unlikely that it will ever have high vulnerability to contagion in the future,” he says.