A new risk of default

As the tequila crisis triggered by Mexico's devaluation of December 1994 begins to recede into the past, Latin America is breathing more easily. So are most holders of Latin sovereign debt, who not long ago had seen Mexico come to the brink of default and had begun to question the sustainability of economic models in Argentina and Brazil.

Mexico, thanks to a $50 billion international rescue package spearheaded by the US, did not default. Neither did Argentina which, with the help of a $7 billion IMF-led cash injection, stuck to its economic guns. Brazil, too, did not waiver and has continued to consolidate gains in its battle against inflation while pushing steadily ahead with economic reforms.

Last year's crisis "tested the resilience of the region, but it withstood it without defaulting", says Jerome Booth, head of research at ANZ Bank in London. Governments did not swerve in their policy programmes, but went so far as to consolidate reforms in the face of crisis. Argentina even pushed through swingeing spending cuts and tax increases only weeks before presidential elections in May 1995.

Having seen Latin countries pass their test of fire, "we have to come to the conclusion that the default risk is now much lower," says Booth. "In the 1980s, it took a decade for the region to recover [from the 1982 debt crisis], during which it had to concentrate on stabilization and crisis management, not structural reforms."

This time round, structural reforms have been hastened, while return to the international financial markets has been incomparably quicker. "Last year, we saw the biggest stress test these markets can go through and access to [voluntary] international finance was closed down for the first half of 1995," says Tulio Vera, head of sovereign debt research at Bear Stearns. "But, after six months, the countries began to access markets again."

The cost of regaining international confidence has often been high. Last year, Mexico suffered its worst recession in 60 years, with GDP dropping some 7% as resources were switched from domestic needs to meeting short-term debt obligations and closing the yawning current-account deficit. Real living standards have plummeted and more than a million Mexicans have been thrown out of work. In Argentina, where $8 billion ­ a huge 18% of the financial system ­ fled the country virtually overnight, the economy was also slammed into deep recession by the reform programme, contracting 4.4% in 1995. Unemployment hit record heights of 18% and social tension is increasing.

There are now signs of faint economic recovery in Argentina and healthier growth in Mexico. But such domestic hardship raises the question of whether governments will find it politically sustainable to continue applying austerity measures at home in the interests of maintaining investor confidence abroad.

Michael Atkin, director of the Latin American department at the Washington-based Institute of International Finance (IIF), acknowledges that there is political pressure to default but believes this is unlikely to happen. "It is clearly easy for a populist politician to say: 'Why are we paying, for example,
$1 million a day to greedy people in Wall Street when children are dying of malnutrition in the slums.' But, in general, in Latin America that kind of populism is out of fashion."

"It isn't necessarily the case that you can just say you're not going to service your foreign debt, and then take those resources and put them into a mother-and-child nutrition scheme, making the country all of a sudden better off," adds Atkin. "Experience shows us that this is not the case. If it were, Latin America, which for much of the 1980s was not servicing its debt, would be in a much better position than it is in today."

ANZ's Booth agrees that the average Latin American now puts much greater store by "getting economic policy right". That, plus the narrowing political agenda, "means it is no longer politically sensible ­ it never was economically sensible ­ to start defaulting on debt. The electorate doesn't buy that rhetoric any more."

But, as last year's crisis showed, default risk can emerge with little or no warning. Sudden loss of confidence can provoke rapid capital outflows that can leave the most solid-looking economy gasping for resources. "All three countries have a vulnerability to capital flows suddenly stopping," says Geoffrey Dennis of Bear Stearns. Business newspapers in Latin America pay as much, or more, attention to US interest rates as to their own countries'.

Bear Stearns' Vera warns: "After all, we are talking about speculative-grade countries with ratings of BB or below. You can never categorically say about any of them that they will not have problems servicing their debt."

Argentina: the price of rigidity

Argentine sovereign debt carries the highest risk premium of the three big Latin economies. In mid-August, Brady bond stripped-yield spreads ­ which remove from the calculation the portion collateralized by US treasury bills ­ had Mexico at 631 basis points over T-bills, Brazil at 709bp and Argentina at 818bp. By comparison, Venezuela, which at least until recently had been considered the continent's economic basket case, was trading at 830bp ­ only 18bp above Argentina.

Argentina, which perhaps more than any other Latin country has stuck rigidly to policy continuity in the face of extreme pressure, is paying the price primarily for its currency board system, which has been in place since 1991. This system, known locally as convertibility, pegs the peso to the dollar and prevents the printing of local currency unless it is backed by foreign inflows.

The purpose of convertibility was to ensure fiscal restraint and to restore value to the peso, which had become worthless after two bouts of hyperinflation in 1989 and 1990. But the side-effect is that the Argentine government is left bereft of policy tools, whether to influence the exchange rate or the level of interest rates. Every dollar of debt-servicing must be squeezed out of the local economy, where the tax take has been weak because of recession, or raised in international markets.

According to recent economy ministry figures, the external debt ­ of which 83% is public ­ has risen from $59 billion at the launch of convertibility to $91.5 billion this year. Total public debt, comprising sovereign paper held by Argentines and foreigners, has risen by a similar amount.

Domingo Cavallo, Argentina's former economy minister, who was sacked in July, says that much of this increase is accounted for by the fact that the state has recognized debts ­ including $13 billion in pension payments ­ that went unacknowledged by previous governments. On the other hand, billions of dollars of sovereign debt was retired in the form of debt-for-equity swaps between 1992 and 1994, when Argentina's sweeping privatization process was in full swing.

Following the tequila crisis, which brought to an end a four-year period of rapid growth, the budget deficit has been stubbornly rising and adding to external financing needs. Argentina has been a frequent visitor to the international financial markets. This year alone it has raised more than $6 billion in US, Japanese and, especially, European markets. It has also depended heavily on multilateral organizations such as the IMF, the World Bank and the Inter-American Development Bank, which financed the core of the $7 billion bail-out package in 1995.

Since mid-1995, Argentina has found it easy, if fairly costly, to access the voluntary international markets. In 1997, partly because of the maturing of $2 billion in local Bocon bonds, debt-servicing payments will jump sharply to $14.8 billion, compared with $11.7 billion this year, according to Merrill Lynch.

"There's no doubt that this could be a problem, especially if the country risk goes up," says Roberto Alemann, a local economist. "Next year there is a hump in amortizations and, if we add a deficit of $6 billion, at some moment creditors are going to say: 'No, it's too risky to lend to Argentina.' "

Alemann strongly advocates tackling the deficit immediately, even if it means introducing unpopular austerity measures. In mid-August, Roque Fernandez, the new economy minister, announced a package to do just that. A combination of tax increases and spending cuts aims to save the treasury between $4 billion and $4.5 billion in 1997. "This will assure us continued access to international financial markets at a reasonable cost with respect to the issuing of new debt," he says.

Booth has a more sanguine attitude than Alemann but agrees that "Argentina has a big macroeconomic problem that is not solvable in the short term ... Its basic problem is overdependence on capital flows. The easiest solution in this case is to attract still more capital inflows, which have grown enormously in the past 18 months. But at some point the addict has to be weaned off. That will be a painful process which will require raising domestic savings rates."

On the bright side, Argentina's short-term debt has never reached anything like Mexican levels. Even with the introduction this year of Letes ­ short-term peso-denominated debt issued domestically ­ the proportion of short-term debt to total obligations is only 14.3%, according to the IIF. "Argentina's short-term debt is much smaller than Mexico's," says Shafiq Islam, chief emerging markets strategist at Credit Suisse. "At least they have a cushion to absorb the drying up of money."

Many Argentine creditors are waiting anxiously to see whether president Carlos Menem has the political resolve to deepen structural reforms in the face of growing social discontent and stubbornly high unemployment. In early August, the country was virtually paralyzed by a general strike called to protest against the economic model.

"Until congressional elections (in October 1997) there's a risk that Menem could fiddle about at the edges of policy to try to create jobs and so on in a way that doesn't threaten the whole programme," says Booth. "But that's not easy."

"They do have substantial gross financing needs in 1997, which will impose serious constraints," says Atkin. "Argentina has to retain its ability to access funds in the international markets. If they do decide to change economic policy, they will have to keep investors fully informed."

Brazil: maturity problem

Brazil's potential problems focus not on its external debt, but on a domestic debt that ballooned to nearly $200 billion last year as a consequence of spending overruns and high interest rates. Of this, according to figures supplied by Bear Stearns, R154 billion ($153 billion) is owed by the federal government and central bank, while R45 billion has been generated by the states and municipalities. Most worrying of all, the average maturity on this mass of debt is a measly four months.

"The short maturity situation imposes a tremendous risk that confidence will not be there to roll over the debt," says the IIF's Atkin. "The internal debt problem is a source of vulnerability and they need to run a tight ship on the policy front to stop the whole thing exploding in their faces."

"In Brazil the real issue is maturity. The debt to GDP ratio [total public debt is about 38% of GDP] is one the Belgians or the Italians would die for," says Dennis. "The real problem is that the majority of that debt matures within 90 days."

Confidence, and with it the ability to continually roll over debt, depends mainly on the government's keeping on track the real stabilization plan. The real plan, introduced in mid-1994, ended hyperinflation and prepared the way for the election to the presidency of its architect, Fernando Henrique Cardoso.

Maintaining the plan, which allows the real to float within a narrow band, depends mainly on success in pushing through structural changes, analysts say. Among these are privatization, deregulation and, crucially, the tackling of Brazil's structural budget deficit, for which controversial amendments to the constitution will be needed.

Rudiger Dornbusch, professor of economics at the Massachusetts Institute of Technology, recently caused consternation among Brazil-watchers by predicting imminent economic crisis. Dornbusch, long critical of Brazil's reliance on tight monetary policy as a weapon against inflation, said the real was overvalued by between 30% and 40%, and as with Mexico, this carried with it the risk of a maxi-devaluation.

Dornbusch also warned that the current-account deficit was out of control and that foreign capital, attracted by very high interest rates, could take off at any time.

Most analysts have dismissed Dornbusch's warnings as exaggerated. The real, they say, is not nearly as overvalued as Dornbusch claims, while the current-account deficit ­ at 3% of GDP ­ hardly merits comparison with the 8% deficit that helped stoke Mexico's crisis.

"Dornbusch's view that there is going to be some macro change in policy is simply unrealistic," says Booth. "The worry was there in April of 1995 when we began to think there was a chance of the real plan being derailed. But it didn't happen. They stuck to their guns. Dornbusch's comments are completely off beam. Brazil's policy continuity is extremely solid and most of the short-term worries have now disappeared."

Where Booth and others are more in agreement with Dornbusch is on the need to tackle the root cause of inflation ­ the failure to control public spending. Because of Brazil's constitution, which guarantees unsustainably high budget transfers from the federal government to the states and establishes very high social security provisions, it is impossible to maintain a balanced budget.

Last year, according to the IIF, Brazil ran a fiscal deficit of 5.5% of GDP. "Over the longer term, they need constitutional reforms that will allow the government to balance the budget or at least to run something closer to a balanced fiscal position," says Atkin.

Booth says that rather than provoking a serious possibility of default, the internal debt could "tempt the Brazilians to let inflation rise in order to erode [the debt] away". The concern is that "a build-up of inflationary pressures some time next year could lead to slippages all over the place."

But Booth believes the Brazilian economic reform process, though slow, is irreversible. Privatizations, especially that of mining group Companhia Vale do Rio Doce (CVRD), will be pushed through, he says, and state finances gradually brought into line. Brazil, like Mexico and Argentina, is over the hump in its banking crisis, which at one point threatened an unquantifiable drain on public resources. Democracy, with its associated parliamentary battles and struggle of interest groups, does slow the reform process, he says. "Policies are taking longer to implement, but at the end of the day you get far sturdier results."

Credit Suisse's Islam says the short-term debt situation, though of concern, is improving. At the end of 1995, the average maturity on Brazil's internal debt was only 2.6 months, a legacy of the country's recent hyperinflationary past. "If they didn't default at 2.6 months, things should be better at four months," he says. "At least it's going in the right direction."

Mexico: still vulnerable

Vera awards Mexico the highest marks of the three big Latin economies for its recent handling of the debt issue. "In general, what we're seeing across the region is a move towards liability management," he says. "The country that has gone furthest in that process is clearly Mexico, doing the most innovative and best job of streamlining its amortization profile and in managing its liabilities most prudently."

In July, Mexico announced it was pre-paying $8 billion of the US-led rescue package, winning approval in Washington, smoothing out potential amortization humps in 1998 and 1999, and saving an annual $125 million in interest payments. Some $7 billion was repaid to the US treasury and $1 billion to the IMF.

Mexico was able to pull off this feat largely thanks to the highly successful issue of a $6 billion five-year note. This was doubled in size from the original $3 billion after receiving a BBB minus investment-grade rating from Standard & Poor's ­ the first time Mexico has ever been awarded a non-junk rating.

The BBB minus grade, on what is said to be the largest single Eurobond issue ever, was assigned because the note was collateralized by a portion of the dollar earnings from state petroleum company Pemex, which are to be kept in an account in the Federal Reserve Bank of New York. The issue, led by JP Morgan and Swiss Bank Corporation, carries a two-year grace period and a coupon of 200bp over three-month Libor.

This was just the most spectacular of Mexico's recent financial re-engineerings. In April, it exchanged $1.75 billion of collateralized Brady bonds for a 30-year dollar-denominated global bond with a yield of 552bp over US treasuries. Goldman Sachs, Deutsche Morgan Grenfell, CJ Lawrence and Salomon Brothers managed the deal. Again, the operation lengthened the maturity of Mexico's sovereign debt and reduced servicing costs. By swapping Bradys (which are collateralized by zero-coupon treasury bonds) for paper carrying pure Mexican risk, Mexico also scored a victory in its battle to regain recognition as a reliable sovereign borrower.

Finally, in August, the government said it would seek an agreement with the IMF to lengthen the repayment schedule of $12.8 billion borrowed from the IMF at the height of the crisis. Again, this would allow it to smooth out bunching in its repayment schedule.

"All this is very positive from the point of view of creditworthiness," says Vera. "It makes debt holders feel much more comfortable."

Of even more importance has been Mexico's tackling of its notorious Tesobono problem. Tesobonos ­ the dollar-indexed, short-term central bank securities at the centre of Mexico's financial crisis ­ were themselves the product of a growing current-account deficit, which had been building since the early 1990s, reaching 8% of GDP by 1994.

Not surprisingly, by the beginning of 1994, investors had grown wary of taking on Mexican currency risk. By issuing dollar-linked Tesobonos, the government simply took that risk off their hands. The use of these securities, now viewed as a terrible error by most analysts, was compounded by poor debt management which allowed a significant bunching of maturities at the end of 1994. After the bungled devaluation, when the peso entered into free fall, the Tesobono bill ballooned and default loomed large.

Islam of Credit Suisse believes foreign investors, the main holders of Tesobonos, were as much to blame for the crisis as the Mexican authorities. "Wall Street people missed the fact that, although the currency risk was transferred to the Mexican government, ultimately investors assumed the (therefore higher) default risk. If something went wrong and the Mexicans didn't have the money to pay, then the investor would have to shoulder the burden."

Lessons appear to have been learned. The US-led rescue package allowed Mexico to redeem all its Tesobonos, no new issues of which have since been made. "Tesobonos are dead," says Islam. "That particular problem is over."

With that risk tackled, Mexican debt levels do not look too bad. According to figures supplied by the IIF, estimated total external debt as a proportion of GDP is 64.3%, while total debt service is equivalent to only 25.4% of exports. Short-term debt is 25.7% of total external debt, compared with 36.8% before the crisis broke.

But ratios only give the investor a "flavour" warns Islam and never paint the whole picture. Before the devaluation crisis, most Mexican ratios looked healthier than those of its Latin American counterparts, he says. "If you had been going by that, you would have had no idea. From these numbers, nobody could have predicted a debt crisis ... Some of the ratios you look at give you some sense, but they don't really tell you who is going to
get hit."

Although Mexico's ratios look pretty solid, Islam shares the concern of many that the country remains vulnerable to a potential shock, be it external or domestic. The devaluation crisis was unleashed by a series of political disasters in 1994, which undermined investor confidence. These included the Zapatista peasant revolt, the assassination of Luis Donaldo Colosio, the presidential candidate of the dominant Institutional Revolutionary Party (PRI) and the subsequent killing of PRI's secretary-general, Jose Francisco Ruiz Massieu.

"I am still concerned. The question is how vulnerable Mexico is to an unanticipated shock because of a domestic event, such as a political assassination, or an outside event, like a sudden rise in interest rates," says Islam. The key to default risk, he says, is not necessarily the shock itself, but the government's reaction to it. Mexico's response to the 1994 crisis was deeply flawed.

Booth of ANZ agrees. Mexican risk, he says, depends on the country's ability to stick to the reform path in the face of possible adversity. This in turn will be determined largely by the outcome of the battle at the heart of the PRI between the "reformers and the dinosaurs". Booth believes the economic and political reform process has probably gone far enough to continue regardless of personality changes. In all, he regards Mexico as "a good and improving credit story".

A way out

In the long term, analysts agree, all three countries must strive to wean themselves off capital inflow dependency by raising their domestic savings rates. In 1995, Brazil's savings rate was 20.3%, Argentina's 18.8% and Mexico's a pitiful 14%, according to ING Barings. None of these comes close to the 30%-plus rates of south-east Asia's successful economies or even Chile's 27%.

In the long run, savings rates should edge up as more and more people switch from state pay-as-you-go pension schemes to private capitalization accounts. In Chile, private pension funds have amassed a huge pool of domestic savings which have not only been an engine for growth but have largely isolated Santiago from the financing traumas undergone by the rest of the continent.

Until they can reach that happy state, though, Mexico, Brazil and Argentina are likely to remain heavily dependent on borrowing. They will therefore have to be extremely vigilant in assuring the continuation of international confidence.

As Argentina has seen, though, sticking firmly to an orthodox policy path is not necessarily enough to bring country risk down. Risk assessment, says Islam of Credit Suisse, is a long way from rocket science. Although he remains mistrustful of ratios, he believes there are some useful calculations to be made. Certainly, he says, there are better measures of a country's risk than traditional stalwarts such as import cover, which do not reflect the speed with which capital can now be transferred. "No matter how high your reserves are, capital can still flow out overnight."

Islam puts some faith in one ratio ­ the one that compares short-term debt added to the current account deficit with foreign-currency reserves. This pits the level of reserves against potentially immediate financing needs. According to Islam's calculations, this could have provided a good indication of the trouble waiting in store for Mexico in 1994. In that year, Mexico's ratio was an enormous 958, against 160 for Brazil and only 101 for Argentina.

Extrapolating data for 1997, Islam's ratios come up with some surprising results. Argentina looks to be in the most solid position with 91, Brazil is second with 163 and Mexico looks worst at 254. This order of risk is precisely the opposite of that perceived by the market in terms of Brady bond spreads.

"These ratios throw out two interesting points which go against the grain of conventional wisdom," says Islam. "First, we can argue that Mexico has lengthened its maturities, smoothed out its repayments and so on, but the fact remains that its short-term debt is extremely high vis-à-vis reserves. Its situation is better than it was, but not nearly as good as it should be."

"Second, Brazil has huge reserves [of about $60 billion], but they also have a huge amount of short-term debt. If they ran into problems they could start losing those reserves extremely quickly."

"I've been covering the debt issue since the early 1980s," says Islam. "And one lesson I've learned is that, especially in the case of foreign-currency denominated debt, if flows dry up and you have to make those payments, you're in trouble. That can happen even to countries whose ratios appear to be very solid."