Now that Latin America has got through the crisis years, investors wonder where the region might be headed next. Will the years to come bring improved economic performance, political stability and enhanced credit ratings, or will the old uncertainties continue? With Ecuador, Pakistan and Ukraine having all successfully restructured their debt in recent months, default is no longer the anathema it was a year ago. Argentina seems increasingly embroiled in a Fiscal crisis with no obvious solution bar devaluation or default, and the political situation in the Andes continues to deteriorate.
All this, as Latin America becomes increasingly dependent on the United States for export-driven growth, and therefore provides increasingly less diversification from US assets: historically, one of the main reasons to invest in emerging markets.
Ask Paulo Leme, head of Latin American research at Goldman Sachs, whether it even makes sense to think of the region as a whole any more, and he’s quick to say that “the concept of a unified bloc is no longer applicable.”
All the same, he says, “there is still a common thread, which is economic structural deficiencies. They are all economies with low savings rates, current-account deficits, and high reliance on commodity prices.” Hardly a reason for spooked US investors, who have yet to re-enter emerging markets after being burned in 1998, to go barreling back in.
And those low savings rates set up a self-reinforcing cycle: if foreign investment increases then growth picks up and investment in the region accelerates. On the other hand, without foreign investment, the region stagnates and can Find itself in an ugly deflationary spiral of the sort with which Argentina has been struggling for the past two years – precisely the conditions which make foreign investors stay away.
Even Latin America bulls don’t expect sovereign bond spreads to tighten much from their present levels. They talk instead about the coupon income should spreads stay more or less where they are. But if investors have learned anything from the past couple of years, it’s that emerging markets crises are all too common. Should anything go wrong – an oil-price collapse, say, precipitating a Venezuelan default – then the losses would be dramatic.
Even amidst success stories, such as that of Mexico, unfortunate investors can still lose out. Moody’s upgrade of the country to investment-grade status sparked a wave of euphoria, and much talk of how Mexico had now differentiated itself from the rest of the region and was more or less the 51st state of the USA. Sovereign spreads tightened so far that specialist emerging market investors lost interest in holding the country’s bonds.
“The sovereign bonds at the short end of the curve are trading through US corporate bonds that are similarly rated,” says Joyce Chang, head of emerging markets research at Chase Securities. “I don’t think the pricing makes it very attractive on a relative-value basis.”
At the height of the euphoria, in March, a small Mexico City telecommunications company called Maxcom issued $300 million of debt with an equity kicker into the US market through lead manager Warburg Dillon Read. The lead manager made a big deal of the fact that this was very much a US high-yield issue, and not sold to emerging market investors. Bonds of this type were relatively commonplace among US telecoms, but this was the First time an emerging market issuer had managed to get one away.
But the immediate lesson of the placement – that Mexico was no longer an emerging market, and that Mexican companies had the same Financing resources available to them as their US counterparts – did not last long. When the dot com bubble burst in April, the price of Maxcom debt, which had been issued at par, fell through the Floor. Bonds were traded at about 70 cents in the dollar only a couple of months after the issue. Not for the First time, emerging market securities were the First ones dumped when the markets became nervous.
“I don’t buy the story that Mexico is no longer a part of Latin America,” says Walter Molano, head of research at BCP Securities. “Mexico is still Firmly an emerging market country.”
All the same, as long as the US avoids a hard landing, Mexico looks to be the best-positioned of the Latin economies. “You have to give Mexico its due,” says Gene Frieda, head of emerging markets research at consultancy 4Cast. “Its exposure to the US is an extreme positive at the moment.”
Goldman’s Leme agrees, up to a point. “Mexico is in a group of its own, and doing very well thank you,” he says. But if investors want to make a play on a continued US expansion, it is easier – and safer – simply to stay in the US.
Leme adds: “In terms of the diversification play, if you were to have a hard landing in the US, Chile would suffer relatively less.”
There are also political questions in Mexico, which have largely been brushed aside in the euphoria over the victory of Vicente Fox in the presidential elections. For one thing, no one knows what will happen to the gloriously oxymoronic Institutional Revolutionary Party, or PRI, which ruled Mexico from the 1920s until this year. For another, Fox does not have a majority, and other parties’ willingness to form a governing coalition is far from clear.
“The big question in Mexico is the PRI as an opposition force,” says Chase’s Chang. “Fox is beginning to slow down the pace at which he’s going to put reforms in. I think the market is going to turn to looking at the external pressures in terms of the current-account and trade deficits. The focus will turn to the fulfilment of high expectations.”
Echoes Goldman’s Leme: “The political situation is quite undefined, starting with the PRI itself. Who will Fox establish an alliance with? Which members of the PRI will he invite into his cabinet? I still think it will probably work out well, but it’s not a sure thing yet.”
Yet good news is on the horizon. It now seems that the only question is when, not whether, Standard&Poor’s will Finally give Mexico the investment-grade rating that Moody’s bestowed in March. Most analysts seem to think it will happen in the Final quarter of 2000, but others think the agency will wait to see Fox prove himself, and only grant the upgrade at the beginning of 2001.
Either way, Mexico as a sovereign credit has already proved its ability to tap the sort of cross-over investors who have been so sorely lacking from the rest of the emerging markets universe since the Asian crisis of 1997 and the Russian crisis of 1998. In July, it issued $1.5 billion of six-year bonds in a Brady swap operation at 241bp over US treasuries, through JP Morgan and Bear Stearns. US investors like the look of their newly-democratic southern neighbour.
What’s more, Mexico, like most Latin countries, has already fulfiled its Financing needs for the year, opening up the way for non-sovereign borrowers to take advantage of the new appetite for Mexican debt.
“As you have had some tightening in spreads, investors like the sovereign story but they like to pick up some spread,” says Leme. “The second step is really the agencies, such as BNDES [Brazil’s national development bank], Petrobras [Brazil’s state oil company], and Pemex [Mexico’s state oil company]. For the corporates, we’ll see Cemex or Telmex do selective operations.”
Yet it does not follow that large numbers of Mexican companies can now fund in the international markets. Cemex and Telmex are both giant monopolies, in the cement and telecommunications sectors respectively, and carry, if anything, even less credit risk than the Mexican government itself. Lower down the creditworthiness spectrum, it remains extremely difficult, and very expensive, for companies to issue bonds. “I don’t see corporates necessarily clamouring to come to the market,” says Chase’s Chang. And, in the wake of the Maxcom deal, US investors will likely remain wary of smaller Mexican companies’ debt for the foreseeable future.
Outside Mexico, US appetite for Latin debt remains thin. Brazil, like Mexico, can do large Brady swap operations, but very little new money has been raised from US investors in recent months. Partly this is because countries have met their international Financing needs, but it’s also because potential investors continue to see higher returns with lower risk elsewhere, such as the US stock market.
The one country which still has significant Financing needs is Argentina, and it has been relying increasingly on European investors and its own domestic pension funds to meet these.
Argentina would prefer to draw on other sources, but these are all the country seems to have at the moment. “There really isn’t that much interest or demand from many of the investors who were active in Argentina two or three years ago,” says BCP’s Molano.
Euro-denominated bonds have been good to Argentina this year: it has issued almost e4 billion in total. But these issues have generally been small, and often sold into the Italian retail market. There’s virtually no secondary trading in these bonds, which pretty much preclude longer-dated deals. And as Argentina continues to saturate the euro market, it has already reached the point where it has to pay more than lower-rated Brazil for its funds.
In fact, Goldman’s Leme believes that Brazil would be trading at the same level as Argentina across the curve even in dollars by now, were it not for Argentina’s domestic pension funds, which can be counted on to buy sovereign debt at longer maturities.
In the debate over currency regimes, Brazil and Argentina represent the two extremes which economic orthodoxy has settled on: Brazil has a freely-Floating currency, while the Argentine peso is pegged one-to-one to the dollar.
As Brazil continues to grow with low inflation, Argentina’s economy remains stagnant, unable to compete with Brazilian exports which became almost twice as competitive in one stroke at the beginning of 1999. “There is no doubt in my mind that currency Flexibility is to Brazil’s advantage,” says Leme. “If you have a large external Financial shock from the US, today Brazil is better positioned.”
A handful of pessimistic analysts think that Argentina is going to devalue. Most economists admit that the pessimists have half a point: there is a certain unsustainability to the present system, where Argentina struggles with large Fiscal deficits and is constrained by its currency peg from inflating or exporting its way out of trouble.
But an Argentine devaluation remains extremely improbable. For one thing, it would be unconstitutional. For another, all of the government’s borrowings, and most of the corporate sector’s, are now in dollars: devaluation would only serve to exacerbate the country’s Fiscal woes. And the economy is so dollarized in any case that it’s not even clear that devaluation is practically possible. There is a good chance that many or most Argentines would simply switch to dollars, and refuse to use the devalued peso.
Even without a devaluation, however, Argentina’s prospects are none too healthy. Industrial production is low, unemployment is high – 15.4% and rising – meanwhile inflation is negative. Low growth has depressed tax revenues, forcing spending cuts. But the government’s room for Fiscal manoeuver is extremely limited, and there are question marks over its ability to implement the expenditure cuts it’s outlined. It has already taken the drastic step of cutting all public sector salaries by a Fifth.
The general impression in Argentina seems to be of a country overtaken by events. When all of Latin America was suffering from hyperinflation, Argentina’s currency board plan was revolutionary stuff, and successful on its own terms. But Brazil has shown a more Flexible way of managing a currency, while Mexico has shown greater ability to deal with sovereign debt management. “It’s not that Argentina has gotten so much worse,” say Chase’s Chang, “it’s that it hasn’t really changed, while the rest of the world has.”
Chang also poses the crucial question with regard to Argentina. “The current slump: is it due to the business cycle, or is it structural?” she asks. The longer that Argentina takes to start growing again, the more the government is forced to cut spending rather than attempt some sort of Keynesian shock to the system, exacerbating the situation and making a cyclical recovery more unlikely. And, notes Leme, “the Fiscal tool is almost exhausted at this point.” Still, he adds, “that does not say that Argentina is in imminent pressure of collapsing.”
4Cast’s Frieda says that “it’s not like you can say that they’re going to go down the tubes tomorrow. Like any crisis country, it’s going to be a long, drawn-out story.” He even holds out some hope that the business cycle might yet pick up of its own accord: “I don’t think it’s totally obvious,” he says, “that that cyclical life-raft is not going to come in.”
But BCP’s Molano is less sanguine, and openly talks of the possibility of default. As Argentina’s pension funds increasingly bear the burden of the government’s Financing gap, he notes, the money they have historically invested in the economy is no longer funding growth. The only scenario he sees where Argentine confidence returns is one where a booming Brazil starts to import more Argentine production, even as soy bean and wheat prices improve dramatically. He admits that’s not likely.
“The government is talking about having to reduce expenditures by another $1 billion,” he says. “Unemployment is almost at an all-time high. Debt service is $18 billion a year. At some point I think they are going to throw in the towel.”
And when the towel is thrown, he says, there’s a good chance that Argentina might decide to follow the lead set by Ecuador. “A debt restructuring is going to look a much better alternative than devaluation. If you connect the dots, that seems to be the place it’s going to.”
Molano is not the only person worried about the precedent which Ecuador’s bondholders seem to have set. One high-profile bondholder will happily, off the record, admit the contradictions inherent in making a substantial short-term gain by tendering his holdings of Ecuadorian Brady bonds even as he knows that this increases the probability that the likes of Venezuela and Argentina might choose to go down the same road.
Yet the broad market in Latin American bonds, after having a bit of a hiccup one day in August 1999 when it started looking likely that Ecuador would default, has generally ignored the goings on in the small Andean nation, dismissing them as irrelevant to the region as a whole.
One lawyer expert in sovereign debt restructurings says that most of the damage was already done by the time that Ecuador defaulted and, in his words, “the sun came up the following morning.” The fact that there had never been a sovereign Eurobond default until 1999 had become something of a mantra: Eurobonds were almost sacred, and a sovereign default was expected to be accompanied by apocalyptic Financial markets scenes.
There was a lot of anger in Washington in September 1999, at the time of the default. Bondholders had lost a lot of money, and they weren’t shy about blaming the US Treasury and the IMF, who they said had encouraged Ecuador to default when it could still meet its obligations. Pointing to the fact that bond documentation requires 100% bondholder approval to change the payment schedule, they said that any restructuring was impossible, and even if it wasn’t impossible it would certainly take longer than the original Brady conversions of bank loans into bonds had. Some of those dragged on for more than 10 years. No one expected that by the time the same delegates arrived in Prague a year later, a successful restructuring would already have taken place.
But there’s little sense of triumph in the bondholders’ world. The overwhelming sense is that the official sector has won, and that the private sector has given up the Fight for the sake of a fast buck and an exit strategy. “The IMF and the Treasury learned the wrong lessons from Ecuador, which is that you can basically force a default,” says BCP’s Molano.
Certainly, the official sector got everything it wanted, and demands from the private sector were ignored without any obvious adverse effects. Bondholders complained that they had already taken a 40% haircut in Ecuador’s Brady deal, and that the Paris Club of bilateral creditors would have to follow suit before they would even consider entering negotiations with Ecuador. Some went so far as to say that Ecuador should demand debt relief from the IMF and the World Bank, despite the fact that the multinationals were the only people willing to lend new money to the beleaguered country.
In the end, there were no negotiations. Ecuador simply presented a take-it-or-leave-it debt exchange oVer, which bondholders took. There was even a roadshow in New York at which John Thornton, the IMF’s mission chief to Ecuador, explicitly said that the official sector would not grant Ecuador any debt forgiveness, even after the private sector took a 40% haircut (and then another 35% haircut on top of that, if they wanted to exchange their new 2030 bonds for higher-yielding 2012 bonds). Principles such as reverse comparability of treatment, burden-sharing and the like were quickly jettisoned.
One person who was certainly watching the whole proceedings with great interest was Hugo Chavez, the unpredictable president of Venezuela.
Chavez, a populist former coup-leader, came to a landslide victory in Venezuela with a lot of anti-capitalist rhetoric, aimed mainly at the corrupt Venezuelan power structure, but also at Washington. He spoke repeatedly during his presidential campaign of restructuring the country’s debt and renegotiating its agreements with western oil companies, but also said the opposite when he was talking to western journalists or analysts.
Chavez has done nothing drastic so far. He hasn’t needed to: the soaring oil price has given him more than enough money to pay the interest on Venezuela’s debt while at the same time increasing government spending.
All the while, Chavez has pursued what Goldman’s Leme dryly calls “economic policies which are non-conventional”. Non-oil growth has been hard to Find, while unemployment has remained stubbornly high, especially after the government pushed through an across-the-board 20% wage hike, claiming it would have no significant impact on inflation. Of course, inflation has been rising steadily, along with the Fiscal deficit.
Now that Chavez has won another presidential election and his position looks secure for the foreseeable future, there seems little incentive for him to change his ways. “There probably will be more pump-priming going on,” says Chase’s Chang. “The economy’s still in a slump and they haven’t got any Fiscal policies in place which would allow them to get any benefits from the higher price of oil.”
Still, the oil price, which has soared under Venezuela’s chairmanship of Opec, has meant that the country has no foreign Financing needs. Furthermore, its macroeconomic ratios are some of the healthiest in the region. Its foreign reserves cover more than a year’s worth of imports, and its debt-to-GDP ratio is low. “We’re very constructive on the outlook for oil for the rest of the year,” says Chang, explaining why she’s bullish on Venezuela’s debt. Leme agrees: “You still have an upside given the high probability that the price of oil will still overshoot. It’s a big strong oil play.” What’s more, he argues: “Despite the very peculiar political situation, Venezuela would stand out extremely well in the case of an external Financial shock to the system. Despite concerns about the policies, it is on our buying recommended list,” he says.
But in the longer term, Venezuela looks the most likely candidate for next full-on economic collapse. “I don’t have a lot of confidence in Venezuela,” says 4Cast’s Frieda. “Venezuela will definitely go into another crisis. If we have another collapse in the oil price to the level we saw two years ago, we’d definitely see a default.”
Chavez is an open admirer of Fidel Castro, and would like to take on his mantle when the great revolutionary Finally dies. He’s a natural tub-thumper, and loves stunts like writing fawning letters to Carlos the Jackal, who is Venezuelan, in his French jail cell. If it seemed as though the Financial community was not willing to give Venezuela what it wanted – and that was certainly the case when the price of oil was depressed – Chavez would probably Find the decision to default quite easy.
“There are two components to sovereign risk,” points out BCP’s Molano. “Venezuela has the highest ability to pay. The problem is willingness to pay.”
Its oil revenue notwithstanding, Venezuela was the First Latin country to follow Mexico’s 1982 lead and default on its bank loans.
Standard&Poor’s recently reaffirmed the country’s credit rating at single-B, the same level as Mongolia and Paraguay, and just one notch above where the agency rates Ecuador’s new bonds. (It’s impossible to Find an analyst who thinks that Ecuador is capable of paying its debts going forwards, even after this restructuring. Yet another default is usually placed somewhere between one and Five years hence.)
“The only reason you pay off your debt is to get access to future debt,” say Molano. “That explains Venezuela’s decision to default [in 1982].” After Mexico’s default in 1982, the rest of the region had no chance of borrowing any more foreign funds. Western countries were hardly likely to invade to get their money back: the Latin countries simply saved their debt servicing payments at the cost of access to the market which they didn’t have anyway.
The original debt crisis placed all countries in the same rating category: unacceptable.
The difierence between the crisis of the 1980s and now is that default seems to be much more acceptable to the official sector. The IMF has demonstrated in Ecuador that it is happy to lend to countries which are in default to their private-sector creditors. The debate has moved from comparability of treatment, which was about the private sector sharing the pain of the public sector, to reverse comparability, which is about the public sector sharing the burden of the private sector.
And after successful restructurings in Pakistan, Ukraine and Ecuador, the disincentives to altering the terms of a country’s debts seem smaller than ever. The question is not whether other countries will follow their lead, it’s which ones will go First. Nigeria is one possibility, and in Latin America, says Molano, “some of the more leveraged countries are definitely looking at it.”
If another Latin country defaults, the Flow of new money to the region will probably dry up completely. That will leave the countries with no foreign private-sector Financing needs – Venezuela, Chile, Peru – more secure, in some ways, than the big three of Brazil, Argentina and Mexico, which are more reliant on foreign investment.
The one thing which doesn’t seem to make much of a difierence is the degree to which countries successfully achieve the status of liberal democracies. Indeed, in the case of Venezuela, the very fact that Hugo Chavez has broken from the Washington mold and is ruling in a very autocratic manner helps to attract funds looking for diversification from US risk.
There is some debate about how undemocratic is too undemocratic. Even the military coup in Ecuador, which has resulted in an unelected president, didn’t seem to materially affect investors’ view of the country.
In Peru, however, there are worries that president Alberto Fujimori might have gone a bit too far this time around. Most jurists think he shouldn’t have run for a third term at all, as the Peruvian constitution limits presidents to two terms. But Fujimori decided that as he introduced a new constitution during his rule, he was allowed two terms per constitution, and then sacked any judges who disagreed with him.
The election was roundly condemned by all independent observers, and ended in the farce of Fujimori being the only candidate on the ballot, his opponent having quit in disgust. “We like the economy,” says Leme, “but Fujimori will have to avoid being slapped by the US and other countries.” 4Cast’s Frieda, however, is less worried: “You have to rely on a benevolent dictator,” he says, “and Fujimori has sort of been there.”
But the biggest political disaster area in the region is not Ecuador with its coups or Peru with its autocrat, but rather Colombia, with a genuinely democratically-elected president.
Many of the drug growers and terrorists who Fujimori managed to kick out of Peru have simply turned up in Colombia.
The United States has promised billions of dollars in anti-narcotic aid, the vast majority of which is set to be spent on an army notorious for its human-rights violations. The government of president Andres Pastrana is weak and increasingly unpopular, the country has long lost its investment-grade credit rating, and foreign investors Find it very easy to Find safer places to put their money to work. Bogota shares with Caracas the fact that foreign businessmen are physically unsafe, something which makes the decision to stick to known quantities like Brazil a lot easier.
In fact, Brazil bears most of the hopes for the region as a whole. Latin America’s largest economy has been doing well of late. Growth has started to pick up, the current-account deficit has fallen, the president’s popularity, while low, is increasing, and Standard&Poor’s seems set to upgrade the country into the double-B category in the near future.
Brazil has even managed to deftly side-step some of the potential event risk pitfalls, such as the recent scandal in which a federal judge ran off with $100 million or so earmarked for construction of a new courthouse in Sao Paulo. The scandal, which threatened to bring down senior members of the executive branch and possibly even the president himself, was neatly managed by the government, which avoided a Congressional investigation and managed to avoid most of the blame.
So if Latin America is to boom, the boom is going to be led by Brazil. It has the size, it has the currency Flexibility, and it also has the upside potential. Yet this does not seem to be reflected in the securities markets.
Brazilian debt is trading only about 100 basis points tighter than Venezuela, a country whose president calls Saddam Hussein “brother”.
A lot of the reason for that is technical. As trading volumes in Latin debt have been shrinking for the past three years, the international Financial community Finds it difficult to source the liquidity it needs in most countries’ securities. So Brazilian debt in general, and the most liquid Brady bond, the C bond, in particular, does a second job as a proxy for the fortunes of the region as a whole.
“One has to separate the technicals, which have really not favoured Brazil, from the fundamentals,” says Chase’s Chang.
And the outlook is not all good for Brazil. The government is extremely unpopular, and Finds it increasingly difficult to get bills past Congress. The upgrade to the double-B ratings bracket, while welcome when it comes, has already been priced in to the market, and is unlikely in any event to attract many new investors. Brazil would need to be upgraded to investment grade for that to happen, and it took Mexico ten years to progress from double-B to triple-B.
But on the other hand, there is at least one way in which Brazil and the rest of the Latin American credits have their wide credit spreads working in their favour. So as long as Federal Reserve chairman Alan Greenspan keeps the US economy ticking along nicely, Latin America is likely to remain at least as healthy as it is now. And with Latin spreads generally wider than the emerging market bond index (EMBI) as a whole, all it takes to outperform the index is to go long Latin America in general, and Brazil in particular.
“Overall, we’re not that optimistic,” says Leme. “But the Latin EMBI index and Russia has more upside, inasmuch as if there’s no US shock, you would outperform the benchmark.”Over to you, Mr Greenspan.
