The evolution of the use of derivatives by corporations in Latin America has not been straightforward. The fallout from the spectacular misuse of FX hedging products by some Latin American corporates continues to throw up practical and psychological barriers in the region. In Brazil, the largest market and comparable only to Mexico in the adoption of risk management trades by corporates, the regulators have just introduced another “macro-prudential” measure that targets FX derivatives. Confusion still reigns about exactly what the new decree means. What is clear, though, is that the latest Medida Provisória will be an impediment for many corporate FX hedging activities. And lastly, markets that need to grow in the region, such as interest rate options and onshore credit default swaps, are awaited more with hope than expectation.
The crisis of 2008 created many losers but perhaps none quite so high profile as some of the Latin American companies that got exposed on currency derivatives. Essentially, companies such as Brazilian food processor Sadia, pulp maker Aracruz and Mexican retailer Comercial Mexicana (known as Comerci) had entered into non-deliverable forwards, target forward agreements and currency options that for many quarters were delivering revenues to the companies.
In the fourth quarter of 2007, for example, Sadia reported R$375 million ($235 million) accounting profit from these trades. CFOs began to see their emerging markets as a safe one-way currency bet: how could their currency stop appreciating against the dollar? The answer came swiftly and dramatically.
The 2008 global crisis initiated a flight of capital to safe havens, funds flowed out of emerging markets and the region’s currencies plunged. The currency tide went out and those who had been swimming naked in the FX market were clearly visible. Sadia lost R$3 billion in 2008 and Adriano Ferreira, the company’s CFO at the time, was fined R$2.6 million and barred from managing public companies for three years. Sadia’s chairman and vice-chairman also lost their jobs. Meanwhile, Aracruz announced derivative losses of more than $2 billion and Comerci told counterparties that it could repay just half of its $2 billion losses.
With such high-profile losses and casualties it is not surprising that there is a reticence among some to propose new, sophisticated FX derivative programmes. “The memory of those companies that lost money in 2008 is still vivid among today’s CFOs, especially on the FX side. There are new products and the banks are willing to trade but many CFOs are very, very cautious,” says Francisco Freitas de Oliveira, head of Americas FX and FX hybrids trading at BNP Paribas in New York. “What’s difficult is that everyone remembers the 10 or so that were affected, but people forget that several other companies did very well out of their FX hedging, despite the downturn, because their hedges were properly aligned with their FX exposures. But because of the memory of a few bad cases the finance directors aren’t pushing too much for internal approval for the second-generation instruments.”
Regulators responded with greater efforts to monitor the corporate sector’s exposure to derivatives (the impact on the banking systems had been minimal as they were already tightly regulated). Companies that had been trading with up to 10 banks at a time are now required to disclose all trades to the regulators so they can see each company’s net exposures. Banks, too, realized that they had been entering trades with companies that made sense for the individual corporate’s underlying exposures but had been unaware their clients had similar positions with nine competitors.
“Bad risk management practices from CFOs who traded against the street were what brought down those few companies that were affected,” says BNP Paribas’ Oliveira. “In almost all of the cases, it was one client against several different financial institutions, so even the banks didn’t have an accurate picture. In most Latin American countries today we still don’t have a legal right to see a client’s overall exposure – Brazil being the only exception pushing for a consolidated derivative exposure reporting that can be accessed by banks if the client allows. But what has changed is that global banks are imposing stricter credit support annex agreements (CSAs) with collateral margins. We are now working with clients who accept more ‘prudent’ CSAs because their derivatives are related to real risks.”
Medida Provisória 539, introduced in Brazil on July 26, is, however, not a regulation aiming to improve the efficiency and transparency of the derivatives market. The measure enables the Brazilian National Monetary Council to provide for the establishment of a maximum rate of 25% for an IOF tax levied on the trading of FX derivatives, as well as compulsory deposits of up to 100%.
The government in effect took a snapshot of the market positions as of July 26 and then immediately levied a 1% tax on any new derivative positions (the currency derivative market in Brazil is much larger than the spot market). The government moved to counter what had been the continuing appreciation in the value of the real against the dollar.
“We are going to make speculation less profitable with all these measures,” said Brazil’s finance minister, Guido Mantega. “We are in the middle of a currency war. Imagine if no measures had been taken – the dollar would be even lower.” However, there is confusion among market participants about how exactly the tax will be levied and collected, and some even question whether the regulation can actually be implemented without clarifying regulation.
Mantega claimed that the new tax would only affect speculators and would not have an impact on “defensive” hedging strategies of Brazilian exporters. However, bankers say that corporations' ability to source FX hedges has deteriorated as several Latin American countries embarked on the "currency wars", imposing regulatory and tax frictions to FX trading, both in cash and derivatives instruments. This has led to dislocations on the pricing of onshore and offshore instruments and has created further burdens for legitimate hedging from corporations and institutional investors.
Brazil’s recent measures regarding tax on derivatives have increased even further the difference between onshore and offshore spreads in the FX markets, leading to a reduction in the volume of FX derivatives transacted in the local markets at BM&F Bovespa and a partial migration of the volume to offshore OTC markets, such as the CME, which is seeing a record volume in BRL Futures in 2011.
“For transparency and prudential reasons that’s a worsening of the status quo,” argues Tony Volpon, head of EM research for Nomura in New York. “The difference in the basis also creates incentives for anybody who can buy offshore dollars and sell onshore dollars to arbitrage. They have to run the basis risk but depending on how you can account [Brazilian accounting regulations can enable companies to split out components of OTC and recognize losses in some cases] for that it’s a pretty good basis to run and I think what is being created is an incentive for corporations to issue more dollar debt. And because companies can offer cheaper onshore dollars it also creates an incentive to do things like intra-company loans.”
At one point, the real had gained about 8% against the US dollar this year, following a 4.6% gain in 2010 to hit a 12-year high just before the new IOF tax was introduced. The real weakened nearly 2% on the news but the economic crisis surrounding the news of the US downgrade, and the sovereign debt crisis in Europe has complicated interpretation of the new regulation’s effect.
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| Source: Bloomberg |
“The crisis has meant that people have been buying dollars so people are moving away from the levels established by the government’s “snapshot”, meaning this new constraint has become a binding constraint,” says Volpon. “But in the few days following the measure when the external volatility wasn’t a factor the market was totally dead: no-one was quoting derivative prices and those who were quoting were just putting the 1% tax on as a cost.” As well as adding friction to the functioning of the FX derivatives market, the new measure is another demonstration of enthusiasm for so-called macro-prudential measures that are widely unpopular with bankers. “We live in new times and there is a lot more government interference in markets across the world so it’s not a phenomenon specific to Brazil,” says Volpon. “Unfortunately the IMF has given this interference philosophical validity – it has almost blessed actions like this in a variety of papers that it has published in recent months that say, albeit with caveats, that it’s OK to take measures like this. It includes all these caveats but in the end you are opening Pandora’s Box and creating an environment where these things are acceptable. The IMF is legitimizing a view that markets are irrational, that they overshoot. Then Brazil launches a measure like this and nobody really says anything.”