Stormy skies over a safe haven

Times have changed since central America had an unenviable reputation for civil wars and death squads rather than its credit ratings. Twenty years on from the bad times of the 1980s, economic integration, stability and growth characterize the region. Central America is rapidly becoming a safe haven for bondholders in Latin America.

Larger Latin American bond markets look set for a volatile year, but investors are still hungry for higher yields. So central America might have its best year yet, as debt from the small economies of El Salvador, Costa Rica, Panama and Guatemala catches the eye of the market.

“There is so much instability in Latin America today that central America has come out on top. It has become a much improved investment in the past few years,” says Alice Faibishenko, analyst at Deutsche Bank in New York.

Panama, El Salvador and Guatemala, whose small economies are dominated by tourism, textile exports, coffee, bananas, and shipping, plan to issue dollar-denominated sovereign debt on international markets this year, with Costa Rica already setting the pace.

Costa Rica sold $450 million in bonds on international markets on January 24, in a deal lead managed by Deutsche Bank. The offering was the country’s largest ever and is part of a drive to cut the republic’s internal debt load. The debt issue came in two parts: a $200 million sale in 6.9% bonds due in 2008 with a yield of 410 basis points over US treasuries and a $250 million tranche of 8% bonds maturing in 2013, with a yield of 417bp over treasuries.

Domestic debt burden

According to finance minister Jorge Bolanos, Costa Rica will use the new issue to pay off $200 million in higher-interest domestic debt due in May and June this year. Burdened with more than $4 billion in high-interest domestic debt, Costa Rica has issued foreign debt several years in a row as part of a long-term debt restructuring strategy.

“There was good demand for Costa Rica. It sold well,” says Francis Rodilosso, who oversees $200 million for hedge fund Van Eck Capital.

With the placement of the bonds, Costa Rica’s foreign debt rose to a little under $2.2 billion, while domestic debt fell to $4.2 billion.

Guatemala, the biggest economy in central America, aims to sell up to $700 million in new paper this year, although it has not yet set the terms of the offer. The so-called peace bonds are seen as crucial to the success of the administration of president Alfonso Portillo.

Portillo hopes they will fund long-delayed commitments of the 1996 peace accords and boost the popularity of his Guatemalan Republican Front (FRG) party before November’s elections. Guatemala’s 25% external debt to GDP ratio is well below Latin America’s 43% average.

Despite allegations of corruption, Portillo’s administration has kept budget deficits small and inflation in single digits, raising hopes that this could feed the brisk appetite for emerging-market investments in the region.

Panama, already a safe haven in Latin America backed by a dollarized economy and revenues from the Panama Canal, is seeking to add to its $5 billion-worth of bonds on international markets, issuing around $250 million later this year, according to deputy finance minister Domingo Latorraca. “We are looking at 10-year bonds to help finance the fiscal deficit,” he says.

El Salvador’s finance ministry has set June or July as the date for its bond sale. Analysts put the El Salvador offer at some $300 million.

Market watchers say Panama, Guatemala and El Salvador are likely to find an enthusiasm from investors similar to that experienced by Costa Rica as investors look for exotic credits and assume more risk.

With yields on Mexican bonds approaching those of US treasuries, investors are looking more closely at nations that pay a premium to attract capital. Yields are around 7% to 9% on central American bonds, which are seen as medium risk, compared with 3% to 4% on low-risk US treasuries.

“Central America looks good in the context of Latin America right now. The majority of countries in the region have a negative outlook,” says Richard Francis, sovereign risk specialist at credit ratings agency Standard&Poor’s.

The domino effect from Argentina’s disastrous currency devaluation and default, as well as investor fears about Brazil’s elections, won by leftist Luiz Inacio Lula da Silva, made for a chaotic 2002 across Latin America.

The debt of market heavyweight Brazil closed 2002 with a loss of 3.4%, limiting the returns of an investor in Latin America to 7%, according to the JP Morgan Emerging Market Bond Index plus. Other emerging markets outside the region, such as Russia, offered returns of 36%, while Turkey gave investors a sturdy 21% profit.

Latin America accounted for just 28% of emerging-market deals last year, tumbling from its 48% slice in 2001, according to industry tracker Dealogic.

This year the region has not got off to a good start either. A general strike brought Venezuela’s economy to a halt between early December and mid-February, and Argentina appears hard pressed to prepare for elections in April amid economic malaise.

Argentina remains exiled from the markets after it defaulted on $95 billion in private debt and an $800 million World Bank loan. Colombia is also struggling, with increased instability as the government toughens its anti-guerrilla stance in its 37-year civil war.

Mexican and Chilean debt, however, remains in high demand. In January, Mexico doubled a planned sovereign bond sale to $2 billion, while Chile sold $1 billion, with demand at $4 billion, according to the Chilean finance ministry.

An indication of central America’s enhanced standing in emerging markets came in January when US investment bank Bear Stearns launched a central American and Caribbean bond index. This tracks $12.6 billion in debt issued by 10 nations in the region. Typically the bonds make up around 1% of a fund manager’s portfolio.

“The index gives investors a simple way to track the performance of an increasingly important part of the emerging markets universe,” says Carl Ross, head of Bear Stearns Emerging Markets Sovereign Research, who created the index.

According to Martin St Pierre, co-head of credit derivatives trading at the bank, the index will also help investors diversify their portfolio. “There is very little information around about central American credits, so the index should help guide investors and potential investors better,” he says.

Central America’s stability is a result of prudent fiscal policies, a new commitment to free trade and diversification from traditional exports such as coffee and bananas, says Rafael Barraza, former president of El Salvador’s central bank and the mastermind of his country’s recent dollarization.

Output from El Salvador’s maquiladora (assembly for export), for instance, soared to $2.5 billion in 2001 from $790 million in the early 1990s. As late as 1990, coffee made up 60% of exports. Today the figure is 8%, according to trade ministry data.

“Negotiations for a free trade pact between Central America and the US will give investors a lot of confidence,” Barraza says. The US and five central American nations – Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua – launched free trade talks in mid-January. Panama is negotiating an independent treaty with Washington.

Central America, excluding Panama and Belize, today sends 40% of its $10 billion annual exports to the US. With the gradual removal of tariff barriers in the Americas, central America’s economic growth is predicted to double by the end of the decade.

The region is also gaining funding to aid trade growth from multilateral agencies such as the Inter-American Development Bank. Costa Rica’s Bolanos is looking to win $500 million in loans from the IADB over the next five years to finance the government’s national plan for development, which includes health, transport and infrastructure projects. The bank is considering granting $100 million for every percentage point Costa Rica cuts off the fiscal deficit, which stands at 3.3% of GDP.

Regional multilateral agency the Central American Bank for Economic Integration (Cabei) is also planning to make more funding available to boost economic growth and stability. Cabei is planning to issue up to $750 million on international debt markets over the next few years, with an initial $200 million 10-year bond sale later this year, led by US investment bank Salomon Smith Barney.

Pressure for free trade deals

US business groups are also backing the regional free trade deals, urging swift negotiations to complete the agreements by 2004, a year ahead of the proposed Free Trade Area of the Americas, slated for 2005.

Any delay would hurt US companies eager to expand exports and would make it harder for central American textile and apparel firms to attract increased investment because of US import quotas that will be eliminated after 2004, says the Business Coalition for US-Central America Trade.

China and other Asian suppliers are expected to dominate the US textile and apparel market once import quotas are removed. The increased competition threatens to squeeze out Latin American and Caribbean suppliers unless they have a tariff advantage.

The US and the central American countries have scheduled nine rounds of negotiations, including an initial meeting in January in San José, Costa Rica.

Central American issuers are also riding on the back of last year’s success, analysts say. In April, El Salvador sold $500 million-worth of 30-year international bonds with an 8.25% coupon, the first central American country to issue a 30-year bond. It was priced at just 265bp over 30-year US treasuries and only 12.4bp above Mexico’s 2031 bonds.

Demand was so fierce that the amount issued was increased to $500 million from an original $300 million and priced one day ahead of its original date of April 3. El Salvador went to market again in July, issuing $300 million in nine-year bonds with an 8.5% coupon and 300bp over treasuries.

El Salvador is one of Latin America’s few investment-grade issuers. Fitch and Moody’s both rate it investment grade, but Standard&Poor’s rates it BB, giving the same rating to Costa Rica, Guatemala and Panama.

Panama’s bond prices are also holding up because its paper is becoming scarcer. In July 2002 the government began a long-awaited buy-back of its global bonds, purchasing up to $750 million in small tranches on international markets over the next year, taking its total holdings up to $1 billion. The buy-back takes about a third of Panama’s bonds out of the market, reducing supply and propping up prices.

Panama has around $3.1 billion in global bonds issued on external markets. The government, which holds $250 million in its bonds, will use a $1.3 billion trust fund to hold them as an investment, effectively paying itself interest of around $20 million a year. Panama is also negotiating an estimated $80 billion stand-by loan from the IMF, which will boost investor confidence.

“As long as there is progress on structural reforms an IMF agreement is always possible. And a loan would be very welcome,” says Walter Molano, fixed-income analyst at BCP Securities in the US.

The popularity of central American debt might not last beyond 2003, however. The region’s debt, still seen as an exotic credit popular for its scarcity value, could be damaged if there are continued issues. The region also still faces hurdles to get its economies in order, analysts say.

“The more that issuers sell, the more closely investors pay [attention] to economic fundamentals. Looking carefully at central America could scare off some buyers,” says Rodilosso of Van Eck Capital.

In particular, fiscal pressures are ever present in El Salvador, Panama and Costa Rica, raising the spectre of less money for debt service. And Guatemala’s failure to tackle its illegal drugs trade could dent that country’s success.

In El Salvador the non-financial public-sector deficit has risen from 1.8% of GDP in 1997 to 3% in 2000. With the inclusion of reconstruction costs from the earthquakes, but excluding costs related to social security reform, the fiscal deficit rose to 3.7% of GDP in 2001 from 3% in 2000 and is now steady at around 3.5%, according to central bank data. Tax reform is also seen as crucial if government revenues are to be boosted so public investment can promote economic growth. The country’s tax-to-GDP ratio remains low at less than 11%.

Panama recently disappointed investors with a weak tax reform, bringing in only half of the $120 million initially projected. Moreover, the finance ministry in early February reported a central government fiscal deficit of 1.9% of GDP in 2002. The figure meets a self-imposed legal limit that requires Panama to achieve a budget deficit of 2% or less every year.

But analysts say the deficit is actually nearer 4.1%. They accuse the finance ministry of using accounting tricks to paper over its poor economic management. The ministry says it has revised the way its calculates Panama’s deficit by counting in the Panama Canal’s budget surplus of around $150 million, despite the canal’s status as an autonomous state entity.

“The canal is part of Panama and we are presenting the absolute reality of the Panamanian state,” says deputy finance minister Latorraca. He adds that no money had been transferred from the canal to government coffers.

Both local and international analysts say the accounting change was deceptive because it hid a larger deficit. “This is a false figure because it does not reflect the true nature of government finances,” says former Panamanian vice-president Ricardo Arias Calderon, who was the first public figure to challenge the finance ministry on its accounting changes in February.

Costa Rica has an even wider fiscal gap, running a budget deficit of 4.4% of GDP, after government spending outpaced tax revenues in 2002. Many analysts see the main policy goals of the new president, Abdel Pacheco, as a zero central government deficit by 2006 and economic growth via specific support to tourism, science and technology, and small and medium-size enterprises.

Political instability in Guatemala is the biggest threat to investors in 2003, added to a three-year-old collapse in world coffee prices, which has dealt a severe blow to Guatemala’s export base. Guatemala was de-certified by the US on January 31 because it said Guatemala was uncooperative in the fight against drugs, which are smuggled from Colombia via central America to North American markets. De-certification is seen as a constraint on Guatemala’s ability to go to markets, analysts say, as it hurts the country’s image as a clean place to invest.

Guatemala’s central bank president, Lizardo Sosa, was kidnapped in February 2002 while out jogging and killings of human rights activists are rising. The Economist Intelligence Unit last year downgraded Guatemala’s political risk rating to E, its harshest rating, as political infighting between president Portillo and his ruling Guatemalan Republican Front party increased.

Portillo is also up against Guatemala’s powerful businessmen, who control much of the press and the economy. When Portillo tried to raise corporate taxes, the business lobby took its revenge by pressuring Guatemala’s banks to reject a $150 million offering of debt on local markets in January, again sending international investors a disappointing signal.