The State of Latin American Bond Markets

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The State of Latin American Bond Markets

• Barry Eichengreen
• Rio, August 11, 2006

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• Joint work with Eduardo Borensztein and Ugo
  Panizza of the Interamerican Development Bank.
• Intended as a synthetic overview of the state of
  the markets.
• Also provides a review of progress on policy
  reform to date and an agenda for the future.
• Methodological innovation is to provide a
  systematic comparison of East Asia and Latin
  America, which I dont think has been done
  before. I hope you will find this interesting.

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Why it Matters

• Bond market development is widely regarded as
  important for financial development and stability
  alike.
• Better diversified financial systems are more
  efficient. Banks and bond markets are good at
  different things.
• Eliminating excessive reliance on banks may also
  help to lengthen tenors and promote financial
  stability.
• There has been considerable progress in recent
  years.
• Market cap has grown. Foreign participation has
  grown.
• But this remains almost entirely foreign
  participation in government bond markets.
• The important question is how much of this
  progress is permanent?
• Institutional reform may have permanently
  augmented domestic and, in particular, foreign
  investor appetite.
• But recent trends may also heavily reflect
  favorable global liquidity conditions.
• Retrenchment in the last two quarters, associated
  with global monetary tightening, is consistent
  with this latter view.
• But the fact that some countries, including
  Brazil, have been heavily if not entirely
  insulated from this pull-back suggests that at
  least some of this progress might be properly
  regarded as permanent.

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Bond markets in Latin America have grown (more
LAC countries are above the diagonal than below)
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Same is true of corporate bonds (most countries
are above the diagonal, though disturbingly close
to the origin)
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While this is progress, Latin markets continue to
lag along a number of dimensions.

• They are still small by advanced-country
  standards.
• With a few exceptions, turnover rates remain low.
• Markets are disproportionately dominated by
  government bonds.
• The duration of issues remains relatively short.
  
• The next two figures provide views of this.

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Share of Short-Term Bonds (residual maturity lt 1
year) LA is still an outlier
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Share of Medium Long-Term Bonds (in purple) LA
is still an outlier
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• Interestingly, this differential in the growth of
  local markets is less pronounced when
  capitalization is scaled by the size of the
  financial sector (by M2 or, even more clearly, by
  the stock of domestic credit).
• Another way of putting the fact that Latin
  American bond markets are small relative to GDP
  but not relative to the financial sector is that
  it is Latin American financial sectors and not
  merely the bond market that is underdeveloped.
• The fact that these markets seem to grow together
  suggests that bond market development is a
  corollary of the larger process of financial
  development.
• The next two slides point up the contrast.

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Here scaled by GDP
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But here scaled by domestic credit
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The role of banks

• The fact that bond markets grow in tandem with
  the rest of the financial system, which generally
  means in tandem with the banking system, suggests
  that banks and bond markets are complements
  rather than substitutes.
• Banks provide underwriting services for
  prospective domestic issuers, advising the issuer
  on the terms and timing of the offer.
• They provide bridge finance in the period when
  the marketing of bonds is still underway.
• They provide distribution channels for government
  bonds and form an important part of the primary
  dealer network.
• Their institutional support may also be conducive
  to secondary-market liquidity.
• Finally, and most directly, banks owing to their
  relatively large size can be major issuers of
  domestic bonds themselves.
• This perspective is rather different from the
  pecking order model of financial development,
  in which bank finance develops first, because the
  information and contracting environments are
  highly imperfect, and in which the bond market
  develops only later.

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• But an imperfectly competitive banking system may
  be an obstacle.
• Banks with market power may collude to discourage
  the development of alternative channels for
  intermediation.
• In Chile, the Latin American country with the
  most active corporate bond market, fully 26
  investment banks have been active in underwriting
  and helping to place domestic debt securities.
• In Mexico three large banks dominate the
  underwriting and sell side of the domestic
  market.
• Is Brazil an intermediate case? (Brazil has 20
  different commercial and investment banks that
  act as lead underwriters. But how many are
  really players?)

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To be sure, all of the preceding are
generalizations

• Bond markets in Brazil and Chile are an order of
  magnitude larger than those of Argentina and
  Peru, even scaled by GDP.
• In addition, those markets are very different in
  composition in Brazil corporate bond issuance is
  very small compared to government bonds, whereas
  in Chile they represent a significant share of
  market capitalization.
• Variation is also evident in maturity.
• And again in terms of turnover.
• The next three slides illustrate these points.

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Total market cap by country
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Maturity by country
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Turnover by country
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What are some of the determinants of these
variations?

• In the paper you have before you, we take market
  capitalization as our dependent variable, if only
  because data are most comprehensive.
• And we do not limit our cross country comparisons
  to LAC.
• We present the data both visually and in the form
  of multiple regressions.
• First visually

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Country size (and minimum efficient scale)
plausibly matter (this figure illustrating the
role of country size is for corp bonds)
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In addition, countries with higher savings rates
evidently have a leg up
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Size of firms also matters for corporate bond
market capitalization
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Institutional investors matter

• Countries with better development of
  institutional investors (privatized pension
  funds, insurance companies, mutual funds) also
  have a leg up (although IIs buy and hold, adding
  little to liquidity).
• There are some data on this in the paper, but
  these are fragmentary.
• For example, In Mexico and Chile, institutional
  investors hold upward of 90 per cent of corporate
  bonds in Peru they hold more than 70 per cent.
• Pension funds hold a very significant fraction of
  government bonds in Chile, Colombia, and Mexico,
  where the reform of pension systems was
  relatively early to get underway.
• In Brazil, the mutual fund industry is the most
  important holder of government securities (along
  with the banking system and BNDES).
• On the other hand, the role of insurance
  companies is smaller in Latin America than in
  Asia with the exception of Chile, where
  insurance company assets under management
  approach 20 per cent of GDP.

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Foreign investor participation can help to relax
constraints on market size and liquidity

• This includes both
• Issuance by nonresidents
• Investment by nonresidents
• However

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LAC lags in nonresident issuance
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Depending on country, LAC compares better on
nonresident investment
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Policy measures

• LAC has made progress but still has a way to go
  in terms of
• Investor protection
• Creditor rights
• Compliance with international accounting standards

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Finally, we provide some statistical analysis of
the determinants of market cap

• Annual data from the BIS (through 2004)
• Estimates by GLS
• Focus here on the corporate bond market
• There are too many results to summarize. But a
  sweeping overview would emphasize

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Summary of results

• A limited number of variables explain the vast
  majority of differences in bond market
  development, so measured, across regions.
• These include GDP per capita, country size,
  development of the financial system (and
  efficiency of the banking system), exchange rate
  stability, openness, investor protection (cost of
  contract enforcement), presence or absence of
  capital controls.
• Thus, more stable policies and stronger investor
  protections would make a difference.

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Results (continued)

• In addition, however, a quarter of the difference
  in bond market capitalization between industrial
  countries and Latin America is due to country
  size (measured by aggregate GDP) and the level of
  development (measured by GDP per capita).
• Level of development can be changed, but market
  size? Does this mean that attempting to develop
  bond markets in small countries is a losing
  fight?
• In addition, about 15 percent of difference is
  attributable to the development of the financial
  system (measured by bank credit to the private
  sector). These variables are not easy to change
  in short order.
• Another 15 percent is related to historical and
  geographical factors (like the origin of the
  legal code and other measures of institutional
  inheritance). Can these be changed at all?

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Results (continued)

• The only policy variables easily controlled in
  the short run that seem to be play an important
  role are macroeconomic stability (proxied by the
  volatility of the exchange rate), openness, and
  the only institutional variables with a first
  order effect are investor protection and the cost
  of enforcing a contract.
• But these can explain at most 1/4 of the
  difference between the Latin America and the
  industrial countries.
• Policy variables like the exchange rate regime,
  the presence or lack of capital controls, the
  level of public debt, bank concentration, and
  banking spreads are all statistically significant
  in the empirical analysis but play a very small
  role in explaining the difference between the
  development of the bond market of industrial
  countries and that of Latin America.

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Bottom line

• Clearly, one should not conclude that policies
  and institutions do not matter.
• Still, the fact that many of the obvious policy
  variables have only a modest effect on bond
  market development suggests that there are
  unlikely to be convenient short-cuts.
• Bond market development is a long hard slog.
• By implication, the same policies that are
  necessary for economic development in general are
  also necessary for the development of domestic
  bond markets.
• But, in addition, the importance of country size
  and firm size raises questions about the
  feasibility of bond market development in one
  country.
• Does this mean that LAC should follow Asia in
  attempting to develop bond markets at the
  regional level?

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Extra-national initiatives

• Asia has sought to integrate national markets
  regionally in order to overcome handicap of small
  market size.
• ABF1 2.
• Regional indices and passively managed funds.
• Asian Bond Markets Initiative.
• Latin America has not gone down this road.
• In contrast to Asia, it has sought to enhance the
  access of its corporates to international
  markets.
• This has included, most recently, efforts to
  issue government debt in local currency in New
  York and other centers, in the hope that
  corporates will be able to follow.
• At least, this is what is suggested by the
  following slide

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LA relies more on international markets(Private
Sector Bonds/GDP)

• Left panel is LA, right panel is EABlue is
  domestic, red is external

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Costs and benefits of the two strategies

• Spreads are often lower on international markets,
  especially for LAC borrowers (reflecting, inter
  alia, weak creditor rights at home).
• Thus, in the case of Colombias November 2004
  domestic currency issue, where we can make a
  direct comparison, primary spreads were 20 to 50
  basis points below those on comparable domestic
  bonds.
• We see the same thing when we look at large
  corporates, which can often borrow more cheaply
  on international markets.
• Thus, the LAC strategy is the obvious short-run
  cost-minimizing one.
• But does encouraging corporates to borrow on
  foreign markets slow the development of local
  market liquidity?
• We find that spreads also decline with domestic
  market capitalization.
• So the Asian strategy may be the long-run
  cost-minimizing one.