External financial fragility in Latin America and its implications

by Daniel Munevar

To talk about external financial fragilities in Latin America is to evoke the memories of the 80’s debt crisis. The stigma that remains to this day identifies high levels of external public debt as the main source of financial instability for the region. However, things have changed in a dramatic fashion over the last 3 decades.

Public debt has decreased across countries in the region, while an increasing share of it is issued in domestic currencies and markets. At the same time, the activity of Latin American corporations in international financial markets has increased exponentially since the financial crisis of 2008. Given this shift in the nature and composition of external borrowing, it is important to set aside old preconceptions in order to understand the external financial threats faced by the region in an increasingly uncertain global context.

Before the regional slowdown that started in 2014, countries in the region had managed to significantly reduce their levels of gross public debt as well as the share of that debt denominated in foreign currency. In the case of the former, public debt decreased from 60% of GDP in 2003, as an average level for the region as a whole, to 35% of GDP in 2014. In the case of the later, external public debt decreased from 40% to less than 20% over the same period. |1| Despite the environment of abundant liquidity that characterized international financial markets in the post-crisis period, as central banks in advanced economies implemented Zero Interest Rate Policies (ZIRP), governments in the region continued to rely on domestic markets to fund themselves. This structure of funding has provided some degree of protection to public finances in Latin America over the last 2 years, as countries were less exposed to the combination of a stronger dollar and higher external funding needs that wreaked havoc in the past.

The same, however, cannot be said of non-financial corporations in the region. Unlike previous episodes, where either domestic or international banks played an important role in intermediating capital flows to the region, non-financial corporations were able to directly tap international financial markets over the last years. For example, whereas domestic corporations headquartered in 5 countries in the region issued on average less than USD 20 billion per year in bonds denominated in foreign currency between 2003 and 2008, this amount tripled to USD 60 billion per year for the 2009-2013 period. |2| The increase in the issuance of external bonds is also reflected on the overall structure of funding of corporations. While these bonds represented 36% of total issuance in 2007, their share increased to 76% by 2013. As a result of these trends, the stock of outstanding external bonds issued by corporations increased from USD 83 billion in 2010 to USD 245 billion in 2015. |3|

This dramatic shift in the structure of funding can be explained by favorable interest and exchange rate dynamics. In the case of the former, the reduction in interest rates that took place in advanced economies allowed regional corporations to issue bonds in USD at lower rates than those prevalent in most domestic markets. In the case of the later, a weak dollar allowed those same corporations to borrow in foreign currency with the expectation of being able to pay on even more favorable terms later on. In order to fully take advantage of this situation, corporations relied heavily on offshore and off-balance sheet vehicles to issue bonds in foreign currency while disguising some of the intra-firm capital flows as Foreign Direct Investment (FDI). |4| Willful ignorance of this disperse structure of funding allowed markets participants to underestimate the real amount of borrowing and risk being undertaken by corporations in the region, fostering the credit boom.

However, this funding structure is inherently unstable in the case of Latin America. Evidence shows that regional firms have used the funds to finance a so-called carry trade. |5| Instead of using the flows of dollars to expand export productive capacity and generate the foreign currency required to pay back the bonds, a large number of corporations, and specially those on non-tradable sectors, have used their balance sheets as a channel for international financial intermediation. |6| By borrowing in favorable terms abroad and providing domestic credit or buying domestic bonds with higher yields, they have been able to obtain substantial short term profits. Conversely, their balance sheets have become increasingly sensitive to exchange rate volatility, as well as liquidity conditions. In the case of the former, a stronger dollar requires corporations to raise larger amounts of domestic currency in order to service a given amount of debt denominated in USD. In the case of the later, an increase of risk aversion on international financial markets limits the capacity of corporations of either rolling over their bonds or directly accessing the required dollars to pay their debts.

Eventually both risks began to materialize in late 2014 revealing a pro-cyclical structure of funding. |7| As the dollar began to strengthen, on the expectation of a series of interest rate increases to be performed by the FED, liquidity dried up. On the creditor side, the risk exposure of investors was magnified and the balance sheet of financial intermediaries became increasingly constrained. On the debtor side, borrowing costs steadily increased and corporations had a more difficult time rolling over their positions. Furthermore, the fact that this time around the external exposure was embedded on the balance sheet of local corporations, instead of banks, established a more direct channel of transmission of the financial shock in at least two ways. First, as firms were engaging on a carry trade that provided additional domestic credit, the reversal of the process placed further downward pressure on domestics financial markets. Second, corporations were forced to curtail investment and production, among other strategies, in order to absorb the shock on their balance sheets. These dynamics help to partially account for the slowdown in economic activity observed in the region over the last 2 years, as well as the lack of response of exporting firms to weaker local currencies.

Despite this grim picture, the situation seems to have stabilized after a volatile beginning of 2016. However, evidence seems to point out that the increase in capital flows to emerging markets that has taken place since March of this year are not necessarily associated to an improvement of the fundamentals of borrowers but comes as a result of developments in advanced economies. |8| International investors have shown they willing to tolerate more risk and return to the region in a desperate search for yield, as an estimated stock of USD 13 trillion in bonds has entered into negative yield territory. |9| This dynamic will most likely be proved short lived, as the situation of corporate borrowers in the region is increasingly dire. The Return on Equity (ROE) of corporations in the region has sunk into a two decade low, falling to zero in 2015. |10| These results are mainly explained by a large increase in corporate bankruptcies in Brazil. An example of the things to come is Oi, Brazil’s largest fixed telephone line provider, which recently filed bankruptcy with debts for a total of USD 19.2 billion, of which 66% correspond to foreign bondholders. |11| The most problematic factor in this regard is that even though Brazilian corporations represent the largest bond issuers in absolute terms, the relative exposure of corporations to bonds in USD in much larger in other countries of the region such as Mexico, Chile, Colombia and Peru. |12|

Thus, a further strengthening of the dollar and an ensuing shift in global liquidity conditions could put significant pressure on governments in the region to provide corporate bailouts as domestic champions, such as Oi, find themselves unable to roll over their external commitments. Placed in perspective, this financial dynamic shows how misguided are economic policies in the region. On the one hand, the expectation that weaker local currencies will help to boost exports providing a much needed support to economic growth will not materialize unless governments and central banks address the pressures that have build up on corporate balance sheets. This could involve among others, to extend the swap lines provided by the FED to Brazil and Mexico during the financial crisis to other countries in the region so as to facilitate access to US dollars to corporate borrowers. On the other, the widespread adoption of austerity measures by Latin American governments in a context where most of the public funding needs are met in domestic financial markets only amplifies the negative impact on domestic demand caused both by the collapse in commodity prices and reduction in investment. The situation might not be as dire as it was back in the early 80’s but it does seem clear that the region is headed towards turbulent financial times.

 

Footnotes

|1| CEPAL. (2015). Panorama Fiscal de América Latina y el Caribe 2015. Retrieved from http://repositorio.cepal.org/bitstr…

|2| This group refers to Mexico, Brazil, Chile, Colombia and Peru. See Bastos, F. R., Kamil, H., Sutton, B., Meier, A., Werner, A., Srinivasan, K., Garcia-Escribano, M. (2015). Corporate Financing Trends and Balance Sheet Risks in Latin America: Taking Stock of The Bon(d)anza. Retrieved from https://www.imf.org/external/pubs/f…

|3| Acharya, V., Cecchetti, S. G., De Gregorio, J, et. al. (2015). Corporate debt in emerging economies: A threat to financial stability? Retrieved from http://www.brookings.edu/ /media/Re…

|4| Stefan Avdjiev, by, McCauley, R. N., Song Shin, H., & Avdjiev, S. (2015). Breaking free of the triple coincidence in international finance, BIS Working Paper 524. Retrieved from https://www.bis.org/publ/work524.pdf

|5| Bruno, V., & Shin, H. S. (2015). Global dollar credit and carry trades: a firm-level analysis, BIS Working Paper 510. Retrieved from https://www.bis.org/publ/work510.pdf

|6| Caruana, J. (2016). Credit, Commodities and Currencies. BIS Speech Retrieved from https://www.bis.org/speeches/sp1602…

|7| Song Shin, H. (2016). Global liquidity and procyclicality. Retrieved from http://www.bis.org/speeches/sp160608.pdf

|8| FT. (2016, June 10). Follow EM borrowing costs drop to 13-month low. FT. Retrieved from https://next.ft.com/content/f5d9a7c…

|9| WSJ. (2016, July 10). Black Hole of Negative Rates Is Dragging Down Yields Everywhere. WSJ. Retrieved from http://www.wsj.com/articles/black-h…

|10| FT. (2016, June 10). Emerging market corporate profitability falls to decades low. FT. Retrieved from https://next.ft.com/content/2444dce…

|11| FT. (2016, June 21). Oi files Brazil’s biggest bankruptcy protection request. FT. Retrieved from https://next.ft.com/content/0f6ea08…

|12| Acharya, V., Cecchetti, S. G., De Gregorio, J, et. al. (2015). Corporate debt in emerging economies: A threat to financial stability? Retrieved from http://www.brookings.edu/ /media/Re…

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