History Repeats Itself

Back in 1992, a New York lawyer and veteran legal adviser to many a Latin American government sat down to write a lighthearted story inspired by one of his clients. Set 10 years in the future, the story by Lee Buchheit of Cleary, Gottlieb, Steen & Hamilton, describes how Enrique Infortunado, finance minister of the Republic of Ruritania, arrives at the Manhattan offices of his government’s US law firm to announce that his country is bankrupt again. The suave minister expects a relatively straightforward renegotiation with bank creditors, as in the 1980s. Regrettably, his trusted legal advisor informs him that Ruritania’s creditors now consist not of banks, but of thousands of unknown bondholders. “They can’t be identified or contacted easily,” says the lawyer. “They probably won’t be susceptible to peer pressure or governmental suasion as were the banks. And they almost certainly can’t be counted on to lend Ruritania more money as part of the workout, something that the banks were prepared – although scarcely pleased – to do in the 1980s,” says the lawyer. He cautions the minister that these creditors could even sue Ruritania to recover their loans. Horrified, Infortunado jumps in a cab and heads to Bloomingdale’s for some retail therapy.

Buchheit was more prescient than he might have wished. In December 2001, to cheers in Congress, the president of Argentina announced that the government would halt payment on $144 billion in debts, of which nearly half consisted of international bonds. Argentina already faces bondholder lawsuits in Europe and in New York. The government of Néstor Kirchner, which took office in May 2003, needs to restructure bonds held by thousands of retail investors in Europe and Japan, plus aggressive US and British institutional investors and vul- ture funds. And the International Monetary Fund is not likely to cough up billions of dollars in fresh loans for Argentina as easily as it once did. Elsewhere, Uruguay has had to restructure its bonds; Ecuador is playing with the idea of a debt restructuring four years after its last default; and Venezuela is teetering on the brink. Brazil, with total public sector debt in excess of $250 billion, had a narrow escape in 2002 and may yet hit the rocks.

Latin American countries have been borrowing, overspending, and going bust since they became independent in the 1820s. The first Latin American debt crisis hit the City of London soon after. The 1982 debt crisis came after Latin American countries had gorged themselves on a flow of floating-rate loans from commercial banks, awash with petrodollar deposits from newly rich oil exporting countries. It all ended when the US raised interest rates to curb inflation and reduced imports from Latin America. Says Arturo Porzecanski, ABN Amro’s chief economist for emerging markets, “There is a timetested relationship that holds in the Americas. When interest rates in the North are high, money is sucked out of the South and flows North; and when interest rates are low in the North, as they are now, money just trickles down to the South.”

Mexico Falls

Surprisingly, it was oil-producing Mexico that was the first Latin American country to default in 1982. Richard Frank, CEO of Darby Overseas Investments, a private investment firm, was in Mexico City the day the government went bust. “It was a freakish scene on the street. I met people who were going into the banks and could not get dollars out,” he recalls. “One man was carrying a garbage can of silver coins. Since he could not get dollars, he withdrew the silver equivalent instead.”

Within months of the Mexican default, governments across the region stopped servicing their debts. Chile and Colombia were the only major Latin American countries to avoid default. The crisis of 1982 marked the beginning of Latin America’s ‘lost decade’ as the region sank into economic stagnation and successive efforts to resolve the debt crisis failed. It took the energy and insight of a small team in the US Treasury to come up with a solution for the debt crisis that was radical and innovative yet conceptually simple.

US Treasury Secretary Nicholas Brady came up with a plan that applied the principles of US corporate restructurings to Latin America’s stricken economies. David Mulford, international chairman for Credit Suisse First Boston, says, “The essence of the Brady plan involved debt reduction and [recognizing] that a market was beginning to develop in the paper of these loans. These banks were selling off pieces of these loans at discounted prices.” The plan offered debt relief on the basis that creditors would collect principal and interest, that countries would agree to economic reforms, and that the debt would be structured to make it more tradable, enabling creditors to disperse it throughout the financial system.

The Brady Plan created $129 billion in new bonds that were liquid, fungible and offered plenty of yield. They were also safe, since Bradys came with US Treasury zero coupon bonds attached to guarantee payment on maturity. An international bond market for emerging market countries quickly sprang up, with Latin American Bradys as its main asset. Mexico was the first country to restructure its commercial bank debt under the Brady Plan, followed by nine others including Argentina and Brazil.

Each country’s Brady restructuring was unique but all included at least two basic options. Creditors could exchange their loans for either par or discount bonds. Par bonds offered no principal reduction but in exchange, carried below- market interest rates. Discount bonds offered floating interest rates but represented a 30%-50% cut in principal. A pledge of zero-coupon US Treasury bonds secured payment of principal of both types of Brady bonds at final maturity.

With the Brady restructurings out of the way, the 1990s saw remarkable growth and innovation in the bond market, helped by a surge in international liquidity and economic reform in Latin America. Investment banks ramped up origination teams, and JP Morgan and Citigroup emerged as the largest underwriters of Latin American bonds with $37.8 billion and $20.3 billion in deals closed since 1990. JP Morgan introduced its Emerging Markets Bond Index in 1992 to act as a benchmark for the market and Latin American bonds account in 2003 for 60% of the index. The emerging market asset class was essentially a Latin American show. In 2002, Latin America made up 63% of JP Morgan’s EMBI Plus index.

Issuance by Latin American sovereigns and private sector issuers rose to a peak of $58.66 billion in 1997 led by Argentina, which sold $78.52 billion throughout the 1990s. Francisco Pujol, Morgan Stanley’s co-head of global emerging markets, says Latin American sovereign issuers also became the most innovative and sophisticated issuers in the emerging markets, but not necessarily for the right reasons. Pujol points out that Argentina was willing to look at some of the most sophisticated structures in the 1990s because it had already tapped out the mainstream market and had to entice investors with interesting structures. “They had to look at more alternatives because their financing needs were so large,” says Pujol.

Mexico developed new variations on bond issues after its 1994-95 financial collapse. The US government led a bailout for Mexico that included a $20 billion line of credit backed by its oil reserves. Mexico later refinanced the loan in the international capital markets, raising $20 billion between 1995 and 1997, when it prepaid the Treasury loan. In November 1995, it issued a cetes bond that became a milestone in the development of the markets. The issue, launched at $500 million, was so popular that Mexico could upsize it to $1.5 billion. Led by Chemical Investment Bank, the $1.5 billion, one-year global bond paid investors principal and interest on maturity at the higher of two rates, either the Mexican cetes rate or US dollar Libor. In August 1996, Mexico issued a $6 billion, five-year floating rate note, led by JP Morgan and SBC Warburg, which investors gobbled up. The bond, which was split between a $5.42 billion bond and $576 million loan, was backed by crude oil export receipts.

Mexico’s sophisticated post-Brady issues helped develop the US market for other Latin American issuers. Brazil’s $3 billion, 30-year global bond in June 1997, led by Goldman Sachs and JP Morgan, established its name in the markets. The sovereign priced the deal at 395 basis points over US Treasuries. Bankers say the 11.19% yield to maturity was tempting enough to attract international institutional investors who would have otherwise stayed out of the deal.

Sovereignty Supercedes Credit

The sophistication of sovereign issuers has been matched with the growing expertise of institutional investors. Latin America’s audience of investors in the 1980s consisted mostly of European retail investors. “Often these people were chasing yield and invested heavily and without a lot of discrimination,” says Paul Tregidgo, co-head of global debt capital markets fixed income for Credit Suisse First Boston. “The Tequila crisis in 1994 and 1995 was a major event in the emerging markets.” It forced Wall Street and investors to invest more in research as awareness of emerging market risk grew in tandem with growing demand for these highyielding bonds.

The surge in issuance and a conviction that the reforms of the 1990s – privatization, trade liberalization, debt reduction – would deliver strong, sustained growth, attracted large institutional money managers to the Latin American sovereign bond market. These new actors included crossover investors from the more mainstream high-yield and high-grade investment market in the US. “The development and incredible success of specialized institutional fund management in emerging markets [means] the natural focus of these professional investors is credit, they look at the credit dynamics of a sovereign,” says Mulford.

Most Latin American countries have understood this and responded by upgrading the quantity and quality of the information they provide to the market. Sir John Bond, chairman of HSBC Holdings and chairman of the Institute of International Finance (IIF), the Washington-based lobby group for big banks, told LatinFinance in September 2001, “A government decides its economic policies and the international community can choose whether or not to participate in its economy. The IIF tries to set standards which it recommends recommends to everyone who interacts with the international financial community.” The basic principles, he says, are transparency and communication. Investors can make more informed decisions if governments provide markets with as much data as possible (see box below). Bond singled out Mexico as an outstanding example of this “effort in investor relations.” The government and its lenders have learned from the devastating peso crisis, which leveled the Mexican banking system. Today, Mexico has “excellent communications with the markets. [It] explains its medium and long-term strategies,” said Bond.

The same could not be said for Ecuador, which in 1999 became the first Latin American country to default on supposedly inviolable Bradys after “vulture” funds, led by Gramercy Advisors, demanded accelerated payment of the bonds. Aided by Salomon Smith Barney, the government imposed a 40% “haircut” on its Brady bondholders by offering to exchange $6.5 billion in Brady and Eurobonds for new 30- year and 12-year bonds. These bonds required all investors to approve a restructuring, a rule exploited by the vultures to demand better terms from the government. But Ecuador – advised by Buchheit’s firm of Cleary, Gottlieb – required those switching into new bonds to approve clauses gutting protection rules from the old bonds. The same team of Salomon and Cleary, Gottlieb took a similar approach when they restructured Uruguay’s $5.3 billion bonded debt in May 2003.

As a rule, a bond’s complexity is inversely proportional to the reliability of the issuer. As Mexico’s creditworthiness improved, it was able to issue more of the plain vanilla bonds that are cheaper and easier to sell than intricate, non-standard offerings that attract relatively few investors. Argentina, never an investment grade issuer, was nevertheless able to issuer large, plain vanilla bonds into the US market during the 1990s. As its debt ratios deteriorated and investors filled up with Argentine paper it had to resort to increasingly desperate measures, particularly its assault on European retail investors who were the last to buy Argentine bonds, long after the smart money on Wall Street and the City of London had left.

The market for developing country bonds had grown enough to accommodate Latin American issuers even with greater risk in the region. In October 2001, Chile successfully issued a $650 million, 10-year bond at 256 basis points over US Treasuries as Argentina continued drifting toward devaluation and default. The void left by Argentina’s December 2001 default enabled smaller issues from Caribbean and Central American countries to come to the market. Argentina’s default also taught investors that it was better to spread their bets over a wider number of issuers, than stick closely to the Embi – which once gave Argentina a 25%-26% weighting. Ariel Sigal, head of global markets for Latin America at Deutsche Bank, believes financial contagion is diminishing in Latin America. “Investors no longer see the region moving in tandem,” he says. “They are able to better differentiate between countries. Latin American countries are more likely to be affected by endogenous issues these days.”

Less robust countries still felt the backlash of Argentina’s crisis and bore the brunt of investor anxiety. Brazil suffered the most as investors and international banks pulled out in 2002. Brazil’s stripped spread in the Embi hit 2,282 basis points over US Treasuries on the eve of the election of Luiz Inácio Lula da Silva, leader of the Workers Party (PT). In August 2002, the IMF stepped in with a $30 billion package that saw Brazil safely through the election year and locked the new government into a fiscal straitjacket by requiring it post a primary budget surplus – before interest payments – of 4.25% of GDP. This, plus Lula’s sound policy stance, averted a debt crisis in Brazil.

A crisis in Brazil would have turned into a cataclysm for Latin America and the emerging markets as a whole. Fortunately, Brazilian borrowers could still fall back on the domestic capital markets. Roger Scher, head of sovereign ratings for Latin America at Fitch Ratings, says Brazil was able to withstand the panic of 2002 because most of its debt is denominated in reais and held locally, unlike Argentina, which issued the bulk of its debt in foreign markets in hard currencies.

Brazil has the largest local capital market in the region, even though issuance last year fell to $5.7 billion from $8.03 billion in 2000. Private pension funds in Argentina, Chile, Colombia, Mexico and Peru have made a vibrant debt capital market possible in these countries. Mexico’s domestic market has picked up, especially after it achieved an investment grade credit rating in 2000. Private sector issuance there reached $4.8 billion in 2002, a 51.3% increase over the $3.15 billion issued in 2000.

Michael Pettis, a former investment banker and author of “The Volatility Machine”, argues that the capital structures of most emerging market countries are fundamentally unsound. He says these countries’ capital structures intensify rather than diminish the impact of external shocks. Governments with large stocks of external, short term foreign currency debt are exposed to interest rate and exchange rate volatility and refinancing risk. Those with fixed rate, long-term domestic currency debt can absorb external shocks more easily. But Latin American governments still run large budget deficits and would crowd private sector issuers out of relatively small local markets.

Breaking Tradition

Latin America may yet break out of its cycle of debt and default, if governments – and voters – accept the need to live within their means. Sound economic policies would reduce budget deficits and debt burdens, allowing interest rates to drop. Economies would grow, making debt levels more bearable. In March 2001, Nicolás Eyzaguirre, Chile’s minister of finance told LatinFinance, “We have tried to smooth government expenditure through economic cycles for more than fifteen years, saving when we have windfall gains.” That is a momentous break from a tradition in which governments overspend and borrow when markets boom, only to hack at spending when crisis looms, which further depresses their economies. Latin American ministers need to follow Eyzaguirre’s example or risk following in the footsteps of the hapless Infortunado. LF15th