Redemption: End of an Era

Mexico, the country that virtually defined the term “Latin American debt crisis,” last month retired the last of the $37.5 billion in Brady bonds that were cooked up to bail it out of one especially nasty such episode in the 1980s. The 30-year bonds weren’t due until 2019 .

Mexico, the country that virtually defined the term “Latin American debt crisis,” last month retired the last of the $37.5 billion in Brady bonds that were cooked up to bail it out of one especially nasty such episode in the 1980s. The 30-year bonds weren’t due until 2019 .

To mark what Mexican Finance Minister Francisco Gil Díaz described as the “end of an era,” Mexican President Vicente Fox, U.S. Treasury Secretary John Snow, International Monetary Fund managing director Horst Köhler, Citibank vice chairman William Rhodes and other financial luminaries gathered at Los Pinos, the secluded presidential compound in Mexico City, on the sunny morning of June 12 to commemorate a genuine occasion: Mexico’s conversion from chronic bad debtor to responsible sovereign borrower.

“Mexico has moved from debt and recurrent financial crisis to a position of growing economic leadership among emerging-markets countries,” proclaimed Köhler of the IMF, which has a more-than-casual interest in Mexico’s reforming its borrowing practices. U.S. Treasury Secretary Snow lauded the country for opening its borders to trade, adopting sound fiscal and monetary policies and granting autonomy to its central bank. “Mexico has followed a responsible strategy,” agreed President Fox, who no doubt hopes that good publicity from the Bradys’ early redemption will help offset resentment over a sluggish economy in this month’s congressional elections.

Latin American debt crises are a thing of the past -- and the present and the future. But probably not in the old, all-encompassing Mexican style that proved to be so debilitating for every country in the region because of “contagion.” Although it is easy to draw too much optimism from Mexico’s Brady ceremony, it’s also easy to underestimate its more-than-symbolic significance.

What is so striking about Latin America today is the huge differential between the prospects and the creditworthiness of, on the upper end, Mexico (whose local currency debt is now rated A by Standard & Poor’s) and Chile (AA) and on the bottom end, countries such as Ecuador (CCC+), Uruguay (B) and Argentina (SD, for selective default). More than ever, investors must resist thinking of the region as an economic monolith: There is no longer such a thing as Latin American debt -- there is only Brazilian debt or Mexican debt or Uruguayan debt.


“The long-term trend will be toward credit differentiation, because people have realized that Argentina can default and it doesn’t take down the rest of Latin America,” asserts Mohammed El-Erian, managing director of Pimco, the biggest holder of emerging-markets bonds, with $12 billion worth. Adds Michael Chamberlin, executive director of New Yorkbased EMTA, the emerging-markets traders’ association: Weaker credit correlations among Latin American countries “has got to be a good thing, because the good get rewarded and the poor less so.”

TO BE SURE, LATIN AMERICAN COUNTRIES have seduced foreign investors before, only to let them down with a thud. Is this another instance of a deceptive come-on?

The whole area certainly looks a lot more attractive. For a start, stock markets are hot. Since the beginning of the year, the dollar value of a basket of Latin American stocks (as tabulated by Morgan Stanley Capital International) has risen 23 percent, roughly double the average for stocks worldwide.

Moreover, capital inflows are skyrocketing, after having shrunk steadily since 2000. The Institute of International Finance, a Washington, D.C.based bankers’ lobbying group, estimates that capital wending its way into Latin America will reach $139 billion this year, in contrast to $54 billion in 2001 and a paltry $14.4 billion last year.

Köhler told the leaders assembled at Los Pinos that IMF calculations projected that the region’s economic growth should resume this year and reach 4 percent in 2004. By contrast, the Fund’s spring economic outlook noted that in 2001 and 2002 Latin America “experienced its worst downturn in two decades.”

Yet the recovery is vastly uneven, reflecting the widening divergences among Latin American economies. The IMF expects Mexico to grow by 2.3 percent this year then smartly pick up the pace to 3.7 percent in 2004. The gloomy forecast for Venezuela, meanwhile, is a 17 percent drop in real GDP this year, although next year looks a lot brighter. And Latin America overall remains as vulnerable to setback as the global economy itself. The Institute of International Finance forecasts that growth for Latin America as a whole this year will reach only 1.5 percent, which works out to a decline on a per capita basis because of the region’s rapidly growing population.

But perhaps the most dramatic, if somewhat ominous, sign of Latin America’s revival is the rush of footloose global money into high-yielding Latin American bonds -- as reflected in that surge in capital inflows. Even investment-grade Mexican bonds, for instance, were yielding almost 300 basis points over U.S. Treasuries in late June. Pimco’s chief emerging-markets bond fund has more than doubled in size since January, from $448 million to $1.05 billion.

An inevitable contraction in credit spreads attests to this newfound but not necessarily enduring enthusiasm. For instance, the margin of Brazilian bonds over U.S. Treasuries gapped momentarily to 2,400 basis points during the run-up to last October’s presidential election, when investors feared that the country would lurch to the left under Luiz Inácio Lula da Silva. But as Lula in office has proved to be surprisingly moderate -- and relieved investors have channeled more money to Brazil -- the spread on the country’s bonds has fallen to as little as 700 basis points. For emerging-markets bonds in general, the spread over Treasuries has narrowed by more than 400 basis points since late September, according to the J.P. Morgan emerging markets bond index plus.

Favored Latin American countries have been quick to accommodate the extra bond demand. Mexico and Brazil have done issues in recent months that were double and quintuple oversubscribed, respectively. Latin American bond issues are expected to top $32 billion in 2003, far exceeding those of other emerging-markets regions. Mexico alone has issued some $6 billion of sovereign bonds so far this year.

But the current appetite for Latin American assets depends less on the region’s improving economic fundamentals than on such external factors as the miserly interest rates elsewhere, analysts contend. “Investors are desperate to get yield, so they are driving up emerging-markets prices,” points out Desmond Lachman, a resident fellow at the American Enterprise Institute and former chief emerging-markets strategist at Salomon Smith Barney.

This isn’t to say that Latin America is attracting only nomadic “hot” money. “It’s not hot money, in that it’s money rationally seeking yield in this global environment. So if you believe that the U.S. Federal Reserve is going to keep yields low for a period of time, it’s going to stick around for a while,” contends James Barrineau, Alliance Capital Management’s senior vice president in emerging-markets research.

Nor are the fundamentals altogether irrelevant to investors’ calculus. As Pimco’s El-Erian points out, “The credit quality of emerging-markets bonds as a class is improving.” Some 45 percent of the EMBI+ index of all emerging-markets bonds is now made up of investment-grade paper, compared with less than 10 percent five years ago.

Yet foreign investors shopping for yield are the ones most likely to turn tail when perceived risks rise or better short-term opportunities beckon.

Thus the biggest threat to today’s capital inflows is the possibility of a rise in Group of Seven interest rates that would lure investors back home, points out Ricardo Amorim, head of Latin American research at IDEAGlobal, an independent research boutique based in New York.

That could leave Latin America, with its comparatively meager domestic savings, in the lurch. “What makes Latin America vulnerable is the need to bring in foreign capital, and this will take a lot of time to change, if it changes at all,” notes Amorim.

Pimco’s El-Erian suggests that the next phase of inflows, starting at midyear, will more accurately track the disparate credit status of different Latin American countries. “The good boats will stay up, and the boats with holes will fall,” he says.

Among those he sees sinking is Uruguay. Sucked into the vortex of the November 2001 default of neighboring Argentina, the country suffered a bank run that sapped its reserves and forced Montevideo to float its exchange rate and devalue. That caused the country’s foreign debt to soar, pushing it into virtual default in August 2002. Uruguay was an “innocent bystander,” maintains the EMTA’s Chamberlin. In May, Montevideo engineered a debt swap in which bondholders took a hit but Uruguay emerged from quasidefault.

Contrast struggling Uruguay with Mexico. “You’re seeing a convergence between stronger emerging-markets countries and the developed world,” Chamberlin suggests. “It’s not the investors that are crossing over; it’s the Mexicans that are crossing over.”

Brady on Bradys Mexico defaulted on its foreign debt in August 1982, and soon other Latin American countries followed. By 1989 the emerging-markets debt crisis was entering its eighth year, and Latin America was suffering through what came to be called “the lost decade.”

The region’s persistent recession, triggered by the aftermath of banks’ overexuberant lending of petrodollars in the 1970s and a commodities bust in the 1980s, had begun to make it clear that this debt crisis was deeper and wider than any short-term liquidity problem. Latin American economies could not simply grow their way out of their debt burdens, which in Mexico’s case was equal to 44.2 percent of its GDP.

ThenU.S. Treasury secretary Nicholas Brady, backed by the International Monetary Fund and the World Bank, devised an ingenious rescue plan that replaced defaulted bank loans with so-called Brady bonds backed by U.S. Treasuries. Creditors stood to lose some -- though by no means all -- of their money, and the countries issuing Bradys had to undertake reforms.

Mexico became the first of 19 nations around the world to launch Bradys. In July 1990 it swapped $37.5 billion worth of loans into Bradys. Within a decade countries from Latin America to Eastern Europe to Africa had issued $150 billion in Brady bonds.

Now Mexico has become the first to retire all of its Bradys. Last month it redeemed its final $1.28 billion worth and commemorated the occasion by inviting politicians and financiers from around the world to a ceremony at Los Pinos, the presidential residence (story).

Today an investment-grade borrower, Mexico can finance its debt without having to offer lenders collateral. Indeed, the country can borrow on foreign markets (though it now meets much of its needs domestically) at spreads of as little as 270 basis points over ten-year U.S. Treasuries. Mexican Bradys peaked at 2,303 basis points over Treasuries in March 1995, during the “tequila crisis,” when Mexico was forced to devalue the peso.

Mexico is the shining example of a Brady Plan success story. Other Brady issuers, however, have had their share of troubles. Ecuador became the first Brady borrower to default, in 1999, and Quito is currently trying to stabilize the economy with IMF support.

Now chairman of Washington, D.C.based Darby Overseas Investments, an asset management firm that develops equity, fixed-income and financial services in emerging markets, Brady, 73, discussed his eponymous bonds and the prospects for developing countries with Contributing Editor Lucy Conger.

Institutional Investor: What’s the significance of Mexico’s retiring its Brady bonds?

Brady: It’s a welcome sign of success. It represents the end of a transition period when many emerging-markets countries moved from debt restructuring to fuller participation in the global economy. The Brady Plan worked.

What gave rise to the plan?

In the late 1980s a debt crisis burdened the whole of Latin America. In the face of this seemingly intractable international situation, we sought to create a sound financial base for a new beginning.

Our approach was pragmatic. Mexico simply was not able to continue to count on commercial banks and international institutions to provide another round of financing. A means had to be found to enable countries to encourage the return of flight capital, free themselves of the burden of external debt and, at the same time, establish a new view as to how they could finance themselves. Through a unique agreement between sovereign debtors and private financial institutions, the Brady Plan linked the countries’ economic recovery to political and financial restructuring.

How so?

The success of the Brady Plan was due above all to the countries’ commitments to establish sustainable democracies and sound macroeconomic policies and to pursue vigorous structural reform. These were, and remain, the key factors for economic success. Governments that commit to pursuing the sort of political, macroeconomic and structural reforms that Mexico, Brazil and others have made will win increasingly strong investor support. Those that do not face harsh global market repercussions. Of all the lessons we’ve learned, the most important is that market-based plans work.

What were some of the reforms fostered by the Brady Plan?

The advance of democracy is only part of the good news. To take Mexico as an example, it established a central bank that is truly independent; pursued an important privatization program among leading industries; decreased regulation and subsidies; enacted a trade liberalization program, including Nafta; and has gone a long way toward revitalizing the banking system. There have been setbacks, but a number of countries have done very well and deserve credit.

Are Latin American countries too deeply in debt again today?

Several have pursued very sound policies, secured investor confidence and are managing their external situations well. Others have failed, to a greater or lesser extent. The Mexican government continues to pursue policies that maintain the strong fundamentals that earned it investment-grade status in 2000. The new government in Brazil has gotten off to a very good start and has been sensitive to pursuing policies that build international confidence. By contrast, you have an exceptionally difficult situation in Venezuela.

Why is that?

One of the problems in the 1990s was that underwriters and investment bankers did encourage some countries to borrow too much, and this led to serious difficulties. The situation has improved in part because of serious crises that took place, and I am encouraged that the IMF and the Group of Seven are now looking to market-based voluntary approaches to crisis resolution.

How do you view country bailouts now?

We are in quite a different period. International official support needs to be limited in scale and in scope. Its real role is to help national governments create conditions where citizens bring home the capital they sent abroad when they lost confidence; revive and build interest among foreign long-term investors; and establish conditions that secure confidence in financial markets. This does not mean mobilizing many billions of official dollars in every crisis. Official authorities need to find ways to bring private lenders and investors into the picture early. What developed countries should be trying to do is extend democratic free enterprise -- democratic politics coupled with a free market -- which produces the greatest progress in alleviating human suffering.