By Nina Mehta

It may not make much economic sense, but the event that sent the Latin American financial markets into a tailspin last year occurred several thousand miles away. When the Russian government declared a moratorium on its external debt payments last August, European and American counterparties started dumping exposures to emerging markets en masse. Although the effects were felt far beyond Latin America, the region was hit particularly hard because it was seen as the next large domino primed to topple as a result of the credit panic.

Capital-raising throughout Latin America ground to a halt. Investors already wary about emerging markets saw liquidity get scarcer. Latin globals and the traditionally liquid Brady bonds saw a reduction in trading activity, and the foreign exchange and interest rate markets became increasingly volatile. Even the Brazil C-bond, the most liquid Latin fixed-income instrument, saw thinner trading.

Then, on January 13 of this year, the markets really fell out of bed. The devaluation of the Brazilian real, prompted by reports that a state government was about to default on its debt, sent investors who had remained running to the exits. Volume on listed real contracts at the Chicago Mercantile Exchange and the Sao Paulo stock exchange dropped swiftly. In the second quarter of 1999, overall fixed-income trading volume in Latin America was $470 billion, according to the Emerging Markets Traders Association—just over half the trading volume for the same period last year.

But ironically, the biggest surprise about the Latin American markets this year has been their reasonably quick recovery. “The markets dropped dramatically after the devaluation, and the Emerging Markets Bond Index spread widened out to a high, closing at 1,503 on January 26, but after that the markets began to stabilize,” says Walter Molano, head of research at BCP Securities, a Latin American fixed-income broker-dealer. “Since then, however, concerns about a probable Ecuadoran default have put renewed pressure on the markets.”

“If you simply block the fluctuation in the foreign exchange rate by pegging it or by dollarizing, you’re not eliminating the underlying problem.” —George Handjinicolaou Dresdner Keinwort Benson

Everything is not back on track in Latin America and most economies remain stalled in a recession, but there are signs of recovery. Interest and interbank-lending rates have come down in the last few months—and inflation, a traditional Latin American scourge, has been kept at bay. The relative resilience of Latin America was also not entirely unexpected. “If the [credit] crisis had happened two years ago, the surprise element would probably have killed Latin America for a much longer period of time,” says Hari Hariharan, head of NWI Management. “The saving grace this time around was that Brazil’s devaluation was the most anticipated heart attack in the history of mankind. It was so anticipated that when the actual event happened, it turned out to be a nonevent.”

Local Activity

While a crisis is no time to think about developing a country’s derivatives market, the local use of structured derivatives in Latin America’s largest economies has been slowly and sporadically rising since before the East Asian crisis began. Over-the-counter interest rate products have been relatively strong for a number of years. Starting in 1997, there has also been a big push among corporates to manage their financial and market risks more actively. Among oil producers, for instance, the New York Mercantile Exchange’s benchmark WTI crude oil contract has become a much more common hedging and financing tool, says Bank of America’s Elizabeth Stanners. OTC crude oil derivatives are also used in connection with project deals as a way to hedge cash flows and get better credit ratings. In a well-publicized deal about three years ago, Argentina’s YPF negotiated a series of oil options to hedge its production as part of a project-financing deal. The transaction proved to other producers in the region that a prudent risk management strategy could not only help secure financing, but could get credit rating agencies to give projects better ratings—in the YPF case, the options enabled the company to hedge part of its cash-flow volatility, which increased its earnings stability. These days, says Stanners, many smaller producers have also been turning to the OTC and futures markets to hedge their exposures. The user side of the energy markets has been slower to follow the lead, but shortly before this past spring’s uptick in energy prices, she notes, a number of Latin American transportation companies began hedging their exposure to the cost of fuel. Many small and medium-sized firms, however, continue to face credit supply problems. FIMAT’s Patrice Blanc points out that there has recently been an increase in hedging activity by sugar mills and large sugar exporters in Brazil, the world’s largest sugar producer. “But to put hedges in place,” he says, “whether firms are in the fixed-income, currency or commodity business, they need credit lines—and when foreign banks sharply reduce their limits on Brazilian counterparties, it’s a problem.” With few exceptions, Brazilian and other Latin banks are unable to step in and take the other side of these transactions since they often don’t have enough expertise in derivatives and structured products. There are a few small, sophisticated investment banks in Brazil, such as Banco Bozano Simonsen, that can price structured deals, but a number of them lost money last fall and can’t afford to be as aggressive as they were a year ago. International banks, note other dealers, are also tentative about trading with small banks. Banco Marka and Banco Fonte in Brazil, for instance, were nearly bankrupted after the real devaluation, when they couldn’t cover futures positions. In both cases, Brazil’s central bank had to step in and sell futures to the banks in order to avoid a systemic risk event in the banking sector. —N.M.

In recent months, the strongest and most active Latin currency has been the Mexican peso, thanks in part to the pickup in oil prices, the reduction in Mexican interest rates and a perception of stronger fundamentals in the economy. Other currency markets—including Brazil—remain sluggish or in the doldrums. Over the past few years, banks, financial institutions and funds had put on Brazilian currency trades in size, often arbitraging between the real in Sao Paulo and the real at the CME—buying volatility in Brazil, where it was cheap, and selling it in Chicago, where it was more expensive. Once the real floated, however, Brazilian and international corporates with natural Brazilian foreign exchange exposures wound up scrambling for trades—and had trouble finding prices in the marketplace to hedge themselves.

“There is essentially no product in the marketplace today to hedge foreign exchange exposures in Brazil,” notes Patrice Blanc, general manager of the New York office at FIMAT USA Inc. and head of fixed-income, currency and commodity sales. The same problem exists for the Argentine peso. “There’s a lack of liquidity providers in the marketplace for these products because there is a lack of limits,” he says. “Many U.S. and European banks are not eager to trade or give limits to Latin America in general. They haven’t increased limits for Brazilian banks, for instance, because they’re worried about country risk.”

“Since a good deal of G-7 fixed-income trading takes place on the back of capital-raising, those volumes fell off considerably last fall.” —Elizabeth Stanners Bank of America

The equity derivatives markets have only partly recovered from their shock. Equity derivatives in Brazil, Latin America’s largest economy, are written primarily on the Bovespa stock index and half a dozen blue-chip stocks. Many investors in equity options were hurt by last fall’s volatility, and a number of houses left the plain vanilla options business to concentrate on other products. These days, the volume on the Sao Paulo stock exchange, which had reached $1 billion a day before the credit juggernaut hit the markets, now hovers at around $300 million a day, says Henri Kistler, manager of international affairs at the Comissao de Valores Mobiliarios, Brazil’s securities commission.

The scene is pretty much the same in the newly less-liquid fixed-income market. With only a few dealers now quoting the market, investors don’t have as many counterparties, price discovery has become more difficult, and there’s less transparency all around. “Since a good deal of G-7 fixed-income trading takes place on the back of capital-raising,” notes Elizabeth Stanners, a managing director in the global markets group at Bank of America, “those volumes fell off considerably last fall.”

The mighty Brady bond market, once the pride of Latin American capital markets, has lately lost some of its stature as well. Not everyone, however, sees this as a permanent shift. “When people say it has dried up a bit, I think it’s because they remember how it used to be,” says a fixed-income dealer at a major bank. “Before, a $50 million trade in our markets wouldn’t impact them too much, but now $20 million can move the markets around as if it were trading like $50 million.”

In the last few years, adds BCP Securities’ Molano, Latin governments have been trying aggressively to retire as many Brady bonds as possible, in order to free up some of the collateral and guarantees embedded in the bonds. “But the bonds take on a new, higher quality when the market hits these periods of high volatility, because they have the embedded collateral and guarantees,” he notes.

Optimists point to another good sign. Although hedge funds haven’t yet returned to Latin America in force, “there has been a recent increase in dedicated funds by pension funds returning to Latin America for the first time in a long time, and retail flow has improved,” notes a New York dealer. A good deal of money is heading back to Brazil, but Mexico “has the biggest mouth,” adds the dealer. Mexico is getting the biggest play since it’s closer to home and the fundamental story there is considered a little clearer.

Nonetheless, the flow of money to Latin America has not been accelerating.

Summers’ Heat

In March, Lawrence Summers, the recently appointed secretary of the U.S. Treasury Department, who was then the deputy secretary, stepped up to a Paris podium at an Inter-American Development Bank meeting and spoke about what Latin America could do to foster international financial confidence—and the flow of capital that foreign confidence brings. “Especially in Latin American countries so exposed to interest rate, foreign exchange and commmodity price swings,” he said, “finance ministries should be...looking for ways to spread or hedge against the risks to which government budgets and the economy as a whole are exposed.” He singled out the commodity markets as particularly ripe for risk management activity since they—along with the Latin debt complex—are a primary source of the region’s external revenue.

Summers also noted that while Latin American governments need to develop their domestic capital markets to ensure access to funds and less-expensive financing during times of crisis, private foreign financial-sector participation can help strengthen financial infrastructures and meet credit needs. During the recent emerging-market crisis, say experienced market watchers, Chile, Argentina and Mexico were better able than other Latin American nations to resist external shocks to their economies, in part because of macroeconomic reforms instituted over the last few years.

Credit Protection, Round Two

Of all the Latin American asset classes, credit derivatives have experienced perhaps the greatest recent reshuffling of players and purpose, courtesy of Russia. The market began trading in Latin America about three years ago, and picked up volume in late 1997 and early 1998 after the collapse of East Asian bonds. Unlike in the U.S. market, however, protection in Latin America is written not on corporate issues but primarily on sovereigns. There are varying claims about which countries see more action in the market, but the main Latin sovereigns on which credit protection is written are Brazil, then Mexico and Argentina, and then probably Colombia and Venezuela. The credit market falls neatly into “pre-Russia” and “post-Russia” phases, notes one credit derivatives dealer. Before Russia’s debt moratorium, U.S. multinationals and foreign corporates with natural Latin American exposures sold sovereign protection to cheapen their financing and development costs. Since the moratorium, they’ve abandoned the game. Here’s how such a deal would work. Assume Coca-Cola is building a bottling plant in Brazil, and the company has a capital expenditure plan of $1 billion a year for five years. Coca-Cola will naturally have outlays in reals over the five-year period. To cheapen its investment, the firm would sell convertibility protection, since it knows it will need to take dollars onshore no matter what happens with the convertibility of the real. If convertibility protection is expensive, the company benefits significantly by selling protection, since it winds up long reals onshore and short dollars, which is what it wants. “The surge in corporate activity in the credit derivatives market over the last couple years drew a number of banks into the market,” says the dealer. “Once banks saw they could lay off risk to clients, they began doing interbank plays and became more willing to take on risk and carry positions on their books.” The main U.S. banks active in the market were Chase, Goldman Sachs, Citibank, Salomon Smith Barney and JP Morgan. The foreign banks that sold credit derivative instruments included Deutsche Bank and ING Barings. Russia’s debt moratorium put the Latin credit derivatives market in a coma, at least temporarily. According to some, this had less to do with economic fundamentals than with documentation issues. The Russian event launched a legal dispute (still reverberating around the globe) about how to define a default and how contracts covered by default protection should be executed in the event of a disputed default. “Before the Russian crisis,” says the dealer, “people were less intense about negotiating documentation. The quality of the documentation was therefore not as great as it needed to be, and after Russia business fell off substantially.” By the beginning of 1999, when Latin institutions were beginning to get their limits back, documentation was tightening up. The real devaluation threw spreads out again, but that eventually enticed sellers back into the market since they were being paid well for selling protection. Nowadays, the sellers are no longer corporates but speculators—primarily hedge funds—and those buying protection are banks that have had their country limits cut. “They want to continue generating business,” notes the dealer, “so they buy default protection to free up lines to be able to generate more loans and more cross-border transactions.” Not everyone agrees that legal and documentation problems were the driving force behind last fall’s dry spell, however. Widening credit spreads in the Latin American markets—particularly Brazil—generated liquidity issues, which took a toll on the total-return and default swaps market, notes Bank of America’s Elizabeth Stanners. The result: fewer transactions. While the credit derivatives market is not yet a truly local market, this is likely to change as Latin American investors become more sophisticated, as corporate issuance increases, and as foreign investors become more familiar and comfortable with the credit quality of Latin corporations. Every Latin corporate currently carries an element of country risk—an Argentine corporation’s ability to service its debt, for example, is potentially hindered by decisions that might be made at the federal government level. Consequently, investors in Latin America cannot always separate corporate risk from country risk; in the United States, on the other hand, where expropriation is considered a nonfactor, there is no worry about country risk. —N.M.

In Argentina, Summers pointed out, 50 percent of the banking sector is foreign-controlled, vs. 30 percent in 1994. And in Mexico, more than one-fifth of banking-sector assets are now foreign-controlled. Argentina has suffered a great deal recently, but its woes stem more from the deterioration of its terms of credit as a result of Brazil’s devaluation (since Brazil is its largest trading partner) and the increasingly onerous one-to-one currency peg it has with the U.S. dollar. “As these countries are learning,” he said, “the result [of reforms] is a deeper, more efficient financial market—and external investors with a greater stake in staying put.”

Few economists and market professionals are likely to dispute Summers’ points, but one of the problems with trying to ratchet up derivatives trading in Latin America is that no countries except Brazil and Mexico have significant and transparent derivatives markets—and many have only the thinnest of illiquid cash equity markets. Venezuela, for instance, has a small futures market for currencies and Argentina has plans to develop a futures exchange, but both currently have limited access to traded risk management tools. Many Latin American countries use OTC swaps and forward markets to hedge interest rate and price risk, but there are few organized markets, says Paolo Garbato, director of operations at the BM&F, Brazil’s futures exchange. There are strong markets for Latin American debt and OTC products abroad, he adds, but even in Mexico, which should have a more sizeable domestic market, “the liquidity flew to the CME.” Some liquidity is now heading back to Mexico, however, as foreign exchange activity is slowly ramped up at the MexDer, the country’s new derivatives exchange.

Liliana Rojas-Suarez, a managing director at Deutsche Bank and the bank’s chief economist for Latin America, concedes that Latin America’s underdeveloped derivatives markets need vast improvement, but adds that caution rather than demand should guide the introduction of derivatives instruments. The most important condition for the development of derivatives markets, she argues, is a solid banking system and strong banking supervision. Since most derivatives activity takes place off-balance sheet, “a bank that finds itself in trouble may be tempted to move even more of its activities off-balance sheet to disguise operations that are not functioning well,” she says.

Nonetheless, positive changes have occurred as a result of the activity of foreign banks in the region over the last five or six years. Foreign banks brought with them modern instruments of risk control, including protection against credit risk. By the time the East Asian crisis began to spread, says Marco Aurelio Teixeira, technical director of the BM&F, many banks in Brazil were already using value-at-risk methodologies to manage their risks, and some were regularly running stress tests to measure their exposures. Over the last year, the use of these models has increased tremendously, he adds, and now almost every major Brazilian bank “relies on at least one of these methods to measure its risk exposure.” Still, sensible risk management policies at the institutional level in Latin America need to go hand-in-hand with prudent monetary policies that strengthen countries’ economic infrastructure.

1994 vs. 1999

Mexico and Peru are the two Latin American countries likely to spin out of the current crisis first. Both have positive, if low, rates of growth projected for 1999—partly a function of the fact that they have flexible exchange rates, says Rojas-Suarez. Both currencies were allowed to depreciate significantly during the crisis when international pressure bore down on the exchange rate, minimizing the upward adjustment of real interest rates and reducing growth contraction.

Mexico in particular did reasonably well through the crisis. Most of the pain suffered by Mexican investors happened last October, says Adrian Valenzuela, vice president of equity derivatives at Morgan Stanley and manager of the firm’s non-Brazil Latin American client base. Earlier, Mexican fund management firms had secured high levels of leverage from Wall Street for long positions in emerging-market debt and equities—which were wiped out last autumn. In addition, many Mexican investors had bets on Russian debt and currency that fell apart at the same time. More significantly, however, the country still hasn’t managed to shuck the effects of the peso crisis of 1994–95. “That changed our marketplace dramatically,” says Valenzuela, “and the effects have lingered. Mexican accounts used to be among the more aggressive OTC derivatives accounts for U.S. banks. These investors are probably doing a tenth, if not less, of what they used to do back in 1993 and 1994.”

The reason for the low volume: the loss of capital after the peso crisis and the fact that Mexico’s regulatory authorities have taken an extremely conservative approach to institutional risk management in the years since. The central bank, for instance, has set stringent capital requirements for banks trading equity derivatives—a requirement that has effectively knocked the legs out from under the market. Banks and broker-dealers have also recently been required to register to trade OTC equity derivatives. In fact, notes Valenzuela, these changes have probably brought about an “overshooting in [firms’] risk managment techniques since the country went from having an extremely unhealthy, open laissez-faire approach to risk management, to the other extreme—having aggressive non-trading policies across the entire institutional base, from banks to local fund managers.”

Compared with Mexico, Brazil has coped with crisis far more effectively. Brazilian banks haven’t had a runaway lending market, in part because of the lesson learned by Mexico when past-due loans exploded after the peso devaluation. “The recent devaluation has been better managed by Brazil,” says Valenzuela. “And derivatives contracts had a good part in making sure there weren’t as many blow-ups, because many institutions were out there hedging their positions and managing their risks. Banks, pension funds and other institutions had access to local instruments and could hedge themselves locally—which is not something Mexican institutions were able to do.”

This past May, Brazil’s central bank announced a new measure to reduce the exposure of banks and institutions to foeign exchange. No entity can now have a net notional position—in cash and derivatives—greater than 60 percent of its net worth. This is a prudent measure, notes the BM&F’s Teixeira, but probably too cautionary. Many traders, he says, agree that the value-at-risk of the foreign exchange position shouldn’t be higher than 60 percent—but not the notional value of the net position.

Overall, last year’s credit crisis and the subsequent blowout in borrowing spreads have made a few key issues central to Latin America’s markets painfully clear. Cash and derivatives markets in countries such as Argentina and Brazil with large external borrowing programs will continue be at the mercy of volatile credit spreads and international liquidity. Countries that turned to fixed exchange rate regimes or currency boards in the 1990s to control inflation and stabilize their economies will be obliged to face stark choices in the near future, if they haven’t done so already—namely, whether to allow the currency to depreciate and take the heat, or jack up interest rates and draw down reserves to buttress the currency, in the process stifling growth. The derivatives markets may be a help in some of Latin America’s volatile markets, but risk management in general needs to take firmer hold throughout the region before that can happen.

The Dollarization Debate

Dollarization—the embrace of another nation’s currency as one’s own—has been much in the news lately. But according to Liliana Rojas-Suarez, managing director and chief economist for Latin America at Deutsche Bank, the subject is quite misunderstood. “People tend to think that if you have a dollarized economy, then by surrendering your monetary policy to the U.S. Fed, interest rates are going to come down to the level of the U.S. rates,” she says. “That’s a fallacy.” Lower rates would be a blessing for Latin economies, since high interest rates stymie growth, but the mistake people make, she notes, “is ignoring the fact that the most important element behind the high interest rates prevailing in Latin America is country risk—and country risk reflects structural and fiscal problems. Dollarization will not make that country risk disappear.” People want dollarization, agrees George Handjinicolaou, executive vice president and head of global markets in the Americas at Dresdner Kleinwort Benson, because they believe it will provide inherent stability. The drawback, he says, is that governments would have to give up “one of the freedoms they have to make policy—namely, the ability to release tension in the markets through a devaluation.” So what would the upside of dollarization be for the United States? To the extent that it creates stability in the exchange rates, says Handjinicolaou, “it could reduce the need for potential interventions and bailouts.” But this still would not address the main issue, which is that crises are often a function of structural problems that get expressed through fluctuations in the foreign exchange rate or interest rate. “If you simply block or eliminate the fluctuation in the foreign exchange rate by pegging it or by dollarizing, you’re not eliminating the underlying problem, which is the structural reform,” he says. “You’re just patching it over.” Dollarization also raises other issues that need to be addressed. If a country doesn’t have its own currency and a domestic bank has problems, who is the lender of last resort? For a system to be stable, foreign banks would be required. One reason many in favor of dollarization point to Panama as a healthy example of a dollarized economy is that most of the financial system in that country is composed of foreign banks. And when there are foreign banks, a nation doesn’t need the liquidity provided by a central bank because the liquidity can come from the foreign banks working abroad—since they have a direct line of credit to the Fed. Another issue in the dollarization debate is how to contend with the loss of interest on a country’s foreign exchange reserves, once it dollarizes. In its discussions about dollarization, Argentina has floated the idea that it dollarize and the U.S. Fed pay the country the $700 million in seignorage it would lose annually—and that the Fed allow Argentina to use the federal discount window if there’s a problem in the banking sector. So far, the Fed has suggested this isn’t an acceptable proposal. Few Latin watchers expect to see any serious, immediate movement toward dollarization. As a medium-term issue, however, Rojas-Suarez believes dollarization “will develop further, because in good times there are simple things that can be done in countries such as Argentina to increase the process of dollarization.” The government could, for example, allow firms to pay taxes and salaries in dollars. Right now that’s not the case, she says, but “if that happens, the process of dollarization could wind up being a market-led phenomenon.” Even Mexico is now talking about a monetary union with the United States. The long-term prospect of that makes sense to some economists, but such a feat clearly needs two to tango, and the United States is still far away from accepting any form of monetary union with any country—let alone Mexico, which is such a large economy. —N.M.

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