The previously fast-paced movement in the emerging markets towards raising funds in local currency has been brought to an abrupt halt by the financial crisis. With fear entrenched among investors, most are extremely hesitant about funding trade deals or projects in local currencies. Ted Kim takes a look at when or even if this market might recover.
Perhaps one of the hardest hit areas of the meltdown in the global banking system has been emerging market local currency financing programmes that had, at least for most of this year, been gaining critical momentum among issuers and investors alike.
At a last minute press conference in October organised but the Inter-American Development Bank (IADB) many of the bank’s economists and debt managers were quick to point out that although fundamentals of Latin American economies were still solid, particularly in commodity and manufacturing sectors that generate a bulk of their exports from dollar denominated export contracts, fall out from the US financial crisis has been rapid.
Essentially, few investors, whether commercial banks or hedge funds, are now willing to take substantial exposure to local FX-denominated debt in what has up to now been an issuance bonanza for the emerging market trade and project finance industry.
The momentum to swing the pendulum away from US dollar and euro-denominated financing to local currency financing began shortly after the last major emerging market crisis in 1998, particularly in Latin America.
The main lesson learned by commercial bankers and finance ministries was that while prudent local currency debt management was well within the range of careful risk planning, events far beyond Latin America could fire a shot through most balance sheets or public sector budget.
In 1998, few emerging market debt managers outside of Eastern Europe and the former Soviet Union had ever heard of the now infamous Russian GKO [short-term state bonds] the obscure ruble-denominated Russian treasury note which eventually defaulted.
That default was the precise trigger that led to a domino effect of crashing currencies, skyrocketing inflation and waves of sub-sovereign corporate defaults throughout the emerging market project and trade finance universe.
Effectively, the financial crisis of the 1990s and even going back to the 1980s in Latin America resulted in an increasing sophistication on the part of emerging market finance ministries and bankers to pay careful attention to FX exposure. Increasing awareness of FX risk management in turn has led to a growing interest to diversifying debt structure thereby reducing the risk of FX mismatches. The result was the increasing trend towards project and trade finance denominated in national currencies as opposed to US dollars or euros.
The rating agencies have certainly taken notice of the heightened FX risk management ability of emerging market issuers and the gradual move away from dollarisation. When the sovereign debts of both Brazil and Peru were upgraded to investment levels by the rating agencies at the start of this year, the size of the small but growing club of sovereign issues rated investment grade increased to a total of four. Mexico’s debt became investment grade in 2000, while Chile’s achieved that status in 1992. The upgrades had an immediate effect on cutting interest expense in trade and project finance deals as the issue of a sovereign ceiling – a general rule that no financing deal could be rated greater that the sovereign rating – had set a floor on the minimum cost of capital.
Meltdown in Miami condos leaves no global market untouched
This time around, in what may turn into a long drawn out replay of the 1998 crisis, hardly any local banker from Buenos Ares to Lima could have been expected to foresee how fast and easy lending to US subprime homeowners in Florida and California could, in the most bizarre chain of events in post-Bretton Woods economic history, yet again bring the emerging market financial system to the brink.
The simple fact that a huge amount of trade and project finance debt out on the market is now denominated in local currency may minimise losses suffered by issuers resulting from currency collapse. But trade and project financiers may face other problems in the months ahead. In juggling the allocation between FX debt and local currency debt, issuers, notably commercial banks and finance ministries, were exposed to a variety of risks difficult to estimate. On the issuers side, moving full swing into local currency issuance may, at least for the near term, help insulate many corporate balance sheets and national budget plans from the ongoing volatility on global markets.
However, there may also be a downside. In 1993, only 5% of Mexico’s debt was indexed to foreign currency on the eve of their financial crisis. After the Mexican financial system experienced a shock, investors had little appetite to buy into peso exposure and demanded that debt rollovers be denominated in dollars. Burning your providers of capital, even unintentionally, is simply not good for business.
The result of the Mexican crisis on the financing of public sector infrastructure projects was rapid. Within a year, the foreign currency composition of Mexico’s debt increased from 5% to 67%. Following many more years of financial recovery, that debt structure was transformed once again. Now more than 80% of Mexico’s debt is in local currency.
Most analysts agree that it is still too soon to gauge how willing investors will be to gain new local currency exposure – particularly with risk aversion hovering around historic highs in the commercial banking sector where much of the global trade finance industry is based.
The lesson from the Mexican crisis of 1994, says IADB economist Alejandro Izquierdo, is that Latin America’s debt managers must not only aggressively build up the presence of national currency in the national debt structure, but they must also “be prepared to deal with a trend back toward dollarisation when bad times come.”
So far, there certainly has been nowhere near the meltdown scenario that follows an outright default – such as Argentina in 2001. Nonetheless, momentum towards growing the business of local currency financing is clearly dead in the water for now.
“The local debt issuance markets are still functioning. For smaller transactions, there should still be enough interest in financing local deals among local banks. Additionally, the interbank market had been okay which was essential. Historically, local FX denominated project finance deals and trade finance have been placed mostly in the local bank market,” explains Ron Dadina, an emerging market debt consultant, who was formerly was a managing director for emerging market structured finance at Fitch Ratings, MBIA and, most recently, Bear Stearns. “Now, however, the local capital markets are nearly dead. The interbank market had been managing to function – until Lehman. Since then, everything has ground to a halt whether it is a bank financed deal and of course any capital market deal.”
The stoppage in the deal pipeline has effectively trumped the attractive underlying economics, however sound, of most trade or infrastructure finance projects.
“The overall business risk from the bank’s point of view of many of these emerging market infrastructure deals, whether a bio-diesel refinery or a new utility plant, may not have changed dramatically over the last several months. And I also do not necessarily think the decoupling argument is entirely out the window as the revenue drivers behind a lot of deals in Latin America have thin to zero correlation with the G5 banking sector,” observes Omer Abdullah, managing director of The Smart Cube, a Chicago-based independent financial research firm.
“However, for the financial side of the equation, risk premiums have skyrocketed and now all the numbers, namely the discounted cash flow calculations, are entirely different. When you add in the risk premium and uncertainty about local currency volatility, then I’d say we are in a whole new ball game for bankers in project and trade finance.”
Going forward, a rebound in investor sentiment, particularly in the G5 based global commercial banking industry, is key to estimating how quickly local currency debt programmes will once again gain traction given the historic levels of emerging markets currency volatility not seen since the Russian crisis. Simply put, with continued heightened risk aversion on the global markets, both in and out of emerging markets, banks will simply be less and less willing to take local FX exposure.
In theory, futures, options and swaps could be implemented to hedge out up to 100% of local FX exposure. In reality, the pricing of these hedging strategists is highly dependent on the implied volume in the market for FX derivatives. Greater uncertainty leads to greater volatility, which then in turn increases the cost of laying out a hedging strategy. Since the profit margins on vanilla trade financing deals, such as letters of credits and commercial bank export guarantees, can usually be measured in a few dozen basis points at best, it is easy to see how the rising premiums on hedging instruments can quickly wipe out the profit margins in financing deals.
In the near term, there is not even a great deal of conviction one way or another about the famed decoupling argument which had driven credit spreads on project and trade financing deals ever tighter.
Decoupling was a growing belief among emerging market financiers that economic development, risk and volatility of emerging markets would slowly but surely decouple from GDP growth – or lack thereof – in developed markets. The opposing “we are all in the same globalised boat” view on estimating volatility in of emerging economies has quickly taken over.
Speaking at the IADB press conference, Nouriel Roubini, chairman of RGE Monitor and professor of economics, Stern School of Business, New York University, explained that the idea of a U-shaped recession in the US, one where the recovery is quick and smooth, has been thrown out of the window.
“The recession will likely last up to 18 months and there is now a risk that the US economy will wind up with the stagnations seen in the Japanese economy in the 1990s. For the emerging markets, there has been a massive amount of ‘re-coupling’ as the fall out on emerging economies from Asia and Latin America has clearly been sharp and significant. Effectively, when the US catches a cold, the rest of the emerging market world gets pneumonia. Contagion from the US will be significant,” Roubini said.
Analysts specifically point to the damage suffered by sectors which rely on global commercial banks that are already seeing extreme challenges in finding fresh sources of financing. During the market turmoil in October, while US Treasury yields fell, the spread between US Treasuries and emerging market bonds, as measured by JPMorgan’s benchmark EMBI-Plus Index, a key funding cost benchmark, blew out to its highest since 2004.
Tightened and costly credit is hitting all emerging markets. In Peru, for example, a rush to provide finance for small cap mining companies – adventurous outfits that rely on capital markets and speculative investors with high tolerance for risk to fund their exploration – has stalled out, as falling commodity prices and tightening credit conditions have deprived them of momentum.
“To me, financing the exploration business is over in this kind of a market,” says Kerry Smith, of Canadian investment dealer Haywood Securities. “For exploration on greenfield projects, where you still have no proven resources, you have to be prepared to wait it out for five years before significant risk appetite in capital markets comes back”.
In South Africa, there had been a degree of confidence that tough regulation had isolated their banking system from the crisis. On the other hand, South African banks are also heavily capitalised by foreign investors and dependent on the global markets. Further, the national economy is suffering from a current account deficit of about 9% of GDP. The Johannesburg Stock Exchange has lost 30% of its value over the past 12 months and the credit spreads on raising banking capital has ballooned out to near historic wides. Similarly, India has experienced a mini-run on ICICI Bank, the country’s second-largest lender, despite public statements from the Bank of India that it was well capitalised.
Light at the end of the tunnel?
On the other side of the argument, there are plenty of investors who believe that decoupling is still alive and kicking and emerging market currencies will be the first to rebound after near-term volatility in the US markets simmers down.
Fewer big emerging market countries are heavily dependent on overseas investors than in previous episodes and their public finances are in much better shape. For example, a decade after the Asian and Russian financial crises, emerging Asian countries have maintained current account surpluses – last year averaging 5% of gross domestic product – and built up a thick safety cushion in the shape of hefty official foreign exchange reserves.
“There is some hope for eventual recovery in local currency financing given that there are presently also huge challenges in raising even dollar denominated deals,” says Brad Setser, a fellow in geoeconomics at the New York Council on Foreign Relations. “The underlying dynamics that favoured local currencies will likely remain in place even after the crisis. It is even more of a heroic assumption to assume that we will go back to a fully dollarised system as we did in the aftermath to the 1998 crisis. What is going on in emerging market local currency is part and parcel of a broad process of global deleveraging as opposed to any specific economic even in Brazil or Peru.”
Setser also points out that much of the attraction of local currency emerging market debt was linked to the export demands for commodities – particularly from the G5. The same local currency debt problem is now also hitting Australia – a highly developed economy that is, nonetheless, highly dependent on global commodity demand. “What we are seeing is not a country specific problem but more of a global import export demand issue,” Setser adds.
Michel Camdessus, the former managing director of the IMF, forecast in a speech in Manila during at the peak of market volatility in October that: “thanks to the dynamism of Asia, the global economy will avoid recession”. Additionally, commodity exporters across the emerging markets have benefited from a near seven-year bull market in food, oil and metals prices.
Looking at the largest multinational exporters at the top of the food chain, most bankers feel that local champions in each sector on a country by country basis, such as a Petrobras in Brazil are still seeing reasonably normal credit conditions from their banking syndicate. Further, the supply side of the equation – that is capital requirements for project finance and trade finance – will continue to be out there.
“With stabilisation of inflation, broadening of local pension funds and global investors like ourselves, we did see a lot more development in local currency debt issuance. A year ago, most borrowers had almost unlimited access to raising capital,” explains Claudia Calich, an emerging market debt portfolio manager for Invesco in New York. “Going forward, the very top tier names should continue to see access to funding with not much change over the next 12 months. But for some of the mid-sized to weaker credits, a huge crunch is hitting and that market may never recover.”
The real question is when the demand side comes back; will investors be willing to buy into deals? For major infrastructure projects and highly structured cross border trade finance where success is dependent on currency risk, sovereign risk, and fickle international investor appetite, the big ticket deal flow might stagnate for some time to come.
“If anything, the deal flow in local currency denominated projects will be the first to rebound. Local banks, particularly in Brazil and Mexico, are still highly liquid compared to the US. The crisis of confidence that has hit the US sector has left many of the major Latin banks relatively unscathed,” adds Dadina.
“But I am not sure how soon dollar investors will come back. For a lot of the more structured exotic deals, much of the private placement of local denominated debt was done to US and European based funds. Since the majority of global investors in these types of deals were specialised hedge funds, a huge bulk of which are seeing a lot of withdrawals, it is hard to say when this bid will return and the emerging bubble will start inflating again.”
Abdullah at The Smart Cube shares this cautious outlook. “Now more than ever investors will want to run, run and rerun all the numbers before committing to any major project or infrastructure deal – even more so if funded in local currency. The olden days of throwing suitcases of cash at anything with a high notional yield pick-up – however hot and spicy the deal may have been – are long over.”