To understand the remarkable policy flexibility in many emerging markets during the crisis, take the case of Chile. Faced with collapsing copper prices and the need for counter-cyclical spending, the national budget has received a bloody nose over the past two years. Public finances have sunk from a record surplus of 8.7% of GDP in 2007 to a 4.1% fiscal deficit in 2009.
Nevertheless, the government ducked issuance in external markets and avoided overloading local capital markets with new bonds thanks to the country’s cash-rich reserve funds. Fiscal surpluses above 0.5% of GDP flow into the government pension fund and the Economic and Social Stabilization Fund, Chile’s sovereign wealth fund.
This year, the government drew down $8bn from these sources to finance a fiscal stimulus package equivalent to 2.8% of GDP.
"Chile entered the global crisis in a good condition because of its decision to save during times of high copper prices," says Patricio Sepulveda, head of the debt management office at the Chilean finance ministry, in an interview with EuroWeek.
Since the turn of the decade, Chile has financed the budget in the local market and last entered the global bond market in January 2004 with a $600m four year floating rate issue. As a result, scarcity value and Chile’s investment grade rating will ensure mouth-wateringly low pricing for any new global benchmark, say debt capital market bankers.
Staying local
But still Chile has snubbed global bond markets even as revenues collapse. "We understood that Latin American companies were having difficulties in raising funds in the external market so we decided to issue only in the local market for the 2009 fiscal year," says Sepulveda.
The government issued a modest $1.7bn in the 2009-10 fiscal year to ensure domestic firms — who were saddled with high premiums in international markets — "were not crowded out by government borrowing locally," says Sepulveda.
In addition, the Treasury and central bank switched their issuance strategies in January 2008 in order to ease pressure on long-term interest rates. The Treasury swapped its issuance format from the typical 30 year inflation-linked note to five and 10 year bonds while the central bank issued longer-dated paper. These moves ensured the market was not cluttered with new issues at the short-end of the yield curve.
The central bank also bought $1bn of outstanding government debt — in order to free up bank balance sheets and boost further purchases. By reducing 20 and 30 year debt issuance, the Treasury managed to ease long-term borrowing costs for companies while the central bank’s quantitative easing policies expanded domestic credit supply.
The timely and deft co-ordination between the finance ministry and central bank this year highlights the growing sophistication of economic policy in emerging markets.
And Chile is following the footsteps of its developed peers by gradually liberalising its debt markets. At present, the domestic government bond market is almost exclusively the preserve of local institutional investors. This is the legacy of strict regulations that have restricted pension fund investments abroad.
However, the government in recent years has relaxed these rules and pension funds by next year will have their cap on capital outflows raised from a maximum 50%-80% of their assets. In addition, Chile in March scrapped the 17% capital gains tax for foreign and local investors in onshore bonds, in line with tax exemptions on equity investments.
But despite these changes, the composition of the investor base in the local government bond market is unlikely to undergo big change, says Sepulveda. "We don’t think these changes will affect domestic demand for government bonds because these assets are always in high demand." He also reveals that the debt management office is also seeking to streamline taxes on derivative products after criticisms over its complexity.
Chile then has had remarkable policy flexibility in the crisis and has underused market sources for borrowing. This might change if the crisis prolongs and erodes the country’s counter-cyclical firepower. What’s more, if foreign investors penetrate deeply into domestic government bonds, Chile will have to live with the volatility that may ensue in any flight-to-safety global sell-off. But to-date, Chile’s strong fiscal position leaves it in a league of its own.