A decade ago, the foreign investors Latin American governments depended on for funding were largely interested in hard currency international bonds and loans. The idea of selling local currency bonds to international buyers was ambitious for most countries, and the suggestion that they could be one of the hottest asset classes around was laughable.
But 10 years on, the situation has undergone a dramatic reversal.
As emerging economies developed their domestic bond markets, international investors became increasingly enthusiastic participants. Foreign investors’ share of domestic debt has risen more than five-fold in Mexico, while local currency bond funds have seen impressive inflows since the 2008–09 global financial crisis.
Equity investors have undergone a similar shift in attitudes. Until recently, holding American Depositary Receipts (ADRs) of major local companies was an adventurous enough way to invest in high-risk emerging markets.
But now foreign buyers increasingly want access to the kinds of companies only available through the local exchange, as demonstrated by the arrival of highly specialized products such as US-listed exchange-traded funds (ETFs) that invest only in Brazilian small cap stocks.
The reasons why foreign investors have become more enthusiastic about investing directly in the full range of instruments available in Latin American markets are no mystery: strong recent economic performance, better creditworthiness and the greater credibility of policymakers on issues such as inflation have led to a reassessment of the emerging markets risks. Many investors would also add accessibility to that list.
At first glance, it appears that all the changes over the past decade must have made Latin American markets significantly easier to access than before. But perhaps surprisingly, there has not been a steady improvement in accessibility across the region, according to portfolio managers, who by the nature of their work contend with each market’s frictions on a regular basis.
While there have been a small number of sizeable improvements, these have been matched by backsliding elsewhere. Overall, progress in the ease of investing has been mixed – just as are incentives to open up markets further.
DOING NOTHING
For example, one of the most notable shifts in Latin American markets has been the recent large increase in international investment in Mexican local currency government debt. At the end of 2011, foreigners held 26% of central government domestic bonds, up from 11% in 2009 – a trend helped by Mexico’s inclusion in Citigroup’s World Global Bond Index in 2010, the only Latin American country in this benchmark.
But this change has almost nothing to do with the increased accessibility of Mexico’s markets – indeed, it reflects what Mexican policymakers have chosen not to do, rather than what they did.
Mexico has long been the most accessible Latin American market and nothing in the past decade has changed that. The local currency sovereign market is large and liquid, with no capital controls. Trades can be settled through Euroclear as well as locally, ensuring minimal hurdles for foreign buyers. Even more importantly, the government remains welcoming to foreign investors, with clear and transparent monetary and fiscal policy and no prospect of capital controls.
All this makes it the obvious destination for local currency bond managers to deploy much of the cash they are receiving from new investors. “We can be nimble in Mexico, going in and out,” says Edwin Gutiérrez, a portfolio manager on the emerging markets debt team at Aberdeen Asset Management.
That puts Mexico in clear opposition to Brazil, which “says it would like to attract investment but sends mixed signals”, through its imposition of the 6% IOF tax on foreign investments into government bonds.
The IOF tax means that despite offering some of the highest real yields available in fixed income, Brazil is now relatively unattractive for new money. Foreign participation in the local currency sovereign market is around 11% – largely unchanged since the point when the tax was introduced. There is no reason to take currently onshore capital out of the country, especially since it can be moved between different government instruments without penalty, says Gutiérrez.
But for new investments, Mexico offers much more flexibility.
While most debt managers view the IOF tax as a backwards step, conversely Brazil is the country that has clearly made the biggest improvements in its equity market. Where once the only investable options were unattractive state-owned firms, today investors can choose from hundreds of local companies, including whole sectors such as IT that barely existed a decade ago.
The direct cause of this was the stock exchange’s decision to introduce the Novo Mercado board in 2000. Although this change took several years to build momentum, it has ultimately made a huge difference, says Fiona Manning, an investment manager on Aberdeen’s global emerging markets team.
A listing on this board required higher standards of companies, such as a single share class with voting rights. Previously, listed shares were typically preference shares without voting rights, which resulted in easy abuse of minority shareholders.
In contrast to Mexico, where the equity market has seen few new listings over the past decade, Bovespa was highly successful in encouraging private companies to list on the Novo Mercado. This resulted in rapid growth in the market and a decisive move towards higher governance standards in new arrivals.
This in turn “gave us a stick to beat other companies with”, says Alan Nesbit, deputy head of global emerging markets equities at First State, resulting in a substantial improvement in standards across the market. Overall, “the evolution has been dramatic.”
Brazil’s largest failing remains its bureaucratic processes. Foreign investors need to be registered, and separate identification numbers and accounts are required for each fund. “From our perspective, it adds extra cost and takes extra back office time,” says Manning. But with a steady stream of companies coming to market and liquidity steadily improving, the extra red tape is unlikely to keep out increasingly enthusiastic foreign buyers.
THE SMALLER ANDEANS
It’s a large step down in size from Mexico and Brazil to the smaller Andean markets, and that shows clearly when considering liquidity. For example, Peru can easily develop stresses at times of trouble, says Claudia Calich, head of emerging markets at Invesco’s fixed income division. “The risk premium rose when Humala was high in the polls last year, and it became hard to trade in meaningful size.”
Despite that, Peru proved increasingly popular with foreign investors, since it is seen as dull but reliable and accessibility is good. Opening an onshore account is straightforward, but foreigners who would prefer to avoid the work can still invest in Soberanos via a liquid market in global depository notes, which can be settled through Euroclear.
As a result, foreign participation is now the highest in the region, with international investors holding 46% of domestic debt.
The central bank intervenes more than its regional peers to prevent currency appreciation, while there is intermittent talk of measures to cool inflows, such as placing a cap on non-deliverable forwards used by foreigners for hedging. But while this could materialize, the risks are seen as small. “Any measure is likely to be much more considered and reflective than in Brazil,” says Calich.
Meanwhile, the Colombian bond market has the lowest foreign participation in the region, at just 3% of domestic debt. This is largely due to its high rate of withholding tax, rather than direct restrictions on foreign buyers: “You could open an account in Colombia and buy onshore, but the tax is so punitive that nobody would want to do that,” says Tina Vandersteel, a portfolio manager at GMO.
The issue of Colombian peso-denominated, US dollar-settled global bonds in the offshore market from 2004 was a small step towards giving foreign investors access to Colombian local currency debt without needing to suffer the tax penalty. But the outcome is a completely bifurcated market, says Calich: different tax treatment and types of investors mean the onshore and offshore bonds trade at very different yields.
On the equity side, there have been a few improvements in accessibility over the long term. For example, Chile has made life easier for equity investors on the administrative side, says Nesbit. Previously, the government was keen to keep foreign buyers out of the market, requiring them to set up a local fund run by a local partner, a lengthy process that could take a couple of years.
That attitude has now gone and with it these restrictions, meaning that investors can more easily look beyond the handful of Chilean stocks with liquid American Depositary Receipts.
Meanwhile, Colombia has made some noticeable improvements in governance and transparency, says Manning. But perhaps the biggest change has been something very country-specific: a much improved security situation that makes on-the-ground research easier. “The reduction in violence has made a big difference to the accessibility of management,” Manning says.
Both Chile and Colombia have some limitations in terms of liquidity, with only a handful of firms suitable for funds managing a billion dollars or so, says Nesbit. This partly reflects the fact that local pension funds are significant buy-and-hold investors in local equities, locking up much of the free float. However, this issue becomes most pressing in Lima. “Peru looks brilliant at first glance, with lots of companies in a wide range of sectors,” says Manning. “But few are investable for foreigners in terms of liquidity.”
AND THE RETROGRESSIVE
While the scorecard for most countries is mixed to positive, two have unquestionably gone backwards: Argentina’s capital controls – which were tightened further towards the end of 2011 – have essentially made onshore investment in the South American nation unattractive due to concerns about getting money back out, say most managers; and Venezuela adds widespread nationalization and expropriation to FX restrictions, making it utterly uninvestable.
The deterioration in these two demonstrates quite how patchy progress has been, says Nesbit – 20 years ago, Argentina was a “miracle economy, the future of Latin American markets”, while Venezuela was also popular. Today, the investable universe has shrunk rather than grown and has also become increasingly polarized, with larger indices forced towards Brazil and Mexico to get adequate liquidity. “This is not what was supposed to happen,” says Nesbit.
The prospects for further progress on the equity side seem limited for now. Greater integration of the three Andean stock markets is likely to have a more noticeable effect on Peru than its neighbours, says Manning; although any change will take time, higher liquidity could spark considerably more foreign interest in the market.
Brazil should continue improving, with steadily increasing liquidity and more new companies coming to market, says Nesbit. However, any growth in listings in Mexico – and increased competition and diversity across the economy as a whole – would require regulators to act against the handful of business groups that dominate both the market and the economy. Change on that score is probably at least a decade away.
In the debt markets, the outlook is slightly more complex. “From a foreign perspective, ease of onshore access has not improved or has improved at a glacial pace,” says Vandersteel. However, the availability of offshore instruments that attempt to mimic the onshore market has increased significantly.
Chile, Colombia and Brazil have launched local currency global bonds, multilateral institutions have issued debt in local currency in an attempt to help develop these markets, and there is a small but growing amount of offshore local currency corporate debt, most notably from Brazil.
Though not a direct replacement for onshore access, it provides an alternative for cash bond investors.
The use of these instruments means that markets remain relatively segregated, with foreign investors no closer to investing alongside locals. But, given undiminished foreign appetite for local currency debt and concerns over destabilizing foreign flows, developing these markets rather than further opening up onshore access may prove to be the easiest compromise.