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Emerging Markets

Liquid dreams

The credit crisis has placed Latin corporate treasurers under financial house arrest, cordoning off bond markets and forcing sizeable premiums on bank loans. As the global downturn deepens, a growing range of Latin companies is straddling the thin line between illiquidity and insolvency

Mix a weak peso with some short-term dollar debt, add overpriced credit lines and a dash of corporate mismanagement. Such is the noxious financial recipe that dished up Mexico’s 1994 ‘Tequila’ crisis.

But if Latin financiers thought never the same poison twice, they have every reason to be worried: that same cocktail of large-scale currency mismatches and surging borrowing costs is wreaking havoc yet again across the region.

Several strategically important Brazilian and Mexican firms have collapsed – or are on the brink – owing to exchange rate volatility, higher credit premiums and falling revenues. As a result, Latin corporate liquidity is drying up, as weak regional growth raises the prospect of further explosive corporate bankruptcies this year.

The financing landscape for emerging market corporate borrowers transformed radically after the mid-September collapse of Lehman Brothers, which caused a synchronized credit retrenchment.

“We used to experience an orgy of credit, but Brazil was really hit by the global deleveraging,” says Sergio Wanderley, director at Coimex, a Brazilian ethanol-trading firm that also specializes in structured finance transactions.

Latin enthusiasts who banked on the relative abundance of domestic liquidity to shore up corporate finances received a bloody nose in the fourth quarter of last year. By mid-October, about half of all short-term trade finance lines in Brazil dried up, prompting the central bank to use its international reserves in November to provide dollar liquidity through the provision of $30 billion credit lines.

Old fears

More worryingly, the shadow of the bad old days of Latin corporate failings and exchange rate risks returned with a vengeance in October following the sudden insolvency of Comercial Mexicana. The large retail chain was caught out by an imbalanced hedging position worth around $4 billion as the sharp devaluation of the local currency prompted unexpected margin calls.

Accusations of poor corporate governance snowballed as a slew of firms revealed their speculative positions to currency and commodity derivatives. In October, Brazilian paper and pulp group Aracruz announced losses of $787.4 million, while food exporter Sadia saw a $365 million shortfall. In January, Mexican glassmaker Vitro defaulted on $293 million of derivative payments, throwing into doubt $1.2 billion of bond repayments. In Mexico alone, the private-sector losses from bad bets on derivatives total between $16 billion to $18 billion, according to RBC Capital Markets.

This unexpected whirlwind of losses has rocked market confidence and raised fears of counterparty risk in the eyes of financial intermediaries. Yet according to Alexander Carpenter, Moody’s chief LatAm corporate credit analyst in Sao Paulo, “the worst of the derivatives crisis is probably over and in any case is down to risk management failings.”

So what’s striking fear in the heart of the market is the prospect of a protracted financing crunch that will tip illiquid corporates into insolvency. Of immediate concern is familiar emerging market risk: Latin companies have a mismatch between their

revenues in local currency and their dollar-denominated obligations. As regional currencies have plummeted, the cost of servicing dollar debt has skyrocketed.

The financial hurdles are huge. Dealogic calculates that Latin corporates have around $60 billion in offshore bond and loan repayments this year. But borrowing sources are few and far between.

International capital markets now impose egregious new issue premiums for even top-rated sovereign and quasi-sovereign issuers. For example, Petrobras, the Brazilian government-owned oil company, priced a $1.5 billion, 10-year global bond in February to yield 8.125%, or 518bp over US treasuries. This represents around a 45bp concession relative to its 2018 notes and a 145bp pick-up to the Brazilian sovereign. The high

borrowing costs for this highly rated quasi-sovereign demonstrates the depth of international market hostility for corporate issuers, say regional and western bankers.

What’s more, in the local Mexican capital markets, highly rated companies enjoyed low spreads over the sovereign benchmark during the bull run, but secondary market liquidity tends to be thin. This systemic weakness led to an abrupt freezing of credit markets at the first sign of market trouble last summer.

Brazil has generally concentrated on boosting secondary liquidity for sovereign debt rather than developing a domestic corporate bond market. As a result, “local bond markets in the region cannot provide an adequate alternative to external financing,” says Nick Chamie, head of emerging markets research for RBC Capital Markets.

Snubbed

As global banks delever their bank balance sheets, corporate borrowers have been snubbed by the syndicated loan market. Since October, this market has been effectively frozen and is only now beginning to see signs of life. Latin mining and energy companies are paying through the nose to compensate for weak commodity prices and scarce capital. Only those firms that have strong deposits and robust capital structure can cement relations with their western lenders – and often only if the prospect of future business is on the cards.

Mirablela’s $280 million, 6.5-year project loan, Milpo’s $130 million, five-year, and BPZ’s $75 million, four-year loan all cost above 300bp over Libor. In addition, for all the talk of abundant domestic liquidity in Latin America, the local syndication loan market has been firmly shut since the end of September. Bucking this trend in March, Mexican breadmaker Bimbo kicked off a $1.7 billion retail syndication with regional and global banks. But to gain any traction the borrower has had to reprice existing loan commitments up by around 25bp to reflect new market conditions.

So to all intents and purposes “the local fixed-income market is effectively shut”, says Kenneth Tinsley, senior credit risk analyst at the Export-Import Bank of the United States. As a result, firms face a double whammy of capital market reluctance to finance large external rollover needs as well as falling revenues as the global downturn intensifies.

The shock bankruptcy in February of Brazilian beef producer Independencia is a case in point. A sharp drop in export demand and subsequent oversupply in the domestic market dragged prices lower, inflicting $1 million daily losses on the firm in the first two months of the year. Credit lines dried up and the bank defaulted on a $100 million shareholder loan.

The bankruptcy generated a wave of sell-offs in yield curves of other Latin corporate issuers and undermined market confidence in companies reliant on working capital finance to fund operations. And contagion could spread further as corporate defaults jump, exacerbating the primary market rut and, further, eroding corporate cash flows, fears Chamie.

Nevertheless, Latin experts point out that Mexico and Brazil have fiscal and monetary flexibility as well as market infrastructure to stem the pace of corporate bankruptcies. These countries have access to dollar swap lines with

the Federal Reserve and healthy reserves to capitalize financial intermediaries. At the end of January, Brazil’s central bank initiated a $20 billion credit line to help domestic companies roll over foreign debt that matures at the end of the year. Similar measures are in place in Mexico.

“Export-credit agencies are giving priority to the largest companies, because their big procurement needs are of strategic exporters they are supporting,” says Valentino Gallo, head of export and agency finance for the Americas at Citi.

This targeted coverage to address the short-term dollar-denominated debt liabilities of strategically important corporates will compensate for the shortage of hard-currency liquidity in private markets. And large firms that have previously had access to capital markets are finding alternative sources of financing thanks to beefed up state development banks, export-import agencies, multilateral policy lenders and state banks.

In Mexico, corporate foreign debt maturities seem manageable. For the remainder of the year, $11.7 billion of loans and $2.1 billion of bonds need to be refinanced, according to RBC Capital Markets. This figure includes $4 billion from politically well-connected cement maker Cemex and $2 billion from Carlos Slim’s conglomerate, Grupo Carso.

Nevertheless, capital markets in Latin America tend to be less liquid and underdeveloped; they have traditionally played a crucial role in financing corporates in Latin America via trade finance lines and relationship-based lending. But pre-export financing has effectively dried up; faith in export volumes and prices has been badly shaken by the market distress. As a result, “banks are now less willing to provide costly advanced lending for small and medium-sized enterprises,” says Tinsley at US Exim. Those firms tied to the cyclical commodities or tourism sector have been particularly affected.

However, trade financing has stabilized since the beginning of the year. Brazil’s central bank now offers banks credit lines at 150bp plus Libor. Banks generally offer 30-day credit lines at around 300bp to 600bp, depending on credit quality and client relationship, says Rodrigo May, trade finance analyst at Banco Votorantim.

In addition, “since this February, we are gradually seeing western banks coming back to the market to offer trade finance lines.” But as corporates tap banks for short-term loans, the maturity structure for corporate debt also shortens, further raising rollover risks, notes Carpenter at Moody’s.

But Morris Dayan, board member at mid-tier Brazilian bank Banco Daycoval, says there is a silver lining to the current provision of short-loan maturities. “Our 30-day, 90-day and 6-monthly loans may soon become cheaper as interest rates in Brazil and in the region in general come down.”

Crucial

Gallo at Citi says the next six months will be crucial. “Corporates are now testing the strength of their relationships with their lenders, while banks are now extremely sensitive about taking credit positions.”

But rather than savaging business models and cash flows, the restricted corporate financing environment will continue to force firms to reduce capital expenditures. In general, internally generated sources of funds finance Latin corporate investments and working capital, explains Carpenter at Moody’s. “Latin firms are, generally, conservative and rely on cash flows and cushions to finance operations and debt rather than external borrowing.”

Cafe de Colombia, Colombia’s largest coffee exporter, illustrates this trend. In November and December, the firm was only able to access 10% of its short-term credit lines but was able to use its balance sheet to finance its business. But now relationship-based lending has been effectively restored. “In Latin America, we have historically lived through volatile times, so this has made us naturally conservative,” says its chief financial officer, Jorge Suescun. Its short-term and long-term debt obligations are balanced, and the firm has hedged coffee price, interest rate and exchange rate risks since 2001.

Either Latin firms have learnt their lessons from previous regional crises to conserve balance sheets – or, more plausibly, the region’s underdeveloped financial system has simply helped limit corporate leverage.

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