PROBLEMS WITH ISSUING FOREIGN CURRENCY

AND FOREIGN INDEXED BONDS

IN THE LIGHT OF MEXICAN EXPERIENCE

Melike Altınkemer

THE CENTRAL BANK OF THE REPUBLIC OF TURKEY

Research Department

Discussion Paper No: 9617

July 1996

PROBLEMS WITH ISSUING FOREIGN CURRENCY

AND FOREIGN INDEXED BONDS

IN THE LIGHT OF MEXICAN EXPERIENCE

In Turkey, it is widely accepted that the ongoing budget deficits and inability of governments to make a comprehensive structural change regarding the fiscal policy is the main cause of inflation. An examination of the consolidated budget expenditures in Turkey reveals that total expenditures according to the latest revisions are to be 26.2 percent of GNP. The share of interest expenditures in this total is the highest with 10 percent of GNP, 8.6 percent of which is domestic interest expenditures while 1.4 percent is foreign interest expenditures. This figure is even higher than personel expenditures which is 6.7 percent of the GNP. This situation naturally forces the authorities to search for means of reducing domestic interest expenditures and issuing foreign exchange indexed bonds together with foreign exchange denominated bonds are considered. In this paper, pros and cons of issuing such bonds in Turkey will be discussed within the recent Mexican experience of switching domestic debt from cetes to foreign exchange indexed tesobonos.

I. A BRIEF SUMMARY OF LDC BOND FINANCING FROM INTERNATIONAL MARKETS

Prior to the 1982 international debt crisis, developing countries successfully tapped the international capital market for external financing. However, during the 1980s most developing countries, excluding Hungary, Turkey, and some developing countries in Asia, were unable to borrow from international capital markets. Bonds that were issued in the late eighties were of debt conversion scheme such as Brady bonds as part of debt service reduction options.

It was not until June 1989 that a developing country was able to obtain voluntary foreign financing through unsecured bond issue in international capital markets, when the Mexican Bancomext issued US $ 100 million bond with a maturity of 5 years and a yield of 17 percent. Also, the first international bond issue by a private enterprise after the debt crisis was in October 1989 by a private Mexican cement company worth of US $ 150 million with a 2 year maturity and a yield of 16 percent. Since then, several public and private enterprises of developing countries have issued bonds in international capital markets.

In fact, between 1990 and 1991, the external resources raised in international markets by developing countries increased from US$ 6.7 billion in 1990 to US $10.7 billion in 1991. These included floating rate bonds, convertible bonds with warrants and non-US dollar foreign currency denominated bonds. Those entities who had problems in raising long term financing in international capital markets gained access to international capital markets through issuing certificate of deposits and commercial paper.

Developing countries offered a variety of instruments to satisfy the investors regarding the default risk, transfer risk and liquidity risk. The new entrants to the market were using collaterals such as credit card receivable of the Mexican Bank, future copper shipments and geothermal energy sales to Californian utilities companies by Commission Federal de Electricidad of Mexico (Gooptu, 1993). In addition, they came up with innovative techniques such as early redemption options and conversion options, put options which allow reselling the security to the issuer at a specified time and price, a call option which allow the borrower to repurchase their bonds at a predetermined price in case of decline in their costs of funds and equity conversion options for reducing the effective borrowing costs.

The new entrants into international markets were succesful in lowering the spreads and lengthening maturities of the bonds in a very short period of time. For example, the bond offering of Bancomext in 1989 was priced 820 basis points above comparable US treasury bonds while in February 1991 a 2 year bond issued by Pemex was priced at 320 basis points above comparable US treasury bills. In September 1991, the same company was able to increase the maturity of its bonds to 7 year while lowering its spread to 245 basis point above comparable US Treasury Bills.

The increase in bond issues from Latin America in the second half of 1991 and 1992 resulted in oversupply of these securities in the international markets which together with political uncertainties and rising current account deficits caused concerns among the investors. In turn, Latin Americans started offering more attractive yields on their bond issues which forced the yield spreads to increase over 130 basis points by November 1992.

The effect of the recent experience in yield spreads on latin American bond issues and the concern about the oversupply of securities has been transmitted to international equity offerings by Latin American firms in the sense of delaying the equity offerings.

This type of difficulty in borrowing from the international markets was somehow instrumental in Mexico for it helped to create, to diversify or to increase the use of the already existing domestic debt instruments ( See Appendix).

II. MEXICAN DEBT STRATEGY

Mexico had simultaneously issued short-term peso denominated debt (cetes) and short-term dollar indexed debt (tesobonos), but as 1994 progressed Mexico changed the currency composition of its short-term debt from cetes to tesobonos so as to strengthen the peso. In January 1994, the dollar value of cetes outstanding was $12.9 billion compared with $302 million in tesobonos. By November, cetes outstanding fell to $7.2 billion, while tesobonos rose to $12.9 billion.

One advantage of this shift was to save on interest expenses while gaining foreign exchange by attracting flight capital from Mexico as well as capital from nonresident investors, since to buy bonos they had to exchange foreign currency. Also, the dollar indexed bonds were seen by the public as the commitment of the government to a more stable exchange rate, since the foreign exchange risk was assumed by the government. This was making foreign exchange regime more credible by imposing a penalty for devaluation. When the debt is held in terms of national currency, a devaluation would decrease the outstanding real debt. However, with the shift from cetes to tesobonos, with dollar indexed debt, devaluation would increase the real debt, hence it is a natural barrier for not to devalue. Hence, this credibility enhancing mechanism was helpful in reducing devaluation expectations as well as inflation expectations.

One should keep in mind that one reason why Mexican bonds were attractive to the US was the low US interest rates. However, during the first quarter of 1994, the US interest rates started rising with a tighter monetary policy. This together with the political instability started to move the capital out from Mexico. With the assasination of Colosio, capital outflow increased. Mexico sterilized this outflow by raising domestic credit and at the same time increased its substitution of domestic debt with the dollar indexed debt. In fact by June, the tesobonos outstanding already exceeded cetes.

In the fourth quarter, another political event accelerated the capital outflow. To sterilize this, again, domestic credit to the banking system was increased, yet the interest rates were not pushed up sufficiently to maintain reserves.

This tesobono strategy was imposed in a period of increasing risk to the financial system and additional trade balance pressures by commencement of Nafta in January 1994, which indicated that Mexico could be risking financial crisis, if it devalued or increased the interest rates further to defend the currency, which would result in a higher amount of bad loans and further capital inflows.

In fact, on December 20, 1994, the announcement that the peso will move from 3.47 pesos to the dollar to 3.99, instead of settling the markets, caused massive capital flight followed with a large increase in interest rates. One reason for the restlessness in the market was the tesobono maturity schedule, which was indicating that obligations in the first half of 1995 were considerably in excess of Mexican dollar reserves due to capital outflows. Foreign reserves fell from around $30 billion in February to about $11 billion in December 1994. Large number of institutional holders of tesobonos wanted to withdraw rapidly from the market in the wake of devaluation announcements. Even though tesobono holders were protected against foreign exchange risk, the perception of conversion risk together with partial default of tesobonos, either through imposition of capital controls or through compulsory roll-over, made the government unable to rollover the tesobonos. Experts believe that inability to roll over the tesobonos debt plays a major role in the events that led to the crisis of December 1994.

The stock of tesobonos inclusive of repurchase agreements which was very high at the end of 1994, has been reduced from $29 billion at the end of December 1994 to $8.9 billion by July 1995. $7 billion of this reduction was due to unwinding of repos while the rest was the result of international support package which helped the government to replace some maturing tesobonos with borrowings from the US government and IMF.

III. MEXICAN MONETARY POLICY IN 1994

Quoting Michel Camdessus, the managing director of IMF "December 20, 1994, the day Mexico had devalued its currency will be remembered as the first financial crisis of the 21st century". The devaluation and the following massive capital flows which was called the "tequila effect", was surprisingly swift in spreading to emerging economies.

Mexico's monetary base was fairly constant and even increased after October 1994 despite a continous decline in foreign exchange reserves. Monetary base- foreign reserve ratio in Mexico was 1.62, the day before the devaluation.

Authorities claim that a devaluation is more likely to take place in a country that backs less than 80 percent of its monetary base than, for example, a country like Argentina which backed up a bigger portion of it monetary base with foreign exchange reserves. However, until October 1994 Mexico almost applied currency board standards and kept this ratio below 1, i.e. foreign reserves has exceeded monetary base. At any rate, the high monetary base reserve ratio in October was suggesting that Banco de Mexico was not in a position to back its monetary base with dollars at the promised exchange rate. This self-fulfilling fear of speculative attack turned real, and Mexico was forced to devalue its currency by 60 percent on December 20, 1994.

The continuous drain of foreign reserves started in February 1994 and exposed the banking sector to the liquidity crunch. To preempt a financial panic and banking crisis, authorities decided to give discount window loans to troubled institutions. This expanded the monetary base beyond the level of foreign reserves after October 1994 and repudiated the previous policy suddenly and almost without warning. This policy may look inconsistent right now, but at the time it was thought that the capital outflows and the resulting loss of foreign reserves were temporary and would reverse themselves once the fears of political turmoil subsided. One also should keep in mind that at that time Mexico was highly praised by international financial organizations with its reforms, growth potential, full balance in monetary and fiscal policies and it was around that time that Mexico was accepted to the OECD. According to Calvo and Mendoza (1995), investors prospects on Mexico's fundamentals suddenly changed in part because of the complexities of ongoing political conflicts. In fact, authorities admitted later on that they underestimated the effects of political uncertainty on Mexico's creditworthiness and at the same time overestimated the increase in demand for pesos. Had they forecasted money demand growth below of what they actually observed and use those lower forecasts as a target in setting domestic credit, monetary base would have grown at a smaller rate than it did. Calvo and Mendoza use this finding to argue that monetary policy might have been to loose relative to the fixed exchange rate target and may have helped the conditions for the speculative attack of 1994.

IV. AN INFERENCE TO THE TURKISH FOREIGN EXCHANGE BONDS

In issuing a foreign currency denominated bond, there are two very important issues to be solved. One of them is the interest rates the bonds will carry, the second is their maturity.

The interest rates on the foreign currency denominated bonds (FCDB) will have to be equal to Libor+Country risk for the simple reason that, if the interest rate on FCDB were to be higher, then it would be very attractive to both domestic and international investors, pushing their price up and hence reducing the interest rate on them to a level comparable to other dollar denominated instruments of similar maturity in world markets. Hence, they will have to carry an interest rate related to the interest rate on dollar denominated assets, i.e libor. However, since FCDB will also be competing in the market with Turkish securities with very high real interest rates, there will be a large interest differential between domestic securities and FCDB, which may be interpreted as the expected devaluation rate if their returns are perceived to be equal. This expectation in fact may be materalized as a self-fulfulling prophecy, leading to running down of reserves. If their returns are not perceived to be equal, then why should there be a demand for FCDB when there is still the Turkish denominated bonds and other bonds in the world market, especially if no structural adjustments are done to correct the fundamentals, such as tax reform when the 1994 crisis and the depletion of reserves are still fresh in the memories? If it is the high country risk that is supposed to attract the risk loving investors, then it should be kept in mind that this type of inflows could be very volatile as was in the case of Mexico, i.e. even foreign exchange risk guaranty could not prevent the massive outflow when the confidence is lost in government policies.

One advantage of FCDB in the short-term could be the revenues from the sale of FCDB. If at least some of FCDB are sold to foreigners, then the supply of dollars in the market will increase, appreciating the domestic currency which will reduce foreign interest payments, and hence budget deficit in terms of domestic currency. Also, the issuance of FCDB will be helpful in reducing the Treasury's domestic borrowing needs, decreasing the supply of TL denominated bonds, which will increase their price and lower the interest rate, reducing again the interest payments on domestic debt.

However, there will be the problem of payment of at least the interest rates in dollar terms at the maturity, even if they are rolled over, which will be paid either from foreign exchange reserves, exposing them to the possibility of depletion, in case of loss of confidence just as in Mexico or they will be paid out by government demanding foreign exchange from the market, which by pushing the exchange rates up, will result in real depreciation and that would mean increased interest payments on foreign debt. Moreover, government will need additional domestic revenue to buy dollars for interest payments. Options are a) higher taxes (unlikely) b) higher inflation (if additional revenue from inflation tax is possible) c) new domestic borrowing in terms of TL (which would mean increasing supply of TL bonds and hence increase in their interest rates.

Hence, the seemingly initial advantage of increasing supply of dollars is eroded and we are back with even higher budget deficit in the short run.

The issuance of foreign currency denominated bonds can be useful only if they had a longer maturity than the domestic bonds, because, in that case the dollar supply can be used towards fiscal reform and improvement of the budgetary structure of Turkish economy. However, in that case, there is the problem of how to make it attractive and credible for buyers without increasing the dollarization of the economy.

If it is a must that either foreign currency denominated or foreign exchange indexed bonds will be issued, it should be advised to issue foreign currency denominated bonds, but only with a longer maturity than the domestic bonds and that it should be issued within the framework of credible and time consistent policies geared towards bulding confidence in the system regarding payment at the maturity. It would also be useful to remember the fact that Mexico had a crisis at a time when it had made a lot of successful reforms, gave a surplus in its budget and was shown as a miracle country by the international organizations.

ANNEX:

Type of Debt Instruments in Mexico

Cetes are treasury bills sold at a discount during weekly auctions with maturity of mostly 28 or 91 days. They were the principal money market instruments with an active secondary market.

Bondes are bonds issued by federal government with maturity of one or more years and with an interest rate linked to the 28-day cetes rates. Bondes are growing in importance consituting half of the government securities in the market.

Petrobonos are 3 year certificates of participation in a trust fund that owns a number of barrels of oil, the interest payments on which interest payments are above libor, calculated on a fixed reference price for oil denominated in dollars.

Pagafes are dollar denominated treasury bills payable only in pesos at a fixed interest rate determined through weekly auctions. Originally issued at 6 month maturity but later issued in 28 or 56 day maturities.

Caps are shares issued by banks up to 34 percent of bank capital. There is also Bonos issued by development banks.

Tesobonos are similar to pagafes but the return is indexed to exchange rate in the free market rather than the controlled market and are issued at 3 or 6 month maturity with interest rate fixed

Ajustabono is another indexed instrument, however this time, the return is indexed to consumer price index.

REFERENCES

Alexander W. E. et al. (1995), The Adoption of Indirect Instruments of Monetary Policy, Occasional Paper 126, IMF.

Calvo G. and E. Mendoza (1995), "Reflections on Mexico's Balance of Payment Crisis: A Chronicle of a Death Foretold", mimeo, Board of Governors of the Federal Reserve System.

Gooptu S. (1993), Portfolio Investment Flows to Emerging Markets, Policy Research Working Paper, the World Bank.

Gould D. (1995), "Mexico's Crisis: Looking Back to Assess the Future," Economic Review, Federal Reserve Bank of Dallas.

Gruben C.W. (1996), "Policy Priorities and Mexican Exchange Rate Crisis", Economic Review, Federal Reserve Bank of Dallas.

IMF (1990), Mexico: Recent Economic Developments, SM/90/169.

IMF (1995), World Economic Outlook, May 1995.

Zarazaga Carlos (1995), Argentina, Mexico and Currency Boards: Another Case of Rules versus Discretion, Federal Reserve Bank of Dallas Economic Review.