LatAm debt

Doug Henwood dhenwood at
Tue Sep 1 11:04:25 PDT 1998


"It's going to be a very tough task for Latin America to meet its external obligations." -- Warburg Dillon Reed's Walter Molano


Latin America could soon find itself in the midst of its second full-blown debt crisis in two decades, which would deal another hard blow to already ravaged U.S. markets.

Brazil, Mexico and Argentina face estimated external debt obligations totaling over $120 billion through the end of 1999.

Lenders, petrified by the protracted emerging markets shakeout, may refuse to roll over a large part of that debt, causing an almighty credit squeeze that could force these countries into default. Latin America spent the '80s in the wilderness after a series of sovereign defaults sparked by Mexico's refusal to pay its bank debt in 1982.

Some pundits are publicly voicing deep concern over the current debt overhang. "It's going to be a very tough task for Latin America to meet its external obligations," says Walter Molano, head of emerging markets research at Warburg Dillon Reed.

Fears of default, and the economic and political mess that would entail, have already prompted an exodus from Latin American stocks and bonds, with benchmark equity indices off 40%-50% for the year. Meanwhile, long-term government bonds have nosedived in price and their soaring yields suggest default probabilities of over 70%, according to Goldman Sachs.

If the panic continues, foreign reserves will be rapidly depleted, bringing the dollar-pegged exchange rates of Brazil and Argentina under immense pressure and dragging the Mexican peso to new lows. The governments of Brazil, Mexico and Argentina have to take drastic action to shore up confidence. But the two main policy options they have -- big hikes in interest rates and deep budget cuts -- involve great pain and may be deemed too politically risky.

Governments may not want to swallow such bitter pills ahead of the important elections scheduled for the next two years, starting with a presidential and congressional vote in Brazil on Oct. 4, followed by contests in Argentina in 1999 and Mexico in 2000.


Brazil has become the bogeyman of the debt nightmare. The country faces amortization on medium- and long-term public and private debt of around $9.8 billion in the remainder of this year, according to Molano, and $14.3 billion in 1999, according to Credit Suisse First Boston.

The country also has a short-term (under one year) external debt stock of $27 billion, according to CSFB. In the current environment, it has to be assumed that some of that short-term credit will not be rolled over.

Another call on dollars is the current account deficit, which could take another $11.6 billion in the remainder of this year, according to Warburg Dillon Reed. Next year, J.P. Morgan expects a current account deficit of $15.4 billion.

Assuming half of the debt gets refinanced, then total obligations come to just over $50 billion. That seems doable if one also takes into account that reserves are around $65 billion and foreign direct investment inflows could total $20 billion by the end of next year. But it's not that simple.

First, no one knows how much of Brazil's $250 billion real-denominated domestic debt is owned by foreigners, who are probably rushing for dollars in this unstable environment. The government, rather fishily, is not saying what proportion non-Brazilians own.

"The numbers coming out of Brazil are muddied compared with those coming out of other emerging markets," says Larry Goodman, chief emerging markets economist at Santander Investment."That only fuels speculation."

Estimates put the foreign share at 10% of the domestic debt. But it could be higher, especially as the government has recently been issuing more dollar-linked debt, which has attracted a lot of foreign buying, according to Ernesto Martinez-Alas, sovereign analyst at Moody's Investors Service.

Second, the Brazilian government, led by President Fernando Henrique Cardoso, is extremely reluctant to attract new inflows by raising rates. That's because higher rates would further constrict economic activity ahead of the elections. And, since over 70% of the total debt has a floating-rate structure, a rate hike would also increase the size of the gargantuan budget deficit, already equivalent to 7% of GDP.

For these reasons, Goodman would not be surprised if the government decided to cut rates at the next central bank monetary policy meeting on Sept. 9.

But such a move would be risky, as the market may think the government cares more about winning an election than shoring up investor confidence. Outflows could accelerate, especially if the locals also stop buying government debt. This is already happening: Last week, one of the government's debt auctions was heavily undersubscribed because rates were deemed too low.

Brazil could just wriggle through. But to do so, it needs a lot of grace from the markets and the new government has to immediately come up with a wide-ranging set of budget-cutting reforms.


Mexico's numbers are hardly more reassuring. Next year, the country faces external government and private debt obligations of $30.5 billion and must cover a trade balance of $10.5 billion. This brings the financing total to $41 billion, according to Paulo Vieira Da Cunha, Latin economist at Lehman Brothers.

Da Cunha expects $10 billion in foreign direct investment next year for Mexico. And he believes that banks making syndicated loans will probably roll over the $12 billion coming due next year. The IMF and World Bank will do the same for the $4 billion they are owed, he predicts. Concerns center on the up to $12 billion in maturing bond debt. But Da Cunha is not too worried about that. "This may be problematic, but I expect the markets to get better," he says. In addition, Mexico has around $28 billion in hard currency reserves to act as a cushion.

Still, Mexico will have to pay a lot more if it wants to refinance in the bond market, as no one expects yield spreads, currently 12%-13% over Treasuries, to rapidly narrow back to 4% and under.

Mexico has been forced to hike rates to stop the peso, which is free-floating, from sliding too fast. The tighter money is slowing growth. This stance will be difficult for the ruling PRI party to maintain the closer it gets to the 2000 presidential elections. Any sign of the government putting politics over debt management could cause steep outflows.


Argentina is also not in the clear.

Next year, medium- and long-term debt amortization for the country comes to $14.3 billion, according to CSFB. Standard & Poor's calculates short-term debt to be around $16 billion. On top of that, the current account deficit could be as high as $12 billion next year, J.P. Morgan calculates.

Total obligations for 1999 could therefore reach $42 billion. This will be reduced on a net basis by inflows of foreign direct investment of up to $5 billion as well as some creditors rolling over. Reserves total around $30 billion.

Another line of protection is the $7 billion pool of emergency cash that the Argentine government has set up with foreign banks for times like this. It can draw on this money at low preset interest rates if investors shun Argentine paper in the international bond market.

But, again, confidence will ultimately depend on the government's ability to stomach an economic contraction. This could be severe under Argentina's currency board, as money supply is reduced when money leaves the country.

If the government attempts to tinker too much with the currency board to loosen the domestic economy ahead of the October 1999 election, the market reaction would be punishing.

And at that point the ghost of '82 would return to haunt.

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