Thursday, 24 January 2019

Taking the plunge

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  • Local currency global bonds return

As global local currency issuance picks up again, the debate over making local markets Euroclearable returns. But with politicians cautious about the impact such a move might have on their currencies and economies, the path from talk to action may be arduous. Christopher Langner reports.

In 2010 Latin America took center stage as a global growth driver. You could even argue that, amid doubts about the stability of the euro, it took on the status of safe haven. It is no wonder that investors have been piling into the region and looking to acquire increasing quantities of local currency debt.

Sovereigns and corporates took notice, and the local currency global bond market revived in 2010. The rise in issuance also revived the old debate about the merits of making local markets Euroclearable. The question had generated considerable interest before the crisis, but fell off the agenda as more pressing matters came to the fore.

Several countries in the region are examining the possibility, some more closely than others. However, they continue to struggle with the need to open local markets to foreign investors, amid fears of creating tax loopholes or exacerbating currency volatility.

The Mexican experience, for one, has piqued interest across the hemisphere. The sovereign has successfully attracted global investors to its local currency bond, and this year started a bookbuilding process as it creates local benchmarks. The system is simple: the bond is issued and cleared locally but is Euroclearable, allowing investors to trade it freely abroad.

Mexico has had the structure to allow this in place for several years, but no corporates have taken advantage of it. For the sovereign the local currency issue is tax free, but if a company were to issue local Euroclearable debt it would be subject to capital gains taxes. The issuer can choose to pay the tax itself or pass it on to the investor. That, added to the increased yield global investors tend to require to put money into local deals, usually makes the transaction too expensive.

There have been discussions about ways to allow local companies to issue Euroclearable debt while avoiding double-taxation of global investors. But the subject is naturally politically sensitive. In a country plagued by rampant violence, the government has more important concerns to deal with.

It is a similar picture in Chile, though the sovereign is yet to fully open investment into its local currency bonds. This year the question of making local currency sovereign bonds Euroclearable returned to the agenda, with the government seeing massive interest in the peso tranche of its US$1.52bn 10-year dual-currency offering. The US$520m-equivalent tranche generated a US$5bn book which allowed it to price at par with a 5.5% coupon. In a similar manner to Colombia’s Global TES market, the 5.5% finish was around 60bp tighter to the local sovereign curve.

Making local debt Euroclearable would save the sovereign the expenses of global lawyers and banks while allowing it to exploit this interest for its local currency debt.

Echoes of the past

The debate, however, is not new in Chile. As part of the so-called MKIII, the third revamp of local financial markets regulation, Chile is expected to tweak a law that will allow local currency issues to be traded abroad. The changes to law 18.657, which was originally enacted in 1987 to allow global funds to be sold and to invest locally, are intended to create a true global peso market.

After having stalled in the electoral period and during the beginning of the Sebastian Pinera’s administration, MKIII is expected to make it through congress early next year. Piecemeal changes have already been enacted but the bulk of the changes are yet to come. As it currently stands, the reform is unlikely achieve its aim of spurring the creation of a whole new peso market.

The problem is the same as in Mexico. Any company that wishes to have its local deal Euroclearable has to apply for it, and will then have to pay the capital gains tax on the issue in lieu of the investor. According to one local banker this adds at least 25bp to the price of the bond over its life. “It’s not economic,” said this banker. “That’s why nobody has done it yet, in spite of all the other advantages.”

The funding manager for one of Chile’s largest companies agrees that it would only be beneficial for companies if they could issue local debt that is tradable abroad. Chile’s local market hinges on around 25 of its largest institutional investors. “The local market has a liquidity problem that would be resolved that way,” he said.

Those 25 institutional investors do provide plenty of liquidity, and most corporate in Chile choose to issue locally as they can sell large US$300m deals with tenors up to 25 years. But once bonds are priced, there is virtually no secondary market. Adding global investors to the mix would create much needed secondary demand.

In fact, the only real secondary market for bonds in Chile is in government bonds. The change to make them Euroclearable, as in Mexico, is expected soon: many bankers believe that by 2011 Chile’s local paper issuance will be freely tradable abroad. But the next step – making corporate Euroclearable debt tax-free so that foreign investors are not double-taxed, remains a long way off.

A political hot potato

Another sovereign that has contemplated making its debt Euroclearable is Brazil. Being an election year, any real discussion about the subject is likely to be pushed out until at least 2011. With Brazil’s congress often quick to attack any initiative that involves greater participation of foreigners in local markets, the subject is sure to be contentious.

Still, bankers have continued to lobby for the change, and once the sovereign takes the first step it could evolve into regulation to allow local corporates to issue Euroclearable local debt as well. The sovereign is concerned that a sudden flood of foreign money would push the currency higher, making Brazilian products less competitive. But the lower costs and yields to issue sovereign debt also are enticing.

The sovereign has a clear idea of what can happen. In February 2006, Brazil was much lauded after it removed a 15% withholding tax on local public-sector debt investments. It opened the door to billions of dollars of foreign investor cash within months, and allowed the sovereign to create five-year and 10-year points on a brand new fixed-rate curve. It was a watershed moment for Brazil. The nation was no longer solely dependent on local investors, which were only interested in buying short-term, floating-rate paper.

But the move also encouraged investors to park their money onshore, with Brazil typically paying 150bp–200bp more on its local debt curve than it does on its real-denominated Globals. The move saw liquidity flow out of the Globals, leading many DCM bankers to conclude it will never come back. Many believe Brazil should now complete the process and follow in Mexico’s footsteps, allowing local public-sector debt to be settled through Euroclear. Should Brazil do this, cost savings of billions of dollars are within its grasp.

By fully opening the door to foreign investors – many still do not invest locally because their statutes demand that investments are settled via Euroclear, for example – Brazil’s local curve should tighten again, once markets and investor liquidity improve. Bankers predict that the spread differential will narrow between its local and Global paper.

The arguments are therefore well understood by the sovereign. Taking the plunge, though, that’s another story.

What may be needed to encourage these, and other, LatAm sovereigns to embrace the idea of making its local debt Euroclearable is further assurance that the market for their local currency debt does exist and is stable. LatAm sovereigns will therefore probably wet their toes by resuming issuance of global local currency debt. Chile and Colombia have done their bit this year, Brazil is yet to return and Peru has for a long time sought to retap its global soles 2037 bonds.

If Chile is any gauge, Brazil’s return to the global local currency debt issuance will encourage several Brazilian corporates come to market. Colombian and Mexican companies are also heard assessing the option.

Once that market is well-established, it may convince sovereigns that a Euroclearable local market would be stable enough to pose no threat to the local currency and, hence, the local economy.

So for now, the prospect of fully open Latin American markets may still be several years away. But observers can take heart that at least they are thinking more seriously about it.

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