Policies for liquid and well functioning sovereign debt markets
Speech by Mr Alexandre Tombini, Chief Representative for the Americas, Bank for International Settlements, at the Panel on Sovereign debt: liquidity and consequences, Central Bank Research Association (CEBRA) Annual Meeting, hosted by the Federal Reserve Bank of New York, 5 July 2023.
Introduction
Thank you, Anna. It is a pleasure to speak on this panel.
As you know, public debt surged around the globe in the wake of the pandemic. Latin America was no exception. The median debt-to-GDP ratio of the six largest Latin American countries rose from 55% at end-2019 to over 60% one year later. Since then, it has fallen somewhat, given the economy's quick rebound and the surge in inflation. But this median hides quite a bit of variation: public debt in Brazil fell just short of triple digits, while in Chile and Peru it never reached 40%.
Apart from in Argentina, debt sustainability is not currently an issue in the larger Latin American economies. Debt levels may be high, but they are manageable.
But even if sustainability is not an issue, higher sovereign debt can reduce policy space, making it more difficult to deal with future shocks. High sovereign debt can also complicate macroeconomic policy, including monetary policy. The main reason for this is the risk premium on sovereign debt, which is very sensitive to market conditions. My colleagues Ana Aguilar, Carlos Cantú and Rafael Guerra have laid this out in a recent BIS Bulletin.1
Policies to ensure healthy markets
So what can central banks, debt managers and other financial policymakers do to ensure that markets remain liquid and risk premia contained?
First of all, there is no alternative to putting public finances on a solid footing. In many countries this means fiscal consolidation and credible fiscal rules that ensure fiscal discipline in the future.
Second, it is important to lift the growth potential of the region, to allow countries to grow out of high debt. In addition to fiscal reforms, this requires supply side reforms that unlock growth potential and improve the climate for crucially needed private investment.
Third, clever debt management and market development policies can help, even if they cannot substitute for growth-friendly fiscal policy and structural reform. Central banks have an important role to play in this regard. Even if they do not act as debt managers for the government, they often have a mandate to develop deep and efficient financial markets, which improves the monetary transmission mechanism.
Debt management
Debt managers cannot affect the overall level of government debt, but they can influence when and under which conditions it comes due. For example, they can reduce their rollover needs each year by extending and distributing maturities. They can reduce the sensitivity of (nominal) payments to interest rate fluctuations by issuing debt at fixed rates. Issuing local instead of foreign currency-denominated debt can reduce the impact of exchange rate fluctuations. Of course, the benefits must be set against the costs: issuers of fixed-rate, long-term debt tend to pay the term premium and those of domestic currency debt a premium for exchange rate risk.
Some 40 years ago, on the eve of the 1980s debt crises, most sovereign debt in Latin America was short-term and denominated in foreign currency. Things have changed considerably since.
Today, less than 5% of Brazil's public debt and less than 20% of Mexico's is denominated in foreign currency. In Chile, Colombia and Peru, the picture is more mixed. In these three countries, the share of foreign currency debt reached a low around 10 years ago, but it has risen again since then.
Debt duration has also increased. Many Latin American economies used the favourable financial conditions after the Great Financial Crisis to issue long-term fixed-rate debt. This has paid off handsomely over the last two years, limiting the pass-through of higher interest rates to debt service burdens.
But debt management goes beyond choosing the composition of debt. Developing a diverse investor base is another key task. Diversity is important because investors with different investment needs and strategies behave differently. They are less likely to buy or sell at the same time, which leads to deeper and more liquid secondary markets. Diversity can also mean a good mix of traders who provide liquidity, and institutional investors who hold assets for the long run.
There has been substantial progress on this front. Domestic non-bank investors, such as pension and mutual funds and insurance companies, have become significant investors in their respective domestic bond markets. For example, in Brazil and Mexico they hold well over half of the outstanding public debt.
International diversification is also important. Latin American sovereign debt has become mainstream among large global money managers and institutional investors. One element in achieving this more diversified investor base has been targeting investors from a broader range of countries. For example, debt managers actively sought investment from Asia as well as from Europe and the United States to reduce reliance on a few key investor regions and enhance market stability.
Central banks also have an important role to play. Low and stable inflation helps to lower the cost of finance for governments. Market participants attach high importance to inflation stability when pricing government bonds.2 Which in turn helps to foster liquidity. The shift towards local currency issuance at long maturities would have been unthinkable without the success of inflation targeting.
The role of hedging markets
Ancillary markets also matter. The bond market does not exist in a vacuum. It requires repo and derivatives markets to become liquid and efficient. These markets allow investors to hang on to their securities holdings when faced with cash needs or if they want to adjust their exposure to exchange and interest rate risk, instead of selling the bonds.
Hedging markets in Latin America have grown in recent decades. FX derivatives denominated in Mexican peso and Brazilian real are the 12th and 13th largest such markets in the world in absolute terms. For interest rate derivatives, the real ranks eighth and the peso 14th.
Improving liquidity in normal times...
In addition, there are a number of technical decisions that help improve liquidity. Latin American debt managers now hold regular auctions at pre-announced dates, providing the reliability that investors need. They also allow international clearing of their securities, which greatly facilitates the participation of international investors in the market.
...and in times of stress
A key challenge is to ensure that liquidity is there in times of stress. If markets suddenly turn illiquid, investors will not be able to exit positions except at great cost. Hedging strategies that rely on liquid markets break down and no longer provide protection. And valuations can become detached from reality because there are no transactions to anchor them. For issuers, raising new funds or rolling over maturing debt becomes extremely expensive or impossible.
Again, a diverse investor base is the best protection against sudden illiquidity. News on this front is encouraging. In contrast to the 1990s, when many investors fled at the first sign of trouble, there are indications that holders of EM debt are becoming more discriminating and are taking a long-term perspective. Contagion across countries appears to have lessened considerably as investors learn more about the individual economies and markets. This is due to a myriad of initiatives, ranging from the timely publication of data to regular interactions with investors.
But there are circumstances when the self-stabilising force from a diverse investor base is not sufficient – the pandemic crisis being a case in point. In such exceptional circumstances, and only then, central banks can consider stepping in to provide liquidity through securities swaps and purchases.
Digitalisation is the next challenge
To conclude, Latin American countries have made tremendous progress in better managing their sovereign debt. Sovereign debt markets are much more liquid, efficient and stable today than in the past.
The next opportunity could be just around the corner. As we lay out in Chapter 3 of our Annual Economic Report published last month, a unified ledger could streamline securities settlement, reduce risks and costs and, hence, improve market functioning. But the benefits of tokenisation will accrue only if central banks and other entities work together and ensure interoperability. We could find ourselves at the cusp of yet another revolution in securities markets.
1 A Aguilar, C Cantú and R Guerra, "Fiscal and monetary policy in emerging market economies: what are the risks and policy trade-offs?", BIS Bulletin, no 71, 29 March 2023.
2 See Committee on the Global Financial System, Establishing viable capital markets, CGFS Papers, no 62, January 2019.
