Andrew Powell Research Dept., Inter American Development Bank BRICS Conference, Hong Kong

1. Promoting the International use of Emerging Country Currencies:debt issuance for Latin America and the Caribbean Andrew Powell Research Dept., Inter American Development Bank BRICS Conference, Hong Kong Dec 10th and 11th, 2012 Opinions are strictly those of the author and are not necessarily those of the IDB or any other institution.

2. Introduction • Internationalization of currencies has several inter-related dimensions with information and liquidity externalities • One extremely important dimension is being able to issue debt in one’s own currency • This paper focuses on LAC: there has been increased use of LAC currencies remains rather limited • If liquidity is self-fulfilling there is a prima facie case for public policy action • But there is a Catch 22 for MDB’s • Conclusions and recommendations for coordinated actions

3. A Word on LAC: Bad Inflation Experience Has Largely been Conquered Hyperinflation episodes in Argentina, Brazil Start of Debt Crisis Consumer Price Index (end of period), annual percent change Lehman Tequila Crisis ≈6%

4. Growth Performance: not doing as well as other EM’s but better than Developed Countries

5. Eight Countries in the Region are Now Inflation Targeters • Can see private inflation and growth expectations as sampled by each country’s central bank here • www.iadb.org/revela

6. Dimensions of Currency Internationalization • Trade settlement – Means of Exchange • Reserve currency usage – Store of Value • Denomination of contracts – a Unit of Account

7. Dimensions of Currency Internationalization • Functions of Money • Unit of Account • Means of Exchange • Store of Value

8. This paper/presentation… • Focus on use of currencies to denominate debt (unit of account) and ability of countries to issue debt in their own currency internationally • I will argue this ability is important for risk sharing and will focus on Latin America and the Caribbean

9. Information and Liquidity Externalities for Currency Usage • If a currency is used in one dimension more likely to be used in others • If market trading focused on the dollar, prices will reflect all available information • Derivatives will give information on expected valuations and expected volatility • High liquidity will make it easier/cheaper for others to trade that currency fueling yet more liquidity • Liquidity is self-fulfilling

10. Top four currency trading market shares have been remarkably stable Source: BIS 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity

11. More movement in next 10 currencies, but from a small base… Mexican peso, MXP Brazilian Real, BRNL Chilean peso, CHP Colombian peso, COP Source: BIS 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity

12. Currency market shares of globalderivative trading… Emerging Asian and LAC currency derivatives are within others’ 9% and residual 2% Source: BIS 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity

13. Global Bond Issuance Source: Dealogic data, author’s calculations

14. Bond IssuanceOf US$139bn of 2011 LAC “deal-nationality” issues, US$82bn were in USD $22bn in BRL $18bn in MXN/MXV $5.4bn in CLP/CLF Source: Dealogic data, author’s calculations

15. And some US$10bn of LAC Currency Issues were under Developed Country Governing Law, the majority under London Law Source: Dealogic data, author’s calculations. Caveat: a large number of deals did not have governing law identified.

16. Why do we care…? • The 1980’s Latin American debt crisis and subsequent lost decade had many origins • But one was surely poor risk sharing… • Commodity prices were high and plunged • US interest rates were low and then soared • The dollar appreciated • And debt was in dollars • Today looks somewhat similar with $82bn of LAC’s $139bn of 2011 debt issuance in dollars

17. To see this more scientifically… • A country’s ability to pay in US$ is related to US$ GDP • A country’s ability to pay in a real domestic unit of account is related to real local currency GDP • If the former is more volatile than the latter, US$ debt has poor risk sharing This argument follows that in Hausmann and Rigobon and Eichengreen and Hausmann who call for local currency inflation indexed debt contracts

18. LAC: US$ Growth vs. Real Growth Volatility Source: Author’s calculations, perriod 1980-2011.

19. And the same goes for the BRICS… Source: Author’s calculations, perriod 1980-2011.

20. Inflation-indexed versus nominal debt • Ability to service debt related to nominal GDP not real • Some LAC countries issuing in nominal local currency • LAC has 8 inflation targeters with good inflation performance • BRICS also issuing in own nominal currency Hausmann and Rigobon likely affected by Chile’s good example, but Chile has been “nominalizing” too..

21. Simulated Volatility of LAC Debt to GDP Ratio with Local Currency vs. Dollar Debts Source: Author’s calculations.

22. Similar Results for the BRICS Source: Author’s calculations.

23. And poor risk sharing of US$ contracts:Brazil simulated debt ratios and growth Dollar strong when growth was weak Source: Author’s calculations.

24. And poor risk sharing of US$ contracts:Peru simulated debt ratios and growth Dollar strong when growth was weak Source: Author’s calculations.

25. What can be done? • Latin American countries have been issuing in local currency, selected pricing points: • Chile: 2020 pesos 4.4% yield, US$ 2022 2.4%. • Colombia: 2032 peso 4.4% yield, US$ 2022 1.8% • MDB’s can lend in local currency • But MDB’s subject to a Catch-22 • Can lend where liquid markets allow hedging • Cannot lend where needed or will eat into valuable capital to back currency risks

26. RDB’s can reduce capital through diversification:volatility of currency portfolios Source: author’s calculations

27. A GDP weighted portfolio brings less benefits:global coordination valuable Source: author’s calculations, LAC countries with GDP weights, RICS with equal weights

28. TCX – www.tcxfund.com • TCX was an initiative of the Dutch aid agency • Financed by official sources (Bilaterals, MDB’s) • Enters into exotic currency swaps • Gives liquidity where none existed • Holds naked currency risks on its books • Benefits from global diversification

29. Guarantees to Kick Start Currency Markets Anderson, Gilbert and Powell “Securitizing commodity contingent debt”, American Journal of Agricultural Economics 1991 Local currency debt contracts reflect more closely countries’ “ability to pay” which is related to nominal GDP To the extent a contract matches a country’s “ability to pay” then a guarantee on that contract will act on “willingness to pay” risks 1 Some countries can already issue in local currency on reasonable terms, others may benefit from the presence of an MDB guarantee A guarantee is a flexible instrument that can be adjusted to particular required demand

30. Guarantees to Kick-Start Local Currency Markets Currency risks TCX-type institution Investors Partial MDB Guarantee Country Issues Local Currency Debt Reinsurance market Other risks Schematic representation of one sample structure to kick start local currency markets

31. Conclusions Several emerging economies are now able to issue debt in their own currencies but subject to liquidity premia But local currency issuance remains limited and yet issuing dollar debt has dangerous risk properties MDB’s can help but there is something of a Catch-22 If liquidity is self-fulfilling, prices are not given Guarantees are a flexible instrument to kick start markets Benefits to global coordination to diversify risks to institutions providing local currency loans or guarantees