Countries in Latin America and the Caribbean have sought to develop deep and well-functioning domestic bond markets since the beginning of the 21st century—a reaction in part to the financial crises of the 1990s and their relationship to government borrowing abroad, mainly in foreign currencies. As a result, the outstanding level of marketable public debt issued under domestic legislation—which is predominantly in local currency—increased from an average of 15% of GDP in the 1990s to 25% of GDP in 2020 in the region as a whole and to more than 37% of GDP in the region’s six largest economies.
Moreover, it has not only been public debt: Private bonds, issued by nonfinancial corporations and banks in the domestic market, have also made progress, with outstanding bonds issued by the private sector in Chile, Brazil and Mexico reaching significant levels relative to the size of their economies.
Foreign Investors as a Double-Edged Sword
If the growth in these historically underdeveloped markets has been welcome, however, it has not necessarily been in the way experts expected. Domestic bond markets were expected to expand in part because domestic institutional investors, pension funds and insurance companies would buy debt. In reality, the entry of foreign investors into local markets has been the biggest factor. This has stoked market growth while also contributing to the volatility and fragility that stems from the reality that such investors, interested in returns in foreign currency, are inherently more flighty than resident ones. When a domestic currency is expected to depreciate, foreign investors are the first ones out the door.
The challenge for the region today, as we discuss in the IDB’s recent flagship publication “Dealing with Debt,” is to build more resilient domestic markets. This requires a stronger counterpart of domestic investors that can buy domestic bonds when foreign investors flee under stress. Such markets can spur economic growth and support macroeconomic stability. They can provide governments with the ability to issue long-term, local-currency instruments that avoid the risk of failing to roll over debt, or of a sudden jump in the country’s debt burden should the exchange rate depreciate. And for the private sector, they can open up opportunities to finance investment at longer terms than those normally offered by the banking sector, while avoiding a currency mismatch between assets and liabilities.
No Universal Blueprint
It is all a question of designing the right strategy for creating or expanding resilient domestic bond markets. There is no universal blueprint for this, but there are enabling conditions. To start with, governments must ensure a stable macroeconomic environment, with a policy framework that leads to low and stable inflation, credible central bank policy, and a stable foreign exchange market. There also has to be a strong legal system that gives bondholders confidence in the rule of law and the assurance that they will be able to access the return on their investment. And governments should avoid using regulations, moral suasion, or other forms of financial repression to compel institutional investors to hold government debt.
Building a solid local investor base that can counteract the weight of foreign ones and add liquidity is key for more resilient domestic markets. Operational infrastructure, including rules that will allow the secondary markets to function efficiently, can make a big difference in this effort to expand the local investor base.
Proactive Government Policies
Governments can embark on still other proactive policies to give a nudge to market development. In Brazil, for example, the government in 2011 introduced a framework by which private companies could issue infrastructure bonds to promote the development of long-term private capital markets and strengthen financing for infrastructure projects. As long as funds are used to finance infrastructure projects, the securities’ interest and capital gains enjoy a tax exemption. Financial institutions that invest in these instruments, meanwhile, can take advantage of a reduced tax rate of 15% compared to a standard rate of 25%. These benefits have helped build an important mechanism for infrastructure financing with local funding. The income tax exemption has made it popular with high-income Brazilian savers; there is currently an active secondary market for these infrastructure bonds and a very low incidence of default.
The government of Uruguay, meanwhile, has spent 20 years incrementally developing a domestic market that has moved through different types of instruments and custody and settlement arrangements to establish a system in which a much higher share of public debt is issued in local currency. This patient progress from the previously high levels of debt dollarization helps to insulate the country from exchange rate depreciations accompanying economic downturns. It also shows that even small economies can develop a strong domestic bond market.
Efforts at multinational initiatives, such as the Asian Bonds Market, launched in 2002 to develop local currency bond markets and achieve regional integration, could also bear fruit in the medium- to long-term in Latin America and the Caribbean. That initiative was very successful at improving market infrastructure and regulations in a coordinated manner among the Association of Southeast Asian Nations, China, Japan, and Korea, and spurring dramatic growth in them. Similar efforts in Latin America and the Caribbean, while incipient, like the Debt Market Harmonization program in Central America and Dominican Republic, could eventually prove promising for countries in the region that face larger obstacles to developing markets on their own and lag in progress towards that goal.
Each country will inevitably have to find its own way to progress, given its particular characteristics and circumstances. Nonetheless, the benefits of deepening domestic debt markets to provide long-term financing to the private and public sectors in local currency is essential to stoking growth and reducing vulnerability.