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Lull hits MILA debt offerings as markets assess global risks

Chile’s proposed return to the international debt markets and Mexico’s recent euro-denominated trade mark a rare sign of activity in the MILA region over the past few months. What is causing the slowdown?

Oct 26, 2016 // 11:37AM

In the past few years the MILA countries – Mexico, Colombia, Peru and Chile – have been some of the biggest benefactors of the EM investment surge, driven by a combination of favourable regulatory frameworks and strong growth channels across the region.

Even as the commodity boom unwound, with Brazil, Venezuela and other big oil and metals producers struggling to cope, the MILA states’ low average public debt levels – 21.3% of GDP in 2013, compared to EM average of 44.8% - provided the monetary and fiscal cushion that helped to avoid the standard pitfalls.

A fortunate combination of strong fundamentals and a price drop in fixed-income markets meant that the region’s corporate bonds offered better returns than some of the high-yield US corporates, while maintaining a better average rating of A-.

According to an IMF report, by 2014, Mexico, along with Brazil, had the largest bond and equity markets in dollar terms in the region, while Chile’s bond market stood out for its size relative to the economy.

However, despite solid market capitalization, low trading volumes are now emerging as a growing concern, which has come to the fore in recent weeks.

Colombia’s credit ratings have been facing a downgrade amid instability caused by the failure to agree the long-awaited peace deal with FARC rebels.

Peru, on the other hand, has been focusing on de-dollarizing its financial sector, with proceeds of its PEN10.25bn (US$3bn) 6.375% 2028 bonds being directed largely towards debt swaps and buybacks to reduce its cost of debt.

For Mexico and Chile, some of the strongest performers among EM economies, a swelling fiscal deficit poses a serious challenge. The latter remains the highest rated country on the continent (Aa3/AA-/A+).

But with US Treasury spreads on it shrinking from 130bp to 87.9bp and with growth remaining sluggish, below 2% for the last three years, investment is drying up. According to Diego Torres, Head of Fixed Income Research at MCC, that is one of three factors main contributing to this lull in market activity.

“Another reason is that Mexico and the Andes did most of their Capex refinancing last year in low US Fed rate and with Brazil largely absent, which they saw as the optimal time for them. Now Brazil has returned to the debt market and is trying to regain some of the lost ground,” Torres explained.

“Finally, another factor is that the market has become much more selective and risk-averse when accepting new issuers,” he concluded.

While Chile’s government debt is likely to reach 25.2% of GDP by next year, the highest in 20 years, according to Moody’s, it is still significantly lower than the +40% seen in many of Chile’s emerging market peers.

A fiscal deficit creeping towards 3.1% of GDP is a much more immediate problem, though the government for now is reluctant to tap into its two sovereign wealth funds, together valued at US$22bn.

“The big wealth funds will remain at the same level next year,” the Finance Minister Rodrigo Valdes was recently quoted as saying in an interview with Reuters. Instead, according to the official, Chile expects to issue up to US$10.5bn in local and international markets over the course of next year.

Additionally, Codelco, the state copper mining giant that has been struggling amid low commodity prices, raised US$397mn in local bond sales last August and many expect it to tap the markets again, albeit with a premium yield due to poor leverage to rating ratio.

“For Chile, and most LatAm states, achieving borrowing targets should be quite easy, as access to international capital markets is very much open. But the annual increase of government expenditures over past 4 years will increasingly worry foreign investors, and lack of pro-business reforms and continued slow growth may limit Chile’s access to foreign capital,” Torres warns.

Mexico, which relies on crude for nearly 20% of federal revenue, has also moved to trim its budget deficit over the last 12 months. In January, the country sold US$2.25bn in 10-year notes, followed by US$2.8 billion in Euro-denominated bonds and most recently, a €1.9bn trade including a new 8-year €1.2bn tranche and a €700mn re-tap of its 2031s – eclipsing its previous commitment to cap its borrowing at US$6bn. This September, state-owned oil company Petroleos Mexicanos (PEMEX) sold US$4bn in long-term bonds to finance some of its existing debt and cover for its funding needs for 2017.

While Mexico’s recent capital outflows in the fixed-income market have also been caused by a combination of external and domestic factors, according to the Senior Economist for Latin America at the IIF Martin Castellano, they have mainly affected short-term instruments; longer term bonds like BONOS are showing more stability.

A drop in revenue from commodity trade – mostly oil income, in Mexico’s case, which is down to about 15% of total fiscal revenue this year – has weakened the country’s fiscal position, the expert admits, but there are other factors.

“The Central Bank’s relatively hands-off approach to the FX market makes the peso an automatic stabilizer – which is why we have recently seen significant peso depreciation, 7% so far this year,” Castellano adds.

 “And with the Mexican economy generally being very open, it is exposed to global economic shifts – namely, the uncertainty associated with the upcoming US elections,” the economist concludes.

Mexico’s latest budget for 2017 proposes a 10% boost to non-oil revenues, helping to offset the 16% drop caused by low crude price. With a continued rise in public spending, the Central Bank has been hiking rates by 175bps since December to prop up the peso.

“In Mexico, public demand for fiscal prudence is strong and, although implementation has been challenging at times, the government is on course to meet the fiscal consolidation targets – mostly thanks to higher than expected non-oil revenue,” Castellano concludes.

Notably, with little hope of a strong oil price rebound in the near future, other sectors have prospered, particularly renewable energy and infrastructure development. One example has been Mexico City's Airport Trust’s issuance of US$2bn (€1.8bn) in green bonds to help finance the new Mexico City airport, with 10-year and 30-year bond tranches offering 4.25% and 5.5% respectively.

And on Tuesday GISCA, a leading infrastructure developed, announced its placement of long-term local bonds for the equivalent of MXN3bn for a tenor of 7 years, yielding a fixed coupon rate of 6.95%; another MXN3bn issuance is expected to follow shortly.

According to Castellano, government-led reforms in such sectors as energy, telecommunications, education, labour and others, while susceptible to short-term risk factors, will pay off in the long-term in terms of investment.

“Climate bonds in general are an emerging trend, particularly in this region. It could become another tool in Mexico’s sound liability management policy, which has helped to minimize the impact of external shocks” Castellano noted.

“Also, infrastructure is another area with a lot of potential – and here, in particular, instruments like green bonds can be extremely useful, particularly keeping in mind the tougher conditions the segment is currently facing due to government budget constraints” he concluded.

Similarly, renewable energy projects have been a success story for Chile, with the auction of contracts to supply 12,430 gigawatt-hours of energy over 20 years attracting a record number of bidders last August. Since then, however, questions have been raised about how these projects will be financed.

According to an NRDC report earlier this year, some of the barriers facing these kind of projects include lack of guarantees, perception of projects as risky and unprofitable, no clear roadmap and poor structured finance knowledge in the local market.

Green bonds and innovative financing structures, the study suggests, can help plug the funding gap. They would also breathe new life into the MILA debt markets, but policy makers will need to drive the process by optimising the regulatory framework and setting the example with initial issuances.

It may not be immediately possible, with global risks, such as the US election, a possible Fed rate hike, and China’s slowdown pushing investors to safer waters. But once those uncertainties are resolved – one way or another – observers of the MILA region expect big moves.

Americas Macro Currencies Policy & Government

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