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IADB- XXII Meeting - LA Network of Central Banks and Finance Ministries

Local Currency Issuance: Fad or Trend?. IADB- XXII Meeting - LA Network of Central Banks and Finance Ministries. October 21, 2005 Gustavo Cañonero Chief Economist Latin America Gustavo.Canonero@db.com.

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IADB- XXII Meeting - LA Network of Central Banks and Finance Ministries

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  1. Local Currency Issuance: Fad or Trend? IADB- XXII Meeting - LA Network of Central Banks and Finance Ministries October 21, 2005 Gustavo Cañonero Chief Economist Latin America Gustavo.Canonero@db.com Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE BODY OF THIS RESEARCH.

  2. Overview • Under normal circumstances issuers would try to match their liability structure with their revenues/cash flows. Therefore, starting from high concentration of foreign currency debt in the 90s, LA governments are inclined to borrow in local currency, if possible long maturity and fixed rate. • Ergo, the recent trend in debt composition mostly reflects significant reduction in borrowing costs in long dated local currency debt. • By decomposing the determinants of local currency rates, we show recent trends and rationalize them through fundamental positive changes in the countries external and public financing situation. • We however acknowledge pending risks of current fast growth amid a high liquidity environment that exacerbates the search for yields overall as well as the positive side of the economic cycle for the region. • We conclude that, in our view, local currency issuance is more a trend than a fad, but recognize that further development in local capital markets may well be a rocky road, with ocassional setbacks that could be sizeable.

  3. Valuation: Fair Local Risky from External Risky Yields Or the way FI investors evaluate the relative return/risk of local assets Source: DB Global Markets Research

  4. Valuation-Adjustment1: Expected FX Depreciation • Short and long term real exchange rate equilibria are obtained from our “Fundamentals to Exchange Rates” (F2X) Model and “Regression (RESRM) Model” Source: DB Global Markets Research • Important variables: Current account balance, USD debt service, GDP growth, etc. • Real expected FX depreciation is transformed into nominal expected depreciation using forecasted Inflation differentials.

  5. Valuation- Expected REER Depreciation and Volatility Appreciation is the new regional trend and volatility has been relatively contained Source: DB Global Markets Research

  6. Valuation-Adjustment2: FX Risk Premium • Classical Linear CAPM leads to Where • Large correlation, smaller diversification: larger FX risk premium. • Large volatility ratio makes local assets unattractive. • Unfortunatelly, overall small premiums and fails to capture tail risk. • We use a non-Linear CAPM, which leads to a more complex formula that captures negative tail risk (skew) and yields a more reasonable risk premium estimate. • Important variables: Correlation between FX and credit spreads, volatilities, skews (the most important variable) and kurtosis.

  7. Valuation-Adjustment 3: Credit Adjustment • Assumming positive correlation between credit and FX risks, spreads in local currency debt are smaller than USD credit spreads. • The reason is the assymetry in the payoffs of local currency debt: • If there is no default, sizeable extra return from FX appreciation can be expected; • in case of default, there is only a small extra FX loss over the recovery value. • Please see our previous Jan 2005 research piece “On the Pricing of EM Currency Linked Offshore Notes”for a detailed analysis. • It just partially offsets the FX RP when skew is considered. • Important variable: correlation between FX and credit spreads.

  8. Valuation – The Negative Relation REER/SPREAD Source: DB Global Markets Research

  9. Valuation - Estimated Values for the FX Risk Premiums Source: DB Global Markets Research

  10. Valuation-Some Applied Results • Brazil: cheap across the curve • Mexico: some value in the belly and long tenors • Colombia: fair valued but slightly expensive on the long end • Argentina: cheap on the short end but expensive on the long end Local Yields: Market versus Model Source: DB Global Markets Research

  11. Valuation- Currency Risk Premium In Retrospective • Floating exchange rate regimes with monetary discipline (Inflation Targeting) • Significant improvement in external and fiscal accounts • …..Fundamentals! Source: DB Global Markets Research

  12. Fundamentals – Equilibrium Real Exchange Rates With apparent room to strengthen with the only reinforcing volatility being added by the Central Banks! Source: DB Global Markets Research

  13. Fundamentals – A Radical Change in External Financing Finally net export-led growth???????? Source: DB Global Markets Research

  14. Fundamentals – As Well as Fiscal Financing Position That among other things enhances monetary prudence credibility Source: DB Global Markets Research

  15. Fundamentals – Inflation Convergence A revealed preference growingly institutionalized Source: DB Global Markets Research

  16. Risks – Liquidity/Commodity/Growth/US Imbalances (1) Historically Correlated with High Commodity Prices Historically Low US Real Rates Source: DB Global Markets Research

  17. Risks – Liquidity/Commodity/Growth/US Imbalances (2) Strong Commodities is Associated with Better EM Credits The Commodity Shock is Perceived as Partly Permanent Source: DB Global Markets Research

  18. Risks – Excessive (?) Foreign Participation Brazil BRL Market Mexico Bonos Market USD bn USD bn Source: DB Global Markets Research

  19. Risks – (Mitigated) – Normal EM Exposure? Cross Over EM Dedicated (% of US GDP) USD30bn USD9bn Source: DB Global Markets Research

  20. Appendix: Formula for non linear CAPM • Recently developped Non-Linear CAPM (Campbell Harvey, Journal of Finance 2000),gives us the more complex formula • We have the 3 extra parameters: = correlation between fx and square market returns (co-skew), 1. always between -1 and +1, by Cauchy Swartz inequality 2. 3. > 3 for fat tail distributions • 2 and 3 can be estimated from implied vol smile. Skew from slope, kurt from convxt. • Skew and co-skew are the big drivers. If they are set to zero, we get Linear CAPM.

  21. Opinions and recommendations inherent in “Macro Strategy” research (i.e., Economics, Quantitative, Portfolio Strategy, Corporate Activity, Momentum/Money Flows, Corporate Governance) may conflict with those of our fundamental industry/company analysts. For more information about valuation methods used by our strategists and industry analysts, please visit our website or call your institutional sales representative. The views expressed in this report accurately reflect the personal views of the undersigned lead analyst about the subject issuers and the securities of those issuers. In addition, the undersigned lead analyst has not and will not receive any compensation for providing a specific recommendation or view in this report. Gustavo Cañonero

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