The Fixed Income Market in Uruguay

1. The Fixed Income Market in Uruguay Julio de Brun (Universidad ORT Uruguay) Néstor Gandelman (Universidad ORT Uruguay) Herman Kamil (International Monetary Fund) Arturo C. Porzecanski (American University and Columbia University) Santiago, Chile April 2007

2. Plan of the presentation • Introduction • The Development of the Uruguayan Capital Market • Private sector • Public sector • Regulatory backdrop • Supply side: the corporate sector • Financial structure of Uruguayan firms • Survey potential issues • Demand side: institutional investors • Investors portfolios • Survey institutional investors • Conclusions

3. Data sources • Firms’ financial statements: • Office of the General Auditor (AIN) 2001-2003 • Survey to potential corporate issuers -2004 • Supply and demand: • Survey to potential corporate issuers, • Survey to institutional investors, • Survey financial intermediates.

4. Development of the Capital Market • The Uruguayan economy stagnated between 50s- 60s. • In the early 70s structural reforms allowed the country to resume growth. These reforms included: • interest rate caps were non binding anymore • exchange rate controls eliminated • financial intermediaries were granted more liberal conditions. • As a result an offshore banking industry developed, but the capital markets remain almost nonexistent.

5. Development of the Capital Market • 1982- Large exchange-rate and banking system crisis. • brought new prudential regulations. Supervision rested on internal control systems and external auditing. • 1990’s - New legislation to spur development of the domestic capital market. • Law of Securities Markets (Law Nº 16.749/ 96) • Mutual Funds law (Law Nº 16.774/96) • Pension Funds law (Law Nº 16.713/95) • Law of Trust Funds (Law Nº 17.703/2003)

6. Peak Development of the Capital Market:Corporate Sector Moro-fraud 2002-Crisis

7. Development of the Capital Market:Public Sector Debt • In the mid-1970s, a domestic market for government securities began to develop. • The BCU started to issue debt through the Montevideo Stock Exchange. (BVM) • This practice continued until the early 1990s, when the BCU began to issue public debt through auctions held in the over-the-counter market.

8. Development of the Capital Market:Public Sector Debt

9. Development of the Capital Market:Public Sector Debt

10. Development of the Capital Market:Public Sector Debt • A liquid market of public debt generates externalities: • Positive: they set a benchmark for private-sector debt issues, useful for pricing. • Negative: crowding-out effects.

11. Public Sector Debt • The potential issuers surveyed seem to believe both effects to be small. • 15% believe that the existence of a liquid market for sovereign debt may facilitate their own issuance. • 22% perceived the government as a competitor in the search for financial resources. • The investors survey pointed against crowding out effects. • Sovereign debt and corporate bonds are not perceived as substitutes in their portfolio. • They also disagree with the statement: • “A large stock of government bonds is important for the development of the corporate bond market”

12. Firms financial structure Data sources: • Office of the General Auditor (AIN) • Pre crisis 2001 • Post crisis 2003 • Survey to potential corporate issuers 2004.

13. Firms financial structure • Banks have been by far the principal source of financing. • 60% of corporate financing needs were met through borrowing and 40% from retained earnings. The external funds sources are banks and suppliers’ credit. • access to a local bond market has never been a realistic option for most firms, except for the few years during the mid-1990s when the Obligaciones Negociables,ONs became popular. • However, the market dried up after 1998 following the filing for bankruptcy of one of the issuers – the poultry firm Moro.

14. Firms financial structure • As a consequences of this sources of funding and the Uruguayan past instability history, Uruguayan firms liabilities are highly dollarized (severe currency mismatches) and have very short term maturity. • Those two characteristics (high dollarization and short term debt maturitiy) are special remarkable in comparison with other LA countries.

15. Firms financial structure

16. Firms financial structure Comparison with other LA countries

17. Firms financial structure • Three stylized facts • the highest level of financial dollarization in the corporate sector; • the highest within-country correlation between firm-specific dollarization ratios and debt maturity profiles • the shortest country-averaged debt maturities.

18. Firms financial structure Systemic effects of a sudden devaluation

19. Supply side: Firms’ survey

20. Supply side: Firms’ survey • The INE conducts an annual survey of economic activity. • Our survey includes all firms regularly surveyed by the INE with more than 50 employees. • The rate of response was 100%. • We ended up with 463 firms, covering: • D-Manufacturing • G-Commerce • H-Hotels and restaurants • I-Transportation services • K-Real estate and machine rentals • M-Educational services • N-Health services.

21. Supply side: Firms’ survey List order effects • In order to avoid the effect of the list order in the evaluation procedure, we generated two types of questionnaires, A and B. • The first item in Questionnaire A became the last one in Questionnaire B; the second item in Questionnaire A became the next-to-last one in Questionnaire B; and so on and so forth. • Questionnaires A and B were assigned randomly to firms.

22. Supply side: Firms’ survey Most firms are 100% owned by Uruguayans

23. Supply side: Firms’ survey Most firms are closed corporations

24. Supply side: Firms’ survey Lack of knowledge about financial instruments is pervasive despite the branch of economic activity and origin of firm capital

25. Supply side: Firms’ survey The capital market is not a source of financing for Uruguayan firms

26. Supply side: Firms’ survey Bank financing • Mostly from local banks • Main problems: • 1. High cost of peso-denominated loans • 2. Collateral requirements • 3. Speed of approval and disbursement.

27. Supply side: Firms’ survey Bond financing • Exclusively domestic bonds • Main problems: • 1. Small size of the market (Uruguay not abroad) • 2. Absence of market for high yield bonds (“junk bonds”) • 3. Credit rating agencies’ fees

28. Supply side: Firms’ survey Bond financing - Willingness to disclosure information • Most firms willing to disclosure information in order to be rated by a credit agency as a preliminary stem to an eventual issuance of bonds.

29. Supply side: Firms’ survey Financing in Uruguay • Banks better with respect to: • speed of access to required financing • information requirements • minimum amount require for loans-issuances. • Bonds better with respect to: • long term funds • Guarantee requirements (but still a considerable problem)

30. Supply side: Firms’ survey Ranking of financial alternatives • Supplier's credit is by far the preferred alternative in almost all dimensions • Uruguayan banks are preferred with respect to long term lending and “close”to supplier's credit with respect to size of potential market.

31. Supply side: Cost of issuance

32. Demand side: institutional investors • The principal institutional investors are the pension funds: • State owned • República AFAP (state owned) • Private banks owned • Afinidad AFAP • Integración AFAP • Unión Capital AFAP. • Other institutional investors include: • Banco de Seguros del Estado • Caja Profesional • Caja Bancaria

33. Demand side: Pension funds • Highly regulated: • Jurisdictions:Not allowed to make any investments outside Uruguay; • Currencies:Investments in f.c. below 60% of portfolio; • Government exposure:Share Central Government securities below 60% assets; • Exposure to banks: Certificates of deposits and cannot exceed 30% of assets. • Exposure to firms (equity and bonds): • Private sector securities constrained by a 25% limit. • Securities issued by any particular firm must be less than 3% of total assets, and less than 50% of the amount outstanding of each security. • Exposure to asset-backed securities: Total ABS must below 20% of assets and ABS of every single issues must be below 3% assets. • Exposure to beneficiaries of the pension system:Below15% assets. • Aggregate exposure to the non-financial private sector: • The sum of the last 3 exposures must be below 40% assets.

34. Demand side: Pension funds

35. Demand side: Pension funds

36. Demand side: Pension funds • Legal and regulatory constraints • are not binding with respect to investing in corporate bonds • binding with respect to investing abroad. • Why they do not invest more in corporate bonds? • Perception of high risk (financial fragility: currency mismatches, high indebtedness). • Limited legal recourses in event of default.

37. Demand side: Pension funds • Not a problem: • Availability of information • Credit rating • Usual strategy: “buy and hold”. Therefore: • Absence of a liquid secondary market not perceived as a problem. • But low capitalization is a problem (they do not have opportunities to invest).

38. Demand side: Pension funds • Allocation of additional funds: • Goal: diversification • How? • Reducing Government Bonds • Increasing (from 0) investments abroad • Increasing investment in corporate bonds • Then, why they do not increase now their participation in corporate bonds? • There is no supply of corporate bonds • They will eventual buy financial sector Deposit Certificates.

39. Demand side: other institutional investors • Also stress the high risk involved in corporate bonds. • Three main differences with Pension funds.They perceive as problems: • Information availability • Quality of credit rating • Low liquidity of secondary market

40. Demand side: financial intermediates • Mostly the same answers as before. • The only noticeable difference is the disparity of perceptions with respect to quality of credit ratings.

41. Conclusions • The macroeconomic instability of the last decades is responsible for the high dollarization of the Uruguayan economy and the absence of peso denominated financial instruments. • The government is pushing a de-dollarization agenda, and institutional investors have played an important role in the development of a market for inflation-adjusted instruments. • Households and firms are somewhat more reluctant to change long-term practices in personal portfolio management • So it is not clear that currency mismatches will soon be reduced.

42. Conclusions • Uruguay has been the most dollarized country in Latin America and yet also the country where corporate debt has had the shortest average maturity. • This situation has generated currency and maturity mismatches that have exposed the country’s firms to dangerous currency and refinancing risks. • This is perceived as the major problem by institutional investors to increase their participation in the corporate bonds market. • Our stress test to a sudden devaluation confirms the persistence of system risk.

43. Conclusions • Although there may be some regulatory deficiencies, the main determinants of this condition of limited access are not of a regulatory nature. • The major perceived shortcomings by institutional investors are not inadequate information to assess the risks involved, but rather the vulnerability of Uruguayan firms to macroeconomic shocks and difficulties to enforce creditor rights in the event of defaults.

44. Conclusions • Moreover, potential issuers declare their willingness to disclosure the requested information in order to be rated as a first step to eventual debt issuance. • Beyond this declared willingness, there is surprisingly little knowledge among corporate managers about financial alternatives to borrowing from banks and suppliers.

45. Conclusions • Despite the fact that transparency is not perceived as a problem by investors and the apparent readiness of many firms to disclose information. • The usual agency problems associated with long-term debt have promoted opportunistic behavior by stockholders that in the end have resulted in default episodes. These episodes generated important negative externalities that affected and still linger in the domestic capital market.

46. Conclusions • Finally, • A deepening of the fixed-income market could help to extend corporate debt maturities, helping to reduce firms’ mismatches and thereby fostering investment in fixed assets and economic growth. • We remain pessimistic about the future development of the corporate bond market. Most firms are likely to remain depending on short-term banking credit.