1

Managing Risks: The Common Interests of Emerging Market

Countries and Investors

Eliot KalterInternational Capital Markets DepartmentInternational Monetary FundJune 15, 2006

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OVERVIEWManaging Risks: The Common Interests of

Emerging Market Countries and Investors

I. Growing underlying strength of emerging market (EM) countries

II. Improvements in EM sovereign debt structureIII. Broadening investor base for EM issuesIV. EM local issues as an investor classV. The portfolio application of local marketsVI. Individual EM country valuation still mattersVII. Implications for International Financial Institutions

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I. Underlying Strength of Emerging Market

Countries

Cyclical factors underlying strength of asset class

• Increased risk aversion reflecting investors’ assessments of global liquidity and changes risk aversion

• Nevertheless, search for yield and credit spread compression

4

Treasury yields increase while emerging market spreads continue to decline

5

Fundamental factors underlying strength of

asset class

• Global financial position of EM Countries has dramatically improved in recent years

• Strong growth of international reserves through capital inflows and current account surpluses

6 25

Emerging Markets: Current Account Balance and External Financing(In billions of U.S. dollars)

1998 2000 2004 2005 2006 2007

Current account balance -113.1 91.1 219.8 423.3 486.7 473.2

External financing 285.4 247.9 449.5 512.1 518.5 489.6of which Foreign direct investment 179.0 178.1 256.4 280.7 288.1 293.0 Private debt 55.3 57.6 173.4 243.0 196.4 163.9

Asset accumulation 172.3 339.0 669.3 935.4 1005.2 962.8 By official sector -4.4 84.2 434.4 525.4 533.3 507.5 By private sector 167.9 254.8 234.9 410.0 471.9 455.3

Source: IMF, World Economic Outlook (April 2006).

Emerging Markets: Current Account Balance and External Financing

(in billions of U.S. dollars)

7

Improved debt structure underlying strength of asset class

Improvements in debt management operations

• Significant improvement in EM macroeconomic fundamentals has enabled public debt managers to be active in markets

• Many EM sovereigns have made major strides in improving debt management capacity

• Focus on reducing exchange rate risk, interest rate risk, and rollover risk

8

Recent liability management activity

• Buy-backs of international bonds through early repayments to IFIs and the Paris Club, and retiring other foreign currency liabilities

• In addition, market is seeing exchange warrants, pre-funding of fiscal operations, and the exchange of foreign- for local-currency denominated debt

• These operations are transforming the market for emerging market assets

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Selected External Liability Operations by EM Sovereigns: 2005

Type of Operation Description Impact on sovereign debt

Prepayment of non-marketable debt to private creditors

Poland (2005)––prepayment of the Paris Club Debt (5.3 billion euros) financed by the issuance of US$ and euro-denominated global bonds;Russia (2005)––prepayment of the Paris Club Debt (US$ 15 billion) financed by Oil Stabilization Fund

- Reduction of US$ debt;- Reduction of debt level- Reduction of US$ debt;

Brady bond exchanges, calls and buybacks

Brazil (July 2005)––retired exchanged its C-bonds for amortizing bonds in 2005

- Collateral released = US$490 million

Global bond exchanges, calls and buy-backs

Mexico (November 2005)––global bonds maturing between 2007 and 2033 were bought back using fx reserves;Colombia (June–September 2005)––US$600 million of global bonds were exchanged for peso bonds; US$1.1 billion of global bonds were bought back, financed mainly by reopening of 2024 global bond.Brazil (July 2005)––US$4.5 billion of C-Bonds with embedded call option were swapped into longer-dated A‑bonds

- Improved liquidity;- Debt reduction = US$1.4 billion- Smoothing of amortizations;- Reduction of US$ debt; - Extension of maturity;- Reduction of US$ debt;- Extension of maturity;- Smoothing of amortizations;

Warrants Mexico (November 2005)––sold warrants allowing swap of up to US$2.5 billion of US$-denominated bonds (with maturities between 2007 and 2033) 2006 for peso-denominated bonds (due in 2011, 2014, 2024)

- Reduction of US$ debt (if warrants are exercised);

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Local Currency Denominated Global Bond Issuance

Colombia (February 2005)––issued US$320 million of 10 year peso denominated bonds payable in US$.Brazil (September 2005)––issued US$1.479 billion of 10 year real-denominated bonds payable in US$

- pre-funding for 2006;- longer maturity in reais

Pre-financing for the subsequent budgetary year

Brazil (2005)––US$1 billion reopening of 2025 bond; US$500 million reopening of 2015 bond; US$500 million reopening of 2034 bond;Colombia (2005)––US$500 million reopening of 2014 bond;Indonesia (2005)––US$100 million of 30 year global bonds and US$900 million of 10 year global bonds;Mexico (2005)––US$1.975 billion reopening of 2015 issue; US$921million of 10 year euro denominated bonds; Philippines (2005)––US$150 million of 11-year global bondsVenezuela (2005)––US$1.215 billion of 20 year global bonds; US$1.5 billion of 10 year global bonds and US$1.5 billion of 15 year global bonds

- pre-financing for 2006- pre-financing for 2006- extending the dollar curve;- pre-financing for 2006-2007;- liquidity in euro segment;- pre-financing for 2005;- pre-financing for 2005- extending the dollar curve;

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Strengthened sovereign balance sheets

• Significant impact on the sovereigns’ debt structure

• Resulting in strengthened ability to deal with negative cyclical events

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Resulting in reduced external debt serviceExternal Debt Service/Exports of Goods and

Services(in percent)

0

10

20

30

40

50

60

70

1990 1992 1994 1996 1998 2000 2002 2004

0

10

20

30

40

50

60

70

Europe

Asia

Latin America

Emerging Markets

13

Emerging market sovereign credit ratings

Emerging Market Sovereign Ratings Actions by Moody's and S&P

2018

9 9

0

32

36

3132

6

0

5

10

15

20

25

30

35

40

2002 2003 2004 2005 2006 (YTD)

Downgrades

Upgrades

14

0

200

400

600

800

1000

2000 2001 2002 2003 2004 2005 2006

Aggregated EMBIG Spreads – Actual and Model

(in basis points)

23

Actual

Model

Corrections

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II. Broader EM Investor Base

Foreign investors attracted to asset class

• Ratings outlook positive and moves toward investment quality

• Improved fundamentals driving asset class and opening door for broadened investor base

• Tide of foreign investor inflows into emerging market assets

• Technical factors also attract investors

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Strong institutional investor demand for EM assetsCumulative Net Flows Into U.S. Based Mutual Funds

(In millions of U.S. dollars, from January, 2004)

-20000

-10000

0

10000

20000

30000

40000

Jan-

04

Mar

-04

May

-04

Jul-

04

Sep

-04

Nov

-04

Jan-

05

Mar

-05

May

-05

Jul-

05

Sep

-05

Nov

-05

Jan-

06

Mar

-06

-600

-300

0

300

600

900

1200

Emerging MarketsEquity Funds

(left scale)

U.S. HighYield Funds(left scale)

Emerging MarketsDebt Funds(right scale)

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Local institutional investors growing in importance

• Banks still the largest domestic investors in EM

sovereign debt

• However, there is a steady increase in the share of institutional investors across EMs

• While central banks reduced role in own domestic sovereign debt

• Nevertheless, further deepening of capacity of local markets required

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Holders of Emerging Markets Domestic Debt(In percent of total)

0

10

20

30

40

50

2000 2001 2002 2003 2004 2005

0

4

8

12

16

20

2000 2001 2002 2003 2004 2005

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005

Share of EM Domestic Debt Held by Banks

Share of EM Domestic Debt Held by Pension Funds

Share of EM Domestic Debt Held by Insurance Companies

0

1

2

3

4

5

2000 2001 2002 2003 2004 2005

Share of EM Domestic Debt Held by Mutual Funds

0

5

10

15

20

25

30

2000 2001 2002 2003 2004 2005

Share of EM Domestic Debt Held by Central Banks

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005

Share of EM Domestic Debt Held by Retail Investors

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III. EM local issues as an investor class

International investors moving towards local-currency instruments

• Sizable demand for external-currency debt while supply from EMCs is declining due to large external reserve build-up and policy to reduce “original sin” and develop local markets

• The search for yield and declining returns on external debt has extended increasingly into local-currency instruments

• Search for “alpha” likely to accelerate investor interest in local-currency instruments.

• Limited supply of liquid local instruments relative to investor interest

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EM Domestic Debt: Shares Held by Foreign Investors(In percent of total)

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005

Foreign Investors Share in Total Domestic Debt Issuance

0

10

20

30

40

50

Urug

uay

Hung

ary

Pola

nd

Turk

ey

Mex

ico

Arge

ntin

a

Mal

aysia Braz

il

Peru

Indo

nesia

Bulg

aria

Foreign Investors Share in Total Domestically Issued Debt, As of end-2004

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Share of Non-Resident Holdings of Government Local-Currency Bonds

(In percent)

0

5

10

15

20

25

30

35

Jan-03 Jul-03 Jan-04 Jul-04 Jan-05

0

5

10

15

20

25

30

35

Hungary

Poland

Turkey

Mexico

Brazil

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Institutional investors contributing to strengthened local capital markets

• Growing MM institutional investor participation shifting from highly active short-term traders towards more strategic and buy-and-hold investors

• The investor base is also diversifying geographically

• Increasing role of MM strategic investors has contributed to improved quality and stability of external financial markets for EM debt

• Moreover,growing prominence of institutional investors critical component of strengthen local capital markets

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EM debt managers have set objective of deepening local capital markets

• EM debt managers are taking advantage of investor interest in local-currency issues to deepen local markets

• Action taken, despite favorable terms in external markets, as insurance against “original sin”

• Mention actions being taken by EMs….Debt Managers Forum

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Mutual benefitsfor EM countries and institutional investors

• Virtuous cycle of deepening local capital markets and broadening investor base is taking place

• Broader investor base enabling EM debt managers to use increasingly sophisticated portfolio management techniques to a better manage risks

• Investors have new opportunities for hedging financial and exchange rate risks (with local derivatives markets)

• Both investors and EM’s gain from ore stable markets less likely to sell-off in reaction to country-specific or creditor-specific shock

• Both investors and EMs better able to reduce the currency and maturity mismatches associated with cross-border transactions

• Nevertheless, caution is required on overly relying on foreign participation until capacity of local markets is enhanced

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V. Portfolio application for local markets

Benefit to institutional investors

• Institutional investors search for risk-adjusted returns has driven the sizable foreign demand for local-currency EM debt

• Investment in local-currency debt provides investors with assets that have different sensitivities to movements in interest rates and exchange rates than EM external debt

• Lower duration of local debt provides some hedge against rising global rates

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• Details on reduced risk

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95

100

105

110

115

Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06

Emerging Market Indicators

21

80

100

120

140

160

180

Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06

Europe

Latin

AsiaMSCI

Emerging Markets

Equity Indices(1/1/2005 =100)

95

100

105

110

115

120

125

Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06

Local Bond Returns(1/1/2005 = 100)

Latin

AsiaEurope

JPMorganGBI

Currency Indices(1/1/2005 =100)

Asia

Europe

LatinU.S. trade-weighted

100

200

300

400

500

Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06

External Bond Spreads(in basis points)

EMBIG

Asia

Latin

Europe

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Emerging Market Corrections Compared(in percent)

-20-18-16-14-12-10-8-6-4-20

S&P 500EM

Equity ForexExternalBonds

LocalBonds

2004

2006

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VI. Individual EM country valuation still matters

Implications for portfolio approach to local currencies

• Market discriminating across asset class rewarding EM countries with stronger fundamentals

• Important to look for structural achievements, taking advantage of current favorable environment

Bottom line

• Countries included in portfolio of local currencies matter

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Credit Default Swap Spreads vs. Sovereign Credit Ratings (In basis points)

5/09/06

(R 2 = 0.8772)6/09/06

(R 2 = 0.8913)

0

50

100

150

200

250

300

350

0

50

100

150

200

250

300

350

As of 6/09/06

As of 5/09/06

A BBB BB B

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VII. Broad Implications for International Financial Organizations

• Underpinning of good macroeconomic and financial policies still required

• Strong fiscal policy and debt management required• Help new market participants, principally lower

income countries, to ensure their initial access to international capital markets is prudent

• Help ensure that EMCs raise resources in sustainable manner and balance sheet risks remain within macro prudential limits, in the context of increased access to capital markets

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Implications for International Financial Organizations (continued)

• Widening the local investor base and broaden local

market instruments, to make these markets more resilient to capital flow reversals

• Encouraging debt managers to issue into this market with the objective of developing benchmark yield curves via a transparent and regular issuance policy

• Government should be prepared to pay initial higher costs associated with domestic issuance for the insurance benefit gained from these markets

• Investing in a program that disseminates information to and gains a good understanding of the needs of a countries investor base