International Mexico Local Currency Bond

International

Mexico Local Currency Bond Market

Local-currency bond markets are turning out to be an alternative funding source in several up-and-coming economies. These markets have grown rapidly, doubling in size from $2.2 trillion in 2003 to $5.5 trillion by the end 2008. These markets are playing a vital role in the terms of economics to emerging-market governments and corporations. These entities were largely shut out of global financial markets during the international financial crisis, and ended up reducing their dependence on the banking sector. In a lot of emerging markets, they are also helping to right currency and maturity mismatches, thus contributing to financial stability (Dalla and Hesse, 2009).

Latin American countries, including Mexico, have made considerable progress in developing their local currency bond markets. With more sizeable local bond markets come improved efficiency of financial intermediation, diversification of intermediation, reduction in the concentration of risks in the banking sector and financing of fiscal deficits in a non-inflationary manner. In addition, the more developed local currency debt markets in these countries should help mitigate important risks and sources of vulnerabilities by reducing systemic instability associated with currency and maturity mismatches. A growing body of evidence says that the development of local currency bond markets, which has gone further than many had expected a decade ago, has strengthened the stability of local financial systems in the emerging market economies as a whole (Jeanneau and Tovar, n.d.).

Local-currency bond markets that are in emerging market countries are varied in size, liquidity, issuers, supporting infrastructure, and degree of openness to foreign shareholders. In 2008, the top ten markets included Mexico, China, India, Brazil, Malaysia, Poland, Turkey, Thailand, and South Africa. All together, these countries made up 85% of the value of local bonds that were outstanding at the end of 2008. During this time eight out of the world's sixteen principal local-currency bond markets measured as a percentage of GDP occurred in emerging markets., Brazil, China, Malaysia, South Africa and Thailand have made extraordinary growth in deepening their domestic bond markets, while recent regulatory reforms in India, Mexico, and Turkey have enabled these countries to make some progress (Dalla and Hesse, 2009).

Mexico is counting on a solid rebound in U.S. consumer demand to recover from a deep recession last year. The peso has increased more than 7% this year to hit its highest in the last couple of years, greatly outperforming other emerging markets. The local currency and peso bonds are also being supported by the prospect of further gains for local debt after Citigroup's recent decision to tap Mexico's peso-denominated debt for inclusion in its World Government Bond Index (WGBI) later this year (Mexico peso, bonds gain on recovery, WGBI bets, 2010).

The domestic government bond market has grown rapidly in Mexico since the mid-1990s. This has in part, reflected a conscious effort by the authorities to develop domestic sources of financing as a means of reducing the country's dependence on external capital flows. The abrupt withdrawal of external capital in late 1994, in what became widely known as the "tequila crisis," resulted in a deep economic and financial crisis in Mexico. This made policymakers acutely aware of the vulnerabilities associated with a heavy reliance on external financing (Jeanneau and Verdia, n.d.).

The Mexican government has encouraged the shift to financing in the domestic market through macroeconomic and structural reforms aimed at strengthening the demand for domestic debt, as well as through the introduction of a clearly defined debt management strategy. These measures have been broadly successful: the government has been able to issue a growing amount of domestic fixed rate securities and to create a long-term yield curve. These are noteworthy developments in a region where short-term or indexed debt remains the rule (Jeanneau and Verdia, n.d.).

Several countries in the region first tried to develop their local bond markets by issuing dollar-indexed debt. This often materialized to be the only cost-effective or practical means of rolling over domestic debt given the high level of domestic short-term interest rates. Nevertheless, the heavy reliance on such debt led in some cases to severe difficulties, as illustrated by the Mexican tequila crisis of late 1994 and the Brazilian crisis of 2001. In Mexico the problem happened when investors became increasingly reluctant to roll over their short-term peso-denominated cetes and instead shifted their funds to short-term dollar-indexed tesobonos. This shift to dollar-indexed liabilities supplied a temporary respite for the government but the short-term nature of outstanding securities also meant that the transformation in the structure of debt towards tesobonos was extremely quick. The rapid withdrawal of foreign investment from the domestic market at the end of 1994 and the resulting sharp drop in the Mexican peso resulted in an explosive growth in the peso value of dollar-indexed government liabilities, thereby adding a fiscal dimension to the external crisis (Jeanneau and Tovar, n.d.).

The local government bond market has expanded rapidly in Mexico since the mid-1990s. In part, this has reflected a conscious effort by the authorities to develop domestic sources of financing as a means of reducing the country's dependence on external capital flows. The abrupt withdrawal of external capital in late 1994, in what became widely known as the "tequila crisis," resulted in a deep economic and financial crisis in Mexico. This made policymakers acutely aware of the vulnerabilities associated with a heavy reliance on external financing (Jeanneau and Verdia, n.d.).

Domestic bond markets have stayed underdeveloped for much of Mexico's modern history. Consistent with the general results of emerging market economies, a poor inflation record and the consequently weak credibility of monetary policy made it practically impossible for the government or other Mexican borrowers to introduce standard long-term debt securities in the domestic market. Indeed, entrenched inflationary expectations meant that lenders were only willing to lend in domestic currency at very short maturities or with returns indexed to inflation, short-term interest rates or the U.S. dollar. They were, of course, also prepared to lend in foreign currencies, principally in U.S. dollars (Jeanneau and Verdia, n.d.).