MACROECONOMICS, TRADE AND INVESTMENT MACROECONOMICS, TRADE AND INVESTMENT EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT How to Attract Non-Resident Investors to Local Currency Bonds: the Cases of Ukraine, Panama, Colombia, and Brazil Antonio Velandia Leandro Secunho ABSTRACT The assumption that emerging market countries could only sell their government securities to non-residents in foreign currency started melting at the beginning of the new millennium. Driven by abundant liquidity and searching for better returns, many foreign investors became well acquainted with bonds denominated in the local currencies of emerging market countries. As documented by the country cases in this paper, Debt Management Offices (DMOs) in these countries happily embraced access to a “new” funding source and a more diverse investor base. The note explores how countries attracted foreign investors for local currency financing. DMOs have used several avenues to sell local currency securities to non-resident investors: from issuing Credit Linked Notes, or, Global Bonds offshore; to facilitating non-resident access to the domestic local currency bond market either by building a bridge with an International Clearing Securities Depository (ICSD), or, by fully integrating them through their participation in the local CSD. Countries, including Chile, Peru and Ukraine, frequently used Credit Linked Notes (CLNs) in the initial stages of local currency domestic bond market development. Others, such as Brazil and Colombia at times and Uruguay more frequently, relied on local currency Global Bonds. These securities save non-residents from the uncertainty of the local jurisdiction and the hurdles of the local clearing and settlement for which investors are willing to accept lower yields than the ones paid by domestic government securities. Neither of these avenues bring non-resident investors directly to the domestic bond market which is desirable if the DMO wants to reap the benefits of a more liquid and transparent market and potentially lower government’s borrowing costs. The participation of non-residents in the domestic bond market would require building a bridge with an ICSD, or, relying on the local CSD. The bridge has been the solution in countries where custody and settlement processes pose unsurmountable obstacles for non-residents to jump into the domestic debt market; successful experiences of this avenue include countries like Mexico, Chile and Peru. The alternate avenue is to develop a local infrastructure robust enough so that non-residents do not miss the ICSD; this has been the path chosen by Colombia and Brazil. No alternative has emerged as a superior solution and each arrangement must be assessed under the context of the particular country. © 2020 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved. This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgment on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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All queries on rights and licenses should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; e-mail: pubrights@ worldbank.org. 4 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS >>> Glossary ADB Asian Development Bank AfDB African Development Bank BIS Bank for International Settlements BRL Brazilian Real CLN Credit Linked Notes COP Colombian Peso CSD Clearing, Settlement and Depositary DGCPNT Public Credit and National Treasury General Directorate (Colom- bia) DMO Debt Management Office EIB European Investment Bank EM Emerging Market EMBI Emerging Markets Bond Index ETP Electronic Trading Platform FX Foreign Exchange GBI-EM Global bond index - Emerging Markets GDP Gross Domestic Product GoS Government Securities IADB Inter-American Development Bank IBRD International Bank for Reconstruction and Development ICSD International Clearing, Settlement and Depositary IFI International Finance Institution IFC International Finance Corporation IIF Institute of International Finance IMF International Monetary Fund IRP Investor Relations Program LX Local Currency MOF Ministry of Finance NTN-F Brazilian T-Bond (Nota do Tesouro Nacional, Serie F) OTC Over-the-Counter PD Primary Dealer USD U.S. Dollar WBG World Bank Group HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 5 >>> Acknowledgements The authors are grateful to Sebastien Boitreaud, Steen Byskov, Jose Gragnani, Frank Slagmo- len and Doerte Doemeland for their contributions and comments to earlier versions of the paper. All errors and omissions that may appear in this work are the authors’ sole responsibility. 6 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS >>> Contents 1. Introduction 9 2. Recent EM Trends on Non-Resident Investors 11 3. Debt Instruments for Non-Residents 14 3.1. Credit Linked Notes 15 3.2. Global Bonds in Local Currency 16 3.3. Buying in the Local Market and Settling and 16 Clearing through an ICSD 3.4. Buying in the Local Market and Holding the GoS 18 in a Local CSD 4. Case Studies 20 4.1. The Case of Ukraine 20 4.2. The Case of Panama 23 4.3. The Case of Colombia 28 4.4. The Case of Brazil 32 5. Conclusions 34 Appendix - Preconditions for Non-Resident Investors to 36 Come References 42 HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 7 6. MTI INSIGHT >>> How to Attract Non-Resident Investors to Local Currency Bonds: the Cases of Ukraine, Panama, Colombia, and Brazil >> 1. INTRODUCTION The assumption that Emerging Market (EM) countries could only sell their government securities to non-residents in foreign currency started melting at the beginning of the new millennium. With the sustained decline of yields in the developed world resulting from the expansionary monetary policies of major Central Banks (CBs), international investors chasing for higher yield found avenues to buy government securities (GoS) issued by EM countries in their local currencies (LX). Most Debt Management Offices (DMOs) in EMs continue to actively attract non-resident investors. Witness to the fundamental contribution of these investors in improving the functioning of their domestic debt markets, many EMs continue promoting their participation. Foreign banks in Latin America have become Primary Dealers bringing healthy competition to the primary market and injecting dynamism to the secondary market. Their participation has also incentivized an upgrade in the market infrastructure from custodial activities to more efficient clearing and settlement procedures that has benefited the entire financial system. Moreover, this expansion of the local sell-side has facilitated the entering of foreign investors and the diversification of the investor base. Enlarging the investor base through a greater participation of foreign investors has the advantage that they commonly demand medium- and long-term bonds, helping governments lengthening the maturities of their debts. While DMOs in EMs have embraced access to this new funding source, they do so at the expense of the risk of a potential reversal in capital flows. Several debt crises in the past serve as reminders to EMs of the consequences of sudden stops and their damaging impact on the exchange and interest rates and, more broadly, on the overall economy. It was precisely in reaction to the Global Financial Crisis that Hungary and Lithuania opted for a rather cautious approach towards foreign investors. In Hungary, for instance, the DMO policy directive was to raise the bulk of the domestic debt with local retail and institutional investors thereby minimizing HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 9 the vulnerability to the sharp reversal of capital flows.1 Before deciding whether to invite non-resident investors to buy government securities denominated in local currency As shown by the Global Financial Crisis, for the authorities each country should evaluate the pros and cons. Each country to prepare and timely react to sudden changes in capital flows conditions are different and so are the pros and the cons as they need to closely monitor non-resident’s participation on the well as the way policy makers value them; it is therefore futile LX debt market. Such a monitoring requires timely information discussing in abstract the advisability of selling LX GoS to non- on non-resident holdings and transactions of government residents, or, trying to determine the optimal share of these securities, which is not easy when they participate through investors in the domestic debt market. Consequently, the nominee/omnibus accounts either with a custodian, or, through paper offers no guidance on the extent countries should seek, an International Clearing Securities Depository (ICSD). or, increase the participation of non-resident investors in their domestic debt market. Instead, the idea is to offer selected Another potential risk is that access to this new funding experiences of countries that have decided to expand the source is viewed as a vehicle to circumvent the budget investor base by inviting the participation of non-residents. constraints dictated by a sound fiscal policy. As stated in the Debt Management Guidelines “…debt management should Those DMOs willing to attract non-resident investors on a be anchored in sound macroeconomic and financial sector non-speculative basis need to offer an economy with healthy policies to ensure that the level and rate of growth in public macro fundamentals, government securities reasonably liquid debt are sustainable”.3 Respect of prudent macroeconomic and a robust market infrastructure. Macroeconomic and policies and close coordination with debt management would financial comprehensive and timely information are essential ensure that the benefit of attracting non-residents to purchase to assess the issuer’s history, standing and prospects. Market local currency securities is not far outweighed by the creation liquidity refers not just to easy entry to and exit from the of macroeconomic imbalances. Foreign investors that witness market at a reasonable cost, but price transparency and ability DMOs circumventing the budget constraints through an to transact in the volumes typically traded by these investors. opportunistic use of the “new” funding source will most likely Lastly, market infrastructure includes minimum standards leave the country since sooner rather than later the weakening of security and efficiency in the trading, clearing, settlement of the macro fundamentals will depress the prices of the and safeguard of the securities, and the compliance with all government securities. regulations, including taxation, affecting transactions. Regarding government funding costs, the impact of non- The relevance of this paper lies in the illustration of a resident investors depends on the channel and volume of range of benefits non-residents can bring to EM issuers. The participation. In general, because non-residents bring a paper shows that at the minimum, non-residents bring more net increase in the demand for government securities, their demand for LX securities with the potential for reducing the participation tends to reduce the overall cost of funding; government funding costs and the exposure to FX risk. At best, the impact is larger the larger is the volume bought by non- non-residents could help DMOs diversify their investor base, residents and the more integrated they are to the local debt improve competition in the primary and secondary markets market. There could be cases where non-residents acquiring and upgrade market practices, for instance, by contributing small volumes of LX bonds through CLNs, or, isolated Global to a more robust market infrastructure. To the extent that bonds make no material difference in the overall cost of LX for most EMs the size of the domestic market and the local debt. Returns to domestic and non-resident investors on the investor base are the major constraints to develop an active other hand could differ depending on the channel used: CLNs and deep market for government securities, non-residents would typically offer lower relative returns to non-residents offer an efficient avenue to help relax such constraints. because of the fees charged by the intermediary, while Globals can also offer lower returns compared to onshore bonds because of their better liquidity and preferred jurisdiction of issuance (legal risk). 1. Although the principle of reducing the participation of non-residents and increasing the role of domestic retail investors in Hungary started before, it was made explicit in 2015 and has remained in the debt management strategies all the way through to 2020. It should be noted, however, that the cautious approach taken by Hungary aims at reducing rather than eliminating the participation of non-resident investors. In the past, both Hungary and Lithuania relied on the participation of non-resident investors to increase their borrowing in local currency and, more broadly, to develop a local market for government securities. For the rationale of the policy change in Hungary see “The Financing Plan of the Central Government and the Public Debt for the Year 2015” https://www.akk.hu/download?id=6916294a-4685-47ad-ade1-084d144102f1. 2. See “Revised Guidelines for Public Debt Management”, prepared by the Staffs of the International Monetary Fund and the World Bank, March 11, 2015 10 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS Expanding and diversifying the investor base is also This paper aims to illustrate the different avenues countries relevant particularly after the Covid outbreak triggered a use to attract non-residents to their local currency securities dramatic increase in the borrowing requirements of most and derive some conclusions based on these experiences. EMs. The surge in government deficits during 2020 and 2021 Section II summarizes the benefits and risks of non-resident will, at the very least, widen out the investment-savings gap participation in the local currency government securities in EMs demanding further contributions of external savings market3 and illustrates the evolution of such participation in the form of government debt. This context makes it even over the last decade. Section III provides a description of the more pertinent discussing the potential to attract non-resident different avenues for non-residents to acquire LX GoS in EMs investors towards the local currency markets. and section IV illustrates how DMOs have used these avenues in four country cases. Finally, section V concludes. >> 2. RECENT EM TRENDS ON NON-RESIDENT INVESTORS Foreign investors purchase of local currency debt aid EMs Healthy competition brought by non-resident investors is not fill the investment-saving gap helping mitigate the vulnerability limited to a net increase in demand for government securities. of the economy to exchange rate shocks. EMs typically exhibit All the market infrastructure development and communication large investment needs that cannot be funded with the limited efforts made to entice these investors to participate in the GoS domestic savings. The attraction of non-residents to the LX market create positive spillovers for corporate debt and equity government securities market facilitates the improvement in issuances, and for direct investment in the country. Investing the composition of the debt portfolio that would otherwise lean in the country “risk-free” asset may serve as an entry door on foreign currency and/or very short-term financing, while for investors learning more about its credit risk and market avoiding the crowding out of financing to the private sector. functioning, in a possible first step to future investments in the This therefore reinforces fiscal sustainability providing more real sector of the economy. space for private sector driven economic growth. Another critical contribution of non-resident investors At the microeconomic level, the presence of non-residents relates to their appetite for medium and long-term securities. can be an effective catalyzer for a substantial upgrade of the While they do buy short-term assets as a vehicle to place domestic debt market. Authorities interested in attracting non- bets on exchange or interest rate changes, or as transitional resident investors must ensure that the market infrastructure investment when shifting strategies, these participants have satisfies minimum standards for the new investors to transact the muscle and multi-country portfolio diversification to absorb comfortably and safeguard their assets while complying with large price changes and thus are interested in exactly the same all relevant regulations. Meeting these standards also benefits instruments a Debt Management Office (DMO) would like to local investors and other issuers. sell, namely, LX long duration bonds. Mexico and Brazil, with the largest domestic debt markets in Latin America, developed The functioning of the primary and secondary markets their nominal fixed-rate medium and long-term curve partly may benefit from the boost in demand brought in by non- thanks to the demand from non-residents. residents. Faced with larger demand, Primary Dealers (PDs) are incentivized to bid more aggressively improving the price However, these benefits come at the expense of the risk discovery process and mitigating the potential for collusion in of reversal of capital flows. Extensive evidence from the debt small markets. A well-designed PD system, where applicable, crises of the 1980s and 1990s4, the global financial crisis in extends the incentives for competition to the secondary market 2008, and the COVID-19 turmoil illustrate the danger of shifts in which results in higher turnover, lower bid-ask spreads and investor sentiment that could trigger a sharp reversal of capital larger ticket size of transactions. PDs response to profitable flows to EMs. While these markets have escaped a major debt market making drives more aggressive participation in the crisis in the last 20 years, in part by increasing the issuance of primary market, generating a virtuous circle. LX government securities purchased by non-residents, they have found that borrowing in their own currencies does not 3. The Annex explores the pre-conditions for non-resident investors to acquire domestic bonds issued by EM countries in local currency. 4. The literature on financial contagion emerged as explanation to a succession of crises: Mexico in 1994-5, East Asia in 1997, Russia in 1998, and Argentina in 2001. See for instance: Guillermo A. Calvo, 2005. “Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy?,” MIT Press Books; Valdés, Rodrigo O. “Emerging Markets Conta- gion: Evidence and Theory”, http://dx.doi.org/10.2139/ssrn.69093. Elvira Sojli (2007). “Contagion in emerging markets: the Russian crisis”, Applied Financial Economics, 17:3, 197-213; Ozkan and Unsal (2012). “Global Financial Crisis, Financial Contagion and Emerging Markets”, IMF Working Paper, WP/12/293. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 11 make them immune to turbulent global financial conditions. like Hungary and Lithuania decided to limit their exposure decreasing the share of government funding raised with The channel through which capital outflows impact EMs non-resident investors. Others however, with relatively large is best described as a new version of the original sin5. participation of non-residents, remained comfortable with When global financial conditions deteriorate, capital starts the funding structure, possibly because they were confident flowing out of EMs and the domestic currency falls. The that their foreign reserves were sufficiently large to withstand sudden deterioration of the economic environment triggers an attack on the exchange rate and/or because they have a revaluation of risk causing the entire yield curve of EMs domestic markets with institutional investors capable of both in foreign and local currency to move upwards. EM absorbing a sudden additional supply of GoS. CBs trying to contain the foreign currency outflow tighten monetary conditions which further slows the economic A severe reminder of the potential consequences of the activity. Non-resident investors are hit by the drop in the price materialization of this risk was given by the initial phase of of the government securities and, more importantly, by the the COVID-19 crisis. The outbreak generated a dislocation of depreciation of the local currency6. If the losses are large all financial markets and a capital outflow from EMs peaked enough, they trigger another round of sales of LX GoS which at USD80 billion, 4 or 5 times larger than those experienced accelerates the fall of the local currency. In sum, EMs still in the taper tantrum and the Global Financial Crisis. Although suffer from the original sin, not because of the mismatch in the the international capital markets remained open7, for a short balance sheet of the borrowers but because investors returns period Eurobonds yields in foreign currency sharply increased are highly elastic to the exchange rate and may trigger sharp and EM DMOs temporarily suspended their regular auctions outflows if the changes in rates are significant. of LX government securities, reduced the offered amounts, or, shortened the offered maturities amid rising uncertainty. The potential for these capital outflows is proportional to the Fortunately, the impact of the virus outbreak on the capital participation of non-resident investors and depends also on flows was relatively short lived thanks to the decisive action the depth of the domestic debt market, among others. After taken by CBs in advanced economies. the Global Financial Crisis hit Eastern Europe, countries > > > F I G U R E 1 - Non-Resident Investors Outflows from EM During Crisis Periods 5. Emerging Markets Aren’t Out of the Woods Yet: How They Can Manage the Risks. Agustín Carstens and Hyun Song Shin. March 15, 2019. Foreign Affairs 6. See “Revised Guidelines for Public Debt Management”, prepared by the Staffs of the International Monetary Fund and the World Bank, March 11, 2015 7. From March to May 2020, the following countries accessed the international capital markets: Peru, Guatemala, Hungary, Paraguay, Philippines, Lithuania, Chile, Serbia, Romania, North Macedonia, Mexico, Egypt, Israel, Panama and Indonesia. The last five countries issued at the 30-year segment of the curve or longer. 12 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS In most cases, EMs are better off selling government of the political and economic climate rather than explicit securities to non-residents that are denominated in local rather policies to disincentivize such participation. Indeed, the role than in foreign currencies. It is difficult to picture a situation of non-resident investors in these markets seems already in which a selloff of LX bonds by non-residents leave the consolidated. issuer worse off than if he had opted for issuing FX bonds. A depreciation of the local currency triggered by a capital outflow Since not all EMs produce information on a regular basis, will raise the value of the outstanding debt proportionally to the Arslanalp and Tsuda had to use multiple external sources to share of the foreign currency debt: the larger this proportion, gather the data presented in Figure 2. This brings us back the larger will be the increase on the debt/GDP ratio and debt to the importance for EMs to have timely and comprehensive service payments. Also, if there is a strong savings industry, information on the participation of non-residents in the it’s likely that the pension funds are able to buy LX securities domestic debt market. As shown later, in the four country cases from non-residents at attractive prices, establishing floors to documented here, DMOs closely track such participation. these prices and helping to stabilize the local currency. The different arrangements to gather this information across Over the last decade, there has been a sustained and countries confirms that collecting the data on non-resident significant increase in non-resident investors holdings of holders of domestic public debt in EMs remains a challenge. local currency. As shown in Figure 2, with the exception of Sienaert (2012) has called the attention to the difficulties of Hungary and Lithuania, the participation of non-residents in ensuring the identification of the actual debt holders given the the local currency debt market increased significantly over variety of custodial arrangements adopted across markets. this period across all regions. By the end of 2019 the average The increasing role of Global custodians, International participation of non-residents reached 20%, a level only CSDs and the use of instruments such as credit-linked notes reached by Hungary in 2009. While the share of non-resident (backed by domestic government securities) require specific investors during the last few years has dropped in Mexico, monitoring arrangements that are not always in place. In any Brazil, Poland, Malaysia and Turkey, this has to do with the case, the most common ways for DMO’s to obtain these data downgrade in the countries credit rating, or, the worsening is through the local CSD (and International, when there is a > > > F I G U R E 2 - Foreign Holdings of Local-Currency EM Government Debt Securities (% of total) Source: Arslanalp and Tsuda (2014, updated) Note: The coverage of debt is central government local-currency debt securities. For Egypt, it is Treasury bills only; for South Africa, it is marketable government bonds only. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 13 a bridge available) and through banks/primary dealers. Finally, DMOs deciding to jumpstart the participation of non- resident investors in their local currency markets typically face EM DMOs need also to track non-resident participation an uphill battle trying to convince these investors. While EM to map the demand for government securities; similarly, countries would be willing to adopt regulatory changes and investors value the DMO’s transparency in this regard as a improvements in the market infrastructure to facilitate the key input to improve their decision-making. Brazil, Colombia, arrival of foreign investors, such willingness is not enough. Panama and Ukraine publish in their websites on regular basis Non-resident investors require minimum preconditions before consolidated information on the main holders of domestic integrating these securities as a new asset class to their government securities. As mentioned above, in most cases, portfolios and these preconditions overlap to a large extent data is collected from CSD without regulation enforcing its with those required for the development of the domestic timely submission or publication. debt market. Such preconditions are already covered in the literature and are summarized in Annex I together with useful references. >> 3. DEBT INSTRUMENTS FOR NON-RESIDENTS When considering attracting foreign investors to buy custodian. LX bonds, Governments need to be aware of four factors that differentiate alternative debt instruments. The first is Accordingly, the channels for non-residents accessing LX the currency of denomination of the security; since in this GoS vary depending on the degree of their integration with paper we are only concerned with securities issued in the the domestic government bond market. At one extreme, non- EM local currency, we direct our attention to the other three residents acquire exposure to LX GoS through Credit Linked factors. The second one is the jurisdiction of issuance which Notes which are instruments that mirror and are backed by LX will determine the legislation and regulation governing the GoS but are issued, negotiated and settled offshore in foreign issuance, marketing, trading and redemption of the security; currency to avoid convertibility risk and the need to hold the in some cases, this could be the non-resident host country, security with a local, or, global custodian. At the opposite or, internationally recognized markets, in others, the EM extreme, non-residents behave just like local investors: itself. The third factor is the currency of settlement of the they participate in the auctions, transact local bonds in the purchase or sale of the security; in some cases, non-residents domestic secondary market and hold the securities with the can settle these transactions in hard currency offshore, in local CSD through a local or global custodian. There are two others, settlement has to be in local currency which can raise intermediate channels between these two extremes. Non- issues of convertibility and liquidity of the foreign currency residents could buy LX GoS offshore when the issuer floats market. Finally, the fourth factor covers the entities charged Global bonds under a foreign jurisdiction; these securities with the clearing, settlement and safeguard of the security; are issued under foreign legislation and settled and cleared these entities could be foreign institutions operating in the in hard currency offshore. Alternatively, non-residents could non-resident home country, or, entities locally organized and buy LXGoS onshore without holding custody accounts in the legally recognized in the EM. local market if the issuer offers a bridge between local and international CSDs. Non-residents’ choice of the channel to acquire an EM fixed income asset will depend on the assessment of those The instruments offered through these alternative channels four factors. Investors that find the local currency too risky, differ in the operational costs, liquidity, return and, more or, unattractive from the point of view of the risk-return, will importantly, on the risk absorbed by the non-resident investor. probably stay away from LX GoS. But if the LX EM asset is As it will be shown below, the more robust the domestic attractive from the risk-return point of view, non-residents will market infrastructure and the deeper the market, the more check whether they feel comfortable with the jurisdiction of comfortable non-residents are to take on more exposure to issuance, the currency of settlement and the type of entities the different risk types. charged with clearing, settling and custody before committing to acquire the LX GoS. The more developed the EM government bond market, the easier it is for the non-resident investor to accept the EM jurisdiction, the settlement in LX and the safeguarding of the security with a local registered 14 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS > > > F I G U R E 3 - Investor Risk Absorption in Different Debt Instruments8 >>> CREDIT LINKED NOTES the issuer on the type and size of the issuance. The issuer may also take advice from the depository bank on facilitating CLNs are issued by a depository bank upon the issuance the issuance and redemption of CLNs . of the underlying government security. The depository bank acquires the domestic GoS in local currency directly from the CLNs are most popular in Latin America and the Caribbean issuer and issues the CLNs upon request from the investors. but have also been issued in Asia and Africa. Active issuers in CLNs trade, settle and pay interest and principal in hard Latin America and the Caribbean include: Dominican Republic, currency and the depository bank conducts the currency Costa Rica, Mexico, Guatemala, Jamaica and Ecuador; in conversion in relation to all cash distributions. Non-resident Asia: Turkey, Vietnam and Kazakhstan; and in Africa: Nigeria investors therefore assume three different exposures: foreign and Zambia . currency risk on the principal and interest of the LX bond, credit risk to the government issuing the security and credit risk to These instruments provide a flexible mechanism for DMOs the depository bank (despite the CLN being an Asset-Backed to expand the investor base to non-resident investors unwilling Security). When issued in the US, CLNs offerings follow the to access the domestic market (directly or through an ICSD same regulations used for Eurobonds issuances and are bridge/link), or, to participate in a Global Bond transaction. made available via Reg S to non-US institutional investors and CLNs serve well sovereign issuers with insufficient technical via Rule 144A to US institutional investors. capacity to undertake transactions in the international capital markets in LX, or, where pre-conditions to entice non-resident The distribution of CLNs takes place through the network of investors participation in the domestic market are not in place. investors of the depository bank. Since the depository bank is They may also be useful for issuers aiming to raise volumes acting mainly as an intermediary, it is well positioned to advise that would be too small for a syndicated transaction. > > > F I G U R E 4 - CLN Issuance and Cancellation Process Source: Citibank (the bank is owner of the Global Depositary Note brand, one of the most common types of CLNs) 8. Clearing and Settlement risk refers to the risk foreign investors may face due to the exposure to local CSD processes, regulations and systems, leading to operational and counterparty risk, otherwise mitigated when operating under an ICSD (which they are familiar with and also support them on transactions with other countries’ GoS). We thank Steen Byskov for providing this table. 9. There are different types of CLNs in the market. While some CLNs can be traded with other investors, others can be traded only with the depository bank. Also, although in most issuance of CLNs the depository bank acts in coordination with the issuer, nothing stops international banks to create asset-backed instruments that allow to replicate a LX GoS. 10. After making a subset of their securities clearable through an ICSD it is unlikely that Chile, Panama and Peru continue raising funding through CLNs. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 15 The recurrent issuance of CLNs on the other hand can last one issued in July 2020 and two LX Global conventional fragment the LX GoS secondary market restricting the liquidity bonds both issued in 2017. No other country has issued LX and delaying the deepening of the domestic debt market. Globals in the region. Fragmentation occurs naturally as non-residents trade only CLNs and remain separate from domestic investors by the For the issuer and the non-resident investor, LX Global barriers explained above. Another significant disadvantage is bonds are more competitive instruments than CLNs. Instead the rather opaque issuance mechanism and the monopsonic of dealing with investors through an intermediary (depository position of the depository bank which translates into a lower bank in the CLN), the use of a syndication mechanism allows transparency of placements compared to domestic auctions, the DMO to get the best possible price in a highly transparent or, syndicated transactions and in often high issuance/ transaction even after taking into account the fees to the lead redemption costs to investors. managers and legal firms that help prepare the operation. Similarly, compared to a CLN, investors get a better return >>> GLOBAL BONDS IN LOCAL CUR- through a more transparent transaction directly offered by the RENCY issuer. Global local currency bonds are GoS denominated in local However, for non-resident investors looking for an active currencies, settled in USD and offered in international markets. participation in the local currency domestic bond market, LX Globals are issued like a regular Eurobond11 in sizes Global Bonds are not the appropriate instrument. Unlike the equivalent to USD 500 million to 1 billion. Foreign currency risk conventional bonds issued regularly through auctions, these is assumed by the foreign investors but since settlement takes bonds are issued infrequently in limited amounts. Non-resident place offshore in foreign currency, they do not need to assume investors that cannot enter the onshore market are confined the convertibility risk. As a Eurobond, LX Global Bonds are to trade fewer government securities with a small subset of issued under the law of international jurisdictions, which these investors. investors are accustomed to (UK or US, for example). Also compared to regular LX bonds issued onshore, LX The offering of these bonds is undertaken through a Globals tend to be less attractive to the non-resident investor syndicate of investment banks that serve as the sales force of and cheaper for the issuer. Interest rates on Globals tend to be the issuer and intermediate the communication with investors lower than those offered by LX bonds regularly issued in the during the transaction. Contrary to an auction, syndicated domestic market reflecting the offshore jurisdiction that may transactions carried out in the international market require attract a broader set of investors. extensive documentation, legal advice and regular contact with lead managers. These institutions provide guidance to >>> BUYING IN THE LOCAL MAR- the issuer before (investors demand, appropriate time window KET AND SETTLING AND CLEARING for the deal), during (market conditions, book building, pricing) THROUGH AN ICSD and after the transaction (settlement, secondary market overview, transaction outcomes information)12. Compared to Global bonds, a bridge between a local and an international CSD provides non-residents with a more In Latin America, Brazil, Colombia and Uruguay have continuous access to LX GoS. Since Globals are issued issued LX Global bonds. Brazil and Colombia were active intermittently, access of non-residents to LX GoS through issuers of these bonds in the period 2005-200713 and carried this channel is restricted and precludes non-residents from out scattered transactions until 2012. Since that year, trading the full range of securities regularly issued onshore. both countries abandoned the idea of building an LX yield In environments where custody and settlement processes curve offshore to prioritize a program of local bond market pose unsurmountable obstacles for non-residents to jump development. Uruguay, the first issuer in the region in 2003, into the domestic debt market, issuers can provide a solution has five outstanding LX Global inflation-linked bonds, the by establishing a bridge between the local CSD and an 11. Similar to Eurobonds, LX Globals require the issuance of a Prospectus providing a detailed description of the macroeconomic and political situation and disclosing the risks associated to the credit and the offer itself. Collective Action Clauses (CAC) that provides specific regulations for resolution of default events are also regularly included. 12. For more details see Van der Wansem, Patrick B. G.; Jessen, Lars; Rivetti, Diego. 2019. Issuing International Bonds: A Guidance Note (English). MTI Discussion Paper; no. 13. Washington, D.C.: World Bank Group. 13. Brazil first issued a 10-y benchmark in 2005, 15- and 20-y references in 8 transactions in 2006, 2007 and 2010 and a new 10-y benchmark in 2012. Colombia debuted in this market with a 5-y bond in 2004, reopened in 2005, when a 10-y benchmark was also created. The latter was reopened three times (in 2005 and 2006), a 20-y bond was issued once in 2007 and a new 10-y benchmarks issued in 2010 and 2012. 16 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS international one. unifying regulation across settlement and payment systems in the region. ICSDs operations in EMs are also subject to the The setup of the bridge/link requires that countries comply regulation of supervisory authorities in their home countries. with legal, infrastructure and regulatory conditions for the ICSD to operate in a domestic debt market. Countries legal systems To establish presence in an EM, ICSDs also require should not impose entry barriers to foreign investors and minimum standards and regulation of custodial activities. should allow ICSD to open nominee and omnibus accounts. These activities should all comply with standards set up by Local CSDs, payment and custodial services must comply the relevant ICSD regulator and include: (i) holding securities with international standards and be subject to appropriate in accounts at depositories in the relevant market; (ii) handling regulation and legislation on settlement finality and insolvency. the distribution of coupons and principal that may involve Finally, the tax authority should not pose burdensome several intermediaries; and (iii) keeping books and records obligations for the ICSD to comply with (for instance, imposing of the beneficial owner, except for nominee and omnibus the obligation to collect taxes on capital gains). ICDSs are accounts. expected to adhere to information disclosure required by countries’ regulation, however abiding to client confidential Compliance with all previous conditions allow ICSDs to offer standards typically ruling in mature markets. non-resident investors the possibility to transact LX GoS in a secured and standardized manner. The ability to use a bridge There are several legal barriers that restrict non-resident between a local and an international CSD permits these investors’ ability to access and operate in the local debt market. investors to transact in an environment that mirrors that of These barriers typically include restrictions on: (i) full currency their home country. convertibility and transferability; (ii) international transfers of principal and coupon payments in the ICSD system; and (iii) Some issuers prefer to establish the bridge with ICSDs international settlement of domestic securities. Establishing for a subset of the GoS. DMOs in EMs typically limit the a bridge with an ICSD in such a constrained environment bridge to medium and long-term bonds and inflation linkers, wouldn’t make sense. where there is more interest in hosting capital inflows. Other issuers however make the entire universe of GoS clearable at The legal framework should also allow ICSDs to open ICSDs to maximize the participation of non-residents. In Latin foreign nominee and omnibus accounts. Since non-resident America, Mexico has been the only country choosing to make investors often hold their securities in the name of an ICSD all the securities euroclearable. Peru and Chile, and more who acts as the nominee account operator of the omnibus recently Panama, have preferred to make only a subset of LX account, this ICSD status and the concepts of foreign nominee GoS euroclearable. and omnibus accounts should be legally recognized in the domestic market to enable the ICSD to provide its services A few countries in Latin America have taken advantage of 14. Omnibus accounts have become standard practice in the the bridge between a local and an international CSD to carry international markets because of their benefits for liquidity out syndications to offer local bonds15. Although syndications management and collateral optimization. do not need a link with an ICSD, this connection with the international custodian attract stronger participation of non- To operate in a local debt market, ICSDs require that resident investors. Chile, Panama and Peru have offered transfers and payments of financial products be properly local bonds simultaneously in the international and domestic regulated to avoid risks linked to the insolvency of participants markets, enabling foreign investors to settle the transaction in the transaction. These risks are subject of a thorough through Euroclear and domestic investors using the local regulation and monitoring in advanced economies. For CSD. In all cases non-resident investors have received most instance, in Europe the “Settlement finality in payment and of the deals’ allocation. securities settlement systems directive” (1998) specifies the rules to minimize such risks, strengthening settlement laws and 14. The name of the entity (rather than the investor’s) appears on the register of the issuer. When securities are traded, the transaction is recorded in the single name of the ICSD, reducing administration time and costs. Nonetheless, in the case of default of the foreign nominee, the beneficial owner of the securities is protected. See PwC Strategy, “The impact of Euroclerability”. April 2019, p10. 15. For decades syndications have been a traditional mechanism to issue bonds in the international capital markets (Eurobonds) but its use for local currency-denominated government bonds in the domestic market has been a more recent development, that originated in Europe shortly after the introduction of the Euro. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 17 > > > F I G U R E 5 - Investor Allocation in Syndicated Transactions Settled in ICSD and Local CSD Source: Countries’ DMOs Among the benefits of the bridge with an ICSD, DMOs non-residents, or, if in the absence of global market makers typically point to the diversification of the investor base and non-resident investors do not feel comfortable to trade with the reduction of the funding costs. Peru and Mexico witnessed local players. Moreover, if non-residents opt to have accounts a profound impact in the demand for government securities with ICSD rather than global banks with presence in the local largely, but not only, due to the setup of the bridge. In both market, their limited activity in co-related local markets (equity, countries the presence of non-residents infused a healthy corporate bonds, derivatives, repo) will contribute little to the dynamic to the domestic debt market that facilitated the broader development of the local capital market. lengthening of the redemption profile and the compression of yields along the yield curve. A PwC Strategy study estimates >>> BUYING IN THE LOCAL MARKET that for countries that have their LX GoS clearable through AND HOLDING THE GOS IN A LOCAL an ICSD the potential reduction in the borrowing cost in the CSD domestic market ranges from 14 bps to 42 bps16. Brazil used the LX Globals as a vehicle to invite non- The main benefit for investors is the wide access to onshore resident investors to participate in the domestic debt market markets through their accounts with the ICSD. As stated later. After a debut Global issue and follow-up transactions, before, thanks to the bridge non-resident investors need not investors became familiar with the currency and the interest worry about custody and settlement processes. In addition, rate features of the “new security”. The issuer then invited the bridge provides local investors with the opportunity to these non-residents to the onshore market which provided trade financial instruments with a wider range of domestic a broader array of government securities, investors and and international investors. This opportunity has materialized market makers, opening interesting alternatives for managing in the Mexican government bond market but may be more investors’ portfolios. Brazil, as any other EM attracting non- limited in other EMs like Panama. residents to the local market, needed a sound clearing and settlement infrastructure, reliable custodial arrangements, and A potential disadvantage of the bridge is the fragmentation a fair and efficient tax treatment. of the LX bond market. If non-residents access the local bonds through the ICSD and trade mostly among them, while For non-resident investors to participate directly in the residents trade in the domestic market through PDs, the domestic debt market, the market infrastructure should government bond market may fragment. Although in theory align to international standards. The bridge mentioned in the investors could arbitrage between the two markets17, this previous section is an alternative because ICSDs provide a may not occur if for some reason the two pools of investors robust clearance and settlement infrastructure and processes do not interact; this can happen for instance, if the trade that mitigate the associated risk (see Figure 3). If the local tickets of domestic investors are much lower than those of infrastructure is less efficient and effective, the DMO will be 16. See PwC Strategy, “The impact of Euroclearability”, Apr. 2019, p6,18 for a more expanded view of the potential benefits. According to PwC, Chile, Russia, Peru, and Po- land “… made significant progress in improving their financial market infrastructure and adjusting their legal framework to modernize their bond markets and ease foreign investor access to local markets...”. See section 3 for a quantification of the benefits of an ICSD. 17. According to market players, PDs in Mexico have ample access to the domestic and the international trading pools. 18 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS less successful in attracting the non-resident investors to the The main disadvantage relates to the potential for capital domestic debt market. outflows to generate turbulence in the financial market, affecting interest and exchange rates and the impact this may An effective vehicle to attract non-residents to the domestic have in the overall economy. As discussed in the introduction, debt market is the presence of international/global custodians. EMs are familiar with the shocks generated by the sudden These specialized financial institutions are responsible for departure of non-resident investors which could be faster the safekeeping the GoS, settling transactions, collect coupons, more liquid the domestic debt markets are. Hungary is an administer related tax documents, maintain currency/cash example of a country that decided to reduce the vulnerability bank accounts, and perform foreign exchange transactions. to these shocks by reducing the participation of non-residents These entities are in fact “global” custodians because they safe in the market of LX GoS. keep assets for their clients in multiple jurisdictions around the world, using their own local branches, or, other local custodian Mexico and Brazil, the two largest fixed-income markets in banks with which they contract to be in their “global network” Latin America, have opted for different models to attract non- in each market to hold accounts for their respective clients18. resident investors and both have been successful. Whereas Brazil attracted non-residents to the onshore market, Mexico A non-resident investor holding a global custody contract opened a bridge with an ICSD. Although the Brazilian story with an international custodian could easily open an account has proven a resounding success on many fronts (see to operate in a new emerging market. The use of international next section), non-resident participation in the government custodians is common in Brazil and Colombia, two of the main debt market has been more active in Mexico. Among other emerging markets in Latin America, that have opted to attract factors, this could be due to the more flexible FX regulatory non-residents to the onshore market rather than opening a requirements and the bridge with an ICSD in Mexico. bridge with an ICSD. The following country cases show different approaches Clarity and stability of the tax regime is essential to expand followed to bring in non-resident investors with the objective non-resident investors presence in the domestic debt market. of improving the functioning of the domestic debt market, Unclear tax regulation that leaves room for interpretation, reducing FX exposure and lengthening their local currency opaque processes to determine administrative fees and yield curve. procedures that are time consuming and change frequently will be a strong deterrent for foreign investors to enter an EM. Tax exemption is not a necessary condition. Taxes, as part of the cost, end up reflected in the security price when investors compare bonds from different countries, but exemption may significantly reduce investors’ operational burden to calculate and pay taxes. The main advantage of the integration of non-residents in the domestic debt market is the increase in the demand for government securities and the broadening of the investor base, potentially improving GoS liquidity. DMOs welcome the interest of these new investors, particularly in long-term securities, because they pressure up the price of the securities and reduce the government funding costs. Non-residents benefit also because the onshore market provides regular access to a broader array of government securities and other financial instruments, opening interesting alternatives for managing their asset portfolios. 18. Assets held in such a manner are typically owned by larger institutional firms including banks, insurance companies, mutual funds, hedge funds and pension funds. As of 2019, the 5 largest custodian banks in the world were: The Bank of New York Mellon, State Street Bank and Trust Company, JPMorgan Chase, Citigroup and BNP Paribas Securities Services. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 19 >> 4 . C O U N T RY C AS E S > > > T H E C A S E O F U K R A I N E 19 To stabilize the economy, Ukraine had to restructure the >>> CRISIS OF 2014-2015 external debt and requested a USD17.5 billion standby program with the IMF, followed by additional financial support from the Between 2014 and 2015 Ukraine experienced a perfect WBG, the European Union, the US, and other partners. The storm. The political volatility followed by massive shocks to disbursement of the financial package was based on reform the economy caused real GDP to contract by a cumulative commitments, including the requirement to strengthen public 16 percent. Inflation rose to 43.3 percent from 0.5 percent finances to make debt more sustainable. two years before and the local currency, hryvnia (UAH), depreciated by about 70 percent (see Figure 6 below). Complementary to the decisive reforms, the Ukrainian debt office worked relentlessly to fill the large financing gap created The devaluation of the Hryvnia resulted in lack of trust by the crisis. By end 2015, the debt office had raised USD412 in the currency and sharply increased the dollarization of million, at a weighted average interest rate of 17% in local the economy. By end 2015, public and publicly guaranteed currency. debt skyrocketed to 79 percent of GDP, from approximately 40 percent two years before, partially fueled by the need for funding the war, but also by the nature of the existing debt stock, 70 percent of which was denominated in foreign currencies. > > > F I G U R E 6 - Inflation and GDP Growth in Ukraine (2006-2015) 19. This section is based on a World Bank mission report prepared by Antonio Velandia and Jose Antonio Gragnani. 20 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS >>> FUNDING PROBLEMS IN 2016 Finally, the investor base was small and homogeneous comprising only state and commercial banks whose assets After a nine-month break, the Ministry of Finance (MoF) were funded by corporates and households’ short-term resumed its UAH issuances in January 2016 and held 240 deposits. In the absence of pension funds and insurance local currency GoS auctions throughout the same year, but companies, there was no natural demand for medium and 60 percent of those auctions failed due to lack of bids, or, bids long-term securities. The few banks that did buy medium-term with low prices that were rejected. bonds were required to put up capital to mitigate the interest rate risk created by the mismatch between short-term liabilities Poor auction performance was the result of four factors: and medium-term assets. Non-resident investors who actively auctions were cleared based on uneven fiscal needs along participated in the domestic debt market until before the war, the year rather than market considerations; communication had disappeared due to political and economic uncertainty. with the investors was lacking; debt instruments were highly fragmented; and the investor’s base lacked diversity. >>> SETTING THE BASE FOR EXPANDING THE INVESTOR BASE The Ukrainian debt office determined the cut-off rate of the auctions based on the available fiscal space, aiming To address the lack of interest in UAH auctions the to minimize the debt service impact on the budget deficit. Ukrainian DMO opened a two-way communication channel However, the cut-off rate was invariably below the market with the banks, gauge the demand for government securities interest rate, which limited investors’ appetite. and started issuing bonds at market interest rates. In January 2017, the debt office started calling each and every one of the There was a great disparity between what the DMO was banks who had a potential interest to invest in the domestic offering in the auctions and the investors’ demand mainly UAH bonds; calls on Mondays were followed-up with auctions because there was no communication between them. This on Tuesdays. This was augmented with regular meetings with disconnection made it impossible for the Ukraine debt office to the primary dealers20. provide investors with meaningful issuance calendars. Gradually the number of unsuccessful UAH auctions Focusing on managing the cash inflows and outflows, the decreased, from 63 percent in the first half of 2016 to 19 DMO opted for issuing small volumes of bonds with multiple percent by the end of 2017, as both actions took hold, and the maturity dates. In 2016, 75 percent of all outstanding UAH debt office and the market players views started converging. bonds had less than 35 days between maturity dates, sometimes with volumes below UAH100 million (USD 20,000). Having more certainty on the results of the auctions allowed This approach created a massive amount of securities with the the authorities to better plan a quarterly issuance calendar. The potential of cannibalizing each other making it impossible for ministry’s commitment to the planned calendar increased over market participants to trade these securities in the secondary time and gave them more credibility which in turn encouraged market. the banks’ more active participation in the primary market. > > > F I G U R E 7 - Total and Failed LX GoS Auctions in Ukraine (2016-2017) 20. Although the PD system was in place before the crisis, the domestic market came to stand still in 2014 and the system stop functioning. With the revival of the auctions in 2016 the PD slowly came back in that year only for those activities related to the primary market. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 21 > > > F I G U R E 8 - Benchmark Bonds in Ukraine (2017-2018) The ongoing communication with market players allowed such as currency liberalization (June 2018), adoption of the debt office to “sell” the need to reduce the number of the concept of the Nominee Holder (November 2018) and security lines in the much-fragmented market. By being able cooperation and linking with Clearstream (May 2019), to bring everybody on the same page, the debt office could eliminating the requirement for foreign institutions to use a stress the importance of developing benchmark bonds. The local custodian. debt management office started re-opening particular bonds until they reached a critical mass, UAH3 billion, equivalent to As a result, non-resident participation in the local currency about USD150 million, gradually pushing the market towards bond market increased from almost zero in July 2017 to 12 securities that would provide a reference for selected tenors percent as of June 2019 and 30 percent by the end of that which forms the basis of a yield curve. year22. A large portion of these capital inflows was invested in short-term securities in 2018 but investors’ appetite gradually >>> EXPANDING THE INVESTOR BASE moved to medium-term and long-term securities in 2019 (US$2.8bn out of US$3.5bn). There is no question that the After clearing the auctions at market prices, establishing presence of non-resident investors has increased competition, regular communication with investors and consolidating the strengthened the price discovery process and improved the issuance around fewer land larger benchmark bonds, Ukraine functioning of the domestic debt market. reached out to non-resident UAH investors. In 2018, Ukraine started exploring an expansion of the foreign investor base by Unfortunately, the market turbulence triggered by the allowing foreign banks with a presence in the domestic market COVID-19 outbreak caused a major reversal of capital flows to issue Credit Linked Notes (CLN). This allowed non-resident in 2020. After reaching a maximum outstanding of UAH129 investors to acquire local currency securities without taking billion in mid-February, non-residents sold UAH29 billion in the the convertibility risk and made offshore trading a possibility. second quarter and another UAH16 billion in the third after The authorities also started discussions with Clearstream, which their holdings stabilized at around UAH85billion, about an ICSD, to make UAH government securities eligible and 16% of the marketable stock of local currency securities. At explored issuing a local currency Global bond21. the time of writing this paper the situation had improved both for the local currency that recovered some ground and the Ukraine took multiple steps to provide the legal and yield curve had moved downward compared to the levels seen operational framework for attracting international investors at the end of the first quarter. The authorities are conscious 21. This idea was dropped because the authorities thought there was a significant overlap between the demand for offshore and onshore securities and this would have fragmented the market. 22. Ukraine Minister of Finance, Debt Department. The participation is calculated excluding the local currency bonds held by NBU. 22 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS of the threat represented by the potential reversal of these makers. To address this market distortion and improve the capital inflows and are working on the next critical objective: price discovery process, the authorities built a bridge with extending the average life of the domestic debt portfolio. Euroclear and launched a local bond through a book building process with a strong participation of non-resident investors: Finally, in the case Ukraine, it is especially relevant that this local bond was launched in April 2019 and reopened in debt management is anchored in sound macroeconomic and September 2020. financial sector policies to ensure that the level and rate of growth in public debt are sustainable. Given its high debt >>> CONTEXT: SUPPLY AND DEMAND OF levels and the substantial foreign currency and refinancing GOVERNMENT SECURITIES exposures of the government debt portfolio, it is of the utmost importance that Ukraine access to new financing provided Panama meets its financing needs mainly by issuing by non-residents is not used as a manner to relax the fiscal bonds in the international capital market and borrowing from stance that makes its debt sustainable. multilaterals. Only a fifth of the government debt is raised in the local market. Panama aims to increase this share up to 30%, partly in response to the assessment of the rating agencies25. > > > T H E C A S E O F P A N A M A 23 Local debt instruments include 6, 9 and 12-month T-Bills Panama is a fully dollarized economy with one of the lowest and fixed coupon securities with maturities up to 10 years. debt/GDP ratios in the region, about 40% in 2019. Panama All securities are placed in auctions conducted through the reached high-income status in 2017, according to the World Stock Exchange and open exclusively to the Primary Dealers Bank classification methodology, and enjoys the highest per (PDs) and entities aspiring to the primary dealership (APD). capita income in Latin America. At the end of 2019, Panama The security leg is cleared thorough Latin Clear (local CSD) central government debt reached USD 31 billion, comprising and the cash leg through BNP (Banco Nacional de Panama) official loans from bilateral and multilateral institutions, 20%, without DVP. Global Bonds, 58%, and government securities issued in the domestic market, 22%24. Domestic debt in Panama is small relative to other Latin American economies. Although few domestic benchmark In Panama, excess demand for government securities by bonds were built up in the past few years, their sizes barely the Social Security Fund (the largest pension fund in the public reach USD 1 billion. This reflects the authority’s preference for sector) reduces the yield of these securities to abnormally placements in the international capital market combined with low levels deterring other investors from buying government too many domestic securities and relatively small financing securities and inhibiting PDs to fulfill the function of market needs. > > > F I G U R E 9 - Debt Composition (2015 - April 2020) Source: Public Financing Directorate, Ministry of Economy and Finance 23. This section is based on World Bank mission reports written by Antonio Velandia, Leandro Secunho and Carlos Blanco. 24. Source: Public Financing Directorate, Ministry of Economy and Finance 25. See debt management strategy document 2014-18 in https://fpublico.mef.gob.pa/es/SiteAssets/Home/FolletoEstrategia.pdf HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 23 > > > T A B L E 1 - Domestic Debt and Benchmark Bonds in Selected Latin American Countries (2019/2020) ABSOLUTE DOMESTIC NUMBER OF BENCHMARK NUMBER OF BENCH- DEBT (USD BN) DOMESTIC DEBT/GDP NOMINAL BONDS > USD MARK NOMINAL BONDS 1BN > USD 3BN BRAZIL 1,463.80 80.4% 5 5 COLOMBIA 95.30 29.1% 10 8 CHILE 65.92 26.2% 9 5 PANAMA 6.80 10.2% 3 0 PERU 37.90 16.6% 10 7 Source: BIS and DMO’s websites > > > 26 T A B L E 2 - Size and Number of Auctions by Instrument (2015-2019) # represents the number of auctions in the respective year > > > T A B L E 3 - Domestic Debt Stock of Marketable Instruments (2015-2019) 26. The government debt instruments in Panama are classified according to their tenor: Treasury Bills up to 1 year; Treasury Notes between 2 and 10 years; and Treasury Bonds equal or greater than 10 years. 24 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS Coupon securities are issued few times a year in sizes Banks do not show much appetite for government securities roughly ranging from USD30 million to USD150 million. On- despite the relatively friendly regulation of the Superintendence the-run securities are regularly reopened until a target level of Banks28. First, local bonds are illiquid, leading some determined by decree at inception is reached. This level institutions to allocate risk capital even though this is not ranges between USD600 million and USD1 billion. Compared required by the Superintendence of Banks; and second, local to the Global Bonds, the outstanding stock of local bonds is securities are too expensive compared to Panama Global much smaller. Bonds. Until 2019 more than half of the stock of government securities Until April 2019, other investors also found local bonds issued locally were held by the public sector with the Social unattractive because of their relatively low return. Non- Security Fund (Caja del Seguro Social - CSS) absorbing one residents had no incentive to open a custody account in an third of the total. Private banks held another 20%, equivalent unfamiliar market where expected returns and liquidity are to less than 1% of their total assets, that exceeded USD100 generally below those of the Global Bonds. Retail investors billion. The rest was held by other investors. on the other hand find government securities too expensive compared to the competitive rates offered by bank deposits CSS balance sheet and cash inflows are too large for the in a country that has no history of banking crisis. Figure 10 size and frequency of the auctions of local bonds. As per its shows the dominant position of CSS and the recent gain in investment policy, the bulk of CSS long term assets is invested importance of non-resident holdings through Euroclear. in Panama government securities and bank deposits. In 2019 the CSS had reserves in excess of USD7 billion and close to USD3 billion were invested in GoS, most of it in local coupon bearing securities. With assets growing at an annual rate close to 20%, CSS is by far the dominant player in GoS auctions27. > > > F I G U R E 1 0 - Evolution of Holders of Government Debt Instruments (USD MN) (*) September 2020 Source: MEF Directorate of Public Finance and CSS financial reports 2014 and 2015 27. The CSS latest available financial report for 2018 (http://www.css.gob.pa/estados%20financieros%202018.pdf) showed USD0.7 billion invested in Eurobonds and USD1.6 billion in domestic bonds; a provisional balance sheet for 2019 shows an increase of about USD1 billion in long term investments (http://www.css.gob.pa/rendi- ciondecuentas2020.pdf). Other public investors include entities charged with collecting obligatory savings from public servants and educators; as of closing to 2019 their total savings were close to USD0.5 billion and grow at a 15% annually. These entities delegate the management of savings to specialized fund managers who place most of the funds in bank deposits and about 20% in local bonds. 28. Holdings of GoS whether local or external do not consume risk capital and are considered liquid assets for all liquidity indicators. In addition, GoS do not compute for the limits related to economic conglomerates. See Superintendence of Banks’ Acuerdos 004–2008 y 008-2016: https://www.superbancos.gob.pa/superbancos/documents/ laws_regulations/rules/2008/agreement_4-2008.pdf https://www.superbancos.gob.pa/superbancos/documents/laws_regulations/rules/2016/rule_8-2016.pdf HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 25 >>> THE RELATIVE PRICE AND LIQUIDITY and non-resident investors and strengthen domestic funding PROBLEM as an alternative to the external funding. These objectives are fully aligned with the government debt management strategy Small and infrequent auctions together with the monopsonist to make the government finances more resilient to external power of CSS make local bonds illiquid. A large part of the shocks and sudden stops of capital flows29. supply of local bonds ends up in CSS balance sheet at abnormally high prices, misaligned with those of the Global The security was a 7-year benchmark and the issue size Bonds and drastically reducing their potential trading in the USD1 billion. Although the bond was issued under local law, secondary market. the offering documentation followed 144-A/Reg S format to facilitate the marketing with non-resident investors. The Due to their higher liquidity, investors would expect Panama security was listed in LatinClear and Euroclear. Two thirds of Global Bonds to yield less than their local peers. This was the placement were allocated to asset managers (67%) and indeed the case for many years and the relative high yield the rest was distributed among pension funds and insurance of the local bonds was the main explanatory reason for the companies (16%), banks (14%), and hedge funds (2%). Local authorities to lean more towards external funding. The situation investors received 25% of the placement, US investors 48% however inverted with the rapid growth of CSS balance sheet. and the remaining 27% was allocated to investors from other While lower funding costs driven by CSS aggressive bidding countries. are good news to the government, such a benefit comes at a high cost to pensioners that may need to be compensated in The substantial increase in size made the local bond more the future by government transfers and, more importantly, by attractive to all investors, diluted the participation of the the damage inflicted to the secondary market. CSS and significantly improved the price discovery process. Together with the size of the placement which could not be The relative illiquidity of the local securities becomes achieved in an auction, two other features were essential for apparent when compared to the Global bonds issued under attracting a strong demand especially from non-residents. the New York law. Whereas typical tickets of Globals are First, the fact that the security was Euroclearable increased USD20-30 million, tickets for local GoS are USD0.5 million. the demand because investors could use the security as Orders for several millions of local bonds cannot be executed collateral for repo operations offshore which they couldn’t do in the Stock Exchange platform without moving the price. The with the local securities since local repos do not comply with liquidity problem is compounded by the fact that Global Bonds the Global Master Repurchase Agreement (GMRA). Second, can be easily used in repo transactions, whereas local bonds is the potential for the security to be included in the EM bond cannot, and the relevance of the liquidity argument is further indices. aggravated by the fact that contrary to other EMs, Panama lacks a central bank that can act as a lender of last resort. Pricing looks more aligned with the fundamentals. As illustrated in Figure 11, since its inaugural issuance the spread In a nutshell, the relatively small size of the domestic between the Panota (new domestic 7-year benchmark) and securities auctioned by the DMO combined with the large the Global Bond, both maturing in 2026, has averaged 31bps absorption by the CSS distort the price discovery process, as of December 2020, with the local security yielding more compressing the yields below those of similar securities issued than the Global Bond, probably reflecting the jurisdiction and offshore. As a result, these artificially low yields reduce the issue premium. This spread widened out significantly after the appetite of other investors and inhibit the potential for trading yields spike observed in the beginning of the COVID-19 crisis in the secondary market. and the subsequent stronger price recovery on the Global bond compared to the domestic note (averaging 61 bps from >>> PANAMA’S APPROACH TO FIND A SOLUTION May 18th to mid-December 2020). In the last quarter of 2020, the average spread has tightened to 45bps. In April 2019 Panama issued a large government bond (Panota 2026) under Panama law through book building and clearable and settled directly in Euroclear for non-residents and through the local CSD for resident investors. The objectives were to attract widespread interest from both local 29. See https://fpublico.mef.gob.pa/es/SiteAssets/Home/FolletoEstrategia.pdf 26 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS > > > F I G U R E 1 1 - Yield-to-Maturity of Domestic Panota and Global Bond, Both Maturing in 2026 Source: Directorate of Public Finance Better pricing has also promoted more active trading in the Most trading however has not occurred in the Stock secondary market. Although there are no consolidated figures Exchange but in the Euroclear platform. As shown in figure on the turnover of government securities, reports from the 12, transactions in Euroclear quickly grew after the launch Stock Exchange and from the DMO indicate a strong pick up of Panota 26 exceeding the USD1 billion mark in the second of trading in 2019 and 2020 after the launch of the Panota quarter this year. It is important to point out that these figures 2026. In the first nine months of 2020, transactions with may include repos and could grossly overestimate the true Treasury Notes in the Stock Exchange reached USD0.8 billion turnover of securities. Nonetheless this information together to represent 42% of all secondary market activity; this is a with the reports from the Exchange do offer strong evidence substantial increase compared to the entire 2019 with USD0.3 of higher trading activity after the operation conducted in April billion and 17%, respectively. 2019. > > > F I G U R E 1 2 - Transactions of Government Securities in Euroclear (USD MN) Source: Directorate of Public Finance HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 27 The Panota 2026 was reopened in September 2020 in a trading pools may take advantage of arbitrage opportunities triple-tranche transaction for a volume of USD 325 million, out mitigating this potential fragmentation. of USD 2,575 million total deal, paying an annual return of 2.77%. The yield of the reopening was 100 basis points below > > > T H E C A S E O F C O L O M B I A 30 the original one due to the compression of yields in EM bonds; however, the yield of the Panota 2026 has increased relative At the end of 2019, Colombia considered launching a 30- to the Globals. In fact, the new 10-year Global maturing in year nominal domestic bond in local currency. The longest 2032 issued in the same transaction was priced at a yield of maturity for a nominal TES was 15 years and the authorities 2.25%, significantly lower than the one paid by the reopened weighted the potential of a longer tenor bond in terms of Panota, regardless of being 6 years longer. This may indicate smoothening the redemption profile, providing a reference that issuance jurisdiction and possibly investors’ expectation rate for mortgages and becoming the only issuer in the in terms of liquidity still favor the external instruments. region, aside Peru, of 30-year securities in local currency. This section summarizes the analysis conducted in mid-2019 Panama’s experience suggests the timeliness of a review that supported the launching of a 30-year domestic bond in of the debt management strategy to help attract non-residents September 202031. to the local market. The debt management strategy could lean more on the domestic debt instruments and make it explicit a >>> SUPPLY AND DEMAND OF LOCAL CURRENCY policy to create and maintain large benchmark bonds. Such BONDS policies will help build more volume in selected points along the yield curve while reducing the problem created by the The outstanding stock of domestic government securities at dominance of CSS. the closing of May 2019 was COP 316 billion, 28% of GDP; one third comprising inflation-linkers and the rest nominal Auctions may not always be the best mechanism for the fixed-rate bonds. All domestic bonds (TES) are issued placement of government securities and, in the case of through weekly Dutch auctions restricted to PDs. Nominal Panama, could contribute to the pricing and liquidity distortion and inflation-linked bond auctions alternate every other week created by the dominance of CSS. Small economies like and all on-the-run benchmark maturities are offered at every Slovenia privilege the use of syndications over auctions to auction. The size of individual lines in the regular auctions is deal with the combination of low funding requirements and on average less than USD100 million equivalent. a small local market. Syndications guarantee better pricing and facilitate the functioning of the secondary market as a Benchmarks for nominal bonds are 5, 10 and 15-years and continuous mechanism for price discovery. 5, 10 and 20-years for inflation-linkers. The longer maturities are reopened until their remaining life reaches the next shorter Auctions could still be used for T-Bills and even for reopening benchmark. At the beginning of 2019, there were 16 benchmark of benchmark bonds initially launched by syndication. The lines. While no defined target is set for the outstanding volume latter possibility could be reinforced if CSS is given investment of a benchmark bond, there is an indicative ceiling for the alternatives other than government securities. Both the debt maturing in any given year equal to 8% of total debt large size of the syndications and the alternative investment outstanding to contain refinancing risk. This ceiling amounted opportunities will reduce CSS’s dominant role in the GoS to approximately COP 25.2 billion, or, USD7.6 billion in 2019 market mitigating the current distortion. and was exceeded by several individual bonds as illustrated in the redemption profile presented in Figure 13. Finally, while newly issued Euroclearable bonds will be better priced and more liquid than other domestic bonds there is the Domestic pension funds are the largest holders of TES, danger that the market for domestic government securities representing close to 30% of the total. They are followed by splits into two. The fragmentation may occur if non-residents non-resident investors slightly above 22%, with a focus on the keep trading in the Euroclear platform while local investors longer maturities (10-year and beyond). Commercial banks trade with PDs and settle and clear their trades in the local (17%) and public sector entities (18%) also hold a significant CSD. Nonetheless, if price divergences arise, international share of the domestic debt (see Table 4 below). players with access both to the domestic and the international 30. This section is based on a report prepared by Sebastien Boitreaud and Antonio Velandia. 31. The decision to launch a 30-year TES in local currency was made later in 2019 and should have been implemented during the first quarter of 2020; however, due to the market turmoil unleashed by COVID-19, the transaction was postponed until September 2020. 28 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS > > > F I G U R E 1 3 - Redemption Profile of Colombian Domestic Government Debt Source: DGCPNT > > > T A B L E 4 - Ownership of TES by Category of Investors in May 2020 CATEGORY OF INVESTORS % OF PARTICIPATION PENSION FUNDS (DOMESTIC) 29.73 NON-RESIDENTS 22.57 COMMERCIAL BANKS (DOMESTIC) 16.60 PUBLIC SECTOR (DOMESTIC) 18.39 INSURANCE COMPANIES (DOMESTIC) 5.13 REST OF THE PRIVATE SECTOR (DOMESTIC) 7.58 Source: DGCPNT The share of non-residents has been increasing over the In total there are about 2,000 non-resident investors past ten years partly because of the reduction in the withholding who hold TES through accounts with local custodians as tax, from 14% to 5% in 2019, and partly in response to the there is no bridge between the domestic central securities inclusion of the TES in the GBI-EM in 2014. Over the 18 depository (CSD) and international CSDs such as Euroclear months previous to May 2019, these investors’ share had been or Clearstream. Demand for long-term securities concentrates relatively stable at around 25% (USD 23 billion) and remained on pension funds and non-residents. As illustrated in the chart diversified. From a geographical perspective, accounts from below, the bulk of GoS with tenors beyond 7 years is held by Northern America represented the largest share (41.3% in these investors. 2018), followed by Europe (39.8%) and Asia-Pacific (16.8%). HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 29 > > > F I G U R E 1 5 - Holdings of TES by Maturity and Investor Type in September 2019 Source: DGCPNT. Maturity is expressed in years and the horizontal axis measure volumes in COP billions >>> ANALYSIS CONDUCTED IN MID-2019: Auctions presented a main obstacle for the participation CHALLENGES FOR LAUNCHING A 30-YEAR LOCAL of non-residents as their tickets (USD20-50 million) are CURRENCY BOND too large for the auction size (average: USD100 million for inflation linkers and USD200 million for nominal bonds). For The main snag for launching a 30-year peso TES was its many nonresident investors, syndications are the preferred long duration and corresponding high interest rate exposure investment mechanism because they have better control on for those investors with short-term horizons. This is typically the pricing and can acquire the desired volume in a single the case of commercial banks and most public and private transaction. Similarly, large size auctions leave little room for investors with limited capital to absorb large fluctuations in the the issuer to react if demand surprises on the low, or, high side securities’ market value. Pension funds are the only domestic compared to syndications where they have more flexibility to investors with a balance sheet that could comfortably absorb adjust both the price and the quantity. the new security. This is partly because of the size of their assets and the nature of their liabilities, but also because In the absence of non-residents, PDs could reduce their pension funds can classify their bond holdings for trading, or, participation in the auction since it would be more difficult held to maturity and only those securities held for trading need for them to make a market for these securities. Capital to be booked daily at market prices. consumption of these bonds for banks is large and pension funds monopsonist position would make the market making Non-resident asset managers however were willing to take of these securities a highly risky proposition for the PDs. In the risk as returns were attractive and market liquidity provided addition, for the issuer, the absence of non-residents presented a reasonable exit door. In terms of aggregate size, non- the risk that pension funds would push up the yield of the bond, residents demand could easily surpass that of the domestic increasing the cost of financing to the government. pension funds especially if the new security were incorporated into the global indices. These investors typically trade large To avoid these snags Colombia decided to frontload the tickets and would be uninterested if the amounts placed were participation of non-resident investors through a domestic relatively small. syndication rather than an auction. The main advantage of the syndication was the attraction of non-resident investors. The Colombian authorities estimated that for a USD1 billion Syndications also provide a more robust price discovery issue of the new security a third of the demand could come process which is particularly important given that the TES yield from pension funds and other domestic investors. This means curve for nominal bonds went out to 15 years only. Pricing that the bulk of the demand for a new 30-year TES would have through a syndication is superior for two reasons: (i) the to come from non-resident investors. basis for the pricing is a placement 10 times larger than that of an auction; and (ii) the iterative process allows feedback 30 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS to adjust the bids involving the issuer, lead managers and a high-performer PDs for government securities according to the large number of investors. More balanced allocation between evaluation conducted by the DMO. Among the bookrunners, different investors profile is also facilitated in a syndication a Colombian bank with a large balance sheet and a wide transaction. network with local investors played a critical role to ensure a smooth clearing and settlement of the transaction. The On the other side, reputational risk needed to be cautiously other two bookrunners focused on different pockets of non- assessed in case that the transaction failed due to mistake in resident investors all of which already had custody accounts the market reading. Lead managers could provide a backstop, in Colombia33. absorbing possible lack of demand, but this could also jeopardize trading in the secondary market. To mitigate this risk The bid-to-cover ratio was close to 2 and the transaction and maximize the probability of a successful transaction it was was executed in less than 6 hours. The transaction attracted critical for the DMO to clarify the plans for future reopenings of purchase orders for close to USD2.2 billion equivalent (COP9.1 the security through further syndications, or, regular auctions. billion) and the DMO opted to close the transaction relatively quickly after seeing strong demand from real money investors Clear communication with local investors and PDs and and the marginal yield converging at the high end of the range strong marketing were identified as the key elements to the anticipated by the bookrunners and internal assessments. success of the transaction. The public announcement of the government intention to issue a new 30-year nominal Most of the new securities were allocated to non-resident rate benchmark bond had to be followed by a discussion investors. The final allocation to non-residents was close with key domestic investors about the benefits of adding a to 70%34, higher than the 60% anticipated by the DMO. As new point to the yield curve, the manner this will affect the expected, the major domestic investors were the Colombian issuance strategy and the issuer’s commitments to regular pension funds. Also, as expected, very quickly after its launch re-taps through auctions, including the market making on the the security was included in the JPM and Barclays local secondary market. currency bond indices. Finally, deal and non-deal roadshows were considered to The transaction settled in T+3 to facilitate the role of the help affirm interest of non-resident investors already familiar local CSD, mitigate the volatility on the FX market and limit with the issuance of LX GoS and attract new accounts. operational risks. Following the local standard of T+0 would Thereafter the transaction could be announced to the market have been inconvenient given the size and innovative with the details of the mandate32. In the execution of the dimension of the transaction. Allowing a longer window for transaction the price guidance and the intended issuance settlement helped mitigate the impact of the transaction on the amount following informal discussions between the lead FX market as non-residents had more time to convert foreign managers and investors regarding demand were considered currency into COP. critical for their implications on the performance of the security in the secondary market. Since the inaugural transaction, the 2050 TES has been reopened at regular auctions for a total amount of USD300 >>> EXECUTION: THE TRANSACTION IN DETAIL million equivalent close to 25% of the original outstanding. The yield of the 2050 TES has compressed significantly in A 30-year local currency bond was launched on September the secondary market reaching 6.88% at the end of October 9th, 2020 for a total amount of USD1.2 billion equivalent 2020 and the new bond is one of the top 3 securities most (COP4.8 billion) priced at par with a yield of 7.25%. The new traded in the secondary market. Part of this activity has security maturing in 2050 issued under Colombia law is the been triggered by anecdotal evidence about the opening of longest-term fixed-rate bond in local currency that has been new custody accounts by non-resident investors. After the issued in the country and is the first placement made through syndicated transaction, the bond was included in the list of the mechanism of syndication. eligible securities PDs are requested to trade, as the minimum required volume for the activation of this obligation was Three bookrunners were selected for the transaction, all achieved. 32. Selection of 3-4 book runners / lead managers who will prepare the transaction: settlement modalities with the local CSD, legal documentation, feasibility of a bond exchange, informal feedback from non-resident investors, etc. 33. Even though investors with a global account with any international custodian could open a local account in Colombia in about 3 business days, there was no evidence of new accounts participating in the transaction. 34. On the share allocated for non-resident investors, 2/3 was sold for fund managers, ¼ for pension funds and the remainder for insurance companies, private banks and hedge funds. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 31 It’s important to emphasize that the transaction was the composition of the government debt towards the end of conducted as a pure domestic offering without any 144a/ the decade. These reforms undertaken against the backdrop Reg S documentation or SEC filings. Avoiding 144a/Reg of external debt crises in the 80’s and 90’s allowed the S documentation or other SEC filings required that the stabilization of inflation anchored on the tripod of a primary book-building process, communications, underwriting and surplus, a floating exchange rate and an inflation target settlement be all managed by the local offices of the banks regime. The diversification of the investor base, including involved. The documentation emphasized that the placement larger participation of non-resident investors and increasing was offered outside the US exclusively to Colombian residents, reliance on the domestic market underpinned this transition. or, to investors with custody accounts in Colombia. The accumulation of international reserves35 driven by portfolio and direct investment inflows and greater reliance on domestic Judging from its main two objectives, the transaction was LX GoS helped reduce FX risk and avoid the repetition of the an outstanding success. First, the transaction achieved the external crises witnessed in earlier decades. objective of elongating the domestic yield curve helping mitigate refinancing risk at a juncture when the pandemic has >>> BACKGROUND: DEBT COMPOSITION AND dramatically increased the financing needs in the middle of a INVESTOR BASE IN THE EARLY 2000S very difficult macroeconomic environment. Second, the TES 2050 contributes to the development of the Colombian capital At the end of 2002, the Brazilian debt composition was market, serving as a benchmark for potential issuers from the highly concentrated in overnight floating rate bonds36 and public and private sectors of long-term instruments such as FX securities issued domestically and offshore. Domestic pensions, annuities, insurance, mortgages and infrastructure debt37 represented 70% of the total but had a high exposure financing. to foreign currency, interest rate and refinancing risks. By December 2002, the share of fixed-rate bonds was only 2.2% >>> THE CASE OF BRAZIL and debt maturing in 12 months was about 40%. Targets set for the main risk indicators in the 2002 Annual Borrowing Plan Brazil successful stabilization monetary and fiscal policies were not met due to the difficult market conditions faced in adopted in early 2000s, led to a significant improvement in that year. > > > T A B L E 5 - Debt Composition and Maturity Profile (Brazil, 2000-2002) Source: Brazilian National Treasury 35. International Reserves/GDP: 6.4% in Dec 2001, 11.4% in Dec 2008 and 20.1% in Dec 2018. 36. These instruments called “Letras Financeiras do Tesouro”, LFT, are floating rate bonds with interest that compounds daily and are issued in tenors up to 7 years. 37. Debt issued in the domestic market irrespective of the residence of the investor, or, the currency of denomination of the issuance. 32 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS The risky debt profile was not just a reflection of the published since 2001 and Monthly Debt Report since 2000). An macroeconomic environment and the contagion in the Annual Debt Report was first published in 2003, and auctions previous 5 years, but, to an important extent, a result of a and other information started to be published in English homogeneous investor base. In December 2002, domestic and uploaded to the website together with presentations for commercial banks and mutual funds held more than 80% of investors covering areas beyond debt management. More the domestic debt stock. While the former are typically funded importantly, a handout was made available in the website by short-term deposits, the latter tracked the overnight rate, covering the overall process for non-resident investors to holding portfolios with very short-term securities. access the local market40. >>> BUILDING-UP PRIOR CONDITIONS TO A Primary Dealer system was created in 2003 under a joint DEVELOP THE DOMESTIC MARKET AND ATTRACT arrangement with the Central Bank. In the initial structure, NON-RESIDENT INVESTORS PDs were split in two groups: primary market and specialists. The PD system regulated the PDs participation in the auctions To address the vulnerability of the government debt portfolio, and trading in the secondary market. Quoting obligation in Brazil implemented policies to develop the domestic market. electronic trading platforms was introduced only in 2008. These policies included the reorganization of the DMO, the creation of domestic bond indices, a significant upgrade of The policy for the creation and maintenance of benchmarks the DMO communication with the market, the creation of a was also established in 2003. The consolidation of government PD system, and the consolidation of issuance on benchmark securities under fewer benchmark securities facilitated PDs bonds. to comply with the quoting obligation and fostered liquidity in the secondary market. While the longest tenor for fixed-rate An institutional reform in 2001 reorganized the debt nominal GoS was only 18 months41, 2003 represents a turning management office under a back-middle-front office structure point from the perspective of the organization of maturities: prevailing in the most advanced countries. A dealing room was T-bills (zero-coupon bonds) started to be issued with maturities established in 2002 to strengthen the market monitoring and in the first day of January, April, July and October; floating communication with market participants38. rate zero-coupon bonds in March, June, September and December; and inflation-linked bonds would to be issued to In 2001, before the creation of benchmark bonds, the mature on May (for odd maturity years) and August (for even Brazilian Association of Financial and Capital Market maturity years). Association (ANBIMA) launched the first fixed income index tracking domestic public bonds. Later in 2005, under a joint >>> LENGTHENING DEBT MATURITIES AND effort with the DMO, ANBIMA (former ANDIMA) expanded the IMPROVING DEBT PROFILE: THE ROLE OF NON- family of indices aiming to provide references for mutual funds, RESIDENT INVESTORS which are key players in the Brazilian financial market and whose portfolios track mostly the overnight rate. Alongside The efforts to lengthening the yield curve and improve with a general index that follows the return of all GoS issued the debt composition continued in 2004 and 2005 with the under competitive mechanisms, subindices reflecting groups launching of 4, 5 and 7-year fixed-rate bonds. of securities (fixed-rate, inflation-linked, floating-rate, and subdivisions by tenor and duration) were also introduced in The next step, in September 2005, was the placement of the following years39. a 10-year LX Global Bond. Aware of the lack of domestic demand for such a long tenor, the DMO decided to issue A dedicated investor relations unit was set up in the middle- an offshore local currency Global Bond42. At 12.75%, the office to strengthen the DMO and MoF communication with yield of the Global was over 200 basis points lower than the market participants in 2002. The new unit conducted the longest nominal fixed-rate domestic bond, which was a 7-year communication function in a systematic manner and enhanced benchmark43. the transparency already in place (Annual Borrowing Plan 38. In the same year, the Brazilian DMO launched a retail debt program (“Tesouro Direto”) to promote financial education and expand the access to government securities. 39. https://www.anbima.com.br/pt_br/informar/precos-e-indices/indices/ima.htm 40. https://www.gov.br/tesouronacional/en/federal-public-debt/investor-relations/non-resident-investors-handout 41. Floating-rate zero-coupon bonds were issued with maturities up to 4 years, while inflation linked bonds (mostly targeting pension funds and still representing a small portion of the debt) were issued for tenors up to 28 years. 42. The first 10-year benchmark was issued on September 19th, 2005 with a maturity date on September 2016 for a volume of BRL 3.4 billion, equivalent to approximately USD 1.5 billion at the time of the deal. 43. The 7-year local bond (NTN-F) maturing in 2012 was sold in a regular auction on September 20th, 2005 at an average yield of 15.10% for a volume of BRL 0.25 billion. The spread of 235 bps (despite of the local bonds being 4 years shorter) illustrates how attractive local currency bonds offshore were to the DMO. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 33 In 2006 and 2007 the DMO kept issuing local currency auctions with exchanges and special incentives for PDs in bonds in the international markets to extend the maturity the first auctions of a newly created benchmark (occurring profile. Seven transactions were conducted during this period every 2 years). This practice was conducted regularly until including the launching of new 15- and 20-years benchmarks. 2018 and was abolished in 2020, as the new benchmarks As with the initial transaction, the authorities found very could be developed relatively fast through regular weekly strong demand from non-residents and were able to extend auctions. Adjustments in the Annual Borrowing Plan and the yield curve at an attractive cost. Two additional LX Global auction calendar were also made in 2020 given the impact of bonds were launched in 2010 and 201244 to take advantage COVID-19 in the market and the borrowing financing needs. of relatively low yields, but by then the DMO had decided to concentrate its efforts in deepening the domestic debt market Since 2015 the participation of non-residents in the domestic and concentrate efforts in the International Capital Markets debt market has steadily declined. This trend responds to on the development and maintenance of liquidity in the USD the loss of the country investment grade in 2015/2016, the curve. political turbulence that has accompanied the country during the last two administrations and, to a less extent, the decline In May 2015, the participation of non-resident investors in domestic interest rates46. However, the role of non-residents in the LX domestic bond market peaked at 20.8%, possibly in the extension of ATM remains critical as illustrated by the indicating that LX Global bonds would not bring as much value fact that although their share of total domestic debt in October as they had in the past. Non-resident investors had become 2020 was 9.8%, their holdings of Notas do Tesouro Nacional, familiar with the domestic market infrastructure, standards Serie F - NTN-Fs (medium- and long-term fixed-rate T-bonds) and procedures. Also, the liquidity of T-bonds45 had improved securities was over 40%. significantly underpinned by the diversification of the investor base, PD system reforms and the substantial improvement in The Brazilian Annual Borrowing Plan for 2020 indicates debt composition. the possibility of issuing, for the first time, a fixed-rate benchmark longer than 10 years in the local market. Given the The 10 and 7-year benchmarks, the preferred habitat of development of the COVID-19 outbreak, this plan has been non-residents, have become increasingly important in the postponed as the Treasury has to deal with a sharp increase government borrowing strategy. To speed up the buildup of in market volatility and a significant steepening of the yield new 10-year benchmarks, the DMO supplemented the regular curve. >> 5. CONCLUSIONS Macroeconomic and market characteristics of each country establishing a bridge between local and international CSDs are different and so is the authorities’ evaluation of the pros and integrating these investors to their domestic debt markets. and cons of the participation of non-resident investors in the CLNs and Global Bonds seem to be associated to early stages LX public debt. Consequently, the paper offers no guidance on of the process of attracting non-residents whereas the bridge the extent countries should seek, or, increase the participation with ICSD and the full integration with domestic bond markets of non-resident investors in their domestic debt market, or, via correspond to a more advanced stage. LX Global bonds. However, during the last two decades the participation of these investors in LX emerging bond markets The CLN channel is the easiest and most flexible to has increased significantly suggesting the DMOs’ perception implement. It offers an avenue to attract non-resident investors that the pros outweigh the risk of sudden capital outflows. unwilling to access the domestic market, with a minimal effort from the DMO and great flexibility to accommodate relatively DMOs that opt to rely on non-resident investors to support small amounts that would not be economical in a syndication the implementation of their government debt management operation. Ukraine began using this avenue right after the war strategies find four main channels. These channels include: as the only acceptable possibility for non-residents at the time. using CLN-type of instruments, issuing of LX Global bonds, While some DMOs have switched from using CLNs to a bridge 44. The last offshore operation in local currency bonds took place in 2012. It was an exchange that helped create a new 10-year benchmark. In this transaction, the Global BRL bond maturing in 2024 was issued with a yield of 8.60% while the 10-year benchmark in the domestic market (NTN-F 2023) was issued in an auction 2 days later with an average yield 10.77%. This spread seems to indicate the continued importance of convertibility risk for non-residents, although considerations on scarce/infre- quent supply in the previous years need to be made. 45. A 10-years local benchmark bond was firstly issued in 2007. Since then, the 10-years benchmark became increasingly important in the government borrowing strategy representing a reliable reference in the yield curve. Currently, bonds maturing in 2027, 2029 and 2031 are issued in the auctions (2027 and 2029 have alternate fortnight- ly issuances, while 2031 is weekly issued). 46. There is no question that the diversification of the investor base has helped to avoid major turbulences in the market on the back of these capital outflows. In October 2020, roughly ¼ of the debt was held by pension funds, another ¼ by banks and same share by mutual funds. 34 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS with the ICSD, others trying to follow the same route have not strong demand from non-resident passive asset managers being able to do so because the issuer does not meet condi- and other sophisticated investors. tions of minimum issuance volume, or, has regulations that restrict operations of foreign investors, or, obligations on tax Brazil and Colombia have preferred to have non-resident collection that the ICSD cannot meet. investors use their domestic market infrastructure. Compared to establishing a bridge with an ICSD, this channel is far Local currency Global Bonds have been used as a temporary more demanding for the issuer needs to convince investors option to attract the interest of non-resident investors. The that the local infrastructure for clearing, settlement, custody authors found no evidence of countries whose strategy for as well as the environment for exiting the market fully satisfy attracting non-resident investors is anchored on the issuance their requirements. Three motives could help explain why of Global Bonds for a sustained period of time. Rather, as Brazil and Colombia declined using the ICSD channel: (i) The shown in the case of Brazil, these instruments tend to be used presence of global custodians in the domestic fixed income in transition to integrating non-residents to the domestic debt market; (ii) having non-residents clear their trades in the market, or, opportunistically when yields are significantly lower local CSD integrate them more fully in the domestic bond than those of onshore securities. The reason could be that market reducing the risk of fragmenting trading in different issuers try to avoid creating two yield curves: one offshore and platforms: for instance, one in the ICSD for non-residents and one onshore, which splits the liquidity and may become an another one for domestic investors; (iii) a robust clearing and obstacle for the deepening of the local currency bond market. settlement infrastructure for domestic bonds that host foreign investors can be easily expanded for other financial assets, In countries with an established base of non-resident benefiting other agents and contributing to the broader agenda investors, there is no strong evidence that a strategy to of developing the domestic capital markets. clear and settle domestic government securities locally or internationally would make a difference in the contribution While the integration of non-residents to market development of these investors to the development of the domestic bond in Brazil and Colombia was critical, other countries with less market. Nothing in the evidence analyzed in this document developed domestic markets may choose a different route. allows us to conclude that for a DMO having non-residents Many Middle-Income countries in Latin America and elsewhere buying in the local market and holding the government lack the breadth and depth of a domestic bond market to securities in a local CSD is better, or, worse than establishing justify the changes in the legal and regulatory framework and a bridge with an ICSD. In the Latin American region, Mexico, the substantial upgrade in the market infrastructure needed to Chile and Peru went for the ICSD option whereas Colombia adopt the Brazil/Colombia model. For instance, for countries and Brazil preferred that non-residents trade LX GoS using with relatively low domestic funding, like Panama, the ICSD the local infrastructure underpinned by the presence of global path could be more efficient and realistic. custodians. In Chile and Peru, the evolution from using CLNs to a bridge The success in attracting non-residents reflects the breadth with the ICSD has proved a sound and successful choice. This and depth of the domestic market and the inclusion of LX evolution has de facto terminated with the CLN channel that securities in the global indices rather than the channel used has become inefficient and expensive. The creation of a link to bring in the non-residents. All the five Latin American with an ICSD has been shown an effective mechanism to countries referred to above have active secondary markets attract foreign investors not only in EM but also in advanced and a strong presence in the global local currency bond economies. This market infrastructure tool does not need to indices. Peru, for instance, found that a policy for issuing large be discontinued once foreigners directly access the domestic benchmark bonds was a precondition to improve liquidity in market through global custodians. As shown in Mexico, the the secondary market and for the inclusion of its bonds in two avenues can coexist; however, considerations need to international indices. After the setup of the bridge with the be made in terms of possible market fragmentation and the ICSD, Peru has seen a dramatic increase in the demand from objective of a broader development of the domestic capital non-residents and a corresponding tightening in the yields market.  of government securities. The case of Colombia shows that targeting the inclusion of the 30-year TES in the JPMorgan and Barclays local currency bond indices was key to attract HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 35 >> APPENDIX - PRECONDITIONS FOR NON-RESIDENT IN- V E S T O R S T O C O M E 47 In the search to maximize profits, non-resident investors Fundamentals also include political stability, the soundness are constantly exploring opportunities to enter markets that of the institutional arrangements and the robustness of the provide attractive risk weighted returns. This includes carry legal and regulatory framework. Political turmoil, volatile trades and short-term bets on exchange rates that drive large regulations and a weak rule of law constitute highly risky capital flows. Because of the potential destabilizing forces, environments where swift decisions by authorities on few small EM economies are fully open to capital flows. exchange controls, taxation, or other fees can severely affect Controls on the FX operations, reserve requirements, limits the return of assets on which non-resident investors have on type/amount assets non-residents can buy and taxes are little protection. Investors are naturally interested in reform frequently used to limit capital inflows. EMs however welcome agendas that improve these environments to take advantage medium and long-term investments. In this annex we explore of attractive returns; otherwise, faced with such a high risk, the conditions non-residents need to integrate local currency investors maybe opt for a peer market where remuneration government securities as a new asset class in their investment may be lower, but risks are too. portfolios48. Although the issuer fundamentals are typically assessed by Non-resident investors assess emerging markets by the the credit rating agencies, such an assessment is not always underlying macro fundamentals and demand reasonable complete and timely as proven by the last global financial liquidity and a robust market infrastructure to integrate crisis. In consequence, non-resident investors need rapid them into their portfolios. Macroeconomic and financial access to information related to the so-called fundamentals, comprehensive and timely information are essential to assess or, any other information that may lead to the change in the the issuer’s history, standing and prospects. Market liquidity issuer’s credit rating. Having to choose between two similar refers not just to easy entry to and exit from the market at a EMs, non-resident investors would lean for the one where reasonable cost, but price transparency and ability to transact information is more transparent and timelier. in the volumes typically traded by these investors. Market infrastructure includes minimum standards of security and > > > F U N C T I O N I N G O F T H E P R I M A R Y efficiency in the trading, clearing, settlement and safeguard A N D S EC O N DA RY M A R K E T S of the securities, and the compliance with all regulations, including taxation, affecting transactions. When non-residents acquire local currency government securities through the primary market, transparency and >>> M A C R O E C O N O M I C predictability of the issuances are essential. First, the issuer is F U N D A M E N TA L S expected to publish an annual borrowing plan49 supplemented by regular updates (quarterly or monthly auction calendar) with Macroeconomic policies largely determine the fundamentals further detail of securities and aggregate amounts to be placed. of local currency government securities. A sound monetary Second, auctions need to be announced with a few days of policy reflected in low and stable inflation provides a base for anticipation indicating the expected amounts to be issued stable growth, whereas a responsible fiscal policy with sufficient on each due date. Third, the results should be announced fiscal space and buffers for bad times enhances the issuer quickly after the auction is closed. Auctions regularity in terms repayment capacity. These internal policies are complemented of frequency and volumes is also highly valued by investors with those to manage the balance of payments. The latter because it facilitates the buildup of positions according to serves as an indicator of the adequacy of the exchange rate market conditions and investment strategies50. and the appropriateness of the level of international reserves. Sound fundamentals include also a robust financial system Non-residents will probably be reluctant to enter markets with a well-capitalized and well-functioning banking system where the government funding is perceived to deviate from that lend to the private sector and the efficient handling of a competitive market practices. This could be the case of secure payment system. countries where financial repression keeps interest rates 47. This annex is in part based on a 2019 Technical Assistance report authored by Sebastien Boitreaud (Finance, Competitiveness and Innovation Global Practice) and Sylvain Choquette (international consultant). 48. Even though non-residents may leave if the financial conditions turn unfavorably, their investments are not exclusively driven by the expectation of short-term returns associated to exchange or interest rates, but by the contribution of the new asset class to their overall portfolio return. 49. Ideally underpinned by a Medium-term Debt Management Strategy (MTDS). 50. In a few small economies with a strong fiscal position, public debt and borrowing needs are so low that regular auctions are not feasible. A few syndicated transactions, or, scattered auctions may offer a better alternative. 36 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS significantly below market levels, or, where DMOs use private The inclusion of benchmark bonds in the most widely used placements with selected investors, such as public banks, domestic bond indices is a highly effective tool to attract non- or, State Owned Entities (SOEs), to lower the cost of funding residents to the LX GoS. JP Morgan GBI-EM, FTSE EMGBI below what could be considered fair market levels. Although (ex-Citi) and Bloomberg Barclays EM LX are the most popular flexibility on cutting the auction is desirable from the issuer’s in the asset management industry. The inclusion of LX GoS perspective, setting interest rate caps that do not reflect inves- in these indices places immediate demand from investors tors’ demand can jeopardize price discovery and reduce the that follow passive strategies by replicating the indices and demand for government securities. put the asset in the radar screen of others to include it as alternative for active management53. DMOs should be aware A clear policy to create and maintain benchmark bonds is of the conditions for access to these indices, for instance the particularly important because it contributes to the liquidity minimum size, and make sure they are complied with. of the securities in the secondary market. The more aligned with the international standards primary markets are, the more comfortable non-resident investors feel about adding LX GoS to their portfolios. Among these practices51, a clear policy to create and maintain benchmark bonds determines to a large extent the functioning of the secondary market and the liquidity of the securities which is a condition for the non- resident potential exit of the market. Benchmark bonds not only foster their liquidity in the secondary market but define key nodes of the yield curve. Well- defined tenors and a strategy to build them up facilitate non- residents understanding the menu of available instruments and the comparison across EMs52. These references are not limited to long-term bonds, and governments should not overlook the development of short-term references (up to 1-year) in coordination with the central bank, anchoring the establishment of a reliable yield curve and contributing to develop a healthy money market. 51. Other less critical standards refer to the calculation of price and yield. 52. Bloomberg provides updated prices for domestic local currency GoS broke down by tenor (benchmark), for countries with well-established points along the yield curve. 53. Being in the index could even help those issuers with low levels of yield that in principle are not enough to attract the attention of non-resident investors. On the one hand, investors who replicate the index strive to hold all of the underlying securities in the index. During periods of high risk, a flight to quality benefits the safest stocks in the index, even if their performance is low. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 37 >>> BOX 3: EM LOCAL CURRENCY BONDS INDEXES: CAPTIVE DEMAND FROM PASSIVE FUNDS The increasing participation of foreign investors in EM local currency bond markets illustrated in Figure 2 has multiplied the number of countries investors need to monitor to manage the risks created by these “new” securities. Portfolio diversification using passive management strategies, for instance, through ETFs, is a common way to mitigate these risks by taking exposure to an asset class instead of individual countries, and to substantially reduce the cost of monitoring the issuers. The implementation of these type of strategies has been greatly facilitated by the availability of indices that capture the theoretical return of the asset class. Such indices also become the benchmark to measure the performance of fund managers that adopt active strategies placing bets on specific assets expected to outperform the asset class. In the early 1990’s, JP Morgan launched the Emerging Market Bond Index (EMBI) that became popular with investors monitoring the yield spread of a specific country against an average of EMs, based on the return of their Global dollar-denominated bonds. Later in 2005, JP Morgan launched the EM Local Currency Bond Index (GBI-EM) shifting the universe of assets from Eurobonds to domestic bonds. The GBI-EM comprises 20 EM countries with the weights given by the market value of eligible bonds and a cap to ensure that no country exceeds 10% of index. According to JP Morgan (Thompson Reuters), by September 2019, this index was tracked by funds with net asset value amounting USD202 billion. Before including a country in an index, its bonds are temporarily kept on a “watchlist” to confirm that all index conditions are met and modifications in the index are phased throughout months to avoid abrupt changes in the benchmark. The first step already tends to pull in inflows to the local currency market and the flows typically accelerate after the confirmation. During the last three years, Chile increased the size of euroclearable local currency bonds through liability management operations. This increased the country’s share in GBI-EM to 3.3% in September 2019 from 0.1% in 2016. Using a similar strategy, Peru lifted its share in the index to levels close to Chile and the participation of non-resident investors in the local bonds market rose from 34% on early 2016 to 48% at the end of 2019. However, the participation in an index can also trigger capital outflows from non-residents. In recognition of the progressive opening of China’s financial market, 9 of its bonds started to be included in the index as of February 2020, which will set China’s GoS share at the 10% cap, reducing by about 1% the weight of countries like Thailand, Poland, South Africa, Colombia and Malaysia. 38 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS For non-residents entering through the secondary market freeze the money leg in advance, or, more generally where pre and post-trade transparency are fundamental conditions. settlement is not Delivery versus Payment (DVP) can also be Non-residents should know the price at which they can regarded as inconvenient to non-residents. Similarly, blocking transact at any time54. This includes the availability of a reliable of the securities before trading poses an additional constrain yield curve to price any individual security. Similarly, the timely for market-making, limiting secondary market liquidity. reporting of prices and volumes of closed transactions allows the investor to monitor what is going on in the market. Non-resident investors may be unwilling to open an account with the local CSD through a local custodian. Entering into Electronic trading platforms (ETP) complement the phone- an unknown market through unknown counterparty requires based over-the-counter (OTC) market and help improve a thorough due diligence process that is likely to be too price discovery and transparency55. Phone-based OTC is cumbersome and expensive. Since there are many EMs the dominant trading environment in most emerging and competing to attract them, foreign investors would choose advanced markets, where big ticket transactions are usually those offering a clearing and settlement environment they are undertaken. However, ETPs serve as an important and already familiar with. complementary tool for non-resident (and other) investors to easily monitor price changes and, in some cases, to facilitate A plausible alternative is offered by specialized entities post-trade compliance. These platforms typically host PD that act as custodians in many different markets becoming quoting obligations (where verification of fulfilling them is in practice Global Custodians. Once an investor opens a made possible) and provide an enabling environment for custody account anywhere in the world it is relatively easy market making (business-to-business – B2B). to open accounts in other countries since the due diligence (know your client, KYC) has already been completed. Global The more PD systems align with international best practice, Custodians therefore save non-residents going through the the more familiar they are for non-residents and the easier detailed assessment of the local counterparties and the CSD for them to trade in the new market. Most non-residents are process. familiar with PD systems. PDs rules that promote trading of key benchmarks in minimum size with reasonable bid/offer Some large non-resident investors may prefer to trade, clear spreads will most likely incentivize the participation of non- and settle directly from their own accounts with International residents. Clearing and Settlement Depositories (ICSD). This alternative is made possible when the issuers establish bridges between However, in some countries, PD systems may not be the CSD and ICSD letting non-residents use their accounts with appropriate vehicle for fostering the demand in the primary ICSD and eliminating the additional layer offered by the global market and the liquidity in the secondary market. A minimum custodians. market and debt size, appropriate market infrastructure and a reasonably diversified investor base should be in place for Robust regulatory and legal frameworks are required to a PD system to work. The costs and benefits for the issuer address failed transactions and enable covered short-selling, in establishing the system and for candidate institutions to which can also be supported by an active repo market. participate should be carefully assessed. Also, the conditions to attract non-resident investors may be reasonably satisfied Another component of the market infrastructure relevant without the existence of a PD system. for non-resident investors is the availability of liquid foreign currency hedging tools. While FX hedges should not be a >>> MARKET INFRASTRUCTURE hard constrain for non-resident investors to acquire LX GoS, their availability is highly desirable. These instruments may be Secure and efficient clearing and settlement systems is preferably offered in the interbank market; however, if this is another requirement typically demanded by non-resident not the case, the central bank can partially fill this gap. FX investors. They will be unwilling to take counterparty risk if hedging instruments are also key for international issuers to trades are settled in an institution that is not well capitalized, consider issuing bonds denominated in the local currency of a or, that is not properly regulated and supervised to protect specific EM country. the rights of the participants. Markets that require buyers to 54. In some countries where markets are shallow, securities are priced for regulatory reasons based on yield curve models. These prices may not accurately reflect those available in the secondary market. 55. In Europe, ETPs are considered OTC since they are not a regulated market. However, this is not the case of most EMs. HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 39 As of December 201956, International Financial Institutions (IFI) had issued LX bonds in at least 38 currencies57 with an outstanding over USD 85 billion. The success of these transactions suggests that investors were willing to take the currency exposure but not the credit risk of the countries issuing those currencies , or, were reluctant to use their market infrastructure. If this interpretation is correct, IFIs bonds in EM LX might be a first step for non-resident investors to add LX GoS to their portfolios. The figure below shows the main local currencies in which IFIs have issued: > > > F I G U R E 3 - Countries of Currency Denomination of IFI’s LX Bonds > > > F U N C T I O N I N G O F T H E P R I M A R Y In contrast, the participation of non-resident investors A N D S EC O N DA RY M A R K E T S frequently leads the DMO to establish clear and regular communication with investors. Often, the active participation of DMOs with captive local investors and negligible presence non-residents triggers local authorities to review the processes of non-residents see little relevance in establishing and for communicating their intentions, the predictability of their cultivating strong and long-standing relations with investors. In actions, the way funding plans are designed and executed, these countries, investors are regarded as agents focused on the clearing and settlement of the transactions as well as the maximizing their profits at the expense of higher funding costs custodial arrangements available for investors. for the government and transparency is perceived to work against the interest of the issuer. This perception is reinforced Non-residents need abundant information before they by DMOs that see the primary market as the border of their decide whether to incorporate a LX GoS to their portfolio. It’s remit58 and by a captive investor base comprising SOEs and not enough for this information to be available: it should be large public asset managers accustomed to operating in a easy to find and timely produced. International sound practice rather opaque environment. indicates that investors are used to dedicated channels where 56. Source: Bloomberg. It considers the existing stock of local currency bonds issued by IBRD, IFC, EIB, EBRD, ADB, AfDB and IADB. 57. Figure 3 shows the currencies of denomination of LX bonds placed by IFIs. Under the category “Others” there are 28 countries, each representing less than 1%: Romania, Argentina, Czech Republic, Philippines, Hungary, Georgia, Ukraine, Colombia, Peru, Uruguay, Nigeria, Ghana, Croatia, Zambia, Chile, Malaysia, Uzbekistan, Armenia, Costa Rica, Egypt, Botswana, Serbia, Uganda, Namibia, Kenya, Bangladesh, Korea and Thailand. 58. Moreover, this approach is contrary to the need to promote the development of a local market for government securities and to the objectives of building a debt portfolio resilient to shocks while lowering medium-term funding costs. 40 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS all relevant information can be readily found on a timely basis. The Institute of International Finance (IIF) launched in These channels, managed by Investor Relations units, include 2004 the “Principles for Stable Capital Flows and Fair Debt dedicated websites, pages in Bloomberg, meetings with in- Restructuring” which includes the evaluation of Investor vestors, emails and other contact access among others. Relations programs (IRPs) in 38 countries60. The assessment that includes 20 criteria for the evaluation of Investor The website is probably the most important communication Relations and 23 for the evaluation of the data dissemination channel. Aside from the information on the planned supply of may be used as a guide for countries aiming at improving GoS, dedicated websites typically include: (i) comprehensive their communication strategies and attracting non-resident guide for investors including guidance on how to buy GoS, investors. regulation of capital and foreign exchange markets, taxation, prospectus; (ii) key data on the government securities such as relevant regulation, auctions results and transactions in the secondary market; (iii) historical statistics on yields and volumes primary and secondary market; and (iv) presentations for roadshows and conferences covering macroeconomic and other relevant issues of the public finances. Another key communication vehicle are the roadshows in which the issuer presents at various locations a sales pitch to institutional investors of the security to be offered. During roadshows the issuer may take the opportunity to attract specific investors and enhance the transaction59. Non-deal roadshows serve to provide public information to investors, including updates on the issuer situation and vision for the future, except that no debt securities are offered. 59. Brazil also use the roadshows to promote investment opportunities beyond the GoS: Excellence in Securities Transactions (BEST), created in 2004 as a roadshow managed by BRAIN (Brasil Investimentos e Negocios) to promote Brazil as a Financial Center, under a joint initiative of the Brazilian Financial and Capital Markets As- sociation (ANBIMA), the Brazilian Exchange and the Brazilian Federation of Banks (FEBRABAN), with the support of the Brazilian Securities and Exchange Commission (CVM), the Central Bank of Brazil, and the Brazilian National Treasury (GoS issuer) - http://brainbrasil.org/en/best-en/about-best/ 60. https://www.iif.com/Portals/0/Files/content/Research/pcg_report__10_22_2019.pdf HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS <<< 41 >> REFERENCES Arslanalp and Tsuda (2014, updated) – https://www.imf. 2020; org/~/media/Websites/IMF/imported-datasets/external/pubs/ ft/wp/2014/Data/wp1439.ashx Accessed on June 25th, 2020; Ozkan and Unsal (2012). “Global Financial Crisis, Financial Contagion and Emerging Markets”, IMF Working Paper, Brazilian National Treasury - Ministry of Economy of Brazil - WP/12/293. http://www.tesouro.fazenda.gov.br/en/annual-borrowing-plan / http://www.tesouro.fazenda.gov.br/en/monthly-debt-report / PwC Strategy&, April 2019, Impact of Euroclearability; http://www.tesouro.fazenda.gov.br/ documents/10180/268746/Informe_emissao_BRL_2024. Thomson Reuters (international information agency) - https:// pdf/7bd1ec9d-80cf-4594-b7ab-78b7f883da5e / http://www. www.reuters.com/article/china-markets-bonds/update-2- tesouro.gov.br/resultados-dos-leiloes Accessed on June 26th, jpmorgan-adds-china-to-emerging-bond-index-from-february- 2020; 2020-idUSL5N25V3F4 Accessed on June 26th, 2020; Elvira Sojli (2007). “Contagion in emerging markets: the Valdés, Rodrigo O. “Emerging Markets Contagion: Evidence Russian crisis”, Applied Financial Economics, 17:3, 197-213; and Theory”, http://dx.doi.org/10.2139/ssrn.69093 ; Guillermo A. Calvo (2005). “Emerging Capital Markets in Van der Wansem, Patrick B. G.; Jessen, Lars; Rivetti, Turmoil: Bad Luck or Bad Policy?,” MIT Press Books; Diego (2019). Issuing International Bonds: A Guidance Note (English). MTI Discussion Paper; no. 13. Washington, D.C.: Institute of International Finance (IIF), October 2019 – World Bank Group. Principles for Stable Capital Flows and Fair Debt Restructuring - https://www.iif.com/Portals/0/Files/content/Research/pcg_ report__10_22_2019.pdf Accessed on June 26th, 2020; Investor Relations Colombia – Ministry of Finance and Public Credit - http://www.irc.gov.co/webcenter/portal/IRC/ pages_publicdebt/statistics/outstandingtesbonds / http://www. urf.gov.co/webcenter/ShowProperty?nodeId=%2FConexionC ontent%2FWCC_CLUSTER-128301%2F%2FidcPrimaryFile &revision=latestreleased Accessed on June 26th, 2020; Ministry of Economy and Finance of Panama – Directorate of Public Financing - https://fpublico.mef.gob.pa/en/informacion Accessed on June 26th, 2020; Ministry of Economy and Finance Peru - https://www.mef. gob.pe/contenidos/english/presentations/MEF_London_ presentation.pdf / https://www.mef.gob.pe/contenidos/english/ investor_relations/B8_Debt_31122019.pdf / h t t p s : / / w w w. m e f . g o b . p e / c o n t e n i d o s / d e u d a _ p u b l / bonos/internos/bonos_sobe/stock/Stock_bonos_ soberanos_310520.pdf Accessed on June 26th, 2020; Ministry of Economy and Finance of Uruguay - http://deuda. mef.gub.uy/innovaportal/file/28779/2/sovereign-debt-report- may-2020.pdf / http://deuda.mef.gub.uy/innovaportal/file/6297/1/2009- 07_+debt+report+july+2009.pdf Accessed on June 26th, 42 >>> HOW TO ATTRACT NON-RESIDENT INVESTORS TO LOCAL CURRENCY BONDS