89224 JUNE 2014 • Number 152 Long-Term Finance in EMEs: Navigating between Risks and Policy Choices Otaviano Canuto, Anderson Caputo Silva, and Catiana García-Kilroy Emerging market economies (EMEs) are making important strides in developing long-term finance capital market vehicles to support investment in strategic areas such as infrastructure. However, since last year, EMEs have suffered from big shifts in terms of market sentiment. While EMEs’ prospects were clearly overhyped in the wake of the crisis, the bleak forecasts that dominated headlines in the second half of last year were similarly exaggerated. There are still a number of factors indicating that EMEs’ role in the global economy will continue to grow—just not as rapidly or dramatically as previously thought. There are two main reasons for the shifting market sentiment ized by massive amounts of liquidity and low interest rates regarding EME assets. First, there is the fact that the broad- because of unconventional monetary policy in advanced based growth slowdown in EMEs that began last year appar- economies—led most EMEs to use their policy space to build ently reflects underlying fragilities. The previous enthusiasm up existing drivers of growth, rather than develop new ones. regarding EMEs’ growth prospects stemmed from the percep- After a postshock, fast recovery, growth returns have dwin- tion that they had some postcrisis avenues of opportunity, dled, while imbalances in several EMEs have worsened (Ca- regardless of the feeble recovery in advanced economies (Ca- nuto 2013a). nuto, García-Kilroy, and Silva 2010). Healthy public and pri- The second reason for shifting sentiment on EME assets vate balance sheets in the aftermath of the crisis and existing has been a change of perspectives regarding the recoveries of infrastructure bottlenecks would provide room for increased advanced economies, particularly that of the United States, investment and higher total factor productivity in many de- which is now deemed to be steadier than at any time since veloping countries; technological convergence and transfer of 2008. While such a scenario change entails rising prospects surplus labor to more productive tradable activities could for exports from EMEs, it also points to normalization of the continue, despite advanced economies’ anemic growth; rap- U.S. monetary policy and thus to tighter external financial idly growing middle classes across the developing world conditions for those economies that do not address rising im- would constitute a new source of demand; and, with their balances in due time. While growth prospects are still dim in share of global gross domestic product (GDP) increasing, de- the eurozone, and the European Central Bank has announced veloping countries would sustain relative demand for com- a round of unconventional policies, there has been a steady modities, thereby preventing prices from reverting to the low flow of resources into its sovereign debt market. levels that prevailed in the 1980s and 1990s. In fact, two bouts of volatility and downward adjust- Nevertheless, EMEs’ motivation to transform their ment of exposure to emerging markets since last year can be growth models to explore those opportunities was weaker traced back to those factors. First, a global portfolio rebal- than expected. The global economic environment—character- ancing was put in motion during the summer of 2013, fol- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise lowing talk of the U.S. Federal Reserve shrinking—and even- in particular, have been one of the fastest growing assets tually reversing—its asset purchase program (QE, or classes in the world, with average annual growth close to 24 quantitative easing), a policy change that began to be effec- percent in the last 13 years (figure 1). More than 80 percent tively implemented in December (Canuto 2013b). Second, of emerging market government debt is currently financed news last January about the increased possibility of a disor- in local currency, and maturities are being extended up to or derly unwinding of China’s shadow banking over-leverage of beyond 10 years in countries such as Brazil, Turkey, Mexico latter years, associated with a burst in domestic property and Poland, providing “risk-free” price references that facili- markets, led to a further worsening of risk-return prospects tate issuances by corporate sector institutions. Neverthe- for assets in other EMEs vulnerable to a significant growth less, the gap in the development of bond markets between deceleration in China (Canuto 2014). Policy responses— advanced and emerging economies remains wide. The risk higher interest rates, exchange rate devaluations—on the is that changing conditions may stall the progress of EME side of those countries most affected in both stressful situa- bond markets. tions have been followed by relatively stable capital flows Large and frequent swings in investor sentiment are im- since then. portant, but not the only concern in EME bond markets. In- Emerging and developing economies as a group continue vestors are facing larger spreads to trade and market turnover to show strong growth, lower than before the crisis, but high is far below the peak reached in 2010 (IIF 2014). Two causes nevertheless.  The World Bank forecasts their growth to re- are potentially structural: (i) stricter regulatory constraints, main below 5 percent this year, but reaching 5.4 and 5.5 per- leading market makers to reduce their inventories, and (ii) cent in 2015 and 2016—broadly in line with predicted poten- growing participation of buy-and-hold domestic institutional tial. These economies will have to cope, however, with a investors. Larger insurance and pension fund industries in changing world environment.  With tighter financial condi- some EMEs are enhancing opportunities for long-term fi- tions and a tougher financial environment, foreign investors nancing (discussed later), but the overall drop in liquidity em- will become more attentive to country-specific vulnerabili- phasizes the need for a policy agenda to keep EME bond mar- ties, and macroeconomic weaknesses will become more cost- ket development on track and to mitigate risks of “disorderly ly. Financial bumps, such as those two bouts of volatility since adjustments” in those EME bond markets. last year, may certainly take place again. Furthermore, unless On the side of government, bond market countries the exhaustion of old growth patterns is recognized and the should focus on crisis response preparedness and on measures needed structural reforms to enable exploration of new op- to support liquidity. A rich set of measures were adopted by portunities are pursued, EMEs will fall short from fulfilling EME governments to contain funding pressures and volatile their potential as the global economy’s main engines of secondary markets during the market turbulence of 2008–9 growth. (Anderson, Silva, and Velandia-Rubiano 2013). Policy mak- ers could draw on these experiences and build contingent Prospects for Long-Term Financing via plans to withstand similar shocks in the future. Secondary Capital Markets market liquidity could be fostered by: Greater susceptibility to shifts in market sentiment can i. implementing issuance programs that reduce debt frag- weigh down EMEs in the process of developing long-term mentation and concentrate debt in larger benchmark financing via capital markets. EMEs’ local currency bonds, instruments; Figure 1. Outstanding EME Domestic Debt Securities by Type of Issuers 9,000 annual growth 23.71% 40 nonfinancials financials 8,000 governments % of GDP 7,000 30 US$, billions 6,000 % of GDP 5,000 20 4,000 3,000 2,000 10 1,000 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: BIS table 16. Notes: EM countries included: East Asia—China, Indonesia, Malaysia, the Philippines, Thailand; Europe/Central Asia—Croatia, Hungary, Poland, Russian Federation, Turkey; Latin America—Argentina, Brazil, Chile, Colombia, Mexico, Peru; South Asia—India, Pakistan; Middle East/Africa—Saudi Arabia and South Africa. The 2013 is September, 2013. GDP is from IMF WEO October 2013. 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise ii. aligning incentives of primary dealers to quote firm and bond markets involves at least one of the items discussed competitive bid and ask prices; here. Countries such as Morocco and South Africa are iii. developing repo markets and securities lending facilities making substantial progress in their secondary market ar- to help market makers finance and cover their positions; chitecture. Similarly, countries are studying liquidity sup- and port mechanisms (Brazil) and improving regulations for iv. improving secondary market architecture, including the securitization (Turkey), whereas multilaterals and govern- effective design of electronic trading systems that could ments are providing a wider set of guarantees and credit lead to enhanced liquidity and price discovery. enhancements. On the nongovernment bond market agenda, the Financing Infrastructure main challenges are to broaden access to a wider variety of issuers and attract a diversified investor base. Significant ef- EMEs’ potential to change their growth models relies heav- forts are underway to simplify securities offering proce- ily on their capacity to close their growing infrastructure dures and minimize time and financial costs for issuers gaps. Globally, it is estimated that infrastructure invest- while also providing adequate disclosure to investors in ment needs by 2030 range between US$57–67 trillion countries like India, Malaysia, and Thailand. But more (figure 2), of which EME requirements account for around needs to be done. For example, greater availability and use 37 percent. Most of these investments are required for en- of credit enhancement tools and securitization could am- ergy generation, roads and telecommunications, all of plify the breadth products and issuers, and (innovative) which are essential to support growth, competitiveness, solutions for liquidity support, such as more effective mar- and job creation. ket-making schemes, could help bonds attract a diversified EMEs are facing twin challenges: how to develop these group of investors. projects into bankable structures and how to access long-term The good news is that these agendas are in progress in funding in the postcrisis era. Traditional funding sources several countries. Approximately 80–90 percent of the de- from governments and commercial banks, while still relevant, mand for World Bank advisory services in government are retrenching due to postcrisis tighter fiscal constraints and more conservative prudential regulations for banks (shorter maturities and lower risk tolerance), following Basel III. Ad- Figure 2. Estimates of Needed Infrastructure Investments, 2013–30 ditionally, lending from foreign banks has declined signifi- roads rail ports airports cantly since 2007, and this trend is not expected to reverse 80 power water telecom (Canuto 2013c). constant 2010 dollars 70 62 67 57 In this context, EMEs need to tap new sources for long- 60 US$ trillions, 50 term funding. Foreign capital is still flowing into EMEs debt 40 (figure 3), but it is doubtful that it will be the dominant play- 30 er in infrastructure finance, given perceived risks and compe- 20 10 tition for infrastructure investments in their home (ad- 0 vanced) economies. projection based projection based projection based on historical on external Nevertheless, EMEs have been gradually building their on ratio of spending infrastructure estimates own pool of sizeable long-term assets managed by institution- stock to GDP al investors, mainly pension funds and insurance companies, Source: Dobbs et al. 2013. totaling around US$5.5 trillion as of end 2012 (figure 4). In- frastructure assets are ideal investments for pension funds Figure 3. Capital Inflows to EMEs 200 150 100 US$ billions 50 0 -50 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1 2014Q1f 2015Q1f -100 foreign direct investment inflows portfolio investment debt inflows -150 portfolio investment equity inflows inward-other -200 Source: IIFCountry sample: BRICS, Turkey, Mexico, Chile, Poland, and Indonesia. Note: f = IIF forecast, e = IIF estimate. Inward-Other—Other Inward Investment (mainly bank loans, but also trade credit and official lending, plus some more obscure items like financial derivatives, financial leases, and so forth). 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 4. Volume of Long-Term Assets Managed by Institutional Investors a. Emerging market pension assets at US$2.1 trillion at end-2012 b. Emerging market insurance company assets approaching US$3.4 trillion 2,500 EM Asia EMEA Latin America 4,000 Latin America 2,000 emerging market East Asia US$ billions 3,500 US$3.4 trillion 1,500 emerging market Asia 3,000 1,000 US$ billions 2,500 500 2,000 0 1,500 US$1.3 trillion 05 06 07 08 09 10 11 12 13 1Q 1,000 20 20 20 20 20 20 20 20 500 Source: Official sources and J.P. Morgan 0 2005 2011 2012 and insurance companies because they tend to match their ment of government and multilaterals in making these long- long-term liabilities, provide inflation-protected yields, and term vehicles financially viable are critical for their success. have a lower correlation to other financial assets. An addition- Furthermore, the development of an active infrastructure al benefit is that a large base of domestic institutional inves- project bond market could have a number of positive exter- tors could make infrastructure investments more attractive to nalities in reinforcing a long-term fixed-income market for a foreign investors, because they will be perceived as a potential broader range of issuers. This could compensate for the high- liquidity buffer in times of capital outflows. er volatility in foreign capital flows and support local fixed- The task ahead is to develop financial vehicles that can income markets in EMEs that are less dependent on foreign channel EMEs long-term institutional savings into financially investors. viable infrastructure projects. The growing share of public- Acknowledgment private partnerships (PPP) for infrastructure projects is facili- tating the development of innovative financial structures to The authors would like to thank Carlos Senón Benito for his fund these projects. excellent research support. The views expressed in this article Local fixed-income markets, through infrastructure proj- are those of the authors and do not necessarily represent those ect bonds, could fill in a large share of the remaining funding of the World Bank or World Bank policy, nor do they commit gap, complemented by more traditional unlisted products, as the World Bank in any way. long as policy makers develop the appropriate framework for issuers, investors, and intermediaries. Infrastructure project About the Authors bonds are also an innovation in advanced economies, but are Otaviano Canuto is Senior Adviser and former Vice President of showing growing relevance, with several types of bonds and the World Bank. Anderson Caputo Silva is Lead Securities Mar- credit enhancement schemes being tested, depending on the ket Specialist, and Catiana García-Kilroy is Lead Securities Mar- project (for example, greenfield, brownfield). kets Specialist, both with the World Bank. The challenge for EMEs in developing these bonds is two- fold. The first is building a minimum fixed-income market References regulatory and institutional framework so that structuring, Anderson, P., A. C. Silva, and A. Velandia-Rubiano. 2013. Sovereign issuance, and placement of infrastructure project bonds is Debt Management in Crisis: A Toolkit for Policy Makers. World cost-efficient. Most large EMEs already have that framework Bank, Europe and Central Asia Region, Report No. ACS4934, in place and are in a position to support such bonds. The sec- Washington, DC. Canuto, O. . 2013a. “Lost in Transition.” Project Syndicate, Decem- ond challenge is to develop the appropriate credit risk en- ber 3. hancement instruments so that project bonds have credit rat- ———. 2013b. “Emerging Markets and the Unwinding of Quantita- ings acceptable to institutional investors, generally domestic tive Easing.” Capital Finance International. Autumn. investment grade or above (BBB-). Governments, multilateral ———. 2013c. “Currency War and Peace.” Project Syndicate, March organizations, development banks, and commercial banks 12. ———. 2014. “China and Emerging Markets: Riding Wild Horses.” should play a key role in either supporting or providing these Huffington Post, February 4. risk-mitigating instruments. Canuto, O., C. García-Kilroy, and A. C. Silva. 2010. “Foreword.” In As infrastructure financing options are developing, it is Euromoney Emerging Markets Handbook 2011, ed. Peter Townsh- becoming clearer that public policies and the direct engage- end. UK: Euromoney Institutional Investor. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Dobbs, Richard, Herbert Pohl, Diaan-Yi Lin, et al. 2013. “Infra- Ruivivar, O. S. 2010. “Emerging Markets: From ‘Niche’ to ‘Core’.” structure Productivity: How to Save $1 Trillion a Year.” McKin- Goldman Sachs Asset Management. Perspectives, April. sey Global Institute. Wheatley, J. 2014a. “EM Liquidity: The Danger Stalking Global IIIF (Institute of International Finance). 2014. “Background Note.” Markets.” The Financial Times, June 6. Market Monitoring Group. ———. 2014b. “EM Trading: Will It Ever Be the Same Again?” The Plender, J. 2014. “Déjà Vu: Echoes of Pre-Crisis World Mount.” The Financial Times, May 29. Financial Times, June 10. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise