DEBT SUSTAINABILITY
Adjustments in the wake of the pandemic will need to be gradual and most countries in the region will require more access to low-cost financing
By JO BRUNI
The coronavirus pandemic is causing a severe strain on Latin America’s public finances. Many countries in the region may not be able to pull out of their increasing debt burdens unscathed unless they can secure enough low-cost credit in the coming years.
“The improved liquidity in markets created by the US Federal Reserve and the European Central Bank is a step in the right direction,†Omar Zambrano, professor of economics at Venezuela’s Andrés Bello Catholic University (UCAB) and former senior economist at the Inter-American Development Bank (IDB) said referring to the massive monetary policy supports from two of the world’s leading central banks.
“The trouble is that this will give access to financing only to the good boys in the movie, to the best behaved. But this shock is global, affecting everyone, the good, the bad, and the average,†Zambrano said.
The region was already suffering from slow economic growth and weakened public coffers when COVID-19 bulldozed its way throughout the world. Latin American’s lockdown pummeled the region’s economies, forcing nations to issue more debt under emergency circumstances, often with multilateral lending institution support. Surging debt levels followed as tax collections plummeted, government deficits widened, and financing needs increased.
“Overall, we think that Latin American sovereigns are going to emerge from the coronavirus crisis with higher debt burdens and weaker debt affordability,†said Renzo Merino, vice president, and senior analyst at Moody’s Investors Service.
“The ratio of general government gross debt to gross domestic product (GDP) will increase by an average of nine to 10 percentage points, and the debt affordability metric, interest payments to government revenue, will worsen on average by two percentage points,†he said.
These metrics gauge the ability of governments to service their debt at any point in time. But the stability of these measures over time is also relevant.
“Key to debt sustainability is whether the debt to GDP ratio will at least stop growing,†said Pablo Sanguinetti, chief economist and vice president of knowledge at the Development Bank of Latin America (CAF). “All debt levels are increasing in the region, the immediate cause being a rising primary deficit that has reached an average of 7% of GDP. The question is, how will debt levels stabilize?â€
“Even if rates are low and remain so for some time, what matters is the rate at which the countries grow. Some Latin American countries will go to market at interest rates of 4% or 5%, which in most contexts are not high. But if their economies grow 2% or 3%, then these rates are high in relative terms.â€
Pablo Sanguinetti – Chief Economist, CAF
In 2020, Latin America and the Caribbean is suffering an average 9.1% decline in GDP, compared to the global 5.2% decline, according to the United Nations Economic Commission for Latin America and the Caribbean’s (ECLAC) most recent projections.
“During the pandemic, growth in government funding needs in Latin America have come more from a loss of tax income than from increased government expenditures,†said José Antonio Ocampo, director of the Economic and Political Development Concentration at Columbia University’s School of International and Public Affairs.
On average, the region’s decline in government revenue during the second quarter was 25% compared to the same period in 2019, Moody’s said in a debt affordability report released in mid-September.
Panama has been particularly hard hit, with revenue losses of 58% compared to the same period in 2019.
“It’s not related to a decline in transit in the canal, which has not been much affected. We expect the canal authority to give the usual transfer to the treasury at the end of the year,†said Moody’s Merino. “What we have seen is a significant decline in economic activity that has translated into lower consumption and lower imports, and that has affected the collection of the country’s value added tax (VAT) equivalent as well as customs duties.â€
A recovery of household consumption in the next few years is crucial because Latin American governments have become more dependent on VAT and income tax since 2014 when commodities prices fell, Merino said. Investments also need to start ramping up to support economic activity and employment levels, he said.
The region’s economy is expected to grow at an average rate of 3.7% in 2021, according to the International Monetary Fund’s most recent projections, which will not compensate for the 9.4% average drop in 2020.
This reversal comes as an additional blow to a region already suffering from a slow 0.8% average growth from 2015 —after the fall in commodity prices— to 2019, according to World Bank data.
“We expect Latin America’s rebound to be slow. It will take until 2025 to recover the income levels of 2015,†Sanguinetti said. “It will be a lost decade,†he said, adding that there are reasons to believe growth might not kick in so fast.
For one, the countries will probably have few resources to invest and increase aggregate demand because they blew through their dry powder to counter the virus.
“It will be hard for them to sustain a primary deficit of 7% of GDP next year. There is going to have to be some fiscal adjustment. So on that side, there’s going to be less growth,†Sanguinetti said.
Growing economic informality, double-digit unemployment rates, and the inability of governments to invest in infrastructure could dampen the private sector’s enthusiasm to put fresh capital work, thereby cutting into economic activity and debt sustainability equations.
The good news is that both local and external borrowing costs have been decreasing, economists agree.
“In terms of debt affordability, borrowing costs are not going to put as much pressure as we thought at the beginning of the pandemic in March and April,†Merino said.
In March, the region experienced increasing interest rates and capital flight. But by May, these trends had reversed as the Fed and ECB’s expansive policies stabilized the markets.
Spreads, which had widened considerably during March and April, have since narrowed from recent peaks. Countries that had the narrower yield spreads at the start of the year are almost back to those levels. Countries that started the year with wider spreads have also seen a comeback, but to a lesser degree, data from JP Morgan shows.
In the case of many issuers, absolute rates —which in addition to the spread take into account the drop in interest rates in the US and Europe— have come back to levels of January and February.
“If a Latin American government were to go to the markets today, it would probably be looking at borrowing costs similar to those before the shock,†Merino said. “For debt sustainability, it’s more going to be an issue of higher debt stocks, exchange rate depreciation, and lower government revenues.â€
But slow economic growth could imply that even with lower interest rates, international borrowing would become expensive.
“Even if rates are low and remain so for some time, what matters is the rate at which the countries grow,†Sanguinetti said. “Some countries will go to market at interest rates of 4% or 5%, which in most contexts are not high. But if their economies grow 2% or 3%, then these rates are high in relative terms.â€
There is excessive optimism about the capacity of markets to provide the finance that Latin American countries are going to need, Mauricio Cárdenas, former minister of finance and public credit of Colombia from 2012-2018.
“Governments need to be aware that they will need more bullets,†he said in late May at a World Bank seminar. “Large deficits may last longer than we think.â€
Months of social unrest in Latin America preceded the coronavirus hitting the region, and governments may not be able to quickly remove the emergency subsidy programs put in place during the pandemic, the economists said. Governments could end up paying credit guarantees that they created to support financing needs during the pandemic.
Investors have a tendency to flee to quality, Cárdenas said. As deficits increase and regional numbers become more negative, investors could lose their appetite for the region.
Countries will need a kind of financing that will give them time to make gradual fiscal adjustments. If reductions in government expenditures are too drastic, governments will not be able to make the investments required to put countries back into a path to economic growth.
“Today, the market gives low-cost finance to a few countries, but not to all,†Sanguinetti said.
Chile and Peru, the countries whose governments had the largest savings at the start of the crisis, and thus have the best fiscal positions, have and will most probably continue to have access to low-cost financing in the market, Sanguinetti said. But countries like Bolivia, Costa Rica, Argentina, and Guatemala, to name a few, are going to need help because the rates they face are too high. Even for Mexico and Colombia, if growth is sluggish, rates will be high, he said.
“Plus, the market could turn around very quickly,†Sanguinetti said. “And countries will need financing at low rates for two to three years.â€
For investors like Luis Strohmeier, partner and wealth advisor at Octavia Wealth Advisors in Los Angeles, California, investing in Latin American sovereign debt is not something he would consider now because the region is going through very tough times.
"It’s cataclysmic, probably the worst I’ve seen in 40 years. The recovery will take some time, so you have to be very wise and choosey" said Strohmeier.
He would only consider putting money into Chilean and Peruvian sovereigns, but would rather go for corporate than sovereign debt. "Corporate debt gives a higher return and some large banks and mining companies are safer than governments. So why would you take that risk for a yield that is lower?"
Access to low-cost multilateral financing during this crisis has been limited for most Latin American countries, and may continue to be so, economists said.
“The countries trapped in the middle, those that are not so good, but not so bad, not so rich but no so poor, that is, most countries in the Latin American region, are being left out.â€
Omar Zambrano – Professor of Economics, Andrés Bello Catholic University (UCAB)
Part of the problem arises from the simultaneity of the shock.
“This simultaneity of increased financing needs is unprecedented,†Zambrano said, “and there’s not enough money to go around in multilateral institutions.â€
The region’s natural sources of financing, the Inter-American Development Bank and CAF, are pushing on their lending limits. CABEI, a much smaller regional institution has recently expanded its lending capacity. The World Bank has increased its credits to the region, but they are lower than in the 2008 crisis, Ocampo said.
The lending policies of the IMF, the institution with the greatest lending capacity, are leaving out most countries in the region, Zambrano said.
“The IMF is helping the poor, highly indebted countries with automatic restructurings of their debts. In this region, that only benefits Haiti,†Zambrano said. “At the other extreme, it’s providing large credit lines to the best-behaved governments and economies. In Latin America, this benefits primarily, Chile, Peru, Colombia, and Mexico.â€
“The countries trapped in the middle, those that are not so good, but not so bad, not so rich but no so poor, that is, most countries in the Latin American region, are being left out,†he said.
