Brazil’s Government Bond Market: A liquidity mechanism or crowding-out effect?

It is the country that leads the infamous BRICs, coined by Jim O’Neill, Brazil. The 5th largest country in the world now also boasts an almost corresponding, 6th largest economy in the world, recently overtaking the once economic powerhouse, the UK. As far as Latin America is concerned, Brazil is the flesh and blood proof that success stories can come out of a perpetually hopeless case that is Latin America. As recently as November 2011 Standard & Poor’s upgraded sovereign dollar-denominated foreign debts to BBB from BBB- and government’s local currency debt from BBB+ to A- . Renewed hope in the last decade and a half in Brazil’s strong macroeconomic fundamentals and a commitment by it’s three previous and current governments has signaled with enough longevity to the market that Brazil is a good place to investment. With foreign financial managers constantly in the hunt for higher returns, Brazil is a paradise for high returns with relatively lower risk as far as emerging market countries are concerned. The confidence in the market for Brazilian securities has allowed the government to galvanize this huge source of funding for their gargantuan financing needs. With a stable level of over $350 billion in foreign currency reserves, a weakening yet stable economy and strong leadership on the monetary and fiscal side of politics, the Brazilian government has been able to issue huge amounts of bonds and even adjust their strategy to change the composition of their debt, whether international or externally, foreign or domestically denominated, fixed or floating rates . This paper looks to inquire further into the depth of such a market and what it represents in the bigger picture. This paper also aims to look at the regulatory aspect that both enhance and impede the type of long-term growth and integration that is necessary in the future. In order to be able to set the stage for this biggest picture, first we must take a look at where Brazil’s market stands as of now.

A current snapshot The Brazilian government sold over $825 million in long-dated bonds on a single day in early January with demand so unexpectedly high that the yield for the securities came in at 3.449%, a record low with the bond’s coupon yield at par of 4.875% . Given Brazil’s historically high interests, the buyer’s demand for these bonds made for a historic lows in interest payments for Brazilian foreign debt issued. Brazil has reached a point in the global capital markets where Sovereign US dollar paper issued by them is a go to for investors during volatile times. This shows a turning point in history, or at least financial history, where Brazil’s steady growth together with the low levels of public debt has largely removed the stigma of prior dictatorships, periods of hyperinflation and closed and opaque market conditions. According to the Wall Street Journal’s Credit Markets summary since March of this year, investors have added $18 million to funds that hold debt, mainly issued by Brazilian companies and government agencies meanwhile back in Brazil the currency (real) has depreciated and the BOVESPA has plunged . In the recent sell-off in emerging markets then, why has Brazil not suffered the same fate? While the Eurozone’s economic woes continue and China’s consistent double digit growth slows to single digits, Brazil’s bond market is considered a steady and relatively safe bet which allows it to enjoy developed country effects of investors flocking to it in hard times (refer to Figure 1 below).
Another, and perhaps more important development of the bond market, is a rise in the sale of reais-denominated government bonds to oversea investors which are not subject to taxes on foreign investment, a recent move that has proven positive in the market. In April of this year Brazil sold 3 billion reais worth of these bonds at yields of 8.6% (currently trading at 7.5%).

Figure 1
Source: "Brazil Debt Seen as Safe Bet: Bond Market Offers Access to the Countr'ys Steady Growth and Low Public Debt." Wall Street Journal [New York] 29 May 2012, US Edition: Credit Markets n. pag. Web. 19 Dec. 2012. http://online.wsj.com/article/SB10001424052702303395604577434412657454798.html

What makes Brazilian special, even as it enjoys this heightened status, are its highly positive nominal and real rates which provide a sharp contrast with emerging Europe and Asia.

Figure 2
Source: JPMorgan, Bloomberg, as of February 28, 2011. EM Global Divesified Index.

Some of the high interest rates can be explained through the huge increased level of subsidized lending to the national development bank, BNDES . The subsidized lending allows BNDES to lend at not the benchmark overnight rate set by the central bank, which stands at about 10% but its own rate of 6%. With these lower rates flowing through the economy, the clearing rates that the central bank needs to set for the rest of the players in the market has a lot of upward pressures in order to avoid inflation (which is currently, supposedly, targeted by the monetary authority within a range not to surpass 4.5% at the upper limit .

Development of Brazilian Bond Markets The government bond market finds its success mainly in the government’s own engineering of the system and regulations in place that stimulate both domestic and foreign investment in government bonds. As recently as 2011 the government extended an exemption to foreign investors on income taxation when they hold government bonds. This move was not applied to corporate bonds or other private sector debt leading to an obvious bias for foreign investors towards government debt instruments. This type of move is consistent with what critics call the Brazil government’s crowding out effect of other players in the market . Brazil’s bond market is one of the most liquid among emerging market country, offering both breadth of debt instruments and depth in volume traded and demanded. Their fixed an floating-rate treasury bills are the most liquid securities in the market and can be used, along with other Treasury instruments as collateral in repurchase agreements with the Central Bank as well as the secondary market which is the one that most suffers from the incessant government interventions and regulations. In addition fixed-income instruments are issued with standard maturity dates instead of fixed maturities like in the US. There is much transparency and set expectations in terms of the Treasury’s dealings; for example at the beginning of each week there is an auction on treasury bills and in the beginning of every month an auction of inflation-indexed bonds . This constancy and transparency in procedures provides investors with a peace of mind knowing that they have constant access in a recognized manner to the government bond market. Brazilian federal bonds can be dealt with in the secondary market in two ways, over the counter and through the screen, which means through he Brazilian Mercantile and Futures Exchange (BM&FE) . Through the electronic system of the BM&FE public bonds can be traded among banks and pension and mutual funds who have an electronic trading platform.
Domestic Bond Market Composition In order to get a good idea of the positive developments in the Brazilian bond market it is important to look at the evolution from 1995 (the initial stages of the new Brazilian economic era).
Table 3 (found on the next page) depicts the composition of local government bonds as a percentage of GDP from 1995 to 2005. In it we can see that while central government bonds increased, the level of local government bonds decreased from 6.10% of GDP to 0.11% of GDP in 2005 . This is due to a history of defaults that have made investors wary to further investment. However, there are exceptions to the rules. For key cities like Sao Paulo, Brasilia and Rio de Janeiro not only do they issue their own municipal bonds in the domestic market, but they also have issued bonds in foreign market in foreign currency . Also interesting is to note that in Table 4 (refer to next page) where we can see the Central Bank Bonds by level and composition we see a significant decrease in from 10.18% of GDP in 2001 to 0.35% of GDP in 2005. This move is in compliance to the Fiscal Responsibility Law, which prohibits the Central Bank to issue debt enacted in 2000, post-
Figure 3 Source: Domestic debt issued Leal, Ricardo, and Andre Carvalhal-da-Silva. "The Development of the Brazilian Bond Market."Coppead Graduate School of Business at the Federal University of Rio de Janeiro. (2007): 1-65. Print.
Brazilian currency crisis to keep government budgets from slipping into deficits and causing market lack of confidence in the government’s abilities to meet its obligations, especially the foreign denominated ones. All Central Bank bonds were issued domestically and most were short term with nominal and overnight rates. Post-1998 the Central Bank changed its bonds to be USD dollar adjusted interest rates to ensure most cohesion with the economic leader of the world and no interest rates mismatches that could prove detrimental.
Figure 4 Source: Central Bank issued debt Leal, Ricardo, and Andre Carvalhal-da-Silva. "The Development of the Brazilian Bond Market."Coppead Graduate School of Business at the Federal University of Rio de Janeiro. (2007): 1-65. Print.

According to this table the floating-rate bills outstanding amount to R$ 497.91 billion, which represents 50.80% of internal debt. The next category is fixed-rate bills, which represents 27.86% of the internal debt, inflation adjusted notes at 14.37% of the debt and US dollar notes, a negligible 0.53% . This last category is in notable contrast in comparison with 1998 period, which is when the Central Bank began to adjust for US dollar interest rate. It would seem that floating-rate bills has been the preferred instrument of debt since the Asian Crisis and has ranged from 40.09% to 63.90% of the debt composition . Even though fixed-rate bills decreased from 36% in 1995 to 2.44% in the early 2000s the Treasury has implemented a strategy of replacing the floating-rate securities for fixed rate ones and that resulted to a jump to 27% at the end of 2005 . There was a conscious effort on the part of the Treasury to lower the amount of internal debt denominated in foreign currency and therefore we see a profound drop in the US dollar indexed securities in the past 15 years.
Capital market strategy In the past decade the government has focused on consolidating Brazilian yield curves in markets such as the big three (US dollar, yen, and euro) . This move is so that they may have a more solid value proposition to investors both in their currency and in the international capital markets. They are doing this by using liquid benchmarks, diversifying the investor base of Brazilian public debt and creating opportunities for borrowers to access long-term financing. In order gain back autonomy or lessen constrains the government has also bought back huge amounts of restructured debt, like the infamous Brady bonds, and they have replaced them with more liquid securities such as Eurobonds. Besides issuing success, Brazil’s government bonds have been particularly successful in the secondary market where trade volume exceeded R$79.51 trillion and the turnover reached a height of about 81 . Even through government strategies to reverse floating-securities’ dominance, they are still the high traded security reflecting mainly the Letra Financeira do Tesouro or LFT (equivalent of a US treasury bill). Things are clearly moving in the right direction, with much thought being given by the government to changing their debt composition and removing exchange rate risk and interest rates volatility. There’s also a big push in international markets, especially the big 3, which was partly hampered by the Euro crisis and 2008-2009 global financial crisis. The longer maturity goals, rising demand, higher investment ratings/lower sovereign risk as well as some hints of foreign investor friendly moves will continue to keep Brazil on the gaining end of even the worst of crisis.
Issue to address
Taxation
In 2005 fixed income transactions were 22.5% for a holding period of 180 days or less. For longer time horizons like 181 to 360 they were 20%, and anything longer than 2 years had a flat rate of 15% . This is a progressive tax system meant to incentivize longer-maturity investments, which provide more certainty in the flows and reflect positively in the market. Foreign investors are taxed at a flat rate of 15%, which came down from a rate of 20% prior to 2005 .
Crowding out effect Many analysts believe that Brazilian domestic government debt is helping the government raise funds at the expense of corporate debt due to a crowding out effect. Even though the size of the public debt market makes it hard to follow this logic due to its sheer size. A study of 40 countries conducted by Eichengreen and Leungnaruemitchai showed that there was no significant correlation on impact and size of the bond market which to the contrary showed positive effects due to liquidity effects an market infrastructure benefits which offset the crowding out. There can however be a point made for the crowding out effects when looking at the regulation patterns that the government has which tend to favor government debt rather than the development of private sector corporate financing market. Some argue that they do so in order to be able to finance the immense infrastructural costs, especially the ones linked to the World Cup 2014 and Olympics 2016. The foreign investor tax exemption mentioned in the beginning of this paper, which only pertains to government debt rather than corporate debt is an example of such trumping efforts of corporations trying to further integrate in the capital markets. Furthermore, the capital adequacy and prudential rules that are biased towards government debt need to be revised so as to at least partly reduce that bias. In order to do this there need to be some lobbying on regulators to be able to reach the different levels of government: central bank for commercial banks, Comissão de Valores Mobiliários mutual funds, the ministry of Social security for closed pension funds. This however would take a big push on the part of a government that believes in further integration and development of the corporate financial markets. Additionally there need to be a change in the cultural sense which would see the end of forced savings, the beginning of full convertibility and more income-less taxes like taxation over revenues or payroll. There should be an extention of the tax exemption of foreigners to others types of debt too by lifting the financial transactions tax, CPMF, on securitized tradabales . The reduction of forced savings, which at present finance the National development Bank, BNDES as well as housing and agriculture loans, which are subsidized, would increase competition and transparency in the market. The institutions, which now rely on these subsidized funds would have to go out ino the market and issue their own debt on a competitive basis and given their sheer size this would increase liquidity and deepen the market. Another very important facet to the success of the bond market in Brazil is the Central Bank’s commitment to inflation targeting and its credibility. Since adopting inflation targeting Brazil has only once in 2003 been above the target range, until recently when it seems that inflation targeting has slipped the Central Bank’s president’s agenda. This is not good for interest rates that are already some of the highest in the market’s as far as major countries go, and a slip in inflation targeting (last inflation figures came in at 5.7%, well above the 4.5% upper limit) would force a raise in interest rates signaling this danger . The government correspondingly needs to get a hold of its fiscal budget, which is suffering great pressures from the infrastructure spending for the World Cup 2014 and Olympics 2016. This reduction in fiscal spending needs (and financing through the bond market) would surely level the playing field somewhat by reducing the need for a crowding out effect.
Keys to success The Brazilian government has been key in the success of Brazil’s bond market through their genuine commitment to many of the pillars of economic stability. The enhancement and deepening of the bond market have helped to provide liquidity and set a foundation on which to launch one of the world’s largest emerging country debt markets. It has allowed the Central Bank to influence the interest rates underlying the banking system through open market transactions, and this is partly due to the success of the government debt instruments in the secondary market . A couple of the principles, going forward, that the government and monetary authority will have to pay attention to is insuring that the bond rates are market-determined and there isn’t too much protectionism and government ‘managing’ that takes place or else the market investors will be less attracted to the bond market in Brazil. Brazilian government bonds have been excellent debt instruments to hedge and speculate and has by consequence made all other securities more liquid . There is a hope that after the massive undertakings of the two major sports events there will be a normalization for the financial needs of the government and the influx of liquidity in the market will be capped in order to be able to get a handle on inflation. This will require a commitment on the part of the federal government who has thus far been less free market than interventionist.

Bibliography

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