2005 ANNUAL MEETING
Peru’s Finance Minister Zavala Addresses EMTA Annual Meeting
On December 1, 2005, at the downtown Manhattan offices of Citigroup, over 300 attendees heard Finance Minister Fernando Zavala of Peru deliver the keynote address at EMTA’s Annual Meeting. The event also featured two panel discussions on the current economic outlook for Emerging Markets countries.
In his opening remarks, EMTA Executive Director Michael M. Chamberlin noted that during its 15-year history, EMTA had not previously had the privilege of having a keynote speaker from Peru and that he was delighted to welcome Minister Zavala.
Zavala Reviews Recent Economic Performance in Peru
Zavala began his presentation with a brief review of recent Peruvian economic performance. The Minister highlighted that the country’s fiscal deficit declined from over 2% of GDP in 2001 to 1% in 2005, and was projected to decline to 0.8% by 2008.
The Minister confirmed that Peru’s GDP was expected to rise 6-6.5% in 2005, and then stabilize at 5% over the following three years. He underscored Peru’s uninterrupted economic growth between August 2001 and September 2005 (the latest month for which data had been published), and pointed out that the past fifty-one months of consecutive growth was a phenomenon not seen in Peru for three decades. Growth has been led by exports, private investment (up 12% in 2005, y-o-y) and private consumption, and has led to job creation and increased real income, Zavala stated.
Export growth in Peru has been led by traditional mineral products, as well as by non-traditional sectors such as agricultural products and textiles; and has pushed Peru’s trade balance to a surplus of 5% over GDP. The Minister noted that the country’s exports are expected to amount to over US$16.7 billion in 2005, stressing "that means double the amount of our 2001 exports." The Minister acknowledged that some of this is due to strong commodity pricing, "but that is not the only reason—45% of the increase in the value of our exports is due to increased volumes," he stated. He highlighted the growth in non-traditional export sectors, which were up 16% y-o-y in 2003, and rose 37% in 2004.
"We are working to close the Free Trade Agreement (FTA) with the United States," Minister Zavala noted, as the US purchases 28% of Peruvian exports. He described Peru’s additional efforts to promote free trade, pointing out that his country has now signed a free trade agreement with Thailand, is negotiating with other Asian members of APEC, and expects to begin talks with the European Union in the first half of 2006. [NB: The US and Peru announced the conclusion of negotiations on a free trade agreement several days later; see http://www.ustr.gov/assets/Document_Library/Press_Releases/2005/December/asset_upload_file744_8518.pdf for further information.]
Zavala then discussed monetary policy, commenting that stabilized inflationary expectations have laid the groundwork for sustainable growth. "Peru has an excellent track record in monetary stability," according to the Minister, who proudly compared Peruvian consumer price inflation to higher-rated emerging countries. The nation’s firm monetary policy and price stability have led to low interbank interest rates, currently below 3%, and non-performing loans have declined sharply from 11% in 1997 to less than 3% as of October 2005. At the same time, dollarization in the banking system has declined from 70% in 2000 to 54% in 2005, "reflecting greater confidence in monetary policy and economic stability," he affirmed.
As for fiscal policy, Zavala reminded attendees that Peru had initiated a comprehensive fiscal reform package in 2003, including an important new VAT withholding mechanism, "and we will continue improving the fiscal side with administrative measures," he pledged. Public debt is expected to decrease from 45% in 2001 to 39% in 2005, according to the Minister, with a further contraction to 36% forecast for 2007.
Minister Discusses Liability Management Goals
Zavala then addressed the reprofiling of Peru’s public debt. The Ministry has three goals—"to reduce refinancing risk through market-based operations which will increase average duration; to reduce exposure to market risks such as interest rates and currency exposure; and to reduce nominal value of the debt and achieve net present value (NPV) gains." Such reprofiling will be carried out via bond exchange offers, swaps operations and debt pre-payment.
The Minister credited "pro-active, market-based debt management strategies" with successfully reducing Peru’s upcoming amortization payments. He noted that a nearly US$1.6 billion Paris Club pre-payment was financed with a combination of 20-year dollar-denominated bonds and 11- to 15-year sol-denominated local treasuries, and resulted in savings of approximately US$350 million in amortization payments over the next four years.
Zavala observed that liability management operations have increased the amount of sol-denominated debt as a percentage of public debt from 10% to 16% while paring down the amount of euro-denominated debt from 12% one year ago to 6%. Peru’s exposure to interest rate fluctuations has also decreased, as the amount of fixed-rate debt has grown from 51% at year-end 2004 to over 60%. The growth of assets in local pension funds (from US$1.9 billion in 2000 to US$9 billion in 2005) has provided domestic demand for Peruvian government debt, he noted.
Peru’s 2006 projected financing needs total US$2.4 billion, the Minister stated, with US$1 billion expected from foreign sources and US$500 million to come from multilaterals. While the Minister stressed that Peru did not plan to tap the international capital markets in 2006, he informed attendees that US$650 million of the government’s financing needs was expected to be raised in the local bond market.
Zavala detailed the development of the local market, highlighting the recent extension of the local curve to 15 years, double the previous maximum tenor of seven years. Foreign participation in the local markets has increased significantly, with 35% of 2005 bondholders being non-residents. "This shows confidence in our sovereign creditworthiness," the Minister affirmed.
Upcoming elections might cause some concern on the part of investors, the Minister conceded, but institutional safeguards are in place. The fact that the new Constitution does not discriminate between foreign and local investors, the autonomy of the Central Bank, and recent pension and structural reforms all act to protect the foreign investor, Zavala stated, while recent moves toward political decentralization also serve to promote fiscal responsibility.
Following his formal presentation, the Minister responded to several audience questions. He provided further details on FTA negotiations with the US and projected export pricing. He also sought to calm investor concerns about a populist successor to President Toledo and discussed a potential credit-rating upgrade.
Minister Zavala’s slide presentation is available on the EMTA website at http://www.emta.org/media/yk3p1hyv/3c6b0ab4-94aa-444a-bc4f-fac5881aab57.pdf.
Sell Side Panel Reviews a Resilient 2005
The meeting’s sell-side panel was moderated with characteristic aplomb by Joyce Chang of JP Morgan. Chang prefaced the discussion with her observation that the Emerging Markets had "exceeded relatively modest—even pessimistic—expectations for the fourth consecutive year." Not only EM debt but also EM equities and local currencies had outperformed other asset classes, she noted.
Reviewing the year, Chang opined that the dominant theme of 2005 was local market investment, and referred to recent JP Morgan research which revealed that as much as 80% of new inflows into the Emerging Markets asset class is directed to local markets. The EMBI index proved "remarkably resilient" in 2005, up 9% at the time of the meeting. In comparison, local market debt rose 2.1%, making passive investment in local debt "difficult to justify in my view," Chang commented.
Chang described several additional noteworthy trends which characterized the year: In 2005, EM debt traded at a premium to US corporate bonds across every ratings category. In addition, for the first time since 2001, EM spreads were less volatile than both the US high-yield and US high-grade markets. The EMBI also achieved its highest average rating, at BB+. Finally, Chang observed that financing needs for emerging countries declined sharply, with only $48 billion to be obtained in 2006, down from $60 billion in 2005, with the majority of 2006 budget gaps already having been pre-financed.
Referring to a chart featuring each panelist’s forecast of key economic variables for 2006, (see http://www.emta.org/media/1melulxe/39073f98-f4c9-4ef6-81d5-3bc7bde709b1.pdf) Chang summarized that there was general agreement on where MXP and BRL exchange rates would be in twelve months; that Merrill Lynch was the most bearish on credit spreads; that JP Morgan forecast the highest CNY appreciation at 13.4%; that there was a near consensus that WTI oil would trade at $64-65 next year (the outlying JP Morgan forecast $55 a barrel); and that all firms expected the EMBI to widen next year (with forecasts ranging from 20 to 50 bps). Chang justified JP Morgan’s relative optimism about 2006 EMBI performance, expressing her expectation that inflows would remain "diversified and strong, with less emphasis on hedge fund investors, and more inflows from Asian retail, Middle Eastern petrodollars, and pension fund money following the downgrades of the auto sector."
Global Economic Backdrop Debated
Merrill Lynch’s Tulio Vera led off a discussion on the overall global situation. "The bottom line will be less supportive in 2006, because the key drivers of the EM debt class, ample global liquidity and low risk-free rates, have started to change," he commented. Vera asserted that global liquidity is beginning to roll over because the pace of foreign investor purchases of treasuries is slowing down; and while risk-free rates will likely remain low, inflationary pressures are starting to build, particularly in Asia. As a result, investors are likely to see a global tightening begin in 2006. "We are at the cusp of tightening by the global providers of savings—Asia, in particular China, and to a lesser extent Europe," Vera predicted, concluding that "bottom line, a process of normalization of risk will bring spreads wider, 40-70 bps wider for the EMBI Global."
Prompted to also discuss the effects of US rate hikes on the EM marketplace, Vera offered his assessment that "Fed policy is relatively less important than it has been in the past because the US is a net borrower, not a provider of savings." If the Fed were to overshoot on interest rate hikes, global growth would be affected, "but at the end of the day it’s a contraction in global liquidity which would cause pressure on EM assets," he stated.
Goldman’s Paulo Leme ventured that, just as the panel had been surprised in 2005, global growth might prove stronger in 2006 than current forecasts predict. "Commodity pricing could remain relatively supportive for some of the larger emerging countries, and we could see decent performance," he speculated. Leme cautioned that even in such a positive scenario, the hunt for value remains difficult, pushing investors to take on riskier and less liquid instruments. Leme concurred with Chang that, as a result, local markets will "continue to be king" in 2006.
EM Debt: Overvalued?
Discussing the relative value of Emerging Markets debt and similarly-rated US corporates, Kasper Bartholdy of Credit Suisse discussed a recent analysis he had undertaken that suggested that higher-spread EM sovereigns would require a one- to three-notch upgrade to justify the current trading levels. This might lead one to think that EM debt is overvalued, but Bartholdy observed that EM fundaments had trended up for years and this is likely to continue; he commented that credit ratings tend to be a lagging indicator, perhaps one or two notches behind, so the gap is actually not unreasonable. The asset class has moved from being cheap, Bartholdy declared, to "slightly expensive but not widely off fair value."
"The Emerging Markets asset class is not cheap…but relative to what?" Leme asked rhetorically. Fundamentally, with the US current account deficit and the removal of at least $100 billion in supply of Latin American debt via re-payment, pre-payment or default, current pricing should not be a surprise, he reasoned, and investors can still find examples of "flagrantly cheap" assets such as Brazil, where recent political noise has not interfered with economic stabilization. Leme expressed considerable doubt that President Lula will be re-elected, and this allows for significant upside potential.
Chang offered the panel’s most optimistic outlook, underscoring Leme’s comments on the reduced supply of outstanding sovereign debt, and highlighting the accumulation of US$1.3 trillion in increased reserves in the past decade. "Macro legitimacy has not been accompanied with micro legitimacy, and as a result investors are still under-allocated," she declared.
Overcrowding, Overexposure to Long-Dated Paper Risks in Local Markets
Despite 19 countries being included in the JP Morgan local market index, Chang noted, much local market investment is in three "relatively crowded" trades: Brazil, Mexico and Turkey. Chang pointed out that all three countries faced simil1ar challenges—including high real rates compared to inflation and possible overvaluation on a long-term basis—and suggested that there might be "too much money chasing these trades." She asked her colleagues to share their concerns about investing in local market instruments.
For Leme, the largest risk is the fact that foreign investors’ holdings consist mainly of long-dated paper, whereas domestic market participants are concentrated in the short end of the curve. He called for all three countries to enact structural reforms. Finally, Leme described the recent moves by several EM countries to issue local currency-denominated global debt as "nice crutches that substitute for the lack of reform in the domestic capital markets."
Vera saw the largest risk in local markets as liquidity, especially in the local swap markets. He also noted that capital controls create price differentials between on-shore and off-shore markets, and voiced concern that increased supply could result from recent increases in government spending.
Following up on Leme’s concerns, Gavin described the recent evolution of his thoughts on the local Mexican markets. Whereas he was previously preoccupied with the concentration of foreign investors in long-dated local paper, in recent months he has become increasingly convinced that the bulk of these investments are from the large real-money accounts searching for added value in Mexican debt.
Elections Likely to Add Volatility
Taking its cue from Gavin, the panel next debated the risks posed to the market by the 19 major Latin American elections coming up over the next two years. Gavin acknowledged that his thinking on this has changed over the past couple of months; he is no longer as tranquil as in the recent past, when he believed that no major policy changes were at stake. While many countries would "certainly not accept the [Venezuelan President Hugo] Chavez model, he is being mainstreamed in the Latin American political context," Gavin warned, adding that this is to a substantial degree the result of "the withdrawal of the productive role that the US has occasionally played in Latin America."
On Brazil, Gavin expressed slightly less optimism than Leme, calling Lula "severely discredited" by recent political scandals and thus less able than ever to enact potential policy reforms. In recent weeks, Gavin continued, a new positive scenario has evolved in Mexico in which PAN candidate Felipe Calderon wins a close election that the PRI loses convincingly. Calderon "does ‘get it’ and would, as President Fox did, put in place pro-growth economic policies." A defeat of PRI candidate Roberto Madrozo could push the PRI to view the loss as "a rejection of the rejectionist wing of the party, a faction that had refused to support the reforms that Fox and previous PRI governments had tried to pass." The downside risk is the potential election of Andres Manuel Lopez-Obrador (AMLO), who, while "not a radical or someone who would blow up public finances, would make a spectacularly poor President of Mexico."
Gavin’s survey of upcoming races also included a relatively benign assessment of Colombia’s presidential election, and a brief appraisal of the Ecuadorian and Venezuelan situations as "bad." Gavin speculated that "there is no limit to how far Chavez’s Bolivarian revolution could go in Venezuela—he is close to extinguishing, for all practical purposes, the private sector, whether intentionally or not."
"People have become completely complacent and these elections are going to add stress to the market," agreed Leme. Clarifying his prior upbeat remarks on Brazil, Leme acknowledged that while the "soap opera will have a happy ending, there will be a lot of tempestuous episodes." Finally, he lambasted "inept" governments that are missing an opportunity to get their economic houses in order. Vera concurred with Leme that volatility will almost certainly occur during the election cycle, but stressed that, long-term, the global backdrop remains the more important factor.
Chang concluded the hour-long discussion with a call for panelists’ 2006 recommended longs and shorts, and introduced a new tradition of asking for a guess at the coming year’s greatest market surprise. Most panelists included Brazilian and Mexican local markets in their favorable picks for 2006. Leme recommended investing in post-election Brazil, while Vera would buy Argentine GDP warrants and select long-dated Brazilian and Philippine paper. Gavin asserted that an opportunistic approach to the market was warranted in 2006, and Chang cautioned that the investment-grade component of the EMBI would underperform.
Bartholdy’s list of potential market shocks included both higher-than-expected US inflation and above-consensus Argentine growth. Leme repeated his earlier comment on a failed Lula re-election bid, and added that one day the market will turn around "and it will be a lot quicker and uglier than we think." Vera and Gavin both suggested a substantial commodity price shock, with Vera also mentioning Ecuador "getting it together" and an early adoption of the euro in the EU’s new states. Chang’s own stabs at a 2006 market surprise included an earlier-than-expected US troop withdrawal from Iraq leading to a Middle East power vacuum, and losses by both AMLO and Lula at the ballot box.
Investor Panel
Citigroup’s Don Hanna, who inherited the mantle of long-time investor panel moderator Tom Trebat, invited speakers to comment on the global macroeconomic picture.
Hari Hariharan (NWI Investment), recalling that last year’s investor panel had forecast mediocre returns at best, proclaimed that "here we are hugging our double-digit returns for the year again!" He observed that no one had expected the size of Asian capital flows that had occurred, nor had anyone predicted the reserve-building that took place in EM countries, nor the resilience of the American consumer. Hariharan described the nature of EM investing as having undergone a tremendous change from the days when traders made large profits on "wild swings of the C-Bond." The case for bearishness is premature, he opined, until there is evidence of a large drop in aggregate demand from the US. Thus, the case for contagion is "no longer from the Emerging Markets into the core, but from the core—the US—to the Emerging Markets," he summarized.
Aegon’s Sarvjeev Sidhu expressed concern that "we are probably headed into a difficult year in 2006" due to G-3 tightening which could "choke liquidity." Adding the 2006 election cycle to the mix could create a "perfect storm," he warned.
The unusual confluence of high commodity prices and low global interest rates is unlikely to persist, predicted Art Steinmetz of Oppenheimer, depriving emerging countries of their current tailwinds. While the market has been preoccupied with the ramifications of rising US interest rates, Steinmetz asserted that increased reliance on local market financing has diluted their effects and made them less important. Yet at the same time US rates are more important as they have accounted for more of Emerging Markets debt total return than ever before. This has forced Steinmetz to become involved in US Treasury hedges, he acknowledged.
Local Market Investments Reviewed
Dave Rolley (Loomis Sayles) concurred with the sell-side panel’s predictions on the growing importance of local market instruments. Rolley quoted EMTA Volume Survey numbers which showed that 47% of third-quarter 2005 trading involved local treasuries, and predicted that they would account for more than half of trading in 2006. "We will have to think about local currency drivers in 2006 rather than dollar solvency drivers, so many of us are going to need different tool kits," he emphasized. Rolley questioned whether local players would be as enthusiastic about owning local debt as foreign investors.
Hariharan criticized the constraints some emerging countries have placed on foreign participation, and argued that access would continue to be an issue. "I still do not understand why Brazil will not allow foreigners to go into the futures market," he specified. Sidhu described the "uphill climb" his firm had encountered when preparing for local market investments, and when explaining his investment rationale to his clients. "It’s not been an easy task; as a heavily regulated manager of dedicated long-term insurance fund assets, we don’t have the mechanisms available to hedge funds or offshore entities," he commented.
Turning to corporate issues, Hariharan inquired how each of his co-panelists’ firms organizationally structure Emerging Markets corporate bond analysis. Rolley responded that Loomis Sayles has assigned its analysts by industry, assuming that a G-7 mining firm could not be fully understood without factoring in emerging-country competition. Sovereign experts then contribute to the analysis by explaining the local context.
Sidhu commented that Aegon had a similar structure, with a top-down approach that first requires interest in the country. He advised that Aegon generally avoided corporates which were rated below the sovereign in non-investment grade countries. "No high yields in a high-yield country, which restricts our universe, but we found that those are the companies that usually do well," he summarized.
Steinmetz conceded to being "the odd man out" because of a self-confessed aversion to EM corporates. "Maybe I have been in this business too long," he commented, "but the instant the sovereign gets into trouble, the corporates go ‘no-bid.’" Liquidity issues do not justify using firm resources to cover corporates, although Steinmetz looks to pick up additional yield from quasi-sovereigns or structures such as credit-linked notes.
Investment in Africa?
Hanna polled the panelists on how far the search for yield in local markets will go. Sidhu expected to find some interesting trades in Africa, although he has not gone beyond South African positions thus far. Steinmetz observed that Zambian kwacha trades are now to be considered seriously. He commented further that it was discouraging that despite a "dire need" for infrastructure, the lack of the rule of law and good government in many African countries prevented large external debt issues which could finance such projects while restricting foreign interest to large commodity exporters.
Rolley, referring to the early loan-trading days of the EM marketplace, added that the lack of external debt issues for an African country probably meant that "even 1970s or 1980s bankers wouldn’t lend the country money." A minimal level of income, capital market infrastructure, governance, and hard-currency cash flow generation were required to appeal to foreign investors, he reasoned. "We seem to forget on occasion that one cannot lend money to a country without a tax base," he suggested.
Brazilian Local Markets the ‘Boring’ Recommendation for 2006
At the end of the panel, Hariharan conceded his "boring" recommendation would be Brazilian and Mexican local markets, in addition to shorting Hungarian bonds. Sidhu speculated that Russia could be awarded a single A rating in 2006 or 2007, but cautioned against owning Venezuelan credits. Rolley voted for corporates as both the best and worst ideas for 2006, expressing general skepticism about Asian corporates ("you have to worry if no one will lend them the money in Asia, where all the money is," he explained). Steinmetz seconded a recommendation for Brazilian local markets, defending his call by highlighting the number of investors who are still trying to get authorizations and approvals to enter the market. Steinmetz also stated that Philippine external debt is an anchor in his portfolio, for its defensive properties rather than total return potential, due to its unusual status as a low-beta high-carry EMBI credit.
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Completing the celebration of EMTA’s 15th Anniversary year, the Annual Meeting also featured a display of the photographs of 34 notables from EMTA’s past and present, including former EMTA keynote speakers, panelists and prominent Board members. The display drew a great deal of interest from EMTA’s Annual Meeting guests, and in one case, excessive interest (one photograph went missing for several days -- it was later returned!) The display is set to reappear on EMTA’s website sometime in the near future.