[OPE-L] Shackles severed?

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Shackles severed - how the developing world is
striving to free itself of debt

By Joanna Chung in London

Published: February 9 2007 02:00

The head of the Nigerian government's Debt Management
Office is as mild-mannered as debt management officers
come. But even he could not resist what in that
profession must be the equivalent of a sportsman's
victory dance: a flourish to demonstrate the
consummate mastery of his game.

Into his PowerPoint slide presentation detailing
Nigeria's clearance of more than $30bn (£15bn, ?23bn)
of its external debt, Mansur Muhtar, the official,
slipped an unexpected but dazzling image of fireworks.

It signalled that Nigeria, once seen as one of the
world's financial basket cases, had entered a
promising era: from $35bn, debt was almost entirely
cleared last year, through write-offs and windfall
revenues from oil.

Nigeria is just the latest example of a phenomenon
taking root in the developing world. After decades
under mountains of debt, many countries are digging
themselves out. Thanks to high commodity prices and,
in some cases, debt forgiveness programmes, many of
the seemingly hopeless cases of old are paying off
debts and avoiding new ones.

Russia, whose $40bn domestic debt default and
financial collapse in 1998 sent shock waves throughout
the world, has used its windfall from high oil and gas
prices to pay off a large chunk of its foreign debt.
Moreover, debt reduction has not been limited to oil
exporters: Argentina, historically a serial defaulter
- most recently on $100bn worth of debt in 2001 -
ended its relationship with the International Monetary
Fund a year ago and is paying more money back to
creditors than it is borrowing in fresh loans or bonds
(see below right).

Countries scarred by past crises, including Mexico,
Brazil, Indonesia, the Philippines, South Korea and
other countries in Latin America and Asia have taken
steps over the past five years to insulate themselves
from the effects of a future global financial crisis.
In stark contrast to past periods of strong global
growth and low interest rates, they are husbanding
resources rather than spending them - many are paying
off public debt, running budget and/or current account
surpluses and building foreign exchange reserves. When
they do issue bonds, governments are increasingly
doing so locally rather than in international capital
markets.

One striking measure of this new thriftiness is what
has happened to the stock of Brady bonds - the once
dominant market instrument in emerging markets, issued
in the 1990s in exchange for defaulted bank loans of
the 1970s and 1980s. With governments increasingly
buying back or exchanging the bonds for new ones at
advantageous rates, the supply of such bonds that
reached a peak of $156bn in March 1997, according to
IMF data, has virtually disappeared.

"Governments are taking advantage of favourable market
conditions to deleverage and pay off external debt,"
says Mansoor Dailami, manager of international finance
at the World Bank's development prospects group. "The
ratio of total external debt to gross domestic product
has significantly dropped in many of these countries.
Some of these countries are no longer high debtor
countries, though obviously there is still high
internal debt."

This is all the more unusual because it has never been
more attractive for emerging economies such as these
to borrow internationally. A glut of savings worldwide
has driven interest rates and risk premiums - the
extra interest paid on riskier bonds - to historic
lows. Investors' hunger for higher returns has driven
a flood of money into emerging markets in the past
four years.

Certainly, the ability of many low-income countries to
pay down debts would not have been possible without
the commodities boom witnessed in recent years. Helped
by rising demand from China and India, the price of
oil and raw materials has risen sharply. Commodity
exporters like Brazil and Nigeria have boosted their
export earnings and no longer need to raise much cash
from the capital markets. Inflows from other sources -
such as the remittances that migrant workers send back
home - have also risen usefully in many emerging
markets.

As a result, developing countries that spent the 1990s
with huge deficits have enjoyed a turnround. As a
group, they ran a current account deficit of $89bn in
1998. But by 2005 this had moved into a surplus of
$248bn, according to the World Bank's latest Global
Development Finance report. In 1992-97, the group ran
a cumulative deficit of $547bn.

"The tide has turned," says Stephany Griffith-Jones,
an economist at the Institute of Development Studies
at Sussex University who has tracked capital flows for
almost 30 years. "It is quite an anomaly but
developing countries are now the net exporters of
capital."

The reluctance to accumulate foreign debt also appears
tied to a change in attitude towards global capital
markets, which just a decade ago were seen as the
quick route to jump-starting economic growth.

But painful memories of past financial crises have not
faded from the minds of government officials and
policymakers. The financial turmoil resulting from
crisis in Latin America in 1982, the so-called
"tequila crisis" in 1994-95, the Asian contagion in
1997-98, the Brazil crisis in 1999 and Argentina
upheaval of 2001 have steadily taught developing
countries that a reliance on volatile world capital
markets has serious consequences. When the world
economy is strong and liquidity plentiful, bankers and
bond investors alike have been happy to lend money to
developing country governments. But when times have
turned tough and when governments have really needed
the money, the markets have denied them access to
finance. As the American author Mark Twain is once
said to have remarked: "A banker is a fellow who lends
you his umbrella when the sun is shining and wants it
back the minute it begins to rain."

Martin Redrado, president of the central bank of
Argentina, says: "The financial crises taught
[emerging market governments] that they cannot
continuously finance the public sector deficit through
the international capital markets. Self-insurance is
the best way to deal with volatility and shocks in the
international capital markets."

This distrust of global capital markets has led some
governments to experiment with capital controls, or at
the very least, efforts to dissuade foreign investors
from flooding their markets with hot money. Facing a
rapidly appreciating stock and bond market and a
surging local currency, Thailand, for example, imposed
capital controls in December, a move that caused the
stock market to fall 15 per cent in a day before the
military government was forced into partial retreat.

Liqun Jin, vice-president of the Asian Development
Bank, says it was a pre-emptive action. "Thailand has
experienced excessive capital flows for speculative
purposes which has put a lot of pressure on the export
sector andis disruptive to the economy."

Underlying the skittishness about foreign capital is
the volatility it introduces into a nation's economy:
capital inflows can cause currencies to appreciate and
domestic inflation to rise, making exports
uncompetitive. Worse still, when the tide turns and
investors and bankers lose their appetite for riskier
assets - money flows out. The results can be
catastrophic, as central banks raise interest rates to
protect their currency, which can cause waves of
bankruptcies and hurt domestic banks.

Such experiences have encouraged governments to
strengthen their finances, helping to drive a
four-year boom in emerging markets. Many governments
have been consciously increasing their holdings of
international reserves. Commodity exporters including
Chile, Russia, Kazakh-stan and Algeria - unlike during
past booms - have used stabilisation funds to save
substantial parts of the windfall.

Hung Tran, deputy director of the monetary and capital
markets department at the IMF, says: "Many countries
have made use of the strength of global growth and
buoyant commodity markets to improve their fiscal
stances and build up their foreign exchange reserves.

"Many have pursued active debt management operations
to reduce foreign currency debt and replace that with
local-currency debt, thus making them less vulnerable
to external shocks than in the past."

While shifting borrowing to local currencies is not a
panacea, the move helps reduce vulnerabilities to
foreign exchange rate risk. At the same time,
governments have taken advantage of the appetite of
investors for emerging market debt by issuing bonds of
longer maturities, thereby reducing the stock of
shorter-dated debt.

In addition, a widespread move from fixed to floating
exchange rates has made many emerging market economies
more resilient. Unlike in the past, an outflow of
funds can now be accommodated by falling exchange
rates.

Joyce Chang, head of emerging market research at
JPMorgan, says these and other policy changes mean
that "many emerging market countries find themselves
in a much stronger position to weather a downturn in
the cycle than at any time in the history of the asset
class."

Nevertheless, some observers say the cycle of boom and
bust is inevitable. Boom times for emerging economies
in the past have invariably ended in disaster.
Moreover, few people expect cyclical factors that have
been fuelling the appetite for emerging market assets
- such as excess liquidity and strong commodities - to
last indefinitely.

Some emerging market economies remain highly
vulnerable. Not every government has taken advantage
of the benign financial conditions in recent years to
protect their economies to the same extent. David
Beers, global head of sovereign ratings at Standard &
Poor's says: "The rising tide has not necessarily
raised all boats. Some boats are leaking."

He points out that aside from Russia, much of emerging
Europe, including Turkey and Hungary, is suffering
from large current account deficits. Latin America's
creditworthiness has generally improved but there are
big differences between countries. "Brazil has been
running primary budget surpluses and improving its
debt structure, Venezuela has raised spending in line
with higher oil revenues," says Mr Beers.

Guillermo Calvo, professor of economics, international
and public affairs at Columbia University, thinks
there will be another serious slump in the developing
world. He says that the risk premiums in Latin America
are too low.

"There is no indication in the region that there has
been a big push for major structural reform since
1998," he says. "Everything seems to be going in the
right direction for Latin America but much of the
growth you see is due in large extent to much better
external conditions. If you take away some of those
better external conditions, such as favourable terms
of trade, the growth rate in the region is actually
very poor."

If there is an abrupt slowdown in the world economy,
emerging economies are still likely to be far more
vulnerable than developed ones, say most experts.
Economic slowdowns in the US and China - important
destinations for emerging-market exports - number
among the top concerns of emerging-market investors.

New categories of risk exist too. While emerging
market governments are borrowing less, borrowing by
emerging market companies is on the rise. According to
JPMorgan, corporate debt issuance has risen from $21bn
in 2002 to $111bn in 2006. While this shift to
corporate borrowing is generally welcome, Mr Tran of
the IMF says it needs to be monitored.

"For this new set of borrowers, it is important to
understand the impact of the debt on their balance
sheets to ensure that there are no undue stresses," he
says. "A fundamental currency mismatch in the
corporate sector was at the root of the Asian
financial crisis [that began in 1997]."

Meanwhile, in line with the growth of domestic bond
markets, overseas investors have been pouring money
into local currency assets in search of higher
returns. A change in sentiment or sharp currency moves
could lead them to pull out their capital.

That could trigger a fall in local markets,
particularly in the absence of a strong domestic
institutional investor base. Some of the worst
financial crises in the past followed defaults on
domestic debt, such as in Russia.

Alejandro Werner, Mexico's undersecretary of finance
and public credit, admits the last few years "have
been exceptionally good for emerging markets".

He has no doubt that some emerging economies will
suffer if global economic circumstances change. "But
you have to separate what is a normal adjustment to a
change in the business cycle from a complete
disruption to the operations of the capital markets
that you have seen in the past," he says. "Emerging
economies are on much more solid economic ground now
and that means there are no amplification mechanisms
that turn a downturn in the business cycle into a
full-blown crisis."

Ricardo Hausmann, director of Harvard University's
Center for International Development and a former
planning minister of Venezuela, says: "A systemic
shock to the market looks less likely and the
countries that used to be epicentres of crises - the
Argentinas, the Brazils, the Mexicos - don't look
particularly vulnerable." But he adds: "People are
always looking at a repeat of the last crisis, the
kind of imbalances that caused it. Maybe the next
crisis could come from somewhere completely different
and unexpected."

That message is reinforced by the ADB's Mr Jin: "Never
rule out another financial disaster . . . It is
absolutely important for policymakers to keep the
spectre of past financial crises in mind."

Additional reporting by Dino Mahtani

Copyright The Financial Times Limited 2007