In my previous posting I argued that it is important to focus the attention back on private investment in Latin America. It is well known that a necessary condition for private investment to become an engine of growth is that property rights are well protected, and that the business environment is good enough to attract and retain entrepreneurs and investors. In other words, the rules of the game have to be well defined and be common knowledge for all those who can invest. If there is too much uncertainty, investment opportunities remain untapped.
Although the level of private investment is very sensitive to this investment climate, the cost of its financing is a key determinant of its variations over time. This is particularly clear at times of turmoil in financial markets, as it is happening right now. What are the drivers of the private cost of financing in emerging market economies (EME’s)? This is not only a relevant, but a tricky question, that we recently try to answer using information on corporate bonds.
Even though the bulk of private investment in Latin American region has historically been financed through banking credit, some (predominantly larger) firms have been quite successful floating corporate bonds since the mid 1990’s. This is true even when local bond markets in Latin America continue to lag behind economies in Asia in a number of dimensions (see the 2007 issue of the annual Economic and Social Progress Report titled Living with Debt published by the IDB). It is quite possible that with increased financial development, the opportunities for debt financing will become available to a larger share of firms. And, therefore, sudden negative shocks to the cost of financing like the one that is manifesting itself now in the EME’s bond markets, will become increasingly important in explaining the downturn of the investment cycle.
The good thing about corporate bonds for research purposes is that when they are bought and sold in secondary markets we can typically observe the spreads at which they trade and thus make inferences about the cost of financing and its determinants. This is what we do in a recent paper co-authored with Patricio Valenzuela. We take advantage of a largely unexploited dataset from Bloomberg on corporate bonds spreads that are cleaned from the portion of the risk that is attributable to the so-called “embedded-options” (and which is very hard to account for). In essence, Option-Adjusted Spreads (OAS) from Bloomberg, is a method of comparing bonds with different cash flow characteristics on a more equal basis.
We focus on the determinants of the corporate spreads for 139 bonds issued by 65 corporations in 10 EMEs, six in Latin America and four in the East Asian region, with available data in Bloomberg. We use quarterly data from 1996 to 2006. The question we address is what are the determinants of these spreads taking into account firm idiosyncratic characteristics, country (sovereign) risk, global liquidity factors, and country and sector fixed-effects (to account for possible unobservable things such as business climate).
Our main finding is that firm-specific variables (i.e., profitability and leverage), macroeconomic conditions in the country where the firms operate, sovereign risk (measured as the EMBI spread for each country) and global factors (i.e., VIX, the High Yield, etc) are all important determinants of the cost of financing for private firms. But more interestingly, and perhaps even surprisingly, a variance decomposition analysis indicates that firm-level characteristics account for the largest share (one third) of the variance of corporate spreads (see graph).
All in all, these results underscore the importance of good management as the main determinant of corporate risk in EME’s, even when these are countries where macro volatility is always in the headlines. Does this mean the appropriate business environment matters less for investment? I don’t think so. There are several qualifications to be made: (1) remember that the appropriate business climate (however you want to define it) is a necessary condition for private investment opportunities to reach a level capable of sustaining rapid growth. Our results are mute on this; (2) the results are limited to the sample of firms that can issue debt which is traded in secondary markets. This is conceivably a pool of larger firms that (possibly) operate in multiple markets and that are more immune to the volatility of the local economy; and (3) the strength of the linkage between sovereign and corporate risk is likely to vary with the external cycle. In periods of tight global liquidity conditions, the “Transfer Risk” (i.e., the risk that if the government encounters difficulties in servicing its debts, it will transfer those problems to the local private sector) goes up. We provide evidence of this effect in the paper.
But even with these limitations our paper shows that good management may at least dampen the negative effects of sudden negative shocks to the private cost of financing. And this is something very important in times of financial turmoil.