While there is still a lack of credit in Latin America, the region has proved it can continue to grow, paticularly with improved bankruptcy regulations and corporate governance
Is it possible that some emerging markets economies grow strongly without credit? A recent report by economists Guillermo Calvo, Alejandro Izquierdo and Ernesto Talvi, called Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crisis, examined this very question.
It found output recovers with virtually no recovery in either domestic or foreign credit, a phenomenon called the Phoenix Miracle, where output 'rises from its ashes', suggesting that firms should go through a process of financial engineering to restore liquidity outside of the formal credit markets.
So what are the reasons for the underdevelopment of credit markets? And what are the opportunities for hedge funds to participate in the provision of credit outside the formal credit markets?
crisis of confidence
There are many reasons why credit markets in the Latin American region are underdeveloped and why credit is not only scarce but expensive. The causes include economic instability in the region, market structure, lack of legal infrastructure as well as an over-regulated environment.
As a result of the recurrent banking crises in Latin America, credit availability is extremely volatile. For the period 1974-2003, the region has had an average of more than one banking crisis per country, with 35% of the countries being repeat offenders.
Banking crises are very costly and result in the interruption of credit, the payments system and often times a drastic reduction in the value of savings. In addition to the obvious vulnerability of an emerging economy to drastic changes in the international macro environment (including commodities prices, interest rates and contagion effect), banking crisis are caused by two main domestic factors, which are the high dolarisation of banking assets and the high participation of public sector assets in the banks' balance sheets.
Some argue that recent changes in both market structure and the legal and regulatory environment are being driven by the need to strengthen the banking system to make it less vulnerable to economic instability.
However, over the past decade, the banking sector in Latin America has suffered very drastic changes to its market structure due to a high number of banking crises, reforms and privatisations. The concentration of the banking sector has been an international phenomenon, and in the developed world the driver for this concentration has been essentially market driven.
In Latin America, the driver for concentration has been essentially macroeconomic, with the aim of reducing the vulnerability of the banking system. However, this has suffered from heavy state intervention, with 55% of the system's assets held by the top three banks.
The process of concentration is difficult to detach from another important change to the market structure - the internationalisation of the system. Today, more than 60% of private sector credit is granted by international banks.
These two changes to the market structure have had both a positive and negative effect. On the negative side, these changes have affected the credit availability for small to medium-sized companies. This is because of a standardised application process that concentrates on the decision-making process and neglects the information collected by branches on the different subjects of credit.
On the positive side, these changes have led to a more efficient and modern banking system, which has improved the system's stability. Meanwhile, some argue that when there are major crises in the region, international banks tend to exit these markets, exacerbating the negative effect of the crisis, and destabilising the market further.
These changes to the market structure have not been followed by a reduction in the role of the public sector in the banking system. The existence of large dominant public sector institutions affect the competitive process in the system, enhancing the negative effects of concentration and internationalisation.
steps to recovery
Public sector banks are subject to political cycles, with frequent changes to management and objectives that swing from profitability to social framework.
On the regulatory front, most banking systems are governed by a complex web of regulations for minimising the chances of a banking crisis. This over-regulation of the market (maximum interest rates and high minimum reserve requirements) carries a high cost in terms of delaying the development of the credit market.
On the legal front, Latin America has always been feared by creditors because of its weak laws and poor enforcement prospects. Although this continues to be a weak spot, over the past 10 years there have been many improvements in the areas of corporate governance, securities laws and bankruptcy. These are still far from perfect, but are an improvement.
Over the past five years there has also been a substantial credit improvement in most emerging markets, in many cases validated by credit upgrades as seen in financial markets. This has been the result of a combination of fundamental and technical factors.
On the fundamental side, over the past 10 years most of these countries have implemented reforms that have resulted in primary fiscal surpluses, independent central banks disciplined monetary policy, low inflation rates, and flexible exchange rates systems. These, combined with a favourable global environment - evidenced by low interest rates and strong commodities markets - have reversed the flow of capital and made many of these countries net creditors of the world, with current account surpluses.
In Latin America the fundamentals of the credit markets, combined with a more stable macro environment and an improving legal framework, presents a great opportunity for hedge funds looking for returns in an uncrowded space.
There are a number of areas that can be looked at, including export and pre-export financing, A/R discounting with enhancements, leveraged buyout financing, asset-backed lending, mezzanine financing and bridge financing.
Overall, hedge fund strategies in Latin America should move from distress and reorganisations to mergers and financing growth over the next couple of years.
Nevertheless, it is crucial for a company operating in Latin America to have a strong network of contacts and a deep understanding of legal and regulatory systems.
Credit growth hindered by over-regulation and lack of legal framework
Opportunities for hedge funds to participate in the provision of credit outside the formal credit markets
More than 60% of private sector credit is granted by international banks
Hedge fund strategies should focus on mergers and financial growth over next two years
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