The Techniques of Market Access — Federico Sequeda

What does it actually mean to "restructure" debt?  Federico Sequeda, a portfolio manager at Morgan Stanley, discusses the intricacies of default with our CEO Rasheed Griffith. No two restructurings are the same and we get to the bottom of the how and why behind the hard conversations Caribbean governments find themselves in to attempt fiscal correction.

The region is no stranger to default.  A dearth of foreign investment and a glaring lack of projects to invest in may be to blame. Coupled with a faltering reputation due to lapses in accountability and a failure to produce attractive products and services on the international stage, the region finds itself struggling to compete.

Federico argues that the Caribbean should take steps to attract more private foreign investment (FI) such as making more information on the health of the business landscape readily available. He gives some insight into the informal world of "roadshows" and how countries present themselves to be more lucrative to foreign investors.

The governments of the Caribbean find themselves locked out of international lending markets after restructuring because they have abandoned their responsibilities: internally to fiscally course correct, and externally to diversify their sources of funding.
Harmful rhetoric from leaders can also potentially scare off valuable FI.

Join us for an exciting dive into this important reality for the region on this episode of Caribbean Progress.

Recommended Reading
Sovereign Defaults:  The Price of Haircuts by Cruces and Trebesch

Follow the Caribbean Progress Studies Institute on Substack

Transcript

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Federico: In my opinion, frankly, really the only big picture reason to have a pegged currency instead of just full dollarization is if you actually plan to make use of de-pegging that currency. 

Rasheed: Hi, everyone. Today, I am joined by Federico Sequeda. He is an executive director and portfolio manager on the emerging markets team at Morgan Stanley.

We had a frank discussion on the role of foreign private-sector investors in the Caribbean. What they want, what they look for, and how they react to defaults. Federico has been in the room during sovereign default negotiations, and we discussed what can make those difficult conversations more productive for both the foreign creditors and governments. To hone in on some of these points, we took a deep dive into the 2018 default of Barbados, which Federico's portfolio had exposure to. Much of the conversation also focused on the notion of debt sustainability, and how views of the private lenders, who actually have skin in the game, may differ from policymakers and academics.

I plan to have a series of conversations on emerging market debt management and this was a superb kickoff point. So please enjoy my conversation with Federico Sequeda.

Hi Federico. I am very happy to be talking to you again. In person this time, we're here in DC, and I think this is my very first in person podcast. 

Federico: Oh, wow, Rasheed. I am absolutely honored. I love being able to talk to you again. It'll be very exciting. I think you also occupy a really interesting corner of the whole podcasting and think tank universe.

I can't think of a lot of people who do both music and Caribbean history and can put it all together in one episode. So your episode on Calypso, I thought was fantastic. So I'm honored to be here. 

Rasheed: Thanks. I plan to do a lot more of those music policy episodes, they're pretty fun. Just to go into our immediate conversation.

I do think that the idea of private creditor lending in Caribbean is very under discussed, given its relative importance to Caribbean economics. And for our listeners to get a framing, some context for why we're gonna have this conversation, I guess my first question is this. Why would a large foreign investment firm like yours actually want to invest in public bonds in small Caribbean countries?

Federico: That's a good question to start out to really frame the different parts of the discussion. I will answer the question from two different angles. The first angle is maybe the more generic of why would a large firm be interested in investing in the Caribbean period, and the second one is more specific to my circumstances.

When you're looking at the universe of public investment in euro bonds or bonds issued by different countries, the first thing to note is that it's actually really important to know what the index does. So these days, a lot of investing in euro bonds is actually done off of the basis of large asset managers receive an allocation from a client.

A client says, I want to invest, for example, 500 million in emerging market bonds. And then the asset manager manages that money, but they basically start off with an index. And the asset manager, a lot of their allocation decisions are actually going to be based off of what the index is constituted of.

Now the Caribbean is quite small. That is one thing. So to start out with is that the money invested in the Caribbean is probably not going to be all that much just because the index doesn't do that all that much. For very rough context, I think the Caribbean is probably something like less than 5%, maybe less than 4% of the overall universe of emerging market assets.

So it's reasonable to expect that approximately that percentage of money is going to be going into the Caribbean as well. Now, it's also worth noting even further that you don't see investments in the Caribbean sort of pro rata because in order for a country to be in the index, it needs to be above. It needs to have a minimum size.

So if a country issues, for example, a 300 million bond, it's actually not going to go into the index. It normally has to be at least 500 million. So the countries that just barely make that cut off, there's something like Barbados, whereas a country like Grenada, which may have bonds of smaller issue size, are not actually going to make it there.

So that's one thing, just the index, which is interesting when you think about it, because it's basically saying that a lot of the people who are investing money in the Caribbean are doing so for reasons that don't really have a lot to do with the Caribbean. It's just whatever the index says. 

Rasheed: Who compiles the index?

Federico: So the index is compiled by J. P. Morgan. This is at least the one that is the most commonly used. So it's called the J. P. Morgan Emerging Markets Bond Index or MB. And that's the one that the most clients use. There are some other indices, but that's really the overriding one. Now, when it comes more to my specific circumstances and the institution that I represent, when we make investment decisions, we are aware of what the benchmark has of what the index has, but we don't let that drive our investment decisions.

The reason why we don't do that is basically because we don't really think that we should be allocating our money purely on the basis of what are the available bonds out there and make some allocation that represents the universe of bonds. There's probably lots of countries that are great investments where you should invest a lot more than whatever the index says, and some countries that may be large in the index, but aren't good investments, and so you wouldn't want to invest in them at all. So the main thing that we're looking at is actually the quality of policy going forward. And what we want to do is we want to identify those countries where we think that over the medium term, so call it over the next five years, we think that the quality of policy is improving.

So it may not be very good today, but as long as it's getting better, we think that's actually a place where you should place your capital. And then the converse is that we want to avoid those places where we think that policy is getting worse. So even if policy in the country is good, but it's getting worse over time, then we think that's a place where you actually don't want to be putting our capital.

Maybe the last thing they'll add here, but of course, there's a lot more that we could dive into this question is we and I personally like to look at places where I feel that other people aren't looking that much. And I say that because in the world of asset management, you have a lot of very smart, very hardworking people who are all trying to find the best investments.

And frankly, I don't want to be competing with all the smartest people. I'd rather try to look at a place or at set of countries where I feel like people might not be looking at that much. And I think one of those regions is the Caribbean because they're so small. And because people frankly just don't talk about it all that much. I think that's an area where it's worth spending my time on. 

Rasheed: You mentioned the idea of quality of policy, but what aspects of policy are you concerned with? 

Federico: The quality of policy question is a really important one. So I'm glad that you bring that up. It encompasses a number of things. I'll focus on two of them.

So one is the quality of the business environment. And when you think about this is really what is going to generate a lot of long term growth. When you think about long-term growth, I think what you want to see is a lot of investment. A lot of investment, and we can get into this. It ultimately is coming from the private sector.

What you want to have is an environment that is hospitable to private capital so that you can have a lot of private capital so that you can have a lot of investment, which is gonna generate a lot of growth. That will generate a lot of jobs. Hopefully, that will also generate a lot of stability, which leads to social stability, political stability, and that's a very positive self-reinforcing cycle.

That's one thing, the business environment. The second thing, which I think is much more specific to Euro bond investing to lending money to other countries, is you want to have a predictable fiscal policy that is also planning for the long term and not just planning, let's say, for the next election cycle.

So we want to see countries that run relatively manageable deficits and also importantly, that have plans to be able to finance that deficit and that are able also to have not just the plan A: "what do we expect to happen next year? And we're ready for that" but also who can say, "but if this thing happens, which is negative, this is our plan B and there's a plan C and a plan D."

So that sort of policy predictability in the business environment is very important as well as more specifically on the fiscal policy side. 

Rasheed: On a more granular level, how do you actually assess the quality of the policy? Given that Caribbean countries don't necessarily have the best past dependence when it comes to fiscal prioritization of fiscal planning.

Federico: This is also a very important topic. The way that I think about it is authentically every country is its own unique snowflake. And so you really have to dive into the details of every country. It's somewhat similar to stereotypically Warren Buffett.

Whenever he makes an investment in a company, he doesn't just understand the balance sheet. He doesn't have just one metric that he looks at and then he makes a decision that he understands the balance sheet. He understands the income statement. He knows the history of the CEO. He knows how often the CEO plays golf on the weekend and with whom, who the former employees are, whether or not they are disgruntled or whether they were happy.

And this is something that we try to do as well. We'll try to understand the history of the country, not just over the last five years, but longer than that, because I think that gives you a sense of what sort of drives policy in that country. For example, in the Caribbean, if you look at the history of the Caribbean, you understand why they value their pegs so much and why they are extremely unlikely to do something that is going to result in a de-pegging, or at least they were at least try to fight that very hard.

Rasheed: At least in Barbados.

Federico: Correct. Yes, at least in Barbados. Now, the other things that we'll look at. So there are some indices that we look at that we think are good. Economic freedom of the world from the Fraser Institute is a fairly good one, but it's relatively lagged. So I think if you look at it today, you probably only have the results for 2021 or so.

But then what we do too is since we talked about the business environment, right, we go to the country and we meet with a lot of people, including the private sector, including think tanks, including academics. And we asked them, how is the business environment here? The reason we do that and the reason why it's this very at times qualitative process is because we know that you can't generalize a lot.

If you're looking at the Caribbean, I think it's very important to understand what tourism looks like. That is a major, a driver of foreign exchange earnings. If you look at an oil producing country, you might actually really be interested in what the oil producing companies in those countries look like.

A lot of it is again, trying to understand the history, which I think explains the present and the future. And then also you have to travel to the country and meet and just talk to a lot of different people. 

Rasheed: How often do you do a travel visit? Because if something can break down in five years, for example.

Federico: So I did this math recently. The emerging markets team, we have about almost 40 people or so. And just the research and investment side of that is a good 15 people or so. We probably do a year, a total of 100 to 130 country visits. 

Rasheed: Quite a lot. 

Federico: Yeah. Now it's not, of course, 130 different countries each year.

That's a little bit larger than the number of investable countries that we have. But we do have at least that number of different country visits. So there are some countries where we might actually go three times per year.

Rasheed: So earlier you mentioned that the emerging market index does not take into consideration offerings below 500 million, say, and in the Caribbean, most countries do not issue over that amount. Can you walk me through your mental model for how to decide to allocate to a country where the offering does not appear in the index?

Federico: What we will do in this case is we will be aware that this bond is not going to be in the index. Because of that, we don't Take any direct action. We try to not let the index dictate what our investment decisions are going to be. That being said, we do recognize then that the bond is going to trade in a little bit of a different way.

If we ever want to sell that bond in the future, it's likely going to be a bond that is more difficult to sell. And because of that, Essentially, we're going to demand a little bit of a higher premium. Maybe let's say that there is a bond that we thought would be interested with more liquidity at, say, an 8 percent yield.

If we know that it's not going to have that much liquidity because it's not in the index, then we might say maybe we need a 9% yield or something that is a little bit higher. That being said, again, I think it's really important to note, we don't let the index dictate what we do and what we don't do because there are some cases where we'll find that there's actually opportunities in these smaller size bonds. Now I will use the opportunity that you gave here. I think it's important for countries, frankly, to understand the way that the market works for their bonds. Because when I'm saying, "Hey, if you're not in the index, I'm going to only buy your bonds if there is a higher yield", the country should immediately say, "Hey, we should try to issue bonds such that there are index eligible so that we have lower yields." Any debt management unit, any ministry of finance in a country should understand the environment under which their bonds trade and should try to structure things so that they pay the least amount of financing cost possible.

Rasheed: Do you find that the country issuers tend to understand that point, or is it a matter of, let's say they would say, we really don't need that extra money. It seems unlikely that would be a rationalization, but they do say that. Is there a reason why they tend to under issue to be outside the index? Or should I ask a different way, is that besides the actual amount of money or bond value being issued, are they not eligible for the index for other structural reasons? 

Federico: As you correctly say, there are times where simply a 500 million issuance for a country that is not that large is just too much money. And ergo, it's probably right that they issue something much smaller because some countries probably don't have good uses of 500 million, at least not all at once.

Outside of that, I think sometimes... For some countries, they may find it a little bit challenging to deal with a larger issuance purely because of the additional what we call roadshow and other sort of information sharing requirements that there are. If a country is going to issue a relatively small bond, and by the way, if they issue a small bond, they might actually structure it as a loan because loans by their nature are designed to be less liquid instruments that can be more bespoke, where the different lenders can be much more specialized in the credit and not depend on having other investors who they can later sell to. But so if a country wants to issue a large bond, so call it 500 million or more, it's quite common that they should make an investor roadshow to different financial capitals. Normally you would have a minister of finance, the head of the debt management unit perhaps the governor of the central bank, maybe one or two more advisors. And they would traveled to New York. They would spend a whole day in New York. They would meet with as many institutions as possible. They would travel to London. They would do the same. They might travel to some other places. They might go to California.

And when they do that, they're going to be meeting with investors who have met with many different issuers in the past who are going to ask a lot of very complicated questions and who are going to recognize probably when the answer that they're given is not really the answer and rather there's something else being covered up. That can be frankly a difficult process to do.

And so if a government thinks that they don't really have all the human resources to be able to prepare for that roadshow, then that might be another reason why they don't do it. 

Rasheed: So during that roadshow, what kind of difficult questions would an investor ask? 

Federico: Whenever a country presents to you their fiscal plan, they rarely present a fiscal plan that has deficits increasing or has deficits remaining at a very high level.

But it is not uncommon, unfortunately, especially now, to have a number of countries that have had fiscal deficits increasing for a number of years or fiscal deficits remaining at relatively high levels. And so a classic question is simply, okay, if you're telling me that your fiscal deficit is going to contract over the next three years, just tell me why and what's different than what has happened over the last five years to explain that.

And it can oftentimes be very difficult for a government official to give a credible answer to that question because the political dynamics that determined the desire to have that large fiscal deficit are probably still there. And so these are the sorts of things which investors really seize on and then they'll be quite skeptical and then ask a number of other follow on questions.

That's definitely one type of question. There's a credibility one. The second one. Which I think will be more common with some of the smaller countries will be why don't we have that information readily available. With a number of countries, certainly in the Caribbean, but in other places too, the issue is not specific to the Caribbean. Countries don't publish their data in a very timely fashion.

And sometimes they don't publish it at all, or sometimes it's even irregular. It would really be beneficial, I think, to the country's financing costs so the country would be able to issue at lower rates. Frankly, it would be, I think, also the right thing to do for the citizens of that country to have information on what your government is spending its money on and to have that also in a relatively timely fashion. But a lot of countries don't unfortunately do that very well. 

Rasheed: So in the instances where a country would have irregular data and you still invest in that country, what is the delta that still make you confident to invest in country? 

Federico: We would normally have a lot less confidence in investing in a country where we don't have that data.

What we would have to do is essentially triangulate that data with other sources and a lot of it is, again, country visits. So when we spend those 130 country visits, a lot of them are going to be meeting with people in the ministry of finance, meeting with think tanks, meeting with academics, meeting with all sorts of people who can give us a sense of what's actually going on the fiscal front.

But what I would, one message that I would try to send though to anybody from a debt management unit or a financial planning office is you really don't want your investors to have to do that, even if your investors are happy to do that, and investors love traveling this I think one of the most fantastic parts of my job is that I actually get to travel to all of these countries and talk to different people.

But you don't want your investors to have to do that. If your investors have to do that, they will attach a premium to investing in your country's bonds because they just can't be that certain about what that information is. I'll tell a story here. An example. So Bahamas used to have a problem with not releasing a lot of its fiscal data, they actually hired an advisor and that advisor helped produce monthly reports on all of their fiscal data, income, expenditure, debt ratios.

It was all published very clearly on a website without delay. Investors really like that. This was actually chatter in the market. "Oh my God. Have you seen Bahamas? A fiscal accounts and fiscal reports." Investors sometimes get excited about things, of course, that other people wouldn't. And that was authentically, I think, a good thing for Bahamas.

And I genuinely believe that other investors started to look at the Bahamas because they realize, Hey, we have this timely data. That's actually really great. Let me take a look. 

Rasheed: So when you say you have less confidence in a particular market because of the data issue, I would assume that means less exposure.

Federico: Absolutely, yes.

Rasheed: The Jamaican Ministry of Finance announced this week that they issued an international bond priced in Jamaican dollars linked to USD. That is, the bond is officially priced in Jamaican dollars, but bond holders are repaid US dollars based on the 10 day rolling average of the Jamaican D-USD exchange rate.

And this made a very big splash in the news. Now there is a lot of discussion about local currency denominated bonds in the Caribbean, or mostly emerging economies, and they are very aggravated by the fact that why should foreign investors want a USD bond or some other foreign currency, but usually USD.

So from your perspective, why would you a US investor want a USD bond? 

Federico: An investor, a foreign investor that is investing in a country is ultimately interested in goods and services of that foreign country, and you can think about this as a very basic way, right? So if I'm investing and let's say Jamaica, but I'm a US-based investor, all of my liabilities are really more attached to the United States, or at least to some other country that is unlikely to primarily be Jamaica. Jamaica is a fantastic destination. You may want to go there on a lot of tourist trips and that would be fantastic, but that's not really where you're looking to spend the bulk of your money.

Ergo, whenever you have an investment, you're interested in an investment that will pay you in a stream of money that will allow you to fulfill those liabilities. And so that's basically just not a currency or it's not something that would only allow you to get goods and services from Jamaica. So foreign investors, they want to ultimately have some sort of call on foreign currency, which is different oftentimes for local investors, even though, and again, you see this in the Caribbean, a lot of what is consumed locally is actually imported or at least has a very large import content.

So even then you can't just entirely rely on domestic currency. You know that you need to be able to convert that domestic currency into something foreign. There's a couple of important points here. Important practical points. One is when a country is looking to borrow from abroad or to get foreign investors into its country for a particular project, they should really be thinking about how the way that they use that money, the way that the investment plays out is able to generate foreign currency that can then be used to pay off the foreign investor.

This is, I think, why you see a lot of investors who are interested in equity stakes in a specific country, they're primarily interested in companies that can export, because that immediately provides a way that they can get repaid. So if you think about hotels in the Caribbean, or you think about commodity exporters. That does not preclude foreign investors from doing things like building roads or building infrastructure that can be very useful for a country that may be a public good that can help grease the wheels of the economy. But you just have to realize, though, that the foreign investor is going to want to be able to take their money out, even if it's only after a very long period of time.

And when that happens, there is going to be a drain on the balance of payments. And again, that's not intrinsically a negative thing or something to be avoided at all costs, but that is something that the government should plan for. If somebody is going to be doing an investment that is largely producing domestic rewards, then there will be that balance of payments drain.

Now, just to go back to the Jamaican dollar. Yes. So I saw that announcement as well. And this was an investment that was talked about quite a bit. And I would say that it's quite impressive that Jamaica can actually attract foreign investors that are going to have at least their cash flows be dependent on the Jamaican dollar.

I think that is actually a very strong signal of confidence in the Jamaican economy. And again, in the policy of the government more broadly, there's like very technical reasons why investors actually have to get paid in dollars, which I'm happy to discuss. But I do think that investment is just a sign of confidence in the Jamaican economy.

Rasheed: What are those technical reasons why they have to be paid in USD? 

Federico: So foreign investors, in order to be able to be paid in JMD, in Jamaican dollars, they actually need to have an account that is set up to receive Jamaican dollars. That is a surprisingly difficult thing to do. That is not the case for every single currency.

Foreign investors, if they want to get paid in euros or if they want to get paid in pounds, it's actually fairly easy to open up an account so that they can get paid in those currencies. Countries that have a lot of capital controls for capital control reasons try to make it difficult for people to open up accounts that allow them to trade their currency. And so that's essentially one important thing that is going on in the case of Jamaica. It would probably be difficult for, I think, an investor to directly receive Jamaican dollars and then sell those Jamaican dollars in exchange for US dollars. 

Rasheed: If bondholders still demand to be paid in USD, and Jamaica knows that they need to be paid in USD, then why issue the bond in JMD in the first place?

Federico: From the perspective of the debtor country, I actually understand that quite a bit. You can think about... debt as a contract, and the terms of that contract cannot change. If you really want to increase your credit-worthiness and you want to make sure that you have very sustainable debt, you would really like the debt payments to not become more onerous when you are in trouble.

Now, when a country is in trouble, their currency tends to depreciate, and I'm thinking here about, of course, a country with a flexible currency or at least a semi flexible currency. So if the country is earning primarily In domestic currency, so the government is getting a lot of tax revenue and it owes foreigners dollars, it still owes foreigners the exact same amount of dollars, even if their currency depreciates a lot and their tax revenue is worth a lot less in dollars.

In other words, the risk of currency fluctuations is shifted over to the government. In the case of Jamaica and Jamaica borrowing in Jamaican dollars, the currency risk is essentially shifted. Right now, if Jamaica were to have some crisis at some point in the future, and you see some meaningful currency depreciation, for the Jamaican government, it frankly makes very little difference.

They made a promise to repay Jamaican dollars, even if they have to translate that into US dollars, and the ones who are left holding the bag, in other words, the ones who are left with the currency risk, were actually the foreign investors. 

Rasheed: Now this does dovetail into a conversation we've been back and forth on for a while now, which is about the dollarization process.

So Jamaica's going through all of these loops just to maintain the JMD but also to pay back holders of the bonds in USD. And this is a similar consideration across the Caribbean, but this does bring the point of why do the Caribbean countries maintain domestic currency in the first place? All the foreign producers, foreign buyers need to be paid in USD, and they always have to use USD to input anything into the country.

If countries did not have the currency risk, which means they did not have exchange rate risk, and therefore that means they don't have the balance of payments risk, which translates to less monetary crises and of course that means more fiscal credibility. Would that have a higher dimensional structural fiscal credibility from your view from portfolio allocation?

Federico: You're opening up a really great point in this dollarization discussion. And in prior episodes, also, I think done a really useful service of pointing out that a pegged currency is not the same thing as full dollarization. Even though way too many people these days talk about these things as if they were interchangeable.

In my opinion, frankly, really the only big picture reason to have a pegged currency instead of just full dollarization is if you actually plan to make use of de-pegging that currency. That may actually be something that the government wishes to do. The government says, "no, we don't plan on doing this. We really don't plan on doing this," but behind closed doors, they say, "if things ever really get that bad, we know that we can print money."

Unfortunately, we know that this is something that took place in Barbados. If a country, though, authentically says we really want to stay on peg to this currency for forever, it makes actually quite a bit of sense to just fully bite the bullet dollarize and no longer have to have this potential risk overhang of saying, "Hey, maybe this currency would be devalued at some point in the future."

I will also add, and I think this is what you were implying as well. It actually will impose a little bit more fiscal constraint on the government because there will be no central bank or at least no central bank that can print money directly to be able to finance the government's deficit so there's gonna be more of a fiscal straightjacket there and depending on your views on fiscal policy, that may be a good thing.

Rasheed: One of the inevitable results of having Caribbean currencies is that they often end up in balance of payments crises, which inevitably end up into some kind of bond default, particularly to foreign investors. And this has happened time and time and time again. So from your perspective of a foreign investor, what happens when a country says, "Hey, I cannot make any payments on the interest or even the principal", but particularly the interest from your perspective, what happens when this scenario pops up?

Federico: This is a difficult situation for a bond investor, but I also think it is a situation that a bond investor needs to plan for the moment when things go very poorly. I'll tell you the way that I think it should ideally work, but then also talk a little bit about how sometimes it does not work. Process here is really important.

It's impossible to determine ex ante what the outcome should be, but I do think that we can talk about what the process should be. The process should generally be, as the country finds itself in difficulties and sees that there's more and more problems coming, the government should be in contact with its creditors to see if there is some sort of solution that can be found.

Maybe there's something that can be done before the really bad moment arrives. Maybe there's some liability management operation that can be done on market voluntary terms, but let's say that no, we crossed that moment it's really not possible. I think at this moment it's good for the government to hire advisors.

Advisors in this case are actually extremely useful because the government will have to have a number of complicated conversations with other entities, managed a lot of different processes. The government should try to come up with a reform program that is its own. This program should really tackle all the issues that led to the problem.

We can talk about this more, but I think oftentimes the debt restructuring in of itself is framed as the problem. I do think that it becomes a big problem and it can have a lot of negative societal effects, but it's mostly just the consequence, the symptoms of some other deeper problems that have to do with fiscal policy, the government should then take this homegrown program to an institution that will provide credibility to its reform program. Normally these days it's International Monetary Fund. And this institution should also be able to provide financing to the country and basically help get some more financing for the country. Because in this case, since the country is defaulting on its debt, it's unlikely to be able to raise money from any other market participants.

During this process, the government should also be sharing a lot of information with its creditors. The sharing and the information transparency is really key. And it should be with all of its creditors, not just its so called official sector creditors, so when governments lend to governments, but also with its commercial creditors. And then as the government gets its program approved, it should then really move to engage with its commercial creditors.

And when I say engage, I mean, it's actually a honest one-on-one conversation about, okay, what is it that we can offer you? What is it that you need? How do we meet in the middle? Not the sort of negotiation where one side comes and has these three talking points and repeats the three talking points over and over again.

Rasheed: Are there any good examples of this more open, transparent style of negotiation?

Federico: An example of this that I think worked out very well was Uruguay in the mid 2000s. Uruguay, this was right after the Argentine crisis found, itself in problems, was unable to repay its debt, but they were very serious that they wanted to tackle all the issues that they had.

They talked to their creditors, they got to a consensual restructuring relatively quickly. It did not result in large losses for creditors, but, and importantly, it also resulted in the country regaining market access, I think very quickly. One of the fastest restructurings and the fastest regaining of market access for the country, which I think is extremely important.

Happy to talk more about the market access point as well. One of the processes which is not that good is maybe if you just stay in that same vicinity and you look at Argentina in 2005. This was a country that essentially declared a moratorium on his external debt for a long period of time, didn't really have any sort of plan for addressing the difficulties, didn't even try to engage a lot of the international financial institutions until much later.

And then when they finally engaged with creditors, it was in a very unilateral take it or leave it type mode. It took them basically 11 years or so to restructure their debt. And when they did, it came at a great cost to their credibility, to their ability to raise financing, and that's the opposite of what you should be doing.

Rasheed: You mentioned the term ex ante default. How close are you as the foreign investor in monitoring potential of a country's default before they even come to you and say, "Hey, oh, we have a problem?" 

Federico: We're extremely close. This is essentially our primary job. When we make the decision to invest in a given country, that investment decision does not stop there.

But essentially every day we wake up and to oversimplify, we ask ourselves, do we still want to make this investment decision? So we, in some sense, mentally start the portfolio from scratch every single day. We may have allocated capital to, say, 40 different countries. And every single day we ask ourselves the question "today, if we started a portfolio from zero, would we want to allocate our capital to those same 40 different countries?" Now, of course, it's not that simple to do. You can't really sell an investment in a very short period of time, but this is the way that we're approaching things. In terms of different metrics to look at when we're thinking about getting closer to the possibility of default and ideally we would like to be very far ahead of identifying that it's in some sense, the same variables that would lead us to make a decision to invest in the country, but just the opposite. So if we see that policy quality is really deteriorating, and that might be because of an election that might also, frankly, it might be that we had a perception that policy quality was going to improve and it turns out to not be correct.

This happens all the time as well. And it may have been that your initial perception was wrong. And at that point, the only right thing to do is to admit that was a mistake and move on. You shouldn't focus. too much on the fact that you already made a decision yesterday. You don't want to get stuck in your old ways.

And then you were also looking at fiscal policy for a number of countries. Maybe the one variable that you might be looking at is, and I think Dr. Worrell would probably say this as well. You want to look at reserves. Reserves, because again, this represents, in some sense, the size of the bank account that the government can use to pay back foreign investors, because foreign investors are interested primarily in foreign currency.

When that is starting to decline rapidly, and when it's also at a relatively low level, then you know that is a moment of danger. At times, that may already be priced in. You may have realized that when it's too late, but that's definitely a good metric to look at.

Rasheed: In 2018 Barbados defaulted. I know that your portfolio at the time had exposure to Barbados and you were very active in the default and restructuring negotiations. I want to use this as a kind of case study in trying to figure out the mechanics of how these situations play out. I guess to start, we have to contextualize the reason for the default. So then my question is, what happened in Barbados that default was the decided route that the administration chose? 

Federico: The case of Barbados is one where I spent a lot of my time on, so it's a case I'm very happy to talk about. The case of Barbados is somewhat controversial because of some of the things that they did as part of their restructuring or their moratorium or their comprehensive default.

There is a variety of terms that they used. As you, I'm sure, remember very well, this happened on the heels of now Prime Minister Motley winning in a landslide election. The market was considering that Prime Minister Motley was going to bring about an improvement in government policy. The prior government had tried to make some adjustments to the fiscal accounts, but it was not doing it very well.

A lot of the adjustments were done simply by running arrears, in other words, by simply not paying people or not paying for goods and services that had already been rendered. Reserves had been falling, and if you look at the statements, the public statements made by the government right during the moratorium, as well as afterwards, they said that the main reason that they defaulted on the debt was actually to preserve reserves and ergo to preserve the peg.

That's at least the kind of the face value reason that the government gives. Now, the reason why I think it was controversial is because if you travel to the country and you met with, say, banks and other institutions right before that election, there was already a bit of a plan in place. There was discussion over the size of the local debt, and frankly, part of this was a result of just the large fiscal deficits that were running before, but also the associated money printing from the central bank that resulted essentially in financial institutions being forced to buy that debt, and there is thought that maybe there can be some sort of very large liability management operation that could be done domestically and that you could have some sort of liability management operation as well on the external side. Debt to GDP at the time was quite high in Barbados.

It's surprisingly difficult to measure debt to GDP because you have a number of entities that hold debt. And it's not exactly clear how you count or how you consolidate. But I think today they would have said it's probably 160% of GDP at that time. The vast majority of that was domestic. So I think a bit more than 100 percentage points of GDP.

And so the external debt was a lot smaller. And then if you look at the commercial external debt, that was much smaller as well. So the thought was we can have some sort of liability management on the domestic side and on the external side that may be possible to, but it can be a what you would call like a relatively market friendly one, not one that was a unilateral moratorium as it took place.

The second reason why it's somewhat controversial is that most of the time these days, when a country decides to restructure its external debt, they actually restructure all external debt, at least all bilateral, so official sector and commercial debt, not multilateral debt for reasons that we can get into later.

But Barbados took the decision to only restructure the commercial debt and none of the bilateral debt, which then made some of the negotiations a little bit more contentious, if you will say, on the commercial side. 

Rasheed: Okay, why exactly was it more contentious? 

Federico: Here we have to get into the way that the IMF plays a role in this whole process. And this goes back to the point that I was making about process and outcome. So I think process should be pretty clear, the process should always be followed. The outcome itself cannot really be mandated in an ex ante way. And the part that was contentious here or that led to that contention was the IMF DSA.

So the IMF runs a debt sustainability analysis. A debt sustainability analysis, and I'll save you all of the fancy math is essentially a way to just forecast what debt ratios are going to be far into the future, say 15 years out. And then the IMF will make a judgment on whether or not the debt is sustainable.

The IMF took a very concrete view in the case of Barbados that debt to GDP had to reach 60 percent 15 years out. Now, forecasting debt to GDP next year is pretty difficult. Forecasting debt to GDP three years out is essentially impossible. Forecasting debt to GDP 15 years out, I believe Lee Buchheit has called that an exercise in cult divination, it's really something that can't be done with any sort of certainty.

But when we were having these conversations, it was all framed as we need to be able to reach this number. This becomes more contentious because when you don't restructure the external bilateral debt, that basically leaves a greater burden on the external commercial debt. So if all the holders of debt restructure their holdings, then no holder has to restructure as much as if you only restructure a certain class of holders. And this is one other additional contention. So the fact that the IMF says 60 percent needs to be 60, not 60.5, not 60.3 and the fact that number essentially does not get distributed among all creditors, but some creditors get excluded.

Rasheed: And to add clarity, what exactly do you mean by restructure in this case? 

Federico: Restructure, it's the technical term for changing the contract of what the debt claim is owed. So instead of saying, hey, I owe you 100 cents on the dollar 10 years out at a 6% interest rate, restructuring would mean a combination of, I'm not going to pay you 100 cents, maybe I'll only pay you 70.

It may also mean a combination of, I'm not going to pay you in 10 years, I'll pay you in 15. And also, I'm not going to pay you 6%, I'll pay you only 3%. 

Rasheed: Is it usually the fact that you pay less money or is it often just push back the payment schedule? 

Federico: Very good question. So the terminology restructure means you pay less. Restructuring is generally a contentious subject because it means clearly that the creditor is losing some money relative to what was promised. Another term is called a reprofiling. Reprofiling is a more market friendly one. And I think at the beginning of this process, there was probably an opportunity for Barbados to have reprofiled its debt because they did have some debt payments that were coming due in the short term.

And those debt payments could have been pushed off a number of years. So that is what is called a reprofiling. Reprofiling is oftentimes a term that is used in conjunction with a liability management operation to liability management operation. Again, it's just saying, instead of you paying me back my principal tomorrow, why don't you pay me back in five years? And we can discuss at what interest rate that would be.

Rasheed: So back to the IMF decision making there in this conversation. Many times I've discussed the IMF with people they always say that I don't understand why they would do this. So why would they do this? That is the question all of again, because if I have a conversation with devaluation modeling, there is no rational reason that a model could show that devaluation is an improvement, but it's still pushed for devaluation, a side topic.

In this case, as you mentioned, the idea of forecasting out 15 years, this idea is pretty absurd. So how was it that this was part of a serious conversation? 

Federico: Let me try to give you, I think, what the IMF response would be to because I would like to be entirely fair to the IMF. I think the IMF does have a lot of very smart people, very well intentioned people so I want to be entirely fair to them. The IMF would say we actually aren't trying to get involved in your restructuring whatsoever. However, the country is asking to borrow money from us. And since the country is looking to borrow money from us, it is our prerogative to say under which conditions we would lend them this money.

And we would feel comfortable lending money to Barbados if they are able to achieve these targets, one of which is a target of 60 percent debt to GDP 15 years out. They say, this makes me feel comfortable. This makes me think that the country can repay me. And then they say, I'm not saying that this has to have implications for the creditors, I'm just saying this is what is going to make me comfortable now. In practice, because the IMF is managing this whole process and because the IMF is providing the stamp of approval to the reform program that the country has, it inevitably becomes this International Monetary Fund debt sustainability analysis, a very important part for the debt restructuring negotiation, which is solely between the government and its creditors.

So even though the IMF says we have nothing to do with the negotiation in practice they have a lot to do with the negotiation, because they are, in some sense, the gatekeepers to financing for the government. And because the government needs that financing, the government is willing to take the conditions of the IMF as not exactly set in stone, because they do think that those conditions get negotiated somewhat, but close to set in stone.

Now, why does the IMF come up with these numbers anyways? This is another very important point. They actually have a lot of empirical work on this, which is why I think I may have my differences with the IMF, but I think when you talk to them, you're talking to people who came to their viewpoints using reason and logic.

The issue is that they'll tend to look at a very broad swath of countries. So oftentimes they have models that say, we think that this debt to GDP level is sustainable in conjunction with this gross financing needs to GDP metric and other metrics as well. And they will basically run like very large historical regressions saying which countries run into stress levels when they have these levels of debt to GDP.

But it's then hard to take the results of that model. And as you may know, any model has huge uncertainty bands associated with it. And to say, okay, the results of this model are going to hold for one very specific country. And again, I want to be fair to the IMF, the IMF. always talks about their use of judgment, so they're never going to use the outcome of a model specifically, but I do think that their ultimate targets are heavily influenced by the use of that model, and it's still hard for the IMF being this institution that looks at countries all around the world to like really understand this other set of countries, which is not going to really be well represented by countries as a whole.

Rasheed: Inevitably, the IMF has the same problem as medicine, where in medicine, ideally, the most accurate model is n equals one. But of course, you can't really do clinical practice based on n equals one models. So when you're doing medical testing, there has to be a generalization based on some statistical group.

Now, the actual doctor needs to take that information and hone in on a particular patient for a particular need, if not, things go awry quite quickly. So, in the IMF case, debt restructuring, fiscal prioritization, things really truly are n equals one, but they try too hard to do generalization. And that's where the good policy, in practice, can't really have that generalization, but they do it anyway, without really being, let's say, the good doctor of trying to hone in on a particular patient.

Federico: I love that comparison of doctors to the IMF because I think it's absolutely spot on. Anybody who has spent a lot of time with doctors and because I've had two kids recently, they get sick all the time. I go there and I love reading and I'm a bit of a math nerd at heart. So I actually like to read the actual medical papers.

So when I walk in there, I know what the recommendation is going to be. But then I also know what the uncertainty is. And it's really great when you have a doctor that understands all the particulars, yeah, maybe your kid meets these symptoms, but we also know that these are the specific things that are going on, so it's probably fine.

Or no, it's probably really not fine because we know that these things have been going on. Just to give you some examples here on the debt restructuring front about why this problem is. And again, I'd love to frame it in the terms of process and outcomes. I think the process can be more or less the same for every single country, but not the outcome.

I truly think that every single restructuring is different. It's its own unique snowflake. And just picking a few off the top of my head. So you have Barbados restructuring was, I think, the cumulative result of a lot of policy mismanagement with the specific decision made that we want to have a comprehensive restructuring, not counting a bilateral debt, but otherwise comprehensive at that point in time.

But the future looks reasonable and okay, and nothing specific or very different going on. Contrast that with Suriname. Suriname also had policy mismanagement, but they also have a lot of oil money that is going to be coming over the next 5 to 15 years, like a transformational amount of oil money where they actually see themselves as "we're in a really strong position we just need a bridge to get there." Contrast that with Ukraine today, where it wasn't really policy mismanagement that got them where they are it was a war. And in the future, they're going to need a lot of money, not just public sector money, but private sector money to rebuild that whole country. And is there a DSA that can tell me what to do with numbers in Barbados, in Suriname, in Ukraine?

I authentically don't believe so. I think we need to approach all of these cases with a very similar process. But then as you laid it out very well, the doctor needs to look at the nuances of each situation and recommend a treatment that's appropriate for that specific patient. 

Rasheed: In the case of this restructuring, was there any room for negotiation on the commercial credit side? Or was it really just a, hey, this is what we are willing to do, we can't really do anything else? Yes or no, that's good, but was that the case? 

Federico: There was definitely room for negotiation on the commercial credit side. One thing that we have to be very practical with in a restructuring is just recognizing that it's a bad situation and in a bad situation, we may wish that situation didn't exist, but we are where we are and we have to make the best of it as I think in any negotiation, though, you really have to understand the other side, because if we have a disagreement, we and then I just keep on trying to ram at you with my exact same argument I don't think that we're really going to make a lot of progress. In the case of Barbados, some of the progress that we were able to make was by really understanding what the government wanted. In most restructurings, governments see themselves as not having a lot of payment capacity today, but having more payment capacity in the future.

So on the commercial creditor side, we generally said our proposals for restructuring the debt is going to involve debt payments that are weighted further into the future than in the near term. But we had a couple of very useful conversations with the government where they said, no, really, what we care about is achieving that debt to GDP target.

The way that the math works without getting into the details is that if you really care about your debt to GDP target, you actually want to make debt payments. Today, making debt payments afterwards won't really help you reduce your debt all that much. And the government's reserve situation had improved significantly.

In my opinion, it had already been improving even prior to the default, and that improvement continued. And so the government said, okay, we're willing to make payments earlier. We as creditors, because of the time value of money, would rather have a dollar today than a dollar in five years. And so this was something that helped bridge that gap.

Rasheed: Back in 2018, When the Barbados government had announced they're going to default on the debt. Of course, the actual term was not default. But I remember the government affirming it as such a, almost like a revolution in some ways. And there was a particular quote from the Prime Minister that I will use now.

To quote, she said, "Today, my friends, we pry off the hands that have been strangling us" referring to the foreign investors that lended money to Barbados. So I'm wondering if this kind of rhetoric reduces your willingness to invest more money in the country going forward. 

Federico: In a nutshell, yes. Foreign investors are, or should be, relatively clever when trying to understand if certain statements are made for a domestic audience or not.

This is sort of part of the game, knowing that politics are important and that certain statements are made for domestic constituencies, not necessarily for foreign investors. And again, this is not an issue that is specific to the government or to the governments of the Caribbean. But I do think in general, yes, if you treat foreign investors worse, then they're not going to come as much.

By the way, there is actually a lot of academic literature on this. So, there's a paper, a fantastic title called "the Price of Haircuts", uh, written by Cruces and Trebesch, if I'm not mistaken. And they essentially look at what happens to countries that get haircuts from their creditors that are larger than what is actually needed.

And the empirical evidence that they show is that those countries that impose larger haircuts, afterwards they have to pay higher financing costs. It also takes them a longer time to reaccess markets. And I believe the ratings are also hurt as a result. I may be misremembering that last point. So it is something that I think is detrimental.

Beyond that, there's also a lot of literature on preemptive defaults versus, sorry, I should say preemptive restructurings. So these are restructurings like what Uruguay did in 2005 where they really say before things get really bad and we just say we're not going to pay, we talk to our creditors. And there are papers that compare what those situations look like to other situations where the country just stops paying and actually enters into a full fledged default.

And what you find as well is that the outcome of the countries that engage in preemptive restructurings is far better than the ones where they engage in post-default restructurings. And that's far better for everyone involved. So the country's economic losses are a lot less and the recovery secretaries are also better.

This is why I think that even though today we see this in the media, we see this on social media, on all sorts of media. Sometimes this framing of foreign investors or even just private sector businesses as like taking something away from somebody, I really don't view it that way. I authentically view it as we can grow the size of the pie significantly.

And by just growing the size of the pie, everybody can have a larger slice of the pie. And that is, in my opinion, it's actually like the history of the world over the last many several thousands of years. Of course, Doesn't mean that everything is better every single year and necessarily every single decade, but by having a lot of private sector investment in your country, like your country will grow, there will be more jobs, there will be more social stability, there will be more political stability, and that will lead to lower financing costs, which will eventually actually lead to your foreign investors getting paid less, but for entirely good reasons. It's because your creditworthiness is so high, and I think that's what we should be striving towards. 

Rasheed: The idea of market access, you've mentioned it a few times in the conversation, and we're seeing in the Caribbean, the problem that comes when you do such a harsh default, you now have much less market access, and you see it almost, in some ways, a bit implicitly, for example, right now, in terms of Barbados, the Prime Minister is doing her own roadshow, as it were, on the international forum, talking about climate finance.

That is the new term, that's the case now. It's always framed as the Caribbean cannot access the required financing to improve the infrastructure of the country. And when I hear that, I'm like, this is a surprise to me because the Caribbean is very small. They don't need that much money to fix the roads, the houses and so on.

Why can't you access the money? It doesn't seem like you need some new financial product or some new financial organization to do it, or some like green bond or blue bond or so on. It seems that you just don't have the correct credibility that investors want to invest in your country, or you don't actually have the amount of quality products or projects that people want to put money in.

What's your view on this new idea of the lack of climate financing for small global economies? 

Federico: Climate financing has been one of the biggest topics, or at least I'll say in the topics of growing importance over the last couple of years, and I think the simultaneous the following two statements are simultaneously true.

One is that countries should strive to get more climate financing. And then number two, that having more climate financing is not going to solve all of your problems. So yes, I think the prime minister, in my opinion, is probably right to try to seek more climate financing, but I wouldn't put all of my eggs in that basket.

In fact, I would try to make sure that there's a lot of eggs in other baskets. Let me give you maybe a couple of related points here. One, again, going back to the importance of the private sector. Think about investment, which I think investment is a lot of what drives growth. Let's look at a country that is stereotypically seen as being very big government.

So take Sweden, the proportion of private sector investment in Sweden as a percentage of total investment is a little bit north of 80%. That's in a country that is viewed as having big government. So the point, even if in the big government country, and of course there's other countries that will vary, but if in the big government country, the government is doing 20 percent or maybe a little bit less than 20 percent of the investment, there's still a pretty big role for the private sector.

So that's point number one. Point number two, in terms of even getting more investment into the public sector, I think it's very correct what you're implying, which is that it's oftentimes not necessarily the access to money, but really the lack of credible projects and of a credible framework for those investments to take place.

In Barbados, and you probably know this better than I do, so I'll just ask, is there opportunity to invest in, let's say, solar panels or to have some sort of investment that would make you rely less on non-renewable fuels? 

Rasheed: You would think there are a lot of good projects to put money into in Barbados, or in most Caribbean countries, but I don't think that is the case.

Even if you read the Invest Barbados blue book, or brown book, or whatever colour they said it was. You read through it, and you see the proposals from the government, but they're very poorly designed, very poorly informed, even the graphics are very weird in my view. And, to step back a bit on the larger question, larger point, this need for climate finance, this rhetoric behind climate finance seems to me, like a very plain category mistake.

There is no climate finance. When you complain that, okay, hurricanes come and they destroy roads and destroy schools. Well, the problem is that the schools and the roads are destroyed. So you have to fix the schools and the roads, that's industrial policy. And there, if you want to finance industrial policy, you have to have the industrial policy programs and projects properly laid out to get the investment.

So while there is a wide category of projects that should get investment in the Caribbean or Barbados, there are very few projects that actually have high investability. 

Federico: Crucial point in that last framing that you gave is really important. There is, are there projects that at least in theory, us sitting around this table could talk about as, Hey, this would actually make a lot of sense to do.

The answer is yes. Then there's two other questions. A little tree, one branch of the tree comes out to, is there money for these projects? And then there's another very important branch of this tree is, is this project actually investable? In some cases, it's going to require government permits to be able to do a certain amount of things, probably even to get the money inside the country it requires a number of permits too. It requires some involvement of the government. And if you don't have those things, then I think even if you had the money you wouldn't necessarily be able to get more projects. This reminds me of a fund that was set up to actually deal with a lot of regional investments in Colombia, where I'm from, and this was a number of years ago, the government created this fund and it essentially said, okay, any region can apply to this fund.

And get projects going. I think for the first year there was essentially no projects whatsoever. And why? Because the regions didn't really know how to actually get a project going from the ground up. It's not an entirely easy thing and sometimes that's the constraint that we have. So I think it's really important to think about what those specific investment opportunities are because you can have a lot of money but if there's no investment opportunities then you're still not going to make those investments.

Rasheed: So final question, what is one thing we haven't discussed so far or enough that you think Caribbean policy makers should really understand when it comes to foreign investors? 

Federico: That's a really tough question because I think we've had a very comprehensive discussion. I think I would tell governments is foreign investors are really interested in investing in your country.

Foreign investors are very happy to learn about your country, but what we really need is more engagement and engagement, frankly, on some terms and on some information that may not be standard or that the government may not always be used to talking about, but we need to be able to understand each other.

And so that just means try to sit down with investors as often as you can. Sometimes, and this is actually specific advice that we give to a lot of governments, talk to investors, not just when you need their money, but talk to investors regularly. You know, it could be ideally every three months you have, and by the way, your large Wall Street banks will probably organize this for you for free, have what they call a non-deal roadshow or an investor update.

And you just talk about how things are going. in your country that will make any subsequent conversation that has to do with those investors much, much easier. So it's really just try to engage with investors as much as possible. Investors are super happy to do, and you don't need to have a concrete ask when you do that.

Rasheed: Federico thank you very much.

Federico: My pleasure Rasheed.

Rasheed: That's it for this episode. For updates about the podcast, please subscribe to our sub stat blog found on cpsi. media. You can also read our newsletters. and Lung Farm content on Caribbean policy improvements.