Capital Flows to Latin America and the Caribbean: Recent Developments

Latin American and Caribbean markets have been extremely active since the beginning of the year, reflecting their enduring appeal to international investors. As long as developed countries’ interest rates stay at historic lows, LAC bonds are likely to remain supported by the hunt for yield.
New buyers are turning away from local currency in favor of dollar assets – and few asset classes have benefited more from this year’s market turmoil than EM hard currency debt. LAC debt capital markets volumes are expected to top US$100 billion this year. More recently, the boom in debt issuance is taking place amid a broader increase in capital flows to EM assets, following the QE3 announcement by the U.S. Federal Reserve in September and hopes that the worst for the euro-zone has passed.
However, the explosion in EM debt issuance raises concerns that investors may be overlooking risks in their hunt for yield. The strength and soundness of issuing companies and governments may become an issue if enthusiasm for LAC assets continues unabated and investors lack discernment. On the supply side, smaller and less established credits that have taken advantage of unprecedented demand, may find it harder than expected to repay debt if the environment changes suddenly.
Excessive fiscal tightening in the U.S. next year caused by the fiscal cliff, a deeper than currently expected recession in the euro-zone, a hard landing in China, and an oil price supply-side shock because of resurfacing geopolitical risks are downside risks to the global environment. A surge in agriculture prices (up 26% from June to September) and the effect on inflation is another downside risk.
On the other hand, upside risks to the global economy could materialize: in the U.S., a compromise on fiscal issues could be reached before the end of the year and positive news – the bottoming and recovery of the housing sector, resurgence of manufacturing, and the shale/gas oil boom – could surprise to the upside. In the euro-zone, progress on banking union together with more easing by the ECB could shorten the recession. The new Chinese leadership could accelerate reforms.
On balance, however, risks are tilted to the downside. The rally in corporate debt since the summer is now showing signs of slowing, as investors start to pull money from the asset class amid fears of the U.S. fiscal cliff and resurgent euro zone concerns. Although LAC assets continue to look attractive in comparison to developed market assets, caution is required. LAC assets can be vulnerable to a change in investor sentiment caused by a weak and deteriorating global growth picture. The region’s corporates and sovereigns – while continuing to take advantage of the unprecedented demand in international capital markets – must exercise caution and be prepared for a sudden change in the external macro outlook.