Capital Flows to Latin America Fourth Quarter 2004

Two major factors drove emerging and Latin American markets in 2004: i) global liquidity and risk appetites, and ii) fundamental credit improvements in the domestic economies. The positive interaction of external factors (in the form of abundant global liquidity combined with an environment of low interest rates, higher commodity prices and search for yield) and domestic factors (in the form of improvements not only in emerging market economies, but also in the health and structure of the emerging market asset class, created a favorable environment for capital inflows in emerging markets and in the Latin American region. According to the Institute of International Finance (IIF), capital flows to 29 emerging market nations reached US$279 billion in 2004. This is more than double the 2002 level, and close to the US$287 billion posted in 1997, the year that Thailand's currency collapsed, sparking a flight of capital from Asia. Capital flows to Latin America reached US$26.1 billion in 2004, a 51% increase over 2002 and a 4% increase with respect to 2003.

The majority of emerging market credits closed 2004 considerably stronger and better insulated from external shocks. Emerging market economies posted healthy growth rates, reduced fiscal imbalances, accumulated cushions of foreign reserves and surpluses in their trade accounts, and kept their currencies floating. Latin America posted the best rate of growth in seven years, and is expected to keep growing in 2005, although at a more modest pace. This growth is based on the recovery of domestic demand, the impetus given by the external sector, especially due to higher commodity prices fueled by global economic recovery and strong demand from China, and a favorable international context. As a reflex of this performance, credit rating agencies increased their sovereign debt ratings for several Latin American countries in 2004.

The IIF report noted that there has been a significant improvement in the average credit rating of emerging market countries since 2001. The trend toward higher credit ratings of emerging market issuers has been supportive of the significant compression in spreads that has taken place since the latter part of 2002. According to the benchmark EMBI+, spreads in emerging markets fell from 1041 basis points at the end of September in 2002, to 356 basis points at the end of December 2004. For Latin America, bond spreads declined from 1399 to 420 basis points over the same period.

According to Goldman Sachs calculations, about 40% of the tightening of spreads is explained by domestic fundamentals, while the other 60% is explained by external factors: 17% by stronger export prices and global growth, 20% by greater availability of global liquidity, and the remaining 23% by lower risk aversion . Although further spread compression is limited, there is still room for more tightening as long as risk appetites remain healthy. However, most analysts believe that the likely tightening of global monetary conditions and associated economic growth slowdown could widen emerging market spreads in the second half of 2005. They see local and equity markets offering 2005's best emerging markets opportunities.

The large number of upgrades in 2004, combined with record tight spread levels, supported a record volume of debt issuance. According to Merrill Lynch, emerging markets debt issuance reached US$96.1 billion in 2004, up from US$74.6 billion in 2003, with US$36 billion originating in Latin America. Emerging Europe contributed to the largest share of deals (US$38 billion), because of the considerable volume of Eurobonds from Russia and Turkey, but Latin America came in a close second.