Capital Flows to Latin America Second and Third Quarters of 2005

Despite an increase in risk aversion in April and the turbulence in corporate debt markets triggered by the downgrade of General Motors and Ford in early May, capital flows to emerging and Latin American markets were strong in the second quarter of 2005. Capital inflows remained strong in the third quarter, as emerging debt markets continued to enjoy favorable market conditions. Abundant global liquidity, as well as low bond yields and flat yield curves, encouraged investors to seek higher returns in emerging markets, compressing credit spreads and helping borrowers to increase new bond issuance and engage in liability management.

Emerging market spreads showed resilience to financial market volatility during this period. The market reaction to the turmoil in U.S. credit markets was much more subdued in emerging markets than in the U.S. and European high-yield markets. Emerging market spreads decoupled from U.S. corporate spreads, peaking earlier (in mid-April) and returning more quickly to their previous lows. The correlation index between emerging market and U.S. high-yield spreads fell from 0.8 in the first quarter to 0.2 in the second, and turned negative in the third quarter.

Improved fundamentals in emerging markets (with countries experiencing growth with moderate inflation, improved current accounts, and better economic policies) combined with the favorable external environment to support compressed spreads, new debt issuance and debt liability management operations. The trend toward higher credit ratings in emerging markets continued in the second and third quarters of 2005.