Capital Flows to Latin America and the Caribbean: 2011 Overview and Recent Developments

In 2011, the year started on a positive note, with perceptions of relative risk improving, but global economic conditions were soon derailed by a series of events: a surge in commodity prices following the Arab spring, the Japanese earthquake, a deepening in the European sovereign debt crisis, and political deadlock over the U.S. Treasury's debt ceiling in the summer. The external outlook for Latin America deteriorated significantly in the second half of the year, as the euro zone fiscal crisis and a frustratingly slow recovery in the U.S. weighed heavily on investor sentiment.

Following the August downgrade of the U.S. sovereign rating, emerging markets were engulfed by a wave of market volatility, which was further heightened with increased uncertainty related to the resolution of the European crisis. The closely watched Chicago Board Options Exchange (CBOE) Volatility Index (VIX) - a key measure of market expectations of near-term volatility and a barometer of investor sentiment (conveyed by S&P 500 stock index option prices) - reached 48 in the beginning of August, its highest level since March 2009, and spiked again in October, coming down to lower levels of volatility since then.

Asset prices broadly recovered some of their previous losses in the first quarter of 2012, however, as the severity of the euro area sovereign and banking crises eased somewhat. The announcement of the European Central Bank's Long-Term Refinancing Operation (LTRO) last December providing funding for the banks, together with better-than-expected data releases for the U.S. economy in the first two months of the year led to a sharp improvement in investor sentiment. Market volatility and risk aversion declined as a result, with the VIX dropping to 14.26 on March 26, its lowest level since June 2007.

With investors keen to put risk back on the table, and amid continued investor wariness over developed markets, bond and equity funds dedicated to emerging markets enjoyed their best start to a year since 2006. Buoyed by the renewed surge in capital inflows, emerging market currencies also enjoyed a strong start of the year. The rally has been intense, but it has only partly reversed some of 2011 losses.