Capital Flows to Latin America: Recent Developments

The external environment has improved in recent weeks, as data in the U.S. and other developed countries have shown glimmers of stabilization. Since the lows reached in early March, U.S. equity and U.S. High Yield markets have rebounded, raising hopes, according to JPMorgan, that the "synchronized global downturn will be followed by a synchronized rebound." Financial markets saw a bounce in risky assets in recent days as a result. 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, fell below 30 in May, the lowest level since before the collapse of Lehman Brothers. This implies that investors expect the heightened market swings of recent months to soon diminish.

Last fall, following the Lehman collapse in mid-September 2008, the VIX index reached close to 90 (values greater than 30 are generally associated with a large amount of volatility). Since then volatility has been slowly declining. In mid-May 2009, when uncertainties around the results of the Federal Reserve's bank stress test and the swine flu receded, the bets that the VIX could pass 40 in the short-term - which more than doubled in early May - stopped. Systemic risks seem to have abated with the fiscal stimulus measures that have already been implemented in several countries, the easing in monetary policy and an increase in official support, allowing policymakers and markets some breathing room for the first time since Lehman Brothers filed for bankruptcy.

In contrast to past downturns, this time around Latin America and the Caribbean have shown increased resilience. The Latin component of the JPMorgan EMBI+ widened sharply from mid-September to the end of the 2008, but has been on a declining trend since then. The Latin component widened 423 basis points from end-August to end-November 2008, but since then it has tightened by 225 basis points, from 748 basis points at the end of November 2008, to 523 basis points at the end of May 2009 (see chart 2). New international debt issuance in the region picked up in the first quarter of 2009, following a dry spell in the second half of 2008, and continued to be active in April and May. Most of the issuance has been in the higher-quality credits, however, either in higher-quality sovereigns or in the better corporates. Inflows into Latin American equities have also picked up since the beginning of the year, and the Morgan Stanley Capital International (MSCI) Latin American Index gained 4.5% in the first quarter of 2009, after losing 34.8% in the last quarter of 2008. In comparison, the MSCI for emerging markets gained only 0.5% in the first quarter, while the G7 lost almost 13%.

The "decoupling" theme has made a big comeback over the past month among market participants, and has contributed to drive Latin American assets forward. However, the way it has been discussed recently is a little different than before, when it was assumed that "decoupling" meant that the large emerging markets countries (particularly the BRICs - Brazil, Russia, India and China) had found their own sources of internal growth and could grow even if the U.S. and Europe went into recession. According to Credit Suisse, most market participants, when applying the "decoupling" thesis nowadays, seem to expect that emerging markets countries will: survive the global recession in better shape than the more developed countries will and grow faster than the more developed countries once the global economic crisis is over. However, the fate of the emerging markets economies is clearly not independent of that of the developed countries, particularly of the G3 (United States, Europe and Japan), and any shock that would cause U.S. asset prices to plummet would affect investor confidence all over the world in a significant way.

Assuming that economic conditions are indeed stabilizing in developed countries, and that growth will resume in the second half of the year, market participants thus see reasons for optimism about the prospects of emerging markets countries. This optimism also reflects the return of an appetite for risk in the markets, which normally accompanies a more positive outlook for the global economy, and a belief that the countries of the region are ready to resume strong economic growth.

However, conditions still require some caution. Exports and foreign investment flows, critical to region, remain weak. Although government spending has taken up some of the slack, concerns about rising fiscal deficits limit how much more policy makers in the region can do to stimulate their economies. In addition, while commodity prices represent a boost, they also reintroduce inflation uncertainty. According to JPMorgan, the rise in commodity prices represents an upside risk to regional inflation, "as the weight in the CPI baskets is much larger than it is for developed economies.