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Thursday, 14 December 2017

Lessons from tequila

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Latin America may have side-stepped the global financial crisis but the region is set for challenging times as QE tapering threatens to trigger a rise in interest rates that will put pressure on local borrowers.

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In 1994 the US Federal Reserve started to raise interest rates, triggering a run of events that led to the tequila crisis and a deep recession in Mexico. Fast forward two decades to the taper tantrum and Mexico secured US$7bn in foreign investment in January 2014 alone and was upgraded to Aa3 by Moody’s.

This is perhaps the strongest indication that at least parts of LatAm and the Caribbean have learnt the lessons of previous crises, according to Jim O’Neill, former chairman of Goldman Sachs Asset Management.

“I think many Latin American countries – with some caveats – are in a much better position to withstand some of these things than in the past,” he said.

For those with long memories, the resilience of Latin America’s economies and financial markets in the wake of the global financial crisis was little short of miraculous.

The last three decades have seen the region hit by three major crises and recessions: LatAm’s own debt crisis and “lost decade” in the 1980s, the Asia crisis of the late 1990s and the recent global financial crisis. While the first two hit the region hard, the recent crisis that brought Western economies to the brink of a new great depression barely scathed the region, whose GDP is now 25% higher than its pre-crisis level.

Weathering a crisis

The region’s policymakers clearly learnt the lessons from those first two downturns. Jose de Gregorio, central bank governor of Chile from 2007 to 2011, said LatAm was resilient because of good macroeconomic policies, strong financial systems, and “a bit of luck”.

However, he warned against complacency given the febrile nature of capital markets.

“The region weathered the crisis very well but that is not a guarantee that there will be more progress,” he said. “After you weather such a big storm perhaps you should not be complacent and think that you can weather any sort of problems.”

But once again a region that is no stranger to financial crises is being put to the test. LatAm faces a double whammy threat. The first comes from a rise in global market interest rates as the Fed continues to tighten monetary policy by withdrawing its quantitative easing programme.

Second is the region is facing a prolonged period of weaker growth after riding on the coat-tails of a boom in commodity prices during the past decade. The World Bank sees GDP hovering around 3% over the next three years after posting growth as high as 6% in 2010.

Inflows, outflows

One of the headline-grabbing features of the 2014 taper tantrum was the outflow of “hot” money from the region as investors embarked on a flight from risk.

Almost US$1bn of debt investment flowed out of the region in the final week of January, according to EPFR Global data. Bond investors have pulled money out in all but four of the 36 weeks to January 29.

Amid the frantic flurry of news and comments it is easy to overlook that those outflows come against the backdrop of what has been a solid increase in debt capital market activity over the past few years.

Debt issuance surged from just over US$40bn in 2008 to a record of US$164bn in 2013, the highest volume on record and an increase of 2% from US$162bn in 2012, according to Dealogic. January saw 17 deals worth US$21.1bn, a four-month high.

This is not just a sovereign story. Corporate investment-grade issuance in LatAm hit US$76.9bn last year, rising 3% from US$74.9bn to set yet another annual record. Corporate IG bonds represented almost half (47%) of total activity in 2013.

The list of deals reads like a Who’s Who of the LatAm business world. The largest debt deal of any type was the US$11bn IG bond issued in May by Petrobras Global Finance BV, part of the listed oil and gas giant, making it the largest emerging market dollar bond offering ever.

State-owned Mexican energy giant Pemex was the second largest thanks to three deals in that totalled US$6.9bn.

Game of three halves

The question for borrowers in Latin America is whether their access to finance will be squeezed as the Fed continues to withdraw the amount of stimulus into the US economy.

The Institute of International Finance expects that the 10-year US bond rate, a key market benchmark, will rise gradually to 3.5%–4% by the end of 2015 from around 2.7% currently.

In this environment, debt inflows are likely to evolve less favourably than equity inflows. It expects that debt flows over the 2014–15 period will remain around 16% below their 2012–13 level, driven by non-bank flows.

Any analysis of Latin America before long encounters the problem that it is not a homogenous region but made up of 21 countries (42, including the Caribbean). The group on the Pacific side from Mexico down to Chile, including Peru and Colombia has strong macroeconomic policy fundamentals and the growth story is pretty much intact, said Charles Collyns, chief economist at the Institute of International Finance.

On the Atlantic coast countries such as Venezuela and Argentina have major macroeconomic imbalances building up for some time, even before January’s dramatic plunge in the value of the Argentine peso.

In the middle is regional superpower Brazil, soon to be the focus of global attention when it hosts the Football World Cup.

Pool depth

According to Collyns, this three-way split also describes the depth and sophistication of the domestic financial and investments systems in each group.

“Those economies with quite well-developed financial markets, particularly those on the Pacific side, have quite deep domestic financial markets that can to some extent offset the impact shifts in foreign investment in securities in their countries,” he said. ”Brazil also has quite a deep and well-developed financial market which is a source of resilience. Other countries have less well-developed financial markets and are therefore more at risk.”

According to Neil Shearing, chief emerging markets economist at Capital Economics, there is no doubt that borrowing costs will go up. They are going to pay a higher price and some of the more risky borrowers will have to pay a particularly high price.

“Those that were the chief beneficiaries of low interest rates over the last five years and those will be the ones that I suspect will be under most pressure as the tide starts to turn.”

“The fundamentals in many of these economies are quite sound by international standards. These are better credits”

Rafael de la Fuente, senior economist at UBS, agreed, adding that slower growth, fewer capital inflows and a weaker currency is what should happen in open economies such as LatAm.

“If there are companies or sovereigns that need to access hard currencies, they will have to pay higher rates for them. We are in a higher rate environment,” he said.

De la Fuente doubts that Western banks will start cutting commercial lines to LatAm. “You are going to be paid to stay,” he said. “The fundamentals in many of these economies are quite sound by international standards. These are better credits.”

At the same time governments are well armed with foreign exchange reserves to intervene in case of a liquidity crunch.

There are mixed signs on the ground: debt deals are fewer but larger. According to Dealogic there were 24 deals worth US$24.7bn in the first seven weeks of 2014 – an average of US$1bn per deal. In the same period in 2013 there were around 73 deals worth US$350m each.

Typical is January 2014’s US$5.1bn four-tranche bond by Petrobras.

‘Don’t freak out’

The IIF has long advocated emerging markets to develop domestic institutional investor bases. Hung Tran, its executive managing director, said LatAm had seen very noticeable growth in the past 10 years of local pension funds, life insurance companies and the mutual funds industry.

“This will mean more and more domestic institutional investors exercising stronger ownership and impact on domestic financial markets,” he said. “This will help these countries to some extent to cope with the more volatile movement of international investor involvement.”

But O’Neill, now a visiting fellow at the Brussels think-tank Bruegel, is not convinced. “I don’t think the pools of domestic capital are big enough,” he said. “It might be in Brazil given how big Brazilian markets are but elsewhere probably not.”

He said the best option for the region’s capitals was to continue to learn the lessons from past crises.

“Doing things that get people really excited about the structural trend of an economy’s performance is the right way to deal with this [tapering] issue because you take away your vulnerability to short-term interest rate-sensitive financing or hot money portfolio flows by doing the right thing and attracting long-term investment.”

This lesson holds good for corporate borrowers too, said De la Fuente. “If they are going to continue to grow, corporations have to make sure they continue to be attractive as investment destinations, make appropriate returns and have good corporate governance.

If Treasury and other bond yields were to go through the roof, O’Neill acknowledged that would cause “challenges” for everybody. “But emerging countries should not freak themselves out and say ‘oh my God, we’re doing something wrong’ because if the Fed ever gets back to normal levels of interest rates some of that is going to happen.”

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