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Storm Watch

Nov 1, 2011

Latin America may be better prepared to face contagion risks, but the debt crisis in Europe will bring unexpected surprises for the battle-tested region.

by Ben Miller

After dodging a bullet in 2008’s financial crisis and subsequently fixing vulnerabilities exposed during that period, Latin American policymakers feel more prepared than ever to face future contagion risks. Events in Europe, however, are being watched with increasing unease amid the realization that the continent’s debt predicament will eventually wash upon the region’s shore in some form or another.

A splashy announcement by euro-zone leaders in late October sent markets sharply higher, but the plan’s lack of substance and the difficulties of executing it left many observers unconvinced that the uncertainty hanging over Europe had passed, meaning that Latin America will have to live with the ensuing volatility for quite some time.

"This package is still as opaque as it gets – big announcements are very different from actual logistics and implementation," says Robert Abad, a senior analyst at Western Asset Management, which has $3.6 billion under management in EM.

Each crisis brings its own set of surprises and this one will be no different. Finding the possible transfer mechanisms that leave Latin America vulnerable to broader market volatility – caused in this case by debt problems in Europe and anemic growth in the US – is a popular thought experiment conducted among the region’s policymakers and market participants these days.

In Latin America’s case, this volatility could manifest itself in several ways. Weakness in the commodity complex if China’s economy slows, volatility in the FX rates, and a lengthy lull in capital markets activity are just some of the areas of susceptibility in the months ahead.

But perhaps above all else, bankers are wondering what the sovereign debt crisis and subsequent recapitalizations will mean for European banks, many of which have a broad on-the-ground presence and have been active participants in Latin America’s loan markets, particularly infrastructure financing.

For now at least, the immediate horizon looks stormy but manageable. Expectations for the developed world may be below 2.0% for this year, but JPMorgan and other forecasters see EM GDP above 6.0% for 2011 and between 5.0% and 6.0% next year. The shop estimates that LatAm growth should dip to 3.2% in 2012 from 4.0% this year, putting it behind its 3.6% potential, but not by far.

In the event that worst case scenarios unfold in Europe, it is thought that Latin American countries will have more staying power than many others. Learning from prior crises, the region has won top marks for building the defenses necessary to protect itself against exogenous shocks.

"The one region that has experienced the most crises and is the most battle-tested market has always been Latin America," says Abad. "For anyone who is positioned defensively or for normalization, LatAm is where you want to be."

Overall economies remain in healthy shape, albeit with declining growth expectations. Some can still boast trade and fiscal surpluses, not to mention substantial firepower thanks to record reserve levels.

"Needless to say, we will experience some turbulence because of the interconnectedness of the global financial market, but we feel our main financial variables will be anchored by the strong fundamentals," Augustin Carstens, Mexico’s central bank head and former minister of finance, tells LatinFinance.

Though the region is still reliant on foreign capital to grow, the development of local markets in countries like Mexico means both sovereigns and corporates now have an important alternative funding pool. Such efforts have gone a long way toward tackling the problem of "original sin" – a termed coined by economists Ricardo Hausmann and Barry Eichengreen to describe countries’ inability to borrow abroad or domestically in their own currencies.

However, successes on this front have created their own challenges at a time when foreign investors have become increasingly enamored by local currency plays. These often crowded trades leave countries once again exposed to sudden movements in international portfolio flows, though this time borrowers need not fret about currency mismatches.

"A lot of the selloff has been in those countries where the foreign position has been highest," says Joyce Chang, head of emerging markets and global credit research at JPMorgan.

Still, corporate Latin America remains an improving credit story, and in most cases CFOs have more than enough cash on hand to cover upcoming maturities should capital markets remain shut indefinitely. They are also now more constrained from taking the FX derivative bets that caused several corporates to implode during the last crisis.

Forget Decoupling

Yet the notion that Latin America, or emerging markets overall, can decouple from events in G3 countries has been broadly rejected, at least until the region can move beyond its reliance on commodity in exports, establish stronger domestic economies, and further reduce its need on foreign capital, say some observers.

"Under the current conditions, there is a pretty good external backdrop for the most part," says Javier Kulesz, chief economist for Latin America at UBS. "But if we move to a more hostile environment, LatAm will not decouple."

Balance sheets and reserves might be stronger now than in 2008, but that is not a guarantee that the region is on the whole better prepared for a downturn, Kulesz says. The last crisis saw expansionary fiscal moves to soften the blow of the downturn, but that leaves government with less room for maneuverability this time around.

"Emerging markets in totality have been, are and always will be price takers of G3 risk whether it is exchange rates or interest rates," Abad says. "As awesome as balance sheet positions in LatAm are, the fact remains that if you see continued volatility, especially on the FX side, that is eventually going to crack some of the balance sheet position because it has really been a deep one way trade for the last few years into emerging markets."

Aside from FX and interest rate risks, borrowers and bankers alike have been wondering about the broader implications for European banks and how much they stand to suffer from a Greek debt restructuring and more turmoil in the peripheral euro-zone countries, not to mention higher capitalization requirements ahead of Basel III.

Bank Worries

Cost of funding and banks’ willingness to lend to Latin American credits in this environment has come under scrutiny, and borrowers are already feeling the pinch.

"We are finding more and more clients turning to us saying they can’t count on so and so," says one senior syndicate official in New York who works on emerging market bond issues.

Less lending from European banks and moves to shore up capital are likely to result in a domino effect, with immediate and longer-term repercussion for Latin America.

Asset sales among European banks would potentially have an immense impact on credit markets everywhere. European borrowers that have traditionally been reliant on bank lending may also push pricing higher as they seek funding alternatives elsewhere.

"If they get forced into the bond market they are all going to the same investor base [as LatAm issuers]," says a senior banker at a US institution. "You can’t have that shift without impacting pricing."

European banks’ heavy involvement in infrastructure financing is not good news for the region’s efforts to raise trillions of dollars in this sector. The glaring absence of French banks in OSX’s recent $850 million FPSO loan may be a sign of things to come, and mean even more disintermediation amid efforts to bring infrastructure deals to the bond markets.

In the medium term, export credit agencies and multilaterals will likely have to increase their lending role, particularly when it comes to supporting participation in infrastructure financing, says Valentino Gallo, global head of export and agency finance at Citigroup.

A big pullback from European lenders that have been part of the trade line supply to LatAm would be problematic, though some see euro-zone banks as less likely to cut trade finance lines than they were in the 2008-2009 credit crisis.

"This is not as bad as it was three years ago when the liquidity dried up overnight," says Citi’s Gallo, "There is a little more confidence that regulators have been monitoring liquidity levels."

Jaime Rivera, CEO at foreign trade bank Bladex, voices a similar optimistic view. "It was a problem, but it was resolved as trade lines were reduced and central banks put in place credit facilities," he says. "They had the means to do so and they have more firepower at their disposal now than they had in 2008."

Strong Locals

Fortunately for Latin America, the region’s own banking systems are now on a surer footing after having been the catalyst for many a crisis in the past. Not only are they highly liquid and well-capitalized, but they have a stable funding base.

"Banks by and large are now funding 100% of their loan books with stable deposits," says Bladex’s Rivera. "So from that perspective the health of LatAm banks is not going to be impacted by what is happening in Europe."

In some countries such as Mexico, the banking system remains a potential vehicle for growth, largely thanks to where it stands in the credit cycle. It is neither cooling off from an overheated credit expansion such as in Brazil, nor is its banking system in the process of cleaning up balance sheets and strengthening its capital base.

"We are not in either extreme," says Carstens. "So I think our banking system has the capacity to increase lending and contribute to growth."

This doesn’t mean that the financial system can’t act as a contamination channel should the situation in Europe deteriorate.

"If it keeps going, the risk is that through the financial channel things in EM might start to suffer," Carstens adds.

The broad presence of European banks, which Fitch says make up between 10%-20% of assets in Latin America’s local banking system, could in theory act as Trojan horse for Latin American economies. But, in reality, such subsidiaries lack the strong funding links with parent institutions that are seen in other emerging markets, the agency adds.

Nevertheless, Alejandro Díaz, the country’s head of public credit, recognizes the dangers posed to banking systems like Mexico’s which is largely owned by foreigners including Spain’s BBVA and Santander. According to Fitch, in Mexico European subsidiaries take up a 45% market share.

"That could clearly take a dynamic of its own," Díaz says. "We saw something of that nature in 2008. [But] there have been regulatory measures put in place to ring-fence this in a more efficient way."

Commodities Remain Key

Meanwhile, commodities continue to be key for a region, where, as Chang explains, they represent 50% of exports and well above that level for major countries like Argentina, Brazil, Chile, Colombia, Peru and Venezuela.

In that context, what happens to China remains vitally important for the region, though threats to growth in that country come less from events in Europe and are driven more by internal factors such as a possible overheating of the real estate and credit markets, say analysts.

If China and other countries’ appetite for commodities wane on the back of a slowdown in global growth this would unwind some of the terms of trade gains that have supported consumption and investment in the region, Chang says.

Furthermore, LatAm’s trade dynamics may not be as strong as they first appear. Imports are on the rise, and price effects explain more than 50% of increases in exports, says Kulesz. "When you have that kind of structure, you are on weaker footing if the situation turns around," he adds.

That said, Kulesz says his shop does not forecast significant changes in commodity prices ahead. Crude oil, copper, and soy should finish 2012 at similar levels to 2011.

The prospects of sub-par growth remain a worry for many policymakers in Latin America and this has clearly been reflected in the abrupt shift in monetary policy in counties like Brazil. The Brazilian government has its sights on growth above 5.0%, and has aggressively pursued such goals through monetary policy and inflation targeting, says Tony Volpon, head of emerging markets research for the Americas at Nomura Securities in New York.

"Even if Asia holds up and even if Europe can avoid a negative conclusion, there should still be lower growth in Brazil, as credit growth and labor growth slowdown," Volpon says. "I don’t think Brazil will grow at the 4.5%-5.0% pace we’ve seen in the last couple of years. Once we have been through the slowdown, you won’t see 4.0%-5.0% growth, but 3.5% growth."

This may cause investors to reconsider the Brazilian domestic growth story that has drawn them to the region’s largest economy in droves.

Tricky Sell

Given the uncertainty hanging over the markets, selling the LatAm story will certainly be a trickier affair for both ECM and DCM bankers, who say market uncertainty means that issuers have to be fleet of foot and jump through windows of opportunity while they can.

"What has changed are the recommendations and the dynamics of the market," says Gustavo Ferraro, head of Latin American DCM at Barclays Capital. "Before, you set out your strategy and you would execute on that strategy. Now, because things are changing constantly, fine tuning is very relevant. Otherwise, you can miss out tactically."

Yet many corporates and sovereign are already well positioned to weather the storm in the short term, and are often more than content to wait on the sidelines.

"We have the benefits that we have anticipated our initiatives in capital markets by raising equity while the ECM was still open," says Leandro Bousquet, CFO of BR Malls. "Now we have the cash. We won’t change our plans in terms of our growth plans and investments. We are well capitalized and well prepared."

The Brazilian shopping mall operator has been a regular user of the international debt and equity markets in the last few years, loading up on funds it uses to acquire new assets in what is still a fragmented industry.

Though it’s impossible to predict how long the volatility will last, local DCM in Brazil is pretty open, Bousquet says. BR Malls is not planning any fundraising in the near future, but bonds, securitizations and bank loans are available locally to issuers.

"What we have seen in the past, at times of high volatility like we saw in last quarter of 2008, for good names with good histories there is always a market, even for equity," Bousquet says.

Equity Hopes

If one asset class has learned to live with the volatility it is equity capital markets, which has only seen intermittent issuance since July, and only the odd follow-on from top secondary market performers or better-known names.

Latin American McDonald’s franchisee Arcos Dorados raised nearly $1 billion in October as its private equity investors took their planned exit. This followed Brazilian wireless operator TIM Participações, whose $925 million sale was supported by parent Telecom Italia taking two-thirds of the deal.

Colombia’s Ecopetrol raised $1.34 billion in July, but demonstrated the vulnerability that the country’s local issuers face as they keep their books open for a prolonged period with the intention of attracting retail investors.

"We need to see a reduction in volatility, we need to see a more healthy IPO market in the US which we aren’t seeing yet, and we still need to see a reversing of foreign flows into Brazilian markets," says Fábio Nazari, head of ECM at BTG Pactual.

Speaking in late September, Nazari says the peak of the outflows has already happened, adding the region could see 40-50 new equity deals in the next 18 months. However, when sales resume targeting the local LatAm investor will be key for many of these stories.

"To get a deal done in Brazil, if the local investor community is fully engaged you are halfway toward a successful deal," Nazari says.

Bond issuers also began in October to reopen the markets after a lull – but only quasi-sovereigns – aware that a European-induced slide could quickly shut things down again.

"These environments might be less comfortable, but they can yield some good opportunities," says Luz Padilla, portfolio manager at DoubleLine Capital, which manages $500 million in emerging markets. "There are some opportunities opening up. There are a lot of good credits that have cheapened up, but the question is can they get cheaper."

While the flight to quality has funds flowing into high-grade sovereigns and blue-chip names, Wamco’s Abad is eyeing opportunities in the high double B space, among names that may be on the cusp of investment grade.

As with 2008-2009, there should be ample opportunity to pick up solid credits for those who understand the region’s fundamental strengths and take the view that growth in LatAm and China will remain reasonable.

"If you take your eye off the ball and are worried about the top down and getting out, you are going to miss the potential pickup of some really good value in some credits if you look at it from the fact that their balance sheet strength is so much better than some of the US names," Abad says. LF

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  • STUART ALLEN Dec 14, 2011

    We are very far from the nadir in the Eurozone crisis and the mechanisms for transmission into LatAm are many. Those most commonly cited include:
    > generalized flight from perceived risk
    > weakness in China and thus in many commodity prices
    > slowdown in global trade and rationing of trade finance
    > withdrawl by European banks as they seek to protect their balance sheets in face of the crisis and coming legislation
    > indirect affects on esp. Mexico though impacts US growth...

    However a closer look suggest LatAm is insulated from most of these, and fears are most often based around crude partial equilibrium analyses where, for example, capital flowing from European banks is reduced with no response from multilaterals, governments, other private sector banks, or borrowers themselves.

  • Dec 14, 2011

    EM Assets are still overvalued generally.

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