Latin financial markets must dig in for an extended period
of volatility as policymakers grapple with the fallout -
including on local currencies, prices and interest rates - of
rising US Treasury yields, leading experts have warned.
Guillermo Calvo, a former IDB chief economist, said that
domestic interest rates could rise sharply as liquidity dries
"The whole bonanza period and the prices of bonds in the
region are very much due to external factors. Once those
factors threaten to change - and we've seen this before, in
1994 for example - the markets can get very nervous and this
can have a very strong liquidity effect on the region and have
an impact on interest rates in particular," he said.
Investors have sharply readjusted allocations away from
emerging markets in recent months in anticipation of
normalizing US monetary policy, driving long-term US interest
rates up and Latin currencies down.
But Calvo, co-author with Carmen Reinhart of a seminal study
on the impact of US interest rates on capital flows to Latin
America, said authorities in the region could be forced to hike
interest rates as they move to defend their currencies.
Brazil faces the most pressing macro challenges, he said. "I
see Brazil, for example, being reluctant for its currency to
devalue because they feel there's going to be very quick
transmission from devaluation into inflation. The last thing
they want now is inflation," he said.
"The moment the market realizes that they are starting to
lose reserves - even though they have a bundle of reserves -
that could feed into higher interest rates at home. That feeds
into the fiscal deficit, which is still a problem for them. So
they may get into the vicious cycle in which they were immersed
in the 1980s. "
Calvo added that heightened policy uncertainty across the
region remained the biggest risk. "The factor that is crucial
to the story is: what will governments do if the situation
worsens? They haven't been tried by fire.
"I'm afraid they will start resorting to old-fashioned
policies of intervention and capital controls. If the market
factors that in, this can become deadly. In that case, no one
in their sane mind will buy Latin American bonds because all of
a sudden these firms won't be able to repay because of capital
The impact of higher US Treasury yields - which by Monday
had hit 2.5%, 64 basis points higher than at the start of the
year - is already being felt in Latin markets. Analysts at
Itaú Unibanco have raised their inflation expectations
for Mexico this year by 10 basis points to 3.6%, saying the
devaluation of Mexico's currency has been "more intense and
longer lasting that we previously thought".
The peso, which had been strengthening all year,
reversed the trend sharply in early May. Investors dropped the
currency, pushing it down from 11.98 pesos to the
dollar on May 8 to 13.31 in late June, although it has since
retraced some of the fall, trading at 12.96 pesos to
the dollar on Tuesday.
Neil Shearing, chief emerging markets economist at Capital
Economics in London said the regions is on a "far more stable
footing" than it was in 1994, when a sharp hike in US short
-term interest rates devastated Latin economies. "This time
around they have less foreign currency debt, so there is less
worry about currency weakness."
But the possibility that US interest rates could rise faster
than expected remains a source of concern. "What worries me is
that if the Fed finds itself in a situation where it has to
hike interest rates very quickly, then we could have a
problem," said Liliana Rojas-Suarez, senior fellow at the
Center for Global Development. "Rates could rise much faster
than the market is currently pricing in. The market could force
it to happen." LF
LatinFinance July Cover Story: The writing on the
LatinFinance Daily Brief: EM exodus picks up pace