Foreign exchange: Latin America currency volatility driven by changing allocations
US dollar strengthening in anticipation of QE tapering; in response, emerging market assets have repriced.
The recent volatility in Latin American currencies in likely to persist as global investors adjust their allocations to the region to a level more consistent with a tighter US Federal Reserve policy, according to experts.
Most of Latin America’s key currencies have depreciated substantially during the past month and to a lesser extent during the past year. On June 26, the Brazilian real was down to R$2.19 to the US dollar from R$2 at the end of April and R$2.06 one year ago. The Mexican peso dropped to Ps13.16 a year ago from Ps12.13 at the end of April, but was up from Ps13.92 one year ago.
The Colombian peso depreciated to Ps1,930 to the dollar on June 26 from Ps1,825 at the end of April and Ps1,802 one year ago. The Chilean peso reached Ps505 to the dollar at the end of June against Ps471 at the end of April and Ps508 one year ago. The Peruvian sol fetched NS2.79 to the dollar at the end of June against NS2.64 at the end of April and NS2.66 12 months earlier.
During the past few weeks, the US dollar has strengthened against most emerging markets currencies as it became clearer that the Fed planned to taper off asset purchases under its quantitative easing III programme. This has resulted in higher global core yields and the sharp repricing of most emerging market assets, including those of Latin America. For example, in Brazil, the local yield curve has sold off massively, with one-year swap rates climbing by almost 200 basis points to 9.89% from the beginning of May to the end of June, according to Barclays.
Waves of liquidity
During the past couple of years, quantitative easing and credit easing more generally created a huge wave of liquidity searching for yield and was the main reason for the massive asset-price appreciation that emerging markets experienced. Market participants now fear that this bull run is becoming much more bearish.
"Financial conditions have tightened across the board, and this will have negative implications for real growth," says Alberto Ramos, Latin America analyst at Goldman Sachs. "Higher core yields and the repricing of EM risk are akin to a negative shock to the capital account, potentially impacting net portfolio inflows and the conditions for access to external financing."
Goldman Sachs has lowered its growth outlooks for Brazil and Mexico for this year to 2.3% and 2.8% from 2.5% and 3.1%, respectively. In foreign exchange, it has downgraded its three-month, six-month and 12-month Brazilian real/US dollar forecasts to R$2.10, R$2.10 and R$2.25 from a flat R$2.05; and for the Mexican peso/US dollar it is now predicting a weaker three-month, six-month, 12-month path of Ps12.80, Ps12.50 and Ps12.20 from Ps12.40, Ps12.20 and Ps11.80 respectively.
During the past five years, Latin American currencies have been shored up by rampant economic growth in China and strong commodity prices. However, China’s annual GDP growth has slowed to 8% from 10% in 2010, according to the IMF; on June 20 and 21, Brent crude notched up its biggest two-day drop since September to $100.
How well Latin American economies will fare in the new environment depends on a number of factors including the size of their current account deficits and gross external financing needs. The size of their foreign reserves is also an important factor. For example, Brazil’s foreign liabilities amount to some $1.4 trillion, according to Rio de Janeiro Federal University (the long-term debt service will add up to $70 billion a year during 2014 to 2015). The country is running a $75 billion current account deficit, according to Goldman Sachs.
|Alejandro Arreaza, Latin America analyst at Barclays|
On the positive side, the central bank enjoys a comfortable $375 billion in reserves, part of which could be deployed to ease any potential capital-account shock and anchor the currency. "Although the ongoing reduction in capital inflow may have been triggered initially by factors that are exogenous to individual economies, such as Fed policy, we believe country-specific variables will determine whether an initial moderation in the flow develops into a full-fledged sudden stop," says Alejandro Arreaza, Latin America analyst at Barclays.
Goldman Sachs now predicts that Copom, the Brazilian central bank committee that decides interest rates, will increase rates by 50 basis points in both July and August and by a final 25bp in October, leaving the Selic at 9.25% at the end of the tightening cycle.
Weaker Latin American currencies mean real assets in the region are cheaper in dollar terms and there is a possibility that US firms will start to make more acquisitions there. However, US companies might be put off by the region’s general economic slowdown.
Latin American countries must adjust fast to higher global core yields, weaker commodity prices and slower Asian economic growth. The rapidly changing external backdrop has put the region’s biggest economy, Brazil, in a difficult spot. The central bank might have to increasingly employ its vast dollar reserves to shore up the currency.