Latin America FX: a tale of two currencies
Latin American commodity-linked exchange rates are increasingly driven by individual domestic macro issues, especially inflation/deflation, than external factors, say analysts.
One of the most interesting dynamics observed in the emerging FX markets since the beginning of the year has been the broad resilience of Latin American asset prices to recent global shocks. This notably includes fears over China’s growth slowdown, as so many of the region’s economies have been particular beneficiaries in the past of China’s golden growth years.
In broad terms, the Chilean peso and the Venezuelan bolivar – the two currencies that have had the greatest exposure to China’s uber-growth –– are set to perform the worst in the coming months, as China’s growth settles at a lower rate and shifts from manufacturing-fuelled to consumption-led growth. Meanwhile, the Mexican peso, which has had the least exposure, should be an outperformer.
However, as highlighted by last week’s stunning performance by the Colombian peso – which posted the biggest weekly gain among the world’s currencies at 2.4%, despite being the third most-exposed to the China-dominated commodities sector – the LatAm FX asset class should not be regarded as a risk-on/risk-off asset class.
Instead, regional currencies should be traded as individual stories, rather than high-beta bets on external factors, says Claudio Irigoyen, Latin America FX strategist for Bank of America Merrill Lynch (BAML), in New York.
“Because the degree of investor involvement has been low, LatAm FX still offers a risk-reward profile driven by individual stories that minimize global exposure and provide very clean positioning,” he adds.
While LatAm FX was appreciating, the main concern of FX policies across the region was growth and thus the bias to intervene to weaken currencies, but the coin has now flipped, and with LatAm FX now on a multi-year depreciation trend, sooner or later the focus of FX policy will shift to preventing pass-through pressures on to inflation.
“In Brazil and Peru, this process has already begun, with both central banks currently engaged in sizeable and consistent USD selling programmes, which should continue to lend support to the BRL and PEN for the foreseeable future, promoting outperformance over the rest of the region,” says Marjorie Hernandez, Latin America FX strategist for HSBC, in New York.
In Brazil’s case, the inflation dimension remains a particularly sensitive subject, given the country’s history of hyperinflation, and with presidential elections scheduled for October, and tradable goods inflation in annual terms having doubled from 3% to around 6% since 3Q12 (tracking the depreciation of the BRL), the authorities are likely to be wary of additional pressures coming via a weaker real, she adds.
In Peru, the impact of a weaker PEN on tradable and imported goods has been even more pronounced, with annual core inflation running at around 3.8%, and imported goods inflation having shot up from 0% to 4.8% in less than a year.
In its latest monetary policy press release, the Central Reserve Bank of Peru acknowledges that “inflation is forecast to remain initially close to the upper band of the target due to the lagging effect of the supply shocks” before converging back towards the 2% mid-point target, and all of this whilst growth is decelerating.
Despite the recent hawkish comments about the US’s rates trajectory in the coming months, Mexico’s fundamentals – notably its inflation numbers and growth – also look appealing, says BAML’s Irigoyen, although, given the likely earlier and greater-than-previously-expected rate hikes north of the border, taking a long MXN position against the USD would appear ill-advised.
Instead, with growth in Chile, the world’s largest copper producer, likely to continue to slow, as demand from China’s construction sector continues to diminish (the average US house uses enough copper in pipes to fill an Olympic-sized swimming pool), he favours going long MXNCLP, despite former Chilean finance minister Felipe Larraín Bascuñán’s view the country is on track to achieve developed-nation status ahead of the 2018 target.
“The positioning of the trade is clean, as investors are disappointed with the recent [levels] in Mexico’s economic activity, and the approval of the secondary laws of the energy reform should ... help,” says Irigoyen.
“Because of a likely further slowdown in Chile’s economy, a dovish central bank will continue cutting rates, and there is no risk of FX intervention.”
At the other end of the spectrum for most market players remains the Argentine peso, with Argentina the most extreme example in the region of the depletion of FX reserves resulting from unwillingness to allow a free float of the currency.
Through a combination of official appropriation of reserves for the payment of USD liabilities and active intervention via USD sales, reserves have fallen from a peak of $52.5 billion at the beginning of 2011 to below $30 billion in the past month, and HSBC expects that – with limited sources of FX inflows (other than grain exports) – this will fall to below $20 billion by end-2015.
“The more the central bank continues to spend reserves in keeping the currency fixed at around ARS8.0/USD – which we still view as expensive – the more pressures will build down the line for further FX depreciation,” concludes HSBC’s Hernandez.
Despite the Colombian peso appreciating by 2.4% to USDCOP1,994.51 last week, the most since June 2012, analysts say there might be even more, sustained, follow-through for the currency on the news that JPMorgan Chase has increased the weight of Colombia in its local-currency bond indices, the GBI-EM Global Diversified and GBI-EM Global.
According to JPMorgan, the increased allocation was taken as a result of the improved transparency and accessibility for international investors in the local TES [Treasury bond] market.
Daniel Chodos, Latin America FX strategist for Credit Suisse, in New York, adds it might also be related to the decrease in withholding taxes to foreign owners of local TES bonds from 33% to 14%, after the 2012 tax reform, and the relaxation of restrictions to set up local accounts.
In sum, he expects Colombia’s weight in the GBI-EM Global Diversified to likely increase to 8.0% from 3.2%, and to 5.6% from 1.8% in the GBI-EM Global, with a broader range of bonds also included in a phased approach over five month-end periods, starting on May 30 and ending on September 30, with JPMorgan estimating the re-weighting could translate in around $9.4 billion of additional demand for these bonds.
“The initial market reaction to the announcement was positive, but we see the potential for further benefits for Colombia’s local bonds and currency in coming months, aside from JPMorgan’s inflow estimates, as, for a start, the balance-of-payments impact of such an inflow could be significant,” says Chodos.
“Besides the benefits on asset prices, greater demand for Colombian debt could help lower government funding costs and diversify the country’s investor base away from only local players [just over 6% of local bonds are held by non-residents in Colombia, while in countries such as Brazil, Mexico and Peru these levels border 17%, 35% and 50% respectively].”
He concludes: “We estimate that this ratio for Colombia could reach around 17% if the full amount of possible inflows materializes.”