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August 19, 2005

Latin American Spreads Continue to Defy Increases in US Interest Rates
The Latin American financial markets continue their strong showing, notwithstanding the tightening monetary policy in the United States. The Federal Open Markets Committee, FOMC raised the federal funds rate for the 10th time since June of 2004 and hinted that the tightening will continue at a measured pace in the future. This was on the back of strong employment numbers for June: the six-month moving-average of the monthly employment data rose above 200,000 for the first time since the recession that began in the fourth quarter of 2001. The 10-year US Treasury yield has correspondingly increased to about 4.40% before dropping to the 4.20-4.30% range amid indications by the FOMC is that rates have not peaked yet. Such increases in US rates and return on US assets relative to those of emerging markets usually results in souring sentiments towards emerging markets. Capital flows to emerging markets may slow down as returns on less risky US assets move higher towards those of emerging market credits. exchange rates, relatively low inflation, policy improvements, positive current account balances, and ample liquidity in U.S. Figures 1 and 2 presents the 10-year treasury rates and U.S. federal funds rate against the JPM Latin America EMBI spread index. The successful completion of the long-running Argentine debt restructuring saga explains the considerable drop in the Latin EMBI index in June 2005. The JPM Argentine Spread index dropped from about 6080 bps on June 10th to 938 by June 15th leading to a significant tightening of the index (see figure 3). Argentinean spreads now fall about 400 bps, just slightly higher than those of Brazil. The tightening reflects positive investor sentiment and the strong appetite toward Argentina debt since the conclusion of the restructuring. Yields however, are still relatively low in US and other mature capital markets and the equity markets remain subdued despite strong growth in corporate profits. Investors are starving for higher yields and are turning to emerging markets. The strong economic fundamentals in Latin America, ample liquidity in U.S. according to the Federal Reserve, and the low yields help explain the tight spreads in Latin America and other emerging market debt in spite of rising U.S. interest rates.

Spreads Continue to Defy US Rates

The JPM Latin America EMBI spread index has, however, been narrowing over the past year as a result of strong economic fundamentals: greater fiscal stability, flexible

Figure 1: Ten-Yr Treasury Against the JPM EMBI Latin Spreads Index
6 5 4 3 2 1 Mar-05 Jul-04 Dec-04 Feb-05 May-05 Aug-04 Aug-05 Sep-04 Jan-05 Apr-05 Jun-04 Nov-04 Jun-05 Oct-04 650 550 450 350 250

Figure 2: Fed Funds Rate Against the JPM EMBI Latin Spreads Index
4 3 2 1 Feb-05 Jul-04 Jan-05 Oct-04 May-05 Sep-04 Nov-04 Mar-05 Jun-04 Apr-05 Aug-04 Jun-05 Aug-05 Dec-04 650 550 450 350 250

10-Yr US Treasury
Source: JPM and Bloomberg

Latin EMBI

Fed Funds
Source: JPM and Bloomberg

Latin EMBI

Latin American Economic Commentary Weekly

Figure 3: JPM EMBI Spread Indices
1000 900 800 700 600 500 400 300 200 100 0 Feb-05 Jul-04 Mar-05 May-05 Jan-05 Nov-04 Dec-04 Sep-04 Jun-04 Apr-05 Oct-04 Aug-04 Jun-05 Jul-05 Aug-05 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0

Source: JPM






Ample Liquidity Favor EM Debt

The Federal Reserve in its July FOMC notes has stated that there is ample liquidity in the U.S. economy. Mutual funds have a lot of cash and demand from mutual funds is also pushing Latin America and other EM debt up. Mutual funds have already bought nearly $3.9 billion of EM debt so far this year, compared with $2.78 billion for the whole of 2004. But EM debt only accounts for about 3% of their portfolios. The availability of funds will lead to more buying of Latin American debt as they seek higher yields and diversification. Latin America accounts for close to 50% of EM debt traded. The JPM GBI was also established in June to track local government bonds as funds become increasing invested in local currency debt. Both PIMCO and Fidelity Investments have set up funds that invest in local currency debt.

the asset class took place. In fact, the spreads narrowed slightly for several economies. As opposed to March, when there was a significant correction at the 10-year treasury yields climbed to over 4.40%, the response this time is a slight boost to EM debt as the EMBI spreads underwent a minor tightening in Latin America.

Equity Indices
The upward trend in US rates has not significantly dampened equity markets, even though volatility is on the rise for several of the major indices. Most equity indices in the region continue the stellar growth of the past two years. The glaring exceptions are Brazil (5.02%) and Venezuela (-37.02%). In the case of Brazil, the scandals surrounding President Lulas ruling party are taking their toll on equity markets. Venezuelas near freefall has much to do with negative investor sentiment resulting from President Chavezs efforts to renegotiate contracts with energy companies. The decline in Venezuelas Stock Market Index has erased all the gains from last year (34%). Colombia continues to perform extremely well with 58% y-t-d growth after a breathtaking 86% growth last year. Chile (20.55%), Peru (20.06%), and Ecuador (17.23%) are the other high performers so far in 2005. Volatility in the equity indices has started to inch up, especially in the case of Brazil, Colombia, and Venezuela. Brazils daily volatility measures in the 20%-25% range and is trending upwards, while that of Venezuela which used to be in the low mid-teens now comes in around 27%. Some of the volatility and decline in the equity indices could be ascribed to political noise.

Fundamentals Solid in Latin America

But strong fundamentals vibrant growth, robust exports, strong fiscal position, free flowing exchange rates, improved current accounts, high levels of foreign reserves and generally low inflationary environment underlying credits in Latin America and other emerging markets. The debt- to- GDP ratio for emerging markets has fallen from a little over 50% in 1998 to about 41% by the end of 2004. The exchange rate regimes are generally flexible, and even though there is market intervention to promote export competitiveness, there are no fixed exchange rates to defend in Latin America, with the exception of Ecuador and Venezuela. The EMBIG spreads for Latin America have largely waived off the rate increase and little widening of spreads in

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Latin American Economic Commentary Weekly

Exchange Rates
Latin American currencies are holding their own against the US dollar. Over the last two years, only the Argentine peso and the Venezuelan bolivar depreciated against the dollar. The rest of the currencies have been appreciating relative to the dollar. The Brazilian real has so far this year appreciated 17% against the dollar, with most of this appreciation taken place since the government announced that it will not intervene in the swap markets. The real has gained 4.9% against the dollar so far in August. The Mexican (5.28%), Argentinean (3.42%), and Colombian (2.72%) pesos also gained despite market interventions to promote export competitiveness.

Njundu Sanneh in New York

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