Protected from the subprime chaos

It was a most unusual reversal. Across markets worldwide, asset prices were in freefall. But contrary to many financial crises in the past quarter of a century, this time the firestorm had its origin elsewhere.

In the aftermath of the US subprime mortgage meltdown, Latin America is limping like markets everywhere. But the damage so far seems contained and although certain countries - Argentina, Ecuador and Venezuela - have been hit harder, for the most part the region can boast unprecedented resilience.

Whether it was the Mexican debt crisis of the 1980s or the shocks that hit Brazil and Argentina a decade later, the region has paid a high price for fiscal mismanagement and policy weaknesses. But in the past five years, almost every country in the region has gone to great lengths to open up their economies, increase savings and reduce debt levels. They've also diversified exports away from the United States and implemented reforms designed to boost competitiveness.

The homework has paid off. Interest rate spreads, although wider than their pre-meltdown July lows, are well below levels observed even 18 months ago. Stock market values have declined in dollar terms, but are about 40% ahead of a year ago, outperforming by a factor of three the gains on Wall Street. International reserves in Brazil, Latin America's largest economy and by far the region's biggest debt issuer, have surged to a record $175 billion, more than enough to cover its entire debt load even if it were to be cut off from credit markets completely.

Is Latin America - and emerging markets generally - becoming a safe haven from the subprime storm?

That all depends on your world view and whether the current market turmoil and predicted slowdown of the American economy turns into a systemic worldwide crisis. But even if such a dreaded scenario does come to bear, there are reasons to conclude that Latin America and other emerging markets are less vulnerable than ever before to external shocks.

Back in the game

Despite enhanced risk aversion worldwide, investors are so far barely recoiling. After the mid-July tailspin forced an immediate retreat, investors in late August started returning to the region, albeit at a less frenzied pace. According to Emerging Portfolio Fund Research (EPFR) Global, which tracks fund flows around the world, so far this year investors have poured a net $3.32 billion into emerging market bond funds, about half of which are weighted in Latin America. Although the market sell-off on Wall Street was the most severe of the past seven sell-offs in recent years, outflows from the region during the crisis - about $1.44 billion - were the most modest ever. And in the last week of August, a net $74.8 million in new money returned to emerging market bond funds. "It's the mirror image of where things were in 1998, when emerging markets were the most vulnerable and implosion of some of the most fiscally unstable countries spilled over into developing markets," says Brad Durham, managing director of EPFR.

Among those betting on a rosy future for the region is Dutch insurance giant ING. At the same time that global markets were seizing up, affiliate ING Americas announced on July 27 that it had reached an agreement with Spanish banking giant Santander to acquire its pension businesses in Chile, Mexico, Colombia and Uruguay. The $1.3 billion deal would make ING the region's second-leading pension fund manager, with assets under management of EUR33 billion, the majority of their portfolio in sovereign bonds. (ING already owns a pension fund in Peru and is in talks to acquire Santander's partly owned fund in Argentina).

"From a capital markets perspective, the difference in Latin America between today and 10 to 15 years ago is astronomical," says Tom McInerney, the ING executive board member who negotiated the deal. "Even leftist governments like Brazil and Argentina clearly understand now the importance of managing their economies well."

Natural bounties

Although McInerney expects the subprime mortgage crisis to halve US growth estimates, he's not expecting any huge spillover effect. Reassuring him and most foreign investors has been the region's surfeit of oil, grains, copper and other commodities that are all very much in demand by booming economies in China and India. To the degree that the prices of raw materials hold up - and so far they mostly have - the region will fare reasonably well, the logic holds. And large sugar producers like Brazil and Colombia may reap additional benefits should the biofuels craze continue.

For now, nobody is revising downward their economic growth outlook for the region, which the International Monetary Fund estimates will be 5% for 2007 and 4.25% for 2008. With foreign investment pouring in, and every country except Colombia boasting huge trade surpluses, a regionalised credit crunch is unlikely to be felt any time soon.

But a few contrarian observers believe the region's strong fundamentals may be giving it a false sense of security. Walter Molano, analyst for BCP Securities in Greenwich, Connecticut, predicts the region is heading for a sudden whiplash. "Myopically focused on their own situation, regional leaders, policymakers and most local analysts have no realisation that the deleveraging of the US financial system is going to reverberate throughout the globe, and that Latin America will not be immune," he says.

Just as Latin American governments were slow to spend the commodity-fed windfall when they awoke to the potential of China around 2003, now that the purse strings have been loosened nobody is sure - especially given the region's history of profligate, political spending - if they'll be able to tighten them again in time. Excluding oil-rich Venezuela, primary spending before debt servicing grew by 7.3% last year versus just 1.8% and 2.7% growth in 2003 and 2004 respectively. This year it's expected to grow even faster. "Latin America isn't any more resilient than it was before the commodity boom," warns Molano. "The only difference now is that the spending spigot is turned full on."

Indeed, unlike the US Federal Reserve, the top priority for most of the region's central banks remains controlling inflation and cooling off overheating economies. Central banks in Mexico and Colombia, for example, left their target interest rates unchanged, with a tightening bias, at their last meeting. And Chile even increased its borrowing rates by a quarter-percentage point in the face of a rise in its year-end inflation forecast to 5.5%. "You'd have hoped that in a globalised economy with real-time information, they'd be acting as aggressively as people in New York and London," says Molano.

Resilience

While the hype surrounding Latin America's reform agenda may be overblown, most analysts shrug off the doomsday scenario. "Who cares if it was a passive or active stance, or just the commodities boom, that has led to the accumulation of so much reserves. The fact is the region's fiscal situation has never been stronger," says Siobhan Morden, Latin American debt strategist for ABN Amro in New York. Indeed, the IMF estimated earlier this year that any external shock resulting in more than a 5% drop in commodity prices during a quarter, or a widening of 115 basis points in spreads over US Treasuries, would affect growth in the region by less than 1%. "Clearly the region is in a less vulnerable situation than ever before," says Morden.

Boosting the region's defences is the scant exposure among banks to subprime mortgages or collateralised debt obligations in foreign markets. More flexible exchange systems and the ability to issue debt in local currencies have reduced two other important sources of past vulnerability. Even though corporate and sovereign bond sales have remained at a complete halt since July, every country in the region except Peru has covered its financing needs for the rest of the year and many have already given themselves a head start on 2008.

Capping off a trend towards local sources of financing in recent years, rating agency Moody's predicts that many Latin American companies will for the next year be able to find adequate financing in their home markets. Led by Mexico and Brazil, trading in local currency bonds accounted for a record 64% of $1.75 trillion in emerging market trading volumes in the second quarter, itself an all-time high. That compares with a 45% share in 2004, according to data from EMTA, an emerging market trade organisation. "For countries with strong fundamentals, there should be plenty of local liquidity to pick up the slack in foreign demand," says Ricardo Amorim, emerging market strategist for West LB in New York.

Picky

Analysts concur that even if a global recession is avoided, some Latin American credits will be punished more than others. For the first time, investors are beginning to differentiate among the region's sovereign credits instead of lumping them together. On one side of the growing divide, deserving preferential treatment by creditors, are big issuers like Brazil and Mexico, joined by smaller Chile, Colombia and Peru, which have largely followed orthodox policies. On the other are Argentina, Ecuador and Venezuela, all of them governed by populist leaders who have threatened in the recent past to snub foreign creditors. Indeed Argentina, five years after its $100 billion default, remains locked in a heated public battle with creditors holding on to unpaid bonds totalling $20 billion.

Despite its poor relations with creditors, Argentina in recent years has ridden the wave of global liquidity more than any other country. When the sovereign returned to market (locally in pesos) in May 2005, the spreads were off the charts at 900 basis points over Treasuries. But investors with cash to burn found its booming economy attractive and forgave its past sins, pushing spreads below 200 in January of this year.

Brazil, following more prudent policies recommended by the IMF including amassing a primary surplus equivalent to 4.25% of GDP, was rewarded with only a slightly better risk premium. Since the market downturn, however, Argentina has widened again to over 450 basis points even as Brazil has stabilised at around 200bp. Overall, the region's risk premium has widened since the start of the crisis from 150 to 240bp, according to the JPMorgan Emerging Market Bond Index (Embi+). "Countries where policies are weak, like Argentina, Ecuador and Venezuela, need to act promptly to avoid serious damage from the current turmoil, as was the case so often in the past," says Claudio Loser, former head of the Western Hemisphere department at the IMF and now a senior fellow with the Inter-American Dialogue. "The others seem well prepared to confront any unpleasant surprises."

Analysts predict that, withstanding a global recession, Brazil as well as Mexico and Chile - the region's only two investment-grade sovereign issuers - could in the coming months climb back to their previous highs. Already in the topsy-turvy credit scenario sparked by the subprime meltdown, Brazil is seen as less of a default risk than high-yield US and European corporate debt. Spreads on the country's five-year credit default swaps now stand around 114 basis points compared with 142 for five-year CDS on investment bank Bear Stearns, rated single-A plus.

The most likely to suffer if there is a US economic downturn is Mexico, 85% of whose exports are destined for the United States. But even a downturn strikes, the news isn't all bad. Investors are betting on imminent approval of a fiscal reform package in Mexico that would boost tax collection by at least 1.5% of GDP and could lead credit rating agencies to raise Mexico's sovereign debt rating. There is even talk that the rating agencies may fly in the face of market turmoil by upgrading Colombia, Peru and Brazil to investment grade in the short term.

While that's good news for the countries' economies, it means dedicated bond investors are unlikely to see the huge returns of the past few years any time soon. "The kicker credits like Argentina, where risk-tolerant investors made the bulk of their money, are no longer in play," says Enrique Alvarez, Latin American fixed-income analyst for IDEAglobal in New York. "After a very broad shake-out, risk intolerance has been thrown out of the window and all the riskier credits that were dragged to pump up yield no longer seem attractive."