Capital flows to Latin America: first quarter 2005

Latin American markets entered 2005 with impetus, as the favorable environment for capital inflows at the end of 2004 persisted in the beginning of the year. However, investors' sentiment deteriorated as the first quarter progressed, and concerns about economic conditions (including rising interest rates in the United States and lower liquidity in global markets) increased. In February, Fitch, the credit rating agency, released a report warning that a combination of slowing global growth and higher-than-anticipated U.S. interest rates would lead to a less favorable environment for emerging market borrowers, as investors reduce their exposure to borrowers with weak credits. Investors moved into risk aversion territory in March, according to J.P. Morgan's Liquidity, Credit and Volatility index (LCVI), after spending the early part of the year in risk seeking mode. Goldman Sachs' Risk Aversion Index (RAI), after falling to a trough of 3.65 in February 2005, a level last seen in early 2000, rose to 4.32 in March and 4.60 in April . Although two points do not make a trend, many investors believe risk aversion is gaining momentum. After declining in February, Latin American spreads rose in March, reflecting the deterioration in investors' sentiment towards the end of the quarter. Despite the increase in March, spreads remained at low levels. There were many more positive credit rating actions than negative in Latin American markets during the quarter, since the combination of less vulnerability to liquidity shocks (as a result of the structural changes of the past 5 to 10 years) with the favorable global environment in the past few years bolstered solvency in Latin American countries. Latin America new debt issuance in the first quarter was strong, covering more than half of the regions financial needs for 2005. The Latin American region has performed strongly in the past two years, and continued to perform well in the first quarter of 2005, despite deteriorating external conditions towards the end. The most remarkable fact regarding the region's performance is the fact that the biggest challenges in the near future, according to market analysts, are not of a domestic nature. They are the risk of a hard landing in China, the potential impact of the U.S.'s rising interest rates, weakening dollar and slowing economy, and the effects of increasing oil prices on the global economy. According to the Institute of International Finance (IIF), rising interest rates in the U.S. and the continuing current account imbalances in the global economy point to a more challenging phase ahead for all emerging markets. The IIF has warned of excessive risk-taking by emerging market investors, adding its voice to concerns expressed by the International Monetary Fund and the World Bank about the potential for a disorderly adjustment in global financial markets.