Capital flows to Latin America: first quarter 2006

Asset prices in emerging markets rallied to record highs in the first quarter of 2006, with bonds and equities posting strong performances on top of already remarkable 2005 gains. Spreads on dollar-denominated bonds issued by Latin American borrowers tightened by 68 basis points in the first quarter of the year, according to the Latin component of J.P. Morgan's EMBI+ index, while the Morgan Stanley Capital International (MSCI) for Latin America, an indicator of stocks' performance, increased by 15%. Emerging and Latin American markets continued to be supported by active debt management in the first quarter of 2006, as countries continued to take advantage of the favorable external environment. Brazil, Colombia and Venezuela announced buybacks during the quarter, with up to US$25 billion of bonds to be retired from the market. A large part of the buybacks concentrated on Brady bonds (US$6.6 billion for Brazil and US$3.9 billion for Venezuela). In the first quarter of 2006, new Latin American debt issuance amounted to US$15 billion, its highest level since the first quarter of 2000. Capital inflows remained strong during the quarter, and interest in local markets continued to grow. In the near future, Latin America's external debt should be supported by strong demand and by a diminishing supply of foreign currency-denominated bonds resulting from the region's low financing needs for the rest of the year, and its increasing focus on local currency issuance. Investors' interest in emerging markets assets has been a result of their perception that emerging market countries' fundamentals are strong. Improvements in emerging markets' external positions in recent years, as well as solid fiscal and monetary policies, are credited to have increased resilience to shocks. However, improvement in fundamentals alone cannot fully explain why investor demand for emerging markets assets has been so intense. Risk appetite seems to be as important as fundamentals in explaining investors' enthusiasm, and it has helped to drive spreads to their current low levels. In the first quarter of 2006, global liquidity contributed not only to lower emerging market spreads, but also to lower high-yield spreads. While in the second half of 2005 the correlation between emerging and high-yield spreads turned negative, it turned positive again in early 2006 (0.8), as global conditions benefited both asset classes. This past May brought a hearty dose of volatility to financial markets. Uncertainty towards the global economic outlook amid rising interest rates prompted investors to abandon riskier markets around the world, and stocks in emerging markets plummeted as a result. The turbulence of the past few weeks was a wake-up call, showing that emerging markets could yet be derailed despite the improvements in local markets, the diversification of investment and the use of new instruments such as credit default swaps, which have helped to transfer and spread risk. Whether increased volatility may be an inflection point in emerging markets remains to be seen, however. It will be a test of the notion that things are different this time around for this traditionally volatile asset class.