Capital flows to Latin America: quarterly developments

In the second quarter of 2006, a hearty dose of volatility returned to financial markets. During May and June, uncertainty towards the global economic outlook amid rising interest rates prompted investors to abandon riskier markets around the world. Stocks in emerging markets plummeted as a result, while bond spreads widened. The May-June turbulence was the first test of the progress achieved by emerging market countries in strengthening economic fundamentals and reducing the burden of foreign debt. Emerging markets rebounded after volatility subsided, with stocks recovering much of their earlier losses and spreads tightening in July and August. In Latin American markets, spreads on dollar-denominated bonds widened by 40 basis points in May, 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, decreased by 14.2%. For the quarter as a whole, spreads widened by 20 basis points, and stock prices fell by 4.1%. New Latin American debt issuance amounted to only US$3.5 billion in the second quarter of 2006, the lowest level since the last quarter of 2002, and a drastic reduction from the US$14.7 billion issued in the first quarter. Corporate issuance surpassed sovereign issuance, accounting for 89% of the total Latin American issuance in the second quarter. Given the extremely favorable global conditions, Latin American sovereign issuers had actively pre-financed future external obligations in 2005 and in the first quarter, making it possible to forgo new issuance in the second quarter, when market conditions became less favorable. Risk appetite has been an important factor in explaining investors' behavior in recent months. In the first quarter of 2006, global liquidity contributed not only to lower emerging market spreads, but also to lower high-yield spreads. In the second quarter of 2006, turbulence in financial markets contributed to widen spreads both in emerging and high-yield markets. While in the second half of 2005 the correlation between emerging and high-yield spreads turned negative, it turned positive again in the first half of 2006 (0.7), as global conditions first benefited, and later adversely affected both asset classes. The May-June turbulence showed that financial markets now face a new reality of reduced liquidity and greater risk aversion. The slowdown in the U.S. economy has brought uncertainty to the global economic outlook, despite the good growth performance thus far this year in the Eurozone, in Japan and many emerging markets. The market is now facing a number of uncertainties, including the future direction of the U.S. Fed interest rate policy, as well as the pace and the degree of the U.S. economic slowdown, with geopolitical tensions adding to investors' uncertainty. The risk of a disorderly unwinding of global imbalances remains a concern.