Capital flows to Latin America: quarterly developments

In the first quarter of 2007, Latin American spreads tightened to new lows and equity prices climbed further, despite a brief bout of market turbulence in late-February and early-March. The good macroeconomic performance of the countries of the region contributed to these favorable developments, but the high level of liquidity in global markets, as well as elevated risk tolerance among market participants, also played a very important role.The negative shift in market sentiment in late-February and early-March was triggered by steep declines in global equity markets - which came after an almost 9% drop in the Shanghai market on February 27, its biggest fall in a decade - as well as by concerns about the U.S. mortgage market and its potential impact on the U.S. economy. Although brief, the bout of market turbulence lifted implied volatilities in most markets. Global equity markets quickly recovered, and Latin American stocks continued their winning streak, surging in the quarter. The Morgan Stanley Capital International (MSCI) Latin American Price Index gained 5.6% in dollar terms in the first quarter, following a gain of 21.1% in the fourth quarter of 2006. For the first five months of the year, Latin America's MSCI gained 22.1%. The quick recovery of Latin American asset prices after the sell-off indicated that market confidence on the region was not easily displaced, even by sharp fluctuations in asset prices.As a result of the search for yield in face of ample global liquidity and improving fundamentals, Latin American bond spreads continued to tighten to record low levels in the first quarter, despite widening briefly during the sell-off of late-February and early-March. According to JPMorgan, the EMBI+ Latin component tightened 11 basis points in the first quarter and 18 basis points in the first five months of year. Compared to U.S. corporate spreads, Latin American spreads of similar credit rating continued to trade at tighter levels. As long as returns remain attractive relative to alternatives such as the U.S. high yield, the region will continue to be an important destination for capital flows, with inflows moving to corporate and local currency debt, as well as stocks. Latin American markets were also supported by active debt management in the first quarter, as countries took advantage of the favorable external environment to improve their debt profiles, increase issuance in local currency and develop local markets. Sovereigns in Latin America are estimated to have already met 74% of their 2007 external debt financing needs according to Credit Suisse. Pre-financing and debt management has led to improved debt structures and increased resilience to external shocks.