Jesse Rogers and Jonathan Levine clock the currency game in Latin America
Some like it hot – but for global investors, Latin American currencies are losing their sizzle, as a one-two punch of slowing Chinese growth and a rising US dollar puts downward pressure on exchange rates.
The unwinding of the global carry trade—the practice of borrowing, typically in US dollars, to invest in higher-yielding emerging market currencies—has accelerated a slide in emerging market asset prices that began last July, when underwhelming growth numbers showed China falling short of officials’ 7.5 percent annual target.
In the months to follow, a nascent US economic recovery and expectations of Federal Reserve tightening pushed major Latin American currencies further south, with the Brazilian real and Colombian peso falling more than 10 percent, at the upper-end of the 25 emerging market currencies tracked by the MSCI global index.
While countries with large trade deficits—think Turkey, India, South Africa, and to a lesser degree, Brazil – were the first to fall into investors’ crosshairs when Fed began to scale back, or “taper”, its US$85 billion monthly bond buying program in December 2013, the latest slide has been broad-based, targeting surplus and deficit countries with equal fervor.
In Mexico, where external debt is less than 2 percent of GDP – well within the 3 percent threshold considered sustainable by most economists – a sliding peso is testing inflation already at the top of the central bank’s target range, potentially offsetting any gains in competitiveness from a cheaper currency.
The peso has fallen more than 4 percent since July, almost twice the level of the MSCI index.
Though Latin American finance ministers are keen to call off the Hemisphere’s so-called currency wars, few are cheering the current fall.
Brazilian Finance Minister Guido Mantega, who accused the Federal Reserve of “throwing money from a helicopter” in an oft-repeated shot at developed countries, has recently compared a rise in US interest rates to a giant “vacuum” sucking capital from emerging markets.
Some fear he may be right.
For years, Latin American currencies were among those most favored by investors partaking in the global carry trade, which helped drive over US$600 billion in short-term portfolio flows to the region since 2010.
When the dollar weakens, the carry trade rewards spectacularly, with traders gaining first from a strengthening peso (or real), and then from interest rates that tend to exceed those offered in the US. But now, a surging dollar has pushed carry returns for most emerging market currencies into the red, with foreign currency losses devouring any gain from higher interest rates.
It is difficult to put a number on the global carry trade – some estimates figure about US$2 trillion – though most Latin American countries are now less dependent on short-term portfolio flows than in the past. Yet even when investors purchase foreign purchases of stocks and bonds over a longer horizon, if and when carry returns eat into capital gains, a slowdown or reversal in capital flows could be in store.
In October, short-term portfolio flows to Latin America dropped 33 percent from the month before, falling to US$5.6 billion, according to data gathered by the Institute of International Finance, though the drop could also have been triggered by higher financial market volatility stemming from a sharp decline in crude oil prices.
For now, the potential acceleration of inflationary pressures through higher import prices is a more immediate concern, complicating efforts by central bankers in Mexico, Chile, and Peru to fight slower growth by lowering interest rates.
But not all depreciations are equal.
While currency depreciation has contributed to higher inflation in Mexico and Brazil, officials in Chile, Colombia, and Peru have yet to blink, with Colombian Finance Minister Mauricio Cardenas arguing in September that a continued, “healthy” depreciation of the peso would improve competitiveness by lowering the price of Colombia’s exports.
If he is right, the current slide in Latin American currencies might just be enough to bring back the heat.
Jesse Rogers is an energy analyst focusing on natural gas markets in Latin America. He previously worked as a finance and politics reporter for Impremedia and as a research assistant for Mexico City’s Centro de Investigación y Docencia Económicas (CIDE). See his previous work for No Se Mancha HERE
Jonathan Levine is a private equity associate focusing on emerging markets. Before moving to DC, Jonathan worked in Singapore as a foreign currency analyst for JP Morgan.