LATIN ECONOMY: Tie me up, tie me down

Fears are growing that Latin America’s current policy mix will prove powerless to confront the lingering economic threats

  • By Sid Verma
  • 17 Mar 2012
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While central banks in the West are caught up in something approaching an existentialist crisis, their Latin counterparts have had, at least on the face of it, a relatively easier ride coming out of the global financial crisis.

Alarm bells are ringing over the longer-term impact of the European Central Bank’s (ECB) de facto nationalization of the eurozone’s credit system, while there is widespread concern over the fallout from ultra-loose monetary policy in the US.

By contrast, since the global crisis erupted over four years ago, Latin America’s policymakers appear to have been reaping the fruits of reform. By and large, Latin central banks have emerged with their reputations unscathed, even enhanced by the crisis.

Independent monetary authorities in the region, especially in Brazil, Chile, Colombia, Mexico and Peru, have dealt with run-away inflation and the stubbornly fixed exchange rates of the 1990s. The reduction in price pressures, combined with stronger sovereign fundamentals, has allowed central banks to influence the economic cycle. “The de-dollarization of the financial system is a structural change and has provided the region with macroeconomic independence. Therefore, you have seen a big improvement in monetary policy in recent years,” says Luciano Cohan, economics professor at the Universidad de Buenos Aires.

Most recently, in 2011, inflation-targeting central banks – with the exception of Mexico – hiked interest rates to cool inflationary pressures from rising energy and food costs as well as strong aggregate domestic demand. But in the second half of last year, central banks changed tack, keeping rates on hold – or, in Brazil’s case, cutting rates – as the eurozone crisis deepened.

Brazil and Chile have resumed their respective easing cycles to prop up sagging growth. On March 7, Banco Central do Brasil (BCB) cut the benchmark overnight rate by a surprise 75bp to 9.75%, more than the anticipated half-point cut. Markets expect the pace of easing in inflation-targeting regimes will be determined by the traditional trade-off between domestic growth calculations and inflationary pressures.

Deeper questions

But aside from the cyclical outlook for interest rates, deeper questions remain over whether Latin America’s monetary policy framework can buffer the region from potential shocks, both domestic and external.

These threats veer in extremes: a negative growth shock in a global crisis, a terms-of-trade shock if China’s commodity appetite wanes, to an inflation and currency appreciation shock triggered by large-scale capital inflows in the face of western monetary stimulus.

Underscoring the volatile global backdrop, there is little consensus on which of these threats is most probable.

But in recent months, the monetary policy calculation has undergone a volte-face. After capital outflows led to the abrupt weakening of the Brazilian real in the second half of last year, Latin American markets have rebounded, partly thanks to the ECB’s efforts to reflate banks’ balance sheets and prop up the eurozone sovereign debt market.

Booming capital inflows have come at an all-too familiar cost: export-damaging currency appreciation, which has sparked concerns about deindustrialization and led to calls by besieged domestic manufacturers in Colombia and Brazil, in particular, to intervene in the foreign exchange markets.

This year, the Brazilian and Colombian central banks have intervened regularly in the spot and forward market, in attempts to limit their currencies’ upward path. Meanwhile, the BCB has embarked on a flurry of reverse-swap auctions to remove real exposure in the market.

But in Brazil, the challenge is particularly extreme. The country’s commodity wealth, strong prospects for domestic consumption and high interest rate regime – in absolute and relative terms – have all served to haul in large-scale portfolio flows this year. The result is that the Brazilian real has gained 10% year-to-end-February while the MSCI Brazil index is up 21.9% over the same period.

The country has opted for an interventionist approach to the challenge of export competitiveness: active currency intervention, capital controls and slapping import taxes on automobiles.

Raising the stakes globally, Brazil has charged – famously by its finance minister Guido Mantega but also recently by president Dilma Rousseff – that the international trading system is in the midst of a global ‘currency war’ with nations embarking on competitive devaluations of exchange rates, the principal weapon in trade protectionism.

Brazil’s frustrations stem from the central bank’s impotence so far in dampening the currency’s strength through its traditional strategy of intervening in the foreign exchange market.

At present, the central bank intervenes to ensure the real trades within the R1.70/$-R1.95/$ dollar range. But the real carry trade remains attractive for investors even with regular interventions since the market can predict the central bank’s moves.

According to Claudio Irigoyen, economist at Bank of America Merrill Lynch, if the Brazilian real appreciates from R1.85/$ to R1.75/$, a carry trade investor can generate a tidy 5.6% return via the currency forward market, an attractive short-term investment in a liquid market.

By contrast, “the BCB’s approach only deters investors when the real is close to the threshold level at which the BCB steps up intervention, probably at 1.70,” he says.

PSYCHOLOGICAL GAMES

Against this backdrop, calls are growing for the Brazilian central bank to intervene at unexpected levels. The psychological damage caused by an interventionist and unpredictable central bank – acting as either a net foreign exchange seller or buyer – would help to keep hot money at bay, says Eduardo Levy Yeyati, economics professor at Universidad Torcuato Di Tella.

The Brazilian real would no longer be seen as a one-way bet, and investors could incur losses. This move would also help to improve the composition of portfolio flows in favour of long Brazilian real positions.

If that fails, the Brazilian central bank might need to break a taboo: to let the markets know that it can and will intervene in the foreign exchange market if need be.

“At present, it looks like they are improvising; it’s high time for the central bank to issue an explicit wording of its policy to stabilize exchange rate expectations,” Yeyati says. The Swiss National Bank broke the appreciation cycle of the Swiss franc last year when it pledged to defend the exchange rate at a certain level via aggressive foreign currency purchases.

But regional central banks are reluctant to push for a change in their mandates to encompass exchange rate concerns, since this would open the door to political scrutiny and heap on pressure to hardwire development policy objectives into monetary policy frameworks, says Yeyati, a former chief economist at Argentina’s central bank.

Such a move would also encounter strong resistance. Formal exchange rate targeting is likely to be seen as the kiss of death given Latin America’s troubled history under fixed exchange rate regimes, such as the Mexico ‘Tequila’ crisis of 1994 and the Argentina crises in 1999–2002, says Carmen Reinhart, fellow at the Peterson Institute for International Economics.

If a nimbler approach to exchange rate intervention is unlikely in the near term, a cyclical reduction in interest rates might, at the margin, help ease currency appreciation pressures – but only if the interest rate gap between G4 economies and Latin America narrows significantly. (With the ECB’s and the Fed’s stated commitment to keep rates at historic lows, that seems unlikely for now.)

Self-inflicted wounds?

Some analysts fear Latin American policymakers have shot themselves in the foot since domestic policy calculations have also contributed to currency appreciation – which has chipped away at regional manufacturing – in recent years.

In Brazil, Colombia and Peru, for example, the inflationary effects of loose fiscal policy set off interest rate hikes, fuelling yet-more capital inflows between mid-2009 and mid-2011. The BCB raised rates each month during the first half of last year to reach 12.5% by July – one of the highest real interest rates in the world.

Calls are growing for tighter fiscal policy to give central banks more room for manoeuvre. “Pro-cyclical fiscal spending remains a secular trend in Latin America. A reduction in government spending would help monetary policy,” says Guillermo Calvo, professor of economics at Columbia University.

At the heart of the challenge is the tradition in large Latin American economies whereby fiscal policy is at the vanguard of growth while monetary policy attacks inflation. In Brazil, monetary policy is further challenged by the quasi-fiscal activities of the Brazilian Development Bank (BNDES), whose heavy lending in fixed-rate credit markets has fuelled inflation.

As a result, a more coordinated fiscal and monetary policy is needed, says Calvo, a former chief economist of the IDB.

But for some observers, the efficacy of the inflation-targeting monetary policy frameworks in Latin America, more generally, is open to question, given the over-zealous monetary policy response to price pressures and rising global headwinds.

“Policymakers in Brazil last year not only tightened prematurely, they were also misguided in seeking to counter inflation fuelled by external factors,” says Alfredo Coutino, Latin America director at Moody’s Analytics, citing how price pressures came with high commodity prices.

“The central bank accommodated market pressures rather than applying sound monetary principles – making policy consistent with the nature of inflation – since markets insisted the economy was overheating and demanded rate rises,” says Coutino. This “unjustified policy overreaction” reduced growth, in part, since the strength of the real – exacerbated by the high interest rate environment – crimped investment and exports.

As a result, says Coutino, inflation-targeting central banks in the region should be bestowed with a dual monetary mandate: maximum growth with minimum inflation, akin to the US Federal Reserve. This would increase the chance that fiscal and monetary policy is more synchronized and reduces the risk of self-defeating rate hikes, he says.

Others, however, disagree: “Over the past year, it’s clear that interest rate hikes to reduce inflation are a powerful signal to the market that central banks have the policy tools and willpower to confront the challenge,” says Calvo.

He is sceptical that the monetary policy transmission – that is, the extent to which a change in interest rates will affect economic behaviour – is sufficiently strong for rate hikes persistently to depress growth below its potential output.

Instead, Calvo reckons Latin American central banks should make greater use of banks’ reserve requirements as a means of raising lending rates without encouraging unwanted capital inflows.

Growth prospects

However, Latin America’s structural growth prospect is itself in doubt, as the developed world struggles under its debt burden and China faces weaker growth in the coming decade, increasing the need for lower borrowing costs to boost growth.

Graciana del Castillo, managing partner of Macroeconomics Advisory Group, says: “I worry about Brazil’s growth rate [at 2.7%] since growth needs to be a lot higher because of all the needs in infrastructure, social development needs and security, which all require a large amount of investment.”

To add to the challenges for central bankers, the global crisis has underscored the need for monetary authorities to adopt beefier macro-prudential regulations and factor these objectives into monetary instruments. The stakes are rising at a time of large-scale capital inflows, which risks greater financial sector leverage, orientated towards unproductive sectors.

Latin American central bankers, like their European and American counterparts, are faced with the challenge of ensuring policy tools balance exchange rate, inflation, growth and macro-prudential concerns.

But the dilemma is particularly acute in the large inflation-targeting commodity exporters at a time when government spending is high, and the odds are seemingly evenly balanced between a negative growth shock or the persistence of export-damaging capital inflows.

  • By Sid Verma
  • 17 Mar 2012

All International Bonds

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 09 Jun 2017
1 Citi 206,449.53 755 8.84%
2 JPMorgan 192,919.68 823 8.26%
3 Bank of America Merrill Lynch 175,174.46 602 7.50%
4 Barclays 144,195.77 526 6.17%
5 Goldman Sachs 139,497.22 445 5.97%

Bookrunners of All Syndicated Loans EMEA

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 20 Jun 2017
1 Deutsche Bank 23,530.61 67 7.96%
2 HSBC 20,994.25 74 7.11%
3 Bank of America Merrill Lynch 20,490.14 49 6.93%
4 Credit Agricole CIB 15,076.29 72 5.10%
5 BNP Paribas 14,834.05 81 5.02%

Bookrunners of all EMEA ECM Issuance

Rank Lead Manager Amount $m No of issues Share %
  • Last updated
  • 20 Jun 2017
1 JPMorgan 10,673.78 46 8.06%
2 Citi 9,632.20 60 7.28%
3 Goldman Sachs 9,310.79 46 7.03%
4 UBS 9,230.61 36 6.97%
5 Morgan Stanley 8,508.94 46 6.43%