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On Aug. 12 Latin American finance ministers will meet for the second time in a week to discuss how to contain the damage from their currencies’ steady appreciation. They may soon face the opposite problem: what to do if investors react to the debt crises in rich nations by dumping emerging-market assets, a move that might actually crater the region’s currencies.
Latin America’s six major currencies strengthened 30 percent as the region bounced back from the financial crisis of 2008. Capital flooded in thanks to near-zero interest rates in the U.S., Europe, and Japan that led investors to seek higher-yielding assets elsewhere. Another factor: Asian demand soared for the region’s iron ore, copper, and soy.
Brazil’s real, propped up by inflation-adjusted interest rates of more than 5 percent, has reached its strongest level since 1999. To stem its rise, Brazil has tripled, to 6 percent, a tax on foreign purchases of domestic bonds, increased reserve requirements on short-dollar positions, raised levies on foreign loans, and bought record amounts of dollars in the spot and forward markets. Brazil also slapped a 1 percent tax on bets against the dollar in the futures market.
None of this has worked very well, though the real has recently given up some of its gains against the dollar. Traders who had bet on yet another interest rate hike by Brazil’s central bank are now thinking that Brazil will actually lower rates as inflation finally starts to cool.
Now investors may be underestimating the risk of a sudden selloff, says Gray Newman, chief Latin America economist at Morgan Stanley. “This may all turn quickly,” he says. “The sharp appreciation of the real and of the other currencies raises the specter and the concern that you could see a sharp reversal.”
The International Monetary Fund warned in April that the region’s currency appreciation could come to an “abrupt end” if easy financing dries up or commodities prices fall. The super strength of the real makes it vulnerable to a change in sentiment, Newman says. JP Morgan’s Latin America Currency Index dropped 20 percent after Lehman Brothers’ bankruptcy, led by 24 percent drops in the real and Chilean peso.
If a selloff does hit the Latin currencies the region will be better prepared to handle it. Brazil would go into any fresh crisis with foreign currency reserves of $350 billion, up from $205 billion before Lehman collapsed, and public debt of just 39.7 percent of gross domestic product, compared with 69 percent in the U.S. and 119 percent in Italy.
Colombian Finance Minister Juan Carlos Echeverry said in a radio interview on Aug. 8 that his country’s reserve levels would protect it from any “turbulence,” while Chile’s central bank President Jose De Gregorio said on Aug. 9 that Chile’s economy is in a “good position” to keep growing. If the region shows it can withstand another crisis as well as it did the last one, says Gustavo Rangel, ING’s chief Brazil economist, investors may start to question whether Latin America is really riskier than so-called safe havens.
The bottom line: Latin American currencies could depreciate suddenly if investors, worried about financial losses, dump emerging market assets.