In 1994, Mexican blue chip Gruma, the world’s largest corn flour producer, was expanding rapidly into the U.S. and other markets. It had spent hundreds of millions of dollars to build corn-processing and tortilla-manufacturing facilities on both sides of the border, taking on huge debts. Most were being financed by peso-based operations in Mexico, Gruma’s main source of revenue.
Then came a sharp run-up in U.S. interest rates and the related peso-devaluation crisis of December 1994. The Mexican economy was plunged into recession and its financial markets devastated. Gruma and numerous other Mexican companies came close to ruin as they struggled to pay expensive dollar debt with shrinking peso revenues.
Fast-forward a decade. The prospect of rising U.S. interest rates is once again worrying foreign investors in Mexico and the rest of Latin America. But throughout the region there is an air of hopeful confidence among companies, as well as most governments, that this time things won’t be so bad.
Gruma, for example, today derives only one third of its sales from Mexico, making it less dependent than before on peso-based revenues. Operations in the U.S. and several other countries are thriving, spinning off more dollars to pay debts. Over the past three years, the company’s debt has been reduced by $156 million, to about $561 million. Last month Standard & Poor’s raised Gruma’s rating to investment grade.
On top of all that, Mexico itself is better prepared than it was a decade ago, with the government’s debt load much more equitably distributed across medium- and long-term as well as short-term maturities, the economy expected to grow by at least 3 percent this year and inflation subdued.
The story is much the same throughout the region. Mexico, as the Latin American country most closely linked to the U.S. by trade and emigration, has special reason to brace for stiffer U.S. interest rates. But throughout the region economies appear to be in better shape to fend off interest rate contagion.
Certainly, the Latin American markets took the U.S. Federal Reserve Board’s June 30 quarter-point increase in the funds rate in stride. After two months of sharp losses -- partly in anticipation of the hike -- the Morgan Stanley Capital International Latin America free index gained 1.8 percent on June 30 to finish the month up 3.6 percent. The price of the benchmark Brazilian C-bond, the most widely traded emerging-markets debt instrument, gained 0.8 percent on the day, driving its yield down to about 10.2 percent -- still way above the 8.6 percent yield on April 1.
“The countries have improved their macroeconomic positions, growth has improved, their reserve requirements are better, and most countries have already taken care of their debt servicing in 2004,” says Keith Savard, director of global economic analysis at the Institute of International Finance in Washington.
Arturo Porzecanski, chief Latin American economist at ABN Amro in New York, concurs: “Latin America is in much better shape to survive an interest rate cycle than previously.” He points out that “there isn’t the bubble of short-term indebtedness. Companies and banks and governments have learned the hard way not to be penny-wise and pound-foolish by getting into a lot of short-term debt.”
In one conspicuous case -- Argentina -- the menace of higher U.S. interest rates may be the least of the country’s troubles. “Argentina has so many structural problems at the moment that a rise in the Fed funds rate will have comparatively little effect on us,” says Guillermo Bedino, director of corporate finance for MBA Banco de Inversiones in Buenos Aires. “It’s not good news, but what’s more important for us is the oil price, the soybean price, soybean consumption in China, the restructuring of the public sector, the renegotiating of contracts with privatized entities. These are the issues that will more affect the flow of new funds into Argentina.”
Overall, however, Latin American is fiscally fitter than in past interest rate cycles. Although its external debt at the start of 2004 was $728 billion, compared with $570 billion in 1994, the ratio of that debt to what the region takes in annually from exports of goods and services and other foreign earnings is 1.8, versus 2.7 a decade ago, according to the Institute of International Finance.
Stronger economic growth is a big factor. Brazil, for example, saw GDP increase by an annualized 2.7 percent in the first quarter of 2004 after contracting 0.2 percent in 2003. Argentina’s economy grew at a brisk 8.8 percent last year and an annualized 11.2 percent in the first quarter of 2004 after four straight years of recession; the government is forecasting slower, but still strong, 6 percent growth for the full year. Mexico’s economy grew at an annualized 3.7 percent in the first quarter, compared with 1.3 percent in 2003.
To be sure, the likelihood of a steady climb in U.S. interest rates is already having an impact on Latin America, and it could become more pronounced, depending on how far and how fast the U.S. Fed nudges up rates. After yields on U.S. Treasuries first spiked in early April in advance of the Fed hike, Latin American equity markets dropped more than 10 percent through late June, as measured by the MSCI Latin American free index. Brazil has been particularly hard hit: The Bovespa index declined 16 percent in dollar terms through late June.
Fitch Ratings deems Brazil the second-most-vulnerable country in the world to rising borrowing costs (behind Turkey), mainly because of a public-debt-to-GDP ratio of close to 60 percent. And the next three most vulnerable countries on Fitch’s list -- Argentina, Colombia and Mexico -- are also Latin American. Nonetheless, Brazil’s debt burden is weighted much more toward the long end than it was a decade ago, as the country has taken advantage of low interest rates to lengthen its debt portfolio.
“No country I could point to in Latin America right now is on the ropes of default,” notes David Menn, an emerging-markets debt trader at INTL Trading in New York. “The market is more stable than it was a few years back.”
Not all seasoned observers of the region find the auguries auspicious, by any means. “Latin America is in a very difficult position right now because they have already had their little boomlet,” cautions Charles Calomiris, who teaches emerging-markets finance at Columbia Business School and has been warning for months that Latin American economies are susceptible to higher rates. The rising cost of paying off sovereign debt, a strengthening dollar, a lack of political will to enact new reforms and the possibility of worsening trade terms could all make rising rates difficult for Latin America, he says. “It won’t be a depression but several years of muddling through,” Calomiris adds.
Gauging the interest rate effect can be challenging. Rising U.S. rates have tended to have a negative impact on Latin American markets in past interest rate cycles -- but not always. In 1994, when the Fed increased rates six times in quick succession, most Latin American stock markets were already in the midst of a strong rally and weren’t affected by the rate increases until months later. However, the bull market started to peter out toward the end of the year and came to a crashing halt in December when Mexico devalued its peso, precipitating a crisis that rocked investors and led to a Washington bailout.
Upward U.S. interest rate shifts have a multilayered effect on Latin America. Not only do they create higher borrowing costs for the region’s companies, they also increase sovereign debt loads, lifting the repayment burden and making it harder for governments to issue new debt as older debt matures and as interest payments come due. Accelerating inflation and rising rates in the U.S. can also lead to higher interest rates and inflation in Latin America and can weaken local currencies and make it more difficult for central banks to defend those currencies. The Inter-American Development Bank estimates that domestic lending rates in Latin America rise 5 percentage points or more for every 2-percentage-point increase in U.S. rates. Additionally, higher global interest rates make Latin American debt and equity less attractive to foreign investors, who can find high-yield, less risky investments elsewhere.
But interest rates aren’t the only variables that drive Latin American markets, and this time around, there are four positive factors at work that could lessen their impact:
One, Latin American countries are better equipped financially and economically. The region’s interest payments on foreign debt this year amount to only about 11.1 percent of what Latin America takes in from exports of goods and services and other foreign earnings, down from 16.3 percent in 1994, according to the IIF. “This is different from what took place in past crises, where you had a lot of leverage in the system,” the IIF’s Savard says.
Two, some of the impact has been factored into equity and debt prices. By late June, U.S. Treasury rates had jumped some 115 basis points and the spread between U.S. and emerging-markets yields, as measured by the J.P. Morgan emerging-markets bond index, had risen to about 500 basis points from 400 or so basis points at the beginning of the year.
Three, while some countries -- notably, Argentina and Venezuela -- are on shaky ground both economically and politically, a comparative lack of overt social upheaval and the absence of any major upcoming elections mean that the political confrontations that exacerbated so many earlier economic and financial crises don’t seem as likely this time.
And four, Latin American equity markets are more correlated to their U.S. counterparts than they were during past interest rate cycles, not only because of greater inter-American trade but also because of the consolidation of global equity markets and the growing percentage of Latin American companies that list their shares on U.S. exchanges. As a result, a rising U.S. stock market bolstered by a continuing recovery (higher interest rates notwithstanding) could do a lot to support Latin American equities.
Then, too, rising U.S. rates reflect economic growth and hence demand -- which should be an immediate boon for Mexico post-Nafta and have a spillover effect for the rest of Latin America (especially Brazil, whose trade with Europe has suffered from the Continent’s sluggish economy). Also in contrast to 1994, many more major Latin American companies -- all big Mexican banks, for example -- are foreign-owned, so have deeper pockets for coping with currency and other troubles.
Latin America’s economic underpinnings are sturdier than in the past. For a start, monetary regimes are a lot stronger. Brazil’s real and Mexico’s peso both have a decade of stability behind them and don’t depend on central bank intervention to prop them up -- a stark difference to 1994, when Brazil was emerging from six straight years of hyperinflation. “The chances of waking up and finding that the central bank has exhausted its foreign exchange reserves by defending some artificial exchange rate isn’t there,” says ABN Amro’s Porzecanski.
The trade picture has also improved as higher commodity prices, including those for oil, copper and soybeans, and the addition of China as a major trading partner have given most Latin American countries trade surpluses. China consumed 55 percent of the world’s cement production last year, a large portion of it coming from Mexico, and 36 percent of the world’s steel, much of that produced in Brazil. Falling commodity prices and a possible slowdown in China could reverse this trend, but those surpluses are unlikely to disappear any time soon. Latin America’s current-account balance, which showed a deficit of 2.7 percent of aggregate GDP in 2001, was in surplus by 0.6 percent last year and is forecast to expand to 2 percent this year, according to the IIF. By contrast, in 1994 there was a current-account deficit of 3.3 percent of GDP.
The best thing that is happening politically in Latin America may be that nothing much is happening. With the exception of Venezuela and Colombia, there is precious little social unrest and no presidential elections in any major country until 2006. That removes a big measure of uncertainty. Still, although there is little bad political news, there isn’t much good news. Other than in Chile and Colombia, “there is not a lot of enthusiasm for good liberal economics,” notes Columbia’s Calomiris.
So far there hasn’t been a rush toward the exits by foreign investors. For example, the 70 international funds, emerging-markets funds and Latin American equity funds tracked by Emergingportfolio.com saw redemptions of $97.7 million through late June, just 3 percent of their total assets of $2.9 billion. Foreign outflows don’t necessarily mean the end for the region’s equities, in any event. “The onset of domestic bond markets and pension funds has created a domestic institutional base to which companies and banks and governments can turn as an alternative to foreign funds,” Porzecanski says.
Although Latin American countries and companies are clearly better prepared for higher interest rates this time around, there are still internal and external forces that could cloud the horizon and threaten another crisis.
Chief among them is the question of just how far and fast U.S. interest rates will move. If yields on ten-year U.S. Treasuries climb to 6 or 6.5 percent within the next year, Latin American issuers will have a harder time rolling over debt and meeting payments. “The big question going forward is how aggressive the Fed is going to be for the rest of the year,” says Juan Katz, the São Paulobased manager of the ABN Amro Latin American Equity Fund. Currency weakness -- and a strengthening dollar -- could also cause an exodus of foreign capital.
Politically, Latin American politicians are undergoing a popularity crisis of sorts, with Brazil’s President Luiz Inácio Lula da Silva, Argentina’s Nestor Kirchner and Mexico’s Vicente Fox all slipping in the polls and in their ability to effect reforms. Other domestic problems, including an energy crisis in Argentina and continued unrest in Venezuela, could also throw a wrench into market stability.
Last, trade terms, which have been so beneficial to Latin America over the past few years, could be on the verge of switching directions. If China’s economy were to suffer a hard landing, the impact on demand for everything from Brazilian soybeans and steel to Chilean copper could be severe.
Despite being better prepared to confront higher interest rates, Latin American “countries will still have to undertake good policies to attract investors,” says the IIF’s Savard. The real danger, he adds, is that governments will continue to dilly-dally on reforms.
