Global Investor: War fears buoy Latin America

news.ft.com By Richard Lapper, Latin America Editor in Sao Paulo Published: February 24 2003 17:13 | Last Updated: February 24 2003 17:13 Global political uncertainty on the scale we are witnessing at present ought - on the face of it - to be bad for higher risk assets. But you would not get that impression from a cursory glance at what is happening in Latin America.

So far this year investors in Latin American bonds have made total returns of 3.1 per cent, following up on last year's gains of 7.1 per cent. Returns in some equity markets have been even more impressive, although shrinking liquidity means it has been very difficult to take advantage.

Since the beginning of November when it became very clear that fears of a debt default in Brazil had been exaggerated, yields have been dropping. In the last two months alone average spreads of all emerging market bonds over US Treasuries - the most widely accepted measure of political risk - have fallen by half a percentage point, with Brazil's yields down by one-and-a-half percentage points over the same period.

In January Latin American borrowers raised $4bn, the biggest amount of new issuance for three years. Liquidity is still pretty thin but dealing spreads are smaller than in the US corporate bond market and a number of banks have moved to overweight positions.

So why is this happening ? After all, the risks that have bedevilled the region in recent years seem to have been increasing. Venezuela faces especially serious problems, with local business confidence all but dead in the wake of an unsuccessful two month general strike against President Hugo Chávez. Argentina - which defaulted on its debt just over a year ago - is still some way from rehabilitating itself in international financial markets. President Luiz Inácio Lula da Silva is making good progress in Brazil but his economy is struggling, and last week's one percentage point increase in overnight interest rates - the fifth rise in the same number of months - will further damp consumption and investment in the short-term.

Part of the reason is that specialist emerging market and higher risk investors, high yields - and the good returns of last year - are attracting more buyers at a time of falling interest rates and depressed equity markets in Europe, North America and Asia.

Investors are encouraged that fiscal and monetary fundamentals are still intact in most parts of the region. Investors are hopeful that war could be good for some countries. Peru, now the world's second biggest exporter of gold as a result of massive foreign investment in the last five years, will benefit from the recent hike in gold prices.

Only Chile and the smaller Central American and Caribbean countries would be really badly hit by a rise in the oil price. Since most countries are either self-sufficient or net exporters. Even Brazil now produces about four-fifths of the oil it consumes.

Finally, as David Lubin, chief emerging markets economist at HSBC in London points out, the supply of emerging market assets has shrunk, as countries adjust to the broader increase of risk aversion since the Asian crisis and Russian debt default of 1997 and 1998 by reducing current account deficits.

"The collapse in capital flows has been very devastating but we are now living in a post-collapse world," says Mr Lubin. "This has created a more balanced market."

The problem though is that Latin America - in particular - is also extremely vulnerable to any heightened risk aversion among investors that might ocur if the war in Iraq were to be longer than is generally expected or if it were to be followed by a spate of terrorist attacks.

Guillermo Calvo, the chief economist of the Inter-American Development Bank, says that Latin American bond yields have been increasingly correlated with other high risk assets such as US corporate bonds, implying that any increase in risk aversion will directly impact the region.

"This is a completely different kind of contagion. It is very visible and coming from the north," says Mr Calvo. "You could have very strong winds blowing from the capital markets."