As global financial markets undergo a new phase of repricing risks and normalization of global asset prices, after the peak of a Minsky credit cycle, the current (long or short) period of turbulence in Latin American financial markets is also bound to continue. Whether or not the benevolent credit squeeze becomes a deadly credit crunch ahead, and the current period of financial market turmoil unfolds as a systemic risk episode, it seems that the period of exceptionally low levels of global risk aversion and plenty of liquidity sources to tap has come to an end. Therefore, Latin risks and assets will also be re-priced accordingly.
However, I believe the most likely outcome in the region yet to be only a mildly higher average risk premium, with higher differentiation among Latin risks, as compared to the relatively undifferentiated and exceptionally low risk premiums of recent years. In my view, the Latin American asset price adjustment ahead will be a moment along which the fiscal and balance-of-payments evolution of last years, if maintained may generate a stronger correlation between risk premiums and their differentiated domestic determinants.
Are (Bad) Old Times Coming Back in Latin America?
Andrew Powell introduced here last week (July 31) the results of an empirical research on the relation between spreads and ratings, and on how the levels of spread in that relation rise and fall in tandem with global indices of risk aversion (VIX in his case). Everything else equal (including no change in country ratings), the ongoing ascension of global risk aversion would inevitably be leading toward higher spreads for all Latin American countries. If, e.g., the VIX end up returning to those levels attained during the 1998 LTCM crisis, sovereign spreads might skyrocket as well.
A strong statement comes when he remarks: “if the increase in risk aversion is related to events that also weaken fundamentals then we would also expect some downgrades to occur. Indeed (…) most of the improvement in the fundamentals that drive credit quality (and hence credit quality itself) has been due to global factors or put another way, the significant improvement in country fundamentals has been mostly endogenous to such developments as unprecedented world growth and export prices”. Not only the abnormally low risk premiums of the recent past in the region, but even the predominance of rating upgrades, would all be basically derived from “good luck” in the global environment. Most of what has been taken by many as locally driven improved fundamentals in several countries – less inadequate public debt composition, more sustainable public debt trajectories, accumulation of foreign reserves etc. – would in fact be either non-significant enough to make a difference or simply endogenous – and reversible – with respect to global factors. And “good luck” is just waning…
In my view, it is worth distinguishing the particular component of “abnormality” in the record low spreads that can be directly associated to the simultaneous “abnormality” of ultra-high confidence and liquidity abroad. As Powell highlighted in his previous blog (July 26): “Spreads are significantly lower than would be expected even considering today’s high ratings given the past relationship between ratings and spreads”. This wedge between actual and expected levels is a feature specific to the maybe now-ended period of aggressive practices of risk slicing and transfer, boldness in risk taking, and extraordinarily low risk aversion.
That “abnormal” willingness and ability to assume risks may also explain why differences in risk premiums among emerging economies as a whole have not been as accentuated as what their fundamentals might imply. Huge differences in terms of balance-of-payments and fiscal conditions have not reflected in risk premiums and availability of finance (see here).
Let me then argue why, after some period of global financial market turmoil, during which that abnormal wedge between expected and actual risk premiums will dissipate, the possible permanence of some favorable fundamentals in the region will lead to an only mildly higher average spread, with more differentiated country assessments by markets.
When flows matter
Guillermo Calvo and Ernesto Talvi pointed out reasons why current-account surpluses in Latin American economies should not be taken as ring-fencing them completely against worsening global conditions. Positive flows can hardly make up a solid defense when stocks of assets stampede out of a country. And “in spite of its strong current account position, the region might find it difficult to roll over existing stocks of debt if there is a significant tightening in global liquidity.”
On the other hand, we should also recall that holders of local assets try to liquefy their wealth and run away massively only when a significant probability is assigned to sudden devaluations of a comprehensive portion of that local wealth. Flows matter because they affect the likelihood of such abrupt events (default or drastic currency/asset devaluation), unless fears about stock values predominate. When the combination of flows and expected stock values make up a sustainable overtime trajectory, under reasonable margins of confidence, the probability of run-outs tends to be low.
In effect, all Latin American experiences since the 1990s with sudden exits and “twin crises” have had at the core either fiscal and/or balance-of-payment trajectories perceived as unsustainable. When self-fulfilling expectations and multiplicity of equilibrium appear in the explanations, references to some kind of weak fundamentals are always unavoidable.
The favorable public-debt and net-foreign-liability trajectories of several Latin American economies in the recent past are a clear departure from the scenarios prevailing during their corresponding crises. Therefore, even if sudden stops by investors are ever conceivably possible, the likelihood of such stops seems to be substantially low where, under reasonable simulations, the current financial turmoil and economic slowdown abroad will not dismantle sustainable fiscal and balance-of-payment trajectories.
Calvo and Talvi also refer to the fact that current-account surpluses do not mean that all sectors have a positive savings-investment balance and, thus, shrinking foreign sources of liquidity may hurt those sectors dependant of foreign finance. But sectors and companies capable of normally obtaining funding abroad are also among those that are in best conditions to tap domestic sources. Not by chance, the exhibition of some resistance to shocks among Latin economies has been directly correlated with the health of domestic financial intermediation and of general financial conditions. Again, it is also by no chance that domestic credit conditions have evolved favorably in recent years in those Latin economies that have improved their fiscal and monetary management, and that have started to recover some domestic demand-led expansion.
Watch out for Commodity Prices
Calvo and Talvi express some skepticism on the survival of current-account surpluses and of favorable balance-of-payment dynamics in the region if commodity prices fall substantially. Despite the heterogeneity of commodity-dependence conditions among countries, the authors are right in highlighting this channel of transmission of potential damage from an economic downturn abroad. Even assuming that sustainable domestic fiscal trajectories are kept, the erosion of current-account balances could undermine the protection against imported shocks.
Nonetheless, the IMF has just reviewed upward its projections for the global economic growth in both 2007 and 2008, despite haircutting the expected growth of the US economy. “The major upward revisions have been for emerging market and developing countries, with growth projections substantially marked up for China, India, and Russia.” This obviously augurs well for commodity prices.
As Adam Cole (from RBC Capital Markets) observed last week, “there is one asset class that has so far remained immune to the turmoil caused by fears of a US credit market meltdown: commodities” (Financial Times, August 3). While since mid-July, equity, foreign exchange and fixed-income markets have been driven by the ebb and flow of appetite for risk, “commodity price movements have remained uncorrelated with bonds, equities and FX”.
That relative autonomy of commodity price movements heretofore tells us two things. First, the dynamics of supply and demand – more than liquidity and search for yield – has been at the basis of the evolution of commodity prices. Secondly, the global economy as a whole may be less vulnerable than what one might think just looking at falling equities and widening credit spreads. As Adam Cole noticed: “if current worries on financial market liquidity really extended to real economic variables, commodities should already be falling with other cyclical asset classes”.
Bottom line
Our guess is that risk premiums will not go back to the extraordinarily low levels of the recent past, as a trend in the region. On the other hand, it is also our hunch that they will neither stay at crisis levels, nor remain as undifferentiated as they have also been and will be during the turmoil period.
First appeared at Roubini EconoMonitor