Latam currencies continue to falter

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A new wave of asset sell-offs has placed fresh depreciation pressures on the region’s currencies. Given the uncertain political and policy climate, it appears increasingly likely that Latin American currencies will undergo another stress test in 2022.

Early on in the year, many regional currencies showed signs of stabilisation—and some, such as the Chilean peso, even recorded solid gains. However, in recent weeks all of the region’s major currencies have succumbed to renewed depreciation pressures that have taken them back below pre-pandemic levels. By and large, the current account is not a cause for concern: virtually all Latin American economies are reaping the benefits of soaring commodity prices and robust external demand.

Instead, the main source of currency weakness is the financial account. This partly reflects weak foreign direct investment, which remains below pre-pandemic levels across most of the region. However, the more important factor at play is the exodus of portfolio capital. The elevated level of political and policy uncertainty across Latin America has prompted foreign institutional investors to reduce their exposure to the region. Meanwhile, domestic economic agents are also dollarising their portfolios to hedge against radical policy shifts. This was especially evident in Peru, where outward portfolio investment rocketed to an all‑time high of US$5.9bn in the first half of 2021.

Political volatility is unlikely to abate in the near term. Chile, Colombia and Brazil all have a general election in the next 15 months, with left-wing candidates emerging as presidential front-runners in each of those countries. Additionally, an ongoing process of constitutional reform in Chile, unstable institutional dynamics in Peru, and tenuous negotiations between Argentina and the IMF over a new lending arrangement will all dampen market sentiment and sustain the potential for capital flight.

Complicating matters further, the outlook for global financial conditions has started to darken. The Federal Reserve (the US central bank) has indicated that it will wind down its ultra‑loose monetary policy sooner than previously anticipated. Central banks across the region have pre-emptively started to tighten domestic policy, in order to widen interest-rate differentials and contain outflows related to developed-market policy normalisation. Nonetheless, as illustrated by the 2013 “taper tantrum” episode, Latin American economies are especially susceptible to sudden stops in foreign capital.

Even taking into account the comfortable reserves position of many central banks in the region, risks are tilted towards increased currency weakening than we had pencilled in for 2021-22.

Wed, 13th Oct 2021 Article tags BusinessDigital paymentsEconomyRiskAmericasCountry AnalysisEIU Store