How will the sub prime/credit market correction affect Latin America for the rest of this year?
It is an opportunity for those who want to remain invested in Latin America. As long as the credit adjustment remains contained, US growth may slow down gradually, allowing Latin America to decouple from the credit correction. In this setting, Latin America’s financial and economic performance will remain sound. If the sub-prime mortgage markets crisis leads to a severe credit contraction in the US economy, a recession will appear more likely. This will push commodity prices lower on the back of weaker US growth, further squeezing equity and currency assets in Latin America. Interest rates will also come under pressure. After that, external and local currency curves will steepen. A strong technical element is exacerbating the pressure and leading investors to be more careful about finding entry points. As a result, the lowest-rated countries that most deteriorated will benefit the most. Argentina would recover if its policy stance strengthens after the presidential election in October, which appears likely. After that, to some extent, Venezuela and Ecuador would also benefit. The more liquid intermediate plays, the investment grade convergence stories, Brazil, Colombia and Peru, are positioned to follow, with currency rallies and rates coming off at the long end to support much flatter curves. Brazil, which remains the best financial story in Latin America, is also likely to recover markedly.

Which countries are most exposed and why?
The lower rated countries – Argentina, Venezuela and Ecuador – because the repricing of risk leads to an exaggerated adjustment in spreads, resulting in much higher yields. Argentina has felt it most acutely. Its external debt component of the EMBI has dropped 33.7% in the first seven months of this year. Roughly half of those losses came during the last week in July and first week in August. Most external debt positions are expressed through the credit default swap (CDS) market and again we saw Argentina widening the most, followed by Venezuela. Some local markets move much more dramatically because they tend to be much smaller and therefore less liquid. Argentina’s domestic market is a good example of this. Even amid some recovery, you are seeing local Argentine funds and investors taking advantage of any uptick in the market to reduce exposure. Colombia’s local market has also come under pressure, but that has to do with a very limited ability of local funds to hedge risk, so all adjustment takes place through spot currency and rates across the curve. Locals in Colombia have no other way to reduce risk exposure but to buy dollars. A recovery, possibly led by interest rate cuts in the US to ease credit pressures, would lead to a dramatic recovery in the high yield countries that underperformed most significantly, as well as in those markets where foreign investors are the most involved, notably Brazil and Mexico.

What are we learning about this crisis?
That investors see this as a temporary correction and that there is a lot more differentiation going on between credits. Most countries’ dollar curves have held up well, with the short end moving out a little more than the long end of the curves. Even in CDS, where the long end tends to be under pressure, most countries are tighter after this correction than they were a year ago. In early August, 10-year Chilean CDS tightened two basis points and 10-year Brazil CDS tightened 70 basis points compared to their levels in January 3 of this year. Again the biggest adjustments took place in one to three year CDS, with Argentina widening out the most, as investors reassessed their exposure. Nonetheless, Ecuador remains the widest, as its spreads had already widened on concerns of a high probability of default over the next one to three years, as its economic and fiscal performance continues to deteriorate.

Where are the safe havens in Latin America?
The more defensive positions are in the external bonds of higher-rated countries such Mexico, Chile and Brazil, followed by Peru. Indeed, the most defensive assets to be in are the most liquid dollar securities, then CDS and lastly local market debt and local currency assets, which tend to be more volatile and under more pressure. Countries with sharp, tight monetary stances and strong economic policies will fare much better than those that have too much liquidity at a time of both global credit pressures and rising inflation. The best examples are Mexico, Chile and Brazil, where the impact of the correction is relatively limited. Brazil was still 70 basis points tighter on 10-year CDS in August compared to January. By contrast, Argentina’s one year CDS traded 137 basis points wider in the same period. I would expect to see that pattern continue until the end of 2007, or when global credit conditions begin improving later in the year. LF