Chapter

II. Latin American Linkages to Global Financial Market Turbulence

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
April 2008
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Resilience So Far, but Global Context Weak

As described in Chapter 1, the region’s financial markets have so far been much less affected by the global turmoil originating in the United States than in past periods of crisis. This partly reflects the much-reduced reliance on U.S. capital inflows. More importantly, the strengthening of monetary and fiscal policies and public debt management in recent years, together with the adoption of more flexible exchange rate regimes in much of the region, have also helped to build resilience.

Nonetheless, there is a risk that the weakened financial conditions in the United States could have a significant impact on equity prices and ultimately on the cost of capital more broadly in the Latin American and Caribbean (LAC) region, particularly if there is a protracted global credit crunch (Box 2.1). This chapter examines the region’s linkages to global financial markets through the banking system as well as corporate financing more generally, and discusses potential vulnerabilities going forward. Box 2.2 focuses on recent developments in the Caribbean.8

Box 2.1.Financial Flows from the United States to Latin America

This box documents the financial exposure of U.S. investors to the Latin American region, and highlights the fact that tighter U.S. financial conditions can have significant spillovers to domestic financial conditions in Latin America. The share of Latin American assets in U.S. investors’ portfolios has dropped since the Asian crisis, while the degree of home bias of U.S. investors has increased (measured by the ratio ωusm in the first table).

Portfolio Characteristics of U.S. Investors’ Holdings of Foreign Assets 1/
20061997
ωusωmωusmωusωmωusm
Latin America0.592.480.240.802.260.36
Argentina0.030.150.170.170.310.56
Brazil0.251.190.210.231.120.21
Chile0.030.160.180.040.180.20
Colombia0.010.090.150.020.060.34
Mexico0.250.630.400.290.480.60
Peru0.010.060.150.020.030.49
Venezuela0.010.210.070.040.080.45
Emerging Asia1.188.830.130.474.280.11
Industrial countries8.8146.940.195.7845.670.13
Sources: Treasury International Capital System; World Federation of Exchanges; Bank for International Settlements; and IMF staff calculations.
U.S. Investors’ Holdings of Foreign Securities, 2006(In percent of market capitalization)
EquitiesDomestic and International
Country or RegionLong-Term Debt Securities
Latin America15.14.2
Argentina5.46.6
Brazil15.32.3
Chile3.116.2
Colombia1.78.4
Mexico24.65.9
Peru1.816.0
Venezuela7.92.2
Emerging Asia7.01.0
Industrial countries13.82.5
Sources: Treasury International Capital System; World Federation of Exchanges; Bank for International Settlements; and IMF staff calculations.

However, an international capital asset pricing model suggests that U.S. investors are less underweight in Latin American assets than in assets from other regions. While Latin America accounts for less than 1 percent of U.S. investors’ total portfolios, the absolute size of these portfolios means that U.S. investors are systemically important in at least some Latin American securities markets. Indeed, U.S. investors have significant direct holdings in equity markets in Brazil and Mexico, and bond markets in Chile and Peru. Indirect exposure of U.S. investors through derivative instruments is also large in some markets, though harder to measure.

To analyze the causes and impact of financial flows from the United States, vector autoregressions (VARs) were estimated for Brazil, Chile, Colombia, and Mexico. Similar research typically seeks to explain the causes/effects of financial flows as a function of U.S. interest rates and industrial production, and macroeconomic and financial variables for the country concerned (short-term interest rates, industrial production, the dividend yield, and equity returns). The analysis here adds U.S. equity and bond flows and the VIX measure of risk aversion.1 The results suggest that U.S. portfolio flows to Latin America are driven partly by U.S. financial conditions, or “push factors,” as well as domestic fundamentals, or “pull factors.” For most countries (except Chile), the VIX is the most important variable. Turning to the impact on domestic financial conditions in Latin America of U.S. financial conditions and flows, the VAR results suggest that shocks to flows do not have much of an effect. Rather, it is found that shocks to the VIX are important in explaining the equity-dividend yield and equity-return movements (except Chile), and that VIX increases are associated with significant drops in equity returns and persistent increases in the equity-dividend yield. The results suggest that U.S. financial conditions, especially measures of risk aversion like the VIX, could affect domestic financial conditions (i.e., equity returns and short-term interest rates) in Latin America. Moreover, the much smaller effect of U.S. financial conditions on Chile presented in this box suggests that a long track record of macroeconomic stability can help dampen the impact of changes in risk sentiment on domestic macroeconomic and financial conditions.

Note: This box was prepared by Ravi Balakrishnan and is based on Balakrishnan and Goncalves (forthcoming).1 A Choleski decomposition is used to identify the VAR and various robustness checks are performed (e.g., using different variables, for example the U.S. high-yield spread instead of the VIX; and excluding certain variables).

Box 2.2.Financial Linkages in the Caribbean

Caribbean stock exchanges and bond and interbank markets saw little impact from the recent financial turmoil, reflecting limited direct exposure to structured credit products and low levels of financial integration. Sovereign spreads, however, have risen for some internationally traded bonds (Belize and Jamaica, in particular), consistent with a general repricing of risk. In Jamaica, higher emerging-market debt spreads reduced the local currency yield premium on domestic debt (compared with Jamaica’s Eurobonds), encouraging a portfolio shift by domestic institutions, resulting in reserve losses.

Caribbean Stock Market Indices

(January 2004 = 100)

Sources: Bloomberg; ECSE authorities; and JPMorgan.

Caribbean Spreads

(In basis points) 1/

Sources: Bloomberg; ECSE authorities; and JPMorgan.

1/ A structural break in the Jamaica series in April 2007.

2/ Trinidad and Tobago sovereign bond spread.

Banks have relied on strong domestic deposit growth to finance private credit—rather than increase in net foreign liabilities—limiting their vulnerability to deteriorating global financial conditions. However, given that foreign banks account for almost 60 percent of assets in the Caribbean banking system, the risk of curtailed lending by stressed parent banks spilling over into domestic credit conditions needs to be monitored closely.

Potential risks could also arise from large foreign asset positions of some banks in the region and from reduced FDI. Gross foreign assets are a significant component of banks’ portfolios in the region, accounting, for example, for one-fifth of banking system assets in Jamaica, and one-third in the ECCU. Thus, should the current problems in selected products spread more widely to other asset classes, the balance sheets of Caribbean banks as well as other regional financial institutions could weaken. Finally, Caribbean countries are recipients of sizable FDI inflows, including into the dominant tourism sector. A disruption of these flows could harm economic activity and Caribbean banks’ balance sheets.

Contributions to Private Sector Credit Growth, 2005-07

(In percent)1/

Private SectorOf which: Contributions from
CreditPrivateNet foreignNet liabilitiesOther
Growth, Totaldepositsliabilitiesto public sector
ECCU14.912.4-0.3-1.23.9
Bahamas, The13.89.00.2-0.54.8
Barbados14.221.11.6-1.1-7.3
Jamaica22.921.6-0.5-6.58.3
Trinidad and
Tobago21.523.8-4.7-1.63.9
Source: IMF, International Financial Statistics.
Note: This box was prepared by Christina Daseking and Padamja Khandelwal.

Recent Developments in Banking Systems of Selected Countries

Interbank rates have remained stable.

Credit to the private sector has been growing rapidly. . .1/

. . . funded largely from domestic sources.

Banking system financial conditions have held up well.2/

The level of structured finance is still very small.

Household debt burden has risen, as consumer credit has grown rapidly.

Sources: IMF, International Finance Statistics; Bloomberg; national authorities; Fitch Ratings; and IMF staff estimates.1/ As of November or December for 2007 in the 20 largest LAC countries.2/ Unweighted average of Argentina, Brazil, Chile, Colombia, Mexico, and Peru. June 2007 for Mexico.3/ Liquid assets to short-term liabilities for Peru. Aggregate does not include Chile.4/ Interest payments only for Colombia and Argentina.

Potential Pressure Points on the Region’s Banks

Money markets in the LAC region have largely avoided disruptions since mid-2007. Interbank markets have been relatively stable, as three-month interbank rates have held steady in Brazil, Chile, Colombia, and Mexico, and have declined somewhat in Argentina. Yields on domestic short-term government securities have also been fairly stable in Brazil, Chile, and Mexico, while rising somewhat in Colombia, reflecting a tightening of monetary policy. The relative calm has been helped by the moderate rise in spreads on external sovereign bonds.

The region’s banking systems have so far remained largely immune to the financial stresses in the United States. According to recent financial stability reports, the domestic banking systems in most of the largest economies in the region remained profitable and well capitalized, with relatively low levels of nonperforming loans (figure on p. 31). Stress tests conducted by central banks of the four larger economies suggest that the banking systems in those countries appear to be well buffered from market risks arising from volatility in yields on their investments (a large share being government securities). The region’s banks have been insulated in part by their reliance on local deposit growth and issuance of subordinated debt and other domestic borrowings to fund the recent expansion of credit across the region. With the exception of offshore centers (Panama), most regional banking systems had less than 10 percent of total liabilities funded by nonresidents at end-September 2007, compared, for example, with nearly 50 percent in some central and eastern European countries.

Another strength has come from the limited role that structured financial products play in the region’s financial activity and low direct exposure to subprime-related structured credit products.9Regional authorities and market participants note that this low exposure may reflect the relatively high returns to domestic banking operations in the region, which may have reduced incentives to search for yield in foreign-structured credit products.

In addition, regulatory frameworks in several countries strictly limit bank exposure to external assets, especially complex derivatives and structured finance products.10 And the fact that domestic capital markets and securitization are still at an early stage of development in the LAC region has contained the risk of exposure to structured finance products in home markets.

Latin American Banks’ Gross Interest Income, 2006

(In percent of average earning assets)

Sources: Bankscope database; Bloomberg; and IMF staff calculations.

Another channel through which global credit conditions could affect the region’s banking systems is the behavior of global banks—which have significant operations in the LAC region. CDS-based default risk premia for the major international banks operating in the region have increased sharply—rising from below 20 basis points in the first half of 2007 to the range of 110–175 basis points by March 2008. To the extent that these banks were to come under capital and/or liquidity pressure in their home markets, they could seek to scale back lending and withdraw liquidity from their operations in the LAC region. However, as of late 2007, there were no clear signs that foreign-owned banks were cutting back their lending in the region. Credit extended by foreign-owned banks remained strong, for example, in countries with significant presence of international banks, such as Chile, Mexico, Peru, and Paraguay, where major international banks accounted for more than 40 percent of total banking system credit.

Credit by Foreign-Owned Banks

(In percent of total credit; end-year) 1/

Sources: National authorities; and IMF staff estimates.

1/ For 2007, rates are based on latest available data (November or December for most).

The latest provisional BIS data also indicate that international banks’ claims on the region increased up to the third quarter of 2007. Compared with other emerging markets, a relatively large share of international banks’ claims on the region is in the local claims of their local offices, which have been shown to be more stable than direct cross-border claims (Herrero and Pería, 2007). Moreover, these local subsidiaries have been largely funded locally, are highly profitable, and contribute substantially to overall group income in many cases. Nonetheless, while there is no sign yet of significant pressure from global banks, this channel should be closely monitored to help assess the risk to the region’s banking system from ongoing credit tightening in the mature markets.

Tightening of Market Financing Conditions for Corporate Sector

As in other regions, most LAC corporations rely on retained earnings for the main source of their funding. A 2006 World Bank survey of firms around the world shows that internal sources account for over 60 percent of the funding for LAC corporate investments and working capital, followed by bank lending.

Available data on publicly listed firms in the six largest Latin American countries show that liquidity indicators (such as the ratio of current assets to current liabilities and the interest coverage ratio) have improved, rising to levels considered adequate for withstanding funding difficulties in the short run. For example, the weighted average current assets of publicly listed firms exceed their current liabilities by a margin of 50–100 percent, suggesting relatively good standing in meeting short-term debt obligations. However, there may be risks of funding difficulties in smaller and less profitable firms, as the median values of liquidity indicators are considerably lower for some countries.

Corporate Current Assets to Current Liabilities Ratio

(2005-07 average) 1/

Sources: Economatica database; and IMF staff calculations.

1/ Publicly listed nonfinancial firms for which data are available.

In addition to internally generated funds, the region’s corporations also rely on credit from domestic financial institutions to fund their new investments and working capital. Nonetheless, the region’s corporate sector is exposed to changes in conditions of cross-border capital market funding, a growing feature of LAC corporate finance along with the fast-growing local capital markets. Combining financial system credit data and data on market issuance11 yields a picture of net financing (i.e., gross credit/issuance net of repayments) for the region’s private corporations. It shows that the strong growth in domestic financial system credit in recent years has contributed most to net financing in the past two years, with the rest coming roughly equally from local securities issuance and international securities and syndicated loan placements. International placements accounted for almost 25 percent of net new financing for the corporate sector in the second half of 2007, reflecting several large syndicated loans contracted in the third quarter. If cross-border mergers and acquisitions were to be included, the dependence on external finance would be even higher. As a result, tighter credit conditions globally could, over time, have an adverse impact on the financing of the region’s private sector.

Nonfinancial Corporate Net Financing

(In billions of U.S. dollars)

Sources: Dealogic database; national authorities; and IMF staff calculations.

Bond Financing

Since the onset of the global financial turmoil, external spreads on corporate bond issues in the LAC region have risen, by 120–250 basis points in Argentina, Brazil, Chile, Colombia, and Mexico. The increases generally are less than those in the United States and other emerging market regions. There is also some evidence of risk differentiation facing the LAC corporate sector. Spreads have risen by almost 400 basis points for lower-rated LAC companies, while spreads paid by blue-chip firms have generally experienced moderate increases. At the same time, the volume of cross-border debt issuance by the region’s corporations fell sharply during the second half of 2007, coming to a virtual halt in early 2008 (figure on p. 37).

Local bond markets in Brazil and Mexico, and, to a lesser extent, in Chile, Colombia, and Peru, have also been playing a growing role as a source of corporate finance in recent years. While there is some evidence that higher domestic bond issuance has offset the cutback in external access in early 2008, this reflects activity by a few large firms, including debentures issued possibly on behalf of some local banks. In recent months, smaller issuers have largely retreated from the local markets.

Equity Financing

Equity market capitalization in the region—although relatively low by international standards—picked up in the past few years as share prices rose. Financing through local equity markets increased strongly during the first half of 2007, as a number of firms issued initial public offerings (IPOs) locally but targeted at domestic, regional, and international markets simultaneously. However, since mid-2007 equity prices in the region have generally retreated, reflecting the global sell-off in stocks, and the volume of equity issuance has fallen sharply so far in 2008. Equity price volatility has also picked up. Indeed, the relative riskiness (or “beta”) of the region’s equity-market index has risen to post-Asian-crisis levels, with a 10 percent drop in global equity returns correlated with a 16 percent decline in LAC equity returns at end-February 2008. Moreover, stock markets in Latin America appear to be more responsive to falling equity prices in the United States than to rising equity prices (Box 2.3). This points to an additional possible downside risk to share prices in the region. If the spillovers from the United States lead to further increases in equity volatilities or external spreads, the region could face a higher cost of capital. Greater equity price volatility has the potential of raising the rate of return required for investors to hold LAC equities, while widening external spreads could exert upward pressure on the overall cost of corporate debt.

Box 2.3.Stock Market Linkages Between Latin America and the United States During ‘Tail Events’

Asset prices in Latin America have been closely linked to those in the United States for some time, but it is important to know whether the region’s financial markets react more sharply to global developments during turbulent than in tranquil times. January’s steep equity market sell-off was a stark reminder of the exposure of the region’s financial markets to extreme financial events originating in the rest of the world.

In this analysis, we test whether the joint co-movement between equity returns in Latin American and U.S. equity markets during turbulent periods (so-called tail events) is different from that in tranquil periods between January 2003 and February 2008.1 We find that the degree of financial contagion between equity markets in the United States and Latin America appears to be greater during periods of financial turmoil, i.e., when equity prices are falling dramatically. The results also suggest that estimating the correlation of stock returns using traditional linear analysis masks the asymmetric nature of shock transmission across markets, understating the potential for downward movements in LAC equity returns in response to a continued global sell-off.2

In addition, we obtain the following results:

  • Latin American stock markets are more responsive to falling equity prices in the United States than to rising equity prices. This is shown in the first figure, where the probability of joint co-movement across markets (ranging from 0 to 1) increases substantially as we move from positive to negative returns. In most countries, the highest probability of co-movement is observed at the lowest percentiles (or “downside tail”) of the distribution, corresponding to periods of extreme negative returns.

  • Conventional correlation measures tend to understate the high cross-border linkages between Latin American and U.S. stock markets during periods of large declines in equity prices. As shown in the first figure, the linear correlation coefficient (the black horizontal line in the figure) of Latin American equity prices with respect to U.S. equity prices is typically below the degree of stock market dependence observed in the downside tail of the distribution, especially in Mexico, Chile, and Peru.

  • Over the entire sample period, stock markets in Chile, Mexico, and Brazil have been the most sensitive to downturns in the United States. Stock market returns in Peru and Colombia, on the other hand, have been the least susceptible to negative shocks in the United States on average between 2003 and 2008. At the lowest percentiles of the return distribution (corresponding to “downside tail events”), the likelihood of joint co-movement ranged between 0.3 and 0.5 for Colombia and Peru, compared with close to 0.9 for Chile and Mexico.

  • In Colombia, the occurrence of very large negative returns has become much more synchronized with those in the United States since mid-2006. As shown in the second figure, in the lowest first and second percentiles of the return distribution (i.e., during times of unusually large, negative returns), Colombian equity prices have become much more responsive to events in the United States.

  • Peru’s and Brazil’s stock markets, on the other hand, have exhibited much lower “tail dependence” since early 2007, as measured by the declining probability of large negative equity price movements in the United States being transmitted to these countries’ stock markets.

Latin American Stock Markets’ Dependence on the United States, 2003-08 1/

Brazil

Chile

Mexico

Colombia

Peru

Sources: Bloomberg; and IMF staff calculations.1/ The nonlinear dependence measure is calculated over the entire sample period using daily log returns of the country-specific MSCI Equity Index and the U.S. S&P500 index. The sample period is 1/2/2003- 2/29/2008, with 1,349 observations. It is estimated on 100 percentile intervals using the delta method for estimating the statistical significance of an adapted chi-square measure as in Jobst (2007).

Probability of Co-movement with the United States During Periods of Extreme Negative Returns

(Time-varying measure of dependence, 2003–08) 1/

Brazil

Colombia

Peru

Sources: Bloomberg; and IMF staff calculations.1/ The nonlinear dependence measure is calculated over one-year rolling windows using daily log returns of the country-specific MSCI Equity index and the U.S. S&P500 index. The sample period is 1/2/2003-2/29/2008, with 1,349 observations. The charts plot the time-varying measure of dependence at the most extreme percentiles of jointly negative realizations of equity prices. 36
Note: This box was prepared by Andreas Jobst and Herman Kamil.1 The analysis uses multivariate extreme value theory (EVT) to quantify the joint (asymptotic tail) behavior of extreme realizations (or “co-exceedances”) of returns across different markets (Coles, Heffernan, and Tawn, 1999). Our measure of the probability of co-movement is based on the percentile-based dependence of extreme realizations that exceed a large optimal threshold value. Optimal threshold values are different for the negative and positive tails of the return distribution, and vary across countries as described in Jobst (2007).2 This result is consistent with the analysis in Chan-Lau, Mathieson, and Yao (2004) of stock market contagion across several emerging markets between 1987 and 2001. The authors find that reliance on simple correlations as a measure of contagion could be misleading. 35

Recent Trends in Private Corporate Financing in the Region

Yield for lower-grade LAC corporates rose since last July, but less than for their U.S. counterparts. . .

While private cross-border issuance has slowed. . .

. . . but driven by a few Brazilian bond issues. . .

. . . and LAC equity price volatility jumped relative to global equity price volatility.1/

. . . domestic private bond issuance has been strong. . .

. . . and smaller issuers have largely opted out.

Sources: Credit-Suisse; Datastream; Dealogic database; and IMF staff calculations.1/ The Beta coefficient is estimated by regressing the historical returns of the dollar MSCI LAC index against the historical returns of the dollar MSCI world index, using a 60-month rolling window.

Conclusions

In sum, although the region has been somewhat affected by tightening financial conditions in the global economy, the impact has so far been muted compared with past periods of stress. On the positive side, the effects have been limited by relative strength in the region’s banking sectors, which are fairly liquid, profitable, and well capitalized. Domestic deposit growth and local market borrowing have been important sources of funding for banks to expand their balance sheets, and firms have increasingly sought finance from both local and international capital markets.

Nonetheless, external financial conditions are beginning to show some signs of tightening, including particularly for corporate sector debt issuance, while equity flows have also slowed. These pressures on the cost of capital could be exacerbated by further equity price declines. Moreover, while the domestic banking systems and capital markets have deepened in recent years, the region’s financial systems are still relatively shallow compared with those of advanced countries, making them more sensitive to protracted credit turmoil in advanced countries.

Enhanced cooperation between supervisory authorities in the region and their counterparts in the home countries of their main foreign bank subsidiaries will be important. This will facilitate a greater understanding of the overall position of the international banking groups and also will allow supervisors in Latin America to react quickly should foreign parents start to come under greater financial stress. Well-functioning disclosure and reporting frameworks are also vital. The recent experience of industrial countries shows how uncertainty can have a pervasive effect on the workings of even the highly developed and liquid capital markets. Both foreign and domestic investors need reliable information about the health of the region’s financial institutions to make good judgments about asset allocation, particularly in periods of stress.

Given the focus on the possible effects of global financial conditions, this chapter does not examine the effects of a more generalized economic slowdown and credit tightening in advanced economies. Such a real slowdown would likely have an adverse impact on bank balance sheets beyond the direct market impact of spillovers from global financial conditions.

There may be some indirect exposure to structured credit products through foreign investments of bank clients, but this is difficult to gauge.

Private pension funds in the region are subject to prudential limits on the share of their portfolio that can be invested in foreign assets and on the quality of these assets.

Data on local and international capital-market transactions reported here are compiled from the Dealogic database.

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