MercoPress. South Atlantic News Agency

Latin American bonds are shaken but not stricken

US interest rates will rise and it may take slightly longer for Brazilian overnight rates to fall than was previously expected.

This seemingly innocuous economic news was all it took last week to set Latin American asset prices plunging, providing a reminder of the strong speculative element in the recent run up in the prices of bonds, stocks and currencies in the region.

Brazil, which led the recent rally, was hardest hit; spreads on its widely traded paper - the C Bond - widened by 86 basis points in the past week. The question now is whether the bubble is about to burst.

On balance this seems unlikely for four reasons. First, although the region still depends heavily on external capital flows, its current accounts have been improving. Last year, soaring commodity prices helped exports at a time when - with most economies only just beginning to recover from recession - imports were depressed. This helped produce an overall current account surplus.

Second, credit quality has improved, even though Brazilian, and especially Argentine, debt-to-GDP ratios are still uncomfortably high. Third, economies are beginning to grow again, with the outlook for 2004 the best for at least four years.

Fourth, exchange rate flexibility coupled with more disciplined monetary policy mean there is no "big bang" event - such as the Mexican devaluation of 1994, the Brazilian crisis of 1999 and the Argentine devaluation and default at the end of 2001 - waiting to happen. "Everything that could blow up has blown up," says Ben Laidler at UBS in Santiago, Chile.

There have been some quite sharp up and downward movements in some currencies in recent weeks. Chile's peso, traditionally sought out by Latin American currency traders as a hedge against the volatility of the Brazilian Real, has been a case in point. Trading at a low of 750 to the US dollar early last year, it rose to a high of 550 in January and fell back to 583 early yesterday.

But in other countries - most notably Brazil and Argentina - central banks have intervened successfully to contain similar instability. Mr Laidler says this kind of action simply shows the increased sophistication of economic management in the region.

Nevertheless, Latin America will inevitably lose out when interest rates in the US, Europe and Japan rise. Higher rates will reduce the attractions of higher-yield markets and depress the flow of liquidity.

The trick for investors will be to pick out particular areas of overvaluation. Brazil's underperformance last week showed how its bond prices had lost touch with fundamentals.

The picture might well be different for equities. In spite of the strong performance of equity indices in the past 15 months, Brazilian equities are rated on an average forward multiple of only nine, while Mexican stocks are rated on a price earnings ratio for 2004 of 14.

By contrast, the Chilean stock market is on a more expensive p/e of 18. Chilean companies have lower financing costs, cheaper services and overheads. But the competitive character of the Chilean market also means these companies tend to be less profitable than their Mexican counterparts.

Most of the premium in the Chilean market reflects technical factors, including heavy demand from local pension funds and the fact that the free float - shares easily available for purchase - is relatively small for many companies. The message is that as investors prepare for tougher times even within the same region, they should look more carefully between countries and asset classes.