Large capital inflows to Latin America have resumed in recent months, which may result in a threat of overheating and asset price bubbles if they continue, according to a Capital Economics report.
Going by the report, rapid inflows have caused currencies to appreciate by 5-10% against the dollar since the turn of the year. With fears about unbalanced and overheated growth coming back on the agenda, the Central banks of Brazil and Colombia have already begun to take measures to prevent further speculative inflows. Meanwhile, both equity and bond markets have soared throughout the region.
Rapid inflows could continue unabated for the entire year, says the report. When capital flows first picked up sharply in Q4 2009, the region was still recovering from the global recession. On the economic front, slack in the economy meant that inflows were easier to absorb without running into capacity constraints. At the same time, asset prices were fairly depressed, so it took the best part of a year for concerns about unexpected growth to emerge.
The expert report warns that the key difference this time around is that the region has little or no spare capacity. The region has been operating above potential this time around and is therefore likely to run into capacity pressures more quickly, thus creating inflation.
Capital Economics states that if the current intensity of capital flows persists, Brazil and Colombia would perhaps be most at risk of overheating. As for the markets, equities in Mexico already look expensive in comparison to historical price/earnings ratios.
Policymakers look set to take further steps to deter speculative capital inflows. However, Capital Economics has forecast on a negative note that while their measures may alter the composition of capital inflows, they are unlikely to prevent them altogether.