By Win Thin

Central bank chief Uribe warned that Colombia would consider capital controls if the peso appreciates due to heavy short-term inflows. However, he stressed that nothing was planned and that recent COP gains were driven by FDI inflows and positive terms of trade movements. Clearly, many EM countries are still nervous about a strong currency from potentially destabilizing hot money.

Given recent moves by Indonesia, Korea and Taiwan to control hot money, we expect nervousness about spreading capital controls to remain in play, which will most likely slow down any EM gains. Colombia has solid fundamentals, and the removal of political risk with the election of former Defense Minister Santos has given markets an excuse to buy COP.

Moody's made supportive comments this week, saying there was potential for an investment grade rating for Colombia. Our model rates Colombia as BBB, well above actual ratings of BBB-/Ba1/BB+, and so we think a move by Moody's is overdue. Note Colombia is a fallen angel, having lost its investment grade rating from Moody's back in 1999.

In Latin America, BRL and MXN are clearly the heavy hitters, but we would put COP and CLP in the next tier of investment-worthy currencies in terms of liquidity, size. PEN has very good fundamentals, but the FX market is quite small. We think there is scope for USD/COP to revisit the 2009 low of 1812, as this pair just notched a new 2010 low at 1879 last week.

However, markets will again get nervous about capital controls if the peso does move toward 1800. Talk of capital controls intensified back in October 2009 when COP last traded near 1800, and that was around the same time that Brazil reinstituted the IOF tax. Much will depend on market risk appetite, but we note COP was the top EM performer in Q2, rising 1% vs. USD, even as most saw big declines (PLN, HUF were worst at -16% vs. USD).

With the economy recovering quite smartly now, interest rates have likely bottomed at 3% and may head higher by Q4. As it is, COP has a yield advantage over CLP (1%) and PEN (1.75%).

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