Higher U.S. Rates Could Hurt, but Not Cripple, Latin America

Friday's CPI number in the U.S. could put a scare in Latin American economies.
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Friday's blowout U.S. inflation number will be a deep source of worry -- but not despair -- to Latin American countries struggling to recover from a grisly two-year economic and financial crisis.

The higher-than-expected 0.7% rise in the

Consumer Price Index

could be the first sign the

Federal Reserve Board

will soon have to increase interest rates, a move that would hit Latin American countries, which borrow billions of dollars on international financial markets.

The Fed's policy-making committee meets on Tuesday to decide whether rates should be raised to prevent inflation from taking hold in an economy that has grown without generating higher prices. While it is unlikely the central bank will move on one month's data, many economists agree that as the prospects of higher U.S. rates grow, emerging markets are a potential casualty.

Higher interest rates would damage developing countries in two main ways. Big emerging nation borrowers would have to pay more for their debt. Second, rate hikes would almost certainly prompt a sharp selloff in the U.S. stock market, which would send destabilizing aftershocks through other markets.

The U.S. raised the Federal funds rate six times in 1994 to 5.5%, crushing emerging markets bonds in the process. The target for the Fed funds rate is currently 4.75%. Already, evidence is cropping up that the current round of U.S. inflationary fears is whipping Latin American markets. On Friday, key Latin dollar bonds slipped in the midst of a brutal selling spree in the U.S. Treasury market.

Argentina, which has already gone deeply into debt this year, is the most exposed to a rate hike, says Desmond Lachman, emerging markets strategist at

Salomon Smith Barney

.

Argentina has already raised some $6 billion in the bond market this year and the country's government may have to issue another $3 billion of bonds in 1999, according to Fernando Losado, an economist at

ING Barings

. The pressure will remain on Argentina for another two years: In 2000 the government has to use the bond markets to refinance some $13 billion in amortizing debt, says Losado. Argentina's net external financing requirement could amount to $25 billion this year once private sector debt servicing, the current account and foreign direct investment is taken into account. The same overall total is likely for 2000.

Financing fears are rising just as the political consensus behind the government's tough fiscal policy is crumbling ahead of the October presidential and congressional elections. Last week, Congress voted down elements of the government's budget-cutting program, prescribed by the

International Monetary Fund

.

Some pundits think Argentina's strict dollar-peso currency peg will not survive much longer. "It appears that Argentina is quickly going down the slippery slope, with little chance of getting out," wrote Walter Molano, economist at

BCP Securties

in a research note last week. Molano thinks the dollar peg will probably last another year or so.

Others have more confidence. The Argentine government has arranged an $8 billion credit line with foreign banks to protect itself against a run on its banks and currency, while the IMF would probably provide extra cash in an emergency. Adds Losado: "Argentina is going to make it. The peg will remain."

Brazil is in for an easier ride -- but it's by no means in the clear.

The country's net overall external financing requirements for 1999 and 2000 could be $50 billion and $52 billion, respectively.

However, according to

JP Morgan

, Brazil's external financing requirement for the bond markets will probably only come to $12.8 billion next year, even if (as is highly unlikely) the market refuses to roll over any of the $38 billion in public and private amortizations due next year. This, says JP Morgan emerging debt analyst Drausio Giacomelli, is because the country can expect some $33 billion in foreign direct investment and trade credit.

Also, in an emergency, Brazil could fall back on the $20-or-so billion remaining in its

International Monetary Fund

program.

Mexico is even less burdened. Most of the amortizations on government foreign debt due this year and next is on non-market loans disbursed by multilateral lenders like the IMF and the

World Bank

as well as other governments. That means the government only has to meet market amortizations of some $1.5 billion this year and $1.8 billion in 2000, says Pedro Perez, economist at

Barclays Capital

.

Michael Pettis, emerging markets banker at

Bear Stearns

, cautions Latin America investors -- using 1994's emerging bond selloff as a yardstick -- not to overreact to the prospect of interest-rate hikes. A massive repatriation of Japanese capital prior to the first 1994 U.S. rate hike could have been a chief cause of the subsequent emerging bond selloff, says Pettis. In addition, political instability in Mexico throughout 1994 weighed heavily on emerging markets' financial assets.

And one economist thinks the Fed would balance domestic U.S. economic conditions with concerns about emerging nations. "Even if we did not have such a benign outlook for inflation in the U.S., the Fed does not act in isolation," says Charles Blitzer, emerging markets economist at

Donaldson Lufkin & Jenrette

.