You don’t need to be in Washington to know when US Federal Reserve chairman Alan Greenspan and his brethren emerge from their regular policy-making huddle. The global finance community awaits the result with bated breath. But in a break from the typical secrecy that shrouds Federal Reserve meetings, the outcome of the officials’ latest sit-in, held on August 10, was expected. As advertised, the Fed raised its target for short-term interest rates from a 46-year low of 1% at the beginning of 2004 to 1.5%. It marked the second interest rate rise since June.
US officials play down the effects that climbing rates in the US can have on other countries. “The rise in interest rates shouldn’t have a major impact on Brazil or other emerging market countries,” US Treasury under secretary John Taylor told reporters recently. He added that rate spreads between Brazil and Argentina relative to US rates have narrowed greatly over the past one and a half years.
Policy consequences
But government officials and chief executives in Latin America do not have the luxury of shrugging off the possible consequences of changes in US monetary policy. Low interest rates in the US have boosted much of Latin America, enabling investors to look to the region for buying equity and high-yielding bonds. The activity has led to a narrowing of interest rate spreads, lower borrowing costs and a general economic pick-up.
Higher interest rates in the US are reversing all this. Rate spreads are widening, albeit gradually, and exchange rates throughout Latin America are seeing ups and downs.
In Brazil, Latin America’s biggest nation, worries over the country’s debt burden persist: the country’s foreign debt is at about $220bn while its public debt is at a worrying $391bn. The debt load keeps local interest rates in Brazil among the highest in the world. Higher rates in the US only compound the situation. For Brazil, like most emerging markets, a rise in US rates means a reduction in international liquidity. This puts pressure on countries that have large debt-servicing responsibilities, such as Brazil.
Thankfully, Brazil (Latin America’s leading issuer in US dollar volume) has managed a reduction in government debt linked to the US dollar, a shift that has prompted Standard & Poor’s recently to revise its outlook for Brazil’s long-term foreign currency credit rating to positive from stable.
At present, the US credit rating giant rates Brazil’s long-term foreign currency debt at B+, four levels below investment grade.
In the days following the Fed’s decision, the main index of the Săo Paulo stock exchange lost 2.3% of its value. This halted a steady recovery in the local bourse. Since then, and as the Brazilian economy sees an upturn, the exchange has bounced back, but investors remain cautious.
Confidence levels
Company executives in Brazil do not appear too concerned about how rising US interest rates may affect their companies’ bottom-line.
“In our case, the increase in interest rates is not so important because we’re decreasing our international debt loads, shifting it more to the local side,” says Romeu Alberti Sobrinho, chief financial officer at Ripasa, a large Săo Paulo-based Brazilian paper maker.
“We’ve been hedging for the last two years. We’re protected. But not all companies in Brazil have been putting in this type of protection.”
Mr Alberti says: “Consumption of food and products are strengthening, and inflation and the fiscal deficit are under control. I think we’ll see strong indicators later this year.”
Syésio Batista da Costa, head of institutional relations for CCE da Amazônia, Brazil’s largest maker of televisions, radios and other electronic equipment, is not so optimistic: “Our internal debt load is too high and the government of Brazil has no plan that addresses this,” he says. “We have a leftist government now that isn’t taking on the right measures to make Brazil more competitive or strengthen the internal market. This can’t last.”
For now, the country’s local currency, the real, is proving steady. The amount of dollars coming from trade into Brazil remains strong. This is helping the currency, with the rate averaging 2.99 reales to the dollar this year.
Strong indicators
Expected inflows from overseas bond sales are expected to keep demand for the real stable this year. Industrial activity is also improving, driven mostly by improving exports.
These indicators allowed Brazil to become the first emerging-market country to sell debt – $750m worth of 10-year global bonds – after the Fed’s announcement. Orders are strong and demand for Brazilian debt is looking good.
But a close eye is being kept on the administration of Luiz Inácio Lula da Silva. So far, the government has been keeping to the tight fiscal and monetary goals set by the International Monetary Fund (IMF). Most of the credit goes to finance minister Antonio Palocci, who has maintained fiscal discipline while facing increased demands for more spending on social programmes.
But the president’s reform agenda, which includes a long-awaited bankruptcy bill, improvements to the judicial system and new regulations for private-public investment projects, has stalled in Congress. So have new laws to the labour code.
If the legislative standstill continues, foreign investor confidence may wane. This could test the economic recovery and make it tough for Brazil to ride out any rockiness on Wall Street.
No movement on the government’s policy agenda could create higher-risk perception and, along with the knock-on effect of rising US interest rates, produce higher funding costs. This is the recipe for a financial crisis.
Mexican caution
In Mexico, where nearly the entire economy depends on the US, local government and corporate leaders are taking the higher rates with a dose of caution.
Some warn that Mexico is unable to afford a rising interest rate environment, that Mexican securities will become unattractive compared to US investments. Inflation is rising in Mexico – on a 12-month basis the rate now stands at 4.49%, above the government’s maximum 4% target. And the peso has been suffering some volatility this year, hitting all-time lows, as speculation grew over the likelihood of higher US interest rates.
Higher costs
Government officials are digesting the warnings. “We’ll see the base rate increasing, along with the spreads. So we could see higher costs for the issues that we might be conducting in the future,” Alonso García Tamés, Mexico’s deputy finance minister, told The Banker.
“But a big portion of the increases is already incorporated in the prices. We’ve already taken many of the steps, such as increasing the duration of local maturities, needed to limit the impact of higher rates,” says Mr García. “From the public finances point of view, we’re in a better position. We’ve already funded all of our obligations for the year.”
Meanwhile, Mexico’s Central Bank has been tightening monetary policy in the wake of the US rate rise. Mexico’s interbank lending rate has risen 1.2% to 6.6% so far this year.
“We’ll be very alert and vigilant because, higher interest rates aside, we also must watch our own inflation levels,” Guillermo Ortiz, the central bank chief, recently told reporters.
Tricky subject
Companies with debt issues waiting in the wings appear wary. At Vitro, Mexico’s biggest glassmaker, a high-ranking executive said anonymously: “It’s a tricky subject, if you say higher rates will have no effect, then it looks like you don’t have a grasp on things. But if you say, yes, there will be an effect, then the markets get spooked.”
The executive added that a significant portion of Vitro’s debt is at a fixed rate, which keeps jitters low. “There’s a tendency to overreact to these rate changes. But there’s an incentive for Wall Street to exploit the volatility – that’s how they make money.”
Mexico’s ace is its proximity to the US. The country’s volume of exports to its northern neighbour is recovering from a three-year slump, between 2001 and 2003, when US demand slowed. With more than 90% of Mexico’s exports heading to the US, any boost on this front will make up for market shake-ups caused by rising interest rates.
And with economists believing that the US economy is on track to record in 2004 its best growth in two decades, things are looking up in Mexico.
Recovery position
Although Argentina’s economy is not as closely linked to the US as Mexico’s, it is still recovering from a year-long recession that began in late 2001, when its currency crashed along with the political system.
Last year, the economy grew vigorously, by more than 8%, driven by better investment and domestic consumption.
However, lower prices for soya – a major export for Argentina – along with higher oil prices and increasing US interest rates threaten to stop cold the country’s comeback. Energy shortages also loom. If the domestic economy slows, a higher core rate in the US will make it more difficult for the government to settle its still-enormous debt problems and work out new agreements with the IMF.
Meanwhile, more US rate increases may be necessary if inflation is not controlled enough. Any changes will likely come at a quarter-point at a time, with the next possible rise to come in November.
However, most analysts do not see the rate moving beyond 1.75% this year. Most market watchers in Latin America agree that the region’s businesses and economies should be able to roll with the hikes as long as the US economy keeps growing. “If demand for our product is growing in the US and if higher inflation is bringing up the cost of our products, then that’s better for us,” says Mr Alberti, whose company exports about 25% of its goods, mostly coated paper and pulp, to the US.
Mr García in Mexico agrees. “If we see an increase in interest rates that is driven by more solid economic growth in the US, it could neutralise any negative effects.’’
