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Regional Currency Investment Perspective on Latin America

By Richard Willsher

Choice, diversity and uncertainty

High GDP growth rates in Latin America are fuelling currency plays and investment opportunities across the region, though it is not all plain sailing.

Brazil leads the pack by virtue of the size of its economy relative to that of the other countries of the region. It has benefited hugely from rising prices of commodities on the world market and burgeoning demand from Europe and North America and particularly China, which in 2009 displaced USA as the country's second largest export market.

JPMorgan's Sebastian Luparia noted in a recent interview with Citywire, that three quarters of its exports to China are comprised of iron ore, pulp and soy beans which he regards as a major risk should demand from China weaken. However this masks the large and increasing diversity of Brazil's economy and also the growth in its internal consumption. Among Latin American currencies Brazil remains a strong favourite with many investors and also plays a key role in global and emerging market currency finds.

Argentina's growth rate looks impressive but with presidential and legislative elections scheduled for 23rd October 2011 investors seem to be in wait-and-see mode. Moreover high net worth individuals are moving cash out of the country, buying property and other assets in Uruguay among other things. While Argentina as well as Brazil is continuing to benefit greatly from foreign currency inflows deriving from its exports of high priced agricultural commodities, the politics are clouding the picture.

Not so Chile. Long regarded as a nice house in a sometimes not so nice neighboured, its status as a well managed and well funded economy makes it a popular destination for foreign direct investment. The world's largest copper producer, it is currently running a trade surplus of the order of US$17 billion according to the Economist Intelligence Unit. With a population of only 17 million to feed, its institutions and private investors are awash with cash to invest, some of it into currency products.

Chart 1: Nominal LATAM FX performance vs the USD since end-1Q09 (trough of financial crisis)

Colombia is a relatively new Latin American boom story. Its oil revenues have burgeoned, as world prices have remained the high. The Colombian Peso is on many investors' lists. There is still the dark shadow of drug related crime and corruption but currency fund managers believe the country's economic fundamentals are increasingly strong and appealing.

Mexico is similar in some respects. Its economy and currency are strongly correlated to the price of oil and although its foreign revenues from hydrocarbons may not be robust long term, its juxtaposition to the US provides it with the full benefit of its trade relations and membership of the North American Free Trade Association. The big question marks over Mexico are its internal law and order issues connected to drugs and whether or not it is too closely yoked to the sickly US economy for its own good. The Peso remains a popular choice for investors.

Sources: International Monetary Fund / Economist Intelligence Unit

Venezuela's economic fate is also closely aligned with oil prices but its political policies and uncertainties constantly overshadow its story. Of the six major Latin American economies and currencies, this may be the most uncertain of all. The health of President Chavez is a constant subject of discussion and he is reported to be in Cuba receiving treatment for cancer. Meanwhile inflation rages, growth is minimal and it is by no means clear what may follow the Chavez regime when it does, sooner or later, come to an end and what policies it may then pursue in its economic management and currency control.

Jonathan Clark

"As a general rule currency intervention is not a good thing for a systematic manager because we are trying to capture movements that are market driven and central banks are attempting to manipulate markets, so they can distort interest rates, or price movements."

Interventions and controls

2011 began with a Chilean intervention, which exemplifies one of the chief concerns investors have with LATAM currencies. On the first working day of the year the Central Bank announced that it would immediately begin a US$12billion US Dollar purchase programme. It was reported that this would involve buying US$50 million per day from 4th January until 9th February. The purpose was to weaken the Peso, which had stood at a three year high, in order to maintain competitive pricing for its exports and enable the country to continue to register high rates of growth.

For Chile this was an unusual move. It had rarely intervened previously and it had waited some time before taking the decision to do so as compared to other emerging markets such as South Korea and Brazil. The result however was that against the Dollar the Peso fell 6.9% in value in the space of a week.

This sort of intervention, as Jonathan Clark, vice-chairman and head of research at New York-based FX Concepts explains, is at the very least unhelpful and at worst painful for currency investors and systematic currency managers. "As a general rule currency intervention is not a good thing for a systematic manager because we are trying to capture movements that are market driven and central banks are attempting to manipulate markets, so they can distort interest rates, or price movements. Currency wars are not good for investors and modelling it adds additional challenges in trying to create good portfolios."

Clark describes the Chilean move as "a classic" and points out that there are plenty of similar actions taken by authorities in Latin America that serve to dissuade investors from buying their currencies. "Argentina is on a depreciation schedule for example. If you are going to make money [the Peso] has to depreciate less than the rate that they pay on the interest rate differential with the Dollar, which is 11%. So you're making a guess as to whether the Central Bank will depreciate it faster or slower than the interest rate differential. And that's trying to anticipate a central bank's intervention policy. That's very tough to do."

Chart 2: Net foreign speculative positions at the BM&F

Brazil's introduction of its "IOF tax" - a tax on financial operations - in July, is a more recent case in point. In a research note at the time David Beker, chief Brazil economist and currency analyst at Bank of America Merrill Lynch in Sao Paolo, pointed out that once the USD/BRL rate had crossed the 1.55 level the government had intervened to curb further appreciation of the Real. "The two key points," he wrote, "were the provisional measure in which the CMN (National Monetary Council) [took] charge of implementing FX measures, and the presidential decree in which the government implemented a 1% IOF tax on the increase in short USD-BRL positions on derivatives held locally. Notably, the provisional measure gave much power to the CMN, which is consistent with the speech by Finance Minister Mantega where he stated that if the measures do not avoid further BRL appreciation, the government would announce more."

Ominous, especially for those currency investors keen to seize the opportunity to gain from Brazil's growth story through the appreciation in the value of the currency while enjoying a significant level of carry.

Beker began his note under the headline "LatAm re-entering currency war," "With the ongoing deterioration in the global growth backdrop and the renewed outlook for low yields in the developed world, pressure for appreciation in LatAm currencies has increased," it read. "This is stoking the currency war among countries, with Brazil taking the lead." Fortunately Mexico hasn't followed suit, which is one reason at least for its continued popularity among some managers and investors.

Chart 3: …especially relative to the past decade

"We prefer Mexico to the Real," explains Colin Harte of Baring Asset Management, who runs Barings' Alpha Currency Funds currency hedge fund. "It's cheaper and both the central bank and the finance ministry are open to appreciation. They operate a peg system to some extent but they are open to free market movements whereas you are not seeing this in Brazil where they have very high real interest rates and the currency is at well above pre-Lehman levels. The central bank is trying to resist further appreciation. It is therefore open to debate whether Brazil is still quite cheap." Similarly Panama, which is closely correlated with the Dollar, is popular with some managers because of its hands-off approach. Colombia meanwhile as David Beker points out, has a good economic story to tell "…but there is always a risk that the government implements legislation (political risk). I do not think that they are willing to allow more FX appreciation."

Institutional investors

Controls and interventions are a fact of currency investing life in Latin America but they have not deterred foreign investors. Local investors have long experience of living with them but the main issues that concern them are rather different.

Colin Harte

"These markets are going to develop and have different regimes, and central banks will be using currencies as a policy control tool for macro economic management and this will create opportunity in Latin America."

The first is that pension funds, insurance companies, sovereign wealth funds and other institutional investors are flush with funds and need to invest. Yet the investment choices facing them are limited within their own countries, say in Chile for its pension funds for example, but also in Latin America as a whole.

"Pension funds in the region are growing at a very fast pace," says David Beker of Bank of America Merrill Lynch. Research carried out by his firm forecast domestic Latin American institutional assets to reach US$3.3 trillion by 2015. The bulk of this investment by pension funds and mutual funds finds its way into equities and fixed income. "The problem that they face is that their investment universe is pretty small. That is particularly the case for Chile, Colombia and Peru. So they need to find alternatives and we've seen investment flows moving from one Latin American country to another. This is a relatively recent trend that has been happening only over the last three or four years."

David Beker

"With the ongoing deterioration in the global growth backdrop and the renewed outlook for low yields in the developed world, pressure for appreciation in LATAM currencies has increased,"

At the same time however pension funds in particular are faced with serious constraints on what they can invest in. For example as Ismael Perez of Montevideo-based Aqua Advisors notes, Peruvian funds, which are growing rapidly, are not allowed to invest in any strategy involving the use of derivatives. For Colombian pension funds a capital warranty needs to be in place. Brazilian funds are restricted as to the amount they can invest outside the country. In general, pension funds in Latin America as elsewhere; tend to be conservative in their investment tastes. Yet they are in search of yield and have begun to look at alternative asset classes, such as private equity, real estate and currency funds.

"Institutions are looking for a mix," says FX Concepts' Maximilian Spiess. "There is a lot of request for the traditional hedging mechanism but more people realise that currency is an asset class and can actually produce alpha. And also as a consequence of 2008, they say "if equities or fixed income do not achieve desired performance I better look around for something else." We have seen more interest because investors have been searching for new areas to allocate their money."

According to Ismael Perez the investment vehicle and the strength of its regulation is a key selling point. He says that previous currency schemes that have been sold out of Colombia and Panama turned out to be fraudulent. So when Aqua Advisors began representing FX Concepts UCITS III funds they found that investors wanted to hear what they had to say. At the same time currency preferences among institutional investors continue to include Euro, Dollar and especially Swiss Franc. Moreover one of the key appeals of currency funds to investors is their non-correlation to other asset classes. Nonetheless they are conscious that it is not easy to always achieve positive performance in currency strategies, so in times of negative performance it is difficult to convince their investment committees to enter into a new asset class.

Maximilian Spiess

"We mainly focus on investors in Brazil, Chile, Colombia and Panama - the strongest markets but also Peru which has been growing very strongly."

Retail investors

Retail investors are, however, less constrained and tend to be more fleet of foot. The latest annual Cap Gemini Merrill Lynch World Wealth Report finds that Latin America's high net worth individual population grew by more than six per cent in 2010. Their wealth itself was up over nine per cent. "There is now more money," confirms Maximillian Spiess. "We mainly focus on investors in Brazil, Chile, Colombia and Panama - the strongest markets but also Peru which has been growing very strongly. In Brazil a millionaire is made everyday. There is more wealth to be invested in alterative investments plus people who have a larger amount to invest look to alternatives to diversify their portfolio."

As for institutional investors, funds subject to strong regulation and managed by well-known and established providers are a key attraction. Moreover, retail and institutional investors alike will look at alternatives of all sorts but allocations to them, across all such assets classes are likely to be of the order of 10% of their portfolios. "Currencies are viewed as exotic," says Ismael Perez. "They don't understand the drivers. The institutional investors find it difficult to explain to end clients."

Correlations with the S&P 500

For currency investment in Latin America there is a bit of a mountain climb yet but in a region where exchange rate volatility is common, in general rates of inflation burgeon and interest rates are high, currencies appeal in terms of carry, speculation, diversity and non-correlation.

The outlook therefore is strong both for foreign investors in the region and for local people with wealth to invest. "As we go forward we will look at other Latin American type trades," says Barings' Colin Harte. "We'll look at more value trades between one Latin American currency and another rather than playing it on balance with a Latin currency against a G10 currency… It is the same as with Asian markets. These markets are going to develop and have different regimes, and central banks will be using currencies as a policy control tool for macro economic management and this will create opportunity in Latin America."

"I am really optimistic," says Ismael Perez. "The potential is very interesting for currency managers in the region. There are not too many here and investors are realising that adding a currency manager to their portfolio lowers their volatility. It is a great opportunity here now."

Ismael Perez

"The potential is very interesting for currency managers in the region. There are not too many here and investors are realising that adding a currency manager to their portfolio lowers their volatility."

How dependent this scenario will be upon continuing high-level commodity prices generating new wealth remains to be seen. Doomsayers point to growing inflation and falling real growth rates in Asia as a sign that the Latin American wealth boom may be over.

Others, more bullish about the region, point to the growth of internal demand within economies such as Brazil, Colombia and Mexico. They say that the economic powerhouses of Asian emerging markets are likely to continue to stoke demand for mineral and agricultural commodities as well as for hydrocarbons for the foreseeable future and so Latin America will continue to meet some of this need.

What is for sure is that Latin American currencies are on investors' radar as never before. If emerging market currencies were once too exotic and too illiquid for many tastes, routes to market through major banks and traders, as well as through funds, are well and truly open for investors to explore and more are now seizing the opportunity to do so it seems.