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Emerging Markets of Latin America

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Recent Developments

1. In the LAC region, growth is moderating after reaching a 24-year high in 2004. (Figure 26) Nonetheless, projected growth rates of about 4 percent in 2005 and 3Ñ* percent in 2006 are still well above historical averages. Recent growth performance has been supported by the continued strength of global commodity and raw material prices that have boosted terms of trade and exports receipts. Mexico and countries in South America have gained, in particular, from the surge in fuel, food, and metals prices, and have generally been able to exploit these opportunities by expanding volumes-in some cases very substantially. Domestic demand has also generally remained robust (showing renewed strength recently in Brazil), and investment ratios are nearing, on average, a relatively high 20 percent of GDP, although some countries are beginning to face capacity constraints after their strong recoveries (Argentina, Uruguay).

2. A strengthening of policies and improved confidence have been reflected in exchange rate appreciations since mid-2004. For six large countries in the region (Argentina, Brazil, Chile, Colombia, Mexico, and Peru), the nominal effective rate rose by an average of about 9 percent since the beginning of 2005 (based on data through end-July), with a larger increase in Brazil (24 percent), without significantly affecting exports. At the same time, reserves have continued to rise; for example, in Argentina, they are approaching US$26 billion, some nine months of imports of goods and services, and in Peru, reserves are more than 270 percent of maturing short-term external debt. Reserve accumulation in the region reflects current account surpluses and the renewed strength of investor sentiment toward the region, but in some cases the efforts by some countries to resist a rapid appreciation of their exchange rates that they fear could reduce competitiveness. However, looking ahead, preserving flexibility in exchange rate management-as part of the improved macroeconomic policy mix-will be very important, especially with regard to inflation targets.

3. The increasing role of domestic currency financing in the region also represents a source of resilience. (Figure 38) A number of countries-most notably Brazil, Chile, Colombia, Mexico, and Peru-have increased their reliance on domestic debt issuance, reducing their vulnerability to exchange rate risk and increasing the liquidity of local currency markets. Some countries, including Brazil, Colombia and Uruguay, have also issued global bonds in local currency. The increased use of domestic debt instruments at longer maturities-most prominently in Colombia, Chile, Mexico, and Peru-has also helped improve debt profiles. In some cases, foreign investors have shown strong interest in domestic bond issues (in Mexico, some of the issues at the long end of the curve, at times, have been taken up almost entirely by foreign investors). There are signs that improvements in credit ratings have helped make local-currency debt more attractive for international investors, suggesting that improved fiscal and current account positions have helped keep Latin America's external gross and net issuance of bonds, equities, and loans below the peaks observed in the late 1990s.

Risks for the region

1. A sharper-than-expected slowdown in key trading partners or international trade. Despite the success in recent years in diversifying exports, the U.S. market accounted for over 40 percent of the increase in the Latin American region's exports between 2002 and 2004. Thus, robust growth in the United States, and continued access to U.S. markets, will be necessary to sustain healthy export performance, especially for countries with strong trade linkages to the United States, such as Mexico. For the region as a whole, the risks related to a slowdown in growth in China appear to be low, given its modest share of total exports.

2. Higher world oil prices and/or a weakening of global commodities markets. Recent increases in oil prices are not expected to affect the region's growth prospects as a whole, but for some smaller net oil-importing countries, there would be a significant negative growth impact. More generally, however, a continued surge in oil prices, through various mechanisms, could weigh on growth in partner-industrial countries, weaken robust world demand for non-fuel commodities, and lead to a more rapid reduction in their prices than envisaged under the baseline forecast-reversing some of the improvements to the trade balance realized since 2002.

3. Widening risk spreads for emerging market countries would also adversely affect fiscal and external positions in many countries in the LAC region. (Figure 42) The region has benefited significantly from the unusually low level of global interest rates, which has encouraged a "search for yield" and bid down spreads on emerging market debt. Although countries in the region have used this favorable environment to strengthen fiscal positions and debt management, debt-to-GDP ratios in many countries remain very high-generally still above 50 percent of GDP-and there remains a high dependence on exchange-rate linked and short-term instruments. Against this background, the region still remains vulnerable to sudden shifts in global capital market conditions, including those that might be triggered by concerns regarding the large U.S. current account deficit. Given that the larger economies of the region comprise a significant share of emerging market financial instruments, any turbulence for the asset class, as a whole, could have serious consequences for the region.

4. The fourth and final risk relates to the political context. (Figure 45) In the next 18 months, 19 countries in the region, including the largest Latin American



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