Watching the Tide

• Author: Andre Meier

Watching the Tide Finance & Development, September 2015, Vol. 52, No. 3

Andre Meier

Latin America appears better prepared to handle capital outflows than in the past, but its resilience might soon be tested

Since 2009, foreign investors have sent a massive $1.7 trillion to the six Latin American economies that are financially integrated with the rest of the world—Brazil, Chile, Colombia, Mexico, Peru, and Uruguay. Foreign purchases of bonds, equities, and other securities—or portfolio investment—alone accounted for about $640 billion.

These capital inflows were significantly higher than the average over the previous decade, even in relation to GDP. And portfolio investment of similar magnitude has not been seen since the early 1990s (see Chart 1).

The recent strong flows to Latin America reflect a global pattern of capital going from advanced to emerging market economies. Many advanced economies have been stuck at low growth and near-zero interest rates since the global financial crisis, prompting investors to look elsewhere for opportunities. As a result, there has been sustained diversification into assets of emerging markets, where growth and interest rates were higher and overall economic conditions appeared more robust.

A mixed bagThis influx of foreign investment has its benefits. Foreign credit may provide recipient countries with critically needed funding for investment or permit a smoother path for consumption than would otherwise be possible. The recent large inflows have also allowed Latin American governments and firms to lower their interest bill by issuing bonds with lower rates and longer maturities. And to the extent that foreign investors take a stake in the domestic economy—and domestic investors simultaneously invest abroad—they effectively start sharing risk, which can help countries that depend heavily on the fortunes of a particular sector, such as commodities in many South American economies.

However, the strong inflows also have potential downsides. Many observers believe that the recent capital inflows could be followed by large-scale, disruptive outflows. Historically, flows into Latin American bond and equity markets have been especially volatile, creating exuberant conditions during good times, but suddenly stopping or even reversing when investor sentiment changes. Past capital outflows have been triggered by such developments as increases in interest rates in advanced economies, rising risk aversion in global financial markets, and bad economic news from within emerging market economies.

It is easy to see why there are concerns about possible outflow pressures in Latin...