Carry-trades into Latin America

With the spectre of the 1980s hunting emerging markets, stronger interconnectedness may mean higher volatility across global financial architectures. Some interesting data capturing cross-border exposures for Chile, Colombia, Mexico, Brazil and Peru (LA5).

 

Debt held by non-residents fell by an average of 30% across LA5 after Lehman, to then double (Colombia) or triple (rest LA5) in volume (here are the carry-trades Paul Tucker talked about ). In an effort to stem currency appreciation, central banks intervened in currency markets, leading to large sterilizations of an average of 20% of GDP across the group between 2010 and 2012. Despite these interventions, exchange rates appreciated by around 30% for Chile and Colombia, 25% for Peru and 10% for Mexico.

For some time now, I have argued in my research that sterilizations can, and have, also be used for capital account management. Basically, sterilizations offer a carry vehicle for domestic banks (and non-residents, if allowed to hold central bank instruments), who borrow cross-border, exchange foreign funding in the currency market where central banks are anxious about the appreciation pressures stemming from large capital inflows (and most are, as shown above) and then place the domestic liquidity in risk-free sterilizations. This explains the massive sterilization figures above, and why several countries have taken steps to curtail access to sterilization instruments. Colombia decided to issue long-maturity sterilization bonds in 2012 while Peru had for a while capital controls on non-resident holdings of sterilization instruments.  It also sheds some light on the rapid build-up of cross-border interbank loans in these five countries (all figures in bn USD):

Once the central bank intervenes in currency markets, it relinquishes control over domestic liquidity. By borrowing from parents or from cross-border wholesale markets, resident banks can endogenously create domestic liquidity to pursue one of the following carries: buy sterilization instruments, buy other domestic currency assets or lend the domestic currency to non-residents who cannot otherwise take positions in domestic currency asset markets. This is Helene Rey's dilemma - with some more institutional detail - and it may mean that capital controls will be normalized much sooner than expected if EMEs continue to experience carry outflows.