The Latin picture

China’s voracious appetite for commodities has helped boost the economic performance of many Latin American countries. However, in the second half, investors are probably best advised to pay close attention to domestic developments. Over the past five quarters, the Mexican central bank has hiked overnight rates from 5.5 to 9.9 percent. While this appears to have dampened price pressures, it is coming at the price of a slower economy. Mexican inflation peaked at the end of last year just below 5.5 percent, and in April stood at 4.6 percent. It does remain above the government’s year-end target of 3 percent, Finance Minister Gil Diaz indicated there was room for lower rates by the end of the year.

Mexican growth was cut in half from 4.9 percent in the fourth quarter of 2004 to 2.4 percent in the first quarter of 2005. In addition, the integrated North American auto sector also provided a headwind to the economy.

Auto output fell 10 percent in March, which helped drag down industrial output by 4.7 percent.

The political situation in Mexico became clear in the second quarter. Mexico City Mayor Andrea Lopez Obrador managed to rebuff efforts from the two main political parties to prosecute him and thereby block his presidential bid. He remains far aheadin the polls, and in many ways he is in the tradition of Brazil’s President Luiz Inacio Lula da Silva.

Mexico should be that lucky. Although hedge fund manager George Soros had warned in 2002 that a vote for Lula would be a vote to bankrupt the country, quite the opposite has happened: The Brazilian real has appreciated by around 40 percent since Lula took office in January 2003. It has gained almost 25 percent in the past 12 months. Both last year and thus far this year, the Brazilian real is among the world’s strongest currencies.

Inflation in Brazil peaked in May 2003 near 17 percent. However, it appears to have bottomed a year ago just above 5 percent and over the past 12 months is running at a little more than 8 percent. The central bank has hiked the key overnight rate by 375 basis points since last September. The latest move came in May, lifting the overnight rate to 19.5 percent.

The incredibly high nominal and real interest rates are taking a toll on the economy. Retail sales are slowing and April imports dropped almost 10 percent. Fiscal policy is also tight as the primary budget surplus hit a record of more than 12.5 billion reals in April. Under Lula, tax revenues have increased and the growth in spending on social security has slowed.

The combination of strong currency (reaching its best levels against the dollar in 3-years), tight monetary and tight fiscal policy warns of the increasing risk of an economic slowdown. As with Mexico, Brazil’s overnight interest rate may be near a peak.

However, unlike Mexico, Brazil’s inflation might creep higher, perhaps preventing the central bank from cutting interest rates this year. This analysis would suggest that both the peso and real might also be near their peaks.

And although some fund managers may be attracted to local currency bonds as they prepare for lower interest rates, the risk is that the losses on the currency could offset the capital gains on the bonds.

The other major development in Latin America that helps set the stage for the second half is the successful conclusion of Argentina’s debt restructuring plan. In the middle of the first quarter it received acceptance by 76 percent of its creditors, representing more than $80 billion in defaulted bonds of its restructuring plan, which paid 30 cents on the dollar. In the middle of the second quarter, the restructuring received the OK of a U.S. court over the objections of some speculators who hadbought the debt (at an estimated 60 cents on the dollar) just before the default was announced in 2001.

The debt restructuring will likely clear the way for supportive actions by the IMF, which may not only allow Argentina to defer interest payments to it, but might also fund a new program. Regardless, Argentina’s fundamentals are looking better. The economy is expanding for the third consecutive yearafter a four-year recession. The Argentine peso is holding its own in the face of a generally firm U.S. dollar. The big surprise may be that Argentina is able to once again borrow in the international capital markets much sooner than most would have suspected a few months ago, perhaps as early as the second half of next year.