Latin America | Yet another stress test

Siobhan Morden | February 25, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

There are initial winners and losers in Latin America in the wake of the Russia-Ukraine conflict. The likely winners are oil exporters that benefit from the spike in oil prices while the likely losers are oil importers that need external credit to finance either external or fiscal imbalances. The knee-jerk reaction to the outbreak of war was a wave of risk aversion. But the region appears quite resilient and mostly a beneficiary. It is a competitor to Russia in commodity exports and has limited economic ties to Russia. Ecuador stands out among the high yielders as the most likely to benefit while El Salvador is perhaps the most at risk without an International Monetary Fund anchor. But at least El Salvador is already trading at distressed Eurobond price levels.

The high yielders are typically the most vulnerable with the weakest fundamentals and the least policy flexibility for navigating external shocks. This may be true at the early phase of shocks.  However, the mature phase of the Covid crisis has strengthened policy management, with stronger IMF relations at an advanced phase of economic recovery.  Latin America is also fairly isolated from any direct economic shocks due to limited economic integration with Europe and Russia specifically.  The oil exporters within the region—Ecuador, Colombia, and Mexico—would also directly benefit from the latest surge in oil prices as well as potential support across the region from higher prices for corn and wheat.

Global market integration typically amplifies external shocks. It can either restrict access to external credit or pass through from foreign exchange weakness to higher inflation. The IMF remains an important lender of last resort across the region with formal programs in Ecuador, Costa Rica, and final stages of negotiations in Argentina. Bancolombia just canceled their issuance due to the uncertain global situation. But market access typically normalizes quickly for ‘BBB’ and ‘BB’ credits. There was only one brief month of inactivity in March 2020 throughout the entire Covid crisis. The foreign exchange stress is clearly inopportune, with inflationary pressures and output gaps still in place across the region, especially for countries such as Brazil, Mexico and Chile with high global financial integration.  The severity of the financial contagion clearly depends on the duration and intensity of the global shock as well as the policy flexibility to counter the fallout.  If a relatively isolated event, the more important credit differentiation shifts to commodity prices.

Ecuador initially reacted to the outbreak of war with prices down 2 points to 3 points. These losses quickly reverted after the market anticipated higher oil prices and weighted strong IMF relations that reduce Ecuador’s dependence on external capital markets.  Ecuador is perhaps the least vulnerable among the high yielders. It has low dependence on global financial markets, and that only declines with higher oil prices.  Ecuador has been the notable emerging market outperformer this year and may still offer relative outperformance from the impact of higher oil prices on the external and fiscal accounts.

The spike in oil prices is a negative shock to the oil importers within the Caribbean and Central American countries.  However, this does not suggest relapse into broader regional crisis.  Costa Rica has delivered impressive fiscal adjustment with momentum for further economic reform and prospects of policy continuity under a smooth political transition. There are also prospects for a stronger IMF anchor and low dependence on external capital.

El Salvador stands out as most at risk as the only high yielder without an IMF program and only marginal financing alternatives if geopolitical uncertainty prevents access to external credit.  However, the country’s distressed bond prices in the 50s already discounts a high probability of default, low recovery value and minimal coupon payments until the 2025 maturity. There are still sufficient domestic financing alternatives to muddle through the 2023 amortization payment. And despite all the hype about volcano bond issuance, bond prices had yet to shift towards a protracted muddling-through scenario beyond 2025.

The latest shock could also perhaps force a pivot towards more responsible management as policymakers react to the external pressures.  This may be the case for Argentina that now enters a critical phase of negotiations with the IMF.  The IMF anchor becomes increasingly relevant with the bounce on agricultural prices an insufficient buffer against still weak fundamentals.  Argentina bond prices are also in distressed territory closer to the historic low on recovery value near 30.