LATIN AMERICAN ECONOMIC COMMENTARY WEEKLY

August 19, 2005

Latin American Spreads Continue to Defy Increases in US Interest Rates
The Latin American financial markets continue their strong showing, notwithstanding the tightening monetary policy in the United States. The Federal Open Markets Committee, FOMC raised the federal funds rate for the 10th time since June of 2004 and hinted that the tightening will continue at a measured pace in the future. This was on the back of strong employment numbers for June: the six-month moving-average of the monthly employment data rose above 200,000 for the first time since the recession that began in the fourth quarter of 2001. The 10-year US Treasury yield has correspondingly increased to about 4.40% before dropping to the 4.20-4.30% range amid indications by the FOMC is that rates have not peaked yet. Such increases in US rates and return on US assets relative to those of emerging markets usually results in souring sentiments towards emerging markets. Capital flows to emerging markets may slow down as returns on less risky US assets move higher towards those of emerging market credits. exchange rates, relatively low inflation, policy improvements, positive current account balances, and ample liquidity in U.S. Figures 1 and 2 presents the 10-year treasury rates and U.S. federal funds rate against the JPM Latin America EMBI spread index. The successful completion of the long-running Argentine debt restructuring saga explains the considerable drop in the Latin EMBI index in June 2005. The JPM Argentine Spread index dropped from about 6080 bps on June 10th to 938 by June 15th leading to a significant tightening of the index (see figure 3). Argentinean spreads now fall about 400 bps, just slightly higher than those of Brazil. The tightening reflects positive investor sentiment and the strong appetite toward Argentina debt since the conclusion of the restructuring. Yields however, are still relatively low in US and other mature capital markets and the equity markets remain subdued despite strong growth in corporate profits. Investors are starving for higher yields and are turning to emerging markets. The strong economic fundamentals in Latin America, ample liquidity in U.S. according to the Federal Reserve, and the low yields help explain the tight spreads in Latin America and other emerging market debt in spite of rising U.S. interest rates.

Spreads Continue to Defy US Rates

The JPM Latin America EMBI spread index has, however, been narrowing over the past year as a result of strong economic fundamentals: greater fiscal stability, flexible

Figure 1: Ten-Yr Treasury Against the JPM EMBI Latin Spreads Index
6 5 4 3 2 1 Mar-05 Jul-04 Dec-04 Feb-05 May-05 Aug-04 Aug-05 Sep-04 Jan-05 Apr-05 Jun-04 Nov-04 Jun-05 Oct-04 650 550 450 350 250

Figure 2: Fed Funds Rate Against the JPM EMBI Latin Spreads Index
4 3 2 1 Feb-05 Jul-04 Jan-05 Oct-04 May-05 Sep-04 Nov-04 Mar-05 Jun-04 Apr-05 Aug-04 Jun-05 Aug-05 Dec-04 650 550 450 350 250

10-Yr US Treasury
Source: JPM and Bloomberg

Latin EMBI

Fed Funds
Source: JPM and Bloomberg

Latin EMBI

Latin American Economic Commentary Weekly

Figure 3: JPM EMBI Spread Indices
1000 900 800 700 600 500 400 300 200 100 0 Feb-05 Jul-04 Mar-05 May-05 Jan-05 Nov-04 Dec-04 Sep-04 Jun-04 Apr-05 Oct-04 Aug-04 Jun-05 Jul-05 Aug-05 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0

Latin
Source: JPM

Brazil

Chile

Ecuador

Mexico

Argentina

Ample Liquidity Favor EM Debt

The Federal Reserve in its July FOMC notes has stated that there is ample liquidity in the U.S. economy. Mutual funds have a lot of cash and demand from mutual funds is also pushing Latin America and other EM debt up. Mutual funds have already bought nearly $3.9 billion of EM debt so far this year, compared with $2.78 billion for the whole of 2004. But EM debt only accounts for about 3% of their portfolios. The availability of funds will lead to more buying of Latin American debt as they seek higher yields and diversification. Latin America accounts for close to 50% of EM debt traded. The JPM GBI was also established in June to track local government bonds as funds become increasing invested in local currency debt. Both PIMCO and Fidelity Investments have set up funds that invest in local currency debt.

the asset class took place. In fact, the spreads narrowed slightly for several economies. As opposed to March, when there was a significant correction at the 10-year treasury yields climbed to over 4.40%, the response this time is a slight boost to EM debt as the EMBI spreads underwent a minor tightening in Latin America.

Equity Indices
The upward trend in US rates has not significantly dampened equity markets, even though volatility is on the rise for several of the major indices. Most equity indices in the region continue the stellar growth of the past two years. The glaring exceptions are Brazil (5.02%) and Venezuela (-37.02%). In the case of Brazil, the scandals surrounding President Lulas ruling party are taking their toll on equity markets. Venezuelas near freefall has much to do with negative investor sentiment resulting from President Chavezs efforts to renegotiate contracts with energy companies. The decline in Venezuelas Stock Market Index has erased all the gains from last year (34%). Colombia continues to perform extremely well with 58% y-t-d growth after a breathtaking 86% growth last year. Chile (20.55%), Peru (20.06%), and Ecuador (17.23%) are the other high performers so far in 2005. Volatility in the equity indices has started to inch up, especially in the case of Brazil, Colombia, and Venezuela. Brazils daily volatility measures in the 20%-25% range and is trending upwards, while that of Venezuela which used to be in the low mid-teens now comes in around 27%. Some of the volatility and decline in the equity indices could be ascribed to political noise.

Fundamentals Solid in Latin America

But strong fundamentals vibrant growth, robust exports, strong fiscal position, free flowing exchange rates, improved current accounts, high levels of foreign reserves and generally low inflationary environment underlying credits in Latin America and other emerging markets. The debt- to- GDP ratio for emerging markets has fallen from a little over 50% in 1998 to about 41% by the end of 2004. The exchange rate regimes are generally flexible, and even though there is market intervention to promote export competitiveness, there are no fixed exchange rates to defend in Latin America, with the exception of Ecuador and Venezuela. The EMBIG spreads for Latin America have largely waived off the rate increase and little widening of spreads in

Moodys Investors Service -----2-----

Latin American Economic Commentary Weekly

Exchange Rates
Latin American currencies are holding their own against the US dollar. Over the last two years, only the Argentine peso and the Venezuelan bolivar depreciated against the dollar. The rest of the currencies have been appreciating relative to the dollar. The Brazilian real has so far this year appreciated 17% against the dollar, with most of this appreciation taken place since the government announced that it will not intervene in the swap markets. The real has gained 4.9% against the dollar so far in August. The Mexican (5.28%), Argentinean (3.42%), and Colombian (2.72%) pesos also gained despite market interventions to promote export competitiveness.

Njundu Sanneh in New York

Moodys Investors Service -----3-----

Report Number: 93964 Copyright 2005, Moodys Investors Service, Inc. and/or its licensors including Moodys Assurance Company, Inc. (together, MOODYS). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODYS PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODYS from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, such information is provided as is without warranty of any kind and MOODYS, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, completeness, merchantability or fitness for any particular purpose of any such information. Under no circumstances shall MOODYS have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODYS or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODYS is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings and financial reporting analysis observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODYS IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding or selling. MOODYS hereby discloses that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferred stock rated by MOODYS have, prior to assignment of any rating, agreed to pay to MOODYS for appraisal and rating services rendered by it fees ranging from $1,500 to $2,400,000. Moodys Corporation (MCO) and its wholly-owned credit rating agency subsidiary, Moodys Investors Service (MIS), also maintain policies and procedures to address the independence of MISs ratings and rating processes. Information regarding certain affiliations that may exist between directors of MCO and rated entities, and between entities who hold ratings from MIS and have also publicly reported to the SEC an ownership interest in MCO of more than 5%, is posted annually on Moodys website at www.moodys.com under the heading Shareholder Relations Corporate Governance Director and Shareholder Affiliation Policy. Moodys Investors Service Pty Limited does not hold an Australian financial services licence under the Corporations Act. This credit rating opinion has been prepared without taking into account any of your objectives, financial situation or needs. You should, before acting on the opinion, consider the appropriateness of the opinion having regard to your own objectives, financial situation and needs.

Moodys Investors Service -----4-----