LATAM FX Talking: Post-Covid challenges weigh on sentiment
LATAM currencies have been under pressure, underperforming EM FX generally and, somewhat surprisingly, failing to rally amid USD weakness. That performance is, however, comparable to FX trends seen in the more fragile EM economies
Executive summary
Domestic drivers that should pave the way for intra-region differentiation should consist of data on the ongoing economic recovery and the enactment of legislative initiatives that ensures the long-term debt-sustainability of the public sector.
Recent data from Brazil suggests that the country is recovering a bit faster than its neighbours, while Congress has resisted approving fiscal measures that extend the fiscal stimulus into 2021. That has helped circumscribe the fiscal deterioration to 2020, but pressure is building to approve legislation that suspends or weakens the centrepiece of Brazil’s fiscal-sustainability framework, the spending ceiling. That’s not our base-case scenario but, should that happen, Brazil’s fiscal anchor would be destabilized, adding considerable downside to local assets.
Colombia faces similar challenges and is, additionally, likely to lose its investment grade at some point over the next few quarters. Mexico should face the deepest GDP contraction of the three, but it should avoid the fiscal deterioration that is likely in Brazil and Colombia. For Mexico, the risk of loss in investment grade is a longer-term threat, that would reflect the failure of the current administration to enact growth-enhancing policies, resulting in a slower but more persistent deterioration in fiscal metrics.
Of the three countries, Mexico also maintains a more FX-supportive monetary policy guidance, and the MXN’s yield advantage should continue to give the MXN a short-term edge. That could change next year if the central bank, faced with grim economic data, joins its regional peers and lowers its policy rate towards its effective lower bound.
Overall, we remain circumspect about LATAM’s medium-term outlook. The impact of the recession and of the Covid-related fiscal relief over fiscal accounts is likely to be considerable. A strong fiscal tightening is necessary to return fiscal dynamics to a sustainable trajectory in 2021, which may create political friction later in the year.
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