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Analysis

Latin American funds remain healthy

by Michael Kalavritinos

Latin American funds remain healthy

Since the financial crises of the 1980s and 1990s, central bank reserves in Latin America (Chart 1) have grown significantly, exceeding $700bn, and sovereign wealth funds have evolved in some countries.

Chart 1: Rapid increase in central bank reserves

Bank reserve increase, selected countries, 2003-15

BNY Chart 1

However, the macro picture is now different. The region will hardly grow in 2016, held back by the end of the commodity super-cycle, slowing growth in China, and the prospect of further interest rate rises in the US.

Latin American central bankers face challenges in trying to mitigate the rate of currency depreciation (through selling reserves) and inflation targeting (by raising interest rates) while political will is tested to ensure public finances remain controlled and structural reforms persevere. Central banks generally have sufficient reserve coverage to support trade, financial flows, exchange rates and banking systems.

Despite declines in reserves and sovereign wealth funds over the past two years, these have grown considerably over a longer period and remain healthy, providing more than sufficient coverage of short-term external debt (Chart 2).

Chart 2: Latin America’s improved financial stability

Ratio of foreign exchange to external short-term debt, 2016

BNY Chart 2

A large proportion has been allocated to investment-grade dollar and G7 (Canada, France, Germany, Italy, Japan, the UK and the US) sovereign securities.

As such, the focus has been on short-term rather than long-term liquidity (stabilisation rather than savings), with some exceptions (Chile, Colombia, and Trinidad and Tobago – all commodity exporters). Savings and stabilisation funds have also taken root in recent years, for example in Mexico, Panama and Peru. Some countries, notably Brazil and Peru, have tapped them to finance public spending gaps.

As Latin American sovereign wealth and stabilisation funds mature, they face knowledge, political, regulatory and operational challenges. Although many sovereigns participate in multilateral programmes and seminars, many of these institutions accept that they still face a steep learning curve, specifically in respect of sovereign wealth management. As a senior executive of a South American sovereign wealth fund notes, ‘We are used to managing deficits not surpluses.’

Today, many finance ministries, under whose jurisdiction sovereign funds fall, defer to central bank colleagues to manage and service them. However, their experience consists of managing and servicing historically conservative dollar-based portfolios, rather than asset classes further along the risk continuum.
Central banks often pursue conservative strategies to mitigate political, legal, reputational, and headline risks, particularly during times of economic stress. Some, like those of Argentina and Paraguay, display concern with legal claims and the security of their assets in major financial centres by placing their reserves with the Bank for International Settlements.

As many contracts are under New York law, some sovereigns waive immunity under the US Foreign Sovereign Immunity Act. This affords sovereigns certain conditional safeguards but specifies that protections for commercial activities under international law are not applicable.

Technical experience
As sovereign funds diversify away from investment-grade sovereign debt, certain financial institutions, such as global custodians, can provide operational, technological, product, and regulatory expertise. Central bank reserve departments are generally selective in respect of recommending new asset classes or business initiatives to their boards. This is to ensure not only that there is a proper business justification (risk/reward), but that they have appropriate operational infrastructure to support them.

This includes access to real-time position information and pricing, valuations, and performance and risk analytics. It is key they understand if their assets are segregated in the local market; what occurs in the case of insolvency of the sub-custodian; and whether the assets are identifiable in the market.
Partnerships with global financial institutions that are experienced in the sovereign segment and its issues can provide the technical expertise and experience required to support decision-makers as they seek to create safety nets for future generations. However long-standing observers of the region recognise this will be a slow, incremental process.

Short-term considerations will take precedence over longer-term ones where reserves and sovereign wealth can play an important role in monetary and fiscal policy. Countries such as Mexico, Chile, Colombia and Peru should be commended for using some of those assets to defend their currencies, supporting fiscal shortfalls while behaving fiscally responsibly.

In classic counter-cyclical style, Chile did this in 2009, tapping $9.2bn to support its economy. Unlike other less responsible countries, such as Venezuela, countries like Chile understand the importance of not losing sight of their long-term aspiration to accumulate and diversify rainy day funds. ▪

■ Michael Kalavritinos is Deputy Head, Global Client Management, Latin America at BNY Mellon. The views expressed herein are those of the author only and may not reflect the views of BNY Mellon. This does not constitute business or legal advice, or any other business or legal advice, and it should not be relied upon as such.

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