Latin America raises guard against sharp currency swings

February 23, 2016

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Central bankers in Latin America took their fight against high currency volatility to a new level last week, with interest rate hikes in Mexico and Colombia and a ramp up in interventions in foreign exchange markets.

But that will probably be insufficient to halt currency losses, economists say, as the region suffers from a long-lasting economic slowdown, low oil prices and growing fears of a spike in inflation.

Colombia’s central bank raised interest rates, as expected, for a sixth straight month last week to 6.25 percent, front-loading rate hikes to fend off rising inflationary pressures and avoid a credit rating downgrade. The benchmark rate is now nearly double its 2013 level of 3.25 percent.

In addition to the rate hike, Colombia also lowered the bar for government interventions in the currency market by cutting to 3 percent from 5 percent the moving exchange rate average it uses to auction U.S. dollar call options.

The trend is similar in Mexico.

Its central bank has sprung into action with 75 basis points of rate hikes since December after more than a year of standing pat on policy at 3 percent. The latest of the increases, on Wednesday, came as a complete surprise and boosted the peso by nearly 3 percent from record lows.

The decision to hike was largely attributed to the more than 10 percent weakening in the Mexican peso over the past 2-1/2 months, even as inflation remained near record lows.

Mexican authorities followed the rate increase with the first direct intervention in currency markets since 2009.

Brazil has also been jacking up interest rates in the recent past, despite its economy heading into further trouble.

Some economists have said the central bank there could start cutting rates later this year as the currency has stabilized in recent weeks, but policymakers have tried to throw cold water on any hopes of monetary easing by pointing to the high level of inflation expectations through 2017.

While the currencies from those three countries have rebounded in recent days, partly reacting to the policy measures and partly because of the rally in oil prices, many economists are skeptical over longer term prospects.

UBS economists Rafael de la Fuente and Bhanu Baweja wrote in a research report:

“The central bank’s actions do count for a lot – the Mexican peso would likely be much worse without them.”

“(But) given the stock of debt, persistence of unexplained outflows, and the current international environment we think it will be challenging for the authorities to arrest the weakness in the peso.”

Barclays economist Marco Oviedo expects volatility to diminish, but currency weakness to persist.

“Worsening expectations of global growth and depressed commodity prices will likely continue to weigh on the Mexican peso,” he wrote.

And Nomura economist Mario Castro had a similar view on Colombia’s peso, currently trading around 3,300 per dollar:

“The (rate hike) announcement does not change our view of a weak peso ahead. Specifically, we continue to expect the currency in the 3,500-4,000 range in coming months.”

With reporting by Siddharth Iyer

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