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Moody’s: Currency weakness will primarily impact sovereigns with large external imbalances in Latin America

New York, June 04, 2018 — A number of emerging market countries, including several in Latin America, have experienced currency depreciations and a decline in foreign exchange reserves in recent months. The tightening of monetary policy by the Federal Reserve and country-specific macroeconomic imbalances have affected capital flows to emerging markets.

“To the extent that currency fluctuations are driven by capital outflows — or significantly lower inflows — they are credit negative for countries with large external funding needs,” says Moody’s analyst Renzo Merino; “While present conditions do not place material downward credit pressure on most sovereigns in Latin America, we have seen significant pressures emerge for Argentina in particular.”

In the case of Argentina, the depreciation of the peso was the result of adverse market reaction to the authorities’ decision to ease inflation targets in late 2017, and a capital gains tax on foreign holdings of peso-denominated debt instruments that became effective in late April. In addition, Argentina’s credit profile incorporates underlying macroeconomic weaknesses, including the presence of large fiscal and current account deficits and persistently high inflation — factors that make the country stand out at times of global market volatility and asset re-pricing.

While other countries in the region have seen a worsening in external debt metrics in recent years, Moody’s sees limited contagion risk from Argentine. “There are important mitigating factors at play,” says Merino, “including higher and more stable foreign exchange reserves and government external liquid assets that can provide debt service coverage if needed, in addition to a greater prevalence of flexible exchange rates in the region.”

Although less vulnerable than Argentina, Costa Rica, Chile and Paraguay stand out because of their large external borrowing requirements relative to reserves. The presence of mitigating factors in Chile (steady foreign-currency revenue stream) and Paraguay (current account surpluses contributing to reserve accumulation) limit credit risks there. While Brazil has also experienced currency pressures in recent months, its main credit vulnerability is domestic, related to challenging fiscal dynamics.

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