However, the main purpose of fixed exchange rates was to provide an anchor for inflation expectations, which raises the question of whether inflation could accelerate in the future. This could jeopardise long-term economic and political stability, and hit domestic savings rates. Greater confidence in local currency denominated bonds has allowed low inflation countries such as Peru and Mexico to issue longer maturity domestic bonds, and hence reduce their issuance of foreign currency bonds.
A GDP-weighted index of consumer price inflation in the 10 largest countries reveals that inflation trended down from 11 per cent in 1998 to 6 per cent last year, albeit with a sharp jump in 2002 because of Argentina and Brazil.
In Brazil the central bank has hiked interest rates by almost 4 per cent over the last year, while the fiscal deficit has halved to 3 per cent of GDP in the last six years. Likewise in Mexico, core inflation has stayed within the 3-4 per cent range in the last few years, yet with one eye on wage pressures the central bank has orchestrated a substantial tightening of monetary policy.
Unfortunately not all countries are on such a virtuous path. Argentina’s monetary base has trebled since the 2002 devaluation, and continues to expand at a pace that risks pushing inflation up to 10 per cent this year. The pro-growth policy bias is understandable following years of recession, but a rebound in inflation could hit confidence in the peso and encourage Argentine savers to continue their decades long tradition of channelling capital offshore. Venezuela has experienced a rapid monetary expansion driven by lending to the public sector, but strict price controls on basic goods have kept inflation below 20 per cent.
Higher inflation does not pose an immediate risk for investors in Latin American currencies, because it is unlikely to generate currency weakness without first tipping trade surpluses into deficits.
John Cleary, chief investment officer, Standard Asset Management
