Forex Overview. ARS: Financing-related risks have eased, but we still expect a gradual depreciation.

Transcription

1 Latam Mexico D.F., 18 June 2010 Market Analysis FX Global FX Chief Strategist PABLO ZARAGOZA FX LatAm Chief Strategist MOISES JUNCA, CFA, CMT com Claudia Ceja Recovery expected over the short term ARS: Financing-related risks have eased, but we still expect a gradual depreciation. BRL: Based on a brighter prospect for the domestic economy and portfolio investment inflows, our outlook on the currency remains positive. CLP: Given technical signals, flows, and prospects of economic recovery, we think the peso will appreciate in the short term. COP: Various domestic factors will continue to support the currency Accordingly, we have revised our year-end estimate to USD/COP1920. MXN: After depreciating in May, we expect an increasingly positive bias for the peso. PEN: Despite steady demand for nuevos soles and increasingly positive economic cycle expectations, we believe the currency will remain stable. Table 1 Short and medium term outlook Spot 1M 3M 6m Revision of medium term forecast USD/ARS = USD/BRL = USD/CLP = USD/COP USD/MXN USD/PEN = *Spot rate as 9 of June 2010 Source: BBVA Global Markets Research, S.A. REFER TO IMPORTANT DISCLOSURES ON THE LAST PAGE OF THIS REPORT BBVA Global Markets Research, S.A. is a legal person incorporated under Spanish law and is not a member of the New York Stock Exchange or the NASD. The persons who have prepared and or contributed to the preparation of this Report are not registered members of the NASD. No part of this report may be copied, conveyed or distributed into the United States of America or furnished to any person or entity in the United States. The failure to comply with these restrictions may breach the laws of the US.

2 ARS/USD Depreciation trend continue, but we expect a correction in long term forward points Financing risks have eased and the outlook on capital fl ows remains favorable. However, we continue to believe the peso will depreciate gradually as the central bank s reserves accumulation policy will add ongoing pressure, and medium- and long-term risks remain present. We anticipate a shift toward the 3.95 zone by the end of the month. Short-term outlook In line with the rest of Latam, the risk premium measured by the 5Y CDS spread came under pressure at the beginning of May and increased more than 500bp on the fi scal crisis in EU periphery economies. Besides the potential impact of this crisis on the domestic economic cycle, concerns have emerged on the expectations front regarding the defaulted debt swap which began at the beginning of May and, in principle, was schedule to end on June 7th. This was due to the following: The swap involved a fi rst tranche of securities maturing in 2033 to be exchanged over the April 12 - May 7 period (a 24-hour extension was given), a global 2017 issuance amounting to US$1bn, and the placement of a euro bond maturing in According to the Finance Minister, turnout was expected to be 70-75, which included a 65 remission. As a result, the transaction should have corresponded to 67 of defaulted debt (the total amount of defaulted debt is US$29bn). However, market sentiment became more negative following news that the payment of accrued interest would not be included in the swap (making the total amount US$18.3bn). Furthermore, given risk aversion in international markets, the issuance of US$1bn of debt was postponed with a view to it even being cancelled. In fact, the results of the fi rst tranche of the swap, aimed at institutional investors, fell short of the market s expectations reaching US$8.5bn. As a result, and at Italy s request (where most of the individual debt holders are located), the second tranche subscription period aimed at individual investors was postponed from June 7 to June 22. It should be pointed out that as at June 1st, participation in the swap amounted to US$9.1bn out of a total of US$18.3bn, resulting in the Finance Minister s 60 turnout estimate (vs. 70 previously). In our view, this extension, as well as our expectation of further consolidation in global markets, should support a more stable risk premium (which had eased to 170bp in early June). Impacts of a higher risk premium on the ARS Although the Argentine peso bears no correlation with the performance of the 5Y CDS (unlike other Latam currencies, which over the last 12 months have maintained a negative correlation of -0.48), it closely tracks the implied NDF curve level, especially the longer maturities. In fact, over the last 5 years, the CDS has maintained a correlation of 0.94 with 12M forward points PAGE 2

3 Chart 1 ARS vs. 5Y CDS USD/ARS Jan-09 Apr-09 Jul-09 ARS CDS pb Oct-09 Jan-10 Apr-10 Chart 2 5Y CDS spread vs. 12M forward points pb Jun-09Aug-09Oct-09 Dec-09Feb-10Apr-10 CDS PF 12M Source: Central bank and BBVA Research This shows that the 12M NDF reacts more to risk premium factors than to yield spreads (in fact implied curve yields are recurrently misaligned). Thus, the 12M outright on the curve is currently at USDARS4.45, which in our view is rather excessive. Hence we believe that forward points should decrease to the extent global markets become more stable and the market prices in more upbeat expectations about the swap derived from the aforementioned extension (despite participation having decreased since the beginning of the process, it is still high, which reduces the risk of short-term external fi nancing). Chart 3 Argentine NDF curve Spot 1M 2M 3M 6M 9M 12M Jun-10 Apr-10 Mar-10 Dec-09 Chart 4 Implied yield on ARS NDF curve M 2M 3M 6M 9M 12M Jun-10 Apr-10 Mar-10 Dec-09 Source: Central bank and BBVA Research This could be encouraged by an expected improvement in foreign capital infl ows. During the fi rst three quarters of 2005 (when the fi rst debt swap with holdouts took place), portfolio fl ows shot up to levels of US$560mn from US$100mn the two previous years. As of this quarter, they have decreased to levels of around zero. Although, as we will explain later on, our medium- and long-term outlooks continue to signal depreciation, in the short term such fl ows could increase and underpin a positive trend at the long end of the curve. On top of this is an increasingly brighter outlook for exports (28 of which correspond to commodities and 39 to farming and cattle breeding) which account for 40 of total trade balance revenue. PAGE 3

4 Chart 5 Direct foreign and portfolio investment 1,400 US$,mn 600 1, , Q 03 1Q 04 1Q 05 1Q 06 1Q 07 1Q 08 1Q 09 1Q 10 Portfolio investment, right axis Source: BCRA and BBVA Research Direct investment Maintain expectation of gradual depreciation Despite the possibility of a positive trend at the long end of the NDF off-shore curve, we still expect gradual depreciation in the short and medium terms based on the premise of the central bank continuing to accumulate reserves which are up 1.8 year to date (they currently stand at US$48bn). In fact, since the end of last year, the BCRA had begun to act as a net buyer of dollars and, by the end of the fi rst quarter 2010, had accumulated net purchases of US$1.2bn despite a positive scenario for exports and private sector asset formation items which account for 51 of trade balance revenues. Chart 6 International reserves US$,bn Chart 7 Net FC purchases from clients (12M) US$,bn Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 Source: BCRA and BBVA Research Source: BCRA and BBVA Research Conclusion While short-term fi nancing risks have eased, and the scenario for fl ows remains favorable, we continue to think the peso will gradually depreciate, as the central bank s reserve accumulation policy will likely continue to exert pressure, and medium and long-term risks prevail. Thus we expect a shift towards ARS/USD3.95 at month s end. PAGE 4

5 Chart 8 USD/ARS: 1M forward prevision Dec-09 Feb-10 May-10 Aug Prob. 80 Probability 10 Prob. Source: Datastream and BBVA Research Medium-term outlook From a medium and long-term standpoint, while the debt swap reduces short-term fi nancing risks, we continue to think that long-term external vulnerability factors in terms of fi nancing will prevail. This takes into account the maturity profile (based on data as at end 2009, US$27.6bn falls due in 2010 and US$24.9bn over the next two years) and the debt structure per currency (at the end of 2009, 54 of debt was foreign-currency denominated). There are also three more factors to note: 1) infl ation risks remain high; 2) we believe the central bank will continue to buy dollars for the rest of the year; and 3) the forgotten debate on the use of reserves to pay 2010 debt maturities, which in any case represents a medium- and long-term risk. Thus, we continue to expect a gradual shift in the peso to ARS/USD4.35 towards the end of this year. Chart 9 Public debt maturity schedule Data as at 4Q 2009 Chart 10 Public debt maturity schedule Data as at 4Q 2009 US$,bn Capital Interest / US$,bn Capital Interest /89 Source: Mecon and BBVA Research Source: Mecon and BBVA Research Table 1 Short and medium-term outlook Forecast Spot 3Q10 4Q10 1Q11 Change in the mediumterm forecast USD/ARS = *Spot rate as of June 9, 2010 Source: BBVA Global Markets Research, S.A. PAGE 5

6 BRL/USD We keep our positive outlook Based on positive prospects for the domestic economy and incoming portfolio investment, our outlook on portfolio fl ows remains positive. This outlook is buttressed by positioning factors which, despite having eased in recent weeks, are still expected to recover in the short and medium term. We thus project an appreciation toward 1.75 by the end of the month, but given the possibility of a central bank intervention, we see this as a likely support level. Short-term view May saw the real depreciate by 4.69 on uncertainty derived from the sovereign risk crisis in EU periphery countries which, upon adopting austerity measures, drove down cycle expectations for the European region. In turn, this situation played havoc in the universe of emerging assets, as domestic markets suffered from jitters about eventual spillover. Thus, global markets were imbued with risk aversion, which resulted in declining portfolio fl ows toward domestic assets. In our view, inasmuch as markets turn attention to cycle factors (Latam growth estimates continue to be revised up), these concerns will tend to dissipate. As such, we expect to see differentiation among emerging currencies, with two factors being decisive in this regard: 1. Cycle expectations In contrast to events in the Eurozone and Brazil s high degree of exposure to the European economy (27 of all exports), domestic cycle expectations have been revised upward over recent months. As a result, Banco do Brasil s survey shows a current growth estimate of 6.47, up from 5.51 at the close of Q1, and an infl ation estimate of 5.67 vs at the end of March. This situation has been underpinned by upbeat numbers from the banking fi nancial sector, which currently accounts for 45 of GDP and a growth yield of 17.6 YoY at April s close. Jobs numbers and external accounts performance have also favored this scenario. PAGE 6

7 Jan-02 Mar-03 May-04 Jul-05 Sep-06 Nov-07 Jan-09 Mar-10 Chart 1 Inflation expectation (average) as per Bacen s survey Current year Next 12M Next year Chart 2 GDP growth expectations (average) as per Bacen s survey Jan-06 Nov-06 Sep-07 Jul-08 May-09 Mar-10 End of current year End of next year 2. Foreign inflows expectations Despite the decline recorded in May, the outlook for foreign infl ows remains upbeat. In the short term, two factors still underpin ongoing fi nancial infl ows: i) Considering the aforementioned cycle scenario, in conjunction with strong commodity prices, we expect to see a correction of May s 6.6 retreat in the IBOV. ii) Even as aggressive expectations have eased with regard to a tightening monetary policy, the market is still pricing in an increase in the Selic rate toward 11.75, which should continue to favor fl ows to carry strategies. Thus, we would expect to see a rebound in the carry strategies index, which in the course of the year has shown a negative 0.9. In fact, April saw fl ows toward fi xed-income instruments score an increase of 168, while equities grew by 53. Chart 3 Net foreigners transactions in Bovespa vs. IBOV (total balance since 1994) Chart 4 12M PRE-DI Swap 1Y T-bill Jan-07 BRL'bn Jul-07 Flows Jan-08 Jul-08 Jan-09 Jul-09 IBOV (right axis) Jan-10 75,000 70,000 65,000 60,000 55,000 50,000 45,000 40,000 35,000 30, Jan-06 Aug-06 Mar-07 Oct-07 May-08 Dec-08 Jul-09 Feb-10 From the medium-long term perspective, FDI fl ows have begun to show signs of recovery. While this trend has not been enough to counter the increase in the current account deficit (the 12M FDI/CA ratio stands at 70), in recent months it has been on the upswing and outlooks remain positive. In fact, the percentage allocated to the primary sector has increased by 22, up from 14 in PAGE 7

8 Chart 5 FDI, CA and external financing requirements (12M total) US$'Bn Dec-03 Feb-05 Apr-06 Jun-07 Aug-08 Oct-09 FDI CA deficit Requirements in FC Chart 6 Sector breakdown of FDI capital allocation Commodities Industry Services Other short-term factors 1. Positioning in the BM&F Foreign-investor positions in the BM&F retreated from US$4.2bn long on reals at the end of April to US$3.3bn short on reals at the close of May, which is in line with the currency s depreciation. As such, foreigners positions currently stand above the average seen year to date as well as above the average over the last 12 months. Thus, in light of greater stability in external markets, we would not expect this position to continue to contract. In any case, we expect a shift toward neutral positions that will favor the real in the short term. Chart 7 Net foreigners positions in the BM&F Ct' Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10 Foreigners BRL PAGE 8

9 2. Volatilities May saw implied volatility of the real increase from a low of 10.6 to 18 and touch highs above 21 in the course of the month. While volatility began to ease near the close of the month, it still stands above the average for the year s fi rst fi ve months. In fact, the transitory structure of implied volatility shows a negative slope, in which 1Y volatility stands at 17. Chart 8 Implied vs. historical volatility May-09 Sep-09 Jan-10 May-10 Implied Realized 3. Central bank interventions The Banco Central do Brasil is still absorbing the totality of fi nancial and trade infl ows to the domestic forex market. The bank, however, began to reduce the level of interventions by the end of the month, with a daily average of US$42mn in the last week of May vs. US$145mn in April. This situation refl ects Bacen s growing conformity with the current level, while reducing the risk derived from greater injections of foreign currency by the central bank. Chart 9 Interventions by Banco Central do Brasil *Spot operations US$,bn Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Interventions *operations on Spot Market Source: BCB and BBVA Research Forex transactions PAGE 9

10 Conclusion In light of the factors described, in our view the real s short-term performance will be defi ned by positive cycle expectations and the favorable outlook for portfolio fl ows. This situation comes amid greater stability in global markets which, by next month, should drive the real to trade in the vicinity of USDBRL1.75 once again. Chart 10 USD/BRL: 1M forward prevision Dec-09 Feb-10 May-10 Aug Prob. 80 Probability 10 Prob. Fuente: Datastream y BBVA Research Medium-term view In the mid-term, we believe the aforementioned factors should contribute to keeping the currency on a positive bias and continue to drive its rally toward the vicinity of USDBRL1.70, where it will fi nd a support level. As 4Q approaches, however, we could begin to see pressures from the October election season. This is compounded by the likelihood of interventionist language from both the central bank and the Treasury, which on previous occasions have hiked interventions within a range. In this light, our outlook calls for the real to trade near 1.80 by year s end. PAGE 10

11 Chart 11 Frequency distribution of the BRL last 3Y Table 1 Short and medium term view Forecast Spot* 3Q10 4Q10 1Q11 Forecast reviewed in the medium term USD/BRL = *Spot rate as of June 9, 2010 Source: BBVA Global Markets Research, S.A. PAGE 11

12 CLP/USD Limited scope for more depreciation Although the peso has depreciated more than any other currency in the region, we expect it to recover in the short term. We anticipate a positive bias for the peso in the short term due to expected infl ows of foreign currency from government sources, as well as a brighter external outlook. This is also underpinned by the current slope of the NDF curve, which has corrected the implied negative yields seen at the shorter end We expect the peso to be stable at around 530. Short-term view In the year to date, currencies in the region have been mixed against the dollar, the BRL and CLP depreciating while the MXN and the COP fi rmed. This refl ects a differentiation between currencies with more exposure to the US economy (which had been lagging at the end of last year) and others, whose exposure to Asia and positive prospects in that region gave them a boost throughout most of last year, but whose exposure to the European cycle has more recently caused them to feel more keenly the effects of the risk premium crisis in global markets. In the peso s case, this external scenario combines with various domestic elements (the late February earthquake and its impact on short-term growth) and steep decline in copper prices (more than 16), to bring about declines among Latm currencies (around 8). Bearing this trend in mind, along with expectations of stronger global markets and an upward shift in growth projections toward year-end, our short- and medium-term outlook is increasingly positive. The main drivers will continue to be the trend in metal prices and the infl ow of domestic and foreign investment. Chart 1 Change in LatAm currencies, January - present PEN MXN COP CLP BRL ARS Chart 2 Inflation and growth forecast Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 IMACEC (one month lag) Inflation (11 months, right axis) Source: Central bank and BBVA Research Jan May-10 PAGE 12

13 1. Copper prices Although the Chilean economy is today less dependent on the mining industry that it was a few years ago (mining now accounts for only 7 of total GDP), trade fl ows remain heavily dependent on the trend in copper prices (mining exports accounted for 62 of the total external sector in the fi rst quarter). Over the past 5 years, the peso s correlation with copper prices has been -0.75, while the 3M correlation is currently So although the peso was affected by the 16.5 decline in copper prices prompted chiefl y by worries over growth in China (particularly given ongoing restrictive measures in that country), since the outlook is for greater stability in the second half of the year, we do not expect the currency to be pressured much beyond the 550 mark. Chart 3 Correlation CLP - copper prices Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10 3M 6M 2. Foreign portfolio investment Since the start of this year, the fl ow of investment to equity instruments in Chile has ebbed, due largely to the downgrade of short-term growth expectations and their possible impact on the private sector. This decline, however, was not matched by the performance of the local stock market, where in fact the IPSA index is up by 8.2 the strongest of the stock indices in the region. We therefore do not believe investment fl ows are likely to continue their decline, particularly given an increasingly positive outlook on the domestic economy. On the other hand, we did mention in earlier publications the risk of an outfl ow of capital driven by a rising appetite for carry strategies, whereby the CLP continues to be used as the funding currency for the region. This remains a present risk (with the start of a restrictive cycle in Brazil, the rate spread against the SELIC will remain high), but the room for returns is dwindling particularly since the market already prices in a hike in the benchmark rate this month and we have raised our rate estimate for year-end to 3. We should also note that the outlook for other currencies with higher rate spreads (like the BRL) is for increased stability heading into the second half of the year. Finally, we believe that expectations of incoming foreign currency from insurance fi rms and the Ministry of Finance in response to the earthquake, should favor a more positive trend in the currency in the last six months of the year. PAGE 13

14 Chart 4 Investment inflows to Chile Ene-04 US$, bn Nov-04 Equity Sep-05 Jul-06 May-07 Source: EPFR and BBVA Research Mar-08 Bonds Ene-09 US$,MM 250 Nov Chart 5 BRL/CLP vs. BRL/JPY carry index Apr-09 Jun-09 BRL/CLP Aug-09 Oct-09 Dec-09 BRL/JPY Feb-10 Apr-10 Jun Flows from PFMs Another risk factor we have identifi ed in the past is the possibility of an increase in PFMs appetite for foreign assets, particularly since these account for 39.8 of the total volume of forwards traded on the formal forex market). Although this risk remains latent (the limit on positions in foreign assets is 60, and at present the position is 46.6), we believe it is increasingly limited as the equity allocation is below the regulatory limit and investments in foreign assets typically go to equities). Furthermore, since the February change in regulations, foreign asset hedging has been declining and was 42 of the total at the end of the fi rst quarter. In our opinion, this decline corresponds to the closing of hedge positions in USD, but investments must still be hedged in their underlying currencies (53.8 is in emerging markets), so we do not expect further pressures on the peso than have already been seen, particularly in longer terms in the NDF curve. Chart 6 Pension fund investments abroad Sep-05 May-06 Jan-07 Sep-07 May-08 Total assets Foreign assets ( of total) Jan-09 US$,bn 125 Sep-09 Source: Superintendency of Pensions and BBVA Research Chart 7 Hedged PFM investment in foreign currency US$,bn Q08 1Q09 2Q09 3Q09 4Q09 1Q10 Net FX hedges FX investment Hedged of FX investment, right axis Source: SAFP and BBVA Research PAGE 14

15 Chart 8 Pension fund investment in equities and foreign assets Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Equity allocation FX allocation, right axis Source: Superintendency of Pensions and BBVA Research 4. NDF curve Following the trend in PFM investment, the NDF curve has been correcting the negative slope it maintained throughout most of last year so that, -as we had expected, the divergence between implied rates and domestic market rates has now practically disappeared. At the same time, the onshore rate in dollars implied in the NDF curve, which was above arbitrage limits in mid-march 2010, has shifted down and the current spread against Libor is now close to zero. Chart 9 Dollar rates on local market Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 3M Libor Onshore US$ rate Onshore spread Feb-10 Chart 10 Onshore rate vs. arbitrage limits Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 Libor+CDS 3M Libor Onshore US$ rate May-10 Source: Central bank, Bloomberg and BBVA Research Source: Central bank, Bloomberg and BBVA Research Since the domestic rate is already at the low limit of the arbitrage range, where it would be equivalent to the Libor rate, we see little room for a further correction in the curve. So although there is a bit of room for forward points to shift up, it is increasingly limited. We do not expect the curve to price in expectations of a further depreciation that might add pressure to the currency. PAGE 15

16 Chart 11 NDF Chile curve Spot 1M 2M 3M 6M 9M 12M Jun-10 May-10 Mar-10 Dec-09 Chart 12 Implied rate in CLP NDF curve M 2M 3M 6M 9M 12M Jun-10 May-10 Mar-10 Dec-09 Conclusions Based on the above factors, we believe the peso s depreciation in recent months has been somewhat exaggerated, so we do not expect the trend to continue in the short term. In any case, we expect a recovery toward the USDCLP530 zone, based on an expected infl ow of foreign currency and a scenario of more stable copper prices, where we are looking for a phase of consolidation in the shortmedium term. Chart 13 USD/CLP: 1M forward prevision Dec-09 Feb-10 May-10 Aug Prob. 80 Probability 10 Prob. Source: Datastream and BBVA Research PAGE 16

17 Medium-term outlook From a medium-term perspective, we expect the currency to be more stable around USDCLP530. Our reasoning is that although we expect a short-term correction of the decline that occurred early in the year, we do not see a lot of room for the currency to move into a phase of appreciation before year-end. This is assuming a further consolidation of portfolio and trade fl ows, as well as valuation elements, particularly because the emphasis the central bank has placed on attaining a real exchange rate consistent with Chile s fundamentals could provide a support level for the cross. Chart 14 CLP frequency distribution, last 3 years Table 1 Short and medium term view Forecast Spot* 3Q10 4Q10 1Q11 Forecast reviewed in the medium term USD/CLP = *Spot rate as of June 9, 2010 Source: BBVA Research PAGE 17

18 COP/USD We revise of perspective to positive Various domestic factors will still infl uence the performance of the currency in the short term. We think the peso will continue to outperform other regional currencies as it has since the start of the year. This is based on a positive outlook on portfolio and trade fl ows and a lower risk of intervention by Banco de la República in the FX market. For the medium term, we have lowered our year-end estimate to USD/COP1920, based on an optimistic outlook on capital infl ows resulting from an increasingly positive political climate. Short-term Outlook Despite volatility in global markets during May, the peso closed the month relatively stable. This stability indicates that the currency was less sensitive to the risk premium crisis in Europe than it had been over most of 2009, when the COP was highly correlated to most risky assets. Earlier this year, however, said correlation loosened up. As a result, the peso has appreciated 3.79 year to date, overperforming other Latam currencies. This appreciation occurred against a backdrop of growth and monetary policy lag against other Latam currencies: Banco de la República cut the benchmark rate 50bp in April in contrast to Brazil and Canada, which began tightening cycles and has intervened in the forex market on a daily basis. As the market expectations have begun to focus on capital infl ows and a brighter cycle than the one priced in earlier in the year, we believe that the lag and interventions no longer hint at depreciations of the currency in the medium term. Below is a detailed analysis of this scenario. Chart 1 change in Latam currencies, YTD PEN MXN COP CLP BRL ARS Chart 2 3M COP correlation with the CDS/BRL/VIX and DXY Jun-09 Aug-09 Oct-09 Dec-09 Feb-10 Apr-10 DXY CDS CO VIX BRL PAGE 18

19 1. Performance of local assets and portfolio flows Just like the peso, domestic assets have performed well since the beginning of the year. The General Index of the Colombia Stock Exchange increased 5.3 from January to July 4, despite oil prices dropping more than 9 and impacting the performance of Ecopetrol, which accounts for as much as 35 in the index. These upbeat results contrast with losses on the order of 10 and 3 in Brazil and Mexico, respectively. Meanwhile, fi xed-income instruments have undergone a downtrend in recent months, with yields currently standing at historical lows. Although this performance reflects in part the monetary policy lag mentioned above, it is also the result of positive news on the local front and favorable expectations for bonds. In this regard, we continue to stand by our positive outlook and our fi xed-income team expects an additional drop of 20bp in the July 20 TES benchmark bond. Chart 3 change in Latam indexes, YTD PEN MXN COP CLP BRL ARS Chart and 2020 benchmark bonds Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-20 May-14 So far this year, investment fl ows into Colombia have remained in positive terrain. Equity investment increased 8.4 in April as compared to drops on the order of 1 in Brazil and Chile while investment in bonds increased 7.3 vs. an average regional increase of about 4.9. Furthermore, Colombia s share of total infl ows to Latin America has been increasing since October If this relatively better performance remains unchanged, Colombia could claim a higher stake of Latam infl ows and reach end-2008 levels. The peso could get a boost from this favorable prospect, especially as portfolio fl ows over the last year represent 31 of total income in the fi nancial account. Chart 5 Investment flows to Colombia Chart 6 Investment flows to Colombia as a percentage of total Latam inflows US$'MM 1, Jan-04 Nov-04 Bonds Sep-05 Jul-06 May-07 Equities Mar-08 Jan-09 Nov Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Source: EPFR and BBVA Research Source: EPFR and BBVA Research PAGE 19

20 2. Trade flows Although our proxy for trade fl ows (trade balance less changes in international reserves, LTM) moved down until February, it recovered slightly by March on the back of improved export numbers. The outlook for trade fl ows is still positive, as 34 of exports are energy products going to the United States. This is so despite declining exports from Venezuela in recent months a risk factor at the end of 2009 and early 2010 that in any case has been priced in. Chart 7 Proxy of trade inflows Chart 8 Exports flows (12M growth) US$'bn 8 cop/usd Feb-04 Apr-05 Jun-06 Aug-07 Oct-08 Dec-09 Proxy COP, right axis, inverted scale Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 Fuente: Bloomberg, Banco de la República and BBVA Research Fuente: Banco de la República and BBVA Research 3. Risks derived from Banrep s intervention ease Since February we have said that Banco de la República s interventions in the forex market could provide a support to the peso and even represent a risk of depreciation in the short and medium term. Nevertheless, the currency has been relatively stable since Banrep announced the plan of daily USD purchases amounting to US$1.6bn. Two factors are constraining the impact of this plan: 1) Banrep s purchases represent only 1.5 of daily average turnover of approximately US$1.2bn in the local market; and 2) the fact that the bank has not increased the volume of daily purchases, thereby easing risks for the currency. Nevertheless, the central bank s TES position has been declining in recent months and, as a result, room for ongoing sterilization is limited. In fact, Banrep announced in April that it would end daily sales of these instruments. Therefore, we do not see room for an increase in daily interventions and, given that daily purchases to be carried out until the end of June have been priced in, nor do we expect further depreciations derived from interventionist language. Chart 9 Volume traded in the interbank market 2800 US$'mm Sep-07 Feb-08 Vol. Jul-08 COP Dec-08 May-09 Oct-09 *monthly average Source: Banco de la República and BBA Research Mar-10 Chart 10 Trend in TES bond holdings and international reserves $Tn COP, RI Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 International reserves TES holdings Source: Banrep and BBVA Research $Tn COP, TES Jan-09 Jul-09 Jan-10 PAGE 20

21 Conclusion Based on the aforementioned factors and volatility abroad, we still expect the peso will move to the vicinity of USDCOP2,000 in the short term and we have made a downward revision to our estimates for the subsequent quarter. By year-end, however, the peso could gain value and move to about USDCOP1,920 on the back of stronger portfolio and trade fl ows, as well as lower risks of a central bank intervention. Chart 11 USD/COP: 1M forward prevision Dec-09 Feb-10 May-10 Aug Prob. 80 Probability 10 Prob. Source: Datastream and BBVA Research Medium-term view In the medium term, we see an increasingly positive environment for capital fl ows based on the outcome of the fi rst ballot in the presidential elections. Juan Manuel Santos, the candidate backed by Uribe, garnered 45 of the votes (vs. polls pointing to 30), thus ending in a virtual tie with candidate Antanas Mockus. In this light, a victory by Santos could result in stronger direct foreign investment fl ows to Colombia, especially to the primary sector where incoming investment declined at the end of 2009, although we could see some volatility in the peso ahead of the June 20 run-off election. This circumstance, coupled with the aforementioned positive factors and a brighter year-end outlook abroad, all point to a strengthening of the peso in the medium and long terms. Chart 12 Sectorial breakdown of foreign direct investment US$,bn Q 06 3Q 07 1Q 07 3Q 08 1Q 08 3Q 09 1Q 09 3Q Oil Mining Financial Manufacturing Others Source: Banco de la República and BBVA Research PAGE 21

22 Chart 13 COP frequency distribution, last 3 years Table 1 Short and medium term view Forecast Spot* 3Q10 4Q10 1Q11 Forecast reviewed in the medium term USD/COP *Spot rate as of June 9, 2010 Source: BBVA Global Markets Research, S.A. PAGE 22

23 USD/MXN Peso will keep its appreciation trend Following the peso s depreciation in May, we expect an increasingly positive bias for the peso. This is based on an expected improvement in the global economy that results in an easing of global risk premiums and a further rise in commodity prices. On top of this, positioning and liquidity factors should result in an ongoing medium-term appreciation of the peso. Short term view After appreciating steadily for the fi rst four months of the year, the peso fell back 5.07 in May and closed the month only 1.2 stronger than at the start of the year. This trend was prompted by risk aversion in global markets, stemming from a growing risk premium in peripheral countries of the European Union and the effects it may have on the global economy. Despite limited exposure to the European economy (only 5 of Mexican exports go to that region) and an increasingly positive tone in fundamentals (e.g. growth expectations continue to trend upward), the peso was more sensitive to the external crisis than other Latam currencies. In fact, it bears a close correlation with other risk assets, which as we explain below, will continue to drive the peso s performance. We therefore think that the short-term drivers will be related to liquidity, positioning, and fl ows. External factors We remarked above that the peso s sensitivity to international market risks will remain the primary source of pressure in the short term. This can be seen from various perspectives: 1. Commodity cycle Throughout the last 2 years, the peso had maintained a 6M correlation coeffi cient with oil prices of less than -0.5, 74 of the time. This is bearing in mind that oil still takes up a substantial share of Mexico s total exports (now at 12.8), although it has declined since the onset of the 2008 crisis. This means the peso should react positively to an eventual rally in commodity prices, but for the moment, despite a strong outlook, they are expected to trend sideways in the short term. PAGE 23

24 Chart 1 MXN vs. oil Chart 2 Oil exports as of total Jan-06 Sep-06 MXN May-07 WTI Jan-08 Sep-08 May-09 Jan Jan-00 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan Global risk premiums Tracking risk premiums in Europe, the 5Y CDS spread rose 16 in May. Although it remains lower than those of Colombia and Brazil, the spread against both of these is narrow compared to its average over the past 5 years. In Brazil s case, the spread is usually around 66bp but is currently at 3bp; for Colombia, the spread averages 76bp but is now at 27bp. Given that there are no funding vulnerability risks, we see a relative-value opportunity here, but in the short term, in a climate of ongoing external risk, the peso could continue to be among the most heavily punished currencies based on a correlation coeffi cient of 0.82 from January 2006 to date. Chart 3 6M correlation between MXN and other risk premiums Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 EMBIG CDS 5Y Chart 4 Spread between Mex 5Y CDS vs. LatAm s PB -220 Jan-09 May-09 Sep-09 Jan-10 May-10 BZ-MX CO-MZ CL-MZ PAGE 24

25 3. Equity indices and flight to quality Like other risk assets, the peso s correlation with equity indices (particularly in the US) is usually high. At the same time, its correlation with assets considered risk-free, like the JPY or the DXY index, is typically negative. The 6M correlation between the peso and the EUR was negative throughout 2009, with a positive relationship between the crosses (appreciating/depreciating on the same factors. Although this corrected early in the year with the peso s recovery, we may still see a certain amount of sensitivity. Therefore, as long as investors continue to seek refuge in the USD (which they may do for the short term), we do not expect any clear appreciation in the Mexican currency. Chart 5 6M correlation MXN-equities Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 VIX S&P Chart 6 6M correlation MXN-other currencies Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 EUR DXY JPY BRL Domestic market liquidity As we remarked earlier, the peso is among the currencies hardest hit by the fi scal woes of peripheral Europe. But within the universe of Latin American currencies, the peso is more exposed to the US economy, where the fl ow of news is increasingly positive. This leads us to believe that one of the main elements in the peso s weakness has been a reshuffl ing of global portfolios in which the need to reduce exposure to the region, combined with considerable liquidity in domestic markets (daily trading volume on the Mexican forex market averages US$10bn vs. an average of US$4bn in Brazil or US$1.3bn in Chile) may have added pressure to the currency. Given the ease of unloading positions in the Mexican market, the peso may have been used as a proxy for hedging (e.g. the 6M MXN-BRL correlation is 0.54). This should in turn act in favor of the peso as global markets strengthen. PAGE 25

26 Chart 7 Accrued monthly trading volume in forex market 350 US$'bn US$'bn Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 With the public Interbank swaps (right axis) Source: Banxico and BBVA Research Chart 8 Accrued monthly volume of FX swaps US$'bn US$'bn Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Swaps with the public Interbank Swaps, right axis Source: Banxico and BBVA Research Positioning 1. Volatility After having reached levels below 10, the implied volatility of the peso ended the month with a rise of 6 vegas, even rising above 20 on days of keener risk aversion. This ascent was greater than the rise in the VIX index (60 vs. 45 for the VIX, which closed above the 32 zone). Thus, volatility is greater than its average in the year to date (12.4), which in our opinion cannot be sustained in the short and medium term. Chart 9 MXN: implied vs. realized volatility (1M) May-09 Sep-09 Jan-10 May-10 Implied Realized PAGE 26

27 2. Position in Chicago During May, the speculative long position on pesos in the Chicago Mercantile Exchange (CME) shrank by US$2.8bn and is now around its February lows, tracking the peso s depreciation (the currency has shown a correlation of over the past 12 months). Note that after plunging almost 50 in the fi rst week, subsequent reductions in the position were marginal, so we do not expect a closeout of positions greater than the one we have already seen, which might result in a depreciation of the peso. Chart 10 Speculative long positions on MXN in the CME 6,000 5,000 4,000 3,000 2,000 1,000 0 md pesos -1, May 08 Sep 08 Jan 09 May 09 Sep 09 Jan 10 May 10 Net position, inverted scale MXN Conclusion Based on these elements, we still expect the peso to maintain a positive bias in the short-medium term and have raised our quarterly FX projections. However, although fundamentals remain aligned in the peso s favor and the global market outlook continues to show an increased preference for risk assets, we believe volatility will persist in the short term, limiting the peso to a range of per dollar. Chart 11 USD/MXN: 1M forward prevision Dec-09 Feb-10 May-10 Aug Prob. 80 Probability 10 Prob. Source: Datastream and BBVA Research PAGE 27

28 Medium and long-term outlook From a medium- and long-term perspective, we continue to believe a combination of positive factors on the domestic front (strong macroeconomic outlook, controlled inflation, expectations of the start of a tightening monetary policy cycle late this year that drives a rise in portfolio fl ows, stronger fi scal and external accounts) and an external climate of rising appetite for risk (where commodity prices will continue to rise) will support a likely return to per dollar for the peso. In fact, although we are not considering this a determining factor in its short- and medium-term performance, the peso is the only currency in the region that is undervalued in terms of purchasing power parity (PPP), at -5.6, which should favor a decompression over the long term. Table 3 Short and medium term view SPOT* 1M 3Q10 4Q10 USD/MXN *Spot rate as of June 9, 2010 Source: BBVA Global Markets Research, S.A. Forecast reviewed in the medium term PAGE 28

29 PEN/USD Relative stability remains In our opinion, the nuevo sol s performance it the short term will be driven by expectations of further central bank interventions in the FX market. So although our outlook on local assets is still positive, we do not expect the nuevo sol to break out of the range in which it has been trading for the past few months. Short-term outlook While most Latam currencies depreciated in May owing to the European risk premium crisis, the nuevo sol remained relatively stable at around 2.85 despite Peruvian exports exposure to European demand being one of the highest in Latam (31 of the total, making Europe Peru s main trading partner) as well as high exposure to commodity prices (although mining exports account for 59 of total exports, the currency was not impacted by a more than 7 drop in copper prices). Thus, as has been the case since the beginning of the year, the main factors driving the nuevo are domestic. Although the central bank has not intervened in the market since mid April given an improvement in liquidity, it has provided the currency with a support level and an intervention remains latent. All in all, other explanatory factors should favor a more positive trend in the short term, although we do not expect the currency to lose the stability dynamic evidenced since the beginning of the year). Chart 1 12M financial system liquidity variation in LC and FC Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 Total FS liquidity Source: BCRP and BBVA Research FS liquidity in FC FS liquidity in LC PAGE 29

30 1. Increasingly favorable cycle expectations Domestic cycle expectations have been gradually revised up since the beginning of the year, such that the central bank s last survey of expectations shows 2010 GDP growth of 6 (our 2010 forecast is 5.7 and for 2011 it is 5.0). This stems from an upbeat outlook in terms of credit, liquidity and foreign and fi scal accounts. In fact, recent IMF and WB estimates assume growth of for the region, with Brazil and Peru as the main drivers. Thus, while the central bank began its tightening cycle in May, a scenario of infl ationary pressures is not envisaged and, consequently, our economists expect the benchmark rate to end the year at around 2.5. Overall, we think this scenario will favor a more positive trend, especially in terms of stronger foreign capital inflows. Chart 2 GDP vs. domestic demand Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 GDP Source: BCRP, BBVA Research Domestic demand Chart 3 Private credit vs. domestic demand Jan-00 Jun-01 Nov-02 Apr-04 Sep-05 FS credit to the private sector Domestic demand (4QMA) Source: BCRP, BBVA Research Feb-07 Jul-08 Dec Portfolio flows could remain positive Given that domestic cycle expectations continue to be raised, local instruments retain their strong appeal, especially equities. The fact that the mining sector accounts for 54 of the stock market s capitalization could favor a recovery towards year end, although it affected the index in May. In addition to this is a diminishing risk premium (5Y CDS are around Mexico or Brazil levels) and expectations of more liquid domestic fi nancial markets, especially given synergies between the equity markets of Chile, Colombia and Peru. Thus, although we do not expect a rebound in portfolio fl ows similar to the fourth quarter of 2009 (assuming commodity price consolidation), following stabilization in prior months we expect them to remain high. Chart 4 Investment fund flows into Peru US$'MM 3,500 3,000 2,500 2,000 1,500 1, Jan-04 Nov-04 Bonds Sep-05 Jul-06 Source: EPFR and BBVA Research May-07 Equities Mar-08 Jan-09 Nov-09 Chart 5 5Y CDS of Latam countries pb Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 BZ CO MX PE PAGE 30

31 3. Ongoing domestic demand for soles Local investors net forward dollar sales rose by US$194mn in May, refl ecting a rebound in demand for soles. While room for banks to take short USD positions that could trigger further appreciation in the sol seems to be limited (banks hedged forex position is at its last 5-year average), local demand for the local currency should nevertheless remain strong. Chart 6 Banks net FX forward forward purchases to Investors since Jan US$,bn Jan-08 May-08 Sep-08 Purchases Jan-09 May-09 PEN Source: BCRP and BBVA Research Sep-09 PEN/USD Reverse scale Jan-10 May-10 Chart 7 Banks hedged FX position US$,bn Dec-04 Apr-06 Aug-07 Dec-08 Apr-10 Source: BCRP and BBVA Research Conclusion Based on the foregoing factors, we believe that while the scenario for local assets is still favorable, the central bank s policy of intervention in the foreign exchange market will continue to offset any foreign currency inflows from both foreign and local investors. Consequently, we maintain our forecast of a stable short-term trading range of PEN/USD2.83- PEN/USD Chart 8 USD/PEN: 1M forward prevision Dec-09 Feb-10 May-10 Aug Prob. 80 Probability 10 Prob. Fuente: Datastream y BBVA Research PAGE 31

32 Medium-term outlook From a medium-term standpoint, we believe the aforementioned positive expectations along with an increasingly stable global environment should favor an increasingly positive trend in the sol. On top of this are favorable trade flow expectations (possibly higher oil exports) and capital flow expectations (a large inflow of DFI for projects associated with commodities is still expected). However, volatility going into the first quarter of next year is something to bear in mind and could provide the currency with a support level of USDPEN2.85. Subsequently, while we expect the central bank to pursue a reserves accumulation policy, it will allow the sol to shift towards levels of 2.75 going into the second half of next year. Chart 9 PEN distribution frequencies, last 3 years Table 1 Short and medium term view Forecast Spot 3Q10 4Q10 1Q11 Forecast reviewed in the medium term USD/PEN = *Spot rate as of June 9, 2010 Source: BBVA Global Markets Research, S.A. PAGE 32