* Mexico, Peru debt mkts most vulnerable to outflows in Latam
* Peru acting to curb FX, Mexico avoiding intervention
* Appetite for emerging mkt debt ebbing after strong inflows
By Walter Brandimarte
SAO PAULO, June 13 (Reuters) - Forex volatility has started to sap foreign investors’ appetite for the local-currency bonds issued by emerging economies, adding pressure on countries such as Mexico and Peru to limit sharp swings in their foreign exchange rates.
Due to their open capital markets, Mexico’s and Peru’s domestic debt markets are the most vulnerable in Latin America to bouts of capital flight unlike Brazil, whose domestic bond market is much less friendly to foreign investors.
“When you look at a sudden reversal in capital flows, you have to look at those countries that have the highest percentage of foreign holdings (in their local debt). And that’s essentially Mexico and Peru,” said Siobhan Morden, head of Latin America strategy at Jefferies & Co.
“The larger the percentage of foreign holdings, the more that requires policymakers to be responsive and proactive in terms of limiting the forex volatility,” she added.
So far, both countries have been resilient in the face of an incipient flight of foreign capital out of emerging markets. But the Peruvian and the Mexican central banks might be forced to become more active in their currency markets if redemptions grow.
Latin American central banks have used a variety of methods to support their currencies during the 2009 crisis, from direct sales of dollars in the spot market to the use of derivative contracts that increase the supply of greenbacks in the futures market. None have resorted to raising interest rates at a time when the global economy is slowing and they need to stimulate domestic consumption.
After attracting record inflows in 2011, emerging market bonds denominated in local currencies lost much of their appeal to foreign investors this year as domestic interest rates dropped and concerns about currency volatility rose.
So far this year, $8.3 billion have found their way into funds that invest in emerging market hard-currency bonds, while a more modest $2.8 billion have flown into those investing in local-currency debt, according to EPFR Global, a fund flow tracking firm.
“That’s just the opposite story from the previous year,” said David Spegel, global head of emerging markets strategy at ING. “Last year, 78 percent of all the inflows into emerging markets debt went into local funds.”
But warning signs have been raised since last month, when those local-currency bond funds started bleeding money. They have lost $721 million in three consecutive weeks of outflows, EPFR data shows.
“That has a lot to do with the foreign exchange volatility that we’ve seen spike this year in emerging markets,” Spiegel said. “Why hold a local currency bond if you think that the foreign exchange rate might go against you? Certainly it’s been more volatile.”
Peru, with 57 percent of its fixed-rate debt stock in the hands of foreign investors, has so far managed to avoid a potentially disruptive capital flight by actively curbing volatility in its foreign exchange market.
The Peruvian central bank last month ensured a steady supply of dollars to investors by directly selling the greenback in the spot market, and by offering dollar repurchase agreements for the first time ever.
As a result, the Peruvian sol erased all the euro-zone related losses it had incurred in May to trade with gains of about 0.8 percent in the year to date.
Mexico’s case is different, though.
The Mexican peso has weakened some 10 percent since mid-March as policymakers have limited foreign exchange interventions to a minimum. Their official policy has been to offer up to $400 million in auctions in the spot market whenever the peso declines by at least 2 percent against the dollar in a single session.
Still, the fact that there have been no outflows from Mexico’s “bonos” suggests many foreign investors might have been hedging out their exposure to the peso, said Jefferies’ Morden.
Foreigners currently hold a record-high 44.6 percent of Mexico’s 1.8 trillion pesos ($128 billion) local-currency debt market. Analysts are unsure how many of them are protected against currency moves, but they say such hedging operations have driven much of the recent volatility in the peso.
Despite that volatility, Mexican policymakers have brushed aside the chance of more aggressive intervention, with central bank governor Agustin Carstens repeatedly affirming that the bank should let the free-floating currency regime function to the greatest degree possible.
“Policymakers are reluctant to be more responsive because Mexico has rules to intervene in the foreign exchange market, but I wonder if those rules need to be reevaluated,” said Morden.
The Latin American country that has been most active in its currency market has not acted to safeguard foreign investors’ appetite for its debt, but rather to correct what it has called “distortions” in the market.
Brazil’s central bank has sold more than $7 billion worth of currency swaps to prop up the real since it resumed this type of intervention last month, but the government still imposes a 6 percent financial tax on foreign investors willing to buy its domestic bonds.
Foreigners hold some 12.3 percent of Brazil’s domestic debt, and Finance Minister Guido Mantega, in his fight against “speculative” money, said last month the government does not care about having more foreign capital in its local bond market.