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Contagion in Latin America: An analysis of credit derivatives

by Jessica Beattie of Duke University

March 2000

Introduction: The Asian currency crisis of late 1997 and Russian default of 1998 produced contagion effects in emerging markets throughout the world. Of the main emerging financial markets: Asia, Latin America and Russia, Latin America suffered the least from the ensuing international credit crunch. The crises in Asia, Russia and Brazil and their effects on economies across the world have brought attention to the phenomenon of international mobility in capital markets. One reason why Latin America experienced some insulation from speculative crises is that countries such as Mexico, Brazil, Argentina and Chile instituted fiscal and financial reforms in response to the Mexican crisis of 1994 and the Latin American debt crisis of the 1980s. The Argentine Convertibility Plan and Brazilian Real Plan are two notable examples. Latin America did suffer some real effects of the Asian and Russian crises spillovers, including currency pressures and strong reversals in private capital flows. This paper will spotlight and compare the contagion effects in Brazil and Argentina as a proxy for the Latin American market. To establish an appropriate context for comparison, this paper will draw on documentation from the International Monetary Fund to identify differences in fiscal policies of Brazil and Argentina and will explain why Brazil experienced significantly stronger speculative pressure than Argentina.

The timings of the Asian financial crisis and Russian debt crisis provide a unique window into how Latin America weathered the contagion effects. The Asian crisis and ensuing contagion caught many investors by surprise. This paper will attempt to show that Latin American corporations were unnecessarily exposed to private and sovereign default risk because they underestimated the importance of credit hedging. By the time of the Russian default in August of 1908, many of these corporations recognized the need to hedge against default risk but were already suffering from liquidity pressures and did not have the capital available to expand their portfolios to make sufficient use of credit derivatives. In the time since the Russian default, the market for credit derivatives in Latin America has expanded at an almost exponential rate. Total credit derivative contracts have grown from $50 billion in 1996 to an estimated $740 billion in 2000.  This is in part due to revised corporate risk models following the capital crises and because of improved regulations in the market for credit derivatives. Although this paper will focus on the credit derivatives market in Argentina and Brazil surrounding the Asian crisis, it is necessary to acknowledge the influence of fiscal and monetary policies to contrast the corporate investing environments in the two countries...

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