By Krista Hughes
MEXICO CITY (Reuters) - Bumper capital inflows to Latin America are putting the spotlight on shock-proofing policies to help economies digest the rush of investment - and guard against the inevitable exit.
Foreign investment inflows to Latin America were more than $280 billion in 2012, according to balance of payment data from countries covering 75 percent of the region's economic output, similar to the flows registered in 2011 as low interest rates in developed economies pushed investors to seek returns elsewhere.
According to the Institute of International Finance, Latin America outpaced other emerging market regions as a magnet for foreign capital in 2011 and 2012, taking the relative size of economies into account, a trend it expects to continue in 2013.
Rapid inflows can push up currencies, cause domestic demand to overheat, create asset price bubbles and fan inflation, but can be offset by tighter fiscal policy and reforms to boost economic efficiency. Peru and Chile have already done much of their homework, but reforms are pending in Mexico and Brazil.
"Currency appreciation pressures are a problem if they are too intense but it's also an opportunity to jump start structural reforms in order to improve productivity, which is one of the Achilles' heels of the region," said IIF Chief Latin America Economist Ramon Aracena.
Data show Peru and Chile are Latin America's foreign investment hotspots, with capital inflows, including banking, direct and portfolio investment, worth more than 10 percent of gross domestic product last year.
Mexico and Colombia follow, with inflows equivalent to around 7 percent of GDP, while Brazil - which has erected strict barriers to speculative financial investment - attracted inflows worth about 4 percent of GDP last year, down sharply.
SURGERY NOT PEPTO-BISMOL
Many countries have responded to the surge in investment with measures aimed at slowing inflows and preventing excessive currency appreciation, ranging from currency intervention to taxes on foreign investment.
But such short-term measures are the policy equivalent of taking Pepto-Bismol when what is really required is abdominal surgery - deep reforms to make economies better able to absorb such inflows without suffering indigestion.
Policies to encourage productivity, a prudent fiscal stance, currency flexibility and adequate foreign reserves also help shield against disruptions when money flows out, although this is not expected until developed economies start raising rates.
Peru and Chile, which undertook a round of structural reforms in the 1990s, score best on a checklist covering these five factors. Of the inflation-targeting countries, Mexico is in third place, followed by Colombia and Brazil.
Running tight fiscal policy can help offset the boost to domestic demand from excess money sloshing around an economy, and gives the central bank room to cut interest rates - making local assets less attractive to speculators.
Chile, the highest-rated sovereign issuer in Latin America, targets a structural budget balance, while Peru is the only major economy in the region that the International Monetary Fund expects to report an overall budget surplus in 2013.
A hands-off approach to currencies also allows the exchange rate to help balance the impact of inflows, dampening demand when inflows are high and providing a boost when flows reverse.
High levels of foreign reserves give countries a buffer against sudden capital reversals and room to intervene to shore up currencies if needed. Peru has the largest foreign reserves as a share of economic output at more than 30 percent of GDP, double the level of Brazil, Chile and Mexico.
High productivity is the ultimate mark of a flexible economy, but Latin America has lagged other emerging market regions - especially Asia - in improving output efficiency.
The Inter-American Development Bank estimates that if productivity in the region were as high as in the United States, per capita income would double.
Mexican Central Bank Governor Agustin Carstens, who has welcomed plans for structural reforms by the country's new government, warned last month that a "perfect storm" may be brewing as a result of the massive inflows to emerging markets, setting the stage for a painful reverse.
Thomson Reuters' Lipper service data show $495 million flowed out of U.S.-based Latin American equity funds last week, the biggest weekly fall since 2007, and emerging market debt also suffered as investors worried about Italy's deadlocked election result.
Funds tracker EPFR said stocks in Brazil, where the Bovespa index has slumped 10 percent since the start of the year, took the biggest hit in the recent outflow.
Many investors have been put off by Brazil's ad hoc capital controls and a failure to undertake deep reforms that would boost growth, although the country has recently started to unwind barriers to foreign investment, for example scrapping a 6 percent tax on purchases of real estate investment trusts.
Veteran emerging markets investor Mark Mobius, who oversees $51 billion in assets at funds manager Franklin Templeton, said he did not see bubbles at risk of bursting - yet.
"You'll know it when everyone is optimistic, everybody is buying and nobody is selling, and when the guy on the street says 'you should be buying stocks,' that's when you know you're in a bubble," he said during a visit to Mexico last week.
(Reporting by Krista Hughes; Editing by Maureen Bavdek)