Waving the storm but not the hurricane…

Favorable changes in global conditions in the last few years, along with improvements in domestic fundamentals in the last decades, have allowed Latin America to enjoy prosperous times and to become less vulnerable to a US economic slowdown and to sudden adverse changes in market volatility.  Furthermore, the possibility that these external settings stay somewhat benign moving forward provides Latin America with a golden opportunity to further structural adjustments.  Nevertheless, the risks of massive corrections in the global economy and financial markets in the short term and unsatisfying domestic political and social conditions in Latin America, pose the greatest threats to the region in the medium to long term.  

Latin America has enjoyed almost perfect external conditions: robust global growth, high global liquidity, benign risk appetite, favorable terms of trade, and strong inflow of remittances. Adjustments to these positive settings, so far, are evolving in an orderly fashion.  Although the US economic slowdown is materializing in 2007, it looks to be a soft-landing and its effect on global growth; risk appetite and commodity prices have been limited. Continued economic growth in other parts of the world, especially in China has improved prospects for continued growth in Latin America.  Furthermore, moderate US growth, along with its large twin deficits, supports the view of stable-lower FED Funds rates and a stable-weaker USD; these conditions, combined with, high savings in Asia and other parts of the world will likely continue to favor global liquidity, thus, making any prospective global correction likely to be short-lived and a possible buying opportunity, as happened in May 06 (inflation scare) and Feb 07 (recession scare).   

Under this scenario, however, the US consumer requires close monitoring; so as long as business investment and unemployment do not worsen sharply and the USD does not collapse, the overextended US consumer will likely endure the wealth deterioration effect caused by the ongoing correction in the housing market.  Finally, expectation that the US deceleration will run smoothly and that US growth will improve in 2008, together with the fact that immigrants of Latin American origins working in the US are very flexible, especially low skill and/or illegal immigrants, means that remittances could be temporarily affected due to the US slowdown but will resume as the US recovers.  One reason why the US housing slowdown has not had a major impact on consumption and unemployment, as it has in the past, is that illegal workers have borne the disproportionate burden of adjustment in the US housing sector.  

The counterbalancing economic role of China to that of the US is a welcoming development for many countries in Latin America.  It supports high commodity prices, which, in turn, sponsor stronger economic growth and wider trade and current account surpluses.  These dynamics allow countries to accumulate large amounts of international reserves, via intervention, and allow them to retire external debt, and consequently, to reduce external vulnerabilities, creating a constructive environment for foreign investment.   

Furthermore, these externalities exert positive financial, monetary and fiscal conditions for domestic demand to flourish.  The strong external inflows place appreciative pressures on the local currencies which, in turn, by helping to fight inflation pressures deriving from strong growth, tend to relax the monetary policy stance and keep interest rates low, thus, making local debt markets more attractive.  Moreover, high commodity prices and strong economic growth improve the fiscal accounts, allowing the government to free up resources for social and infrastructure spending and to develop safety nets to deal with those sectors affected by the appreciating currency.  Additionally, consumers benefit from a strong currency as real incomes improve and credit increases.  So far, countries have been trying to avoid the appreciation of their currencies, via intervention, in order to protect non-traditional exports; however, the large size of trade, financial and capital inflows, along with the aforementioned positive factors and rising sterilization costs, will eventually keep them away from fighting the appreciation trend indefinitely.  After all, the deepening of local debt markets should make favorable financing available to everyone, including the non-tradable sectors, and higher real incomes should support domestic consumption and investment.  Consequently, externally induced positive developments in local finances and fiscal revenues provide constructive conditions for domestic demand to continue expanding.  

 

On the domestic side, most Latin American countries have undergone a remarkable transformation during the last decades.  They have opened up to international capital and trade flows and opted for more flexible exchange rate regimes, thus, reducing the risk of balance of payments crisis by improving financial solvency (strong capital and financial inflows along with large international reserves), as well as diminishing vulnerability to external shocks (wider current and trade account surpluses).   Moreover, countries have improved macroeconomic management (monetary and fiscal policies), strengthened the independence of the central bank and adopted inflation-targeting regimes that have allowed them to keep inflation low.  Furthermore, some Latin American countries have privatized, modernized and internationalized their banking system, in addition to improving their banking supervision, so they can allocate credit more efficiently and deal with run on banks risks more effectively.  Moreover, some countries, taking advantage of favorable global rates and improving local fundamentals, have performed liability management operations to extend debt maturity and deepen local debt markets, therefore, lowering dependency in foreign borrowing and reducing liquidity risks.   

On balance, exogenous and endogenous conditions have improved credit fundamentals and enhanced the chances for rating upgrades, thus, improving the chances of Latin America’s markets of managing and perhaps even profiting from the next period of volatility.  Despite all these improvements, however, many Latin American countries continue to be structurally vulnerable to external shocks and Dutch disease as they rely heavily on their export revenues, while the size of their domestic market and industrial base remains modest.  Among the most likely external factors that will induce a correction are related to a higher than expected increase in global rates (US Fed funds rates way above current levels) due to sharply higher oil prices (geopolitical risks) and/or structurally higher soft commodity prices (ethanol and strong China-India demand for food); or, a sharp decline of US Treasuries support due to a sharp appreciation of the RMB and other Asian currencies; both will severely deteriorate the attractiveness of risky assets.  Or, if the US economy contracts harshly, unemployment rises ruthlessly and the USD weakens swiftly, it will shrink demand for global exports and induce a sharp and prolonged increase in global risk aversion.  Moreover, a US hard landing in the context of a pre-electoral year in the US (2008 presidential elections), will most likely exacerbate the protectionist tone and/or action in Washington against China, fueling a trade war and inducing China and Asia to a hard landing.  Finally, giving these conditions systemic risk is most likely to rise, thus, likely ending the current robust global economic cycle and the buoyant financial run.  

Lastly, there are key developmental issues that Latin American leaders and people should address more forcefully in order to reinforce the aforementioned macroeconomic and financial improvements.  In the modern world, focusing on poverty reduction in a responsible manner, both economically and politically, and within a framework of respect of the rule of law and private property, are necessary conditions to achieve continual stability.  In this regard, improving or promoting investment in human capital (education, health and basic needs), developing infrastructure, reducing the technological gap with the rest of the world, facilitating access to property rights to the informal sector, deepening and modernizing credit markets (consumer and housing), encouraging small and medium size private enterprise, and making the government tax collection and the allocation of resources more efficient, should allow society to create wealth and have a positive impact on the mother of all trouble: unequal distribution of income.  To the extend that many Latin Americans perceive that the status quo and/or globalization are worsening an already chronic income disparity, the rebirth of populism and economic nationalism will be a challenge to macroeconomic management and will cause uncertainty in business investment. While other forms of beliefs tied to Latin Americans psyche such as “caudillismo”, radicalism, anti-US and authoritarianism also will threaten young democracies and the healthy international relations.  Finally, income inequality, along with poor legal frameworks and a lack of transparency and accountability, places the seeds for corruption, organized crime and terrorism to persist, limiting economic and institutional development.      

In sum, in an environment where benign external and internal conditions evolve positively, Latin American markets should respond less dramatically to periods of heightened volatility and some countries should enjoy credit upgrades.  Countries with low external vulnerabilities, deep local markets and sound macroeconomic management should wave volatility better.  However, substantial adjustments in global rates, global growth, and systemic risk should prove overwhelming to Latin America, in the short term.  Finally, unresolved political and social discomfort may propagate political and geo-political risks in the region in the medium to long term.