I am back from a great varacion and ready for a new NFL season. Excitement, competition, injuries, scandals, and crises are just around the corner. Yes, you read correctly, crises. I’m talking about the real NFL; the tough one; the extremely popular one. Yes, the Not Financially Liquid league, not the other one where hits are just incredibly weak and rare.
We got our first scare a couple of weeks ago, and yes markets have calmed down. But do we really think the US adjustment just requires a tiny drop in the interest rates, and a change in the color of the wardrobe of policy makers and regulators to make the US sustainable? Sorry to dissapoint you, but that is not enough. More bad news are to come, and will come, and the US will have to adjust. This will imply a reduction of domestic demand, which means that not only consumers in the US will feel the pain, but somebody else as well.
If this were a normal US recession I would say the region that will suffer the lion share of that adjustment would be Europe. US crisis in the past involve a dramatic drop in import demand, and “poor” Europe almost always had to pay the bill.
But this would be hardly a typical US recession. This would be a credit-worthiness crisis in the US that will drive a liquidity crisis elsewhere. And liquidity crises usually mean that whenever a country in the world suffers from a mild cough, Latin America gets pneumonia.
The contagion to the region will take place through two mechanisms; trade and liquidity. A reduction in the US demand will cause a drop in Latin American exports that ultimately will affect output and growth. This mechanism is at play at all times and actually I do not even call it contagion. To me it is the normal propagation mechanism. However, most of the world do call it contagion, so, for quite some time i decided to give up to the peer pressure. The contagion because trade relationships exist is important and it is unavoidable, but generally, it is small for Latin American countries.
The second mechanism is through financial frictions. And illiquidity is the reflection of one of them. The deterioration of balance sheets and the drop in asset prices in the US will cause a tightening of financial institution constraints that ultimately will squeeze liquidity out of Latin America – and of course other emerging regions, but i have to get visas to visit those regions so, so i usually disregard them. This credit crunch will imply short term problems to the region, with possible medium to long term repercussions. By the way, if you are interested, or you have severe problems falling asleep, I have a theoretical paper with Anna Pavlova explaining the intricacies of how contagion takes place when financial frictions exists: “The Role of Portfolio Constraints in the International Propagation of Shocks”.
As I said before, it is impossible to be prepared to the contagion caused by trade – unless you are willing to isolate yourself – but you can build some cushion to deal with liquidity crises.
I would like to open a discussion on which countries in our region are prepared to handle the liquidity squeeze. Which ones have the space in reserves, in the fiscal accounts, and cash in the financial sector? In fact, can we create a meaningful index to rank the Latin American countries in terms of their readiness to handle the crisis?
Remember, August is just the pre-season. Opening day is early September, and the question really is: Are you ready for some contagion?