Are you ready for the NFL?

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?

5 Responses to "Are you ready for the NFL?"

  1. mark turner   August 23, 2007 at 8:27 am

    Thanks for starting my day with a laugh! Good points made too.  Which players have an extra layer of padding and Kevlar helmets? Well the first that springs to mind is Argentina. Here’s the defensive line-up  ·artificially weak currency (easy to defend from here) ·top exporter of soft commodities ·central bank with a healthy war chest ·IMF debt paid off and gov’t keeping the holdouts at arms length ·not much hot money entered the country (as opposed to Brazil, for example), thus less downside from hedge fund knee-jerks  So Argentina is my tip to go all the way. More generally, in LatAm’s case a lot depends on whether the subprime crime affects chindia commodity demand. I don’t think it will to any great extent so remain bullish on the whole region. Go team!

  2. Guest   August 23, 2007 at 4:36 pm

    Macro and financial fundamentals are much better now in Latin America than in the last few years: primary surpluses, low inflation and independent central banks, current account surpluses and large stocks of reserves, less vulnerability to sudden stop, stronger financial systems. So why should financial contagion be severe? Are you sure you will see severe turmoil?

  3. Vitoria Saddi   August 23, 2007 at 5:16 pm

    Roberto, Here is my index (going from countries that are more prepared to those that are less prepared): 1. Chile; 2. Brazil; 3. Peru and Mexico; 4. Venezuela (Given Chavez); 5. Argentina; 6. Colombia  7. Paraguay (safe haven? So why capital outflow)? 8. Bolivia 9. Ecuador  Great piece!

  4. bsetser   August 23, 2007 at 9:53 pm

    brilliant post — love the metaphor.  mark — there may be a bit more foreign investor interest in argentina than you suggest, tho nothing like brazil.   but fully agree that latam’s true point of vulnerability now is not financial but “real” — i.e. a fall in commodity prices that changes the BoP picture.