At the start of an important week in the markets which will test the Fed’s bold move to lower the discount rate, the risks to Latin America are starting to come into focus. These would seem to involve, in the short-run, the risk of considerable financial volatility even if we accept (as I do) that most of the Latin economies are in a much better position today to absorb such volatility than they were ten years ago at the outset of the Asian financial crisis. It seems equally clear that the biggest risk to Latin America is going to play out in the medium-term and in full public view as the external environment for the region turns less favorable and GDP growth declines.
As much as the Latin economies have done to build in shock absorbers over the last ten years, it is important not to underestimate the short-term risks to the Latin American markets as investors flee risk globally. Countries such as Brazil and Argentina, perhaps for a different mix of reasons, are going to see significant amounts of capital leaving as international investors sell assets in these countries to fund losses arising elsewhere in global portfolios. Both these countries saw alarming currency weakness last week and experienced huge drops in stock and bond markets. In Brazil, the future of the Central Bank’s easing cycle is coming under question as currency weakness is likely to show up in the inflation data. Brazil is especially vulnerable because it has been the recipient of so much international investment. In Argentina, where fundamentals (inflation, fiscal position, trade balance) are already deteriorating, the authorities may have to step up currency intervention to prevent the peso from sliding further. Argentina also adds a degree of political uncertainty into the mix of issues that will concern investors, adding to its vulnerability to an investor pull-out.
If this subprime/commercial paper crisis is anywhere near as serious as Nouriel Roubini and others are warning, the medium-term implications for Latin GDP growth would be the biggest risk by far. The ultimate growth impact in Latin America will determined in large part by what happens to global economic growth, commodity prices, and financial conditions.
In this context, it is useful to recall work by the IMF (Regional Economic Outlook: Western Hemisphere, April 2007, on the IMF website) on the relative contribution of external shocks to fluctuations in Latin American growth. According to this study, external factors account for at least one-half of the medium-term variance of Latin American GDP growth. The biggest influence on growth are external financing conditions which account for 35% of the variance in Latin American growth, followed by world growth shocks (10-15%), and commodity price shocks (5-6%). Just to give examples of the rules of thumb developed in this study, the effect of a world growth shock on Latin American growth is pretty much one-for-one. One standard deviation shocks for commodity prices (about 5%) and the EMBI-Latin America (about 115 basis points) affect GDP growth in Latin America by about 0.4.-0.5%, according to the IMF.
At the time the study was produced (April), the global scenario dubbed one of “disruptive unwinding” of global imbalances – sharp declines in U.S. growth and a spike in U.S. high yield rates amid severe declines in commodity prices – was considered highly unlikely. While it is still not a likely outcome, the probability of this sort of “disruptive” outcome has increased. In such a scenario, the hit to average Latin American GDP growth would be severe. Average GDP growth in Latin America could fall from something like 4-5% in 2007 to 1-2% in 2008. Even if some of the sensitivities (e.g., to financial conditions) have changed for Latin America, and even if the eventual real shock from the current crisis is not so severe, we are still talking about a significant hit to GDP growth in a region that is not growing all that quickly to begin with.
The medium-term costs in terms of lost GDP will be highest for those Latin countries who have rested on their policy oars (so to speak) over the last five years during the “Goldilocks” global economy – content to build their international reserves and diminish obvious financial vulnerabilities to the relative neglect of longer-term growth policies. I will leave it for another time to determine which countries would sacrifice more in terms of lost growth, but certainly Argentina and Ecuador come to mind. Chile would be toward the opposite end of the scale as being relatively less affected with Brazil falling somewhere in the middle.