“Will the global financial turmoil hit emerging markets and Latin America? Or will the region decouple from this turmoil and from the US economic slowdown? Is China more important than the US for the economic fortunes of the region? How much of the recent economic success of Latin America is due to good policies or good luck? How to manage capital inflows that are leading to appreciation pressures on the main currencies of the region?” Those were some of the questions that Roubini brought from the annual meetings of LACEA (the Latin American and Caribbean Economic Association) in Bogotá. Let me give my take.
Repricing of Latin American Risks: an update
As the financial turmoil was starting to show its severity, I argued here (August 9) that the most likely outcome in the region would be a mildly higher average risk premium, with higher differentiation among Latin risks, as compared to the relatively undifferentiated and exceptionally low risk premiums of recent years. I based my belief on the opinion that, as long as there would be no meltdown of the global economy, the predominance of sustainable stock-flow interactions at both fiscal accounts and balance-of-payments in most countries of the region would preclude new “sudden stop” episodes, differently from previous experiences.
Two months later, I still hold the same view. As displayed in Table 1, EMBI spreads in the region have devolved a substantial chunk of the increase that took place between July 23 and mid-August, moving back last week in some cases even to levels lower than before (Brazil, Ecuador, Mexico and Peru). In their turn, local currencies remained roughly flat in average vis-à-vis the dollar (Graph 1), with more cases of appreciation than otherwise (Table 2). Stock markets have also recovered partially – or more than that in the case of Brazil – after an initial tumble (Table 3).
On the other hand, I cannot claim clear victory to my hunch that idiosyncratic, country-specific fundamental factors would play a role in more-or-less decoupling many countries of the region from the financial turmoil. After all, VIX and US High Yields have also returned to initial levels (Table 1), apparently reflecting a relatively benign view of the aftermath of the financial crisis. Graph 2 exhibits a strong relationship between local stocks and the Dow Jones. Furthermore, one cannot easily disentangle what has been due to common, emerging market- related determinants (see Graph 3). Thus, more than visual observation – as well some new up-tick in global levels of risk aversion – would be necessary to check my hypothesis of a “structural break” in the empirical relation between regional spreads and very-high-risk assets in the core economies.
Anyway, even if it is not possible yet to measure “how much of the recent economic success of Latin America is due to good policies or good luck”, I guess it is safe to say that “good policies” and growth perspectives have been necessary – even if not sufficient – conditions for the relatively smooth path through which the region has so far crossed the crisis. Most noteworthy has been the return of IPOs and foreign capital inflows in some countries (particularly Brazil).
Let me then propose another factor of differentiation among countries of the region regarding macroeconomic perspectives in the near future, namely the degree of dependence of domestic growth on the main external factors of adjustment in course (dollar devaluation and the dwindling of the US trade deficit, as well as the Chinese reaction function to that process).Roubini formulated his questions at an aggregate, regional level, whereas we think the heterogeneity of country initial conditions will matter in the following process of global adjustment.
Latin America and the Global Adjustment
There are still diverging opinions on the probable intensity of the US economic slowdown, hinging upon different bets regarding the housing slump and the containment of the sub-prime market woes, the nature of required policies, the implications of those elements in terms of general credit restrictions and the feedback to the real economy, and so on. But there is apparently an increasing convergence toward the opinion that the US$ devaluation vis-à-vis other major currencies has come to stay and likely deepen.
Furthermore, as highlighted by Jim O’Neill, there are signs of a major change in the US external balance, the implications in terms of reshaping world business of which have not so far received due attention. On an annualized basis, the US trade deficit is already running just over 5% of GDP, a significant alteration relative to the 7% of not so long ago. Exports have been growing at the rate of almost 15% year-on-year, while imports have been rising at 5.1%. At that pace, the trade deficit will be bellow 4% in 12 months from now, and maybe 3% or less if a full-blown US recession leads to stagnation of imports and the global economy manages to “decouple” from the US.
Martin Wolf has also called attention to the additional “trade-adjustment stress” established by the Chinese surging balance-of-payment current-account surplus: US$380 billion forecast for 2007 versus US$250 billion last year. By not having its domestic absorption rising faster than its GDP, China would be doing additional sucking of demand from the rest of the world, instead of partially countervailing the US relative retraction as the world net importer of last resort.
The obvious implication of these two processes to emerging-market economies in general, taking into account the low likelihood of Western Europe and Japan replacing the US, will be the hardship to maintain the pattern of current account surplus cum reserve accumulation of the last few years.
As far as Latin American emerging economies are concerned, given the level of reserves and low external financial fragility currently attained by many, I do not believe any stop or even slight reversal of reserve accumulation would be a devastating factor. However, four other features might bear consequences on the country-specific ability to suffer less from the global trade adjustment in course:
(i)Dependence on exports to the US economy;
(ii)The degree of complementarity or substitutability of the country’s exports vis-à-vis China;
(iii)Scope for domestic demand-driven growth, provided that the current starting point in terms of current-account balance allows for some corresponding trade-balance deterioration; and
(iv)Provided that the transmission of the financial turmoil to the real side in developed economies does not end up translating into financial restraints to foreign investments in emerging economies, capital flows will tend to follow the three previous items, reinforcing adjustment trends.
I leave to another day the task of developing here such a kind of exercise of country differentiation, but I may say that I believe those four factors have been relevant in explaining the recent evolution of stock markets, exchange rates and capital inflows in the case of Brazil.