Which way is it for Latin America? It was commonly said in the past that when the U.S. caught a cold, Latin America got pneumonia. By that measure, the shivers in the U.S. economy should have already sent chills throughout Latin America, but that does not seem to be the case, at least not on the surface.
As Otaviano Canuto points out in his recent blog, Brazil is in a financial state approaching euphoria. Foreign direct investment and portfolio inflows are near record levels. Last week’s primary issuance by the BM&F was greeted with the type of exuberance (whether rational or not) reminiscent of dot-com days in the U.S. The IBOVESPA is up 42% for the year! Even the New York Times is reporting that more Brazilian immigrants are leaving the United States to return to Brazil than newcomers are arriving, an amazing turn of events!
So it almost seems almost grinch-like to conclude that the market has peaked in Latin America and is headed for a sharp correction. But that is my conclusion. It is brought on by months of mounting concerns about the U.S. economy, the global financial system, the oil price shock, and the clear signs that the damage is not limited to the U.S., but also threatens Europe very significantly. As a global credit crunch unfolds in 2008, the likes of which we have not seen in a very long time, Latin America is not going to emerge unscathed despite generally upbeat assessments from the Street.
What is the evidence of tough times ahead for Latin America? The case is best understood by starting outside of Brazil where the good times are rolling still.
Looking at the global economy, where the problems always start, the warning signs for Latin America are pretty evident. EMBI spreads have widened significantly from their record lows in July amid signs of a credit retraction from the region. What’s the big deal, you say? After all, reserve levels are high, most of the countries have current account surpluses, and capital inflows remain large, right?
Calvo and Talvi writing in this space last month argued against complacency on capital inflows. If we adjust regional current account balances for 2002 terms of trade, for example, the regional current account balance in 2006 would have been a deficit of something like 4% of GDP. This means that many sectors within the Latin American economy in 2007 are actually running huge deficits in their (sector-specific) current accounts and are highly vulnerable to a cutoff in global credit. It is only a few sectors, those tied to commodity production for the most part, that are generating the huge surpluses and these cannot automatically be transferred to deficit sectors in the event of a credit crunch. Most sectors in Latin America – think manufacturing and services – are very dependent on capital inflows and these are the sectors that are generating most of the region’s employment gains.
The outlook for the region’s trade is increasingly uncertain, and not only because superheated domestic demand is causing imports to rise. Commodity prices, apart from oil, have clearly peaked on worries about a U.S. recession. Copper prices, a usually reliable indicator of global commodity demand, are down 20% from their peaks earlier this year with more weakness predicted. Most of the Latin currencies have appreciated by anywhere between 5-15% against the dollar in 2007, adding a deflationary impulse to the region’s export sectors. The United States is the largest single export market for almost every Latin American market and the U.S. consumer, the source of so much of the export demand, is clearly running out of gas as we saw last week in the Q3 GDP numbers.
Just a quick glance at the main economies in the region outside of Brazil shows why Latin America beneath the surface may be much more vulnerable to the coming global crisis than is commonly thought.
Colombia is experiencing the lagged effects of currency appreciation and witnessing a slowdown in real export growth, with weakness concentrated in the U.S. market which accounts for 35-40% of Colombia’s export markets. Neighboring Venezuela is clearly suffering from huge economic imbalances which not even $160 million per day in oil revenues can mask any longer and which the “No” vote illuminated so clearly. The Mexican economy, which never boomed very much to begin with, is experiencing a growth slowdown, again linked to declining demand from the U.S. which is its overwhelming source of external demand. Chile’s GDP growth proxy dipped to less than 3% in September from levels twice as high several months ago. Argentina appears on the surface to be booming, but many sectors in the economy are vulnerable to a credit crunch, energy shortages loom, and the new government is going to have to exercise fiscal constraint to control inflation.
All of which brings us back to Brazil. The enormous inflow of capital in recent weeks certainly suggests that the market sees no problems whatsoever in Brazil today. But the market often gets it wrong, and it may be underestimating the impact on Brazil of an appreciated currency, a government that seems to have lost any reformist zeal it once had, and a congress completely tied up in knots over an internal scandal. It is hardly the picture of an economy preparing for tougher times ahead by laying the basis for sustained growth. It may not be irrational exuberance that accounts for the market froth in Brazil, but it is probably something akin to it.
How bad will things get in Latin America in 2008? Maybe it will not come to an outright recession for most countries, but I would not be surprised to see growth rates in the region in 2008 fall to one-half the 2007 levels, or from about 5% to 2.5% or less. Worse outcomes are possible, but that one is bad enough for now.