A recent IMF paper examined regional correlations since 1870. The paper, which was written by Marco Aiolfi, Luis Catão and Allan Timmermann, is called ‘Common Factors in Latin America’s Business Cycles.’ The link to the site is http://www.imf.org/external/pubs/ft/wp/2006/wp0649.pdf. In order to commence the exercise, the three economists reconstructed GDP levels for Argentina, Brazil, Chile and Mexico for the past 140 years. Although there was good historical data on sectorial activity and trade, most of the countries in the region did not standardize their national income accounts until after Bretton Woods. Therefore, the IMF economists used backcasting techniques to reconstruct the GDP levels. Not surpsingly, the data revealed a great deal of correlation between the four major Latin American countries and the international economy.
The data showed that the correlation between the four major Latin American countries and the international economy averaged 25% since 1870. That is to say that the region’s level of economic activity was largely affected by changes in external demand. The degree of correlation fell to 12% from 23% after 1930. The onset of the Great Depression marked a political shift to the Left, and many of the Latin American countries adopted import substitution policies to bolster domestic production and boost employment levels. However, the collapse of the import substation regimes in the 1970s led to a gradual reintegration with the global economy. As a result, Latin America’s correlation with the international economy increased to 42%. The data also showed that the region was very sensitive to changes in international interest rates. The level of correlation steadily increased since 1870, showing a negative correlation of 19% until 1930. In other words, increases in international interest rates had a negative impact on Latin American economic activity. The negative correlation increased to 20% until 1970, and it reached 23% in 2004—when the data set ends. The data set also showed that the correlation between the four large Latin American countries was extremely high, averaging 72.5% since 1870. The interesting thing is that trade and capital flows between the four countries was nil. Therefore, they were all affected by common external factors.
The IMF study, which was completed prior in 2006 (prior to the current downturn), counters the decoupling theory. Investors, bankers and analysts in Brazil and Colombia are particularly vehement in their argument that their countries are immune to the U.S. credit crunch. However, the same crowd in Mexico, Chile and Argentina seemed to be more resigned to the fate that lies ahead. The commodity boom of the past 5 years led to greater aperture of the Latin American economies, with trade becoming a larger component of GDP. This increased their vulnerability to changes in external activity. However, the privatization of the domestic pension fund systems gave several of the Latin American countries larger pools of domestic savings to mitigate their dependency on external capital. Therefore, some of the countries may be slightly more resilient to changes in international interest rates—but they are far from immune.
The historical record clearly shows that Latin America is very susceptible to changes in the international environment. The ability of countries to confront external shocks is predicated on their ability to adjust their levels of domestic demand in the face of international volatility. So far, countries such as Brazil, Colombia and Venezuela, are not doing anything to prepare for the gathering storm. GDP forecasts remain high and government spending continues to rise. Other countries in the region are acting more prudently, taking steps to prepare for the deterioration in external conditions. However, one thing is certain. The data shows that the common fate of Latin America hinges on the health of the international economy, particularly the U.S. Therefore, the notion that some of the countries in the region will magically decouple from the global economy is contradicted by 140 years of historical evidence.