COMMODITY CYCLE: Fooled by fortune

Despite stronger fundamentals, South America is more dependent on commodities – and so more vulnerable to global shocks – than at any time since the 1970s

  • By Sid Verma
  • 18 Mar 2012
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The air is thick with symbolism. In February, Brazil called on Germany to boost a European financial firewall to combat the storm ravaging the eurozone. That same month, Mexico commanded its former European colonizers to adopt its own economic blueprint from the aftermath of the debilitating currency crisis in its own backyard, known as the 1994 Tequila crisis.

Latin American bulls have a spring in their step, with the IMF forecasting a 3.6% expansion this year compared with a recession in the eurozone. The region’s projected economic outperformance would seem to confirm that Latin America’s bull run over the past decade – barring the post-Lehman tumult – is not about to end.

And yet, despite accolades for the region’s stronger fundamentals, Latin America remains chronically vulnerable to global shocks – even as economic structures and global trading ties have experienced profound shifts in recent decades. “Economic structures have changed over the centuries, but Latin America’s dependence on commodities – its major source of wealth since the discovery of the Americas in the 15th century – has remained and, on some metrics, has increased,” says Alberto Pfeifer, executive director of the Business Council of Latin America (CEAl).

Indeed, the share of commodity exports as a proportion of Latin America and the Caribbean region’s total exports has risen from 27% to 39% over the past decade. Prices for primary commodities have soared in recent years, with real energy and metal prices tripling since 2003, while food prices have increased by 50% since then, buoyed by Chinese demand.

As a result, the region’s economic fortunes are synched to China’s business cycle like never before.

But Latin America’s commodity picture – and thus its susceptibility to price volatility – varies widely. South America, for example, is the most commodity-dependent sub-region, with net exports representing 10% of GDP in 2010, compared with 6% in 1970. Meanwhile, central America, led by Mexico, typically posts a flat balance of trade in commodities, as increased energy imports and lower agricultural exports over the years have offset oil production.

Within South America, although Argentina, Brazil and Uruguay have taken steps to diversify their economies in recent years, commodities still represent 60% of their total exports of goods and services, according to the IMF.

Countries such as Chile, Colombia, Ecuador, Peru and Venezuela – which specialize in heavy metal and hard energy exports (products that are more sensitive to the global economic cycle than oil) – are piling on fiscal risks. A decline in gold and copper prices to 2005 levels would reduce Peru’s exports by a third, for example.

South America is more dependent on commodities, as a share of its GDP, than in the 1970s, a fact overlooked amid the euphoria over the region’s structural transformation.

A backdrop of commodity dependence and volatile global growth prospects has unnerved some observers. “Many commodity-producing Latin American economies are vulnerable right now,” says Jeffrey Frankel, economics professor at Harvard’s Kennedy School of Government.

The fear is the commodity boom has lulled policymakers and market players into a false sense of security, seduced by the region’s healthier investment, consumption and debt metrics relative to advanced economies.

A dip in commodity prices typically triggers balance-of-payment instability and fiscal stress in large net commodity exporters. Meanwhile, high commodity prices can put upward pressure on currencies – triggered by the commodity windfall and large capital flows – and create fiscal dependence on commodities while entrenching a decline in the domestic manufacturing industry.

This phenomenon, known as ‘Dutch disease’, has infected economies as diverse as those of Norway and Nigeria.

South America’s resource dependence raises fears over deindustrialization during boom periods, and during price dips, that the region’s over-reliance on commodity exports will be revealed.

It is not hard to conjure up regional and global developments that could derail the bull run for a clutch of valuable commodities. These scenarios range from a Chinese hard landing to the introduction of new technologies to extract cheaper energy sources. Moreover, commodity consumption trends come and go, heaping on the risks of a positive supply shock in the coming years.

Examples could include: US soybeans outcompeting Brazilian produce, emerging African oil producers snapping on the heels of Venezuelan producers, or new Brazilian output in the coming years crowding out oil from its regional counterparts.

The decade-long commodity price boom – with the glaring exception of the post-Lehman collapse – is unique in recent history by virtue of its magnitude and broad-based nature, with both soft and hard commodities enjoying blistering price gains.

The pace and duration of this rally inevitably raises questions as to its sustainability. Under the shadow of this risk, emerging exporting economies’ vulnerability to commodity price shocks over the past 40 years provides many a cautionary tale. In a landmark December 2011 report, IMF researchers calculated that a commodity-related terms of trade shock of 1% of GDP in a given emerging market exporter would reduce growth by 0.13% in the same year and by 0.08% in the subsequent post-shock year.

The study – based on statistical analysis of the relationship of macroeconomic variables to commodity-related trade shocks since the 1970s – confirmed two conventional schools of thought.

First, countries with a stronger fiscal position outperform their deficit-challenged peers because of their flexibility to pursue counter-cyclical policies. Second, exchange rate flexibility provides a shock absorber in economies with relatively low financial dollarization.

These are now mainstream policy recommendations, from the IMF and others, for South American exporters to avoid boom and bust cycles. “With the exception of Chile, in recent Latin American history, we have remained inebriated by the commodity bonanza,” says Pfeifer of the Business Council of Latin America. “We have not been wise enough to nurture our extraordinary wealth boom. That has to change.”

However, there is less consensus on the likely success of policies to tackle the other consequence of high commodity prices: appreciating currencies, investment bias and addiction to commodity revenues.

In recent years, Brazil, Chile, Colombia and Peru have endured the relative stagnation of their domestic manufacturing industries, caused by commodity-driven exchange rate pressures.


For Brazil – one of the world’s largest exporters of iron ore, soybeans, ethanol and beef, among others – the stakes are high.

Some 70 years after its first discovery of oil, Latin America’s largest economy is poised to become a major global oil exporter after the discovery of the massive Tupi oil field in November 2007, the largest such find in the West for 30 years.

According to Opec (Organization of the Petroleum Exporting Countries), Brazil had the sixth largest recoverable oil reserves in the world at 123 billion barrels, at the end of 2011.

Former president Luiz Inácio Lula da Silva has described these new resources as “the opening of a direct bridge between natural wealth and the eradication of poverty” and the Tupi discovery as the “second independence for Brazil”.

But the commodity windfall has already come with its own costs, despite the associated fiscal cushion: Brazil’s currency, the real, is up around 40% against the dollar since its 2008 crisis low.

The strength of the currency – principally driven by large capital inflows – has undermined the price competitiveness of Brazilian exports in global markets and, conversely, imports have grown at a faster pace. Brazil recorded its widest monthly current account gap on record in January at $7.1 billion, bringing the 12-month deficit to the equivalent of 2.17% of GDP, driven by soaring demand for foreign products and services.

“Many economic indicators – from high imports of foreign goods, weak export orders for manufactured goods and lacklustre job creation in the industrial sectors – highlight that Brazilian deindustrialization concerns require urgent policy action,” says Graciana del Castillo, managing partner of Macroeconomics Advisory Group.

Despite some signs of life in January, manufacturing has failed to expand since 2007 – despite growth in the broader economy. In the past 16 years, manufacturing has lost three percentage points as a component of total production of goods and services.

“Symptoms of the resource curse abound in Brazil,” says Alfredo Coutino, Latin America director at Moody’s Analytics, citing a stagnant industrial sector; retail sales outpacing industrial production; and employment growth in manufacturing underperforming the services sector by 10% between 2006 and 2011.

The Brazilian government is likely to attempt to distribute the fruits of its growing commodity wealth to the larger population by ramping up social spending. But the risk of long-term output volatility will be exacerbated if production is concentrated in the primary sector, holding the country to ransom to controlled commodity prices externally.


“Evidence for the so-called Dutch disease is all over the place in Latin America. The question is whether anything should be done about it and if so, what,” says Frankel of Harvard’s Kennedy School.

In Brazil, for example, the government in September slapped taxes on imported cars to shore up its domestic manufacturing industry, a move that highlighted the global impact of commodity exporters grappling for export competitiveness.

But aside from active currency intervention and capital controls – policies seen as ultimately impotent in stemming structural appreciation pressures – there are few weapons in the policy arsenal. Government efforts to provide exporters with currency hedging tools and subsidized capital, for example, ultimately cannot solve long-term currency strength pressures, experts say, while large subsidies or import sanctions will fly in the face of international trade agreements.

Put simply, Brazil and other countries in a similar position have to grin and bear it. “Besides what is already being done in Brazil – exchange rate intervention and capital controls – there is little it can do in the near term,” says Eduardo Levy Yeyati, professor of economics at the Universidad Torcuato Di Tella, Buenos Aires, and a former chief economist of the central bank of Argentina.

Others agree. “Brazil is going to be rising up the ranks of global commodity players, so it has to get used to the strength of its currency,” says Marcelo Salomon, an economist at Barclays Capital. Counter-cyclical fiscal policies and a largely flexible exchange rate – with intervention only justified to smooth excessive volatility or correct overt misalignments – are needed, he says.

The flipside of South America’s reduced dependence on foreign capital over the past decade has been its increased dependence on primary exports, says Yeyati. This windfall comes with opportunity costs, while its fruits have been unevenly distributed. A bursting of the commodity price bubble or the prolonged ill-effects, economic and political, of excessive exchange rate appreciation should force policymakers to re-tool the region’s growth model away from cheap credit and a commodity boom.

“Countries need to snap out of this commodity-dependent nirvana and face the need to enhance high-quality investment and education,” says Yeyati. Opportunity costs abound. Coutino of Moody’s, for example, argues that commodities have created the illusion of fiscal strength in Latin America when, in the absence of reforms, non-commodity related tax revenues represent less than a fifth of the region’s GDP compared with a third in OECD countries.

To reduce commodity dependence in the coming years, South America needs a reformist push aggressive in its scope, from overhauling the tax and labour market system to regional trade integration efforts, to jump-start the industrial sector, says Pfeifer.

Ultimately, it might only be a prolonged commodities slump that wakes policymakers up to the seriousness of the situation.

  • By Sid Verma
  • 18 Mar 2012

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