For Latin America, the Great Recession is already little more than a memory.
The savage financial and economic crisis which drove large swathes of the rich world to the brink of bankruptcy was, for the western hemisphere, something of an aberration – its effects on growth relatively short-lived.
The region has, for the most part, bounced back with unprecedented vigour. Today, roaring output and surging commodity demand – together with a flow of cheap capital – has once again helped feed a belief that Latin America has entered a new era of macroeconomic stability, having shrugged off its historical vulnerabilities, including unwieldy public debt burdens, rampant inflation and a legacy of policy unpredictability.
The resilience of regional economies during the global crisis bore this out, as does greater policy stability and flexibility, stronger external balance sheets and low levels of government and external indebtedness. As IDB president Luis Alberto Moreno likes to put it: “This is Latin America’s decade.”
THIS TIME IS NO DIFFERENT
But, in many ways today’s macroeconomic picture is reminiscent of the status quo in the months before the 2008 crisis, when policy debates focused on how to rein in overheating Latin economies against the onslaught of high oil and commodity prices and unremitting capital inflows.
“The global crisis gave us a parenthesis, and now the same issues have come back,” says Liliana Rojas Suarez, senior fellow at the Center for Global Development. “People are once again discussing exactly what we were talking about pre-crisis.”
Today, the near-term challenges facing policymakers are significant – including managing rising consumer prices while grappling with the effects of capital inflows and upward pressure on local currencies. Rising consumer price inflation is being fuelled by a combination of rapid growth, higher food prices, and a resistance to currency appreciation.
VICTIMS OF SUCCESS
Capital flows rebounded fast post-crisis, reaching a record $266 billion in 2010. This was partly a result of ultra-loose monetary policy in the developed economies, spurring on global risk appetite and a flood of liquidity across emerging markets.
The effect has been profound for the region: Latin America’s share of total emerging market capital flows has increased from 13% in 2006 to 25% in 2009, according to the IDB.
But the difference today is that the bulk of these flows are no longer foreign direct investment but rather portfolio flows, representing 55% of total inflows. For Latin America’s seven largest economies, financial flows have increased to 69% of total flows, up from 37% in 2006.
“It’s not that we’re getting the general push [of capital inflows], we’re getting the larger share of that push – that has to be because the region is perceived as more resilient than in the past,” says Alejandro Izquierdo, principal economist at the IDB’s research department.
These sharp capital inflows have prevented the region’s economies from shrinking their current account deficits. “Even though FDI has been falling, financial flows have been compensating,” says Izquierdo. “That’s introducing a new source of vulnerability.”
Guillermo Calvo, professor of economics at Columbia University, says the surge in capital flows is partly the result of opportunism and partly due to a belief that another Lehman-style meltdown will not be allowed to happen. “This rush of funds into the region – it’s not because the fundamentals have increased overnight. I don’t think it’s chasing the region’s fundamentals, otherwise it would have happened sooner.”
“The initial flows have to do with the assurance that we’re not going to see another Lehman, that gave rise to a lot of liquidity,” he adds.
BACKTRACKING
In recent weeks, however, capital has begun to pull back from emerging regions including Latin America. Equities have dropped sharply, while emerging market bonds have started to underperform as investors fret about economic overheating and inflation in developing countries. EPFR, the global fund tracker, estimates that a net $3.1 billion flowed out of Latin equity and debt funds between January and mid-March.
In the short term, these partial inflows have been welcomed by policymakers, as it has eased immediate liquidity and appreciation pressures on local currencies.
“Now you see a partial reversal of the flows – that’s fortunate because you don’t have this huge flood of capital at the moment,” says Rojas-Suarez. This has allowed central banks to begin tightening interest rates in earnest in order to keep a lid on inflation.
But uncertainty is growing over whether flows could reverse more profoundly – with potentially negative implications for Latin American policymakers – especially when monetary policy normalizes in the developed world.
MOUNTING UNCERTAINTY
Consensus in financial markets until recently held that the US Federal Reserve would keep monetary policy loose for the foreseeable future, especially in light of stubbornly high unemployment. But that view has started to shift as inflation expectations inch upwards.
Anxiety about inflation has been boosted by higher prices for basic commodities and food. Political turmoil in the Middle East and North Africa has pushed crude oil prices to $115 per barrel. US consumer prices have inched up in recent months, even though price pressures are relatively contained compared with other economies.
“The present reversals are coming from [concerns about] the Middle East,” says Calvo. The fact that emerging markets have borne the brunt of the outflows “is perhaps because of the fear that it would have an implication on monetary policy in the north. For example, if the price of oil shoots up and food continues climbing up, that could be reflected in a sudden increase in prices in the US.”
Ten-year Treasury bond yields fell to a year-to-date low of 3.22% on March 16, as investors looked for a safe-haven bid amid concern over Japan and Libya. However, they have since rebounded and the future outlook remains far from clear, especially given mounting concern and political deadlock over the US fiscal deficit.
The danger is of a spike in bond yields once the US Federal Reserve ends the second round of its quantitative easing programme (QE2), as private investors demand a higher return to compensate them for the risks of inflation or dollar depreciation. Fed officials have already signalled that QE2 will not be extended beyond June. But with renewed inflationary pressures also bearing down, concern is growing that yields will be driven higher more quickly than many anticipate.
For Latin America, the concern is that a sharp rise in US interest rates could trigger a reversal in capital flows – and a drying up of liquidity. “Liquidity can disappear not only for fundamental reasons but for liquidity reasons, for example if the US interest rate takes a hike. We’ve seen that in the past,” says Calvo.
“The region is still highly vulnerable to liquidity shocks.”
Meanwhile, possible fallout on global financial markets of the eurozone’s worsening debt crisis continues to loom in the background. Portugal’s prime minister, Jose Socrates, was forced to resign this week when the country’s lawmakers rejected the government’s austerity budget – a fact which now makes an international bailout more likely for the country. This came as European leaders gathered for a summit aimed at stopping the crisis from spreading.
CHINA CONCERNS
Aside from easy external financing, the region has also benefitted from strong commodity prices in recent years. China, in particular, has been powering Latin America’s growth through improved terms of trade, expanding export volumes and access to cheap global capital – none of which can be taken for granted over the medium term.
Most economists believe that the long-term fundamentals driving Chinese commodity imports from Latin America remain strong. But as Chinese authorities embark on a series of tightening measures – including reserve requirement hikes, interest rate increases and attempts to control house price growth amid growing domestic discontent – the risk of a near-term slowdown in Chinese commodity demand cannot be discounted.
“We all forget how utterly dependent on China the emerging markets story is,” says David Lubin, chief emerging markets economist at Citigroup. “Chinese growth has been credit dependent. One of the big risks is that we get some trigger that interrupts this virtuous cycle, and that asset quality becomes less hidden. 2010 showed that China, as a command economy, is not that clear cut – that you can’t have so much faith that Chinese policymakers are error-free.”
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China’s inflation is gathering pace, running higher than the official 2011 target of 4% in each of the past four months, according to the National Bureau of Statistics of China. And with the Chinese authorities likely to have to tighten further in the coming months to fight rising prices and cool off overheating, and other large emerging economies across Asia in particular also shifting to a more restrictive monetary stance, some analysts warn that Latin America needs to prepare itself for the possibility that commodity demand from emerging Asia could reverse in the future.
Mauricio Cardenas, director of the Latin America Initiative at the Brookings Institution in Washington, believes that the current favourable external conditions for the region are temporary. “The region needs to make sure that the new paradigm is less dependent on good news from China,” he wrote recently.
Guillermo Mondino, chief Latin American economist at Barclays Capital, believes that the chances of a Chinese hard landing are remote, but nevertheless agrees that policymakers in the region should be preparing themselves for some sort of slowdown in Chinese demand.
“China continues to move towards a soft landing, gradually bringing down inflation and slowing down the growth baseline, but we don’t rule out a faster slowdown in activity, with annualized quarter-on-quarter growth rates of 6–6.5%,” he says. “If we move into this scenario, we would have a pullback in commodity prices which could be a serious risk for Latin America.”
RIDING THE CYCLE
For now, such concerns seem a long way off for Latin America. Instead, the region’s commodity exporters are welcoming the spike in commodity prices for its positive impact on trade balances. But another concern is that a prolonged commodity-fuelled trade boom risks postponing vital fiscal and structural economic reforms. At the same time, overreliance on commodity exports to China poses major risks if the cycle turns.
“The region is facing the incipient phases of Dutch Disease,” warns 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. “Countries are becoming increasingly commodity dependent, which makes some sense in light of the evolution of terms of trade and justifies aggressive action on the exchange-rate front. But this is also something governments need to be aware of, particularly since the drivers of those terms of trade tend to be highly cyclical.”
He adds: “The US ultimately will raise interest rates, China ultimately will grow at 7% instead of 10% and things will happen – global demand will stabilize, and commodity prices will stop going up.”
As a result, Levy Yeyati warns that the policy mix across the region will need to shift “to prevent a cyclical reversal of terms of trade that will catch you too dependent. That’s the main medium-term pressure point on the macro front.”
FISCAL MATTERS
Governments’ willingness to move beyond counter-cyclical stimulus measures towards balanced budgets is now key to sustainable growth. “This is no time for celebration,” says Cardenas of the Brookings Institution. “The new paradigm is here, but is still vulnerable. The basic policy framework needs further consolidation.”
Izquierdo agrees that against this backdrop, the ideal macroeconomic response is a more conservative fiscal policy. “These countries have to unwind the fiscal policies that they used during the crisis. It’s important to show that they can implement countercyclical fiscal policies in good times.
The IDB points out in a recent report, One Region, Two Speeds, that while the region was able to implement counter-cyclical fiscal policies “for the first time in recent history” during the recent global crisis, “it remains to be seen whether countries will follow counter-cyclical fiscal policy during the upcoming expansionary phase.”
The report adds that an early unwinding of expansionary policy “must be accomplished in order to ensure that the region will have enough ammunition in its arsenal to fight future shocks”.
ALL TALK, NO ACTION
But such action is hardly forthcoming. Economists are increasingly concerned that the policy response from the region has been inadequate.
“The policy mix is sub-optimal,” says BarCap’s Mondino. “Fiscal policy remains lax and should be tightened a lot more to absorb the impact of commodity inflation, fighting currency appreciation and helping monetary policy so that interest rates don’t have to rise that much. The cyclical nature of fiscal policy is putting an excess burden on monetary policy.”
Says Alberto Bernal, head of emerging markets macroeconomic strategy at Bulltick Capital Markets: “These countries are using rhetoric and putting all the responsibility at the door of the central bank. It’s much better to control public spending rather than crowding out private-sector investment.
“The implication of this [overreliance on monetary policy] is that it could have a much stronger than hoped for deceleration on investment if interest rates go up fast.”
BRAZILIAN BLUES
The situation is arguably most acute in Brazil, which was much slower in withdrawing stimulus policies than many of its neighbours, despite surging growth rates throughout 2010. The country’s new president, Dilma Rousseff, unveiled a fiscal
consolidation programme in February aimed at delivering R50 billion ($30 billion) in cuts. But many analysts remain sceptical about the implementation of these cuts, warning that the actual cuts may amount to less than a quarter of the headline figure.
“The spending cuts only reduce the real growth rate of spending from 2010 to 2011, but real spending growth will continue to be positive. As such, there is no fiscal retrenchment on the cards, just slower expenditure growth,” says Douglas Smith, head of Latin America research at Standard Chartered. “Fiscal policy is not allowing for a decline in aggregate demand.”
Rojas Suarez of the Center for Global Development believes that Brazil would be particularly affected by a sudden cyclical downturn because of its deeper capital markets. “If there was a problem in Brazil’s financial system, the availability of both international reserves plus any credit line from the IMF wouldn’t be sufficient,” she adds.
Levy Yeyati thinks it’s likely that Brazil will “muddle through”. But, he says, “they’re having problems in managing a reality that is below expectations.
“The government will most likely do less than what the market is expecting in terms of adjustment and less than the public is expecting in terms of growth. They will have to find some place in the middle.”
This matters because, as the IDB’s Moreno acknowledges, today’s policy response across the region will determine the region’s progress for years to come. “How we handle this is going to have an impact on the growth in Latin America,” he says.
The key question for much of the region today is whether economies will be able to capture the recovery’s momentum and turn it into sustainable strong growth. “One of the main challenges facing Latin America if they want this to be ‘the Latin American decade’ is to show that they can grow at Asian rates but without inflation,” says Levy Yeyati.
TOUGH TRANSITION
This is especially important for Latin America, as the region looks to consolidate the gains of a decade of economic progress and as its populations are increasingly clamouring for swifter progress on social, as well as economic, issues.
Levy Yeyati sees this as the result of the stage of development that many countries in the region find themselves at, caught in the transition from developing to advanced economies and faced with making this transition over a far shorter period of time than many developed nations took to do so. “It’s no longer only growth; you have to start looking at social indicators, the political system and a number of micro issues that in the advanced world progressed over a number of decades,” he says.
While focus on micro issues including healthcare, education and infrastructure development is hardly off the agenda for Latin policymakers, the gulf between the rhetoric and reality of the region’s economic development remains vast, he says.
“People are getting impatient. They’re buying the story that they’re close to being advanced economies, and that is something difficult to manage politically.”
He adds: “The question you have to ask yourself as a policymaker is what is needed to go from emerging economy to advanced economy. Markets are only one part of the story – probably the easiest one. You need to develop the economy. And that takes longer.”