Latin America could face a hazardous decline in its terms of trade when the current favourable cycle ends, despite stronger economic fundamentals, finance chiefs warned yesterday.
Chile’s central bank governor Jose De Gregorio warned of looming risks to Latin America’s post-crisis rebound from the effects of a Chinese economic slowdown and US economic policy uncertainty.
He said that rising interest rates in the US could end the era of abundant liquidity, while an eventual decline in commodity prices would also have unpredictable consequences for the region.
“We have a [significant] uncertainty when we look at the world, we say: which emerging markets are resilient to declines in the terms of trade? We have seen [...] progress all around emerging markets, but [this was] in very strong and good external conditions, high terms of trade,” de Gregorio told Emerging Markets in an interview.
“If terms of trade decline, which countries will be able to pass these problems without much turmoil?” While Chile had accumulated a sovereign wealth fund, “there are countries that depend a lot on high commodity prices, so a decline in prices could be extremely harmful,” he said.
A series of shocks from the Middle East and Japan have so far failed to dent the prevailing optimism over Latin America’s economic prospects, but de Gregorio warned: “It is not clear that a rapid adjustment in China will not add some tensions to the world economy again.”
Phil Suttle, chief economist at the Institute of International Finance, said: “If the inflation problem in China gets really bad, you have to expect the People’s Bank of China to be very aggressive, and that would not cause just a sharp slowdown in Chinese growth, but a pretty sharp decline in commodity prices. In that sense it could be quite significant for Latin America.”
Prospects for rising interest rates in the US also come at a critical time, and financial markets volatility could increase sharply. “One thing I have learned, looking at Latin America over 30 years, is never to underestimate the impact of high US rates,” said Suttle. “If you combine it with the China monetary policy shock, it could be significant and worth watching for,” he said.
De Gregorio nevertheless said most countries are well prepared to withstand the shock. “Overall, I think most emerging markets have done the job of having a strong fiscal position, a strong financial system, and well conducted monetary policies with enough flexibility,” he said.
“This is very different from a period in which countries had very large current account deficits, and sometimes there is no financing so they have to go through a strong adjustment.”
He added that any possible reversal of capital inflows to emerging markets “should imply a re-accommodation” where “macroeconomic policies should adjust, but it is not a reason to cause a big turmoil in emerging markets.”
But former IDB chief economist Guillermo Calvo noted that liquidity could dry up fast despite a country’s economic fundamentals. He cited the case of Chile – one of the region’s star performers – which suffered disproportionately after the collapse of Lehman Brothers in 2008. “That had nothing to do with Chile’s fundamentals,” he said. “It’s a small, open economy that’s linked to the rest of the world.”
The IIF forecasts that China will achieve a soft landing and avoid a severe adjustment, and that the US tightening will be modest and limited. Nevertheless, Latin American countries should move quickly to adopt flexible exchange rate policies, its chief economist said.
“The message for policy makers is ‘use exchange rate flexibility’”, Suttle argued. “At present, they should be using it to see some appreciation to counter inflationary pressures.
“But if and when global conditions turn, then allowing exchange rates to depreciate is the obvious thing. [In this respect] - both Canada and Australia represent [...] role models for most Latin American countries.”