OIL: Oiling up for a fall
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Emerging Markets

OIL: Oiling up for a fall

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In the 1966 film The Good, the Bad and the Ugly, it was the Mexican Tuco Ramirez playing the not-so-good looking one. The movie title is a neat way to categorise Latin American countries’ situation in the face of a plunge in oil prices, though half a century on Mexico’s role has changed.

As to be expected, those economies most reliant on hydrocarbon revenues are suffering the most. Mexico derives around a third of its fiscal spending from oil, but it is far from the worst affected. “Venezuela and Ecuador are clearly the ugly, while Chile is the good,” says Neil Shearing, chief emerging market economist at Capital Economics. “Colombia and Mexico would be the bad as both will suffer but should be able to manage the headwinds.”

Some are more hesitant to even qualify the Mexican situation as “bad”, but many believe the shock to Colombia’s economy is being underestimated.

“There are more losers than winners in Latin America,” says Gabriela Santos, global strategist at JP Morgan Asset Management. “For the region as a whole there is a lesson to reduce dependence on commodities for fiscal revenues and economic growth.”

Indeed, although energy reform has earned Mexico plaudits in the past year, if the country’s economy escapes unscathed it is because it has strong drivers beyond oil. Furthermore, the government has hedged much of its oil exposure and can make savings on domestic fuel subsidies.

So while the Mexican government has announced public sector spending cuts equivalent to 0.7% of GDP, increasing economic activity in the US could stimulate its manufacturing sector. “The real growth question for Mexico is not to do with oil but what will happen to domestic demand, with confidence depressed,” says Santos. “I don’t think the momentum that the Mexican energy reform has generated is in jeopardy. Lower oil prices may force the government to offer companies looking to invest better terms.”

Colombian frailty

Further south, things look bleaker. Colombia has been a darling of markets in the last decade thanks to an improved security situation and the commodities boom. But recent movements are placing the country’s heavy dependence on oil under scrutiny. “In Colombia the problems are a little bit more acute than in Mexico,” says Shearing.

Colombia, where around 65% of exports are oil-related, was going along fine with oil at $100 a barrel, but with investment expected to decline and government revenues badly hit, it is unclear what can drive the economy forward.

The peso has been mirroring movements in the oil price and has plunged to P2,650 to the dollar. In theory, curing the country’s beleaguered manufacturers of Dutch disease should at least make up some of the slack, but it will not be easy.

“The whole manufacturing sector has been hollowed out,” says Shearing. “It requires investment and any rebound will not happen immediately.”

Even a thriving export sector would struggle to compensate for a significant deterioration in the nation’s terms of trade. Colombia’s trade surplus is 9.4% of GDP in the oil sector, while the non-oil sector has a trade deficit of 10.8% of GDP.

These figures have some believing that the authorities are failing to grasp the scale of the problem. Central bank BanRep is yet to cut interest rates and has only cut its 2015 growth forecast from 4.3% to 3.6%.

This is over-optimistic, according to Francisco Rodriguez, Andean economist at Bank of America Merrill Lynch. And if the oil price crash does indeed end up teaching Latin America certain lessons in economic management, one may be to pay greater attention to your neighbours.

“Two years ago, Peru and Chile made the mistake of underestimating the effect of the falling price of their exports (gold and copper) and the resulting decline in terms of trade on their growth outlook,” says Rodriguez. “Colombia does not appear to have learnt from its neighbours when it makes its growth projections.”

As Rodriguez points out, Peru could at least point to a story of growing mining output, but there were worries about declining oil production in Colombia even before the oil price slump began. “I’ve not seen a country that has such a decline in its terms of trade without a major decline in growth,” he says. “A 1% deceleration looks unrealistic.”

Timing is hardly ideal for Colombia. The government is looking to get its 4G infrastructure programme off the ground, and it needs to set aside 0.8% of GDP over the next 10 years to finance the implementation of peace agreements that it hopes to sign later this year with rebel group the FARC.

This leaves Rodriguez “fully expecting” Colombia to have to change its fiscal rule before the year ends to avoid breaking it.

Squeezing the left

Look east and south from Bogotá, and Colombia’s predicament does not seem quite so serious. Both Ecuador and Venezuela are paying for having used the oil booms to finance sharp increases in public spending.

“Ecuador seems to have slipped under the radar for some though we hold out hope of a more conventional response than in Venezuela,” says Shearing.

Ecuador’s president Rafael Correa has insisted publicly that the issue is external, not internal, in a dollarized economy that does not have the luxury of a flexible currency.

Santiago Mosquera, head of research at Quito-based Analytica Securities and professor at Ecuador’s USFQ Business School, expects the current account deficit to reach 4.4% this year — a level that hasn’t been seen since 2002.

Despite his insistence on fiscal tranquillity, Correa announced a $1.5bn budget cut in January, and Shearing says that “for all the rhetoric, Correa is a bit more pragmatic”.

Nevertheless, Mosquera says that there is a “large fiscal hole” that may not be covered. Though the budget cut is a “positive signal”, further spending cuts may be needed, he says.

More worryingly, Ecuador is delaying paying certain service providers in the oil sector — some of the same providers that had committed to investing $2.5bn over the next two years. “If these providers do not receive their payments punctually, they may be less willing to invest and this could affect production,” says Mosquera.

Given how reliant Ecuador growth has been on now pressured public spending, it would be a terrible time to lose the fragile confidence of private investors. For instance, FDI would be the ideal way to finance the current account deficit, but this has been below 1% of GDP for the last six years.

“We have seen some more friendliness with bond investors and hopefully that can be replicated with the rest of the private sector,” says Mosquera.

Ugliest of them all

Correa only has to turn his mirror north-east to his allies in Venezuela to reveal that alienating investors can leave you as the ugliest of them all. With oil providing more than 95% of exports, a bulging debt burden and an artificially strong official currency rate, a crash in the government’s revenues has plunged the country’s suffering economy into crisis, with inflation rocketing and basic goods lacking.

The will-Venezuela-default debate is raging as loud as ever, although Rodriguez maintains that the sovereign has shown willingness to pay its debts and is likely to continue doing so as its bonds are secured by state-owned assets, making oil assets fair game for bondholders.

He says it is wrong to claim the government is not adjusting to the new reality, just that it is adjusting inefficiently. “Rather than letting the currency decrease and prices increase, the government rations [food] and creates arbitrage opportunities,” says Rodriguez.

This further rationing of imports is backed up by anecdotal evidence, which has led to a fall in President Nicolás Maduro’s popularity. Rodriguez believes this has made political change “more likely”.

Shearing highlights October as a possible “crunch point”, with billions of dollars of debt due and the government effectively choosing between making dollars available for importing food and basic goods or paying its global bonds. “Our view is it comes down to financing imports or paying bondholders,” says Shearing.

With political volatility high, only the brave can make definite predictions in Venezuela. What is certain is that the country has provided a blueprint of how not to manage oil resources.

“We should highlight that those economies that export natural resources but that are not as dependent — like Mexico — or those that have prepared, for example by saving during the good times, have greater room to react,” says Rodriguez.

Countries that have built up large international reserves have plenty of capacity to react, he says. “Venezuela is at the other extreme, having saved far less than it should have.”

Oil slump cools Chile troubles

Without the easy wealth of oil but with a well-earned reputation as Latin America’s most developed economy, perhaps Chile was due a break.

When Michelle Bachelet (pictured) took office last year her attempts at tax reform received a hostile response from businesses. A prolonged spell of bickering exacerbated a slowdown triggered by a plunge in copper prices.

The largest net oil importer among Latin America’s major economies, Chile stands out as the clear winner. “Firstly, lower oil prices are compensating for lower copper prices in the terms trade,” says Benjamin Sierra, financial markets economist at Scotiabank in Chile. “They are critically helping to improve the current account deficit.”

Inflation in Chile reached 4.5% in 2014 thanks to a rapidly depreciating peso and Sierra now sees an immediate relief on price pressures.

Finally, “for a country with energy problems on the horizon and dominated by sectors that rely on oil (such as copper mining), lower prices can only improve the outlook,” says the economist.

Sierra expects Chilean GDP to grow around 2.8% this year and 3.7% in 2016. Without the oil slump these predictions would be around one percentage point lower, he says. 

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