There will be blood
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Emerging Markets

There will be blood

Euphoria over Latin America’s apparent economic performance could spell disaster without proper scrutiny of the secrets of its success and a cautious plan for an increasingly uncertain future

When it comes to Latin America, the recurring sentiment over the past five years – echoed in varying pitches of euphoria by the official community and financial markets alike – is that the region’s economic fundamentals have changed beyond recognition. Over the past half decade, the region has defied expectations through an extraordinary recovery in capital inflows, a sharp rise in asset prices, a strengthening of domestic currencies and solid growth. And unlike in previous expansions, Latin America is now enjoying a healthy current account surplus, alongside a strong build-up of international reserves.

Moreover, countries which were widely written off as basket cases at the turn of the decade are now strutting their wares, transformed by surging export markets, booming commodity prices and abundant liquidity.

“This is the first time Latin America has not originated a crisis or been in the first concentric rings. This shows we’re doing something right,” says Martin Redrado, Argentina’s central bank governor, pointing out that, by and large, Latin bond prices have been hardly impacted (relative to historical swings) by the carnage in US financial markets.

Deutsche Bank chairman Josef Ackermann argued at a recent gathering of the Institute of International Finance (IIF) in Brazil that the resilience evident across emerging markets will help to underpin broader global growth this year. “Even with a slowing of the economy, the scale of capital likely to flow to emerging markets in 2008 will be formidable,” he said.

Latin America, he suggested, is increasingly seen as a haven of economic stability - marked by low inflation, declining debt and steady growth – in stark contrast to faltering prospects of developed economies.

Redrado says that Latin America’s need for financing is now bound by better fiscal discipline. “No country in the region has any urgency for looking for funds in foreign capitals. We don’t have the pressure to go out to international capital markets at any price,” he says.

“Financing needs are not immediate and if they are, they can be met internally,” adds the central banker.

Notwithstanding the situation in Redrado’s native Argentina – where questions remain over the sovereign’s ability to meet its medium-term funding needs in the local market amid mounting price pressures – there’s plenty of cause for concern for the region more generally.

Though Latin America has yet to feel the brunt of the correction, “the spill-over effects on emerging markets, indeed on the global economy, of the US economic slowdown, and the dislocations in important financial markets, may be more pronounced in the period ahead,” Bill Rhodes, senior vice chairman at Citi, tells Emerging Markets.

“We are witnessing a long overdue correction in asset prices that is reflecting more realistic differentiation by investors,” he adds.

Rhodes first sounded the alarm over excess leverage in the global financial system in an interview with Emerging Markets in February 2006: “If you’re an investor or a lender, you should be prudent in this part of the cycle,” he said at the time. “And if you’re an emerging market, you need to be very careful in managing your fiscal, monetary, debt and exchange rate policies.”

He went further last March to warn of a “definite risk” to global financial stability from the then just emerging US subprime crisis. Rhodes still maintains that “decoupling is not a reality at this moment in time.”

The external factors

Many believe Latin America’s recent expansion is largely attributable to the exceptional improvements in global conditions. “It’s very much a story about external factors,” says Ricardo Hausmann, director of Harvard’s Center for International Development. “External factors are real – it’s a real terms of trade improvement.”

But fears are growing that a US recession and falls in prices for industrial commodities could undermine Latin growth. Although there has been a decline in dependence on the US, which now absorbs under 20% of exports from Brazil, Argentina, Chile and Peru, many markets into which Latin America has diversified will be badly hit by a US slowdown.

“Commodity prices and the soft dollar are positive points for Latin America. But some countries are not getting sufficiently prepared,” Ricardo Lopez-Murphy, Argentine economist and one-time economy minister, tells Emerging Markets. “They think the good weather will last forever. We know this is not the case.”

The prospect of a sharp global slowdown that triggers a steep drop in commodity prices can hardly be discounted. If corporate defaults in the US rise amid a sharper than expected US slowdown, “the credit crunch could become global,” according to Anoop Singh, director of the IMF’s western hemisphere department.

“Such a coordinated slowdown could create downward pressure on commodity prices—for food, fuels, and minerals—that are crucial to Latin America, reverse the capital flow into emerging market economies, and result in a considerably deeper and more protracted slowdown of global growth,” Singh said recently.

The Fund’s baseline scenario foresees a modest slowing of regional growth, to about 4? % in 2008. But all bets are off if a US recession turns out more hostile.

If commodity prices drop to 2005 levels (an average decline of 35%), says Singh, fiscal and trade balances on average in the region would deteriorate sharply, raising financing requirements at a time of tighter global credit markets, and potentially resulting in a regional recession.

New findings

But even the region’s supposedly robust performance in recent years is itself the subject of controversy. A recently published paper by the IDB sets out to challenge the view that Latin America’s recent performance represents a fundamental departure from the past. It concludes that “all that glitters may not be gold” and that growth performance and fundamentals are, in fact, weaker than meets the eye.

The research, coordinated by IDB economist Alejandro Izquierdo and Ernesto Talvi, executive director of Uruguay-based research institute CERES, shows that once impact of the improvement in external conditions on the so-called LAC-7 (Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela) is stripped out from today’s observed macroeconomic conditions the underlying picture is – remarkably – unremarkable. On this analysis, the region’s observed average growth rate of 5.6% for the 2003 – 2006 period drops to an underlying rate of 3.8% for the same period, hardly

deviating from historical norms of roughly 3%.

“Unless there are good reasons to believe that external conditions have been notably different across regions- and in particular, more favourable to the rest of the world than to Latin America – the region’s performance relative to that of its peers has been less than impressive,” the report adds.

The research goes further to argue that, by comparing observed and structural fiscal balances across the region since 1991, the fiscal position of the region has in fact deteriorated, largely because total public expenditure has also risen in tune with the revenue boom.

“Most of the LAC-7 countries have structural budget deficits, once you remove the impact of cyclical components,” Talvi tells Emerging Markets. “If the cycle changes suddenly you’ll be left with spending levels you can’t finance.”

Moreover, public debt levels remain high while changes in composition (currency denomination and maturity profile) may themselves be a result of the external bonanza. The report adds that the current account surplus and the very limited net inflows of foreign capital will not necessarily insulate the region against a global liquidity crunch

Fixed income, different conclusion

The new research also looks to pick apart the subdued reaction in Latin America’s bond markets to turmoil in US financial markets, especially in the US high yield bond market.

In stark contrast to past experience, sovereign spreads have only risen by a fraction of what historical relationships would have predicted since the onset of the US subprime mortgage crisis. But the new research aims to debunk the claim that the apparent decoupling is testimony of the region’s new-found strength.

It shows that once the sub-prime crisis hit, bond prices across emerging markets remained resilient – regardless of the strength of the sovereign credit’s fundamentals. If Latin bond prices post-sub-prime crisis reflect fundamentals, strong and weak credits would diverge – yet this didn’t happen [see graph].

Talvi argues that this could be because the source of the crisis – sub-prime mortgages in the US – is largely unrelated to the price of a sovereign emerging economy asset.

More profoundly, he argues that massive intervention by the US Federal Reserve was the act that stemmed blood loss elsewhere. “We came within 48 hours of total meltdown in the corporate and emerging bond markets, including in Latin America,” says Talvi.

“The Fed and ECB went out to provide unlimited liquidity, understanding that they wanted to avoid contagion. If we argue that Latin America wasn’t hit because now we are much stronger, then we have to have a good reason to say why the crisis didn’t hit other emerging markets.

“The fact is the central banks were there to provide liquidity,” he adds. “We were lucky. It has very much to do with the fact that there was a central bank – the Fed - that had unlimited liquidity.”

This is in sharp contrast to the behaviour of emerging market spreads after the Russian economic crisis, which detonated at the periphery – rather than at the core – of the global financial system. In that case, the Fed did not provide liquidity aggressively and the US financial markets were by and large unaffected.

But Talvi says that now “it’s impossible to think this financial crisis could find Latin America in a situation other than what has historically been the case.”

The IDB research suggests starkly that policy-makers should “resist the temptation of taking comfort in favourable tailwinds alone” and instead work “resolutely towards the achievement of goals that take into account cycles in the international economy, commodity prices and world financial conditions.”

“The conventional wisdom [regarding Latin America] is wrong,” says Talvi. “You need to look at external factors as you would earthquakes. You don’t know where they’ll occur or how strong they’ll be, but you know it’ll happen.”

The point, says Talvi, is that the recent bonanza has displaced many key reform issues – from fiscal consolidation to export diversification. “We are still extremely vulnerable to a sharp changes in the external environment.

“If it leads to a complacent attitude we may be in for a surprise in two or three years.”

Price of change

This is perhaps especially pertinent in light of the other incipient challenges facing the region, notably sharply rising prices. The inflation outlook has deteriorated markedly since the start of the year. An unprecedented surge in global food and energy prices has been compounded by local supply shocks in some countries and demand side pressure in others.

“Inflation: it returns like a ghost to haunt us,” warns Eduardo Aninat, a former IMF deputy managing director.

Inflation, while still much less than it was during the 1980s, has begun to creep up from 3% or 4% to closer to 10%. Argentina and Venezuela are battling inflation rates of close to 20%. Even Mexico, Chile and Brazil have seen inflation targets surpassed.

Yet the real test has yet to come. Liliana Rojas-Suarez, senior fellow at the Washington-based Center for Global Development points out that historically, the most common cause of economic crisis in Latin America has been rising US interest rates. If the US avoids a full-scale financial meltdown this year, it will face resurgent inflation next year and beyond, and will be forced to hike rates sharply.

“That will have a huge impact on Latin America,” she says.

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