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Emerging Markets

Eyes wide shut

Latin America’s dramatic reversal of fortune is shaking the region’s policy-makers from their complacent slumber. But only radical policy action – including a massive mobilization of capital to refinance the region’s public and private debt – can stave off disaster.

By Taimur Ahmad


Latin America’s dramatic reversal of fortune is shaking the region’s policy-makers from
their complacent slumber. But only radical policy action – including a massive mobilization of capital to refinance the region’s public and private debt – can stave off disaster.


In the months following the onset of the US financial crisis in August 2007, Latin leaders rarely missed a beat in proclaiming the region’s resilience to the turmoil ravaging the world’s erstwhile financial superpower. 


Brazilian president Luiz Inacio Lula da Silva famously dismissed it as “Bush’s crisis”. And politicians of all persuasions lined up to trumpet their own apparent successes in the face of economic decline in the West, albeit not always for the same reasons.


This wasn’t just taking pleasure in the misery of others. It also reflected a sense of optimism born of fact: a crisis was unfolding elsewhere, but Latin economies were in better health than ever before. 


And this was a region, many argued, that had learnt its hard-won lessons from past financial crises: many governments had curbed foreign borrowing by both public and private sectors; they kept debt ratios low, floated their currencies to avoid devaluation crises and built up healthy foreign exchange reserves.


Here also was a region buoyed by an unprecedented boom in commodity prices that had set the stage for a bonanza in 2007 and the first half of 2008, while the crisis ravaged far off financial centres.


For the first few months of the US crisis, emerging market bond prices held roughly steady, confirming in the eyes of those who wished to believe it that financial decoupling was a reality.


“In the first phases of the crisis, this only exacerbated the boom in asset price investment and aggregate demand that we’d seen. That was the era of decoupling, and the data appeared to confirm that that perception was correct,” says Ernesto Talvi, executive director of the Uruguay-based Centre for the Study of Economic and Social Affairs (Ceres).


New reality


Then came the collapse of Lehman Brothers and a tumultuous new phase of the crisis, which opened the gates to a crushing wave of financial deleveraging that in turn brought leading economies to their knees.


Spreads for Latin American sovereign credits widened spectacularly, reflecting repricing of risk and declining 10 year U.S. Treasury yields. “We’re closer to a world of disintegration in global finance than we’ve ever been,” Charles Dallara, chairman of the Institute of International Finance (IIF), a trade association of the world’s biggest banks, tells Emerging Markets.


Now, the worst global shock for three-quarters of a century has exposed weaknesses across emerging economies that, until recently, were largely masked by the aggregate numbers.


UK finance minister Alistair Darling acknowledged to Emerging Markets earlier this month that developing economies had moved dramatically into the firing line as the crisis took a turn for the worse. “I can’t over-emphasize this more: for the last year or so, the spotlight understandably has been on developed countries and the banking crisis that spilled over into the wider economy. But now the crisis is hitting developing economies – hard,” he said.


And in Latin America, that recent sense of invulnerability has all but vanished. Commodity prices have plummeted; demand for manufactured goods is declining sharply the world over; stock market valuations have crumpled; and currencies in many emerging countries have depreciated sharply, as capital flows reversed, seeking sanctuary in safe assets.


Forecasts for growth are being uniformly slashed. In a report to be released tomorrow, the IIF expects Latin output to contract by 0.7% in 2009 – a far cry from the growth of 4.1% last year. The balance of risks, it notes, is heavily on the downside.


Earlier this month Morgan Stanley ripped apart its earlier forecast for regional growth, cutting the 2009 projection from -0.4% to -4.3% – its sharpest downward revision for any region this year. It also lopped 0.9% off its estimate for 2009 global growth, from 0.3% a month ago to -1.2%. Its outlook for the region stands in stark contrast to that of the IMF, which remains confident Latin America will fare better than the world economy, which it now estimates will contract by 0.6%.


Foreign credit flows have contracted sharply.The IIF reports that the disruption of global financial markets following the failure of Lehman Brothers in September led to “financial contagion and a ‘sudden stop’ of capital flows to the region”. Private-sector inflows to Latin American economies came to a halt in the final quarter of 2008, with sizable net outflows in October and November.


Sudden stop


Net capital flows to emerging markets will drop to just $165 billion this year, down from $929 billion as recently as 2007, the IIF noted in a report earlier this year. Net lending from commercial banks, says the institute, is likely to go into reverse.


For Latin America, the rollover of corporate and public-sector debt has been disrupted by the freezing up of the international capital markets. Even the domestic debt markets, which have developed significantly in recent years in many of the region’s economies, are suffering from the sudden pull-out of foreign investors.


“Countries and companies are seeing a combination of sharply increased financial costs together with inability to borrow in the capital markets,” notes Talvi.


Some accuse the US and Europe of having “crowded out” emerging markets, sucking up all the available capital to finance their stimulus packages. But emerging markets – and Latin America in particular – are also being hit by a widespread drop in demand for riskier assets, as banks and investors repatriate money to shore up balance sheets and reduce borrowings. Similarly, the global shortage of trade finance reflects a general desire of banks to reduce leverage.


Meanwhile the deterioration in Latin America’s terms of trade could exact a costlier toll than the credit crisis itself. The IIF projects the region to have a current account deficit of 1.9% of GDP in 2009, while new data from Washington-based Centennial Group suggests the terms of trade loss for Latin America could amount to 2–3% of GDP this year.


And at the same time the big economies of the region are all facing difficulties the severity of which few would have imagined just months ago. Brazil’s economy, the region’s biggest, had its worst showing in more than a decade in the last quarter of 2008: GDP contracted by 3.6% from the previous quarter, the worst figure since the current series began in 1996, bringing to an end three years of steady growth. The IIF sees a mild contraction of 0.5% in 2009, while Morgan Stanley predicts the economy will shrink by an alarming 4.5% this year.


Mexico’s economy, Latin America’s second biggest, is expected to see a 2.5% decline in 2009, according to the IIF, while Argentina’s will shrink by 1.2%.  


Policy constraint


Questions are increasingly being asked about whether Latin American governments have the credibility to counter recession by relaxing fiscal or monetary policy. Indeed, some economists argue that improvements in economic management have not been as profound as widely believed.


An IDB-sponsored report last year showed that Latin America’s stellar growth rates of recent years hardly deviated from historical norms of roughly 3% once the impact of the improvement in external conditions was stripped out, showing an underlying rate of 3.8% for the 2002–06 period.


“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 noted.


The research went 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 LAC7 [Latin American Caribbean] countries have structural budget deficits, once you remove the impact of cyclical components,” Ceres’ Talvi explained. “If the cycle changes suddenly, you’ll be left with spending levels you can’t finance.”


But now, Latin authorities are facing the thorny problem of maintaining a degree of fiscal prudence while providing a fair boost to their economies through increased public spending. Yet most national treasuries lack the space to increase spending – let alone maintain existing outlays.


“To think that Latin America is now in a position to run the gamut of policies developed countries can do is a fiction,” says Guillermo Mondino, head of Latin America research at Barclays Capital. “The truth is most Latin countries have credibility issues for their treasuries. There’s a non-negligible risk that they could face payment difficulties.”


The focus of monetary policy in the region has shifted dramatically in recent months from containing inflation to stabilizing the payments system and stimulating growth – with all major economies set to ease rates further. But the scope for pump priming, on the other hand, varies dramatically by country, and is by and large constrained across the region. Chile and Peru – both countries with a very low level of net debt – have announced fiscal packages of 2.2% and 2.5% of GDP respectively, in the case of the former thanks to a successful stabilization fund. But others, including Argentina, Brazil and Mexico, have announced packages amounting to about 1% of GDP, the maximum they can afford because of the level of their debt.


“Argentina or Brazil can only do so much in terms of fiscal stimulus,” says Claudio Loser, a former western hemisphere chief at the IMF. The countries of the region, like many emerging economies, have limited room for expansion, and many countries have already used it, he notes. As a result, says Loser, they “will need to rely on the effect of the external stimulus packages and of their devalued currencies, more than on their own actions, with the possible exception of monetary policy, where margins may be greater”.


Part of the problem is the large-scale destruction of wealth brought about by the financial crisis. Loser calculates that $2.11 trillion of Latin America’s financial wealth – or 57.3% of GDP – was wiped out in 2008 through falls in stock and other asset markets and currency depreciation. This compares to more than $9 trillion (109% of GDP) for emerging Asia.


“The loss of financial wealth is enormous, and the consequences for the economies of the world would be unfortunately commensurate,” he notes, pointing out that the wealth loss will have an enormous impact on domestic expenditure.


Authorities will need to “find a balance between economic stimulus and financial stability. In the end, there is no room for denial or for populist policies; otherwise the crisis will become even deeper and harder to reverse.”


Ready, set, go


“The question is whether the region is sufficiently prepared or not for the sudden stop of capital flows,” says Liliana Rojas-Suarez, chair of the Latin America Shadow Regulatory Committee (CLAAF), a group of prominent economists. “How are they going to finance counter-cyclical fiscal policies?” she asks.


CLAAF, which includes former Latin finance ministers and central bank governors, estimates that on the current trajectory, the region as a whole faces funding needs of some $250 billion this year alone, for budgetary support and to prop up a cash-strapped corporate sector.


The region has some $400 billion in accumulated foreign exchange reserves, equating to about 7% of GDP. But Loser points out that if the downturn lasts longer than expected, the benefits of a strong starting point will be less relevant. “If [forex reserves] come down a lot, I fear people will become extremely scared,” says Loser.


But Rojas-Suarez says that Latin America’s existing resources fall short of what’s needed to deal with the crisis. She notes Latin America’s reserves are largely “borrowed” – namely, through a larger proportion of portfolio capital inflows invested in Latin American stocks and bonds denominated in domestic currencies. When net reserves (discounting borrowed reserves) are considered, the figure comes down significantly.


And even Brazil, with headline foreign exchange reserves of more than $200 billion, could be troubled if the halt to credit continues long into the year.


Unless credit finds its way to the region, Rojas-Suarez notes, governments will be forced to choose between harsh alternatives: painful fiscal adjustment that would amplify the downturn, or more extreme measures such as import restrictions and capital controls.


Questions also loom about the size of support that may be needed for the region’s financial sector – which accounts for roughly 40% of GDP – should the economic climate deteriorate significantly further. Although banks are well provisioned now, a sharper and more protracted downturn could wreak havoc on balance sheets and force a resurgence of non-performing loans.


“You may have to have contingency plans that cover the system on the order of maybe 20% of GDP. It’s a big number,” says Loser. “I’m a bit nervous about this – it could be in the range of $200 billion.”


Finding the funds


To many observers, it’s clear that Latin America will have to return to the IMF – long viewed with varying degrees of loathing by much of the region – for balance of payments funding. The Washington-based multilateral, once the Latin bail-out champion, has in recent years beat a retreat as its former clients repaid their debt. But the stage is being set for the institution’s return. 


“The big thing is the return of the Fund,” says Loser. “[The countries of the region] have to go to the IMF eventually,” he adds, but acknowledges the “stigma” attached to doing so. Latin American nations have often turned unwillingly to the IMF, and judging by recent rhetoric, such a move is still politically unpalatable for most.


“The political cost is big no matter what – but the rationale for returning to the Fund needs to be explained. We are in extraordinary times.”


UK chancellor Alistair Darling told Emerging Markets recently that the IMF is the only institution capable of moderating the slump in emerging economies. “The IMF is the best placed to deal with that, and that’s why IMF needs new resources to carry out that function,” he said.


IMF chief Dominique Strauss-Kahn sought recently to double the Fund’s lending capacity to $500 billion, although US Treasury secretary Timothy Geithner has since proposed pushing it to $750 billion. The question is likely to be resolved at next month’s G20 meeting in London.


Meanwhile the Fund is rolling out a raft of new lending facilities to help well-run emerging nations weather the storm – including a so-called Flexible Credit Line without conditionality and a High-Access Precautionary Arrangement.


But whatever its toolkit, says Simon Johnson, a former IMF chief economist, says the Fund might need $2 trillion to make a big difference – though winning such sum today is highly unlikely.


Too little, too late?


Yet even IMF and multilateral development bank resources – a large chunk of which are likely to be diverted to other crisis regions – are unlikely to be enough to cope with the scale of resources needed for Latin America, says Rojas-Suarez.


Instead, she argues that “unprecedented resources” must be made available – through new facilities and greater resources for existing institutions – to channel funds to the region. The CLAAF has proposed setting up a special “emerging markets fund” to buy up public and private securities in emerging markets, including Latin America. It could be financed through the issuance of US Treasury bills purchased by foreign investors including central banks, she says, with the fundamental goal of reorienting policy towards refinancing the stock of maturing debt across the region.


For now, though, all eyes are on Washington. US stocks surged early this week after Geithner detailed his proposals for public-private partnerships to deal with toxic assets in the financial system, and prominent investors vowed to take part in the programme. But the embattled Treasury secretary remains under fire in Congress for the perceived failure of the administration to control behaviour at financial institutions.


What’s clear, though, is that stabilizing global finance – and thus restoring any semblance of order to the system – must begin in Washington. Says emerging markets fund manager David Dowsett: “Until we can clean up an insolvent G7 banking system, we can’t make meaningful progress in any other part of the world.”

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