Turbulence Ahead? How the Deterioration of Global Economic Conditions Will Test Latin America in 2008
Latin America continued to expand strongly during the first six months of 2007, after a solid performance in 2006, the best in many years for several of those countries. Economic growth in the region in 2007 will average about 5%. The global economic conditions that began in the middle of this year – caused by high-risk mortgage crisis in the U.S. – have led to a downward revision of growth forecasts from the main global organizations as well as financial institutions. Generally speaking, forecasts now call for a modest reduction in the growth rate of the overall region in 2008. Nevertheless, according to the most recent global forecast of the International Monetary Fund, expansion will continue at a strong rate of about 4.25%. That will make 2008 the fifth consecutive year in which growth exceeds 4%.
The IMF report notes that economic growth has risen unexpectedly in those countries where growth was relatively modest in 2006. That’s especially true in Brazil, where the GDP grew by 5.5% in the second quarter of 2007. In most of the other countries, expansion continued to be strong, in some cases reaching historic heights. Even after the turbulence of financial markets in the middle of this year, prices of raw materials remained strong, stimulating economic activity in the countries that export such products, including Peru and Bolivia. In Colombia and Uruguay, growth has been fueled most of all by internal demand, although both countries have also benefited from the strength of their exports. Strong agriculture markets have helped stimulate output in that sector in Argentina and Paraguay in 2007.
Trial by Fire
Looking to the future, studies forecast that growth in Latin America could drop by as much as 2% from current levels. That’s because of the contraction in credit markets and the significant economic slowdown in the U.S., which has had repercussions for global growth and weakened prices for raw materials. For 2008, the IMF anticipates that growth will fluctuate between 3% and 4% in Mexico, Ecuador and Uruguay; between 4% and 5% in Brazil, Chile, Colombia and Paraguay; and between 5.5% and 6% in Argentina, Bolivia, Peru and Venezuela.
Although a slowdown can be expected, current economic conditions do not mean that there has been any weakening in overall confidence. “Latin America continues to enjoy a very favorable economic cycle,” says David Tuesta Cardenas, professor at the Pontifical University of Peru. “We believe that it will continue over the coming year. Two factors help. The first is that they are making progress in the structural reforms that began in the 1990s. They have continued to make improvements despite doubts and fears at the beginning of this century. Above all, they have made significant progress toward providing these countries with a greater degree of competitiveness through tariff cuts, trade agreements and so forth. International investors are starting to arrive because of these visible improvements, which they perceive as more permanent.”
Second, he says, “Emerging countries such as China and India continue to lead the way in global growth, so [Latin America] has enjoyed strong demand for its raw materials [in those countries]. This seems to be continuing despite the global financial situation.”
The economies of Latin America will undergo an important trial by fire during the new year -- a possible deterioration of the external environment. In its latest report on the economies of the region, the IMF notes that “recent global financial turbulence and the slowdown in growth in the United States and other industrial countries will provide the first real test of Latin America’s ability to recover from the shocks it has undergone since 2002.” The big question asked by experts is what impact all these developments will have on growth in the region.
“Financially speaking, the impact won’t be very great,” suggests Mauro Guillén, director of Wharton’s Lauder Institute. However, if the EU falls into a recession, he warns that “Mexico and Central America will suffer a great deal. The other unknown factor is the [U.S.] presidential elections in November. The American candidates are making concessions to protectionist interests and this could derail negotiations for free trade agreements with some South American countries.”
In principle, says the IMF, the recent turbulence in global financial markets and its repercussions on the world economy could affect Latin America through four different channels. The first channel involves real external demand, to the extent that the growth rates of Latin America’s trading partners decline, especially the United States. The second channel would involve declining prices for raw materials and a deterioration of Latin America’s terms of trade. The third channel would come from financial developments, and be manifested by an increase in the cost of capital or a reduction in capital inflows or capital flight. Finally, there is a fourth channel: The slowdown could result in a slower influx of personal remittances within the region, which would reduce revenues in Latin America as well as Latin American workers’ confidence in foreign countries, especially the United States.
The Role of the United States
How much impact Latin America will suffer from any slowdown in exports and remittances will depend on how much its trading partners’ economies falter. Economic conditions in the U.S. will play a major role. However, international economic institutions such as the IMF forecast that a significant slowdown in U.S. economic growth won’t significantly affect overall global growth, especially if vigorous growth rates in emerging markets are taken into account.
Tuesta suggests that as long as the subprime crisis in the U.S. does not visibly affect China, “we anticipate that the slowdown in the region [Latin America] won’t be so dramatic.” Another key factor is that Latin America now depends less on demand [for its products] in the U.S. than in the past. Latin America’s exports to the U.S. have declined from 57% of all Latin American exports in 2000 to just 47% in 2006. However, these shipments remain at an extremely high level in Mexico (85%) and in some countries of Central America.
A more disturbing development would be a sharp drop in the prices of raw materials, which have undergone a strong upward trend in recent months. In its April forecast for the region, the IMF said that a drop of 5% in the export prices of the region would cause the aggregate growth rate of the six largest Latin American economies to drop by about one-third of one percentage point after just two quarters. Those six countries are Argentina, Brazil, Chile, Colombia, Mexico and Peru. Nevertheless, prices for Latin American exports remain at high levels. Over the medium term, projections call for only a slight decline in those prices. A more pronounced drop in those prices seems possible only if there is a steeper global slowdown.
High prices for raw materials (crude oil, gas, copper, iron, soy beans, etc.) also have a negative side in that they can lead to higher inflation. Recently, inflation rates in the region have been more moderate than in the distant past. Nevertheless, following the historic low point in the overall region in 2006, rates have rebounded in many countries.
In Colombia and Uruguay, for example, inflation has increased within the context of solid growth and it is getting close to – or even exceeding – goals fixed by central banks. Inflation in Chile, Mexico and Peru has gone above the goal set by the government because of inflation in the price of food. Inflation has also shot up in some countries in Central America and the Caribbean. Inflation continues to be high in Argentina; it has recently risen to double digits in Bolivia (in annual terms); and it has remained in double digits in Venezuela, despite the fact that imports in that country have helped to alleviate some restrictions in supply. In Brazil, inflation remains below the midpoint in the range set as a goal, but it has also begun to increase recently.
In many countries, rising prices for food began to make inflationary pressure more acute in the middle of 2006. The average difference between annual inflation rates for food and the global rate of inflation reached 3.75% in August 2007, according to the IMF. This has had an impact on both large countries (especially Brazil, Chile, Colombia and Mexico), and on small countries in Central America and the Caribbean. In response, some governments have taken direct measures to reduce pressures on food prices.
“Rising prices for raw materials are helping growth in the region, but they are also generating excessive liquidity, which raises expectations for inflation,” explains Rafael Pampillón, professor of economics and country analysis at the Instituto de Empresa business school in Spain. “The Consumer Price Index may be upsetting to the economies of the region and provoke central banks to raise interest rates, which will put a brake on economic growth,” he warns.
Experts note that domestic political measures can play a determining role in all of these economies, either mitigating or aggravating the problems that occur in 2008. For that reason, international investors are paying very close attention to growing political populism in the region. “The political factor is always a risk in the region,” says Tuesta, adding that “the future impact of populist policies will depend on how effectively governments manage their greatest fiscal resources for social programs correctly focused on longer-term goals, such as education. These programs should aim to improve the productivity of the population and build greater commitment for economic reform.” Pampillón forecasts a “significant danger” if such government leaders as Hugo Chávez in Venezuela and Rafael Correa in Ecuador “move toward excessive public spending, price controls and market controls.
Challenges and Goals
What about the challenges facing Latin America in 2008? In its first annual study, “Economic Prospects for Latin America 2008,” the Organization for Economic Cooperation and Development (OECD) notes that the region’s economic growth rate is “too low.” The report says that the two “most important engines” of economic growth -- Brazil and Mexico -- are losing ground against their Asian competitors. The OECD believes that Latin America “has not achieved its entire potential” and that the region has “multiple opportunities” that it should not fail to exploit. When it comes to investment and trade, the OECD believes Latin America has become one of the most attractive regions in the world, attracting more than $72 billion [in Foreign Direct Investment] in 2006. However, the rising importance of China and India in the global economy has had a major impact on Latin America because it has injected more competition into the battle to win export markets in the United States, the European Union and Japan.
Some countries in Latin America face stiff competition from China and India, especially when it comes to raw materials. The countries that suffer the least from these Asian giants are Bolivia, Paraguay, Venezuela and Chile. The OECD warns, however, that recent economic data suggests companies will need to avoid concentrating on specific export sectors to the detriment of other sectors. “Latin America must see its relationship with China and India more as an opportunity to form partnerships than as a competitive threat,” argues the report from the OECD, which comprises 30 of the world’s largest economies.
Pampillón agrees. “The economic development of China and India provides an opportunity for Latin American countries because they will be able to increase their exports to those two countries [China and India],” he says. Those two Asian countries have become “the factory of the world.” They are demanding raw materials and “Latin America is playing a very important role by selling those raw materials to both countries.” However, Pampillón warns, “There is [always] a danger when you specialize in exporting raw materials. Historically the countries who do that invest less in research and development, which stops them from growing and makes them more dependent on other countries.” The nations of Latin America need to move beyond exporting raw materials and become countries that develop technology, services and industrial goods, he adds.
In the OECD report, experts once again mention Latin America’s age-old but still urgent need to use fiscal and social policy to reduce the region’s vast socio-economic disparities. The countries of the region must also stay on track with their efforts to reform pension systems and they must improve their regulatory regimes so that foreign investment can expand, and contribute fully to the development of the region, the report says.