Latin America: The Case for Caution

M O R G A N S T A N L E Y R E S E A R C H
October 20, 2008
Economics

Weekly Spotlight
Latin America: The Case for Caution by Gray Newman
As the downturn goes global, Latin America has quickly
lost its “safe haven” status. Indeed, during the past month,
the turmoil in the region has moved beyond falling stock
markets to broader financial markets. Derivative deals gone
bad have already hit some of the largest publicly traded
companies in Brazil and Mexico. Meanwhile commercial paper
markets have begun to freeze, trading lines have been reduced,
and a bout of violent currency moves have forced authorities
from Chile and Brazil to Colombia and Mexico to rethink their
exchange rate policies. In the case of Mexico, the rethinking
required the authorities to spend more than 13% of
international reserves in less than two weeks in an attempt to
stabilize the peso. As of October 17, the Mexican peso still
traded near 12.8 per dollar.
Amidst all of the turmoil, caution seems to be the
watchword for Latin watchers. Yet I keep wondering if now
is the time to turn more optimistic and to instead highlight not
only the structural case for Latin America, but also the fact that
the region appears to be in better shape to deal with the current
global downturn than at any time in the past half century.
After all, the time to turn cautious on Latin America was
late last year or early this year when five years of
above-trend global growth had produced one of the best
growth records for Latin America (and emerging economies) in
decades and had, in turn, swollen the ranks of the emerging
market fans.
By late last year, it seemed like everything was in place for
disappointment. On the one hand, our US economics team
was warning of an important downturn in US consumption, and
on the other hand, the advocates for emerging markets and
Latin America had begun to argue a new “safe haven” had
been discovered which would protect investors from US turmoil
if it began to spread. Any doubts about whether we should turn
cautious were resolved once I began to hear the “safe haven”
camp arguments.
Now that the markets have turned and the economies in
the region have begun to weaken, it seems as if all the
“easy extrapolators” are condemning the region to doom.
Where were they before the downturn? Extrapolation is always
the simplest, easiest form of analysis but leaves me
uncomfortable.
But I am not willing to champion Latin America’s
structural story over the cyclical risks, at least not yet, for
three reasons. First, I am concerned that the deterioration in
the region is just getting underway, particularly in the region’s
largest economy, Brazil. And that means that there are plenty
of unknowns to work through after years of abundance.
Second, I am concerned that monetary policy may be of little
aid as the region slows. And third, I am concerned that the
authorities may find that their freedom to use fiscal policy may
be much more constrained than previously thought.

Downturn just starting
The downturn in Latin America is just getting underway.
While Mexico, Colombia and Chile are already slumping, Brazil
and Peru are still posting strong numbers. Peru posted 8.9%
real GDP growth in the month of August, while Brazil saw GDP
accelerate during the first half of the year, reaching 6.1% in the
second quarter, while domestic demand has been growing at
8.5% or higher. Brazil saw retail sales growing at almost 10%
in August. Likewise, industrial production data remained
resilient during much of the third quarter.

It has only been in the past few weeks that we have begun
to see important signs leading to a softening in Brazil. As
Marcelo Carvalho wrote last week, the first signs appeared in
mid-September when international trade financing lines fell to
roughly half of their level earlier in the month. Marcelo notes that
exporters – andcompanies in general - are reportedly lining up
at the national development bank (BNDES), asking for credit.
Meanwhile he cites local press reports that suggest a significant
tightening in local financing, as banks apparently have turned
more cautious in their lending decisions.
In turn, not only long-term financing,but even working capital
seems to have become harder to obtain.
As companies revise down their capex plans, and consumers
turn more cautious, sales of credit-sensitive durable goods
(such as automobiles) look likely to take a hit soon. And there
is talk that Brazil’s agricultural sector may see financing
shortages hitting fertilizer and seed purchases, which could
produce lower crops at the time of harvest. Meanwhile
anecdotal evidence for car sales suggests a sudden and
significant downturn in recent weeks.
And while the downturn may just be getting underway in
Brazil, worrisome pressure points are already emerging
from the currency’s abrupt weakening. We are already seeing
signs in Brazil where years of currency appreciation appears to
have lulled some companies into derivative arrangements that
have begun to turn the other way and hit earnings. Although it
is still too early to estimate how widespread those contracts
have been, the uncertainty is creating difficulties for companies
to access credit. In addition, while Brazil’s central bank took
measures last month designed to allow for larger banks to buy
credit portfolios of the smaller banks, the move served as a
reminder of the importance of international funding of many of
Brazil’s smaller banks.
While much of the demand for dollars may have come as
derivative structures forced the hand of Brazilian
corporates, Brazil’s sharp rise in portfolio flows in recent
years also poses a risk. Despite the strong uptick in foreign
direct investment, combined equity and fixed income flows
exceed that of direct investment . Through
August, Brazil had received nearly $33 billion in portfolio flows
during the past twelve months, just above the $32.7 billion in
direct investment. Our concern is that as the economy slows to
a pace of growth (2% on average in 2009e) below the market’s
consensus, both direct investment and equity portfolio flows
could soften and put more pressure on the exchange rate.
Foreigners currently hold just over one-third of the Brazilian
local stock market as of August. I doubt that Brazil is in the
“second inning” as our global currency strategist Stephen Jen
suggests for EM currencies , but I am
concerned that we are likely to continue to see pressure on the
exchange rate in the coming months as Brazil’s growth slumps
more sharply than most seem to expect.
At first glance, it would seem that Mexico should have
been better prepared for the coming slowdown. After all,
US weakness has already fed through to a downturn in
Mexican industrial activity, which has contracted in every
month since May. And unlike Brazil, Mexico would appear to
have less room to fall—its economy was only growing just over
2% in the first half of the year compared with Brazil’s 6% plus
pace. But the sudden move in the Mexican peso hit some of
Mexico’s best known corporates hard. In turn, the derivative
damage has contributed to the peso coming under additional
pressure, prompting the central bank to directly intervene in
currency markets with sales of $11.2 billion in dollars since
October 8. And the turmoil among corporates with exposure to
derivative losses has contributed to local commercial paper
markets coming to a near standstill.
Although the move in the Mexican peso---nearly 30% weaker
in mid-October compared with its average of the previous two
months—is not that much greater than the moves seen in
Brazil, Colombia or much of the region, the damage on local
sentiment appears to have been much greater. While a
Brazilian real exchange rate at 2.15 or 2.35 represents an
abrupt decline from levels of 1.60 seen in July or August,
Brazilians can remember in 2005 and indeed in 2001 or 2002
when the exchange rate had been at these levels. In contrast,
with the Mexican peso trading during the past decade within a
narrow range from 9 to 10 and then from 10 to 11, the move to
13 and above is seen almost as a promise that has been
betrayed. I fear that the unprecedented exchange rate
readings leave local economic agents more vulnerable to
turmoil. Indeed, I suspect that this is what prompted Banco de
Mexico to engage in massive US dollar sales in an attempt to
break a dangerous cycle of currency weakness begetting
turmoil, which in turn could produce even more demand for
dollars.
Given all of the unknowns regarding the duration of the
downturn in the US and the globe, it seems too early to
begin to look beyond the cycle in Latin America, especially
given the turmoil that we have already seen in the region in the
past weeks. The events of the past few weeks should serve as
a reminder of how quickly the “safe haven” can disappear once
the inflows of abundance have reversed.
Monetary muscle?
The second reason for caution is my concern that central
banks in Latin America may find that they have limited
scope to ease monetary policy faced with one of the most
serious growth challenges in decades. The rapid weakness in
currencies throughout Latin America could easily replace food
and energy quotes as the new threat to inflation targets in the
region.
At a time when real economic activity is coming under
siege, it is difficult to imagine central banks wanting to
keep interest rates high. Around the globe, central banks in
developed economies are easing interest rates. Real policy
rates around the globe had already turned negative at the
beginning of the year in every region except Latin America (see
Exhibit 3). That would suggest that Latin America has room to
ease rates aggressively. Unfortunately, that is unlikely to be
the case in the region’s largest economy, Brazil. Marcelo
Carvalho argues that while the global downturn is deflationary
for the global economy, it is not necessarily so for countries like
Brazil that are facing currency weakness. Indeed, Marcelo
argues that while the central bank may adopt a more pragmatic
approach faced with a much weaker economy, that is only
likely to mean that it doesn’t hike as much as strict adherence
to its inflation target would suggest. In the best of cases, we
see no easing until late next year in Brazil.
Why the contrast between Brazil and the developed
world? In part, because Brazil and much of Latin America
has been the epicenter of inflation not that long ago.
While Germany suffered in the 1920’s and Hungary
in the 1940’s, much of Latin America faced a serious bout of
hyperinflation in the 1980’s and into the early 1990’s. Those
memories have taken their toll on central bank policy makers —
leaving central bankers in the region more willing to respond to
an uptick in prices to limit the risks that a change in relative
prices unleashes a nasty wage-price spiral. Given the track
record, an accommodating central bank in the region that is
easing interest rates as the exchange rate is under pressure
can soon find that its own actions are pressuring the exchange
rate even weaker. Pass-through had gone dormant in the
region, but central bankers are on alert to see if the abrupt
currency moves begin to put pressure on inflation and
expectations despite the weakening in the economy to come.
Fiscal room?
Now is the time for counter-cyclical fiscal policy if there
has ever been a time. But I am cautious as to how much
space the authorities have to engage in fiscal stimulus.
Across the region, the abundance windfall has translated
into a sharp rise in fiscal spending in recent years. Chile is
the only country where the windfall produced a sharp rise in the
budget surplus. And therein lies the problem. With the
exception of Chile, an increase in spending is likely to turn
modest budget deficits into much larger deficits and hence
require that sovereigns increase their reliance on capital
markets precisely at a time when financing is becoming scare
and expensive.
Moreover, we estimate that the budget windfall by
mid-2008 had reached close to 3.9% of GDP among five of
Latin America’s largest economies or nearly $150 billion.
That means that if growth or commodity prices were to return to
pre-abundance rates, the fiscal shortfall would be in the
magnitude of 4.1% of GDP. That is the size of
the spending cuts that the region’s authorities would have to
engineer in order to maintain the current fiscal balance.
Alternatively, the gap represents a rough measure of the
magnitude of new taxes that would have to be raised. In reality,
it suggests an even more daunting task for the fiscal
authorities: just maintaining the current fiscal mix will likely
produce a much larger fiscal deficit.
Bottom-line
Faced with a global downturn, the region’s largest
economies are likely to face a relatively normal business
cycle rather than a full-fledged crisis. That is good news
and represents a graduation from the past for some in the
region. But be wary of over-emphasis on the region’s
resilience. After five years of above trend global growth, the
region is facing its most serious threat in decades and no one is
immune to the slump. Moreover, throughout the region,
authorities may find that the arsenal of policy tools at their
disposal is more limited than they hoped. There is still room for

(posted by Katya Hochleitner)
caution.