Last November, the International Monetary Fund revised its economic outlook for 2009. In the case of the six largest economies of Latin America, the growth projection was lowered from 4 to 3 percent. Two months later, this projection seems overly optimistic. In fact, data released in the first weeks of the year suggest a much sharper than expected deceleration in industrial production during the last months of 2008. The same is true for consumer confidence. Indeed, relative to a year before, industrial output fell by 15.1 percent in Argentina, 6.2 percent in Brazil, 5.7 percent in Chile (all figures for November), and 2.7 percent in Mexico (in October). The decline in consumer confidence has been particularly fast. A 15 to 20 percent reduction in consumers’ perceptions (since mid-2008) is the norm in these countries.
In light of this evidence, most analysts have continued to revise projections downward. The latest consensus GDP growth forecast for the region is 1.4 percent for this year, down from 3.6 last September. The country specific projections indicate zero to negative growth in Mexico, Argentina and Venezuela. The remaining large countries will grow at rates closer to 2 percent (Brazil, Colombia, and Chile). Peru will continue to outperform the rest of the region with a growth rate that will be close to 4.5 percent (but low compared to the 9 percent in 2008).
Of course, these projections are contingent on many variables. The most important are economic growth in the U.S. (which is the largest trading partner for many countries, especially in Mexico, Central America and the Andes), world commodity prices (at least 50 percent of exports in the large Latin American countries are primary goods), and, importantly, capital flows from abroad.
What is surprising is that in spite of the sharp recession in the U.S. (the economic contraction in the U.S. is going to be between 1 and 2 percent), and the decline in commodity prices (nearly 50% since mid-2008), the economies in Latin America are going to be able to grow at all. Growth in Latin America will come from domestic sources, notably consumption and investment. The key here is that a major reversal in the direction of capital flows could change the economic landscape dramatically. Under large capital outflows it will become almost impossible to keep consumption and investment at their current levels.
The good news is that the financial outlook for 2009 does not appear particularly grim for Latin American countries. While in September 08, Latin EMBI spreads hiked to levels bordering 600 basis points over treasuries, since then they have fallen and have stabilized around 400 basis points. At the same time US treasury rates have been falling, together implying that financing costs have not risen notoriously for Latin American economies.
While markets appear to be tighter, and liquidity scarce, several countries have been able to issue international debt in the past few weeks at relatively low financing costs. In December, Mexico sold 2 billion of 10-year bonds at a 5.98% yield (390 basis points over comparable U.S. treasuries), and in January, Brazil and Colombia issued $1 billion of 10-year bonds at 6.13% (370 basis points above U.S. treasuries) and 7.5% (503 basis points above U.S. treasuries), respectively. There are also talks of Chile and Peru planning to tap markets in the near future.
This picture suggests that capital markets may remain open for these market-friendly economies. Until now, high demand for US treasuries has kept their yields relatively low. This has helped Latin America’s financing costs to remain relatively low, despite a higher valuation of risk.
However, there are many variables that could alter this picture throughout the year. An important source of concern for the region’s financial outlook is related to changes in the current account of Asian economies, most notably China’s. A reduction in the current accounts in Asia could alter the demand for treasuries and consequently their yield. Additionally, the yield of treasuries may also rise once the US government taps the market to finance its nearly 1 trillion dollar rescue plan. The US Congressional Budget Office estimates that public debt could rise from 41% of GDP to 54%. The risk that debt may be inflated away can eventually lead to higher interest rates in the US, and hence, given risk perceptions, a hike in financing costs for Latin America and other emerging regions.
One wonders if combined with the region’s own vulnerabilities, events in the U.S. could lead to a stronger halt in capital flows. Some of that may already be under way. While most capital flows figures have long production lags, several indicators such as international reserves and nominal exchange rates, already suggest a net outflow of capital from the region. However the main question is whether things are going to get worse.
The evidence suggests that sudden stops to capital flows critically depend on the size of the current account deficit and the amount of foreign reserves, among other variables. International reserves, despite the recent fall, are also significantly higher than in the late 1990s. Current accounts are likely to become negative given the collapse in exports. However, deficits will be significantly lower than the ones observed before the 1998 crisis. A reduction in financial flows in such cases will lead to a domestic adjustment, but not necessarily a major economic contraction.
But risks are on the downside. Although a sudden stop to capital flows appears unlikely at this point, the region should be relatively prepared to withstand the collateral damage high levels of borrowing by the US Treasury and lower global savings. Fiscal policy in the U.S. is unlikely to crowd out private demand in the U.S., but could seriously harm growth in Latin America.