The International Monetary Fund (IMF) estimates that Latin America’s regional gross domestic product (GDP) growth has slowed for four consecutive years from a peak of 6.1% in 2010, to 1.3% in 2014. Consensus expectations for 2015 GDP growth have also been downgraded to less than 1%, and some analysts are even forecasting an outright contraction this year.
A more challenging external backdrop has undoubtedly depressed economic activity over the past 18 months. This is particularly true for parts of the region that rely heavily on natural resource exports or overseas borrowing. However, Latin America’s current malaise has its roots in a legacy of misguided policies since the early 2000s.
Growth Buffeted by External Headwinds
The countries that will probably struggle the most in the coming years are the major commodity producers. Having benefited from China’s rise as a global industrial powerhouse, exporters of raw materials are now confronted by an environment of weakening demand and prices as China shifts to a growth model with a lower reliance on commodity-intensive investment. Since 2013, sharp falls in the prices of oil, metals and many agricultural goods have weighed on the trade revenues of South American commodity producers.
Meanwhile, countries with large external financing requirements – either as a result of debt repayments or current account deficits – are also facing tougher times. The good news is that debt burdens are for the most part smaller than in the 1980s or 1990s, and a lower portion of borrowing has been conducted in foreign currency, reducing exposure to adverse exchange rate movements. Even so, net capital inflows look set to slow in the near term as the US prepares to raise interest rates. For most Latin American central banks, this is likely to prompt a correspondingly tighter monetary policy stance. In a few places, notably Venezuela and Argentina, hard currency shortages could trigger balance of payments crises.
Home-grown Failures Inhibit Economic Potential
Supportive external conditions between 2003 and 2012 papered over the cracks in economic models which have since proven to be unsustainable. During this period, most governments failed to save any of the windfall from buoyant regional growth, strong capital inflows and high commodity prices. Several countries also stoked domestic demand via expansionary monetary and fiscal policies, leveraging spending on a glut of cheap global liquidity. These tendencies were visible in widening budget deficits and a credit-fuelled consumer boom.
Another common theme was complacency when it came to structural reforms. Under the illusion that Latin America had entered a new growth paradigm, the region elected a string of populist leaders. Only in a handful of places – including Chile, Peru and Colombia – did policymakers take advantage of benign conditions to create the foundations for stronger and more sustainable growth.
The Good, the Bad and the Ugly
The medium-term prospects for each of the region’s largest economies are perhaps best viewed as falling into one of three camps. The most propitious group consists of countries that have managed to look beyond the short-termism of populist politics, such as Peru, Colombia, Chile and Mexico, and arguably Panama and Costa Rica in Central America. Among the unifying themes that bind these countries are openness to trade and foreign investment, fiscal discipline and sustained efforts to liberalise the domestic business environment. Economies in this group are poised to expand at rates of 3-6% per annum over the next few years.
A second group consists of countries that have squandered the gains from favourable external conditions and now require a macroeconomic adjustment. Examples include Ecuador and Brazil, the latter of which is mired in an unenviable mix of stagnant growth, accelerating inflation and external deficits. Brazilian policymakers need to slash public spending if they are to avoid a destabilising loss of investor confidence, however, this will be both politically unpopular and could tip the economy back into recession.
The final subset contains the egregiously mismanaged economies. Fortunately, there are only two genuine contenders in this space – Venezuela and Argentina. The productive capacity of these countries has been hollowed out by years of fiscal populism and a hostile approach to private enterprise. Both are now plagued by dwindling output, galloping inflation and massive hard currency shortages. In the near term, there is a genuine risk of a large economic contraction, as well as the potential for a hyperinflationary spiral.
Treasury Departments Face a Multitude of Currency Risks
The risks facing the treasury departments of multinationals with a presence in Latin America are most acute in the third category of countries. Against the backdrop of accelerating inflation and dollar shortages, the pegged official exchange rates of Argentina and Venezuela have become overvalued and are primed for a large devaluation over the next couple of years. For firms with assets denominated in pesos or bolivar fuerte, this is likely to lead to balance sheet write-downs. And to the extent that devaluation is avoided – or delayed – in either of these places, this might come at the expense of tighter controls on access to dollars, making it harder for foreign companies to transfer funds overseas.
Even in countries with exchange rates that are governed by market forces, currency volatility will be a major challenge in 2015 and 2016. All of the region’s largest economies have witnessed dramatic falls in the value of their currencies against the US dollar over the past year. Moreover, markets are braced for a period of turbulence as the US Federal Reserve inches closer to a first interest rate hike since 2006. Although data on corporate borrowing is opaque, the evidence suggests that many Latin American companies have shunned borrowing in local currency to take advantage of extraordinarily low dollar rates. In places like Peru, such balance sheet mismatches leave treasury departments susceptible to a sudden currency devaluation, which would drive up the local currency cost of servicing dollar debts.
Low Investment Rates Hamper the Business Environment
Another historic adversary of corporate finance departments in Latin America is inflation. Rapid price growth both raises the costs of doing business and makes it harder to forecast cash flows with any degree of precision. Admittedly, with a few notable exceptions, inflation is in the low single digits in most places and will remain under pressure in the near term due to subdued growth and commodity price deflation. However, as growth starts to recover, capacity constraints could trigger a resurgence of inflationary pressures. In this regard, the region’s low investment rate is a major Achilles heel, which has prevented the supply side of the economy from keeping pace with demand.
Sub-optimal investment rates are partly the result of a culture of low domestic savings. Changing this pattern of behaviour will require lengthy and often painful reforms to pensions and welfare systems, as well as deeper and more accessible capital markets. That said, there are other factors that have hindered investment that will be easier to remedy. These include excessive red tape, rigid hiring and firing practices and a high administrative burden of taxes. Most of Latin America still has a long way to go on these fronts. However, for the countries in group one that have made tackling these issues a policy priority, structural reforms will set the stage for a more stable and prosperous business environment in the coming years.
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