As we start out 2019, a growing consensus has been forming among experts and market participants: the increased volatility in international capital markets and rising trade tensions of 2018 will not abate in 2019, and in fact may have adverse spillover effects on economic growth and stability of emerging markets and developing economies (EMDEs). How will this challenging international environment shape prospects for Latin America? As a panelist at a recent CGD event on the state of the global economy and development prospects for EMDEs, I dealt with this issue by answering three questions:
Which are the most important external factors affecting Latin America?
How resilient is the region to external shocks?
And finally, what can policymakers do?
Below, I lay out detailed responses to each of these, including a set of recommendations that policymakers can take on right now.
1. Which external factors might affect Latin America’s economic growth and stability most in 2019?
The short answer: policy-uncertainties in the US
In recent years, developments in China and the United States have been key external factors affecting economic and financial variables in Latin America. Although trade and financial developments interact with each other, China’s effect has mostly been through the trade channel while the US’ effect has largely been through the financial channel.
For example, due to the large number of commodity exporters in the region, China’s slowdown, associated with the decrease in commodity prices, has affected the pace of the growth in the region since 2014. Likewise, financial developments in the United States—e.g., the collapse of Lehman Brothers in 2008, which marked the beginning of the global financial crisis; Ben Bernanke’s suggestion in May 2013 that the Fed might begin reducing its rate of liquidity expansion (the so-called Taper Tantrum); and the sharp volatility of the US stock markets in 2018—increased investors’ risk aversion and reduced their appetite for EMDEs assets, including those from Latin America. On these three occasions, the region was not spared from the reduction in net capital inflows that ensued.
In 2019, there is consensus about a further slowdown in China’s economic growth. However, I believe this slowdown has already been internalized in commodity prices and, based on past experiences, the Chinese’s policymakers’ response has also been highly anticipated.
In contrast, policy uncertainty in the US remains high and there are no signs of improvements in the foreseeable future. Thus, in my view, developments in the United States will be the most influential external factor impinging on Latin America’s economic growth and financial stability.
Specifically, three key sources of uncertainty are:
These lie at the core of the current volatility in international financial markets and may continue decreasing investors’ demand for EMDEs’ assets, of which Latin America is an important supplier.
Figures on the recent behavior of external debt in Latin America provide some initial illustration on potential problems that the region might face if continuation of US policy uncertainties were to result in further increase in investors’ risk aversion and, therefore, further declines in net capital inflows:
While issuance of external debt securities (bonds) increased substantially in all EMDE regions since 2010, and the latest discussion has centered on the issuance of debt securities by non-financial corporations, in Latin America, government debt issuance also accelerated significantly, at much rapid pace than other regions like Asia (see Figure 1 below). In most countries in Latin America, the ratio of total external debt securities to GDP has more than doubled since 2010 (and this, without including other sources of external debt, such as international loans). Of course, countries differ significantly. For example, in Argentina government debt accounts for the lion’s share of external debt securities; whereas, in Chile it’s mostly a private sector issue.
Figure 1. Stock of External Debt Securities / GDP (%)
Among the six largest Latin American countries, excluding Mexico and Peru, total external debt service (amortization and interest payments) as percentage of GDP has also increased significantly, currently reaching about 16 to 18 percent in some countries. As a reference, by 2017 this ratio was about 20 percent in Turkey.
This brings me to my second question:
2. How resilient is Latin America to further deterioration in the international environment?
Consistent with the main sources of uncertainty in the US outlined above, the countries that would probably be most affected are those that have:
the largest external financing needs;
the largest share of unhedged debt denominated in US dollars; and
weak domestic motors of growth and sources of finance which make it harder to face higher international interest rates.
Again, data serves to provide some insights, conveying that Latin American governments allowed economic fundamentals to worsen in a period of high global liquidity and capital inflows:
Among emerging markets, Latin America stands out as relatively vulnerable in terms of external financing needs, given the current account deficit persistence in a number of countries. Figure 2 below compares a sample of emerging markets’ pre-global crisis current account balances, where most Latin American countries were experiencing surpluses, to the latest available observations where all Latin American countries were running deficits.
Figure 2. Current Account Balance / GDP (in percentages)
If we were to rank Emerging Market countries by their current account positions, Turkey and Argentina display the worst ratios of current account balance to GDP (although, of course, Argentina counts right now with the IMF support).
In some countries, the mirror image of large external financing needs has been large fiscal deficits. Argentina is the clearest case in point. But the truth of the matter is that most Latin American countries, including those without large external financing needs, are currently lacking fiscal space to undertake countercyclical fiscal policies in case of shocks. Brazil is a good example.
Regarding the share of debt denominated in US dollars, available data show that Latin American corporations display the largest ratios, led by Mexico, Argentina, and Brazil (see Figure 3 below). A note of caution, however, is that we don’t know what proportion of this debt is hedged against exchange rate fluctuations. But experience also shows that the value of the hedges decreases significantly during periods of stress.
Figure 3. Non-Financial Corporate Debt: (currency composition)
On growth dynamics, except for Chile, most countries in Latin America lack internal and sustainable motors of growth. The June 2018 issue of the World Bank Global Economic Prospects reveals two very discouraging facts: the first is that per capita potential growth in Latin America is below the average for developing countries as a whole. The second is that potential growth is expected to decline further in the region due to sustained weakness in productivity as well as slower labor force growth and capital accumulation.
Now, it would not be fair to talk about resilience by focusing only on vulnerabilities. Moving to a discussion on strengths, it’s important to note four important sources:
Although fiscal space is quite limited, central bank policies in most countries in Latin America have been adequate, keeping inflation within their announced targets (again Argentina is an exception along with the more obvious case of Venezuela) and there is sufficient space for counter-cyclical monetary policies.
Despite the abundance of stresses, no systemic domestic banking crisis has emerged. Not even during the recent Brazilian and Argentinean recessions. This is a great accomplishment as lack of banking problems gives more degrees of freedom to the implementation of counter-cyclical monetary policies.
Low ratios of short-term external debt to international reserves is an additional source of strength (see Figure 4 below). Indeed, I strongly believe that this is the central variable to watch to make forecasts about Latin American countries’ abilities to meet further deteriorations in the international environment. Argentina lost huge amount of international reserves during the previous administration and is now paying the price.
Figure 4. Short-term External Debt/ Gross International Reserves (%)
Source: Own elaboration based The World Bank-IMG Quarterly External Statistics
Exchange rate flexibility has also played an important role as a shock absorber to external shocks. However, these benefits have been supported in the last years by the abundance of global liquidity. As global liquidity declines and risk aversion increases, countries facing a combination of high refinancing needs and important currency mismatches might find that sharp depreciation of their currencies become a problem for maintaining financial stability.
It is the capacity to contain vulnerabilities and improve strengths discussed above that will determine each country’s resilience to face the external challenges of 2019.
3. What can policymakers in the region do?
The challenge for policymakers is clear: how to manage the bumpy and protracted transition from abundant global liquidity—where fundamentals could afford to take the back seat because finding external of finance was an easy task—to a world where strong fundamentals become (once again) the name of the game.
Each country has its own list of pending long-term structural reforms that requires significant attention, including fiscal and labor reforms. Here, however, I will advance three recommendations centered on what policymakers should be doing right now.
While recognizing that structural reforms need to be in place, the truth is that recent surveys by Latinobarometro show that the public confidence on institutions and powers of the state (especially Congress and the judiciary) has been on a consistent downward trend in the last decade. Passing reforms in this environment is particularly difficult, especially when the external pressures are for less growth. In this situation, my view is to protect the independence of those institutions that could prove highly effective if international conditions worsen further. Very specifically, I’m talking about the central banks. As in advanced economies, central banks are the ones that can quickly put in place policies (monetary and macro-prudential) that can minimize the costs of a shock.
“Build up buffers.”
This recommendation, also acknowledged by the 2019 Global Economic Prospects, relates to the first recommendation because several of these buffers can be put in place without political confrontation. In addition to continue efforts to maintain high stocks of international reserves, an active debt management strategy needs to be given high priority, including acquiring information about the degree of unhedged currency exposures of the private sector. Moreover, it is important to establish access to available credit lines from multilateral organizations. One example is access to the Flexible Line of Credit of the IMF. At the moment, only two countries in the region—Mexico and Colombia—have access to this line, although there are others that qualify. Also, it is advisable to explore the establishment of currency swaps arrangements between central banks in the region and between these and the Fed.
“Learn from recent good and bad experiences in other emerging markets.”
One example, discussed by the Latin America Committee on Macroeconomic and financial Issues (CLAAF), is the lessons that the recent experience in Argentina provide for Brazil: In dealing with the fiscal problems inherited from the previous administration, Macri’s government in Argentina undertook an extremely gradual fiscal adjustment. This over-gradualism implied the continuous accumulation of debt, whose service became unsustainable. Right now, the new administration in Brazil is also facing the need for a very large fiscal adjustment—indeed much larger than Argentina (5 to 6 percent of GDP)—to stabilize domestic public debt. Not doing so puts Brazil at risk to join the list of EMDE countries facing severe debt sustainability problems which involves high interest rates and a constraint on economic growth. Under the current external environment, Brazil has even less space for excessive gradualism than Argentina.
Without doubt, we’ll have plenty of news coming from Latin America in 2019. Let’s hope for a positive balance.