Latin America: cycling on or muddling through?
To the Regional study Latin America: changing course overview page
- Economic activity in Latin America is expected to pick up in 2017, though the improvement is modest; in South America the economic downturn has apparently bottomed out
- Historically low commodity prices have led to unfavourable terms of trade changes and increased downward pressure on currencies and FX reserves; the situation has become critical in Ecuador, Venezuela and Suriname
- In 2015 FDI inflows edged lower and natural resources lost ground to services as recipients
- Against a backdrop of low-cost and accessible financing internationally, external debt has increased markedly; however, it remains modest in most countries, which should contain the macro risks of a Fed rate hike to some extent
- Domestic leverage is also modest, leaving room for expansion once economies move into an upturn
- Low inflation gives Central America and Paraguay the room to stimulate through monetary easing; current tightening cycles in Argentina, Brazil, Chile, Colombia and Peru might create some room for monetary easing next year
- In terms of fiscal policy, a mixed bag. Chile, Peru and Paraguay have most room to manoeuvre, while Brazil and Venezuela are in the worst situation and have large fiscal adjustments to make
Economic growth is picking up, but slowly
In our regional study a year ago, we concluded that most countries were in a downturn on the back of a less benign external environment and weak domestic dynamics. Nevertheless we expected the trough to be reached in 2015 and that there would be a recovery in 2016. Meanwhile, GDP growth forecasts for 2016 have been revised significantly downwards and the trough has been extended or postponed to 2016 for many countries (Figure 1). Consequently, most countries on the continent will not see a rise in economic activity until 2017, and even then the improvement will be modest. Countries which have pursued more business-friendly and sounder macroeconomic policies in recent years, namely Chile, Colombia, Peru, Paraguay and Uruguay, are however performing better. They are still enjoying positive and steady rates of economic growth, though not at the levels seen during the commodity boom. Argentina, Brazil, Ecuador, Suriname and Venezuela are expected to record outright contractions in 2016. However, with the exception of Venezuela and Ecuador, all these countries seem to have the worst behind them and are expected to return to growth in 2017. In Central America, economic activity will continue to grow at the steady pace seen in recent years on the back of the recovery in the US and a lower bill for oil imports. Mexico’s economy has been affected by the fall in oil prices, but a sound macroeconomic policy has contained the damage and the economy is growing at a steady pace. Countries with a higher level of income and development, such as Costa Rica, are growing just as fast as their neighbours.
The demand and supply sides of the economy do not present a brighter picture. On the demand side, unemployment is expected to be stable at best or even increase in 2017 (Figure 2), a lagged effect of the economic slowdown in recent years. This will contain domestic demand. The rise in unemployment is sharper in countries where economic activity has recently deteriorated significantly, namely Argentina, Brazil, Colombia, Ecuador and Venezuela. Mexico is bucking the labour market trend as it is the only country where unemployment is actually falling due to higher employment, which should support domestic demand. On the supply side, last year we noted that investment ratios on the continent are fairly low compared to the rest of the world, and these levels are not expected to change much. Several metal and energy producing countries that enjoyed above average investment rates in the past, such as Bolivia, Peru, Suriname and Venezuela, experienced sharp decreases in investment in 2015. The most dramatic decline is in Ecuador, where investment is expected to plunge from an average of 28% of GDP in 2012-2014 to 13% of GDP in 2017.
All in all, we can say that economic activity is moving to a higher pace of growth in the coming years, but the pick-up is too modest to speak of a real upturn. Rising unemployment and persistently low investment levels reflect this picture. As we highlighted last year, without growth-enhancing reforms on the supply side, many countries in the region are likely to muddle through in the future. Hopefully the political changes that recently took place in several countries such as Argentina, Brazil and Peru will usher in a reform momentum that goes beyond tackling recent imbalances and actually boosts the potential for growth.
 We note that labour statistics in Latin America should be taken with a grain of salt, given the large share of the informal economy or low coverage of data (even in Brazil, where statistics are well developed, the reported unemployment covered only the six largest metropolitan areas until the beginning of 2014).
Mind the international super-cycles
The domestic business cycle is also influenced by international developments, especially in countries that are well integrated into the world economy via trade and capital flows. In Latin America after the commodity boom we highlighted the close links between economic performance, particularly in the commodities-producing countries in South America, and international commodity prices. The decrease in prices since the end of the so-called 'commodity super-cycle' (Figure 3), which lasted from 2003 until 2011, has had a negative impact on the region. It has led to a significant deterioration in these countries’ terms of trade and has increased downward pressure on currencies (Figure 4), and, in countries that tried to defend their currencies or intervened to contain volatility, a decline in FX reserves (Figure 5).
Ecuador, Venezuela and Suriname are suffering from very low reserve levels, which have so far forced Suriname to float its currency and request an IMF programme, while Venezuela has been on the verge of a sovereign default for a while, at a time when heavy import restrictions have led to a humanitarian crisis due to a scarcity of vital goods such as medication. Ecuador, a dollarised economy, has suffered the consequences of the liquidity crunch and is struggling to make ends meet and cover its public financing needs. The rest of these countries still hold adequate buffers and their floating currencies serve as a first line of defence. For Latin America, the end of the commodity cycle has also brought a change in FDI inflows, which fell by 9% in 2015 to around USD 173 billion, the lowest level since 2010. The decrease is mostly due to a 23% fall in FDI inflows to Brazil, the largest economy in the region and the largest recipient of FDI. The decline in FDI has been particularly sharp in the extractive sector, with a decrease in the level of reinvested earnings also playing an important role as companies have maintained the level of repatriated profits while margins have been falling. Services have been gaining ground as recipients of FDI, particularly renewable energy, telecommunications, and retail. Trans-Latin firms play an important role in the two last-mentioned sectors.
Another super-cycle that has benefited Latin America until now has been the long period of expansive monetary policy in the advanced world, which has led to a search for yield and made cheap money readily available for emerging markets. In such an environment, a serial defaulter like Ecuador has been able to tap the international capital markets three times since 2014 for a total amount of USD 2.75 billion or almost 3% of its GDP. It has also allowed a shift in corporate financing from domestic bank loans to external finance, particularly bond issuance. This has increased the level of external debt in general, and of USD denominated debt in particular. Private external debt has risen by 80% in Latin America between 2014 and 2015. This could become an issue when the US Fed decides to increase its policy rate. The first rate hike in December 2015 led to capital outflows similar to those seen after the monetary tightening indication in late May 2013 (Figure 6). Market sentiment has frequently fluctuated between risk-seeking and risk aversion ever since, which on average has led to lower inflows and higher volatility. A change in market sentiment and a currency depreciation will affect the ability of corporates to refinance their debt, while refinancing needs are set to rise markedly between 2016 and 2018 (BIS, 2016). That being said, macro risks appear to be moderate as external non-financial corporate debt levels are still modest in most countries (Figure 7). External debt is higher in Panama and Chile, reflecting the high degree of international integration of Panama’s economy and the good credit standing of Chilean corporates. The level of USD denominated non-financial corporate debt also looks modest, reportedly at 13% of GDP in Brazil and 11% of GDP in Mexico. Unfortunately, data on the currency composition of foreign debt are very scarce, so there might be hidden pockets of risk here.
Some help from the credit engine
Credit plays an important role in the business cycle and is intuitively assumed to be pro-cyclical, or as Robinson (1952) put it “where enterprise leads finance follows”. Monetary policy allows governments to either stimulate or temper growth through the credit channel, thereby reducing cyclical volatility. Given the fact that economic activity in most countries seems to be bottoming out or at least be stable, credit growth could play a role in pushing GDP growth higher. However, this depends on the room for expansive monetary policy and the level of leverage in the private sector.
Domestic private sector debt in emerging markets has quadrupled in the past decade, and Latin America has been no exception. In 2014, private sector debt on the continent was 4.3 times higher than a decade earlier. However, credit growth slowed in many Latin American countries in 2015 and even became negative in Brazil, Chile and Colombia. Coming from a low base, the level of private sector debt is still modest at around 50% of GDP in most countries, which leaves room for expansion. The level of private debt is however quite elevated in Brazil, Chile, Costa Rica, Nicaragua and Panama, which will constrain any further leveraging in these countries. Years of state intervention and double-digit inflation have reduced private debt in Argentina to very low levels, and in theory this should be supportive of economic growth now that economic policy is normalising and the business climate is improving. The still high inflation rate of more than 40% y-o-y and the 26,75% policy interest rate will however hinder credit growth for the time being, as investors’ appetite for negative real rates will be minimal. Another country that stands out due to the low level of credit is Ecuador, where this seems to reflect the significant role of the state in the economy, as growth in recent years has been driven by the dominant oil sector and public investment. Moreover, credit is unlikely to pick up during the ongoing liquidity crunch caused by a sharp decrease in the inflow of oil dollars, Ecuador being a fully dollarised economy.
As the level of private debt is modest in most countries, governments could try to boost this channel to help economic growth by easing monetary policy as long as inflation is below target or not too high. There is ample room for this in Central America, where inflation is low and below target in most countries (table 1). The opposite applies to South America, where inflation has spiked and is hovering above target in all countries apart from Paraguay. Nevertheless, the current tightening cycle might create some room for easing in Argentina, Brazil, Chile, Colombia and Peru next year. We also note that the high level of external financing for the governments in Uruguay and Central America, with the exception of Costa Rica and Mexico, exposes these countries to developments in international markets.
On the fiscal front: a mixed bag
Economic cycles can in theory also be smoothed through fiscal policy. Governments that have been running countercyclical and sound policies in the past should have more room to use fiscal stimulus to support the economy in the current slow growth environment. Looking at the room for fiscal stimulus, we see a fairly mixed picture. The modest levels of public debt in most countries (Figure 8) would seem to indicate there is plenty of room for fiscal stimulus, except for Belize and Brazil, and to a less extent Argentina (where debt is very high given the reduction caused by double-digit inflation in past years) and Uruguay. However, all countries in the region are running budget deficits (table 1), so the potential to further engage in expansive fiscal policy is in fact limited. Only Chile, Peru, and Paraguay have sufficient leeway to stimulate their economies fiscally, as their budget deficits in the current downturn are only around 2.5% of GDP and public debt is below 30% of GDP. That also applies to a lesser extent to Guatemala and Nicaragua, as they have similar fiscal balances but they are not in a downturn. Fiscal policy needs to be aligned with monetary policy, otherwise it undermines the effectiveness of the latter. The low level of inflation in the countries that have room for fiscal stimulus means they can actually use this room to support their economies.
In countries with sizeable budget deficits such as Argentina, Belize, Brazil, Bolivia, Costa Rica, Ecuador and Suriname, governments will need to cut spending, which will hurt growth. The situation is particularly critical in countries with double-digit budget deficits such as Brazil (10.5% of GDP) and Venezuela (18.7% of GDP), where the impact of the necessary austerity measures will be broadly felt by the population and the economy.
Looking ahead, while we see economic activity accelerating somewhat all over the continent, apart from the ailing economies of Ecuador and Venezuela, the underlying fundamentals are diverse. In general, countries in Central America are growing at a steady rate. These countries have room for credit expansion and monetary easing. Nicaragua and Guatemala also have some room for fiscal stimulus. The southern part of the continent is still bearing the pain of lower commodity prices, but the impact and the room to respond varies greatly. Sound policies in the past seem to be paying off in these difficult times. Countries such as Chile, Colombia, Peru, Paraguay and Uruguay are still enjoying positive growth rates. Chile, Peru and Paraguay also have leeway to support their economies through monetary or fiscal policy. At the other extreme, unsustainable populist policies in the past have pushed Ecuador and Venezuela into deep recessions that will last until next year. In the middle we find Brazil, Argentina and Suriname, where economic growth should pick up next year but the situation remains challenging, as all these countries need to undergo significant macroeconomic adjustments.
BIS(2016), Capital flows and vulnerabilities
CEPAL(2016), Foreign direct investment in Latin America and the Caribbean
IMF(2016), World Economic Outlook update July 2016
Robinson (1952) quoted by Zhu F. (2011), Credit and business cycles: some stylised facts, Bank of International Settlements
Abbreviations for sources: EIU: Economist Intelligence Unit, IMF: International Monetary Fund
Abbreviations used for countries: AR: Argentina, BZ: Belize, BO: Bolivia, BR: Brazil, CL: Chile, CO: Colombia, CR: Costa Rica, EC: Ecuador, SV: El Salvador, GT: Guatemala, GY: Guyana, HN: Honduras, MX: Mexico, NI: Nicaragua, PA: Panama, PY: Paraguay, PE: Peru, SR: Suriname, UY: Uruguay, VE: Venezuela
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