Latin America: The only way is up
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- The external environment has improved and that bodes well for economic activity in Latin America in 2017-2018
- The fall in commodity prices has put pressure on external balances and external buffers, but the lion’s share of countries have weathered the adverse period well
- Higher inflation has also been a challenge in the past two years, but firm action by central banks has been successful
- Fiscal positions have weakened across the board in the region and is problematic in some countries, such as in Brazil, Argentina and Costa Rica
- Having hit rock bottom in 2016, most economies are expected to perform better in 2017, particularly so in South America. Argentina and Brazil will likely put the recession behind them
External environment improves
Ever since our first Latin America regional study we have been noting the region’s external orientation, with a focus in Central America on the US and a focus on commodity exports in South America (see Latin America: the tide has turned). Positive developments in the external environment in the past year bode well for economic activity in the region. First, commodity prices have stabilized around - on average - higher prices than in 2016 (Figure 1) and the outlook is positive, though we do not expect a spectacular rebound to the price levels seen during the commodity super cycle that ended in 2011. Second, economic activity in the industrialized world is recovering briskly and is expected to keep this pace in the coming year, which is good for both the export of goods and tourism. The recovery in the US is positive for Central America in particular.
External balances unscathed by the commodity trough
The downturn in commodity prices in the past years has put significant pressure on export revenues and, as a result, on the value of domestic currencies (see Latin America: cycling on or muddling through?). Most countries have, however, been able to manage these pressures. Their external balances have adjusted to the new situation and sufficient external buffers were maintained. An important reason for this was the fact that many countries in South America and Mexico have a (free) floating exchange rate system (Table 1) that serves as a first line of defence against external shocks such as the commodity price plunge. The depreciation of the currencies stifles domestic demand for imports and gives a boost to export competitiveness, thereby helping the current account adjust to the new reality. This is visible across the board in South America where the current account deficits of 2015 have subsided in the following 2 years (Figure 2).
In other – commodity importing - countries the lower commodity prices, of energy in particular, have also helped current account deficits to fall. Belize and Panama still have high current account deficits of more than 5% of GDP that need to be financed. Some other countries, like Suriname, Ecuador and Guatemala, have managed to swing their current account balances into positive territory on the back of various other factors (slightly higher commodity prices, import restrictions in Ecuador etc.).
Many countries have also managed to continue to attract FDI, a stable flow of external financing. This reduces the reliance on more volatile portfolio capital flows and thereby the vulnerability to developments in international capital markets such as imminent monetary policy tightening in the US (see Latin America: FX outlook: Carry on and on). FDI inflows have continued to cover the current account balances (Figure 3) in Brazil, Chile, Colombia, Costa Rica, Honduras, Panama, Paraguay, Peru and Uruguay. In the past year, as a result of the global search for higher returns, appetite for emerging market debt has remained high.
Many countries in Latin America have benefitted from this appetite, even countries with a precarious external liquidity situation and an unorthodox policy course, such as Ecuador and Suriname. However, this appetite is set to change with interest rate hikes in the US. From that perspective, it is positive that most countries have maintained foreign exchange (FX) reserves at comfortable levels - 3 month import cover or higher - despite the adverse external conditions (Figure 4).
Argentina, Guatemala and Paraguay stand out, as they have managed to increase their FX reserve levels considerably in the past year. Exceptions are Venezuela, Suriname and Ecuador where the risk of a balance of payments crisis remains high. A Venezuelan default is only a matter of time (see box on Venezuela). Several countries that manage their exchange rate have been forced to draw on their FX reserves. Consequently, Costa Rica, Bolivia and Belize saw their FX reserves decrease by around 10%, though their import cover remains comfortable.
Taming inflation, the success story
Hyperinflation haunted Latin America in the 1980’s and 1990’s and the pick- up in inflation in recent years (Figure 5) raised concerns about prices spiralling out of control again. The main driver behind higher inflation in 2015 and 2016 was imported inflation, as the depreciation of local currencies fed through into higher domestic prices. However, domestic factors, in particular corrections of pro-cyclical fiscal policies during the boom years also played an important role. The spike in inflation was an important test for the central banks in the region. With inflation targeting monetary policy in place in many countries, proper action by monetary authorities has helped them to reassess their independence from political influence and to set an important track record for the future. For example, the Central Bank of Brazil has managed to bring down inflation (and inflation expectations) from a double digit peak reached in 16Q4 to as low as 1.8% in August 2017, below the lower band of the inflation target. The Argentinian Central Bank also stands out in a positive manner, as they have implemented an inflation targeting framework in 2016 and managed to reduce inflation (and inflation expectations) considerably despite the still adverse conditions (e.g. some monetary financing of the budget deficit, low private debt limiting the functioning of the transmission mechanism). Both inflation and inflation expectations remain above the monetary authority’s inflation target for now.
Of course, there are some exceptions to this trend. Some countries, like Uruguay and Mexico, are still grappling with high inflation despite the high quality of their macroeconomic institutions. Suriname and Venezuela, countries with erratic policy that includes monetary financing of the public expenses are grappling with hyperinflation.
Patchy fiscal situation
Performance on the fiscal front has been less positive across the board (Table 2). Lower commodity prices and the slowdown of economic growth (or an outright contraction such as in Argentina and Brazil) have reduced fiscal revenues, and governments have been struggling to contain the resulting widening of the budget deficit and the increase in public debt. In 2016, only Paraguay, El Salvador, Guatemala and Mexico recorded a primary surplus and all countries in Latin America recorded a budget deficit (Table 2). The budget deficits were particularly high in Argentina, Bolivia, Brazil, Costa Rica, Ecuador, Suriname and Venezuela, all countries where significant austerity measures need to be implemented to place public debt on a sustainable path in the future. The high public debt level in these countries is a reflection of the problematic public finances (except for Venezuela and Ecuador where debt is still low, but where the governments are nevertheless struggling to make ends meet). Countries that have pursued sound fiscal policy in the past, such as Peru and Chile, have kept their public debt low and have had the room to provide some fiscal support to their economies.
The future looks brighter
As we predicted last year, economic activity seems to have reached the bottom in 2016 and is now forecast to pick up pace in 2017 (Figure 6). This is particularly the case in South America, while economic growth in Central America is more stable. Only countries that found themselves in a crisis will continue to see their economies contract this year, namely Ecuador and Venezuela (and perhaps Suriname). Argentina and Brazil will see economic activity swing back to positive territory, though weak domestic dynamics will contain the recovery in the latter. The positive outlook for commodity prices and important export markets and the room for monetary easing in many countries are supportive of this outlook. Political dynamics, the impact of interest rate hikes in the US and geopolitical factors are downside risks to this outlook.
Box 1: Venezuela’s instability has broader implications for the region
Venezuela is locked in a downward political and economic spiral. The country’s economy has fallen into a severe crisis, marked by shortages of necessity goods; hyperinflation; social unrest and political uncertainty. After a sham referendum at the end of July, president Maduro has acquired the power to rewrite the country’s constitution, which further increased the on-going political and economic crisis in the country. It also encouraged international actors, particularly the US, to take action against leaders of the Partido Socialista Unido de Venezuela (PSUV) government.
The crisis in Venezuela has broader implications for the region. Beneficiaries of Venezuela’s PetroCaribe policy that started in 2005 stand to lose the most. The oil-backed loan agreements under the PetroCaribe scheme allowed countries in Central America and the Caribbean to purchase oil at favourable conditions. In recent years the amount of oil supplied by Venezuela under the PetroCaribe policy and FDI inflows from Venezuela have fallen significantly. Nevertheless, many countries remain dependent on Venezuela, especially El Salvador, Haiti, Guyana, Jamaica, Cuba and Nicaragua. If oil sales to PetroCaribe beneficiaries were suspended, economic instability in these countries would be at risk. Payments to Venezuela account for around 40% of the Caribbean economies export revenues.
Second, as the economic and political crisis has led to a severe deterioration of the quality of life in Venezuela, more and more Venezuelans are fleeing the country. Colombia, Ecuador and Panama are the largest recipients of refugees. In the case of Colombia, it largely concerns reverse migration (Colombians who had immigrated to Venezuela in the past are returning). The many immigrants increase risks in the recipient countries, as problems such as increasing unemployment, criminality and potential ethnic strife.
Finally, the Trump administration has imposed sanctions on Venezuelan President Nicolas Maduro and other high ranking members of the Maduro regime and has threatened with economic sanctions. These would severely hurt Venezuela, as 42% of its exports go to US. While both the US and Venezuela will likely find alternative supply/clients eventually, the disruption is likely to temporarily push up oil prices. Venezuela, with 300bn of barrels, has the largest oil reserves in the world (300bn barrels) and it is the third-largest oil supplier to the U.S. (after Canada and Saudi Arabia). The disruption is also likely to lead to an increase in fuel prices in the US, as Venezuelan heavy crude oil is currently processed in more than 20 refineries in the US. Many of them are fitted to process this oil grade and replacing the supplies would be disruptive and costly.
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