The Latin American Boom is Over

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Although not necessarily spectacular by East Asian standards, Latin America experienced rapid growth rates from 2003 to 2007. These rates were below the previous record set in the period 1967 - 1974 (5.5% vs. 6.6% per year), due to the relatively slow growth of the two largest economies, Brazil and Mexico. But if we estimate simple averages, the rate of growth is actually the highest in the post-war period (6.0% in 2003-07 vs. 5.7% in 1967-74). This indicates that the average performance of the small and medium-sized economies of the region was excellent.

This boom was based on the extraordinary combination of three factors: high commodity prices, exceptional financing conditions and high levels of remittances. Whenever the first two factors are combined, Latin America always booms. The last time these two positive factors coincided was in the 1970s. All three factors have never been seen together before.

Even independent of the dramatic events that started in mid-September, it is clear that all of these factors have now turned negative. The reversal in the tendency of remittances was the first change, but the other two tendencies have gyrated in adverse directions since mid-2008. If we follow the IMF indices, for example, non-energy commodity prices peaked in March and started to fall rapidly in August. Energy prices peaked later, in July, but have also been falling at a very fast rate since August.

Latin American spreads bottomed out in June 2007, prior to the sub-prime crisis, and have essentially risen since then. Up to mid-2008, however, yields remained essentially trendless, thanks to the fall in reference interest rates, but since mid-2008 they have also been rising. In early October, they reached levels not seen since the beginning of the current boom. Since mid-2008 external capital flows have been cut and, as a result, stock markets collapsed. Exchange rates have uniformly trended down, and sharply so during the recent turmoil. Adverse news in derivative markets severely hit a few countries during the recent turmoil, most noticeably Brazil and Mexico.

The news on growth had already been adverse during the first semester for several countries (Colombia, Mexico and Venezuela) and the others are on a downward trend now. Many countries are still absorbing the effects of contractionary policies adopted to face rising inflation, to which the effects of the current global recession are now added. The most optimistic projections for 2009 (e.g., those of the IMF) are now slightly over 3%, but it is most likely that the rates of growth for the second semester and next year will hover in the 2 to 2.5% range.

There are both positive and negative effects of the way economies have been managed in recent years. On the positive sign, debt levels have been significantly cut and, contrary to recommendations to float the exchange rate, most countries have intervened heavily in foreign exchange markets in recent years, accumulating massive international reserves. The major exception is Mexico, the cleanest floater in the region. This gives room to adopt expansionary monetary policies that countries did not enjoy during recent crises, but it remains to be seen how extensive it is.
 
To this we must add that, contrary to previous adverse external shocks, the chances of domestic financial crises now seem low. Again, it remains to be seen how strong financial systems would be if harsh deleveraging in industrial countries were to lead to a severe cut in external financing. Fiscal balances are generally healthy, but this situation does not reflect counter-cyclical policies during the boom, but rather booming revenues. Chile is the only country where a truly counter-cyclical fiscal policy was put in place and, thus, it will enjoy the room to maneuver that this represents. Other countries may be forced to adopt contractionary fiscal policies in the immediate future.

More generally, the boom was managed in most countries with a macroeconomic policy mix that was, on the whole, expansionary. This is reflected in high rates of inflation in Argentina and Venezuela, and in high or rising current account deficits in Brazil and Colombia, mixed in these two countries with exchange rate overvaluation. The smaller countries of Central America also accumulated relatively large current account deficits. But even the good policy performers among the larger economies, Chile and Peru, are highly vulnerable to the unwinding of the very favorable terms of trade shock they enjoyed in recent years, as we will see below. Mexico is perhaps an exception but it is also the economy most vulnerable to a US recession, and has been one of the poorest growth performers in the region during the recent boom.

 
An important measure of the external vulnerability is the magnitude of the current account deficit adjusted for variations in the terms of trade. The enclosed figure shows the evolution of both the unadjusted and the adjusted current account balances as proportion of GDP, excluding Venezuela. As it indicates, the adjusted current account has shown a strong deterioration throughout the boom, and sharply so in 2007. With the rate of deterioration experienced in that year, it is likely to reach in 2008 levels not unlike those seen prior to the previous crisis.

In turn, the accompanying table estimates the current account deficits of all countries in 2007, both at current prices and adjusted for the variation of the terms of trade. Countries are ranked by the level of improvement of the terms of trade in 2003-07. As can be seen, countries that benefited the most were all mineral (including energy) exporters, essentially the Andean economies in a broad sense (from Venezuela to Chile), while major agricultural exporters (Argentina and Brazil) experienced only moderate improvements in the terms of trade. This is in accordance with a previous contribution to this monitor in which I argued that we were experiencing a boom of mineral, not agricultural commodity prices (José Antonio Ocampo and Maria Angela Parra, “This is a boom of mineral, not agricultural prices”, RGE Monitor, May 2008). Energy importers, such as the Central American countries and Uruguay, had the strongest negative shocks. 

As it can be seen, once adjusted for terms of trade variations, most economies had a sizable current account deficit in 2007. This includes most of the mineral exporters, including well-performing Chile and Peru, which indeed had adjusted deficits that exceeded those of Venezuela and Colombia that year. The only true exception among energy exporters was Bolivia. In several of these countries, we should make an additional adjustment for the heavy profit remittances by foreign investors active in the mining sector, which is likely to decrease as mineral prices fall, but would not change the basic conclusion: adjusted current account deficits were large. Countries with adjusted current account surpluses were exceptional: Argentina, Bolivia, Paraguay and Uruguay. Brazil and Mexico had moderate deficits, but in the former case the current account was deteriorating very rapidly. The other interesting exception was Costa Rica, which was basically burdened by expensive oil; it is therefore the country most likely to benefit from the reversal of high energy prices.

So, Latin America and, particularly, South America, is bound to experience strong pains in the immediate future from its heavy reliance on commodities. And this is likely to affect the access and costs of external financing as well. To the North, most of the smallest countries will benefit from lower energy prices, but they will be more directly hit by the fall of remittances and heavier dependence on exports to the US. The latter factor will lead Mexico into recession.

The panorama for the region is certainly not as bad as during the two previous crises –the “lost decade” of the 1980s and the “lost half-decade” of 1998-2003—but high vulnerability to external events, both positive and negative, continues to be the rule. Perhaps more fundamentally, this refutes the myth that Latin America was growing fast because it had finally gotten the right policies! External factors were more important.