27.1 years: the average (median) age in Mexico (Index Mundi)
6.5%: Chile’s economic growth in 2011 (Index Mundi)
$60bn: Peru’s international reserves, nearly a third of its GDP (Reuters)
18.3%: growth in Brazilian credit in the 12 months to the end of May 2012 (Financial Times)
$332bn: the GDP of Colombia (World Bank)
The extraordinary financial events of the past few years have prompted a structural shift in the conceptions of ‘developed’ versus ‘emerging’ markets. In the wake of the financial crisis, we can no longer assume that emerging economies warrant a substantial risk premium over the rest of the world.
In fact, since the collapse of Lehman Brothers in 2008, the performance of emerging economies, particularly in Latin America, has demonstrated that, in many countries, the consequences of the crisis were milder, and the recovery from it swifter, than in the developed world.
Indeed, for most countries in Latin America, the crisis was an opportunity to test and eventually demonstrate their resilience. Countries that had carried out deep macro reforms over the past two decades were able to reap the benefits when they were most needed. Reducing debt levels, better access to funding, the adoption of credible inflation-targeting regimes and more flexible exchange rates allowed Latin American governments to implement counter-cyclical fiscal policies. Central banks were able to cut interest rates aggressively. And even in the darkest days of the crisis, local markets functioned.
To be sure, Latin America was not left unscathed by the global crisis and the region overall contracted by 1.6% in 2009. A downturn was inevitable, although less severe than in developed markets, and its speedy recovery surprised most. In Latin America, at least for now, we are seeing much stronger balance sheets (read no major concerns about debt sustainability), on top of a still strong macro toolbox. Latin American sovereign credit ratings, on the whole, are higher following the global recession than they were before 2008. This certainly contrasts with trends in advanced economies and has been confirmed by growth in the region. In 2010, Latin America bounced out of recession, expanding by 6.2%. Overall, in the decade to 2012, the region enjoyed an average annual growth rate of 2.8% above G-7 economies.
A deeper global downturn with a precipitous and prolonged fall in commodity prices would challenge the region’s balance of payments and fiscal accounts
The positive dynamics established over the past few years are also set to continue. Domestic credit growth has stayed healthy, supporting the expansion of the middle classes. In some cases, government transfers have also helped to lift millions out of poverty. Younger and healthier populations face a new set of opportunities and challenges. Importantly, in most countries there is also a stronger political consensus around the type of policies that have made this possible. This virtuous cycle has been greased by strong cash inflows, fuelled to a large degree by commodities. We are now confronted with two fundamental questions. Firstly, have we already seen the best of Latin America and are we too late? Secondly, if we’re not too late, how can we take advantage of the region’s positive dynamics?
There are worrying precedents in Latin American history of strong cash inflows followed by even stronger cash outflows, and the greatest risk today still appears to be around commodity dependence.
A deeper global downturn with a precipitous and prolonged fall in commodity prices would challenge the region’s balance of payments and fiscal accounts. Indeed, much of the fiscal recovery of the past two years is mainly due to the rebound in commodity prices. And although some countries, such as Chile, have established stabilisation funds (and others, such as Colombia, are looking to do likewise), direct revenues from primary products still account for nearly a quarter of total fiscal revenues across the region.
Linked to this risk is dependence on China, not only as a major importer of Latin American commodities, but also as a prominent source of investment in the region. Deceleration of growth in China continues to raise questions regarding the Latin American outlook. But detailed examination of recent Chinese investments reveals evidence of some potentially offsetting forces to downward commodity pressures. Beyond securing natural resources from Latin America, China has also started to tap into its large domestic markets and emerging middle class. Indeed, in the past few years, there has also been a substantial increase in overall cash flows towards manufactures such as autos and, particularly, services in most Latin American countries – a trend that is expected to continue.
Meanwhile, there are reasons for optimism about the capacity of Latin American exporters to adjust to the shifting demands from Asia. Chile might have to face lower copper prices as China moves away from infrastructure to consumer spending, but perhaps it can offer quality agricultural products and wine – already competing in developed markets – to the rising Chinese middle classes. Moreover, not all countries are equally susceptible to lower commodities, with Mexico being the outperformer in this respect. Around three-quarters of exports out of Mexico come from manufacturing, in many cases with high value-added features that are produced domestically. Recent evidence points towards significant improvements in Mexican competitiveness compared with its Asian counterparts: labour costs have stayed under control, the exchange rate has weakened, and transportation costs to the US and Europe are meaningfully lower.
As the Chinese growth model shifts towards consumption, there could be a shift in momentum away from the produce of countries such as Brazil towards goods from Mexico. Mexico is likely to finish 2012 having expanded faster than Brazil for the second year in a row, which is sometimes seen as evidence of a shift in dominance towards the Mexican manufacturing powerhouse.
Meanwhile, there are some signs of exhaustion among Brazilian consumers as credit levels deepen. This contrasts with an increased optimism for the dormant demand in Mexico, the lending potential of its banking system and favourable demographics. In addition, Mexico has lower barriers to entry for investors and looks better positioned to push structural reforms, following its elections in July. Ultimately, however, both Brazil and Mexico are large economies with strong growth potential. Whether they achieve their potential will be partly determined by their ability to introduce reforms that overcome their weaknesses.
How can we be sure that increased global volatility won’t derail the positive momentum for Latin America?
The proof is in the pudding: the region has already experienced a massive external shock and came out not only alive, but well. It has also enjoyed more than a decade of sound financial performance. Over that time, Latin American local currency debt has outperformed (measured in volatility-adjusted returns) the rest of the emerging markets. Indeed, Latin American local debt expands the ‘efficient frontier of investment’ (ie you get better returns for any particular level of volatility) among emerging market debt. And emerging market debt as a whole has outperformed traditional asset classes over the long term.
The smaller markets certainly suffer from some liquidity limitations, but even in these the appetite of foreign investors remains strong. This appetite is also evident in the FX markets, where liquidity has increased substantially. But investment has led to currency appreciation, which, in turn, has brought two new challenges. For Mexico, its link to the US and having a liquid and convertible currency with round-the-clock trading and a low-intervention central bank means that the Mexican peso has become the global risk hedge of choice, exposing it to the volatility of international developments. For most other Latin American countries, the overall appeal of their economies now risks being impeded by currency appreciation and, in some cases, capital controls and active interventionism. It is important to differentiate, however. In Peru, for example, central bank intervention has implied lower volatility and an attractive return, but in Brazil such activism has led to some fading in flows of cash. Overall, investors, particularly corporates, need to approach their liquidity and risk management needs on a case-by-case basis, preferably through partners with deep local knowledge and reach.
Alejandro Cuadrado is head of Latin America FX strategy at BBVA.
