Latin America: Coping with the US Recession

After a remarkable string of five years of good growth, Latin America is likely to face its first serious external shock in 2008 as the US enters into a recession. Although the prospect of weakness in the US has hung over Mexico in recent months, I am concerned that the full impact of a US downturn on Latin America has been underestimated by most regional watchers. Indeed, I am concerned that the full brunt of our US team’s move has been underestimated by my colleagues throughout the emerging economies and in our commodities team. As the spillover becomes clearer, I expect that we will adjust our Latin forecasts further.

The coming US recession
Our US economics team believes that the downturn is now underway, with growth just above 0% in the fourth quarter before slipping into two negative quarters at the beginning of 2008. Richard Berner and David Greenlaw expect the US recession to be mild and believe that a more aggressive policy response from the Fed in the form of another 100bp of cuts will ultimately limit the duration of the downturn (see “US: Coming Recession”, GEF, December 10, 2007). Nonetheless, there is no escaping the central message of our US economists: for the first time in more than a decade-and-a-half, the US economy is expected to post three consecutive quarters of growth either near zero or just below it. Private consumption growth is expected to fall precariously near to zero in the first half of next year.

Mexico: The link cuts both ways

We are cutting our Mexico GDP for 2008 to 2.6% from 3.2% previously. It should be of little surprise that Mexico, given its strong links to the US economy, is the top of our list of forecast revisions for 2008. Indeed, some might ask why we are not reducing our Mexican forecast even further, in light of the severity with which Mexico’s economy declined during the last US recession.

The link between Mexico and the US is more nuanced than that of a simple relationship between GDP: the link is strongest in industrial activity and, within industrial activity, in the manufacturing sector. Unlike the downturn in 2001, which hit US industrial activity and manufacturing hard, our US team expects industrial production to continue to grow in 2008, albeit at a slower pace (1.5%) than in 2007 (2.1%).

In addition, Mexican exporters have taken their first steps towards weaning themselves off their addiction to the US. As Luis Arcentales has pointed out, thanks to a weakened dollar and hence a more competitive peso, Mexican exports destined for Europe and Latin America – although making up only 12% of total Mexican exports – have accounted for nearly as much of the total growth in exports so far this year as those destined for the US (see “Mexico: A Decoupling of Sorts”, GEF, October 24, 2007). That is because exports to the rest of the world are growing at a 24% clip this year, while exports to the US have come to a near standstill of just 3% for the first nine months. And Mexico has been gaining market share in the US, which should help even as the growth pace of the US pie slows.

Moreover, the oil windfall accumulating in recent months should help to boost fiscal spending – particularly by states – in the first months of 2008, even as the federal authorities ramp up an ambitious program of infrastructure spending. The authorities estimate that public investment (largely targeted at infrastructure) should exceed US$50 billion in 2008 alone. And credit, which was still on a declining path in 2000 and 2001, has shown a significant upswing in recent years.

While there are some risks to the downside in our Mexican forecast – US industrial activity could suffer more if, as we expect, global demand weakens further and that drop in US IP could hit Mexico – we suspect that most of the downside is built into our Mexican forecast. In contrast, the rest of the region is at greater risk of further downward revisions as our global team works through the implications of a significant weakening in US consumption.

Brazil: As good as it gets

Perhaps nowhere is the tension in our global view for 2008 more apparent than in Brazil. With our China economist, Qing Wang, calling for a slowdown in Chinese growth in 2008 to still produce a 10% uptick in real GDP, it is not hard to see why we are expecting only a modest easing in Brazil growth in 2008 to 4.3% from 4.9% this year. Our commodities team expects the supercycle to continue in 2008 as commodity producers struggle to keep pace with Chinese demand growth. Indeed, our mining team argues that record-low inventory levels are likely to persist for at least another four or five years.

Again, we suspect that we will have to revise downward our forecasts for Brazil growth if the US economy enters the recession path as outlined by our US team and the global spillover turns out to be more significant than our global team currently expects. Two points are worth bearing in mind:

First, even without a recession, Marcelo Carvalho is cautious that capital inflows into Brazil are likely to slow from an unprecedented high of about US$90 billion in 2007 to almost a third of that level in 2008. And Marcelo expects the disconnect between some slowing around the globe and relatively strong domestic demand to take its toll on Brazil’s trade balance – cutting it in half and producing the first current account deficit in six years (see “Brazil: Balance of Payments – How Sensitive to a Global Slowdown?” This Week in Latin America, December 3, 2007).

Second, I am skeptical that the global commodity cycle will withstand a downturn in US consumption. Look at the episode in 2001: while Chinese growth did not slow sharply, a major decline in export demand led to a dramatic correction in Chinese import demand. And that in turn fed through to commodity prices, which declined sharply in 2001. I am not arguing that 2008 will be an exact replica of 2001, but if US consumption takes the hit that our US team is forecasting, I expect both Chinese import demand and commodity prices to be revised downward. And while some argue that demand for soft commodities might be better supported, I suspect that the link between the run-up in food and the run-up in energy prices is strong enough that a correction in energy quotes is likely to produce some correction in food prices as well. That in turn is likely to produce a new set of Brazil forecasts and also a new set of forecasts for the region.

Latin America: Playing the hand

Our global call is a mixed one. It is the collected work of seasoned economists from around the globe. But somehow it strikes us as odd. Our US team is now forecasting a recession and our European and Japanese forecasts are highlighting a slowdown. Our European economists, Eric Chaney and Elga Bartsch, now see a modest credit crunch taking its toll on European growth over a longer period than they had originally anticipated and have cut 2008 growth from 2% to 1.6% (see “Euroland: Slower Growth for Longer”, GEF, December 6, 2007). In Japan, our team is shaving off even more by lowering growth for 2008 to 0.9% from 1.9% previously. In contrast, decoupling appears to be the watchword in most of the emerging economies and in our commodity outlook.

When faced with global uncertainty, we tend to retreat to what we feel that we do know about Latin America.

First, the remarkable gains that we have seen in Latin America during the past five years have come as the globe has experienced an extraordinary period of above-trend growth – a stretch of above-trend years that we have not seen in nearly four decades. And our review of Latin America growth dynamics suggests that the principal drivers of better growth in the region have been a series of external factors reflected in a period of favorable financial and credit conditions, strong global demand and a remarkable surge in the terms of trade.

Indeed, whether you look at Brazil or Mexico or Argentina, the bulk of the upturn in Latin America’s performance since 2003 has come from external factors – the hand that Latin America has been dealt. To illustrate, Daniel Volberg has run a series of models trying to determine the role that external conditions (terms of trade, external demand and international financial conditions) have played in determining growth in the region. The most dramatic case is that of Argentina: had external factors played out since 2003 as our model predicted in the ensuing years, Argentina’s growth would have averaged 3.7% per annum rather than the observed 8.8% – a difference of just over five percentage points. In the case of Brazil, the gap would have been 1.6 percentage points, largely eliminating the recent growth spurt.

Our initial work also suggests that a shock, or reduction, in the terms of trade by 5% would produce a string of 1-1.5% declines in activity in Argentina over four quarters and a similar string of 0.8-1% declines in Brazil. In contrast, in Mexico the change appears to be much more muted. Of course, a shock to the terms of trade is likely to also be accompanied by a wider deterioration in external conditions – including a more challenging financial environment – and that in turn could have an even more pronounced effect on wiping out much of the upturn that the region has seen in recent years.

Second, Latin American policy makers have not done enough to ensure that the current growth boom gives way to more sustainable, long-term growth. Long-term growth dynamics depend on boosting human capital and infrastructure, on the rule of law and a regulatory environment that promotes competition and fosters entrepreneurial efforts. On a host of metrics that attempt to measure progress on those fronts, Latin America has done poorly in recent years. Not only does Latin America have the poorest institutional and regulatory environment on our measures based on the World Bank’s Doing Business Survey, but the pace of reform has also lagged. The World Bank notes that in the 2006-2007 period, only 36% of the countries in Latin America made at least one positive reform, compared to 79% of Eastern European nations and 63% of South Asian nations. The record in earlier years was not much better (see Macro and Micro Radars, 2nd Half 2007, October 17, 2007). Latin America earns particularly weak marks on the tax category, which includes notoriously arcane tax systems and relatively high tax burdens.

The good news

Faced with a US recession, Latin America and the ‘decoupling’ thesis are likely to be tested in 2008. But there is good news of course, which we have been highlighting during recent years.

First, we have seen little of the excesses common in past upturns in the region. The abundance of the past five years has not produced either the ballooning trade and current account deficits fueled by consumer spending seen in the past in Latin America, nor widening fiscal deficits, nor the spectacle of central banks burning through reserves to prop up woefully overvalued currencies. I remember living in Mexico in 1994 as the current account ballooned and was on its way to 8% of GDP. I remember covering Chile in 1997 on the eve of the Asia crisis, when the imbalance was nearly as large, and the growing imbalance in Brazil in early 2001.

Second, Latin America appears to be in better shape than in the past to deal with a downturn in the global economy. If the globe slows by more than our global team expects, then so should Latin America. But the risk that a downturn in growth leads to a major financial crisis in the region’s largest economies is lower today than in the past. With the trio of massive reserve accumulation, current account surpluses and better fiscal results, Latin America has its house in better order today than in decades.

The clearest example of the improvement in the region comes from Brazil. Here is an economy that epitomized all of the risks of emerging markets just a little over four years ago, when investors were worried that it was on the brink of debt default and capital controls. Today, Brazil has international reserves covering two times the entire gross public external debt stock and nearly all of its public and private external obligations. And, as Marcelo Carvalho likes to highlight, Brazil has made important strides in improving the structure and composition of its public sector debt stock.

Third, some countries are making progress on the reform front. Faced with record oil prices, Mexican policymakers this year took a significant step forward in weaning the public finances off of the oil addiction which has long characterized Mexico’s public finances. The fiscal reform came after an important patch on public finances from a reform of the public workers’ pension system was approved by congress. And there are increasingly encouraging signs that an important reform in Mexico’s energy sector is slated for early next year as well as moves to provide greater competition in the telecommunication space. None of these moves immunize Mexico from the hand it is likely to be dealt by a US recession in 2008, but as a macro specialist, all are worthy of praise. They are steps, each incomplete, which should help improve Mexico’s long-term growth profile

Bottom line

If the US recession unfolds in 2008 as our US team expects, look for winners and losers as Latin America faces the first major test of the decoupling thesis. Not everyone is likely to agree on what victory means. For Brazil to emerge with weaker growth but no financial crisis represents a victory from my vantage point. While Mexico’s growth may once again be the poorest in the region, I would argue that its progress on the reform front represents an even more important victory. Meanwhile, watch out for economies that have made limited progress or moved backwards on the micro reform front and simply enjoyed the dramatic boost that abundance brought to growth.

After four years of abundance, the region may face the ultimate test in 2008 of whether policy makers have laid the foundation for sustainable growth. The greatest danger to the region is confusing heady growth brought about by externally driven upturns from more sustainable growth that arises from boosting infrastructure, improving human capital and creating a regulatory environment that promotes competition and helps to foster a thriving entrepreneurial base. That distinction may prove to be more important than ever before.

By Gray Newman & Daniel Volberg New York
Morgan Stanley
December 11, 2007