Latin America in a Global Context - Economic Briefing October 2005

Japan Endorses Reform, Germany Remains Undecided and Hurricanes Overshadow US Economy

Within one week, the world’s second and third largest economies have elected new governments, as the leaders of both countries called for early elections amid a stalemate on economic reforms. In Japan incumbent President Junichiro Koizumi won a landslide victory, providing him with a strong mandate to implement his economic reform agenda. In Germany, in contrast, the elections resulted in a yet un-dissolved stalemate between the two leading parties, which are now forced to form a coalition to avoid re-elections. Thus, Japan is likely to step up its economic reform process, which could revive the long-ailing economy. In Germany, reforms are likely to remain less ambitious, as any initiatives beyond the lowest common denominator stand little chances to become adopted. The U.S. economy is growing at a robust pace and the Federal Reserve continues to tighten its policy despite potential repercussions of the Hurricanes Katrina and Rita. Meanwhile, the outlook for Latin America remained unchanged, as a deteriorating outlook for Mexico compensated for better prospects for most other economies in the region, which continue to benefit from strong commodity prices.

Katrina Hurricane damages exceed costliest storm to date

With life getting back to normal in the Gulf region following on the disastrous 29 August Katrina Hurricane and the more moderate 24 September Hurricane Rita, a clearer image of the economic impact of the disasters is emerging.  According to historical evidence from similar disasters in the past, the impact of storms of this magnitude is typically only of a temporary nature as reconstruction efforts compensate for output loss in the wake of destruction.  However, the damage caused by Katrina even exceeded the costliest storm to date, Hurricane Andrew in 1992.  According to estimates from the Congressional Budget Office (CBO) from 6 October, damage to homes, government buildings, oil refineries and businesses will total between US$ 70 billion and US$ 130 billion, which is considerably lower than original guesstimates provided in the immediate aftermath of the disaster.  Of the total, at least US$ 40 billion in damages are covered by private insurance.  However, current government figures do not include the immediate relief and rescue efforts, which have been paid for by the US$ 62 billion Congress has already approved.  But even including the relief and rescue efforts, the total burden on the budget will fall short of US$ 200 billion, according to the CBO, which sees the total damages in the vicinity of US$ 150 billion.  However, even if closer to the maximum estimate, the total loss is sure to be insignificant when compared to U.S. economic output – in 2004 gross domestic product (GDP) amounted US$ 11.7 trillion.  Even when considering output disruptions in the three most affected states by Katrina - Louisiana, Mississippi and Alabama – the direct impact on the national economy is limited since the three states account for less that 3% of total U.S. output. 

Damages to oil sector send oil prices soaring to new highs

However, the economic ramifications of the natural disasters are more far-reaching than the direct property damages and the concomitant output losses.  The region hit by the storms is an important centre of the U.S. energy sector.  Not only did Katrina batter oil and gas production platforms in the Gulf of Mexico but the hurricane also forced several Louisiana and Mississippi refineries to close and the loss of electric power in the region affected several major pipelines that deliver oil to other parts in the country.  Furthermore, while Katrina affected mainly oil production platforms, Rita affected predominantly exploratory rig activity.  Thus, Hurricane Rita damage is forcing companies to delay exploration activities.  As a result of the damages, gasoline inventory levels that were already at a low prior to the storms have dropped further.  Markets reacted promptly.  In the aftermath of Katrina, the price for West Texas Intermediate (WTI) briefly pierced the US$ 70 per barrel threshold, as concerns about oil supply shortages rattled the markets.  However, initial concerns faded quickly as the International Energy Agency (IEA) announced on 2 September that its 26 industrialized member countries would release 2 million barrels per day (bpd) of oil for 30 days to compensate for the loss of U.S. crude and refining output.  As a result, the WTI oil price dropped back down to US$ 63.00 a barrel by mid-month only to rise again to US$ 66.1 by 30 September amid renewed concerns about protracted oil supply shortages in the wake of Rita.   However, more important for consumer confidence and thus the development of the entire economy is the level of gasoline prices, which in turn depend largely on refining capacity. 

Refinery outages prompt concerns about gasoline supply

On 28 September, the Energy Information Administration (EIA) stated that refinery outages resulting from the hurricanes amounted to lost production of about 1.3 million barrels per day (bpd) for gasoline, over 700,000 bpd for distillate fuel and nearly 400,000 bpd for jet fuel, amounting to a total of over 3.5 million bpd that is currently offline or as much as 15% of U.S. oil refining capacity.  Therefore, with refineries not yet back to full capacity, gasoline price are likely to remain high.  According to EIA information, the average U.S. retail gasoline price in the week up to 3 October reached US$ 2.93 per gallon, up 99 cents from a year ago.  The high gasoline price puts another drain on the already-stretched budgets of increasingly indebted households, which are a key determining factor for the overall health of the U.S. economy. The CBO claimed that evidence to date suggests that overall economic effects will be “significant but not overwhelming”.  On 6 October, the CBO reiterated its initial estimate that the devastation in the Gulf Coast region could cost as many as 400,000 jobs but reduced its cost estimate in terms of economic growth from up to a full percentage point in the second half of the year to half a percentage point..

U.S. economy continued to grow at robust pace prior to Katrina Hurricane

The economy was relatively robust prior to the storms.  According to final estimates released by the Bureau of Economic Analysis from 29 September, the economy expanded by 3.3% in the second quarter, which was unchanged from the preliminary estimates and only down one tenth of a percentage point from the advance estimates released earlier.  Therefore, second quarter growth was considerably slower than the 3.8% pace registered in the first quarter.  However, the slowdown mostly reflected companies drawing down inventories at a greater scale, which sliced 2.14% from the second quarter expansion.  Without the negative impact of the inventories, gross domestic product (GDP) would have grown by 5.4% and if higher gasoline prices do not eat too much into private consumption, inventories will have to be replenished eventually, suggesting stronger growth for the remainder of the year. 

Storms cause dent in economic activity towards the end of this year but reconstruction to lift activity next year

Economists are still gauging the impact of both storms on the U.S. economy.  With three quarters of the year over, the Consensus Forecast for the full year 2005 remained virtually unchanged over last month at 3.6%.  However, Consensus Forecast panellists have pared their outlook for the third quarter by one tenth of a percentage point from 3.8% expected last month to the current 3.7% and see the impact mostly concentrated in the final quarter 2005, for which growth forecasts dropped from a 3.6% expansion projected last month to 3.2% growth.  Next year, however, reconstruction efforts will kick in and should lift economic activity beyond the pace previously anticipated.  Consensus Forecast panellists maintained the growth forecast for the first quarter at 3.4% but lifted their projections for the second quarter from 3.4% to 3.5%, for the third quarter from 3.1% to 3.2% and for the fourth quarter 2006 from 3.1% to 3.3%.  Further downward revisions to the growth outlook are possible if the effect of disruptions in the oil industry and the impact of higher gasoline prices on consumption become more noticeable than anticipated.

Overwhelming majority provides Koizumi with strong mandate to continue economic reforms

On 11 September, Prime Minister Junichiro Koizumi won a landslide victory with 296 seats of the 480-member lower house of parliament.  Following the rejection of the postal privatisation bill in the upper house on 8 August, Koizumi had called for new elections for the lower house two years ahead of schedule.  The upper house rejected Koizumi's proposal to privatise the postal system after rebellious members of the prime minister’s own ruling Liberal Democratic Party (LDP) joined the opposition to vote against the reform bill in a 125 to 108 vote against the government.  Ever since assuming power in 2001, President Koizumi had always declared the reform of Japan Post (JP) a centrepiece of his political agenda.  The postal entityis not only the nation's largest employer but also as a financial institution is the world’s largest savings bank.   However, opponents within the LDP claimed that the reform of the postal system would result in job losses.  Therefore, the defeat of the JP bill by dissidents within the LDP did not come as a surprise and Koizumi had threatened to call for early elections if the bill was defeated prior to the vote.  Since Koizumi had expelled most of the LDP dissenters who opposed post office reform, the 296 seats grants him a sound majority in the lower house to push through his reform plans.  Moreover, LDP’s coalition partner, the New Komeito party, garnered 31 seats, giving the ruling coalition more than 320 seats or a two-thirds majority.  By securing two-thirds of the lower chamber, the coalition can now pass bills through parliament even when facing opposition in the upper house, where the coalition has only a slim majority.  Faced with negligible opposition, Koizumi is likely not only to push through the postal reform bill but also may embark on more far-reaching economic reform projects before handing over power to his successor in September 2006. 

Consensus more optimistic as Japanese economy continues recovery but deflation lingers

The renewed momentum for economic reforms comes at a time when the economy is already showing clear signs of gaining momentum.  In the second quarter, GDP grew at a 3.3%.  While the figure represents a slowdown compared with the 5.8% expansion registered in the first quarter, the first quarter number was inflated by a bounce-back of consumption that previously been held back by adverse weather conditions.  Moreover, the second quarter growth figure from 12 September was triple the initial August estimate.  Private consumption, which had dragged on the Japanese economy in the past cycle, is recovering, assisted by investment, which grew at a robust pace for the second consecutive quarter.  Moreover, initial data suggest that the economy continued to develop along a healthy trajectory throughout the third quarter.  In August, industrial production rebounded 1.2% in seasonally adjusted after dropping 1.2% in July and spending by households headed by a salaried worker rose a seasonally adjusted 3.2% percent from July.  On the downside, consumer prices remain firmly entrenched in deflationary territory.  In August, core consumer prices, which exclude fresh food, fell 0.1% from a year earlier and Consensus Forecast panellists expect deflation to persist through the end of the year with an annual price drop of 0.13% this year.  However, the economy will recover in spite of the negative repercussions of deflation.  Consensus Forecast panellists have lifted their projections for economic growth this year from 1.9% expected last month to the current 2.0%.  For 2006, the Consensus Forecast is also more upbeat, anticipating GDP to grow at the same 2.0% pace, which is up one tenth of a percentage point over last month’s projection.  The International Monetary Fund (IMF) has also beefed up the 0.8% growth forecast from April this year.  In the IMF’s World Economic Outlook from September, officials project the Japanese economy to expand 2.0% this and next year, which is bang in line with the current Consensus Forecast figures.

Elections in Germany result in stalemate between two leading parties

On 18 September, not even a week after Koizumi won in Japan, elections were held one year ahead of schedule in Germany, the world’s third largest economy.  The election resulted in a stalemate between the two leading contenders incumbent chancellor Gerhard Schröder from the social democratic party (SPD, Sozialdemokratische Partei Deutschlands) and the candidate of the conservatives Angela Merkel from Christian Democratic Union (CDU, Christlich Demokratische Union Deutschlands).  As in Japan, a stalemate on reform prompted the call for early elections.  However, unlike in Japan, the electorate refused to endorse a reform-friendly coalition favoured by the polls ahead of the elections between conservative and liberal elements (FDP, Freie Demokratische Partei).  Instead, voters lifted five parties beyond the 5% threshold necessary to have parliamentary representation and weakened the two leading parties, CDU and SPD.  Preliminary attempts to form a coalition with the smaller political parties failed amid strongly differing positions regarding key policy issues.  Therefore, the only feasible solution at the time being is for a grand coalition of CDU and SPD.  So far, however, both leading parties claim the top job for themselves, which is protracting policy negotiations.  As a result, even two weeks after the elections no clear signs point towards who will be the next occupant of the chancellery.  Moreover, if a grand coalition between the two leading parties is formed, legislative initiatives are likely to reflect the lowest common denominator instead of the more far-reaching reform necessary to revive the ailing economy.

Outlook for Asia improves but IMF sees risk that higher oil prices could derail global economic growth

Growth prospects for Asia continue to improve.  Following on last month’s 0.1 percentage point upgrade to this year’s economic growth forecast for the entire Asian region including Japan, Consensus Forecast panellists beefed up the outlook another tenth of a percentage point this month to 4.2%.  Increasing optimism about economic recovery in Japan accounted for the lion share of this month’s upgrade.  However, the forecast for output growth in non-Japan Asia also inched upwards by one tenth of a percentage point from 6.5% expected last month to the current 6.6%.  The regional average growth forecast for 2005 increased even though oil prices continue to rise to new highs.  In fact, in the IMF’s September World Economic Outlook, officials identify high and volatile oil prices as the key risk to global growth.  Since the end of last year, the oil price has risen by over US$ 20 per barrel and with the market very tight, the IMF does not rule out a further substantial jump in oil prices.  According to the IMF, options markets suggest a 15% chance that the WTI price could rise above the US$ 80 per barrel threshold.  So far, higher oil prices have had a surprisingly moderate impact on global growth, in part because higher oil prices had reflected strong global demand.  However, more recent oil price spikes owe less to demand pressures than to concerns about supply.  The Fund claims that further price increases could have a less benign impact on economic growth, especially if the oil price increases have a significant effect on consumer confidence and therefore consumer spending.  In addition, higher oil prices could also feed through to higher inflationary expectations which could trigger a sharp rise in interest rates with deleterious effects on economic growth.

Growth outlook for Latin America remains unchanged as weaker Mexico offsets improved outlook of other regional economies

The outlook for Latin American output growth this year remained unchanged over the past month, as a more pessimistic outlook in Mexico compensated for improved prospects in most other economies.  As a result, the Consensus Forecast for GDP growth in 2005 for Latin America stayed at 4.0%, following on last year’s stellar 5.9% expansion.  However, prospects for next year improved a notch from 3.7% growth expected last month to the current 3.8% projection.  This month, an improved growth forecast for six of the seven major economies was insufficient to lift the regional outlook, as Mexico was revised downward 0.2 percentage points over last month.  Since Mexico is the region’s largest economy, accounting for 34.6% of total output, a downward revision to the regional behemoth is difficult to offset.  The downward revision in Mexico was mainly motivated by worse than expected developments in the second quarter, exacerbated by continued weak showings in the country’s all-important manufacturing sector.  In addition, with almost 90% of all exports directed to the United States, Mexico is the most likely Latin American economy to suffer from potentially slower growth in the United States towards the end of the year in the wake of the Katrina and Rita Hurricanes.

Venezuela profits from strong oil prices while cyclical rebound persists in Argentina

Venezuela experienced the strongest upward revision to the 2005 GDP forecast, which improved from 6.3% expected last month to 7.4% this month, as the country is benefiting from high oil prices.  While the Venezuela oil price has receded from the US$ 58 per barrel threshold it reached at the beginning of September amid supply concerns in the wake of Hurricane Katrina, most observers expect the oil price to remain high amid continued strong demand combined with a constrained supply situation.  The resulting boost to government income from rising oil prices is helping government spending, a key driver behind the current strength in the economy.   However, given the importance of oil in the economy, the pace of expansion is rather a surprise to the downside.  Argentina experienced the second-strongest upward revision to the 2005 GDP forecast, which was raised from 6.8% expected last month to the current 7.3%.  Following on two years of strong growth, most economists had expected the growth pace to moderate, as the cyclical rebound from the preceding recession is drawing to an end.  However, even though economic activity added 8.8% in 2003 and 9.0% in 2004, the devastating recession that held its grip over the economy for full four years has provided for more cyclical recovery potential than anticipated. 

Brazil outlook boosted as Central Bank eases policy

Consensus Forecast panellists again lifted the growth forecast for Brazil by 0.1 percentage points over last month to 3.3%.  This month represented the second consecutive upward revision, and is primarily motivated by the easing of monetary policy but also a persistence of healthy domestic demand.  Brazil’s Central Bank had kept policy extremely tight for more than a year, resulting in one of the highest real interest rates worldwide, which threatened to suffocate the economy.  However, inflationary pressures have been receding, which has allowed monetary authorities to cut interest rates again.  Finally, growth prospects for Chile, Colombia and Peru also improved over last month.  All three countries benefit from a less pronounced slowdown of the external sector and continued strong commodity prices.