Latin America in a Global Context - Economic Briefing October 2008

Global Outlook Deteriorates Sharply

The global outlook is rapidly deteriorating as the financial crisis has spread like wildfire through global capital markets, eroding trillions of dollars in market capitalisation. While markets rebounded after governments announced a host of measures to restore confidence, the major advanced economies all seem headed for a recession. Despite a massive US$ 700 billion bailout, the United States is already experiencing a major slump, as downtrodden consumers and difficult financing conditions are weighing heavily on the economy. Similarly, Europe is headed for a notable downturn. While European leaders have acted decisively and prepared a bank bailout that exceeds US$ 1 trillion, the measures will only serve to mitigate the slump, as the major EU economies are already in or near a recession. Japan’s financial system currently seems better prepared to withstand the crisis but the economy is nevertheless headed downwards. Japan’s businesses are increasingly pessimistic as export prospects wane and consumer sentiment stays near record lows, fuelling concerns that private consumption is unlikely to pick up the slack of faltering exports. Latin America’s growth prospects are also deteriorating. However, years of strong export growth have strengthened the region’s external balances and buttressed public sector finances. As a result, Latin America is well prepared to weather a period of more adverse economic conditions and will continue to expand at a solid albeit more moderate pace next year.

Governments stave off financial sector meltdown but global economy poised for slowdown

The meeting of the Group of Seven in Washington concluded on 11 October, followed by the announcements of European leaders in Paris on 12 October seem to have been sufficient to stem the slide in confidence that had seized investors around the globe in the weeks following the bankruptcy of Lehman Brothers.  With the threat of a complete meltdown of the global financial system averted for the time being, eyes are turning towards the impact of the financial crisis on the real sector.  So far, the effects on the real economy have been limited.  However, in its October outlook, the International Monetary Fund (IMF) estimates that the global economy is decelerating quickly and that many advanced economies are close to or moving into recession.  Based on purchasing power parity, which assigns a greater weight to faster growing emerging markets, the IMF sees global output growth slowing from 5.0% in 2007 to 3.9% in 2008 and falling to 3.0% in 2009 (based on market exchange rates underlying FocusEconomics projections: 2007: 3.7%, 2008: 2.7% and 2009: 1.9%).  Thus, the global economy will end a four-year string of near 5% annual growth, which had constituted its highest sustained rate since the early 1970s.  The Fund expects global output growth to recover progressively in 2009, but recognizes substantial downward risks to this scenario.  For the Western Hemisphere (which is largely identical to the Latin America aggregate covered in this publication), the IMF expects growth to slow from 4.6% this year to 3.2% next year and is thus in line with the current Consensus Forecast.  However, given the speed of events, Consensus Forecast panellists are still adjusting their projections for Latin America to reflect the latest developments and will likely further revise their projections for 2009 downwards in the coming months.  That said, Latin America is better prepared than ever to withstand the effects of a global financial sector crisis.  Due to the commodity price rally and the exports boom observed during the last five years, the region has registered five consecutive years of current account surpluses.  As a result, Latin America has accumulated more than US$ 438 billion in international reserves, and due to the positive external balance results, governments across the region have been able to improve fiscal results substantially.  Last year, the Latin American countries achieved a reduction of the region’s fiscal deficit from the 0.4% of GDP recorded in 2006 to a balanced fiscal result, the first time without a deficit in more than 20 years.  As a result, governments are in better shape to face this economic slowdown and even have substantial leeway to stimulate their economies by raising public spending and thus compensate for weaker external demand.

Latin America will decelerate amid waning external demand and lower commodity prices

On average, the Latin American region will slow 1.2 percentage points in 2009, as growth drops from 4.5% this year to 3.3%.  Among the seven major economies, Peru will experience the most notable slowdown.  In part, the deceleration in Peru is due to a substantial decline of key commodity prices during the past weeks, as the market factors in lower demand amid the global slowdown.  As one of the largest metal miners in the region, Peru will suffer a direct impact on exports growth.  In addition, declining commodity prices may also induce investors to postpone mining investments that had been planned amid record high commodity prices.  However, more than anything, the slowdown in Peru reflects a very strong growth performance in 2008, when the country is estimated to be the fastest growing economy in the region with a projected growth rate of 8.9%.  In fact, with an anticipated GDP growth rate of 6.5% in 2009, Peru will continue to lead the region in terms of economic growth despite the slowdown over 2008.  Next to Peru, Argentina will experience substantially slower growth, as panellists see the economy expanding only 3.8% in 2009, following on a 6.4% expansion this year.  In part, the adjustment in the growth rate also reflects a normalisation of the growth trajectory, following on a six-year long rebound after the devastating recession between 1999 and 2002.  However, Argentina may suffer more than its regional peers from the current financial crisis.  As banks around the globe are deleveraging and investors move their funds to safer asset classes, Argentina may find it particularly difficult to regain access to international capital markets at a moment when the country may need to raise cash as declining commodity exports curb tax revenues.  After the country halted payments on US$ 95 billion of debt in 2001 - the biggest sovereign default ever - about a quarter of bondholders rejected an offer in 2005 that paid investors 30 cents per dollar of defaulted debt and a restructuring of US$ 20 billion of defaulted bonds is still pending.  Venezuela will also experience a notable downward adjustment of output growth.  Consensus Forecast panellists expect the Venezuelan economy to expand 3.7% next year, well below the estimated 5.6% growth rate estimated for 2008 and in fact the slowest pace since the 2002/2003 recession.  The slowdown in Venezuela mostly reflects the drop in oil prices observed during the past months.  More than any other country in the region, Venezuela precariously depends on high oil prices to maintain the status quo.  In 2007, oil accounted for 90% of total exports, more than a quarter of GDP and more than half of total government revenues.  In the week up to 10 October, oil prices plunged 17% on concerns that a global recession will cut demand for fuel and since reaching a record US$ 147.27 per barrel in July, oil prices have dropped 45%.  Oil prices rebounded after the announcement of financial rescue measures on 11/12 October and OPEC is now deliberating production cuts, but prices are unlikely to soon reach the high levels seen in mid-2008.  In addition to the oil price decline, Venezuela is suffering from the unorthodox economic polices adopted by the Chávez administration, including price controls, nationalisations and an exchange rate freeze, which provide little chance that the economy can prosper without the windfall of soaring oil prices.  On the upper end of the slowdown scale, Mexico will shed only 0.2 percentage points of output growth between 2008 and 2009.  However, the moderate adjustment is due to a low comparison base, as the Mexican economy is estimated to grow a paltry 2.2% this year.  With around 80% of its exports going to the United States, Mexico is intimately linked to the U.S. business cycle.  In addition, remittances from Mexicans working abroad have become an important source of revenue for Mexico and the country thus stands little chance to prosper, as a recession seizes the U.S. economy.

Inflation to drop amid lower commodity prices and decelerating demand

Pushed up by surging fuel and food prices, Latin American inflation is estimated to reach 8.6% this year, which would represent the highest level in six years. Next year, a combination of slowing demand and falling commodity prices is likely to contain price pressures.  However, at a projected 7.4% regional average in 2009, inflation will remain high in Latin America.  Currently, several countries continue to experience strong price pressures amid sharp food price increases, supply constraints and public sector wage increases.  Moreover, while the recent moderation in international commodity prices should ease some of the pressure, several Central Banks have lost credibility by letting inflation rise well beyond established target levels.  Restoring this lost credibility will prove to be a lengthy and, in some countries, costly process.  Among the seven major economies in the region, Chile will enjoy the most pronounced decline in inflation between 2008 and 2009.  Consensus Forecast panellists expect inflation to decline 4.0 percentage points from this year to the next.  However, the decline reflects an elevated inflation rate this year.  With an estimated year-end rate of 8.7% in 2008, inflation almost triples the Central Bank’s medium-term 3.0% inflation target.  Moreover, despite the moderation in price pressures predicted for next year, inflation will stay considerably above this target rate, at 4.7% by the end of 2009.  Following Chile, Peru will experience the second strongest decline in inflation, a 2.0 percentage point drop between 2008 and 2009.  Nevertheless, at the 4.0% year-end rate projected for 2009, inflation will remain well above the Central Bank’s target.  Following Chile and Peru, Venezuela will experience a 1.6 percentage point decline in inflation between 2008 and 2009.  However, coming from an estimated 31.6% this year, inflation will continue to constitute a major challenge for the Chávez administration at a projected 30.0% year-end level for 2009.  The country is suffering from the effects of short-term oriented economic policy, which sought to contain price pressures by price controls.  As a result, Venezuela is now facing supply constrains in several important sectors.  Combined with an artificially strong exchange rate and lush public sector spending, monetary authorities stand little chances of reining in inflationary expectations, and inflation will again reach the highest level in the region next year.  Argentina is the only country in the region that will experience accelerating inflation next year.  Consensus Forecasts panellists expect official inflation to reach 12.1% by the end of next year, which is 2.8 percentage points above the 9.3% expected for this year.  However, since the introduction of a methodological change in measuring consumer prices in 2007, the official inflation data have been received with suspicion and most analysts believe that actual inflation in Argentina is considerably higher than the officially reported rate.  Based on a separate Consensus Forecast of panellists that are tracking actual price developments, non-official inflation is estimated to reach 23.5% in 2009, which is virtually unchanged compared to the 23.6% projected for this year.