Finance and Investment

Will the Economies of Latin America Become Overheated?

On April 11, 2011, the International Monetary Fund published a report titled, "World Economic Outlook: Tensions from the Two-speed Recovery." In it, the IMF raised its forecast for 2011 economic growth in Latin America to 4.7% from a previous forecast of 4.3%. While this is excellent news for the region, it doesn't seem that the good news will continue for long: The report also warned that a group of nations it called the "Financially Integrated Commodities Exporters" -- Brazil, Chile, Colombia, Peru and Uruguay -- reveal "signs of a potential overheating, in which capital flows have already caused tensions."

German Sanhueza, professor of management at the University of Santiago de Chile (USACH), agrees with the IMF. Sanhueza notes that the overheating is directly due to increased public spending and growth in domestic consumption, which have also raised domestic prices and contributed to inflation. Adds Francisco Castañeda, also a professor of management at USACH, "This means there are serious risks for the region, such as the potential for an abrupt contraction in GDP over the short term, and a series of restrictions on fiscal policy that have until now been expansive in the majority of Latin American countries."

Reasons for Overheating

Nevertheless, Igal Magendzo, a professor at the business school of the Adolfo Ibáñez University in Chile, says that the real reason for the economic overheating in Latin America is the rapid economic recovery that the region has experienced after taking a beating from the global financial crisis of 2008. In the wake of the economic disaster, he notes, "Latin America managed to move forward rapidly, thanks to the high price of the commodities that it exports to the rest of the world [including copper, iron, zinc, cellulose, coffee, wheat, salmon and soy among other foods], leading to the current export boom and a notable increase in the revenues of the region." He adds that a key factor behind the increase in the price of primary products is the strong performance of China, which has strengthened its position as the principal buyer of the primary products that the region exports.

In addition, notes Magendzo, Asian countries and oil exporters continue to save a significant portion of their earnings. "In a global situation where the developed world is perceived as very risky and not very dynamic, Latin America seems like a very attractive place to put those savings," he says.

Without doubt, the problems facing the United States -- which has yet to move completely beyond the subprime crisis -- and such European nations as Greece, Ireland and Portugal have led foreign investors to redirect capital toward Latin America, notes Guillermo Paraje, professor at the business school of the Adolfo Ibáñez University. "That is reflected in the strong results in the stock markets of Latin American countries, almost all of which have shown gains."

All of these factors have led to significant economic growth in the region, notes Paraje. "Peru leads the way, growing by 8.9% in 2010, followed by Brazil, which expanded by 7.5%. Chile has not done at all poorly, growing by 6% last year. Without doubt, these growth rates are comparable to those in the Asian countries."

However, despite these auspicious conditions, Magendzo warns that Latin America "cannot rest on its laurels." It cannot continue to be confident about the high price of primary products in international markets -- much less rest assured that there will be generous flows of foreign capital to sustain its growth, "since these situations are transitory."

Sanhueza goes further. He warns that there is a possibility that at any given moment China will face much higher inflation rates and have to raise its interest rates significantly. "And when that happens, there is a strong possibility that prices will drop for the basic products that the region exports around the world."

The Special Case of Peru

Experts note that Peru may be one of the Latin American countries most likely to suffer from overheating, considering the fast pace at which it continues to grow -- 8.9% -- and the worrisome increase in its inflation rate.

"Eight months ago, [inflation] was at an annual rate of about 0.5%, while it is now close to 2.5%," notes Waldo Mendoza, professor of economics at the Pontifical Catholic University of Peru. Nevertheless, Mendoza adds that Peru has already taken certain measures. The Central Bank has already raised its interest rate to 4%, up from 3.75%. "The Minister of Economics and Finance has established a policy for contracting [the economy]." In his view, the Peruvian Central Bank's policies, in addition to the policies of the Minister of Economics, will prevent inflation from continuing to increase at annual rates of 5% to 6%.

Moreover, the Peruvian people will be electing a successor to outgoing President Alan Garcia this year, notes Efrain Gonzáles, professor of economics at the Pontifical Catholic University of Peru. "In this situation, we should expect some changes in the current economic policy." On June 5, Ollanta Humala, the leftist presidential candidate and former military officer, will face off against Keiko Fujimori, daughter of ex-president Alberto Fujimori, a right-wing populist, in the second round of the elections. According to a recent report in El Comercio, a local newspaper, Humala is favored by 42% of voters, compared with only 36% for Fujimori. Humala wants to nationalize the hydrocarbon sector and raise the country's mining royalty-- that is to say, increase the income tax on mining companies.

What can the countries of the region do to cool off their overheated economies? Mendoza says this is an enormous challenge, although he notes that "in the case of Peru, it is easier [to achieve] since, with the country's annual growth [currently] near 10%, cooling off its economic system a bit would not be so harmful, and the Central Bank could easily raise interest rates a bit in order for the country to grow by 7% or 8% a year."

By contrast, in other Latin American countries where growth rates are lower, it is harder to undertake contractive fiscal and monetary policies. "This may be the case in Venezuela, which is currently undergoing a recession. Ecuador is another country that is also not growing a lot." Meanwhile, in Brazil, Chile and Colombia, notes Mendoza, where growth rates are above their usual levels, the classic tools of stabilization -- such as raising interest rates and restricting public spending -- can be the optimal instruments for preventing inflation from getting out of hand.

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