In a move that shocked global financial markets, the People’s Bank of China allowed the yuan to depreciate nearly 2% against the U.S. dollar in mid-August, which has weakened demand for the commodities of Brazil, Argentina, Chile and other Latin American countries. The surprising change in policy, amid slowing growth in China, was the largest devaluation in the last two decades.
For the currencies of Latin America, 2015 had already been a difficult year. As of mid-August, the Brazil real lost 33% of its value relative to the dollar, the Mexican peso dropped by 19%, the Colombian peso by 35%, and the Argentine peso by 10%. Shortly before the Chinese devaluation, Christine Lagarde, managing director of the International Monetary Fund, predicted there would be “even more volatility in the currencies of the region, especially when the Fed (the U.S. Federal Reserve Board) raises [U.S.] interest rates.”
Analysts in Latin America agreed that the likelihood of higher interest rates in the U.S. – almost certainly to usher in a stronger dollar – is among the chief causes of the rough patch that Latin American currencies have been undergoing. Janet Yellen, Fed Chair, has forecast that U.S. rates will rise before the end of this year. Many economists had been expecting the Fed to increase rates at its September meeting, but following recent turmoil in worldwide equity markets, that seems less likely.
China’s recent devaluation is an about-face, given that it had allowed the yuan to float up gradually over the past decade. What is the likely short and medium-term impact of the yuan devaluation on the already troubled economies of Latin America?
Needing a Boom
According to Gary Clyde Hufbauer, senior fellow at the Peterson Institute for International Economics, “the whole economy of Latin America is in a very discouraging position. What Latin America really wants is a boom in China, and if India could boom, too, that would great. That would suck up a lot of the raw materials” that Brazil, Argentina, Chile and other nations of the region have in great supply. But of course that is highly unlikely, and along with many other economists, Hufbauer suspects that China’s official growth figure of 7% this year is an overestimate, given “that figure does not comport with the industry figures for imports and exports.”
“The question is whether [the devaluation of the yuan] is going to get a whole lot larger as the Chinese policy evolves.” –Gary Clyde Hufbauer
Should Latin Americans view the devaluation of the yuan as a significant threat to their future growth? “So far, the devaluation hasn’t been very big,” Hufbauer says. “The question is whether it is going to get a whole lot larger as the Chinese policy evolves.” If it does get a lot larger, that could “give Latin America an awful lot of competition [from China] for their industrial exports” as well as some categories of industrial goods in domestic markets. Meanwhile, there is much uncertainty about how far China will carry its new policy.
In Brazil, uncertainties about its currency are magnified by the country’s negative GDP growth and political scandals surrounding President Dilma Rousseff. Brazil’s economy is expected to shrink by 0.15% next year, following a sharp contraction of more than 2% forecast for this year, according to a weekly central bank survey of economists published in mid-August. Brazil has not experienced two years of negative growth since the Great Depression of the 1930s.
Felipe Monteiro, a professor at INSEAD and senior fellow at Wharton’s Mack Institute, noted that in Brazil, “there is a lot of uncertainty” not only in terms of government policy, but also in terms of corruption. “We know that there will be a number of politicians involved” in corruption scandals. But “we don’t know whom the prosecutor will prosecute.”
Meanwhile, finance minister Joaquim Levy is pursuing an austerity plan aimed at reducing Brazil’s fiscal deficit and restoring business confidence. Although Monteiro approves of the plan, he notes that Levy is having a “tough uphill battle” in terms of winning legislative approval for reform measures at a time when “the economy is not doing well, and when, politically, things are very volatile and fragile. When you put all those things together, the situation doesn’t look very bright.” Monteiro adds, “I see the yuan devaluation adding to that uncertainty…. With all the other elements being negative, we don’t need an additional source of volatility and pressure.”
Monteiro also notes: “To me, it’s more a question of what exactly does this [new Chinese policy] mean” for Latin American economies over the longer haul. “It’s more about China’s intentions and less about any immediate impact” on the economies of commodity-producing nations of the region. The yuan has been appreciating for a long time versus the real, in large measure because of political and economic events in Brazil and concerns about whether the rating agencies are going to downgrade Brazil, he explained.
While Monteiro sees “no immediate impact” of the Chinese devaluation on Brazil, he does see “a big concern in the background” longer term. “A big question mark is what will the Chinese government do next? Everyone has the impression that any further measures by the Chinese government [to pursue further devaluations of its currency] will just compound internal problems” in Brazil. Monteiro foresees a direct impact on Brazil’s commodity prices, because China is such a heavy buyer of Brazil’s output. But he does not expect the new policy to have much impact on foreign investment in Brazil, which it’s hoped will play a critical role in reviving the Brazilian economy.
“The problem resulting from the economic crisis and the violent devaluation of these currencies is definitely a political one.” –Sergio Costa
“No one is saying, ‘We are not going to be doing any business in Brazil anymore.’ I haven’t seen any conversations along those lines. The question [politicians and others are asking is], ‘When are we [investors] going to be back in the game, ready to make long-term investments again?’” says Monteiro. “Everyone is just waiting for clarity on that. Some of us thought that it would be early 2016, but now it doesn’t look like that.”
Oscar Ugarteche, professor of economics at UNAM, the National Autonomous University of Mexico, notes that the region’s currency devaluations reflect a readjustment in the levels of U.S. interest rates, following the longest period of very low rates in U.S. history. That caused investors to seek higher returns abroad, but the easy money policies in the U.S. are expected to end soon. “Now, interest rates are returning toward the point where they were before that.”
Ugarteche further notes that an extended period of historically low interest rates in the U.S. – between 0 and 0.25% starting in December 2008 – led to the depreciation of the dollar, and a peak in the prices of raw materials, a key component of many regional economies. As a consequence there was an abrupt increase in the international reserves of emerging economies, which led to an appreciation of their currencies. “Now the process is moving in the opposite direction. Starting from March 17, 2014, [when Yellen first made clear the Fed’s intention to raise rates in the short term,] there has been a relatively rapid drop in the price of raw materials, and a withdrawal of capital from those countries, with a resulting devaluation of their currencies. Along with that, economic growth rates [in emerging economies] have been cooling at the same pace that they have been growing in the mature economies,” Ugarteche points out.
Sergio Costa, a professor at the IESE Business School and Barcelona-based Pompeo Fabra University, also cites slowing growth in China as a drag on Latin American economies. Beyond that, he believes “the problem resulting from the economic crisis and the violent devaluation of these currencies is definitely a political one.” All the major countries of the region will continue to experience distortions in their governments, “whether because of corruption scandals, or mismanagement of their economies and public resources, or changes towards more radical ideals, or because of the close relationship between organized crime and political power. But the most interesting thing is that these countries have decreased the proportion of their business that they do with the United States and Europe and, and as a consequence, increased the proportion that they do with China and Russia.”
According to a report issued in July by the United Nations Economic Commission for Latin America and the Caribbean (ECLAC), other major factors that explain the declining value of the region’s currencies include “the reduced availability of funding in international markets; the reduced appetite for the assets of emerging countries; decelerating growth rates in the countries of the region; and lower interest rates that result from the relaxation of monetary restrictions.”
Devaluations will have direct consequences economies undergoing them – though not always negative ones. According to Ugarteche, “Direct investments in those countries … are already declining because most of them involve primary products. And since the prices for commodities have declined so much, it is no longer profitable to invest in new copper mines or new oil wells, for example.” Most affected will be the countries that rely heavily on commodity exports “such as Chile, Peru, Bolivia, Ecuador and Venezuela.”
“Since the prices for commodities have declined so much, it is no longer profitable to invest in new copper mines or new oil wells.” –Oscar Ugarteche
Nevertheless, he does not believe that rising U.S. interest rates will hurt creditors in Latin America compared with such problems in other regions since “Latin America has almost no external public sector debt.” On the plus side, he thinks the region’s devaluations “can be something good for exports of manufactured goods and services, for stock markets and for real estate markets” because they can lower inflated prices.
Ugarteche also notes that all of this is occurring at a time when the exchange rates of South American currencies “are being determined by expectations, in such a way that when U.S. rates really do rise, it won’t have a big additional impact.” He adds that real interest rates in the U.S., Great Britain, the eurozone and Japan “must return to their historic levels, above the inflation rate plus some remuneration. This will permit people to see the real growth of emerging economies in a normal context, rather than in an extraordinary one.”
Costa, meantime, forecasts “a significant increase in inflation, and a loss of purchasing power … which will lead to a decline in internal demand.” But imports will become more expensive, “which will reduce demand for foreign products and may increase domestic demand. Thus, higher exports and lower imports should increase overall demand and GDP.
While each country must adopt its own distinctive monetary and fiscal policies, analysts point to some key considerations. In its latest report on economic prospects for Latin America, for example, the IMF notes that foreign exchange flexibility can play a fundamental role in facilitating [a nation’s] adjustment to more difficult external conditions. “It is critical that economic authorities guarantee the solidity of public finances and that they maintain under control the vulnerabilities of the financial sector, given that reduced profits, more difficult conditions for financing, and the strengthening of the dollar are putting to the test the resistance capacity of the debtors.”
Adds Costa, “Overwhelmingly, one must look for the sort of political stability that generates security for the international investor and, as a result, for the domestic ones. With respect to monetary policies, central banks can contain devaluation through an increase in domestic interest rates combined with interventions in the foreign exchange markets….”
Finally, Costa notes that authorities should do everything possible to prevent inflation rates from reaching uncontrollable levels, and to assure themselves that the economy can continue to grow in a sustained way, without generating too much social inequality. “Governments must make labor markets more flexible, while searching for productivity growth, because under such [unfortunate] conditions, unemployment often grows as a result of the economic imbalances that are generated.”