If there is a market that draws special attention in Latin America, it is the market for raw materials. The economies of the region are widely exposed to price fluctuations in markets such as corn, soy beans and copper, not to mention the region’s number-one commodity: petroleum.

At the beginning of this year, the governments of Latin America were very happy to watch how prices in these markets were moving. But their cheers turned into frowns during the summer: The Bloomberg Commodity Index, which tracks prices for 22 raw materials, closed the third quarter of 2016 with a sharp decline, after registering significant increases over the first two quarters of this year. Coincidence or not, ever since this kind of data began to be recorded in 1991, such a pattern has happened in only four years — and when it has happened, in three of those four cases, there was a sharp drop in prices in the subsequent fourth quarter of that year.

These sorts of statistics are not the only factor that is making people pessimistic. So is the way investors are reacting to the situation. From corn to petroleum, the existing oversupply in commodities has been making investors nervous about the future. From mid-August to mid-September, investors pulled $791 million out of exchange-traded funds tracking commodities, a reversal from earlier this year that still left inflows up by $34.1 billion this year. Along the same lines, high-risk hedge funds reduced their exposure to raw materials. Said Rob Haworth, Seattle-based investment strategist for U.S. Bank Wealth Management, which manages an investment portfolio of $133 billion, “There’s just not enough to keep speculators interested. There’s not been enough momentum or follow-through in any commodity price.”

Mauro Guillen, Wharton management professor and head of the School’s Lauder Institute, notes, “The issue is that many of these countries have become addicted to commodities. During the 1950s, 1960s and 1970s, they tried to separate themselves from the commodity cycle by investing in manufacturing. Many of those investments were not very good, so they went through a big crisis during the 1980s. And the funny thing is that since then, especially between 2000 and 2008, these economies became addicted again to commodities. When China’s economy slowed down, and prices for commodities came down, many of these countries – Brazil, Peru, Argentina, Bolivia, Venezuela – got into a lot of trouble. The only exception is Mexico. It does have natural resources, but over the last 30 years, thanks to NAFTA, it has become a manufacturing economy, essentially linked to the U.S. economy. Other than Mexico, all of the others continue to be dependent on the commodity cycle. As for Colombia, hopefully they will find a solution to the peace agreement, and then Colombia will also be able to perform very well.”

A Cyclical Change?

These developments have called into question those voices that had claimed that a cyclical change of raw material prices had begun, following the rising prices experienced during the first two quarters of 2016. “It is hard to know, but I doubt that we are confronting a change in the cycle of primary prices,” says Hernando Zuleta, a professor of economics at the University of the Andes in Colombia. “I believe that in order to have a sustained recovery, it would be necessary for the major economies to grow more rapidly. Moreover, supply factors are involved in these price increases. At the moment, I don’t see any signs that either of those two things is happening.”

“You cannot transform these economies or make them less dependent on the commodity cycle unless you invest in education and infrastructure.” –Mauro Guillen

Zuleta adds, “I believe that in around two or three years, we will see the impact of low prices on the supply of raw materials. Then there will be a lasting increase in their prices.” Since the end of June, the Bloomberg Commodity Index has declined by 6.7%. These losses include a 41% plunge in some of the most important components, including 23% for soy futures, and 11% in petroleum futures. In the last month alone, investors withdrew $991 million from energy sector ETFs and $39 million from raw materials ETFs. Nevertheless, prices of some raw materials, including gold, continue to move strongly upward.

Key Factors in the Market

During the first half of 2016, investors placed their money into raw materials, based on speculation that the United States Federal Reserve would slowly raise interest rates, which would consequently weaken the dollar and make prices of raw materials cheaper for those who hold other currencies. At the moment, after digesting recent comments made by some members of U.S. Federal Reserve, analysts say there is a 50% probability that the Fed will raise rates by the end of the year.

However, the price declines haven’t resulted merely from expectations about interest rates. The oversupply that exists in the markets for some products is exerting strong downward pressure on their prices — for example, with corn and copper. The U.S. Department of Agriculture expects that the country will achieve a record high grain crop this year, while Antofagasta, a Chilean producer of copper, forecasts that the current excess of supply in the copper market will last two or three more years.

According to Lourdes Casanova, academic director at the Institute of Emerging Markets of the S.C. Johnson School of Management at Cornell University, “It is not easy to forecast the price of raw materials, and almost all of us make mistakes.” However, Casanova does not expect production levels to reach new heights over the short or medium term. She also doesn’t expect a short-term increase in the price of petroleum.

Petroleum is the product that is traded the most in the world, “and the rest of the products follow its pattern,” Casanova notes. From a macroeconomic point of view, Casanova also sees no major reason for commodities prices to rise for a sustained period. “The growth of the world economy — except in China and India — are continuing at a lackluster pace. And so I don’t believe that we are facing a cycle such as the one we had in the previous decade.”

Adapting to Circumstances

Now that short- and medium-term expectations for a new cycle of price increases have been shattered, Latin America will have to learn how to cope without depending on this source of strong economic growth, economists agree. That was one of the conclusions noted by the International Monetary Fund (IMF) and the World Bank at the annual conference of the Development Bank of Latin America (CAF) in Washington in September. Top economists at the IMF and the World Bank noted that Latin America is in a “weak” fiscal position and has a “lower margin for maneuvering” to deal with the current context of the economic recession. In July, the IMF forecast that at the end of 2016, Latin America will remain in a recession — for the second consecutive year — with its Gross Domestic Product (GDP) declining by 0.4%.

“Most of the Brazilian GDP is not related to agriculture or commodities. [Rather,] Brazil is a services economy.” –Felipe Monteiro

According to Alejandro Werner, the IMF’s director for the Western Hemisphere, “All of the economies of the region are in a weaker fiscal position than they ought to be.” Werner warned that this situation involves significant risks, especially because “the Latin American political class has gotten used to governing during times of abundance” over the past decade, thanks to the boom in primary products then driven by the industrial expansion of China. That period is over. When commodity prices were high, those who governed were not overly concerned about the efficiency of their expenditures, Werner noted. In the current context, however, it is critical for policy makers to reassess those levels of efficiency and to apply structural reforms.

Long-term Thinking

According to Wharton’s Guillen, “You cannot transform these economies or make them less dependent on the commodity cycle unless you invest in education and infrastructure, and unless you set up a regulatory framework in such a way that you are attracting investments.” However, such moves require a long-term commitment, he adds. “The useful political cycle is four years and those things don’t give you good results in just four years. You need a ten-year or fifteen-year time horizon. It’s always been easier for any government in the world – not just in Latin America – to try to capitalize on the windfalls and not to invest for the long run. Unfortunately, there’s no magical solution to this.”

How well are major economies of the region managing their efforts to lessen their dependence on commodities? Guillen notes that Mexico has had the most success of any country in the region when it comes to transforming its industrial sector into a significant part of the global value chain for automotive, electronics and other products. “After Mexico, I would put Colombia,” he adds. Further down that list, “Some people mention Chile all the time but I am ambivalent about it. It is true that at the beginning of 1970s, they adopted a long-term perspective; it has helped a little bit. But 30 to 40 years later, the economy continues to be driven by commodities. Copper is still the most important. They have diversified a little bit but they continue to have problems in the education sector. In the last year, there have been multiple student strikes. They felt that the government wasn’t spending enough on education. Part of the problem is that now the government doesn’t have as much revenue from copper exports as it had.”

As for Brazil, the largest country in Latin America, it is “a world unto itself; a very large economy that is very protectionist,” adds Guillen. “The pity about Brazil is that they didn’t do anything to transform the economy when they had [a] windfall.”

The Case of Brazil

Felipe Monteiro, professor of strategy at INSEAD business school in Paris and senior fellow at Wharton’s Mack Institute, notes that “as Brazil looks at the future, a major question is whether Brazilian companies can be part of the global value chain, and thus less subject to the negative consequences of downward spirals in commodities.”

Monteiro cites two reasons why most Brazilian exports continue to be commodities. First, “It is very comfortable to be a commodity exporter when commodity prices are booming.” Second, many of the Brazilian companies that could have made an effort to compete abroad “are being too lazy” when it comes to globalization. Their experience with the region’s long history of price cycles has led them to believe that commodity prices will eventually bounce back strongly, making arduous efforts to join global value chains unnecessary, he says. Nevertheless, Monteiro is hopeful that, given current circumstances, many Brazilian firms that are focused entirely on the large domestic market will seriously reconsider the long-term advantages of exploiting opportunities abroad. A few leading companies – such as Brazil’s Embraer, the aerospace conglomerate – have built their own global value chains. Embraer is “definitely part of a global value chain. They import so many different parts and work with different suppliers; they assemble, and then they export again.” However, “unfortunately, few Latin American companies pursue this approach. [More commonly], what happens is either they do a lot of local production for local consumption or what they provide to the rest of the world is just commodities.”

“The ideal thing would be to use the transitory booms for reducing debt and increasing spending.”  –Hernando Zuleta

Like the U.S., Brazil is a huge nation in which all too few companies have exploited their opportunities to access foreign markets. In 2013, Brazil’s total exports represented only 13% of the country’s GDP, compared with 32% in the case of Mexico’s exports (and 14% in the case of U.S. exports), according to the World Bank. At that time, Brazilian commodity export prices were high. Nowadays, notes Monteiro, “When you look at exports and foreign trade, Brazil is not doing well, because commodity prices are depressed. And when you look at its internal economy – most of which is services — [Brazil] is also not doing well there [either], because in the internal economy, people are not consuming. So this pattern is putting so much pressure on Brazil.”

Adapting to Change

Zuleta argues that countries must learn how to adapt themselves to the constant changes that are produced in markets for primary products. Thus, he says, “the ideal thing would be to use the transitory booms for reducing debt and increasing spending.”  Nevertheless, in many cases, governments have taken the opposite path, which is something he considers very dangerous, and potentially harmful to the future progress of the economy. “One of the risks associated with transitory bonanzas is to bring yourself up to high spending levels that are then unsustainable in conditions of lower prices.”

Zuleta continues, “This has happened in nearly every country in Latin America; in some cases more than in others. The cost is that ‘countercyclical’ policy cannot be made when so many economies fall into a recession. What happens is that public spending and aggregate demand decline when the price of primary products falls and the recessionary effect is magnified.” The “counter-cyclical” or “anti-cyclical” policies defended by Keynesian economic theories defend the notion that the government should maintain or increase public expenditures during a stage of recession in order to try to reactive economic activity as early as possible and, in this way, to reduce the recessionary economic cycle to its bare minimum.

Casanova argues that “an increase in prices is always positive for those economies that are dependent on exports of primary products, including Latin American economies.” Despite that, she believes that countries should limit as much as possible their dependence on these sorts of products in order to prevent themselves from being strongly affected by the volatility of their prices. She is aware that “it is not easy to change the economic structure of a country over a short period of time.” However, she notes that it is possible: Some of the world’s largest economies – including the United States, Canada and Australia – are rich in primary products, but have learned how to diversify their economic structures adequately.

“The problem comes when a country is incapable of developing its manufacturing sector and/or the industries that surround its raw materials — that is to say, its secondary industries and so forth,” Casanova says. “Latin America is such a case. The region has been given to lurching back and forth in its economic policies,” and whatever changes are made, they require stability. “Let’s hope that this is possible in this new stage [of the region’s development].”