Throughout this year, Latin America has remained in the shadows as attention has focused mainly on rising crude oil prices, the gradual rise in interest rates undertaken by the U.S. Federal Reserve and the emergence of China, whose economy is now so big that it is pushing up prices for primary products. Despite all these factors, however, financial markets in Latin America are experiencing a strong recovery, especially in Brazil and Mexico, where indices are at their all-time high.
Barely two years ago, Brazil was involved in a profound crisis of confidence that shook its currency, debt and equity markets. Luiz Inácio ‘Lula’ da Silva, a former labor leader, had just won the country’s presidency. International investors were afraid that Lula would pursue a demagogic policy that could involve such measures as canceling its foreign debt, and declaring that Brazil was suspending payments. These fears were shaking the foundations of a region that, more than a year earlier, had suffered a grave crisis in Argentina.
Two years later, conditions have radically changed for the better. Both the Mexbol and Bovespa indexes, which measure prices in Mexico and Brazil, have gone from their multi-year lows to their historic high points, rising 26.6 percent and 3.6 percent, respectively, in 2004. The situation has changed from one in which there was low-price debt to rising bond prices today. The rate differential with U.S. bonds is now only 350 basis points. The pendulum has swung from steep currency devaluation to today’s strong performance, which takes advantage of the weakness of the U.S. dollar. How can we account for these changes?
According to Gonzalo Garland, professor of economics at the Instituto de Empresa (Spain), “It is fairly normal to have a recovery in confidence after a crisis. In this case, there were two factors. One factor, more global, was the cooling off in the leading global economies. The other factor, more local, was the crisis in Argentina. However, the trend soon changed. Nowadays the global view is more optimistic. Meanwhile, Argentina is recovering, and fears about Brazil are being dispelled.”
Raúl Sánchez, professor of international economics and finance at the European University of Madrid, agrees. “Mexico has taken advantage of its dependence on the U.S. economy. It is enjoying strong export growth as well as rising oil prices. Meanwhile, Brazil, another large engine, moved beyond fears of Lula’s policies toward uncertainty and into a climate of confidence. Risk in the region has dropped, above all, because of declining risk in Brazil, which accounts for about 68 percent of the Latin American economy. Argentina, at first, had no impact because it did not have much influence on the rest of the countries.”
Nevertheless, not everyone has a positive view. Says Edgardo Barandiarán, professor at the Catholic University of Chile: “I don’t believe there is optimism. There was a pessimistic stage, when adjustments had to be made. Now, those adjustments are having a positive impact. But in some countries the impact can be only transitory. One example is Argentina, because the reforms have not been made.” In his view, “The recovery is due largely to higher international prices for oil and other basic commodities.”
At the end of September, the International Monetary Fund (IMF) published its “World Economic Outlook” report. In it, the IMF raised its growth forecasts for Latin America, thanks in part to rising prices for crude oil. It also revealed some anxiety about the slow pace of reform in the region. The international institution, headed by Rodrigo Rato of Spain, raised its GDP forecast for Latin America to 4.6 percent from its earlier estimate of 3.9 percent last April. Meanwhile, the IMF maintained its forecast of 3.6 percent growth for 2005. As for specific countries, Argentina will grow at a 7 percent pace this year, and 4 percent in 2005. Brazil will grow at a 4 percent rate this year, and 3.5 percent next year. Mexico will expand at a 4 percent pace this year, and by 3.2 percent next year, according to the IMF. These figures are far higher than the 2.2 percent growth forecast by the IMF for the euro zone economies.
These upward revisions are a factor that explains the strong rise in the region’s stock markets. Investors see their economies are growing faster, and they are buying more Latin American shares and debt. Starting in January, investment funds in the region have gained an average of 14 percent, according to a recent report in Expansión, the Spanish newspaper.
According to Sánchez, “This recovery is moving along at a strong pace. Net capital inflows have reached an unprecedented $37 billion. These figures show a return in confidence in the region, although this time, capital is being very selective.” In that respect, Barandiarán stresses that growth has been generated by low interest rates in the United States and Europe, which have put a brake on the outflow of capital.”
The Impact of Low Interest Rates
Experts agree that a major cause of Latin America’s growth is the expansive monetary policy of major Western economies. Rates in the U.S. are at 1.75 percent, after three declines of 25 basis points this year. In Europe, they are at 2 percent; in Japan, they are close to zero.
According to Garland, “It is very important that rates are very low, because that helps companies and governments get the financing they need. We are seeing many Latin American countries go overseas to get financing and offer their bonds to any investor who wants to buy them, whether they are private or corporate investors. This is a new phenomenon. Earlier, debt issues took place in a multilateral way, and then only for large international investors such as banks.”
Sánchez notes that when it comes to demand for debt, “the low level of interest rates in the major economies means that the relationship between profitability and risk is more attractive than it is in the United States.” To take advantage, companies are borrowing money in the major economies at rates of between 1.75 percent and 2 percent, in order to invest in Latin American bonds that have interest rates of above 6 percent. Many hedge funds are following this modus operandi, although they run the risk that there is a drastic change in foreign perceptions of the region. “The speculative game makes sense [today] because there is now an attractive relationship between profitability and risk in the region,” says Sánchez.
Nevertheless, low interest rates are a double-edged sword. According to Garland, “If there is a strong rise in interest rates in Western economies, those countries could perceive a strong risk of being strangled by debt. The key is how the Federal Reserve is going to act when it comes to interest rates. If inflation is high and economic growth solid, then interest rates will rise. But we’re currently in a phase that has unique characteristics. At the moment, inflation is not all that high, and the recovery in growth is threatened.”
Getting Help from Petroleum
This year, the price of petroleum has shot up to historic heights. The price of a barrel is now above $50, both in the Brent rate, the benchmark for Europe; and the West Texas Intermediate (WTI) benchmark used in the U.S. However, in real terms that account for inflation, the price of oil is still only a little higher than half its peak during the energy crisis of the 1970s. “The effect of oil prices is, to a certain degree, similar to the effect of the crisis of the 1970s. Although prices are at their historic peaks in nominal terms, in real terms they are still very far from that. This has a major impact on the economy, but not as much as before,” adds Garland.
In its latest meetings, the U.S. Federal Reserve has noted that it expects the negative impact of rising crude oil prices on the economy to be temporary, and that the economy will gain strength over coming months. (Expensive petroleum acts as a disincentive for consumption and raises costs for businesses.) This argument seems to ignore the worst possible scenario: a rise in inflation accompanied by low growth, which forces an abrupt rise in interest rates and pushes the economy into recession. That would be disastrous for emerging markets, especially Latin America, where several economies – especially Mexico – are very dependent on the United States.
It seems paradoxical that Mexico, one of the world’s leading oil producers, could be threatened by a rise in the price of crude oil. “If the world stops growing – especially if the U.S. stops – then Mexico’s economy also stops,” notes Pablo Rión, a Mexican financial analyst. “The price of petroleum helps us temporarily, because it affects us a lot. The most important exports from this country are machinery and equipment, tourism, and financial remittances from Mexicans who live in the United States. Petroleum is in fourth place, assuming a price of $24 [a barrel] as a reference point.”
According to Garland, “When you talk about the impact of oil prices, you have to make some distinctions. Exporting countries such as Mexico and Venezuela do very well, because [high oil prices] mean extraordinary revenues. While that is hurting oil-importing countries, they are being compensated by the depreciation of the U.S. dollar with respect to their currencies. That factor lowers their cost of purchasing oil (since the dollar is the currency used for buying crude oil).” In Garland’s view, “A lot of uncertainty results from rising prices for petroleum and primary products. China just raised its interest rates, and that signal makes people start to worry about inflation. We’ll have to see what impact it has.”
Rising commodity prices, largely driven by China’s burgeoning economy, have also been a very important factor for Latin America. In countries such as Chile and Peru, metal exporters have benefited. Meanwhile, rising prices for agricultural commodities have helped Argentina, Bolivia, Brazil, Ecuador and Paraguay. Here again, there is always a risk that prices will fall, damaging the region in the future. In any case, Sánchez warns that if rising oil prices lead to rising U.S. interest rates, “that will have a powerful impact on these countries; twice as much an impact as changes in [prices for] primary products.”
Political Structural Obstacles
What other problems does Latin America face? The main one, according to Barandiarán, stems from “political and governmental systems that resist change, often supported by political majorities that are living in the past – or, even worse, who take Europe as their models.”
“There are several obstacles,” observes Garland. “On the one hand, we have to see what happens with Asian growth. Latin America cannot compete with China in the production of low-cost merchandise. Moreover, one of the biggest challenges is to find a way for the growth in Latin America’s major economies to reach the great masses of population. We must manage to achieve a better distribution of income, which extends confidence and enables more stable and sustainable growth.” Rión says that major objectives should be to “move toward a democracy in which legislatures approve reforms; focus on lowering corruption and developing a larger middle class; continuing educational programs and, above all, transparency.”
“The biggest risks are local,” says Sánchez. “I’m focused above all on Mexico, where the biggest problem could be losing control of inflation, and on Brazil, where there is risk of not following through on the tax policy they are planning. If that happens, [interest] rates could go up.”
Experts agree that major corporations will not be making many acquisitions in the region; those will be taking place only in isolated cases. Sánchez says that “Spanish firms already have a presence in the markets that they care about. If they make other acquisitions, it will be because they see a very obvious opportunity. Their risk profile is very asymmetric, and they paid for that in 2002. The Argentine crisis led to a crisis in confidence, and marked an inflection point. Nowadays, [Spain’s] purchasing will be aimed more at Europe – and Eastern Europe,” he says.
According to Barandiarán, “The situation varies widely from country to country. For example, I don’t think there are any investment opportunities in Chile that are appealing for major foreign companies. In Argentina, there could be some opportunities but it is unlikely that companies will be tempted.”
Is the positive performance of Latin American markets sustainable in the short and medium term? “Consumer sentiment about the region has always moved in wide swings,” says Garland. “During the 1970s, there was a current of optimism, but that was followed by crisis during the 1980s. During the 1990s, confidence returned, but with some difficult periods. Long term, you have to be optimistic. But you also have to be cautious and realize that there will be instability in both the short and medium term.”