Thursday, December 9, 2010

The Fed and Money Printing

By Gray Newman | New York
Latin America should post another year of good growth in 2011, although not as spectacular as the rebound seen in 2010 when the region likely posted its second-strongest showing in more than three decades. Despite our favorable outlook for Latin America in 2011, the region is facing two sets of challenges that are likely to continue to attract investor attention. 

Risks to Abundance
The first set of challenges is perhaps the most prominent: the risks from abroad that could call into question our growth story in Latin America. The candidates are the usual suspects: the US economy, the debt turmoil in Euroland and the path of Chinese policy and growth. While our US team expects an improving picture in 2011 with real GDP growth of 3.2%, the risks from a still weak housing market and a more restrained fiscal stance remain two key headwinds that could derail the path to better growth next year (see US Economic and Interest Rate Forecast, December 3, 2010). Meanwhile, our Euroland team remains focused on the risks from the ongoing sovereign debt developments and the potential negative impact on the largest 'periphery' countries in the region. Finally, while our China economist Qing Wang warns of slower growth (9%) and higher inflation (4.5%) in China, he admits that the greatest risk to his forecast is a bout of policy missteps that could produce a boom-bust cycle (see "China Economics: 2011 - A Year of Reflation", This Week in Latin America, November 22, 2010). 
All of these risks to the growth story in Latin America are worth careful monitoring. But we suspect that Latin America watchers are already spending a great deal of time following the events outside the region. After the experience of 2008, it is difficult to hold the view that the region can be a 'safe haven' if the globe suffers a serious downturn. However, we suspect that investors are underestimating the risks from within the region, namely the risks of abundance.

Risks of Abundance
There is a difference between Latin America today and in 2008: in many ways, the region was in better shape in 2008 to deal with the downturn than today. Since 2008, the region has run larger fiscal imbalances that leave it more vulnerable today than two years ago in the event of a sudden reduction in financing. Further, the region is facing an uncertain, perhaps even unstable equilibrium in the global economy with large financing needs - seen in the growing current account deficit positions of the largest economies in Latin America. And one country, Brazil, has seen a dramatic jump in its financing needs even as foreign direct investment has softened: the net result, the country needs portfolio flows to finance its needs to an extent that we have not seen in decades.

It is true that the reserve position in the region has continued to improve, but the rapid deterioration on both the fiscal and current account fronts should serve as a warning. The region has once again begun to spend beyond its means at a rapid pace. In many ways it is more vulnerable today than in 2008; that could matter if our central case of a relatively benign global backdrop does not play out.

Behind the region's vulnerability lies a curious development: the rapid pace at which domestic demand, principally consumption, has outstripped domestic production or supply. If we plot monthly retail sales as a proxy for consumption and compare it to monthly GDP (or industrial production where a monthly GDP proxy is not available), the period of the first era of abundance - 2003 to 2008 - looks markedly different than today's second coming of abundance. Today, throughout the region (with one notable exception), consumption appears to be growing at a much more rapid pace than the overall economy. Nowhere is the gap greater than in Brazil, but it is also present in Colombia and to a lesser extent in Peru and Chile. The exception, of course, is Mexico, where consumer demand appears to be running below domestic production. 

The reason for the growing disconnect between strong demand and less robust supply (the Growth Mismatch)? A strong currency, which in turn is being driven by a robust uptick in the region's terms of trade. Throughout the region, the heavy commodity exporters are benefitting from rising prices for their exports, and Brazil's and Colombia's terms of trade are at historical levels whereas Chile's and Peru's are near all-time highs. The one exception, Mexico, has been dealt a far less favorable hand by the globe. By 3Q10, not only had Mexico's terms of trade given up almost half the improvement observed since the early 2009 lows, but it was running well below the average of the five years preceding the crisis.

The Growth Mismatch in turn creates two risks for the region: a balance of payments challenge and an inflation challenge. The balance of payments risk not only works to undermine the region's manufacturing base as a handful of commodities reign, but it leaves the region even more reliant on external, and in some cases, portfolio financing. Meanwhile, a strong currency, helping to boost the purchasing power of consumers in the region, not only produces stronger demand for imports, but threatens to push inflation higher as well. Part of the inflationary pressures can be offset by a stronger currency reducing the prices of tradable goods, but with authorities around the region now working to limit further currency strength, the risk of more inflation in the region is set to rise.

In a way, boosting domestic demand in the region and the return to current account deficits is precisely what 'global rebalancing' has always been about. The risk, however, is that the burden of strong consumption in Latin America - where savings rates have long been low and where public and private investment have long lagged Asian levels - may be to the detriment of the region's long-term health.

Be prepared as tensions heighten between policy-makers in the region over how to respond to the latest bout of abundance. We've already seen central banks engage in massive dollar-buying sprees in an attempt to limit the currency impact from higher interest rates. And in numerous cases, the moves have raised doubts about the central banks' commitment to its inflation target, especially in countries where inflation has begun to diverge from the target. Meanwhile, the authorities have also responded with a series of capital controls and taxes to limit portfolio inflows taking advantage of widening interest rate differentials. Continued abundance with only modest growth in developed economies is likely to provide a further challenge to central bank autonomy, which remains largely untested in the region. And currency strength is almost certain to prompt more calls for capital controls, intervention in the currency markets and new taxes to limit inflows. 

Brazil: Macro Is Back
Just when you thought that the macro debates in Brazil were behind us and the new focus could be to discuss micro issues such as how to finance Brazil's infrastructure needs, macro is back.  Although the new administration does not take office until January 1, 2011, the macro debates are back in center stage: the autonomy of the central bank, the direction of monetary policy, the acceptable rate of inflation, the role of the state and the magnitude of the fiscal deficit. The reason for the return of macro has less to do with the change in policy-makers (the changes signaled have been limited so far) and more to do with the fact that the current, pro-consumption model is reaching its limits. .

With quantitative easing in the US and strong commodity prices, Brazil's currency has come under significant pressure to appreciate and has prompted a series of controls and taxes to attempt to slow the currency's gains. Despite the authorities' efforts, the Brazilian real is now at it strongest trade-weighted, inflation-adjusted level in more than two decades. That, in turn, has boosted consumer purchasing power and has helped keep demand robust even as manufacturers have suffered from greater import competition: the result is a widening mismatch between strong demand and weak supply (the Growth Mismatch).

We expect the Growth Mismatch to continue in 2011 with GDP up only 4%, even as demand remains strong and prompts the central bank to hike rates to 12.50%. That forecast, however, is subject to significant risk: the new team may attempt other measures to try to rein in demand including further capital and reserve requirements of the type announced in early December. Eventually, we expect the central bank to have to hike interest rates unless the global environment turns less benign.

Meanwhile, the Growth Mismatch is likely to fuel a growing current account deficit, which we expect to reach 3% of GDP in 2011, up from 2.4% in 2010. While the size of the deficit relative to GDP is not alarming, we expect foreign direct investment to continue to fall short of Brazil's financing needs (the Financing Mismatch) and hence portfolio flows will continue to be needed even as policy-makers try to limit those same flows. 

Mexico: Two-Tiered Economy
Since bottoming in mid-2009, Mexico's recovery has been a story of a two-tiered economy characterized by good performance in manufacturing output and exports - driven by the rebound in US manufacturing - coupled with sluggish consumption and anemic fixed investment. In turn, Mexico's weak domestic demand dynamic leaves the economy increasingly vulnerable to the trajectory of US industrial activity. For 2011 and thanks in part to the boost from another strong year for US industrial activity - our US team expects IP growth of 5.1% - and the associated moderate recovery in domestic demand, we look for GDP growth in Mexico to reach 3.9%. 

One of the most important questions facing Mexico watchers in 2011 is whether the quality of the economic recovery will improve, shifting increasingly towards domestic demand as was the case during 2004-07 when growth topped the 5% mark. We suspect that the hand-off from external demand to domestic strength will keep moving forward at a gradual pace, thus keeping domestic demand growth below the norm in the 2004-07 cycle. While more needs to be done on the structural reform front, much of Mexico's sluggish domestic demand seems to partly reflect a negative income shock from deteriorating terms of trade (see "Mexico: Squeezed from Abroad", This Week in Latin America, November 8, 2010). Absent a substantial turnaround in the terms of trade, a more stimulative policy stance would help to offset some of this negative shock; however, the authorities are likely to find themselves with limited degrees of freedom on the fiscal and monetary fronts.

Indeed, the central bank is likely to keep its policy stance unchanged during the course of 2011. Though the threshold for monetary easing remains high, in terms of the risk balance we suspect that a rate cut is more likely than a rate hike. First, with the Fed firmly on hold, Banco de Mexico should feel no pressure to hike interest rates. Second, aside from some recent food-related pressure, inflation trends have been benign, with well-anchored inflation expectations for 2011. And with domestic demand growth likely to remain moderate, the authorities are unlikely to face worrisome demand-side price pressures in 2011. Last, a more substantial bout of sustained currency appreciation would have to take place - leading to a tightening in monetary conditions - to potentially open the door to interest rate cuts, in our view. Importantly, whereas many countries in the region have resorted to capital controls and intervention as a way of limiting currency strength, Mexico is likely to remain on the sidelines for the foreseeable future.

Chile: Upbeat in 2011
Since experiencing a massive negative shock in early 2010 because of the tragic earthquake, the Chilean economy has staged an impressive recovery. While part of the sharp 13.8% sequential annualized GDP growth in the past two quarters was exaggerated by temporary factors - principally the replacement of durable goods damaged by the earthquake and the gradual normalization in industrial output - it also reflected a very benign backdrop of record terms of trade, high consumer and business confidence in a context of stimulative monetary and fiscal policies. Despite the breakneck pace of domestic demand expansion this year, inflation has remained at low levels thanks to currency-linked deflation in tradable goods. The low inflation environment has allowed the central bank to normalize its policy stance at a gradual pace, a trend that we expect to continue despite discussions among the authorities about the possibility of a "transitory pause" in the tightening cycle.
Though many of the temporary factors that boosted growth have already faded - which should lead to a moderation in consumption - the outlook for 2011 remains quite upbeat, in great part thanks to the boost from the earthquake-rebuilding efforts. Indeed, the recently approved 2011 fiscal budget incorporates a real increase of almost 20% in public investment (from an already high base) with a focus on important areas like housing. Encouragingly, leading indicators such as the IMCE diffusion index for construction moved about the 50 neutral threshold in November for the first time since early 2008, likely reflecting rising optimism about the outlook for the sector in 2011. Meanwhile, consumers have been experiencing a very supportive backdrop of rising employment and real wages as well as ample credit availability, which seems likely to persist during 2011. 

Argentina: At a Crossroads
With a supportive external environment and relatively strong fundamentals, the next administration could have an outsized importance in determining Argentina's longer-term economic development
 (see "Argentina: What's Next?" This Week in Latin America, November 8, 2010). After all, on fiscal, current account and economic growth trends, Argentina ranks among investment grade countries far from its current credit ranking. A turn away from policy heterodoxy and towards market-friendly policy management could be the boost Argentina needs to secure an improved medium-term economic outlook and further bolster investor sentiment. However difficult it may be to handicap the likelihood of a policy shift - and there could be numerous twists and turns in the months ahead - Argentina watchers should not lose sight of the relatively healthy macro starting point for the economy and for possibly a new set of policy-makers. We are on record expecting Argentina to move away from policy heterodoxy post-elections next year.

Venezuela: Approaching a Tipping Point
Venezuela is likely to continue to face a hard currency shortage as authorities appear to be focused on pulling the increasingly import-dependent economy out of recession ahead of presidential elections in 2012
 (see "Venezuela: The Dollar Balance, Revisited", This Week in Latin America, November 29, 2010). Unlike the past when high oil prices helped to boost international reserves, we fear that the weight of policy heterodoxy has taken its toll on Venezuela, forcing the authorities to import to help satisfy an uptick in demand. The result: strong demand for hard currency, which has triggered a rapid accumulation of debt, rather than reserves. We expect policy heterodoxy to intensify in the months and quarters ahead. And the combination of intensified economic populism with a policy goal of reviving economic growth is likely to force Venezuela's hard currency shortage to grow and debt accumulation to accelerate.

Peru: Risks of Abundance
Peru's economy appears to be on solid footing, but policy-makers are increasingly concerned that a sustained currency overshooting could lead to systemic risk in the financial system
 (see "Peru: Still a Policy Dilemma?" This Week in Latin America, November 15, 2010). With a strong growth and investment outlook coupled with low inflation and abundant natural resources, Peru is one of the bright spots in the world on the macro front. That may in part explain the recent trend of capital inflow and currency appreciation. However, policy-makers fear that a sustained currency overshooting could end with an abrupt adjustment, posing a systemic risk to the domestic financial system. Thus, we cannot rule out more measures that would challenge the recent currency appreciation trend, at least in the near term.

Colombia: New Controls Coming?
The reform agenda in Colombia remains fundamental to the outlook for 2011. 
 The centerpiece of the reform drive is the fiscal reform: the structural fiscal rule (see "Colombia: Fixing the Fiscal", This Week in Latin America, July 12, 2010). But we see rising risk of disappointment as the fiscal rule adoption is likely to be delayed. While the authorities had signaled for months that Congress would approve the reform by year-end, it now looks unlikely to pass before at least April next year, pushing back implementation by at least a year. And the details of the reform may disappoint as well for two reasons. First, the fiscal rule may be circumvented with relative ease via existing decentralized funds to enable authorities to continue with loose fiscal policy while formally complying with the fiscal rule at the central government level. And, second, the structural oil and mining revenue - defined by the fiscal rule as the proceeds during 2011 when oil and other commodity prices are likely to remain significantly above historical averages - appears too generous, raising the risk that it is potentially too loose a fiscal constraint.

In addition to the reform agenda, the way the authorities deal with continued capital inflow and currency strength may be the other central issue for Colombia's outlook in 2011 (See "Colombia: Controlling the Peso", This Week in Latin America, October 18, 2010). While we expect the Colombian peso appreciation to resume in the months ahead, we cannot rule out that the authorities will put up increasing resistance. While so far policy-makers have made a strong effort to rely on market-friendly measures and avoid imposing administrative controls, we see a real possibility that more onerous measures could be introduced sooner rather than later. After all, strong fundamentals - especially an abundance of foreign direct investment and rising oil output - underpin the underlying drive for peso strength. Thus, while ultimately we suspect that administrative controls are unlikely to be effective in breaking the peso's advance, the prospect that they could be introduced raises an important risk for investors.

Bottom Line
We are forecasting another good year for growth in Latin America with the usual proviso that it is subject to risks from abroad.
 What is unusual this year is just how uncertain the global environment is; the risks to the region's relative abundance appear higher this year. But while the events in Euroland or the US or China may attract the attention of many investors, we suspect that there is another set of risks that are equally troubling for the region: the risks inherent in the abundance the region is experiencing.

A powerful terms of trade shock is strengthening currencies throughout the region, boosting consumer purchasing power and widening the gap between consumption and domestic production. That Growth Mismatch in turn is producing balance of payments and inflation risks. But rather than adopt solutions designed to boost long-term productivity, policy-makers too often are fighting the flows with short-term measures. We have already seen in 2008 the risks to the region's abundance; in 2011, we may begin to see the risks of abundance in the region.

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