Friday, December 21, 2007

Impacts of the U.S. Recession in Latin America in 2008

Latin America has proven quite resilient to the external credit turmoil that started in mid 2007. Since then we observed a weakened in most currencies and a widened in global bonds spreads In contrast with previous crisis, Latin American stock markets rebounded fairly quickly and since then have displayed stability without the need of sharp interest rates hikes. Apparently, it seems Latin countries seem to be in better shape to absorb financial contagion than in the past.

We have observed to a certain extent an increase in financial strength especially considering the ability of some Latin countries to raise funds in international capital markets, despite the continued credit crunch in developed markets. This is the case of Mexico and Jamaica who issued global bonds whereas Uruguay has just completed its debt buyback program. Investor confidence is supported by the commodity windfall on the export side that improves even more the region’s strong external balance sheet. The fact that most countries are running current account surplus and accumulated almost $0.5 billion in international reserves in 2007 reinforces the financial strength of the region. It is important to note that many Latin countries have decreased their debt exposure in foreign currency as they have bought back large shares of their external debt while some have become net public external creditors (Chile, Brazil and Peru)

The critical question is whether the region will prove resilient to continued weakness in the US
economy and a modest softening in commodity prices over the coming two years. In our view, Latin America will be affected by the US slump through both trade and financial channels. Apart from Mexico, Latin America’s direct trade exposure to the US is limited. However, the impact of a global slump on commodity prices would affect all commodity exporters, no matter how much they directly trade with the US. Consequently, a global slowdown will lead to a decrease in the quantity and the price of exports – especially commodities - from Latin America. In fact, Latin countries might then start running smaller surpluses or actual current account deficits, mostly because their recent surpluses have being supported by high commodity prices driven by the abnormally high demand from US and China. The second link may come when investors need to sell their Latam positions as a way to cover their losses due to the subprime crisis. In fact, some emerging securities are sometimes structured in a portfolio allocation as hedge for riskier (CDO based) positions taken in developed markets. In turn, a sell-off in Latin securities may induce depreciation in Latin currencies and hence greater inflation. In turn, the ‘decoupling’ idea is out of the question mostly because the 2008 recession is no longer limited to the United States but spread out in the leading developed economies.

In brief, despite the improvement in Latin America’s financial position, a US slump could have a significant impact on Latin countries, both because of a sharp decrease in exports, the deterioration in the current accounts and a significant decrease in net portfolio investments. Latin interest rates would likely rise even as growth slows, leading to a fall in domestic consumption and a sharp increase in unemployment rates. Besides these negative effects a few Latin American countries will be caught on their back foot. Brazil tends to be particularly vulnerable to a slowdown mostly due to their high debt to GDP ratio that precludes the country to implement counter-cyclical fiscal policies to minimize the recessionary impacts of a slowdown.

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