Tuesday, April 14, 2009

Economic Outlook for Latin America - Part 4

Currency Outlook for 2009

Intensifying disorderly currency adjustments impair the regional inflation outlook. The regional currency environment has deteriorated. The combined effect of weakening global economic prospects, intensifying commodity price deflation and multiple systemic cracks in the global financial sector architecture has translated into a period of synchronized currency depreciation in Latin America. Floating currencies have been in weakening mode since early August. With the exception of Venezuela and those Central American countries which have opted for a de-facto dollarization regime, most top-tier countries have adopted a managed floating currency regime which remains subject to a harsh reality test.

On the currency (FX) side, the Brazilian Real (BRL) remains a source of concern on the inflation front, continuing to show a weakening bias after having depreciated over 30% in the last three months. While Brazil’s external indicators suggest the currency is overshooting, the authorities cannot ignore its persistent weakening. Estimates of the historical pass-through from BRL movements to domestic consumer prices stand at around 8-10% after approximately one year.

The Mexican peso (MXN) seems to be stabilizing after a volatile adjustment phase that affected energy-linked emerging-market economies. Interest rate differentials, banking sector systemic health, a swift government response to the global financial crisis, still large central bank FX reserves, and the reciprocal currency arrangement between the US and Mexican central banks have been MXN-supportive.

- The Chilean peso (CLP) has discounted a sharp contraction in trade-linked currency flows, despite a relatively solid fiscal position. Interest rate differentials are not a CLP supporting factor in spite of the fact that the central bank has earmarked the fight against inflation as a key priority. The sharp commodity price adjustment anticipates a weakening prospect for Chile’s export sector.

- The Peruvian sol (PEN) has been quite stable, trading at an average rate of 3.04 per USD over the past month; during the recent wave of financial turmoil it has also experienced the lowest volatility amongst peer-group floating currencies within Latin America. The central bank will continue to heavily intervene in the foreign currency market if need be. The USD/PEN is expected to close this year at 3.00.

-In Venezuela, the government has stashed away substantial funds during the windfall oil years. With prices falling bellow USD50pb and local inflation rampant the government fiscal accounts remain vulnerable. This will lead the government to devalue the VEF currency sharply in Q2, likely by 30%.

- In Argentina, the central bank is letting the peso devalue in a gradual and controlled manner. The central bank is managing the slide in an effort to avoid further eroding investor confidence in the peso.

We all know the amount of work it took for Latin countries to conquer have significantly better fundamentals. Most countries have small current account deficits, have sound fiscal systems, low and stable inflation. Latin countries do not have the risk of being exposed in dollars (most are net creditors) and no longer need to finance their external debt. South American countries have created a more diverse export base with less dependence from the US. The domestic markets, in leading countries like Brazil, are becoming increasingly important to determine its future growth path. International reserves in all the Latin countries have never been that high. In brief, there is much more than ‘good luck’ to explain the recent economic boom that Latin countries have experienced in the last five years. Still, given the extremely bleak scenario for the world growth in 2009, where countries like the US might register a negative GDP in 2009 of -3.0% (on y/y) and China might experience a hard landing, posting a bleak growth of 5% in 2009. In this bleak world Latin countries might be severely affected.

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