Going South

(right) His crisis too: Brazil's Luiz Inácio Lula da Silva

Going south
January 8 2009 - FT.com

By Stephen Fidler

Until a few months ago, as financial and economic turmoil gripped the industrialised world, Latin America was suffused with optimism that it would escape the worst. "People ask me about the crisis and I answer, 'go ask Bush'," Brazil's President Luiz Inácio Lula da Silva said of his US counterpart in early September. "It is his crisis, not mine."

It is Mr Lula da Silva's now. Brazil's industrial production sank 6.2 per cent in the year to November, according to figures announced this week -- the sharpest decline in output since December 2001.

Across the continent, the crisis has brought about a large-scale destruction of wealth. Claudio Loser, a former western hemisphere chief at the International Monetary Fund, calculates that 40 per cent of Latin America's financial wealth was wiped out in the first 11 months of 2008 through falls in stock and other asset markets and currency depreciation. That $2,200bn (£1,440bn, €1,610bn) loss alone could cut domestic spending by 5 per cent next year, he estimates.

On top of that, flows of credit from abroad have contracted sharply and the region, much of which depends on exporting raw materials, has been pummelled by a collapse in commodities prices. The deterioration in Latin America's terms of trade -- the price of exports divided by the price of imports -- could hit even harder than the credit crisis, says Mr Loser, now with the Inter-American Dialogue, a Washington think-tank. "The fact that the terms of trade have gone so far against the Latin American economies in terms of agriculture, minerals and petroleum is really going to hit the region very hard," he says.

Forecasts for growth are being slashed. Economists generally expect gross domestic product across the region to rise by only 1.4 per cent this year, with Mexico thought likely to slip marginally into negative territory. The balance of risks is heavily on the downside. At best, the economic progress of 570m people will all but stall, with the poor among them hit hardest, according to the Economic Commission for Latin America and the Caribbean, a United Nations offshoot.

But the Brazilian leader was hardly alone in his complacency. Hard lessons from past financial crises had encouraged caution among Latin American policymakers. Many governments had curbed foreign borrowing by both public and private sectors. They kept debt ratios low, floated their currencies to avoid devaluation crises and built foreign exchange reserves. They watched their banks like hawks, which helped to ensure these were mostly free of US toxic debt.

As a result, many economists and government officials saw the region as better positioned than at any time in five decades to withstand a severe blow. But the worst global shock for three-quarters of a century has exposed weaknesses masked by the aggregate numbers.

One such weakness in Brazil and Mexico was a series of flawed derivatives contracts that companies had entered into with a group of investment banks. This left them scrambling to secure dollars, pitching the Brazilian real and Mexican peso into a tailspin during October. "The irony is that this happened from the corporate side; we were watching the banks very closely," says Guillermo Ortiz, Mexico's central bank governor.

Countries so far unaffected by the credit crisis are those that for the most part were already frozen out of international financial markets. But this group, which includes Ecuador, Venezuela and Argentina, will not escape the downturn.

These governments spent freely during the commodities boom. Venezuela's leftist President Hugo Chávez and Ecuador's Rafael Correa enjoyed record oil prices and Argentina, which taxes agricultural exports, basked in the surge in farm prices. But now these economies are in a bind. Unlike Chile and one or two others, their governments set little aside for a rainy day.

With no possibility of raising money by issuing debt, they will be forced to rein in spending, accentuating the downturn: a classic pro-cyclical fiscal policy. Ecuador is further constrained by its dollarised economy, which means it is unable to run an independent monetary policy.

Ecuador and Argentina have both taken action recently to loosen the straitjacket. Ecuador announced last month that it would default on foreign debt for the second time in a decade. Argentina's government has nationalised private pension funds, through which it can get its hands on more resources to pay its debts.

But it is not clear whether any extra leeway this gives the governments will be outweighed by damaged confidence. Argentina's nationalisation announcement, for example, was followed by a mini-flight of capital to neighbouring Uruguay on fears that the government, in emulation of predecessors, would nationalise bank deposits. A history of financial crises and debt defaults limits the options for Argentina. A popular dread of governments debasing the currency means one tool, devaluation, is regarded as useless because any benefits would be swallowed by inflation.

Not only in Argentina does history constrain the policy options. Everywhere there are questions about whether Latin American governments have the credibility to counter recession by relaxing fiscal or monetary policy. Indeed, some economists argue that improvements in economic management do not go very deep.

Even in boom times, Latin American growth has not matched the levels of Asia's best performers. This, they say, is because of structural impediments -- such as monopolies, bureaucracy and inflexible labour markets -- that governments have been unable or unwilling to remove. Even normally exemplary Chile retains a system of indexation that passes price rises straight into wages. This fed inflation last year. As for Brazil, the region's largest economy, Sebastian Edwards of the University of California Los Angeles says Mr Lula da Silva is lavished with praise simply for "not being Chávez".

If any country has built credibility, it is Chile. Santiago has run fiscal surpluses equivalent to 6-7 per cent of GDP over the last three years and now has room for public spending to increase. Chile is "in a much better position than other nations, and than Chile itself in previous episodes, to face this period of turbulence", says Andrés Velasco, finance minister.

Chile and Brazil both have tools not available to some industrial countries. They have been able to direct credit to the private sector through state-owned banks. Brazil's central bank was also able to liberate billions of reals in compulsory reserves to ease liquidity problems of small and medium-sized banks.

Yet if the crisis persists, such marginal extra room for manoeuvre will count for little. Even Brazil, with headline foreign exchange reserves of more than $200bn, could be troubled if the halt to credit continues long into the year.

A proportion of those reserves are already spoken for, tied up in forward currency and swaps deals, economists say -- and more than one-quarter of Brazil's $600bn-plus public debt falls due in less than a year. Even though most of it is denominated in domestic rather than foreign currency, the prospect of foreign debt holders continuing to run for the exit is daunting.

Part of the problem, says Ricardo Hausmann of Harvard University, derives from US efforts to shake off the crisis. Washington is expected to issue trillions of dollars of debt to bail out its financial system, save its car industry and reflate its economy. But this means "people are unwilling to lend to almost anybody except for the US Treasury", causing "fairly well behaved countries" such as Brazil, Colombia, Mexico and Peru to lose most of their access to external finance.

Guillermo Calvo of Columbia University says this shows the US "crowding out Latin America and other emerging markets". He and Mr Hausmann are among economists who estimate that $250bn is needed by the region's public sector this year just to pay off maturing debt and provide budget support.

Brazil, Colombia and Mexico have in recent weeks launched bond issues, suggesting that international markets are not completely closed to them. But it is not yet clear how significant that is If countries cannot raise the sums they need, governments could feel forced to adopt import restrictions, capital controls and, worse, beggar-thy-neighbour policies such as tariff increases and competitive devaluations that intensified the 1930s Depression.

To avoid this, the economists say, the IMF and the other public international financial institutions -- now lending well below $100bn a year to all their government clients worldwide -- should mobilise unprecedented resources. They urge the creation of a special fund that can purchase private and public securities in emerging economies without stigmatising borrowers in the way that traditional IMF programmes have in the past.

Latin American nations have often turned, unwillingly, to the IMF and its sister organisations to help resolve financial crises mostly of their own making. Yet though the region is likely to need the institutions again, this time to surmount a deep crisis whose origins lie far away, it is doubtful that the mechanisms or the resources are in place to do the job.