Latam Economies: Prospects and Pitfalls in 2015

Three Factors Holding Back Growth in Latin America

Three factors that will likely mean slow growth and weak currencies across Latin America in 2015:

  1. Lower commodity prices: US Dollar (USD) prices for agricultural, energy and metals exports have fallen across the board and will reduce export revenue to varying degrees in the region.
  2. Large current account deficits: In many Latin American nations, trade deficits are larger than historical norms and may require weaker domestic demand (less imports) in order to compensate for sluggish (or negative) growth in export revenue.
  3. Rising inflation: Most Latin American economies have experienced an increase in inflation due to the lag impact of weaker currencies. This may hinder the ability and willingness of the region’s central banks to boost demand by easing monetary policy and, in some cases, may lead to more restrictive monetary conditions.

Against this backdrop, there is one countervailing factor: weaker currencies. Nearly all Latin American currencies have been depreciating. The lag impact of weaker currencies will help offset some of the impact of the decline in commodity prices and may put Latin American countries on the path to smaller current account deficits by making imports more expensive and increasing the competitiveness of the region’s exports.

Currency depreciation has its downside, however. With the exception of Mexico, inflation has been creeping up, even in countries where price increases have been relatively subdued, such as Brazil, Chile, Colombia, and Peru. Further currency weakness will likely increase inflationary pressures and may lead a number of regional central banks to tighten monetary policy, which may offset some of the gains from weaker exchange rates.

While our overall outlook is for continued below-potential growth in Latin America in 2015, we emphasize that the region is highly diverse, and growth rates and inflation will differ greatly from one country to another. Among the region’s varied economies, we expect that Brazil, Chile, Mexico, and Peru will be relative outperformers, while Colombia will slow substantially, after many years of impressive growth. Finally, we expect difficult times for Argentina and especially so for Venezuela, where we anticipate a deep recession with the possibility of triple-digit inflation.

Since commodity prices will be a major driver for the different outcomes across Latin America in 2015, this paper will first outline what the impacts are likely to be in the seven largest regional economies. Then we will look at each individual economy more in depth.

Consequences of the Commodity Crash for Latin America

Falling commodity prices will be a dominant theme in Latin America in 2015 and should contribute to a slowing of the region’s economic growth but with disparate impacts that will create interesting opportunities for investors in the region. Oil and copper will trigger the greatest consequences.

Oil: The collapse of oil prices will create highly varied outcomes for Latin American economies in 2015.  It will be a boon for net oil importers such as Chile and neutral for producing countries like Argentina, Brazil, and Peru that meet most or all of their domestic needs but never developed into net oil exporters.  For the oil exporters, however, it’s a different story.  By our estimate, if oil prices stay around $45/barrel in 2015, this will shave approximately 1.3% off Mexican GDP growth, 4.0% in Colombia, and over 10% in Venezuela.  (Please see Appendix: Figure 1 (Back of the Envelope Calculations for Commodity Price Decline GDP Impacts), pg. 22.)

For every $10 move up in oil, we would expect a marginal contribution of approximately +1.5% in Venezuela, 0.7% in Colombia,  0.2% in Mexico, and -0.4% in Chile.

Copper will be a major issue as well, especially for Chile.  While Chile will likely be a beneficiary of lower oil prices, the decline in copper prices may cancel out those gains if copper prices remain near current levels.  Chile is the world’s largest copper producer, mining nearly one third of the world total and producing nearly 3.5x as much as China, the world’s next biggest producer.  Just behind China, Peru is the world’s third largest copper producer, responsible for approximately 7% of the world’s supply in 2013.

Our estimates show that if copper prices remain near $2.50/lb, this will shave approximately 2.6% off Chilean GDP in 2015 and about 0.8% from Peruvian GDP, while having little impact on the rest of Latin America.

For every 10% additional decline in copper prices, we would expect to see approximately 1.3% to be taken off Chilean GDP and about 0.4% off Peruvian GDP.

Agriculture:  Prices for corn, soybeans, sugar, and wheat also plunged in 2014 and 2015.  The decline in these commodities will be somewhat detrimental to Argentina, shaving about 1.4% off GDP before any second round effects are taken into account.  The decline in sugar prices will also affect Brazil, trimming approximately 0.3% off growth should prices remain near early-February 2015 levels.  The impact of the decline in agricultural goods prices should be fairly minor elsewhere in Latin America.  

Figure 1: Estimated First Order GDP Impact of Decline in Agricultural Prices from 2014 Averages

Overall, owing to its reliance on energy, the drop in commodity prices will hit Venezuela by far the hardest, but truth be told, it won’t be good for any country in Latin America.  Colombia, and to a lesser extent Mexico, are also  likely to take a hit from lower oil prices, although much more manageable ones than Venezuela.  Peru will see some negative consequences from falling metals prices while in Chile the drop in copper will largely cancel out the gains coming from falling crude oil prices.  Finally, the decline in agricultural goods prices will add some strain to Argentina’s already struggling economy while having a marginally negative impact in Brazil, which remains the best insulated economy in Latin American from the fall in commodity prices.(Please see Figure 2 below for details.)

Figure 2.

Figure 3.

The above analysis only considers first order effects on the economy. The second order impacts are more complicated. Latin American currencies have already weakened versus the US Dollar over the past 12 months, partly as a result of weaker commodity prices. The decline in Latin American currencies, which began in 2013, will make the region’s goods and services more competitive. (Please see Figures 5 and 6 below for details.)

However, what is worrisome is that the currency weakness has boosted inflation rates in a number of Latin American countries. Thus far, the inflationary impact of weaker currencies has exceeded the disinflationary effects of weaker commodity prices. Inflation rates moving somewhat higher may limit the scope of Latin America’s central banks to respond to an economic slowdown by lowering interest rates.

Figure 4.

In the charts below, we treat the low inflation countries (Brazil, Chile, Colombia, Mexico, and Peru) and the higher inflation countries (Argentina and Venezuela) separately. Paradoxically, falling oil prices are likely to send Venezuelan inflation soaring as the country may have to curtail its fuel subsidies and allow further depreciation of its currency in the face of depleted export revenues and currency reserves.

In contrast with the commodity price crash of the 1980s, for the moment the market grades the likelihood of sovereign default as fairly low, except in Venezuela where it appears to be a 55% probability, according to the sovereign CDS market ask price. Five-year default probabilities for Brazil, Chile, Colombia, Mexico, and Peru range from 1.1% to 2.1%. (Please see Figure 7 below for details.)  Over the course of 2015 as the consequences of lower commodity prices become more apparent, the market might reevaluate some of these likelihoods upward. 

Figure 5.

Figure 6.

Figure 7.

Brazil: Sector Outperform

After a significant slowdown from its post-crisis rebound, Brazil’s growth may be set to pick up again in 2015. We anticipate 1.5% real GDP growth this year, above the 0.5% consensus expectation in a recent Banco Central do Brasil survey of economists. Among the Latin American countries, Brazil is the most insulated from the impact of falling commodity prices. Moreover, its currency has weakened more than most of its peers, which should boost exports, especially to the US, which may replace China as the biggest source of growth for Brazilian merchandise. Finally, Banco Central do Brasil may have a little bit of scope to ease policy, in contrast with many of its Latin American peers.

There are, however, a number of risks associated with this forecast:

  1. Water shortages in Sao Paulo could hurt manufacturing and business more broadly if the drought is not alleviated. New investments in water infrastructure could boost output, however.
  2. Weaker-than-expected demand from China could slow Brazil’s recovery as well.
  3. Tax increases and spending cuts that went into effect in late 2014 and early 2015 might also slow the recovery of the economy.
  4. The rising current account deficit could be corrected at some point with significantly weaker domestic demand (i.e. a recession) if Brazil can’t export its way to recovery. (Please see Figure 9 below for details.)
  5. Rising inflation could limit Banco Central do Brasil's ability to ease in the face of soft domestic spending.

Figure 8.

Figure 9.

Figure 10.

Chile: Caught Between Copper and Oil

Chile appears to be skating on the edge of a recession. (Please see Figure 11 below for details). The lag impact of a weaker Chilean Peso (CLP) may help Chile avoid an outright downturn but one cannot rule out the possibility. Chile’s economy will benefit from the collapse in oil prices but will be hampered by the drop in copper prices. For the moment, the collapse in oil prices (-60%) has been much deeper than the drop in copper prices (-30%). If copper prices fall further and oil prices rebound, that could be a toxic mix for Chile and could tip the economy into recession. As such, Chile’s fate remains to some extent in the hands of the Chinese and their demand for copper, which is Chile’s main export. Slowing growth in China is bad news for Chileans.

Banco Central de Chile will almost certainly have to tighten policy in 2015. Short rates have fallen below the rate of inflation, which has been increasing. (Please see Figure 12 below for details.) The decline in oil prices will put some downward pressure on inflation but this will be counteracted to some extent by the lag impact of the weakness of the Chilean Peso.

Unlike many of its peers, Chile’s current account deficit has been shrinking but it is still relatively large by historical standards. (Please see Figure 13 below for details.) The lag impact of a more favorable exchange rate will help to narrow the gap, but we expect some softness in domestic demand.

Figure 11.

Figure 12.

Figure 13.

Colombia: From Success to Distress?

Colombia has been one of the great success stories of the past fifteen years with falling rates of inflation and robust economic growth spurred by dramatically lower levels of violence. (Please see Figure 14 below for details.) In the long term, we remain optimistic on Colombia but we do see growth taking a stumble in 2015, with expansion slowing into the 0-2% range. Lower oil prices will take a bite out of Colombia’s economy. Some of this will be offset by the weakening of the Colombian Peso versus the US Dollar.

Figure 14.

Colombia’s central bank has been proactively tightening policy for some time and for the moment the rate of inflation remains under control. (Please see Figure 15 below for details.) Even so, the potential for further interest rate raises remains. Colombia is running a large current account deficit and the weakness in COP hasn’t yet begun to correct it. (Please see Figure 16 below for details.) Running a current account deficit is not a problem so long as the corresponding capital account surplus is being productively invested, but with the declines in commodity prices foreign investors may be less forthcoming during the next few years.

The combination of that deficit and the weakness in oil prices may put further downward pressure on COP and might induce the central bank to tighten policy further.

Colombia also has some delicate geopolitical considerations to navigate. First, it has to deal with the increasingly chaotic situation on its border with Venezuela. Second, it is still in talks to end decades of on-and-off violence with FARC. These factors also need to be monitored when looking at Colombia’s markets and economy.

Figure 15.

Figure 16.

Mexico: Slow growth to remain slow

Mexico’s growth rate has been slow the past several years and it appears likely to remain slow in 2015, perhaps in the 1.5-2.5% range as a base case scenario. (Please see Figure 17 below for details.) Fortunately, the country is not as dependent upon oil as it once was. The collapse in oil prices appears likely to shave more than 1% off economic growth in 2015 but the good news is that some of that is likely to be offset by the lag impact of a weaker currency, which should boost exports to the United States, Mexico’s main trading partner. Additionally, US economic growth appears likely to be robust in 2015. (Please see our article on US Economic Outlook 2015.) Moreover, Banco de Mexico has done an exemplary job of containing inflation. Even so, its policy rate is currently below the rate of inflation and one cannot rule out a few rate hikes over the course of 2015, especially if MXN were to weaken further. (Please see Figure 18 below for details.)

Figure 17.

Mexico’s current account deficit is near its historical average and doesn’t appear to be alarming. (Please see Figure 19 below for details.) That said, it may also serve as a restraint on economic growth, though not to the same extent as elsewhere in Latin America.

Finally, there is the issue of Mexico’s stability. The level and pervasiveness of violence calls into question the government’s control over large sections of the country as well as the attractiveness of certain regions Mexico as a business and tourist destinations. This may also hamper foreign investment and economic growth in 2015 unless the government is able to improve the security situation.

Figure 18.

Figure 19.

Peru: Potential for a Currency Devaluation

Peru’s currency, the New Sol, has depreciated to a much lesser degree than its Latin American counterparts. This is problematic given Peru’s enormous current account deficit (Figure 20), relatively slow growth (Figure 21) and the likely impact of weaker commodity prices. As such, we see economic growth remaining weak, probably around 1% real growth in GDP, with a significant risk (35%) of a recession.

Given the disinflationary influence of lower commodity prices, a relatively strong currency (for the moment) and slow economic growth, we don’t see much short-term risk of the central bank tightening policy. This is especially true given that the policy rate is already positive in real terms. (Please see Figure 22 below for details.) Nevertheless, if the New Sol does begin to weaken dramatically, it will put upward pressure on inflation and may limit the ability and willingness of the central bank to ease policy. In this environment we see a significant risk that the New Sol will catch up with its Latin American peers on the downside during 2015. At its current level it will be difficult for Peru to compete in the export market and to redress its current account deficit.

Figure 20.

Figure 21.

Figure 22.

Argentina: Cry for Me

Argentina enters 2015 under challenging circumstances. Inflation is soaring (notice the gap between nominal and real GDP in Figure 23) and the central bank appears to be behind the curve, having just begun tightening policy during the last few months. (Please see Figure 24 below for details.) Moreover, the country is once again in default and appears to be unwilling to negotiate with its creditors ahead of the 2016 elections. Finally, the government of President Cristina Kirchner is enveloped in a scandal involving an alleged cover up of Iranian involvement in the July 18, 1994 attack on the Asociacion Mutual Israelita Argentina in Buenos Aires. Irrespective of the veracity of these allegations, the surrounding controversy could hamper the government’s ability to deal with Argentina’s economic challenges. As such, we expect a year of stagnant to negative growth in Argentina accompanied by further increases in inflation and significant currency devaluation.

Figure 23.

Although Argentina is largely insulated from the collapse in oil and copper prices, declining prices for agricultural goods will likely detract Argentina’s growth prospects in 2015. Additionally, although Argentina’s current account deficit is reasonably small, since the country remains largely cut off from the global capital markets, funding that deficit is a challenge, especially in light of dwindling foreign currency reserves and the large gap between the official and black market exchange rates. (Please see Figure 25 below for details.)

Figure 24.

Figure 25.

Venezuela: Muy Duro (Very Difficult)

Venezuelan President Nicolas Maduro finds himself in an unenviable situation. Inflation is soaring (Figure 26) and real growth is stagnant (Figure 27). Officially, inflation is around 70% and appears headed toward 100%. The price of oil, responsible for the near totality (96%) of Venezuela’s export earnings, has collapsed. Currency reserves are running out so quickly that the central bank converted a loan from China into foreign exchange reserves. In January, Maduro visited China, Qatar and Russia to ask for loans and aid to stave off an impending default on Venezuela’s debt. Shortages of basic goods from toilet paper to tampons are creating social unrest. To make matters worse, Venezuela employs three official exchange rates that apply to different kinds of goods. Officially, there are 6.30 Bolivars to the US Dollar. On the black market, one US Dollar buys 175 Bolivars. Finally, the government’s yawning budget deficit is being financed to a large extent by the printing of money, in the vein of the Weimar Republic (though not on the same scale).

We forecast a deep recession –possibly -10% for GDP in real terms—for 2015, with hyperinflation and a massive devaluation of the Bolivar. Oil traders be warned: the potential for unrest in Venezuela raises the very real specter of supply disruptions.

Figure 26.

Figure 27.

Conclusion: Slow Growth with Diverse Economic and Currency Outcomes

2015 will likely be a subpar year for Latin America as the region grapples with lower commodity prices and large trade deficits. That said, outcomes will vary significantly across the region. Among the relatively low inflation countries, we look to Brazil as being the most likely to outperform, followed by Mexico and Chile, while Colombia and Peru will be more challenged.

Latin American currencies have weakened a great deal since early 2014 as a result of weaker commodity prices, a generally stronger dollar, as well as generally slow growth in the region. If 2015 proves to be a “risk-off” environment (global equities decline), then Latin American currencies are likely to remain weak. If 2015 proves to be a “risk-on” environment, Latin American currencies might be in a position to rebound. In the latter case, BRL might be the biggest beneficiary for two reasons: 1) it has by far the highest interest rates among traded Latin American currencies, and 2) BRL has underperformed its peers and therefore might have the greatest potential to rebound. Although they would benefit, to varying degrees, if carry trades return to favor, we would be comparatively less optimistic about the remaining Latin American currencies. Chile, Colombia, Mexico and Peru all have much lower interest rates than Brazil, making them relatively less attractive than Brazil from a carry trade perspective. Peru’s New Sol looks particularly challenged in light of the country’s enormous current account deficit, relatively low interest rates and the fact that the currency hasn’t declined versus USD.

Appendix: Back of the Envelope Calculations for Commodity Price Decline GDP Impacts

Figure 1: Latin American Oil Consumption, Production and GDP

Figure 2: Latin American Copper Production and GDP

Figure 3: Latin American Corn Production and GDP

Figure 4: Latin American Soybean Production and GDP

Figure 5: Latin American Sugar Production and GDP

Figure 6: Latin American Wheat Production and GDP

Sources for Agricultural Goods:
Index Mundi
http://www.indexmundi.com/agriculture/?commodity=wheat&graph=production
US Grains Council
http://www.grains.org/buyingselling/conversion-factors

Additional Sources: Bloomberg Professional and CME Group

 

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

About the Author

Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.

View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.