How U.S. Financial Crisis Impacts Latin America

No region is immune from the international financial crisis sparked by the subprime mortgage debacle in the United States. This includes Latin America, which had recently enjoyed good times thanks to growing foreign investment and rising commodity prices.

But with the worldwide credit crunch now poised to transmit its effects to the real economy, Latin America will likely see a significant decline in export revenues and foreign direct investment originating from the U.S. over the next couple of years.

The crunch also is likely to increase the costs of debt financing for the region. And it all comes against a background in which economic growth in Latin America was already beginning to slow. Experts analyze the impact the credit crunch will have on various Latin American countries for Universia Knowledge@Wharton.

Notes Anita Kon, professor at the Catholic Pontifical University in Sao Paulo, "Emerging economies will be very much affected by the U.S. crisis, just like the rest of the world, because the financial system is quite globalized and the crisis tends to spread through the system."

Still, Kon stresses, some Latin American countries are better prepared to weather the storm, notably Chile and Brazil, which have taken stronger steps to shore up their economies in recent years. They will now have to review their plans for spending and public-sector investment, and their policies for supporting production, combating inflation, and various social-spending policies.

In contrast, countries such as Venezuela, Bolivia and Colombia, which are undergoing internal political conflicts, have less stable economies and will likely be more affected by financial developments in the U.S, Kon notes. "There is the unique case of Mexico, which has always been different from other Latin American countries because it is directly affected by demand patterns in the U.S. This time, as a result, it will suffer a significant impact."

Inflation, Exports and Structural Measures

Latin America and the Caribbean region have come off of two of the best back-to-back years of economic growth in decades -- up over 5.5% annually in 2006 and 2007. But even before the credit crunch the heady growth looked set to cool off. World Bank forecasts from June for the region already called for GDP growth to slow to 4.5% in 2008 and 4.3% in 2009. It will surprise no one if those numbers get revised down.

The prospects for Latin American economies have always been tied closely to those of the U.S. If the U.S. sneezed, Latin America got a cold, the saying goes. Still, some argue that this time things will be different. David Tuesta Cardenas, a professor at the Catholic Pontifical University in Peru, says that, "Unlike previous crisis scenarios, Latin America will wind up with only a mild cold, not pneumonia. However, it will depend on the support programs that were developed by each of the countries over the past five years. It will be important to see how much fiscal savings have been generated during this period; how well public-sector debt has been managed; and to what extent exports have been diversified. Countries such as Chile, Peru, Mexico and Colombia seem to have managed things better in that regard. However, Venezuela and Argentina may have done less to address those issues ."

One key factor that could help limit any economic fallout from the credit crunch will be controlling inflation, Kon says. Yet, some Latin American countries look unprepared to take inflation on forcefully, said Dominique Strauss-Kahn, director general of the International Monetary Fund (IMF), in July.

Strauss-Kahn warned that inflation was spinning out of control in some emerging nations, and the IMF has forecast that Chile will finish this year with a 7.5% inflation rate; Argentina will reach 9.1%; Brazil will be at 5.6%; and Peru at 5.4%.

At the same time, there are some counterbalancing policies and conditions, notes Tuesta Cardenas. For example, Peru "has managed to consolidate its strong growth, which has an average rate of 6% during the last seven years, and which has been accompanied by prudent fiscal policy. This has enabled Peru to save a great deal of the extra income generated by the high prices of minerals such as gold, copper, silver and zinc. To achieve that, it has been tremendously helpful to use tax regulations that have been in effect since 1998. Equally fundamental have been the advances Peru made during the 1990s, opening the country to trade.

This progress has continued to deepen during this decade, enabling the country to balance, to a certain extent, its trade accounts. Peru enjoys trade surpluses in some manufacturing sectors, such as textiles and agribusiness. Along these lines, it's been critical for Peru to maintain an independent Central Reserve Bank."

Another lifesaver for Peru, said Tuesta Cardenas, is "the fact that a great deal of the current growth is anchored in internal demand, which provides it with breathing room over the short term."

In contrast, countries which depend more on external consumption -- such as Mexico and Venezuela -- will likely suffer more from the financial crisis originating in the U.S. Richard Obuchi, professor at the Institute of Advanced Management Studies (IESA) in Caracas, notes that the "country risk for Venezuela, as for other emerging economies, increased considerably after the Lehman Brothers bankruptcy.

In Venezuela, in particular, the perception of risk grew, moreover, because of events that affected diplomatic relations between the U.S. States and Venezuela that week (such as the decision by Hugo Chávez to expel the American ambassador.) Nevertheless, the main risk for the Venezuelan economy is the high level of that country's dependence on conditions in global oil markets. If the events in the United States lead to an economic recession, there is a risk that weaker prices for petroleum will spark a decline in demand for Venezuelan exports of energy, which would negatively affect the country's economic performance."

However, this is not the only impact that the Lehman Brothers bankruptcy, and the cascade of events that followed, has had on Venezuela's economy.

The events have directly affected Venezuela's finances, leading Sudeban, the Venezuelan agency that supervises banks, to demand that all institutions that owned assets issued by Lehman Brothers and Merrill Lynch ( MER) (which has been rescued by Bank of America ( BAC), also to avoid bankruptcy) secure 50% of the value of their assets. What's more, the National Development Fund of Venezuela has invested about US$300 million in products indexed to Lehman.

In fact, UNCTAD (the U.N. Conference on Trade and Development) has already warned of a setback in foreign investment in Latin America. Its latest report notes that "medium-term expectations have declined because of the global financial crisis, which will represent a setback for growth over the next two years." During the first six months of 2008, UNCTAD notes, the value of international transactions in Latin America was 29% lower than during the same period in 2007. UNCTAD estimates that foreign direct investment (FDI) in the region will drop by 10% for 2008 as a whole.

This falloff in FDI marks the end of several successful years in which Latin America became the preferred destination of many foreign investors. Brazil was the leader, attracting US$34.6 billion in foreign investment in 2007, the fifth-highest total in the world. Latin America enjoyed growing international confidence last year, when foreign investment in the region shot up 36% to $126 billion, according to UNCTAD.

Yet, much of this growth arose from sharply higher prices for oil and other commodities, and given forecasts for a slowdown in worldwide economic growth, those higher prices are now at risk. The future of Venezuela, for example, is narrowly tied to oil. Notes Obuchi recalls, "The country has experienced sustained growth recently as a result of higher oil prices, the country's principal export, which led to increased public spending and greater aggregate demand. If there were a sustained decline in petroleum prices, however, Venezuela could face risks of a different sort, depending on the volatility and the price of petroleum. Nevertheless, current conditions make it hard to estimate the impact that an economic slowdown in the U.S. would have on oil prices, which are a key variable for the Venezuelan economy."

Still, the Latin American countries that have recently acquired the status of "investment grade," including Brazil, have a certain cushion. "These countries are better situated to take in foreign investment, which is the best way to protect the continuation of growth," says Kon. However, despite improved economic policies for dealing with today's crisis, "a countervailing factor is the larger role that these countries are playing in the globalization process of the manufacturing and financial system, which means that the negative impact of such a crisis is considerably higher."

Brazil, Kon notes, "is in a favorable situation when it comes to macroeconomic indicators. On the other hand, price increases for some food products are slowing down, which affects inflation. So Brazil may react better to the impact of the crisis. Still, the decline in external credits and direct foreign investment will affect the growth of private-sector companies as well as the expenditures and investments that the government has outlined in its ambitious plans for building new infrastructure. That's because tax collections are already at an extremely high level and do not show any signs of increasing."

Possible Solutions

Although each country has unique circumstances, expect all Latin American exports to be seriously damaged by the financial crisis. Countries most exposed to the U.S. crisis will be hurt the most of course, notes Tuesta Cardenas. He forecasts "a slowdown in those export sectors that are most closely tied to the U.S. market, such as textiles." Along the same lines, Kon notes that "sectors that are focused on exports, such as steel and other mineral inputs, will also reflect the decline in global demand."

Obuchi sees a generally uncertain future for countries counting the U.S as their main trading partner. "A decline in the growth rate of the U.S. would have direct consequences on demand for products that Latin American countries export." At the same time, "the U.S. financial system is rebalancing its portfolio of assets into positions that are less risky. This has a negative impact on the valuation of the debt of emerging countries. As a result, it could raise the cost of indebtedness for these countries."

What is the best way to limit the damage? "Recipes don't always wind up having positive results. It depends on the chef, the availability of high quality ingredients, and on the reaction of the person who eats the product," notes Kon. Nevertheless, she adds, the basic ingredients in any diet for addressing this crisis are "the containment of public spending; higher interest rates for restraining inflation; precautions about higher-risk investments in manufacturing and financing; and assuming greater control over each country's internal financial system."

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