Latin America and the Global Financial Crisis

By Peter Hakim
El Universal(Mexico), November 22, 2008

Available in Spanish

It was not too many months ago that Latin American governments and financial analysts generally were confident that the quality of the region’s economic management and its solid pace of growth in recent years would enable most countries to withstand a U.S. recession without suffering much damage to their own economies.  Today, Latin America faces the prospect of severe and widespread economic setbacks—because the slumping U.S. economy and international financial turmoil has led to a fall in international credit, diminished foreign investment, slowing remittance flows, weaker export markets in the U.S. and elsewhere, sharply depreciating currencies across the region, and plunging commodity prices. Instead of demonstrating Latin America’s economic resilience, the financial crisis has, ironically, highlighted the interdependence and vulnerability of Latin American economies to events in the U.S. and internationally.

Clearly, different countries will be affected in distinct ways. Chile is in the best position to confront the financial crisis because, unlike other nations of Latin America, it built up savings during the past five years and has the resources to finance, at least for a time, a counter-cyclical fiscal stimulus. Mexico and Brazil have both managed their economies prudently, but Mexico is more vulnerable because it relies so heavily on U.S. markets and remittances, and because oil revenues are so vital to its economy and make up a large share of government revenues. Falling commodity prices will cut painfully into Brazil’s exports, but affect its fiscal situation much less. Like Mexico, Central American and Caribbean countries will be hard hit because of their dependence on the U.S., but they will gain from the drop in food and fuel prices. Venezuela and Argentina are particularly at risk because commodity exports and prices are so critical to their finances and because they have managed their economies badly and alienated their creditors and investors.

Still, these differences aside, growth will diminish sharply in almost every Latin American country in 2009—resulting in increased unemployment and poverty, reduced government revenues, falling reserves, growing official debt, and deteriorating public services. What we don’t know is how steep the drop in growth will be or how long it will last—or what the social and political repercussions will be. That will depend principally on four factors.

The first is the depth and duration of the U.S. and European recessions, and the slowdown in growth in Japan, China and India. The optimistic view is that the U.S. economy should recover in six to nine months, but that is largely based on historical precedent. There is no good way to predict the particular trajectory of today’s unique complex of circumstances. One forecast after another on financial and economic activity has turned out to be overly optimistic, in the U.S. and almost everywhere else in the world (including China, where annualized growth this quarter may fall almost to one half its 2007 pace). And the massive stimulus and bailout packages fashioned by the U.S. and European countries appear consistently to be falling short in their aims to rebuild consumer and investor confidence and get credit flowing again.

Forecasts have been off the mark because of the complexity of today’s financial instruments and the immense difficulties economic analysts and officials have had in uncovering the full range of risks and vulnerabilities that countries confront.  In the U.S. and everywhere else, governments and markets have been surprised and confounded by unanticipated exposure. Hugely leveraged assets and high risk investments are regularly discovered in unexpected places. No one, for example, was aware that private companies in Brazil and Mexico had put large sums into derivatives, essentially gambling against currency depreciation.  Nor is it well known that some 40 percent of the reserves accumulated since 2007 by several of Latin America’s largest countries are effectively offset by increased private sector liabilities. And new risks and vulnerabilities will almost certainly continue to emerge in unforeseen ways. All this suggests that Latin American nations should be prepared for outcomes that are worse than are now being projected. It should certainly not be assumed that the region will again experience a “V” shape downturn and recovery as it has so often in the past.  This time, we may see a protracted period of low growth and a slower pace of recovery, perhaps like the “L” shaped debt crisis of the 1980s.

A second factor at play is how the U.S., Europe, and the Asian nations respond to the crisis. To what extent will they move toward more internationally cooperative approaches that will consider the interests of other countries—or will they yield to domestic political pressures and focus narrowly on their own needs? Will they keep their economies open, or are we likely to see an increase in protectionism, as Council of Foreign Relations President Richard Haass predicts, along with efforts to keep investment capital at home? At recent international conferences, participating world leaders pledged to avoid protectionist measures, but—if the crisis deepens—domestic political pressures could be difficult to withstand. And how will governments deal with immigration and remittances issues? To what extent will the U.S., Europe, and Japan make new resources available for the multilateral financial institutions—or for direct lending to Latin America?

The results of the G-20 summit meeting in Washington, where the leaders of the world’s major economies came together to coordinate approaches to the global turbulence, were disappointing. Agreement was mainly reached on the reforms needed to prevent the next crisis—with few concrete ideas for what to do now to address the troubled global economy. Worse yet, the measures needed to stem future crises (like higher capital requirements on financial institutions) may hamper recovery from the present predicament.

Still, the U.S. and EU, and emerging market countries, seem ready to pursue more cooperative strategies; they are making efforts to coordinate their responses, and proposing expanded support for the international financial institutions. The Inter-American Development Bank and the Andean Development Corporation, for instance, have set up a $10 billion fund to assist credit-starved companies in Latin America. The World Bank and IMF will almost certainly be allotted substantial additional resources to assist developing countries through the crisis. The U.S. Federal Reserve has already made currency swaps of $30 billion each available to four countries (Mexico, Brazil, Singapore, and Korea), to help them to stem further currency devaluations and avoid growth-retarding higher interest rates to curb inflationary pressures. But these efforts may be hard to sustain over time if the crisis is prolonged and the U.S. and EU economies continue to deteriorate.

A third question concerns how each of the Latin American countries will respond to the crisis. The challenge will be to maintain fiscal discipline and husband reserves at a time of diminishing public sector revenues coupled with increased demands from many sectors for government aid. There seems to be wide agreement among economists that, aside from Chile, Latin American countries lack the fiscal capacity needed to expand government spending very much and take other significant counter-cyclical measures. Unlike the U.S. or EU governments, they do not have the resources needed to stimulate their economies, assist their banks and corporations, subsidize consumers, defend their currencies, or protect vulnerable groups. In the view of most analysts, pursuing such initiatives without external support is likely to be a misuse of resources, which could end up jeopardizing subsequent economic recovery.

Fourth, we have very limited ability to foresee the political changes that stagnant economies (and the growing poverty and unemployment, declining government expenditures, and increasing frustration) may bring. In some countries, demagoguery and populism could thrive—and the resulting policies may worsen the economic damage. In others, mainstream economic approaches, if they are perceived to have kept the economy on track, may reward more economically orthodox governments. Still, political tensions, along with more polarized politics, are likely to emerge in almost every country and make economic decision making more contentious.

There is no way in short to accurately foretell how the financial crisis will affect Latin America. It is a mistake, however, to assume (1) that the region has already experienced the worst of the external shocks or (2) that the impact of the shocks will be largely restricted to a slowdown in growth, from which countries will move steadily to resume their previous expansionary trajectories.

There is at least some possibility that Latin America’s economic and political landscape may change in dramatic ways. A deep or prolonged slump (particularly if coupled with a sharp fiscal retrenchment) could undo the region’s impressive economic and social gains of the past five years—accelerating economic expansion, expanding reserves and lower debt, impressive reductions in poverty, a burgeoning middle class, and progress toward a fairer distribution of income—with difficult to foresee political repercussions. International confidence in the economic potential of Brazil, Chile, Mexico, and other Latin American countries could be set back, along with the self-assurance of many of the region’s business, financial, and political leaders, and of ordinary citizens. But it is also true that effective policy responses could bolster confidence in some nations.

It is also possible that the crisis could lead to the collapse or near-collapse of some of Latin America’s most vulnerable and/or poorly run economies. An array of troubling consequences would follow, and recovery could be slow and painful.

This crisis is different from the other crises that have battered Latin American economies in recent years. It is a global affair, with all of the world’s major economies suffering tight credit, shortages of investment capital, shrinking markets, rising unemployment, and uncertain futures. And Latin America today is thoroughly globalized. More than ever before, its growth and prosperity depend on the economies of the U.S., Europe, and Asia. It may be some time before those nations once again have the capacity to offer Latin American nations the export markets and capital (in the form of loans, investments, and remittances) they will need to revive their economic fortunes.