World Economic Imbalances and their Impact in Latin America

1
World Economic Imbalances and their Impact in
Latin America

• LILIANA ROJAS-SUÁREZ
• Center for Global Development
• Mexico, June 2005

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Summary

• In contrast with 2004, 2005 is a year of very
  varied economic growth among industrial nations.
  While economic recovery is expected to continue
  in the US, and Latin America is expected to
  benefit in general from this recovery, European
  and Japanese growth appears weak.
• The extremely high prices of non-agricultural
  commodities benefit the fiscal accounts and
  balance of payments of many nations in the
  region.
• Latin America has also benefited from very low
  international interest rates.
• But 2005 results are very fragile, and the Latin
  American region faces significant risks stemming
  from the need to correct macroeconomic imbalances
  in industrialized nations and China, aside from
  the vulnerabilities specific to each country in
  the region.

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• More macroeconomic imbalances are created in
  international markets. This due to the following
• The need for monetary policy adjustments in
  industrial nations to prevent inflationary
  episodes and/or disorderly exchange rate
  movements.
• Fiscal imbalances in many industrialized nations,
  especially the United States and Japan, which are
  unsustainable for the medium term.
• The enormous US current accounts deficit,
  correction of which requires exchange rate
  adjustments.
• An overheated Chinese economy.
• Conflicts with the Arab world and possible
  terrorist attacks.
• Given the need for global level adjustments, the
  greatest risk faced by Latin America is that 2004
  2005 growth results are regarded as permanent
  and the relatively favorable international
  context for necessary reforms is overlooked.

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The Unusual Global Economic Growth of 2004 will
not be repeated in 2005-2006
The need for global macroeconomic adjustments
will reduce growth in 2005 and 2006.
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The Unusual Global Economic Growth of 2004 will
not be repeated in 2005-2006
Latin America also reflects the global outlook.
Although 2005 still looks favorable, estimates
point to slower growth in 2005-2006, especially
in Argentina and Ecuador.
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The Unusual Global Economic Growth of 2004 will
not be repeated in 2005-2006
Most Central American nations reflect the world
economic outlook.
7
What policy decisions made by the industrialized
world help explain the current economic cycle?

• In contrast with 2004, this year the US Federal
  Reserve is less worried about consolidating the
  economic recovery and more about inflation. That
  is why rates will rise continuously.

Since Japanese growth rates are still very low,
the nominal interest rate will be zero in 2005.
However, European rates are under pressure to
rise.
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What policy decisions made by the industrialized
world help explain the current economic cycle?

• Low interest rates allowed a significant rise in
  housing prices and this induced a wealth effect
  that kept consumption stable in the United
  States, in spite of the stock market drop of
  2000-2002.
• US authorities maintained this expansive
  monetary policy until investment recovered. Once
  investment recovered in 2004, monetary policy
  gradually reverted ---and will remain subject to
  adjustments during 2005-2006, introduced to
  contain possible inflation episodes.

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What policy decisions made by the industrialized
world help explain the current economic cycle?

• An expansive monetary policy was supplemented by
  an expansive fiscal policy in industrial nations.
• But, in contrast with the estimated monetary
  adjustment (at least in the US), no significant
  reduction is foreseen in the fiscal deficits of
  industrialized nations. The fiscal adjustment
  will be slower than the monetary adjustment.

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What Asian policy decisions help explain the
current economic cycle?

• III. The export-centered growth strategy pursued
  by China and other Asian emerging nations has
  increased the global products supply. This main
  factor helps explain the coexistence of expansive
  policies with low inflation levels in the
  industrialized world.

To a large extent the Asian current account
surplus finances the high current account deficit
of the United States.
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What Asian policy decisions help explain the
current economic cycle?

• Higher than 8 growth in China will not fall in
  2005. What may be questioned is the
  sustainability of this growth (as will be seen
  ahead).
• The role of China as a significant world
  economic player is manifested in the extremely
  rapid growth of its trade.

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The productivity effect is reflected in global
economic behavior

• While Asia and North America stand out for their
  impressive productivity growth during the last
  decade, productivity growth in Europe and Latin
  America has slowed down.

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THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON
LATIN AMERICA

• The dramatic rise in the price of
  non-agricultural commodities has benefited many
  nations in the region, but has negatively
  affected net oil importers.

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THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON
LATIN AMERICA
But a series of agricultural commodities such
as sugar and coffee have also shown significant
recovery.
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THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON
LATIN AMERICA
Improved commodity prices influence the non-oil
mining products exported by Latin America. For
example the prices of gold and copper have risen
significantly, and market estimates indicate the
price of gold will continue to rise in 2005 and
2006. Although a moderate drop is predicted for
copper forward prices, not all analysts agree and
some expect the excess global demand that keeps
prices high to be maintained.
The combination of low interest rates in
industrialized nations, a weak dollar and
volatile stock markets has supported rising
prices in precious metals in recent years.
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THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON
LATIN AMERICA

• Capital inflows in emerging nations will
  continue in 2005 and Latin America will benefit
  from this.

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THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON
LATIN AMERICA

• The larger volume of capital inflows is due to a
  combination of factors, including the following
• Still ample liquidity at the global level
  (although diminishing)
• A weakening dollar creates incentives for capital
  outflows to other countries, including emerging
  nations.
• A greater interest in funds dedicated to
  emerging nations counters a reduction in
  international bank loans.
• Increased foreign direct investment motivated by
  the US economic recovery and the favorable
  macroeconomic figures of many nations in the
  region, including current account statements that
  still show a surplus (although diminishing).
  Brazil and Mexico will receive the largest
  portion of direct foreign investment in the
  region.
• Improved foreign debt sustainability indicators,
  since various regional nations took advantage of
  low interest rates to place relatively cheap
  longer-term bonds in order to repurchase
  expensive debt.

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THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON
LATIN AMERICA
One additional positive factor is that not only
has Foreign Direct Investment increased the
Latin American share of total Foreign Direct
Investment in developing nations has remained
stable, and seems to be more resistant to
international interest rate variations as well.
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THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON
LATIN AMERICA
The improved international situation is
reflected in a higher EMBI (bond prices), with
the exception of Argentina.
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THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON
LATIN AMERICA
However, the projected reduction in global
liquidity generated by expectations surrounding
US interest rate adjustments has led to greater
variability in the price of bonds, and
considerably lower returns for investors, for the
period 2004-May 2005 compared with 2003.
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THE RISKS

• The greatest risk to global economic stability
  is that the governments of key nations (the
  United States, Europe and China) fail to adopt
  the necessary measures to correct major
  macroeconomic imbalances.
• Europeans and Asians believe the principal
  imbalance is the low level of savings (especially
  fiscal savings) and excessive imports from the
  US.
• The US government says the opposite, that is, the
  problem is excessive Asian and European savings
  and very low levels of imports by those nations.
• Europeans and Asians believe the most important
  solution is the revaluation of the Chinese
  currency and thus more Chinese imports and less
  exports. What is ironic about this proposal is
  that a revaluation of the yuan would mean that
  China would reduce its purchases of US Treasury
  Bonds!

All of them are right. No single measure (fiscal
and/or monetary/exchange) would in itself suffice.
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THE RISKS

• THE TIMING AND MAGNITUDE OF INTEREST RATE HIKES
  IN THE UNITED STATES

• Expectations
• International financial markets expect the Fed
  to rise interest rates to a neutral position,
  that is, to a rate compatible with the return to
  full employment growth and a stable inflation
  rate (of about 2).
• Market estimates suggest a neutral rate of
  about 4, but also including overshooting to
  curtail inflation episodes and/or excessive
  depreciation of the dollar.

This expected path has allowed investors to
adjust their positions and prevented
distortions in international financial markets.
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THE RISKS

• THE TIMING AND MAGNITUDE OF INTEREST RATE HIKES
  IN THE UNITED STATES

• Uncertainty
• Although the long term focus of US interest
  rates is known, there is great short term
  uncertainty due to the following
• The Federal Reserve may accelerate interest hikes
  if
• Inflation rises rapidly beyond expectations
• The depreciation of the dollar leads to financial
  instability
• Very slowly rising interest rates produce a
  mortgage market bubble
• And already some significant signs point to an
  overheated mortgage market

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THE RISKS

• THE TIMING AND MAGNITUDE OF INTEREST RATE HIKES
  IN THE UNITED STATES

• Uncertainty
• Besides, the Federal Reserve gives great
  significance to unit labor costs as an
  inflation indicator, and these costs have been
  rising significantly while productivity growth
  has slowed down.

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THE RISKS

• THE TIMING AND MAGNITUDE OF INTEREST RATE HIKES
  IN THE UNITED STATES

• An excessive interest rate hike may revert
  capital flows into the region.
• The greatest problem is the rebirth of the debt
  sustainability problems of several Latin American
  nations.

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THE RISKS

• INTERNATIONAL LIQUIDITY IS ALSO AFFECTED BY THE
  DOWNGRADING OF MAJOR INTERNATIONAL COMPANIES

• The General Motors and Ford downgrades led to
  significant losses in financial institutions
  (including hedge funds) that had collateral in
  the stocks and bonds of those companies.
• This has raised risk aversion among investors and
  is increasing the cost for companies of obtaining
  financing through bonds.

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THE RISKS

• FISCAL DEFICITS IN THE INDUSTRIALIZED WORLD,
  ESPECIALLY IN THE UNITED STATES, CAN PRODUCE
  UNCERTAINTY IN INTERNATIONAL MARKETS.

• Due to medium term fiscal pressures originated in
  social security and Medicare in the US (stemming
  from the relative increase in the retirement age
  population), short term fiscal correctives are
  required. Otherwise the fiscal position runs the
  risk of becoming unsustainable, which would then
  require an excessively strong and prolonged
  adjustment. The negative effects produced in
  Latin America by a strong adjustment related to
  economic contraction in the US are obvious,
  especially in the context of new free trade
  treaties.

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THE RISKS

• FISCAL DEFICITS IN THE INDUSTRIAL WORLD,
  ESPECIALLY IN THE UNITED STATES, CAN PRODUCE
  UNCERTAINTY IN INTERNATIONAL MARKETS.

• Given the new Bush administrations intent of
  making the 2001 tax breaks permanent, there is
  greater risk that the fiscal deficit may increase
  in the coming years.
• If a higher fiscal deficit materializes,
  additional pressure may be generated for a strong
  interest rate hike, with the resulting negative
  effects on Latin America.

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THE RISKS

• THE ENORMOUS US CURRENT ACCOUNT DEFICIT REQUIERES
  GREATER DEPRECIATION OF THE DOLLAR WITH RESPECT
  TO THE EURO AND ASIAN CURRENCIES

• Correcting this imbalance is believed to require
  close to a 20 depreciation in the effective real
  exchange rate of the US.

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THE RISKS

• THE ENORMOUS US CURRENT ACCOUNT DEFICIT REQUIERES
  GREATER DEPRECIATION OF THE DOLLAR WITH RESPECT
  TO THE EURO AND ASIAN CURRENCIES

and forward markets reflect the long term
trend, especially regarding the yen.
In spite of the recent slight appreciation of the
dollar, long term equilibrium is expected to
require a more depreciated dollar.
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THE RISKS

• WHAT ARE THE RISKS FACED BY LATIN AMERICA DUE TO
  THE US BALANCE OF PAYMENTS IMBALANCE?

• The first one is that a strong depreciation of
  the dollar would raise production costs for US
  companies (due to more expensive imports) and
  lead to a generalized reduction in imported
  inputs. An attenuating factor, however, is the
  possibility of substituting US imports from
  markets with appreciated currencies by markets
  whose export products are denominated in dollars.
• The second one is that a severe depreciation of
  the US dollar would raise the US inflation rate,
  leading the Fed to sharply raise interest rates.
• The third one is that a severe depreciation of
  the US dollar would reduce the real value of the
  international reserves kept in Latin American
  nations. This is why certain sales of dollars by
  the central banks of both emerging and industrial
  nations (such as Norway, for example) have been
  recently observed.

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THE RISKS

• THE POSSIBLE OVERHEATING OF THE CHINESE ECONOMY
  INVOLVES SYSTEMIC RISKS DUE TO CHINAS GROWING
  IMPORTANCE IN INTERNATIONAL COMMERCIAL AND
  FINANCIAL MARKETS.

• China is the worlds largest consumer of copper,
  zinc, iron and steel, and the worlds second oil
  importer (after Japan). It is therefore relevant
  in determining the prices of commodities.
• T
• The tremendous expansion of investment in China,
  financed with sharp growth in domestic credit
  (achieved especially through government banks) is
  not sustainable. Although some analysts argue
  that the Chinese economy will gradually cool
  down, crisis risks are still present because
  current policies implemented by authorities to
  curtail excessive growth in money and credit are
  still very limited. China already had this
  experience in the early 1990s, but then it lacked
  the international importance it now has.

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THE RISKS

• THE POSSIBLE OVERHEATING OF THE CHINESE ECONOMY
  INVOLVES SYSTEMIC RISKS DUE TO CHINAS GROWING
  IMPORTANCE IN INTERNATIONAL COMMERCIAL AND
  FINANCIAL MARKETS.

• Although international reserves have increased
  significantly, domestic credit has been growing
  at excessively high rates, increasing potential
  financial fragility.
• The good news is that the probability of a
  financial crisis in China is still modest but it
  will continue to increase of efforts are not made
  to cool the economy.
• Another fragility indicator is the accelerated
  growth seen in mortgage market prices.

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THE RISKS

• THE POSSIBLE OVERHEATING OF THE CHINESE ECONOMY
  INVOLVES SYSTEMIC RISKS DUE TO CHINAS GROWING
  IMPORTANCE IN INTERNATIONAL COMMERCIAL AND
  FINANCIAL MARKETS.

• The risks originate in the possible effects in
  international markets of a hard landing of the
  Chinese economy.
• Pressure for a drop in the price of export
  commodities from many Latin American nations, not
  only due to reduced direct demand from China, but
  also to the indirect effect produced on aggregate
  demand from the rest of Asia.
• Global recessive pressures stemming from the fact
  that China accounts for more than 20 of the
  growth in global trade in recent years.
• Pressures that reduce demand for US Treasury
  Bonds, which further exposes the balance of
  payments imbalances of the US.
• Increased volatility in international financial
  markets. Experience demonstrates that this
  volatility tends to increase risk aversion and
  reduce the financing available to emerging
  nations.
• Given the large accumulation of international
  reserves, no devaluation of the yuan is foreseen,
  nor any short term improvement in Chinese
  international competitiveness that could harm
  Latin American nations that compete with Chinese
  exports.

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THE RISKS

• AN ADDITIONAL RISK ORIGINATED IN CHINA

The expiration of the textile trade quotas that
took place towards the end of 2004 (for WTO
member nations) may produce additional pressure
in favor of textile price reductions (and these
products are also exported by some Latin American
nations). Nevertheless international analysts
dont think this represents a major risk, because
US importers prefer not to concentrate their
trade on China, especially after the temporary
imposition of import quotas on Chinese products
headed for the US and given that Europe is also
considering restrictions on Chinese imports.
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THE RISKS

• CONTINUED HIGH OIL PRICES POSE A MAJOR GLOBAL RISK

This is due to already mentioned factors
(economic recovery in the United States,
overheating in China), the high frequency of
weather shocks that raise demand for energy
products, and supply factors, including those
derived from the Irak conflict.
Although estimates point downward, prices in the
futures market are extremely high. This is
because the price of oil has experienced a
permanent increase due to a substantial
increase in global demand.
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THE RISKS

• BESIDES, THE PROBLEM WITH ESTIMATES IS THAT
  ANALYSTS SYSTEMATICALLY SUBESTIMATE THE OBSERVED
  PRICE OF OIL.

And this happened again in 2005.
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THE RISKS

• THE RISKS THAT HIGH OIL PRICES RAISE FOR LATIN
  AMERICA

• One risk basically consists of pressure exerted
  to accommodate oil price increases by relaxing
  monetary policy. Fortunately this risk has not
  materialized because most Latin American nations
  have implemented a restrictive monetary policy.
• Another important risk is the fact that recent
  estimates calculate that each sustained increase
  of US 10 per barrel in the price of oil reduces
  global growth by about ½ percent per year.

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THE RISKS

• A LATIN AMERICAN EXPORT RISK DISSATISFACTION
  WITH THE RESULTS OF DEMOCRACY AND THE MARKET
  ECONOMY.

• Recent surveys point to a high level of
  dissatisfaction with democracy and the results of
  reform in the population. The percentage of
  dissatisfied respondents is higher than 50 in
  all nations.
• This poses a serious risk to the continuation of
  the reform processes that the region requires,
  and must be addressed to prevent reform reversals.

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A RISK SUMMARY

• The greatest risk for Latin America is a
  reduction in global liquidity, given that the
  Federal Reserve will continue to raise interest
  rates in order to correct, at least in part,
  global macroeconomic imbalances.

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A SUMMARY OF OPPORTUNITIES

• Since the resolution of macroeconomic imbalances
  in leading nations in 2006 will imply a reduction
  in global growth, higher international interest
  rates and reduced capital flows into the region,
  2005 looks like a window of opportunities for
  Latin America.
• This is the best time to consolidate fiscal
  accounts, avoid debt problems and accelerate
  institutional reforms.
• Delaying these efforts may be very costly for the
  region. However, given the level of discontent
  among the population with the results of reforms
  already implemented, the inclusion of different
  social segments and the search for a consensus
  are essential.