Latin America: Growing Disconnect, Growing Risk
March 05, 2008
By Gray Newman & Daniel Volberg | New York
The disconnect between the US economy and Latin America has never been greater than in the first months of 2008. While our US economists are focused on the continued fallout from the credit crunch, the housing recession and a weakening labor market, throughout Latin America new growth records keep being set.
Peru announced last week that real GDP grew by 9.1% in 4Q, bringing growth for 2007 to 8.9% − the best pace in more than a decade. Meanwhile in Brazil, the signs of abundance are widespread: locals are boasting that auto production could set a new record – up to nearly 3.5 million vehicles this year – while foreign direct investment doubled in 2007 to US$35 billion compared with just a year ago. Even in Mexico − where the link with the US is strongest − the downturn is not immediately apparent. While Mexico’s 4Q GDP began to show a slowing pace on a quarter-over-quarter basis, the more widely reported year-over-year report showed 4Q GDP up 3.8% − its best quarterly performance during the year. The implications of the growth disconnect on monetary policy and currencies could hardly be more striking. While our US economists revised their Fed call again this past week − they are now expecting a 50bp cut at the March 18 FOMC meeting – Colombia’s central bank surprised the markets last month with yet another hike, and Boris Segura is not willing to rule out that the central bank is finished. For that matter, Luis Arcentales is also concerned that Chile’s central bank is not through. The upshot: Latin currencies have been rallying while the US dollar’s fall has intensified as soaring commodity prices have benefited the region’s balance of payments even as higher foodstuff prices have put pressure on central banks to hike interest rates. One might think that we would be celebrating the growth disconnect. After all, if one wants to make the case for Latin America or broader emerging markets as the new ‘safe haven’, simply take a trip to New York and meet with the economists and strategists there. Then head to Sao Paulo, Buenos Aires or Lima and meet with local businesses. The contrast has rarely been greater. Welcome to the Land of the Lags But we suspect that 2008 is likely to be the year when Latin America faces its first serious external shock as the US recession works its way through trade channels, commodity prices, investment plans and financial markets. We suspect that the disconnect we are seeing today in the first months of 2008 is the product of lags. The reason for our caution? Having reviewed the growth record of the region, we continue to come to the same conclusion: most of the improvement in growth appears to have been the product of external factors. In contrast, the home-grown determinants of growth have contributed very little to the era of abundance that the region has been enjoying during the past five years. Whether one looks at investors’ regional darling (Brazil) or its much more controversial neighbor (Argentina), we find that external factors explained the bulk of the improvement in growth rates in recent years. In particular, Argentina’s average 8.7% growth since 2003 would have been only 3.7% if not for the unusually favorable external environment. And for Brazil, external factors have boosted growth by 1.6 percentage points on average every year since 2003. That is most of the difference between Brazil’s current status as investor favorite today and its previous one as pariah only a few years ago. The Model We tend to shy away from lengthy explanations of the econometric work that supports much of our analysis. But faced with the stark contrast between the growth pace in the US and what we are seeing in Latin America, we thought it would be worthwhile to revisit the work we have done in a bit more detail. We use a series of domestic factors to help construct a fundamental long-run growth rate for the region’s biggest economies. Economists have come up with a long list of variables that determine economic growth in the medium term. In particular, seminal papers by Barro (1996) and Fischer (1993) show that inflation, the fiscal balance, employment growth, education, the investment rate and the most flexible version of the exchange rate are some of the key determinants of long-run growth. We use inflation, the ratio of government consumption in GDP, employment growth, the investment rate and credit penetration in the economy as the domestic factors that determine the long-run growth rate in the three major regional economies. We exclude education because, although we think that it is important in the long run, the data are not available on a quarterly basis; annual data suggest that little progress has been made on improving the quality of education in the region. We augment the domestic growth factors with four external factors to account for the growth dynamics in the region. Our starting point is a research paper by economists at the Inter-American Development Bank (IADB) who examined how regional growth was affected by four external factors – global growth, the world interest rate, the risk premium and the terms of trade. We use their definition of external factors, but place it in a richer framework by augmenting them with the domestic factors that help to determine long-run growth. We use industrial production to proxy the world interest rate, the spread between the US high yield index and the federal funds rate as a proxy for the risk premium and export and import price indices from each country’s statistical agency to construct the terms of trade. Additionally, we depart from the IADB study in that we run a vector auto-regression (VAR) for each individual country rather than aggregating all the regional economies into one. The Exercise We use the model to test how much of the growth acceleration could be attributed to the unusually favorable global conditions over the last five years. To this end, we examine two scenarios. In the first, actual external factors are used in the growth model. In the second, we construct a model for the 1990-2002 period to forecast external factors for the 2003-07 period. Thus, in the second scenario, we work with a forecast of what the global environment was expected to be, in line with the trend from historical data. The forecasts of external conditions project a less favorable globe. Empirically, the most influential external conditions for all three countries – the risk premium and the terms of trade – are projected to be favorable, but less than the unusual improvement that was actually observed in the 2003-07 period. In part this is attributable to the fact that the last five years have been the longest uninterrupted stretch of above-trend global growth in over three decades. For Argentina and Brazil, the terms of trade plays a big role in boosting GDP growth over the last five years. In particular, we find that for Argentina the terms-of-trade boost is the single most important driver of the recent unusually robust growth, while for Brazil it is less significant but still important. This is best captured by the impulse response of GDP growth to a one-time positive shock in the terms of trade. For Argentina, a 5% boost in the terms of trade yields a 1.5% boost in GDP growth. For Brazil, a 5% boost in the terms of trade yields a 0.6% increase. Given that the projected improvement in the terms of trade was 5% below the actual in Argentina and 11% in Brazil, the average boost to annual growth from the terms of trade is 1.5 percentage points in Argentina and 0.7 in Brazil. The Concerns It is true that, over the last five years, the region saw a dramatic improvement in balance sheets, which should make it more resilient. With most regional economies running trade and fiscal surpluses, significant progress on cutting the debt burden, successful liability management of the existing debt and effective progress in fighting inflation, there is less of a chance that a slowing global economy would result in a severe economic crisis in Latin America. That, for us, is a victory. However, we suspect that strong balance sheets will not insulate the region from the business cycle. Given that the current US downturn is consumer-driven, the main impact is likely to come through a reduced demand for emerging market goods. Thus, the main transmission channel is the balance of payments, but the real problem is the capitulation of the developed world consumer. If the US downturn spreads to Europe and Japan as our regional colleagues expect, it is not clear how much of the lost consumption can be made up for by increased demand from emerging economies. The US, UK, Eurozone and Japan account for roughly 80% of global consumption based on market exchange rates. In contrast, the BRIC economies account for roughly 10% of global consumption while the rest of the emerging markets account for the remainder. While purchasing power-adjusted GDP makes sense for many purposes, we would argue that market exchange rates are better suited when trying to compute offsetting consumption. Given the lopsided nature of global consumption, emerging markets would need to boost consumption by another 6% above and beyond their current case in order to offset our global team’s projected 1.5% slowing in developed world consumption in 2008. Given already heady consumption growth in emerging economies, rising inflation and limited infrastructure, we are skeptical that such a boost in emerging market consumption is realistic. The coming global slowing in consumption is likely to work its way through to Latin America and broadly to emerging markets in 2008. Bottom Line It is tempting to join the ‘safe haven’ camp as the growth disconnect between the developed world and Latin America seems to be on the rise. But we suspect that 2008 will end very differently to the way it has started. We suspect that slowing growth in the US and developed world will work its way through to slower growth in Latin America as well. With stronger balance sheets than in the past, Latin America should be better able to weather the slowdown. That is good news for us and should represent a victory for much of the region. But the sharp contrast at the beginning of the year between the heady growth seen in the region and the heightened level of concern in the US is likely to be muddled as the year advances. The era of abundance was largely externally driven, and it can also be externally removed.
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No Upside from the Stalled Selection of a New Governor
March 05, 2008
By Takehiro Sato | Japan
No Upside from the Stalled Selection of a New BoJ Governor The Democratic Party (DPJ) has hardened its stance after the ruling coalition forced the F3/09 budget bill through the Lower House, raising uncertainty about the promotion of Deputy Governor Toshiro Muto to the top spot just ahead of the end of the current governor’s term. DPJ sources assert that there is no chance of the party agreeing to this choice. While some members of the DPJ are suggesting former Deputy Governor Yutaka Yamaguchi as an alternative choice, it is doubtful that this represents a party consensus. The DPJ might be adopting a tough stance on the BoJ governor choice as part of a bargaining effort for a compromise from the ruling coalition on the timing of dissolving the Lower House and holding a general election. The selection process has clearly become a political football. We think that disruptions surrounding the selection process symbolize a decline in government functionality and have even wider implications. Expiration of gasoline tax/other special tax measures and the several sunset laws at the end of March might trigger panic and prevent the government from issuing JGBs. Designated road funds would automatically become general fiscal resources if the law expires. While this might come as welcome news from the standpoint of progress with structural reforms, it would be disruptive since the Lower House is planning to reinstate the law with an absolute majority within a few weeks to months. This situation has negative implications for Japan’s asset markets. Former Deputy Governor Yutaka Yamaguchi Well-Known Internationally but Mixed Sentiment at the BoJ Former Deputy Governor Yutaka Yamaguchi is well-known enough in international financial circles to have been listed as a candidate for the BIS general manager post. He is also one of a few individuals capable of discussing issues on an equal footing with central bank presidents and is likely to receive full market support. However, sentiment within the BoJ is mixed, given Mr. Yamaguchi’s confrontations with former BoJ Governor Masaru Hayami over policy management, and Mr. Yamaguchi has effectively retired from public life since finishing his term as deputy governor. Bank officials hence are interested in having Mr. Muto take over. Yet the Ministry of Finance and BoJ have little influence at this point now that the issue has become a political football. Possibility of Continued Normalization if Mr. Yamaguchi Is the Choice Mr. Yamaguchi is an advocate of normalizing Japan’s monetary policy, similar to former executive director Masaaki Shirakawa, a candidate to be deputy governor. We think that the choice of Mr. Yamaguchi as governor would reduce Mr. Shirakawa’s chance of being selected and increase the likelihood of a MoF candidate, given resistance to having two former BoJ officials in the top-three leadership group. Selection of a BoJ governor with a strong policy normalization stance would be a setback for our scenario of an early rate cut. Still, the basic direction of monetary policy is likely to be determined by economic fundamentals rather than personnel affairs, in our view. Outlook The DPJ is calling for a cooling-off period in Diet operations, according to Diet Affairs Committee Chairman Mr. Yamaoka, including the BoJ governor selection process, and is unlikely to completely reject proceedings for an extended period. Yet the ruling coalition and market conditions could prod the DPJ away from this game amid growing instability in stock and currency markets. The question is whether this happens by March 19, given the possibility of the game continuing right up until the end of Mr. Fukui’s term. Risks In my personal view, Mr. Yamaguchi might reject the BoJ governor position, considering his decision to decline any kind of golden parachute posts normally provided to a former deputy governor (possibly because of the above-mentioned uncomfortable relationship with Mr. Hayami at the time of his departure). This could leave a temporary opening at the BoJ governor position if the DPJ is unwilling to accept Mr. Muto even after a rejection from its only alternative candidate. We can imagine a number of scenarios, albeit somewhat technical, to avoid an opening. The first possibility would be a sudden end to the Diet session from dissolving the Lower House that prevents approval votes by the Upper and Lower Houses. The cabinet can appoint the BoJ governor and deputy governors without Diet consent in this case. The government could use this approach to extend Mr. Fukui’s term. Yet the chances of a sudden dissolution and hence this scenario are low in the near term. The second possibility is an opening while the Diet remains in session. Since the current BoJ Law makes no provision for this eventuality, nifty moves would be needed to keep the policy board functioning. This might take the form of the current governors stepping down, and then taking up positions as executive directors. Diet approval would not be needed to become an executive director, and the Minister of Finance could make such appointments based on the recommendation of the policy board (BoJ Law, article 23, clause 3). The newly appointed directors could then be co-opted onto the policy board in the normal line of business. These proceedings were characterized as the view of the Cabinet Legislation Bureau in the House of Councillors Financial Affairs Committee last November as “a theoretical possibility that is not ruled out” (source: Bloomberg news). The BoJ Law provides that the executive directors may take the governor’s duty when the governorship is vacant (article 22, clause 5). The policy board chairperson is chosen by the other members (BoJ Law, article 16, clause 3). In this case, it should be theoretically possible to elect a newly added executive director as the chairperson of the policy board, and so Fukui could carry on in this role even after stepping down as governor by becoming an executive director until the governor’s post is filled. This is simply a theoretical possibility, and not a stratagem that the government would be likely to embrace eagerly, but is worth keeping in mind should a vacancy in the governorship leave the policy board chair open. Eventually, the BoJ could address the situation by having Mr. Fukui serve as an interim director with continued influence after the official departure. This approach would highlight the decline in government functionality, since a director cannot participate in G7 meetings or other international conferences. While these developments would have moderately negative implications for our view for an early rate cut, economic fundamentals and market realities are likely to strengthen the pressure if political disruption destabilizes markets.
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Inflation Heading Up Again: How Will Policymakers Respond?
March 05, 2008
By Chetan Ahya | Singapore
Headline Inflation Close to RBI’s Tolerance Limit Headline inflation accelerated to 4.9% during the week ended February 16, 2008, from 3.5% during the week ended December 29, 2007. All the four broad components of inflation (Wholesale Price Index) – food, fuel, global commodity-linked products and non-food non-global commodity linked products – have witnessed a simultaneous acceleration in inflation. The largest contribution to this acceleration came from the non-food non-global commodity products index: 67bp out of a total rise of 139bp in headline inflation over the past eight weeks. The second-largest contribution has come from fuel, power, light and lubricants components, accounting for 44bp of the total increase. Budget Measures May Help Temporarily The Union Budget announced last Friday has initiated several indirect tax reductions. The government announced a cut in central value-added tax to 14% from 16%. The central sales tax rate has been reduced from 3% to 2% effective April 1, 2008. In addition, the government has also reduced excise duty for select products, with a specific focus on automobiles and consumer goods. We believe that these measures could help to reduce headline inflation over the next 2-3 weeks by 30-50bp, depending on how much producers pass on the benefit of tax reduction to consumers. Recent Rise in Global Commodities a Key Concern If the current pace of increase in global commodity prices continues over the next 6-8 weeks, headline inflation (WPI) will again cross the RBI’s near-comfort zone of 5%. The key concern arises from potential rises in food, oil and global commodities ex-oil. Over the past eight weeks, the CRB Foodstuff Index has increased by 19.9%, while crude oil (WTI) and the CRB Commodities Index have risen by 6.9% and 11.8%, respectively. What Will Be the Policymakers’ Response? Unlike some of the other Asian countries, India’s policymakers have low tolerance for even the supply-side inflation pressures. We believe that they are extremely focused to ensure that headline inflation (WPI) does not rise above 5%. We believe that the policymakers have the following three options to manage inflationary pressure: 1. Ad hoc measures to influence the product prices: We believe that this will be the most preferred option in the near term. The government has reduced indirect taxes (excise and import tariffs), restricted exports of certain food items, imported food items to supplement supply and regulated oil prices. We expect the government to take some measures to influence food and other global commodity prices by way of further reduction of indirect taxes. In the near term, we believe that the government will prevent another round of oil price hikes even if oil prices rise further. We also do not rule out moral suasion on domestic commodity producers not to aggressively lift prices even as international prices continue to rise. 2. Exchange rate appreciation: This is the second-best option for policymakers. For this option to be available, the global risk appetite environment, particularly for emerging markets, needs to be supportive. In other words, capital inflows into India need to continue. The RBI will choose to allow appreciation of the rupee only if commodity prices shoot up another 10-15% from the current level. As we highlighted in our recent note, the RBI is not very comfortable opting for further exchange rate appreciation. The reasons for its hesitation include (a) the rupee has already appreciated 9% against the US dollar over the last 12 months compared with an 8.3% appreciation of the Chinese renminbi and 5.9% average appreciation of the ASEAN-5 currencies; (b) the currency remains over-valued on a real effective exchange rate (36-country index) basis; and (c) goods export growth (in rupee terms) has already decelerated to an average of 7.3%Y during the 12 months ending January 2008 from 27.1% during January 2007. 3. Monetary policy: Tightening monetary policy further from here will be the last choice. We believe that it’s a low probability outcome. We believe that real interest rates are already high and have compressed consumption growth significantly. Moreover, the banking sector is already suffering from risk aversion (see Rising Credit Spreads and Slowing Consumption, February 19, 2008). Any policy tightening at this time could have an adverse impact on financial stability and a far-reaching impact on growth. However, some amount of automatic tightening will happen if there are large capital outflows, an outcome that is not our base forecast. Conclusion India is witnessing a re-emergence of the inflation problem due to sharp rises in global commodity prices including food, oil, metals and chemicals. We believe that the government does not have any easy policy options to address the inflation challenge. The government is likely to opt for ad hoc intervention in the domestic commodity markets to influence their prices in the near term. If commodity prices shoot up by another 10-15%, assuming capital inflows are still supportive, we believe that the RBI will allow an appreciation of the exchange rate as the second-best option to ensure that headline inflation remains under 6%. Key Risk We believe that the key risk to the inflation outlook is one of potential capital outflows resulting in weakening of the exchange rate at a time when commodity prices continue to rise. In such a market environment, inflation will spike above 6% and market-oriented rates will move upwards even if the central bank does not officially tighten further.
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