Turkey
Macro Conditions Deteriorating Rapidly – Looking for Policy Action
March 17, 2009

By Tevfik Aksoy | Istanbul

Revising Down Real GDP Growth Forecast Significantly on Weakening External Backdrop and the Absence of Effective Domestic Policy Action

In light of recent production, consumer sentiment, sales and employment data as well as the ongoing state of the global economy, we are (once again) revising down our real GDP growth forecasts for 2009 and 2010. Compared to our previous growth forecast of -0.5%Y for 2009 (which had been below consensus), we now expect a deeper recession at -3.5%Y. We have also cut the real GDP growth forecast for 2010 to 3%Y from 3.8%Y.

Our bear and bull case GDP growth forecasts for 2009 are -7%Y and -0.5%Y, respectively. In case global financial and credit conditions remain weak and the government delays policy action to improve the conditions for overall risk appetite as well as consumer sentiment, we believe that the probability of ending up in the bear case neighborhood is high. On the other hand, the timely monetary policy reaction to date as well as our expectation of further easing in the coming months, coupled with sound and efficient fiscal action supported by an IMF Stand-By Arrangement, could also keep the damage to a minimum.

Production Has Collapsed and Capacity Utilization Is at Minimal Levels

In January, industrial production posted a record drop of 21.3%Y, significantly worse than the weakness seen in 2001 when Turkey experienced one of its worst recessions. In fact, the contraction was nearly double the size compared to 2001, which is mostly a result of a simultaneous loss in external and domestic demand. The decline in production was broad-based, especially concentrated on sectors that are geared towards exports such as motor vehicles, electrical and other machinery and textiles. In the near term, we do not expect the picture to change much, other than some milder declines mostly on the back of base-year effects. We base this expectation on the assumption that both domestic and external demand will remain weak (as suggested by various indicators).

Meanwhile, the private sector capacity utilization rate remained at 63%, nearly unchanged compared to January, suggesting that the weakness on the manufacturing front will linger. At this juncture, we are witnessing a period in which almost all manufacturers, whether producing for domestic consumption or exports, have been trying hard to deplete the significant inventories that had built up during the growth boom. The timing is difficult to predict, but we believe that at some point during 2H09 the process will most likely end when some price pressures as well as a partial revival in employment could be witnessed.

One of the clear examples of this, in our view, is the automotive sector, where manufacturers have either been closing down production for certain periods and/or laying off workers to cope with the collapsing demand.

After declining by close to 60%Y in November and December 2008, passenger car sales slumped by a further 38%Y in the first two months of the year. We expect the government to introduce some temporary tax incentives to encourage car purchases, which might accelerate the inventory depletion process.

Unemployment Rate Likely to Hit All-Time Highs

Turkey’s young population, which is mostly regarded as a significant advantage during times of economic expansion, becomes problematic during periods of contraction.

This is so because the annual creation of jobs, let alone the added pressure of job losses, is difficult to maintain. As of November 2008, the unemployment rate reached 12.3% and, in our view, it might hit 15% during 1H09 and possibly ease a little towards late 2009. In the non-agricultural segment of the population, the unemployment rate has already reached 15.4%, and might reach 17-18% in the months ahead. Clearly, the rising unemployment in the country poses social and political challenges and, to us, it had been partially responsible for the delay in the long-awaited IMF Stand-By Arrangement. Due to the anticipated fiscal measures associated with the IMF program, we do not now expect an agreement until after March 29 elections, despite our earlier optimism that this would be sooner.

Over the past 12 months, some 650,000 people became unemployed, which might in fact be an underestimate, given the sizeable number of unregistered labor. We would assume that the actual figure might be in the order of a million. One of the direct impacts of this on the economy has been the worsening in consumer sentiment. Not only have many already lost jobs, but workers in various sectors still face the risk of unemployment, leading the individuals to save. This negative feedback loop is likely to delay the revival of private consumption, despite possible stimulus packages that the government might introduce.

Noticeable Weakening in Fiscal Performance

The deterioration on the fiscal side, which had been gradually picking up speed since mid-2008, gained pace in 2009. The Ministry of Finance budget data for January revealed a noticeable weakening in fiscal performance. The central government budget deficit yielded a sharp rise of 467%Y along with a 78% drop in primary surplus (budget deficit excluding interest) in January. The central government budget revenues remained flat compared with a year ago, with an 8.4%Y drop in real terms, while the overall level of expenditures reached TRY 18.8 billion in January, rising 15% in nominal terms and 5.3% in real terms. The cash-based fiscal data for February as reported by the Turkish Treasury brought no relief. The primary budget yielded a deficit of TRY 3.4 billion, which is likely to be corrected towards a flat reading as the delayed tax receipts show in the Ministry of Finance statistics. However, compared to the TRY 4.3 billion surplus recorded the same month in 2008, the picture points to continued weakening. While it might be argued that the ongoing economic contraction necessitates a counter-cyclical fiscal policy action, we have reservations regarding the efficient use of public funds in reviving demand. In essence, we believe that the local elections-related spending has been the root cause of the fiscal imbalance so far this year.

Official Macro Assumptions and 2009 Budget Targets Are Likely to Be Revised Soon

We expect the government to revise out-of-date macro forecasts, especially the 4% GDP growth rate, most likely in April. This is not only a crucial issue for finalizing a Stand-By Arrangement with the IMF, but also essential to realistically determining the extent of the necessary policy action to be taken. The budget for 2009, which has mostly lost its meaning in terms of attainability, will have to be revised, in our view. Our expectation is that the revenue targets will be cut since tax collection might be highly challenging during the recession. As a result, the government will have to curb spending limits, possibly after the municipal elections. Failure to do so might not only jeopardize the possible agreement with IMF officials, but also result in bigger damage to the debt dynamics beyond that anticipated for 2009.

Inflation Is Not an Issue for the Time Being

CPI posted a negative headline print of -0.34%M in February, pulling the 12-month trailing inflation rate sharply down to 7.7%Y. From the peak of 12% seen in July 2008, inflation had been steadily easing with improved supply conditions in the unprocessed food sector, lower commodity prices, cuts in utility costs and, most importantly, a rising output gap. The lack of domestic and external demand essentially limited the FX pass-through such that even the noticeable depreciations in the currency over the past months has had minimal impact on prices so far. Clearly, this might reverse course later in the year, especially if demand picks up and perhaps equally importantly when producers manage to minimize inventories and resume manufacturing. While we acknowledge this risk in making our projections, we expect the currency to remain broadly stable (excepting occasional blips) and thus predict the marginal pass-through to be limited.  In light of the recent data, our downward revision of the real growth rate as well as our assumption that there will be an IMF Stand-By Arrangement following the municipal elections, we project CPI inflation to decline to 5.9% in 2009. We expect a marginal monetary tightening in 2010 so that inflation remains broadly stable, with the underlying assumption that fiscal policy will be mildly tight.

Aside to the risks associated with a possible FX pass-through in 2H09, an additional concern might be the likely adjustment in certain administered prices and/or consumption taxes to maintain the budget targets. While we expect these to remain limited, any sharp price or tax adjustments will have a direct effect on our forecasts. That said, we would expect the central bank to keep inflation below the 7.5% target even in a more challenging environment thanks to the lack of demand. As an additional note, it must be borne in mind that agricultural output and hence unprocessed prices are likely to extend a helping hand to CPI inflation in 2009, which would be exactly the opposite of the case in 2008.

Core Inflation Heralds No Price Pressures

Not only the headline inflation but also almost all core inflation indicators displayed the lack of price pressures, in our view. In the past three months, most of the core price measures posted negative monthly prints that have encouraged the CBT further in relaxing monetary policy.

Policy Rate Cuts to Continue: To Single-Digits?

In our view, the current environment offers the ideal opportunity for the Central Bank of Turkey to lower the policy rate to new record lows. We have been arguing since late 2008 that inflation would ease, the output gap would expand and, with the lack of external demand, inflation would not be an issue for most of 2009. We maintain our view and we expect the CBT to ease rates by a further 150bp to 10% at a minimum. If the IMF program is put in place in a timely manner, fiscal measures are taken and the need to adjust administered prices as well as taxes is kept at a minimum, we would not rule out the policy rate from easing to single-digits during the year.

Turkish Local Government Bonds Still Offer Value

Taking into account our rate cut projections and the prevailing yield of 14.7% (compounded) on the benchmark bond, we foresee around a 300-350bp contraction in the spread over funding during the course of the year. Benchmark yields have dropped by nearly 450bp since late 2008 (see Turkey Economics: Good News for TRY Bonds? December 1, 2008).

In our view, the gradual easing in rates coupled with clean non-resident market positioning and, most importantly, the limited alternative fund placement options of local banks (no expansion in loans) will be positive for bonds.

That said, the decline in yields might not be as fast as in the past two months, simply due to the fact that we are approaching the terminal rate. Another point to take into account is the supply side of government securities. Looking at the debt redemption profile of the Turkish Treasury, we see that borrowing in March and April will be low since payments are limited. After a brief pick-up in May, another sharp decline in the borrowing requirement might be witnessed in June, which would be positive for bonds.

Current Account Deficit to Shrink to Multi-Year Low

Typical of the periods of sharp contraction in economic activity, the current account yielded a surplus of US$0.3 billion in January, bringing down the 12-month rolling deficit to US$37 billion. On the back of our GDP growth rate forecast revision and tame commodity prices, we revised down our current account deficit forecast to US$9 billion from US$17.9 billion previously. The new forecast is merely 1.4% of GDP.  We have also revised down our foreign direct investment (FDI) forecast to US$8.6 billion, which might turn out to be a conservative estimate, in our view.

With the lowest monthly (net) FDI in more than a year at US$0.6 billion, an outflow of US$0.8 billion on the part of portfolio investments and a low debt rollover ratio on the part of the corporate sector (i.e., net payer of debt), the capital account deficit reached US$2.3 billion in January. This had been the fourth consecutive negative print, and brought down the 12-month rolling figure to US$26.9 billion – the lowest level in four years. In our view, this figure taken alone is a source of concern, especially considering the fact that the private sector debt rollover rate eased to a monthly rate of 71%. While this issue remains one of the top concerns surrounding the external sector, we continue to subscribe to the thesis that a significant portion of external borrowing by firms had been made with deposit collateral and hence constitutes a lesser degree of systemic risk than the consensus view. Unfortunately, due to the lack of data and clear information on the issue, it is bound to remain a thesis that is difficult to prove.

An Error Too Big (and Good) to Ignore

While we expressed our concern regarding the debt rollover rate of the private sector, we must note that the net errors and omissions term had posted another sizeable figure of US$1.7 billion (inflow) in January. This brought the total figure to a significant US$14 billion between October 2008 and January 2009. We should note that the noticeable change in the error term had started with the commencement of the weak(er) debt rollover rates seen in the private sector.

We believe that these two issues might be closely related, and the sharp rise in unrecorded FX inflows is associated with the financial stress in global markets. That is, these funds are most likely associated with the under-the-mattress holdings of residents as well as a partial repatriation of funds held at offshore banks, in our view. The net error term as well as the expected inflows associated with the Wealth Amnesty might be sufficient to cover the overall gap for a while. That said, we maintain our view that the long-awaited IMF Stand-By Arrangement remains crucial to closing the overall financing gap in Turkey.

External Financing Gap Should Not Be a Major Challenge, Especially with an IMF Program

As had been the case back in November 2008, we maintain our view that the overall external financing gap in 2009 could be handled without a major systemic problem. Compared to our previous projections, we now lower the current account gap, which cuts the overall financing need to some extent. On the other hand, we have also revised down our FDI assumptions and most importantly assumed a very conservative 50% debt rollover ratio for the private sector. This still yields a gap of some US$13 billion, which might mean a loss of reserves and/or currency depreciation. It should be borne in mind that by nature we are assuming no FX inflows associated with the net error term, which might turn out to be a strong assumption after all. Hence, we maintain our view that an IMF Stand-By Arrangement with a credit facility of some US$20 billion would be sufficient to ease concerns regarding the financing gap. Nevertheless, for the market to be completely satisfied, a figure of US$25 billion would be more welcome.

Our FX Forecast

In our view, the lira has been through sufficient depreciation and cannot be regarded as over-valued any more. In fact, the recent depreciation that brought it down to 1.8240 was over-done and to us it has been a transitory event. Clearly, we cannot rule out more of these in the near future as the TRY is very much correlated with the global equity markets (especially with the S&P) and recently it had been treated nearly equally with some Eastern European credits; this is a fundamental error, in our view, since we see virtually nothing in common between these countries.

Assuming that the IMF Stand-By Arrangement will be finalized after the municipal elections, the continued lack of domestic and external demand, as well as measured policy rate cuts, we expect the lira to remain broadly stable. We project the year-end USDTRY rate at 1.70, although we do not rule out transitory fluctuations around this level throughout the year.

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Latin America
Lengthening the Downturn
March 17, 2009

By Gray Newman & team | New York

Only two-and-a-half months into the year and it seems clear that the magnitude of the downturn at the turn of the year was much more pronounced than even the most pessimistic forecasters envisioned. We were among the most pessimistic – calling for a Mexican contraction and no growth in Brazil in 2009. Yet, even our warnings came up short. Absent a remarkable reversal in the global cycle, Latin America looks set to suffer its most severe downturn since 1983.

We are revising downward our forecast for Latin America’s real GDP in 2009 to -4.3% from our last comprehensive revision when we expected a contraction of 0.5% for 2009. While the magnitude of the downturn – the Mexican economy contracted at a sequential pace in excess of 10% annualized in 4Q while Brazil fell by nearly 14% – at the turn of the year is an important factor in this revision, the bulk of our forecast cut comes from our new assumption of no recovery during the course of 2009 or most of 2010.

In December, when we cut our forecasts for the region for a second time in three months, we tried to counteract the criticism that our forecasts were too pessimistic. At the time, we argued that – far from pessimistic – our forecasts contained a strong dose of optimism premised on a recovery in 2H09 (see “Latin America: Sliding in 2009”, EM Economist, December 12, 2008). A simple extrapolation from the downturn being experienced in the last months of 2008 would have led to a much more severe downward revision for 2009.  While our global team still expects to see a modest recovery in 2009, there is increasing talk of the upturn being muted, mediocre and uneven (see Cross-Asset Strategies: Path to Recovery; When and How to Play it, February 27, 2009). Indeed, the one uptick of note in our global forecasts – a recovery in China during 2H09 – may turn out to be W-shaped according to Qing Wang, who believes that the upturn could fade into a downturn, given the failure of G3 economies to reignite (see China Strategy and Economics: 2009 GDP Recovery Unlikely to Boost Profits or Equities, February 23, 2009). While a recovery will eventually take place, the timing of the upturn has continued to be pushed back. We suspect that it will be pushed back even further.

We have decided to incorporate virtually no recovery for most of 2010 as well. A great deal can happen between now and then. It is hard to be anything but agnostic regarding 2010; there is simply too much that we do not currently know.  Nonetheless, we have to begin with a baseline, and we prefer to assume virtually no recovery until the end of next year. We would much prefer that our next major forecast revision is upward, rather than to engage in the ‘deli-counter economics’, where forecast revisions are made slice by slice.

There is a tactical element to our forecast revisions as well. There is little to be gained from calling a downturn late, at least in Latin America where downturns are usually sharp, unforgiving and rapid. Unable to divine the timing of a downturn with precision, we’d always be in favor of being early rather than late (we would distinguish being early from perennial naysayers, whose prognosis is not much better, in our view, than the ‘safe haven’ advocates that continued to focus investor attention on the long-run prospects when the region was on the eve last year of the most severe cyclical downturn in decades). In contrast, we have a much harder time making the case for calling the upturn early. When an upturn begins in Latin America, the recovery in economies, markets and currencies is usually measured in years, not months. The downside risks to an early call for an upturn are significant. In contrast, if one is late in calling the upturn by a few months, the losses are likely to pale compared to the multi-year gains from the turnaround.

Brazil: Negative Territory

In Brazil, we are cutting our 2009 GDP forecast to -4.5% from 0% to reflect both a much weaker turn of the year (a lower entry to 2009 from a weak 4Q08 and signs of continued weakness in 1Q) and our concerns that the global picture may prove even bleaker than anticipated.

In turn, weaker growth will probably mute the potential currency pass-through into inflation. Our call continues to see currency weakening (toward 2.80) more likely than currency appreciation by year-end, amid a tight international capital flow environment. But, as before, our forecast does not foresee any massive devaluation ahead. A large output gap should pull inflation significantly below the inflation target, opening room for further rate cuts. Marcelo Carvalho now assumes a total easing cycle of 550bp, so that the policy interest rate falls to 8.25% by mid-year. After an initial 100bp rate cut in January, the central bank subsequently accelerated the cutting pace to 150bp in March. Marcelo sees additional rate cuts of 300bp from here, with two consecutive rate cuts of 150bp each (in April and June). Policy rates would fall into unprecedented low territory, as global interest rates collapse while the global economy moves into uncharted waters. It remains to be seen whether lower real interest rates can be sustained in Brazil. Marcelo’s working assumption is that emergency rate cuts in 2009 will eventually be partially taken back at some point in 2010 (as rates rise to 10%).

Domestic growth slowdown will have other side-effects.  The good news: the current account deficit will shrink as imports plunge and the services account improves – in part helped by lower outflows of profits and dividends. The bad news: labor market conditions are likely to worsen substantially, and fiscal accounts should suffer as tax revenues take a major downturn.

Mexico: The Link Hurts

Mexico’s economy was sluggish during most of last year, and the downturn has intensified significantly in recent months. Indeed, whether we look at the deterioration in industrial output, employment, confidence surveys or retail indicators, the ongoing downturn already eclipses the 2001 recession in magnitude and, in some cases, is approaching sequential declines last seen during the 1995 Tequila crisis.

Accordingly, we have cut our forecast economic activity this year to a contraction of 5% from -1.5% previously. With US manufacturing in the midst of one of its worst downturns ever – output plummeted at a 21% annualized pace in the six months through January – Mexico’s export-oriented industrial sector is under severe pressure, and conditions are set to get much worse: in the past 12 months, manufacturing employment has declined by one-tenth, while industrial exports collapsed 26.8% in January – the deepest annual drop in nearly three decades of available data. 

Though the outlook for economic activity is bleak, Mexico’s fiscal and external accounts are likely to remain manageable, in our view (see “Mexico: Stress-Testing the Balance of Payments”, EM Economist, March 13, 2009, and “Mexico: No Oil, No Problem?” EM Economist, February 23, 2009). The work of Luis Arcentales and Daniel Volberg suggests that neither Mexico’s balance of payments nor its fiscal challenges appear to justify a significant weakening of the Mexican peso to levels approaching 16 per dollar. While our fundamental analysis provides little guidance as to how the Mexican peso will trade in the near term, it does suggest that the extreme stress being experienced by the peso today does not represent a step to a permanently weaker level, absent an extreme bout of capital flight. Accordingly, Luis sees the currency regaining ground to 13.5 by year-end. 

Chile: Tempering the Slump

Aggressive policy actions on the monetary and fiscal fronts, in our view, should prevent a deeper slump than the modest 1.4% contraction we expect during 2009. Chile’s central bank has been the most aggressive in the region, cutting interest rates by a cumulative 600bp to 2.25% since January, and more cuts appear to be in the cards. Importantly, Chile has by far the deepest financial channel in the region, with credit approaching 80% of GDP, and thus monetary easing should have traction: the central bank’s aggressive easing has sparked a healthy amount of domestic corporate issuance. 

Courtesy of its strong fiscal position – with fiscal assets equivalent to some 15% of GDP at the end of 2008 – Chile has been able to deliver a good dose of stimulus. The two rounds of measures announced in 4Q08 worth roughly US$2 billion were focused on the credit crunch and the sectors that seemed most vulnerable including SMEs and housing and, as the credit turmoil morphed into a real economy one, so did the government’s measures with the US$4 billion (2.8% of GDP) package unveiled in January, which included business tax cuts, US$700 million for infrastructure, US$1 billion to fund Codelco’s fixed investment and handouts for low-income families. Lastly, Chile has not been plagued by many of the pressure points that have afflicted the region: relative currency weakness has not led to any high-profile corporate casualty or banking sector problems, nor has it complicated policymaking, as reflected by the central bank’s aggressive monetary easing. With the global economy entering a recession of uncertain depth and duration, Luis believes that Chile will find itself with plenty of levers to pull in order to lean against the strong global headwinds. 

Argentina: The Rise of Heterodoxy?

On the back of a more challenging global environment, we are moving our Argentine GDP growth forecasts to -4.7% from -2.2% for 2009 and to -0.1% from -1.0% for 2010. Daniel Volberg is also moving the currency forecasts to 4.8 (from 4.5) for end-2009 and to 5.5 (from 4.8) for end-2010. Daniel sees three main reasons for a more prolonged and sharper contraction. First, he sees meaningful policy slippage – such as the nationalization of the pension fund industry or rising protectionism – and the risk of further slippage down the line as factors weighing on business and consumer confidence and exacerbating the economic downturn. Second, the policy of import protection by means of a weak exchange rate that boosted domestic employment, wages and consumption during the past five years has unraveled. With the authorities unable to resort to rapid depreciation of the currency due to concerns regarding the local banking system, a prolonged period of global economic weakness is likely to translate into a deeper and more lasting downturn locally. Finally, the downturn in the terms of trade due to falling commodity prices is a significant headwind affecting Argentina’s external balances. Daniel is further concerned that a sharp and prolonged downturn that is accompanied by increasing state interventionism and policy heterodoxy may adversely impact social and political stability, raising the risk of a disorderly adjustment.

The Andeans: No Safe Haven

We still expect to see positive growth from Peru in 2009 – albeit only 0.9%, representing one of the sharpest slowdowns in the region. After all, last year, Peru grew by more than 10% through the first three quarters of the year. Unlike most of the countries of the region (with the exception of Chile), fiscal authorities are able and willing to flex their expenditure muscle. They have been busy executing a Fiscal Stimulus Plan worth 2.3% of GDP, which is likely to cushion to a certain extent a severe slowdown in private demand. Exports are also collapsing, at a much higher pace than imports, widening the trade balance in the process.

Meanwhile, in Colombia, we expect GDP to contract 1.6% (down from our previous forecast of 1.5% growth). The most recent indicators suggest a continued deceleration in economic activity: December industrial activity fell by 13% and shows little signs of revival. Retail sales keep falling, and consumer and business confidence remain at depressed levels. We believe that this leg-down in economic growth is being led by collapsing exports, particularly those to Venezuela. Even when a higher-than-expected fiscal deficit is likely to be financed domestically and with increased disbursements from multilateral creditors, the government does not have room to undertake counter-cyclical fiscal policy via increased public expenditure. But Boris Segura expects further monetary easing by the central bank, with a front-loaded campaign of rate cuts to 5% by year-end (but still little financial intermediation). And authorities are showing no signs of ‘fear to float’, and have kept a hands-off approach vis-à-vis currency weakness, engaging in only minor interventions in the forex market.

Finally, in Venezuela, we now expect a contraction of 4.0% in 2009 (from -1.0% previously). In addition to an increasingly challenging business environment, economic activity has been decelerating throughout 2008. However, given the fall in oil prices since 3Q08, the economic slowdown only worsened; from growing by 8.5% in 2H07, Venezuela’s economy only grew by 3.2% in 4Q08. 2009 is likely to bring even tougher times as the effects of reduced oil prices and lower oil production, as per cuts agreed under OPEC, trickle down to the rest of the economy. Private and public investment is likely to collapse, and consumers are already retrenching. The only cushion is likely to be public consumption, which is to be financed by draw-downs of the public sector’s liquid assets and increased placements of domestic debt.

Given a more challenging balance of payments outlook, Boris still expects the authorities to devalue the currency. It is likely to be either an explicit devaluation of the official rate (to 2.85) or one that channels transactions out of the official CADIVI market into the much weaker permuta market.

Three Principles for 2009 and 2010

While we don’t know the magnitude or the duration of the downturn, we would argue that we do know three things.  These remain our guiding principles for 2009 and into 2010 (see “Latin America: Sliding in 2009”, EM Economist, December 12, 2008). 

Starting Points Matter

First, starting points matter. We have seen little of the excesses common in past upturns in Latin America. The abundance of the past five years has not produced the ballooning trade and current account deficits fueled by consumer spending that we have seen in Latin America’s past and elsewhere today in other emerging economies. Nor is Latin America home to widening fiscal deficits that plague other emerging economies. Nor have we watched as central banks burn through reserves trying to prop up overvalued currencies.

Mexico does not look like the Mexico of 1994 when the current account ballooned and was on its way to 8% of GDP.  Nor does Chile resemble the Chile of 1998, as the Asian Financial Crisis lapped up on its shores and when the current account imbalance was nearly as large. Nor does Brazil have the same imbalance as the Brazil of early 2001.

This is essentially at the core of the arguments being made by the Mexican authorities on the potential shortfalls on the fiscal and balance of payments front and the argument being made by the Brazilians. Yes, there is an important deterioration, but the deterioration is off of a much more favorable base. There is little doubt that the fiscal position of Mexico or Brazil will weaken, but the improved starting point provides for a significant buffer.

Leaning Against the Wind

Our concern, however, is that if the downturn lasts longer, the benefits from a strong starting point will begin to matter less. Latin America is starting from a much improved state, but we are concerned that it will suffer – along with many other emerging economies – from much more limited space to engage in counter-cyclical policy. While governments in developed economies have embarked on an important counter-cyclical fiscal mission, fiscal stimulus is likely to require an important increase in debt financing, precisely at a moment when investor appetite for emerging market obligations appears to be waning.

Of course, the IMF and other IFIs can help provide important support. We expect to see more details as early as next month at the G20 summit, which should be consistent with the calls over the weekend from the G20 finance ministers. However, support from the IMF and others is likely to be most useful in reducing the risks of a full-blown financial turmoil (particularly in the EMEA space), but is unlikely to put Latin America back on a recovery path until the global economy returns with better growth as well, in our view.

Not only is room for counter-cyclical fiscal policy limited, but we also believe that counter-cyclical monetary policy is unlikely to provide an important stimulus in the region. We have already seen, in the case of Mexico, a reticence to cut interest rates aggressively as has been done in Chile and Brazil. While we believe that Banco de Mexico now realizes that the shift from a 50bp cut in January to a 25bp cut in February led to significant market confusion regarding the objective of the central bank, we do not expect to see a return to a more rapid pace of cuts. Mexico’s response may be an outlier, but it serves as a reminder that Latin America’s central banks have lagged their counterparts around the world in easing monetary policy. 

And even as easing gains some ground, the extremely limited level of financial intermediation and the role of credit in most of Latin America is still likely to temper the traction of monetary policy. Moreover, it is difficult to imagine that credit growth will play a meaningful role in boosting economic activity even as monetary policy is eased, given the sharp declines that we envision in consumer and business confidence, the weakness in labor markets and the risks to the quality of the loan portfolio. In some countries, credit growth already appears to be suffering, as caution from financial intermediaries’ international headquarters appears to be taking its toll.

We are not arguing that there is no role for monetary policy to play in 2009. We expect to see some easing, but for it to be modest compared with the reduction in interest rates in the developed world. Further, we would underscore the modest impact it is likely to have, given the under-intermediated nature of most of the economies in the region.

Slip, Slipping Away

Perhaps the greatest risk in Latin America is not simply that policymakers have less room to deploy counter-cyclical policy, but that policy slippage or even reversals take place. It is too early to argue that policy slippage or policy reversals will take place in the region. But we are concerned with ‘translation risks’, as the policy remedies being deployed in the developing world are adopted (and adapted) in Latin America. There seems to be little doubt that the state will play a much greater role in the functioning of the economy in the US, particularly in the financial system. Whatever the merits of greater state control, the risks that such policies give rise to onerous regulations in Latin America are real. And the longer this downturn in activity continues, the greater the risk of further slippage. Although the region has suffered past downturns in 1998 or 2001 without important policy reversal, we expect this downturn to contain greater risk of damage on the policy front. We fear that the downturn in 2009, and into most of 2010, will be substantially deeper than the downturns in 1998-99 or 2001-02. And, the financial sector origins of the current downturn and the significant policy response required in the developed world are likely to set the stage for a more interventionist policy stance in Latin America as well as throughout emerging markets, in our view.

Bottom Line

It is hard to handicap the magnitude or the duration of the current downturn in Latin America. But we suspect that the duration is in part a function of the severity of the downturn that we have watched unfold in recent months. The powerful contraction in the region brought about by global deleveraging by households, by financial institutions and firms and in markets is unlikely to turn quickly. Indeed, our greatest concern remains that the longer the downturn, the greater the risk that the policy reversal in the region can begin to undermine the impact of the recovery when it finally gets underway in the global economy.  

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