Latin America
Latin America: Recovery at Risk?
March 05, 2010

By Gray Newman | New York

Week after week, release after release, the data from Latin America show the upturn in economic activity continuing to gain ground. Whether it's business confidence in Brazil or vehicle production in Mexico, the region is awash in V-shaped rebounds. And yet despite the positive news from most economies in the region, many investors remain in a bit of a funk when analyzing Latin America.  Their concern is not the usual bumpiness of the recovery - lags in employment or credit to consumers; instead investors have decided that the greatest threats to the region's growth performance appear to come from outside the region. 

We largely agree with the diagnosis: Latin America has graduated and is more subject to global trends than I can recall in decades.  But while Latin America's cyclical course is likely to be more closely tied to events outside the region, the region's structural challenges remain an important impediment to a stronger path of sustainable growth.

Awash in Vs

Perhaps nowhere in Latin America is the V-shaped turnaround more powerful than in Brazil.  While the sharp decline that Brazil experienced in late 2008 and early last year was mirrored throughout the region, the rebound began much more quickly in Brazil.  Whether one looks at business confidence or capacity utilization, the indicators at the beginning of this year are just shy of a decade-long peak seen just over two years ago.  Thanks to the length of Brazil's rebound, even labor markets have begun to respond.  Unemployment has fallen and is now close to record lows: seasonally adjusted unemployment reached 7.6% in January - within two-tenths of a percentage point of its lowest seasonally adjusted rate since Brazil introduced the current survey.  Indeed, our Brazil economists Marcelo Carvalho and Giuliana Pardelli note that net formal job creation in January reached 231,000 (seasonally adjusted) - a pace stronger than seen in the pre-downturn period.

Although our focus on Chile is now turning to the task of rebuilding infrastructure after the tragic earthquake that hit on Saturday, the first data points from 2010 showed consumer confidence was rebounding to levels not seen since the peak in late 2005 and early 2006.  The recent uptick in retail sales growth and wage mass had not been seen in over a decade in Chile.  Indeed, Luis Arcentales argues that two key drivers in fueling growth - a strong upturn in investment spending and inventory restocking - will likely both continue to define Chile after the near-term setback from the earthquake.  With fiscal savings totaling almost 10% of GDP at the end of last year and gross public sector debt of only 6.3%, we believe that Chile should have the capacity to rebuild and rebound. 

Even in Mexico - the laggard in regional growth metrics - the Vs are most pronounced in manufacturing, especially in automobile production.  Indeed, thanks in part to auto production growth rates of at least 40% annualized expected by our US team in the first quarter - in Mexico, in the three months ending in January, output was already running at an annualized pace near 200% - Mexico's export-focused vehicle production is set to equal or surpass historical highs only seen during 3Q07.  

Of course, not all is V-shaped in Mexico or around the region.  Labor markets tend to move with a lag and despite the V-shape in formal job growth of late, employment levels in Mexico are far from the levels seen prior to the downturn.  Even in manufacturing where Mexico's recovery in output has been the strongest, employment gains have been modest.  Although our Mexico economist Luis Arcentales is quick to point that out whereas in the aftermath of the 2001 recession total formal employment remained essentially flat until late 2003, in the current cycle new job creation coincided with the first signs that economic activity had turned the corner which appeared around mid-2009.

In Peru, as in most of the region, the V-shaped uptick in some sectors (such as construction and manufacturing, both with double-digit pace of growth on a sequential basis in recent months) is not being matched elsewhere as of yet (credit and employment growth).

Risks to Abundance

Despite the good start to the year in Latin America, most investors appear to be in a bit of a funk.  Their concerns do not appear to be centered on the growth story in the region, but the fear that the globe remains fragile and could interrupt the upturn in Latin America.  I keep hearing three themes over and over again.  First, there are concerns over a new sovereign debt crisis brewing, only this time its epicenter is Euroland, not Latin America.  Second, the two Chinese hikes to the reserve requirement ratio so far this year have caught most China watchers off guard and unleashed a debate as to whether the policy will inadvertently slow the economy too dramatically.  And finally, given the widespread view that asset markets led the real economy downward in 2008 (a view that I would challenge), investors are wondering what the spillover could be this time around if the correction intensifies. 

The disconnect between Latin America and the developed economies is not new.  But there is a twist this time around.  For years, analyzing the economies of Latin America meant focusing on the idiosyncrasies of the region - what was unique or difficult to understand that investors were likely to miss by simply looking at the broader global trends.  That is what, during the last decade, the Latin America economics team at Morgan Stanley has tried to do week in and week out.  

Today, Latin America has graduated or grown up enough that our ‘idiosyncratic economics' approach is inadequate for the largest economies in the region.  There are exceptions of course: the recent turmoil in Argentina between the central bank and the executive branch or the latest moves in Venezuela show that idiosyncratic risk is not dead in the region.  And whether it is the earthquake in Chile or a presidential race in Colombia that overnight has become wide open following a court ruling barring the president from a third term, there are plenty of idiosyncrasies to keep us busy.  But with the new found level of macro stability in the region, the greatest risks to the region appear to come from outside the region.

We aren't arguing that the globe didn't matter to Latin America in the past.  Indeed, we forcefully argued in late 2007 that after five years of above-trend global growth, Latin America and broader emerging markets would not prove to be much of a ‘safe haven' in a downturn (see "Emerging Markets, Emerging Questions", This Week in Latin America, August 27, 2007).  The difference is that in the past, much of the region's volatility was home-grown.  There were plenty of cases where despite a relatively benign global backdrop, policy mistakes and local idiosyncrasies could overwhelm the gains from an upturn in global growth. 

Risk of Abundance

Our task for 2010 and beyond has three components.  First, we will continue to detail the implications for the region of the new set of global threats.  Second, I think we should spend more time working out where the idiosyncrasies are the greatest and hence we can add the most value.  Third and finally, we should remind Latin America watchers never to confuse the near-term cyclical story with the longer-term challenges for the region. 

While we are still working through what the implications of a prolonged bout of ‘muddle through' in Euroland, I fear that the first reaction from investors and policymakers is a dangerous one for Latin America's long-term prospects.  There appear to be a great deal of easy (and sloppy) comparisons between debt and fiscal measures that highlight Latin America's strength relative to developed economies.  And that in turn can breed complacency in the region.

Some of the favorable metrics do make sense: after all, Latin America is not saddled with significant fiscal costs to deal with a debilitated banking system that suffered from the bursting of the housing bubble.  But we would warn against confusing how much of Latin America's strength is structural versus cyclical.  One look at Brazil's pension challenges and outlays should provide reason for caution: Brazil's pension spending as a percentage of GDP (7.2% as of 2009) is in line with that of most developed economies even though Brazil's demographics are much more favorable.  I suspect that a demographically adjusted ‘apples-to-apples' comparison would be alarming.  And throughout the region, much of the fiscal improvement seen in the latter half of the last decade appeared to be more cyclically driven than structural. 

If the troubles in Euroland spread or alternatively, the Chinese economy were to suffer, we fear that Latin America would suffer disproportionately, given much more limited space for counter-cyclical fiscal policy and the limited traction of monetary policy in the region.  We fear that in a prolonged downturn there would be less room for counter-cyclical fiscal policy in Latin America because risk-aversion would likely limit Latin America's access to greater debt financing just when it is needed the most.  And limited financial intermediation would likely play a role in weakening the traction of any attempts at accommodative monetary policy.  That in turn could make less orthodox policy levers all the more attractive.

Latin America still owes China a great deal of credit for the outcome of 2009.  Last year's synchronized global downturn was short-lived and China began to lead other emerging economies out of the Great Recession.  Had the global downturn of late 2008 and early 2009 intensified and lengthened, I am not sure that the popular distinction between weak DM (developed markets) and robust EM (emerging markets) that is in vogue today would exist.  After all, we still believe that the principal drivers of the better growth that Latin America enjoyed during much of the past decade were a series of external factors reflected in a period of favorable financial and credit conditions, strong global demand and a remarkable surge in the terms of trade.

Confusing Latin America's cyclical advantages with its more limited structural progress is perhaps the greatest risk to the region.  ‘Safe-haven' advocates that now hold up Latin America (and more broadly emerging economies) as the example for the rest of the world can end up harming Latin America's long-term growth dynamics.  I am still concerned that in a relatively benign world, policymakers in the region can end up learning the wrong lessons as calls for greater state intervention find fertile ground in the region.  If growth were to surprise to the upside in Latin America, policy mistakes are likely to be forgiven - in the near term.  That, unfortunately, can set the region up for even greater policy blunders. 

Bottom line

In our view, there is no denying that Latin America is in better shape than in decades.  The trio of massive reserve accumulation, current account improvement and better (albeit cyclically induced) fiscal results all helped the region going into the downturn.  And coming out of the downturn, the region does not carry the same kind of baggage as seen in the developed world where much larger fiscal needs (the consequence of bailouts) and much weaker labor markets (the consequence of the housing bubble's hit to construction) conspire to keep growth more subdued.  But the region still owes much, if not most, of its improvement in growth to external factors. 

The risk remains that policymakers confuse the drivers of the rebound and fail to tackle the region's pressing structural reform agenda.  Much more needs to be done to raise human capital, boost public and private investment in infrastructure and strengthen further the framework for a greater competitive environment in Latin America. The ‘risk of abundance' is not only that progress on the reform agenda stalls, but that counter-productive measures are taken that ultimately increase uncertainty in the region.

Important Disclosure Information at the end of this Forum

Global
Debating Debtflation
March 05, 2010

By Spyros Andreopoulos, Joachim Fels & Manoj Pradhan | London

The Greek crisis has brought sovereign debt to the forefront, capturing markets' attention. We think another dimension of the sovereign issue, the inflation risks inherent in high levels of public debt for economies that can print their own currency, is being overlooked by the markets. High levels of public debt in many advanced economies raise the spectre of inflation, in our view: if high debt is deemed undesirable, but the political will for higher taxes and lower spending is lacking, then ‘soft default' through inflation becomes a possibility.

Recently, we have tried to put some numbers on the inflation risks inherent in the current and prospective US fiscal position (see The Return of Debtflation? February 10, 2010). We looked at a hypothetical scenario whereby policymakers attempt to stabilise debt to GDP at the current 60% level over the next ten years. The thought experiment assumes the debt is dealt with in exactly the same way now as in the post-war period (1946-2003). That is, if the same weight is given to inflation and real GDP growth as factors behind the erosion of the debt, we are able to back out the required inflation rates (for any given level of the deficit). We calculate that, over the next ten years, on average,

•           a 5% deficit would require 9% inflation

•           a 3% deficit would require 6% inflation

•           achievement of a 2% inflation target requires a 1% of GDP budget surplus.

Scary stuff.

Clients and colleagues have questioned both our assumptions and our conclusions (see US Economics: We Can't Inflate Our Way Out, February 19, 2010). This is our response.

I. Our Assumptions, or: Why Debtflation Is Possible

For simplicity, we have assumed that interest payments, as a share of GDP, remain constant. True, this is a strong assumption. But even if interest to GDP increases with inflation, we don't think it will be by enough to prevent substantial debt erosion - at least for some time. Here's why.

What matters most for successful debtflation, our colleagues rightly point out, is whether the (effective, i.e., maturity-weighted) nominal interest rate on the debt can be pushed below the rate of growth of nominal GDP. Put another way, the question is whether, and for how long, inflation can lower the effective real interest rate on the debt. We believe that's possible for a sustained period: debt does not roll instantaneously; and bond yields are slow to incorporate changes in inflation. These two factors can be thought of as the crucial frictions that allow for debt erosion.

1. Debt maturities

The fact that the whole stock of debt does not roll every period means that the effective nominal interest rate on the debt is slow to respond to an increase in market yields. For the US, average maturity on Treasury debt is poised to exceed the postwar average of about 5 years by the end of fiscal 2012 (September), on our forecasts. The implication is that even if market yields were to adjust instantaneously to the higher inflation regime, effective nominal interest rates on the debt would respond only partially. So there is a debt erosion effect even if inflation were to be perfectly anticipated.

2. Yields are slow to adjust to a new inflation regime

Inflation - especially a change in the inflation regime - is rarely, if ever, perfectly anticipated. Inflation expectations lag behind actual inflation. In turn, bond yields lag behind inflation expectations. Evidence is abundant:

•           Historically, yields lag behind inflation. Throughout the 1970s, bond yields never meaningfully caught up with the inflation takeoff: real interest rates were mostly very low - indeed negative for sustained periods - a bad time for bonds. Exactly the opposite happened during the Great Moderation of the 1980s and 90s. The sustained decline in inflation meant real interest rates were high, giving rise to a long bull market for bonds.

•           Statistical work suggests the same conclusion. The empirical academic literature suggests both that bond yields take a long time to incorporate inflation expectations, and that inflation expectations themselves are sticky. Put another way, the fact that nominal yields take time to catch up with inflation gives rise to the observed negative correlation between inflation and real yields.

In short, inflation lowers the real effective interest rate the government pays on the debt through reducing a) the nominal effective interest rate, and b) real market yields. Moreover, the evidence suggests that these mechanisms work over a sustained period of time - allowing substantial debt erosion.

And there are additional reasons that make inflation relevant today. The evidence strongly suggests that, for the US as well as internationally, high debt has historically come hand in hand with lower growth as well as higher inflation (see Carmen Reinhart and Kenneth Rogoff, Growth in Times of Debt, NBER Working Paper 15639). For the US, they show that debt to GDP ratios in excess of 90% have meant materially higher inflation and lower growth. Indeed, we expect trend growth to be lower across developed economies over the next five years. But sluggish real growth leaves fewer options of dealing with the debt.

II. The Road to Debtflation, or: Global Inflation Risks Intensifying

Yet inflation is low almost everywhere. And with yawning output gaps, surely inflation is nothing to worry about. Policymakers, some say, couldn't inflate even if they wanted to. 

Not quite. It is true that inflation will remain subdued for some time to come. But inflation risks are visible on the horizon. Our US team expects the inflation picture to turn at around the middle of the year, as import prices pick up and the output gap narrows (see US Economics, Mind the Gap: Even Record Slack in the Economy Won't Crush Inflation, January 29, 2010).

But there are further reasons to worry about inflation (see Global QE, Global Inflation, July 1, 2009).

•           In many advanced economies, there may be less slack than meets the eye. Output gap measures are highly unreliable most of the time - but even more so when an economy is undergoing structural change. The US and the UK for example need to turn from consumers into producers. This means a lot of the spare capacity is in sectors where it is not needed, for example in construction. But worker skills may not be immediately transferable: the resulting unemployment may not exert as much downward pressure on wages. And skill shortages in the expanding sectors may still allow wages to be bid up there.

•           Dollar peggers in EM have been importing the Fed's ultraexpansionary monetary policy. Some of these economies risk overheating, generating upward pressure for commodity prices globally and DM import prices.

•           There is an enormous amount of monetary stimulus in the system. Since the beginning of QE in September 2008, narrow money M1 is higher by 11.5% in the US, and 17% in the euro area. This monetary expansion is unlikely to be reversed before policy rates are back, or above, neutral - a long way off on our forecasts. For the US, additional risks emanate from the 1.1 trillion dollars of excess reserves in the banking system: if banks decide to increase lending as growth recovers, some of those reserves could find their way into the economy (see ER, RR, IOR, and RRR, February 17, 2010).

III. Our Conclusions, or: Inflation Targeting in Times of Debt

Some clients and colleagues also disagree with our view of central banks (CB). Surely, a DM CB would never monetise public debt? In a nutshell, we think that in the game of chicken between the fiscal authority and the CB, it may well be the CB that swerves: it could be preferable for a rational CB to create some controlled inflation now to ease public and private sectors with their debt burden, than risk the debt creating greater problems down the line. We think that CBs are likely to continue to pay lip service to existing inflation targets, while more often than not overshooting them. Cynical? But this would only be a repeat of what happened over the last ten years or so (see From Inflation Targeting to Price Level Targeting? July 15, 2009).

Note also that when public - and private - debt is high, a CB that is being consistent on its inflation targeting (IT) could do serious damage to the economy. Recall that IT works if the CB responds to deviations of inflation from the target by increasing the nominal interest rate by more than one for one with inflation. In other words, IT does by design what is worst for highly indebted public and private sectors: increase the real interest rate on the debt.

In short, public and private leverage imply substantial constraints on monetary policy. At best, the risks are ‘soft' IT and creeping inflation. At worst, (continued) monetisation of public debt and a new regime of high inflation.

Finally, consider this scenario. Suppose inflation jumps higher because any of the risks the Fed itself recognises materialise - even against the Fed's best intentions. Would the Fed then push the economy into recession to squeeze inflation out of the system, or acquiesce and accept higher inflation, at least temporarily? We leave the answer to investors' own judgement.

Bottom Line

The Greek crisis likely marked the beginning of a wider sovereign risk crisis. We think this crisis may well engulf central banks too, as high levels of public and private debt will test monetary authorities' resolve - and ability - to deliver price stability going forward. Meanwhile, we think investors should hedge against inflation risks.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. and their affiliates (collectively, "Morgan Stanley").

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosure for Morgan Stanley Smith Barney LLC Customers The subject matter in this Morgan Stanley report may also be covered in a similar report from Citigroup Global Markets Inc. Ask your Financial Advisor or use Research Center to view any reports in addition to this report.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.