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Sunday, December 24, 2006

Latin America: A Dose of Stability


Gray Newman, Luis Arcentales and Daniel Volberg | New York

As the risks surrounding a global slowdown increase, it might seem overly optimistic to be upbeat on the prospects for Latin America for 2007. After all, the region has benefited in recent years from a period of unprecedented Chinese demand that has boosted prices for commodities from the region and contributed to a prolonged bout of above-trend US growth and low interest rates. Interest rates have now been rising around the globe, the US economy has slumped in the post-housing-bubble shakeout, and there is increasing debate over whether China will engineer a successful moderation of growth. Meanwhile, the region continues to have its “problem countries.” In the past month, Hugo Chavez was re-elected as president in Venezuela, and Ecuador voted in a new president who campaigned on the moral need to repudiate the country’s debt. Still, we are optimistic about Latin America.

Latin America is benefiting from the arrival of macro stability and a dose, however partial, of certainty. In a region where growth has frequently been punctured by crises that have brought down currencies, economic models, and heads of state, the mere fact that 2007 should mark the fifth year of good growth and low inflation is an important accomplishment. Is it enough? Most certainly not. Most of the region’s inhabitants still suffer from glaring shortcomings — from inadequate healthcare and education to an irregular regulatory framework — all of which have limited stronger growth in productivity. But we would argue against underestimating the power of a dose of stability.

Perhaps nowhere is the change that the region is undergoing clearer than in Brazil. Just four years ago this month, Brazil watchers were engaged in a debate over whether the country was on a path leading to debt default and capital controls. Today, Brazil has zero net public external debt (net of international reserves), a declining debt path for its domestic debt, and inflation hovering around that of the US.

Benefits from Macro Stability Should Not Be Underestimated

Our optimism on Brazil might seem mistaken. Indeed, Brazil’s disappointing growth record has prompted calls from within the global economics team at Morgan Stanley to strip the country of its place within the BRICs (see “Hitting a BRIC Wall,” in This Week in Latin America, September 25, 2006). But we would argue that this is precisely the wrong moment to disqualify Brazil from its place within the BRICs. We suspect that Brazil is on the verge of much stronger growth in 2007 and in the coming years, as it delivers continuity on the macro front of the sort that we have seen in recent years.

Our upbeat assessment on Brazil’s growth path in 2007 is predicated on our view that there is a strong case for significant interest rate reduction. Indeed, perhaps nowhere in the emerging markets is the case for a reduction in rates stronger than in Brazil. Inflation has plummeted even as real rates have remained largely unchanged. And that, we believe, sets Brazil up for an important bout of monetary easing in 2007 as real rates begin to decline at a pace previously reserved for nominal rates.

We expect the targeted Selic interest rate to reach 11.25% by the end of 2007 and to fall further in 2008. With projected real rates at their lowest level in decades, we expect Brazil’s growth path to improve. Of course, the challenge is not simply a matter of monetary policy. The economy needs a stronger investment platform, and that means changes in the regulatory environment, improved infrastructure, and a healthier public sector. But the benefits from stability and hence lower interest rates are likely to prove powerful forces boosting the investment cycle in Brazil.

Looking elsewhere in the region, even in Mexico there is still room for progress. Although we are less optimistic about the new administration’s ability to build the much-needed consensus for reforms on the fiscal and energy fronts, there is still room for progress on the stealth reform agenda. Low inflation — core inflation has been running within Banco de Mexico’s target range for the past four years — has begat a dramatic extension of the yield curve and the birth of mortgages and credit to those who had long been beyond the reach of financial intermediaries. That trend is likely to continue uninterrupted in 2007 and provide a significant cushion to a slowing export-based manufacturing sector.

And we still expect Argentina to remain the fastest-growing economy in the region despite its distortionary policy mix. While price controls, negative real interest rates, a heavily managed exchange rate appreciation, and export regulations aimed at controlling inflationary pressures are not long-term sustainable policies, the long term is unlikely to arrive in 2007. Even in the most vulnerable sector, namely electricity generation, we see no major dislocations in 2007. In fact, we expect the economy to keep powering ahead, with domestic consumption doing most of the heavy lifting through expanding credit, a real estate market boom, and rising real incomes.

Bottom Line

We are fairly upbeat on the prospects for Latin America for 2007. If our global team is right and the world sees good, albeit slower growth, Latin America should post another above-trend result. Now five years into the current growth upturn, we have seen little of the excesses of past upturns in the region. The current cycle has not produced the ballooning trade and current-account deficits fueled by consumer spending seen in the past, nor widening fiscal deficits, nor the spectacle of central banks burning through reserves to prop up woefully overvalued currencies. Thus, while the region is hardly immune to a potential global slowdown, we suspect the consequences would be much milder than in the past and would ultimately strengthen the region’s newfound stability.