Latin America: No Hard Landing

While Latin America faces more challenging conditions amidst reduced global liquidity and increased market volatility, the risk of a hard landing is lower than in the past.

LATINVEX SPECIAL
Control Risks

2014 will see the effects of the likely tapering of quantitative easing in the US take hold across Latin America. The region’s assets have been magnets for capital in recent years, and logic has it that an eventual US stimulus withdrawal will increase US bond yields and prompt a reversal in the flow of funds – out of Latin America. That will weaken local currencies, cause interest rates to rise and threaten countries such as Brazil that have heftier financing needs. To paraphrase Warren Buffett, only when the tide goes out do you discover who’s been swimming naked.

2014 will expose the divide between these countries and their more pragmatic cousins, led by the likes of Chile, whose more solid economic fundamentals will better insulate them from market volatility.

These countries enjoy the protection afforded by low current account deficits, higher reserve levels and less dollar-denominated debt. They also have more margin for currency depreciation.

TAPER TANTRUM

The panicked reaction to the US Federal Reserve’s initial tapering announcement in May 2013 means that the withdrawal of stimulus is likely to be modest in its initial stages. We do not expect a repeat of 1994’s so-called ‘Tequila crisis’, when sudden Fed tightening caused a sharp devaluation of the peso in Mexico, with impacts across the region. If tapering advances, it would signify that a sustainable recovery is under way in the US. Although China is now the leading trade partner for the likes of Brazil, Chile and Peru, the US remains Latin America’s pre-eminent trade partner. For Mexico, which sends more than 80 percent of its exports to its northern neighbor, measured tapering should be seen as a boon, not a blow, because it represents a vote of confidence in the US’s economic recovery.

But the economic climate will be less benign for Latin America than it has been for many years. Prices for

commodities, on which many countries relied in the boom years, are on a downward trend as China’s growth slows and in all likelihood enters a new phase of development – a steady clip of 7 percent rather than the 9 percent gallop of the last decade. Studies show that for every percentage point the Chinese economy slows, the Latin American countries with the closest ties to China decelerate by 1.2 percent. Nobody is saying Latin America will catch a cold because China sneezes, but the likes of Brazil and Peru may have a case of the sniffles in 2014. Nonetheless, the picture is far from uniform. Mexico is more of a competitor in manufactured goods markets than a supplier of commodities, and its labor cost advantage is likely to continue in 2014 as near-shoring comes back into vogue

GOVERNING GETS HARDER

While the Mexico-Brazil reversal of fortunes will not be as pronounced as the markets sometimes make out, Brazil’s problems point to a failure to address key issues during the boom years. Faced with a cooling of both domestic and international markets, Brazil will struggle to switch swiftly to an investment-led growth model because of the failure of recent governments to tackle the infamous ‘Brazil cost’ – the umbrella term for the burdens of doing business there, covering poor infrastructure, high borrowing costs, a complex tax regime and archaic labor legislation, among others.

President Dilma Rousseff’s record of state intervention limits reasons for optimism, and suggests she is more likely to address the symptoms of Brazil’s declining competitiveness than the causes. To top it off, Brazil faces a presidential election in October 2014 that will limit the scope for much-needed reforms, including a tax overhaul and an update of the labor code.

Brazil is not the only country where trickier economic conditions will make governing more difficult and reduce the political appetite for reform. Approval ratings for Peruvian President Ollanta Humala are likely to remain low in 2014, though this does not presage a political crisis: his predecessor but one, Alejandro Toledo (2001-06), governed with single-digit approval ratings for much of his presidency. Possible routes to overcome tougher economic conditions will not always be exploited. Peru’s massive Conga mining project is likely to remain hostage to regional elections in 2014, and will therefore remain stalled.

In neighboring Argentina, dwindling support for President Cristina Fernández following a setback in the 2013 legislative elections is unlikely to herald any U-turn on state intervention in the economy or a concerted effort to tackle inflation. The economy is therefore likely to remain weak. Nonetheless, Fernández will continue to defer dealing with problems beyond 2014.

LATIN SPRING?

The 2013 protests in Brazil prompted concern that Latin America may be vulnerable to further outbursts of middle-class unrest. After all, the inequality, corruption and poor public services that triggered the Brazilian protests are problems across much of Latin America. But this does not necessarily herald the onset of a wider ‘Latin spring’, despite the economic frailties and public frustration evident in some countries.

Latin America has long endured high levels of unrest, and it would be wrong to see every strike and protest as foreshadowing the eruption of major social upheaval. Not only were Brazil’s newly prosperous middle classes frustrated with crushing commutes, but gathering inflation, insipid economic performance and most significantly, conspicuous expenditure ahead of the 2014 football World Cup created the conditions for mass protests. The Brazilian middle class – and expectations of its rights and dues – has grown more significantly than that of any other country in the region in recent years, while public spending ahead of the 2014 World Cup and 2016 Olympics is a unique double-barreled catalyst for unrest.

The phenomenon of middle-class frustration certainly exists beyond Brazil. A decade of growth across most of the region has forged new social demands that those in government have not always kept up with. In Chile, frustration has crystallized around the costs and unfairness of the education system.

In Mexico, the YoSoy132 movement, mainly comprising middle-class students, has denounced what it sees as President Enrique Peña Nieto’s too-cozy relationship with the mainstream media. The Mexican middle class will also continue to grumble about tax rises – especially the 16 percent value-added tax on home mortgages that Peña Nieto hopes to levy from 2014 – and the opacity of government spending. Both here and in Chile, urban middle classes increasingly compare their countries to far-flung peers in the OECD, to which they both belong, rather than their immediate neighbors. But this does not portend mass protests that transcend class or sector interests. Mexican teachers will remain restive in 2014 and the left’s losing presidential candidate in 2006 and 2012, Andrés Manuel López Obrador, will whip up opposition to energy reform, but neither of these movements will rock Mexico’s political foundations.

Similarly, a steady background hum of protest will be evident in Venezuela as frustration simmers at government mismanagement of the economy, crime and shortages of basic goods. But this is unlikely to coalesce into a national movement or social explosion in 2014, barring a significant drop in the price of oil. Venezuela will instead remain acutely polarized amid economic confusion, not crisis.

The new demands of emerging and emerged middle classes, and the disconnect between their aspirations and the ‘old’ way of doing politics, will not bring sudden or dramatic political change. The ‘old’ politics is less sclerotic than it is sometimes given credit for, and most demands center on the problems of daily life, not a desire for revolutionary change. (…) Rousseff will win re-election, even though a self-serving Congress will dilute a political reform expressly designed to appease the disillusioned.

In Colombia, where major protests took place across the country in August 2013, the establishment incumbent – or possibly his protégé – will win the 2014 presidential election.

In Chile, (…) former president Michelle Bachelet (2006-10) returned to power March 11, 2014. Bachelet’s pledge to undertake constitutional reform reflects the need for an update of the social contract, which in turn reflects the changes wrought on society by economic growth. Ironically, the need to tweak the underlying settlement between people and politicians will generate outbursts of social strife as Bachelet challenges social conservatives. She will also face pressures on her left lank: she is likely to enact some kind of education reform in 2014, but it will be a watered down measure that will not end protests.

Where discontent translates into protest in the region, it will not always be led by the middle classes, still less by the tech-savvy or urban ‘Twitterati’. Latin America may now be more urban than rural, but traditional sectors with long-standing grievances remain potent actors. In many cases, protests will not represent the phenomenon of the ‘emerged market’, but rather the enduring reality of the ‘bypassed market’: the swathe of Latin America that believes the benefits of stellar growth have not trickled down to them. So mining projects in Peru will remain entangled in locally driven protests amid rising frustration that Humala is failing to deliver socially inclusive growth. In Colombia, concerns over the impact of free trade on local agriculture and the poor state of infrastructure will remain sore points outside the cities. And in Mexico, protests against energy reform will attract NEETS (not in education, employment or training) and retired government employees.

LOCAL VACUUMS

For decades Latin America complained about the overweening presence of the US in its affairs. In the early 2000s, as US foreign policy turned overwhelmingly to the Middle East and elsewhere, the tables turned and some regional policymakers grumbled about US ‘neglect’ in the face of a leftist tide across Latin America. They would argue that Latin America has suffered the effects of a power vacuum for years already. Others seized the opportunity to diversify their trade relations, embracing China as a voracious new consumer of the region’s raw materials. Those countries – led by Brazil, Peru and Chile – must now adjust to a slower rate of Chinese growth, which, if far from representing a vacuum, poses challenges to the commodity export-led model.

Overall, the most significant power vacuums across the region will be local, and none more so than that

triggered by Venezuela’s slow-burn diplomatic and economic retreat following the death in 2013 of its larger-than-life former president Hugo Chávez (1999-2013). The parlous state of the economy – held aloft largely by the price of oil – means Venezuela can no longer afford to punch above its weight on the regional (or world) stage. Most significantly, the retrenchment of Venezuela’s regional oil subsidies is likely to gather pace in 2014, with the Caribbean beneficiaries – apart from Cuba – most likely to face interest rate rises and stiffer conditions from state oil company PDVSA.

The likely curtailing of Venezuelan largesse in the Caribbean highlights the region’s most unreported and disconcerting vacuum, where high debt levels, weak external demand and financial-sector vulnerabilities will persist in 2014. The economies of Belize, St Kitts and Nevis, and Jamaica are in particularly poor shape, with the last remaining under IMF tutelage.

In Cuba, the risk of vacuum has become permanent. Putative presidential successor Miguel Díaz-Canel will quietly continue his apprenticeship to Raúl Castro, but were the latter to die in 2014 (he will be 83), Díaz-Canel would preside over a transition marked by deep uncertainty. Frustration over the government’s cautious approach to economic reform will be ever present, though social control will remain tight, and emigration as ever will provide a neat escape valve.

Honduras represents a more immediately worrying case: political tensions will remain high and the fiscal situation precarious, hindering the fight against rampant crime and the penetration of drug trafficking into the country’s institutional fabric.

While there is no power vacuum in Brazil, 2014 is likely to throw into relief the gulf between the country’s

projected image and reality. The sporting prowess and cultural vitality highlighted by the World Cup will underline Brazil’s already well-established soft power credentials.

But failure to make headway on political reform, the lag in realizing oil projects and continued corruption – which will remain under intense scrutiny – point to the limitations that continue to hold back Brazil’s global power pretensions. Brazil’s quest for the elusive UN Security Council seat will therefore remain unfulfilled in 2014, even if its relationship with the US is likely to recover after the bumps of late 2013.

REJECTION OF DEFECTION

The broad-brush division between left-leaning governments and more pragmatic centrists will persist in 2014. There will be no ‘defections’ from one group to another, though the political momentum in Argentina will continue its drift away from Fernández’s heterodox model, even if this will not culminate until 2015. (…)

Venezuelan leadership of the Bolivarian Alliance for the Peoples of Our Americas (ALBA) will remain muted as domestic woes and economic imbalances limit its ability to shell out oil dollars as liberally as it did under Chávez. Ecuador’s President Rafael Correa will continue to hustle and bustle on the world stage as Chávez’s would-be heir, but his impact will remain limited.

One of the most significant developments in 2014 will be the continuing evolution of the Pacific Alliance – comprising Mexico, Colombia, Peru and Chile, which together account for 35 percent of Latin American GDP – not just as a counterpoint to the ALBA, but as an enhanced platform for increased engagement outside the region. With little fanfare, 2014 could feasibly see the Pacific Alliance ripen into a far more effective alternative to the Southern Common Market (Mercosur) trade bloc, which will continue down the path of gradual obsolescence. The business environments in the Pacific Alliance countries are among the most attractive in the region, with predictable policy frameworks, fewer protectionist tendencies, independent central banks and higher productivity levels.

The cementing and expansion of the Pacific Alliance will consolidate Latin America’s growing links with the Asia-Pacific region outside China. For example, the reinvigoration of free-trade talks between Mexico and South Korea is likely in 2014. Outside the alliance, the consolidation of Venezuelan oil flows to India will  continue and Trans-Pacific Partnership negotiations will conclude, benefiting Mexico, Peru and Chile. Colombia already has a free-trade agreement with South Korea, but is struggling to fully exploit it while its own Pacific region remains retarded by years of government neglect and conflict. A peace agreement should mark the beginning of a regeneration process in the area, even if tangible improvements in port and road infrastructure will only materialize after 2014.

Oil pipelines to Colombia’s Pacific coast from Venezuela will have to wait until after 2014, though with Asia set to account for most of the expected growth in oil consumption in coming years, the stage is set for further geopolitical shifts affecting the region.

China will remain a key player, even if its growth rates drop down a gear, remaining a prime creditor for Ecuador and continuing to take 80 percent of Chile’s copper. China will be a growing oil buyer for Venezuela as the latter continues to decouple commercially from the US. If Venezuela is to maintain Chinese trust, President Nicolás Maduro needs to deliver on oil deals – proof, if ever it was needed, that Chinese interest in Latin America is not ideological but highly practical. China’s interest in Latin America will not detract from the fact that the region’s geostrategic relations will continue to hinge largely on the US, which will retain strong economic and security interests in the region in 2014.

NO HARD LANDING

Latin America faces more challenging conditions in 2014 amid reduced global liquidity and increased market volatility. But the risk of a hard landing is lower than in the past thanks to the trade diversification and reforms put in place across much of the region in recent years. Where reform has been lackluster, vulnerabilities will be more pronounced, but those most affected will in all likelihood muddle through and avoid painful adjustments. Social protests stemming from historic problems and newer challenges that have arisen from growth and economic success will persist, but are highly unlikely to coalesce into movements that threaten stability.
 

Republished with permission from Riskmap Report 2014 from Control Risks.