Russia-Ukraine War: Impact on Latin America

Russia's invasion of Ukraine will exacerbate inflation and curb economic growth

LATINVEX SPECIAL
Moody’s Investor Service

Latin America has few direct economic and financial linkages with Russia and Ukraine; however, the surge in energy prices and new round of supply shocks resulting from the military conflict are constraining access to key food and industrial commodities, resulting in renewed inflation pressures and the likelihood of continued monetary policy tightening.

Inflation dynamics will drag on Latin America's economic growth

We have identified three channels of transmission of geopolitical risk to global credit risk resulting from the Russia-Ukraine military conflict: commodity price and supply interruptions; financial, economic and business disruption; and security challenges, including cyber risk. The direct effects of the military conflict on Latin America will be lower than for most other regions; however, the acceleration of fuel and food price increases since the start of the invasion is worsening inflationary pressures in Latin America that had resulted from economic reopenings following pandemic-related lockdowns and global supply chain constraints.

The continuing upward pressure on inflation will diminish households’ purchasing power and cut into consumption, one of the key drivers of the region's economic recovery from the COVID-19 crisis. Additionally, monetary policy tightening in response to higher inflation will adversely affect short-term investment dynamics in Latin America. However, Latin America has limited trade linkages with the two countries. The median Latin America country's exports to Russia accounted for only 0.3 percent of total exports, on average, from 2017 to 2021. Fertilizer exports from Russia are important for Latin America, particularly for Brazil (Ba2 stable), which could affect agricultural output and prices in the region's largest economy.

We now forecast median growth in Latin America at about 3 percent, down from our prior forecast of 3.5 percent in 2022 before the invasion of Ukraine, which still exceeds the average annual growth rate of 2.5 percent from 2015 to 2019. But growth will be lackluster in some of the region's biggest economies due to country-specific factors. We forecast 0.1 percent growth in Brazil and 1.1 percent growth in Mexico (Baa1 negative) for 2022. The economic and credit impact on Latin America will be more limited owing to the region's modest trade linkages with Europe – countries in the region are more integrated with China (A1 stable) or the US (Aaa stable). Nevertheless, more severe downside scenarios for the global economy are possible and could incorporate larger negative effects if, for example, the military conflict were to further escalate or expand beyond Ukraine

Latin America's exports to the EU (Aaa stable) made up 9 percent of total exports in 2017-21 for the median Latin American country, or 1.6 percent of GDP. Even if the deceleration in European economic growth were to be more pronounced than what we project under our baseline forecast, which anticipates EU growth of 2.8 percent in 2022 compared with a 4.4 percent growth forecast before the invasion, the magnitude of

the shock in Latin America likely would be contained.

Commodity price supply shock will feed into inflation, driving monetary policy tightening and challenging fiscal consolidation

The surge in prices of crude oil, food and metals is feeding into inflation, which pushed up median annual inflation in Latin America to 7.3 percent in February from 2.8 percent a year earlier. We expect inflationary pressures to moderate in the second half of the year but inflation to remain well above central bank targets. Policymakers will likely maintain tight monetary stances throughout the year to

ensure inflation expectations remain anchored.

Transportation prices in Latin America rose 13.1 percent on average in February from the prior-year period, while food prices rose 11.7 percent (see Exhibit 4). Given that these two categories together represent 40 percent of the CPI baskets on average, the price acceleration will contribute to inflationary pressures. Moreover, social tensions could increase as a result of surging costs. This is a risk even in countries with the highest per capita incomes, such as Chile (A1 negative) and Panama (Baa2 stable). Pressure on governments to raise subsidies to consumers will rise.

The military conflict has disrupted Russian and Ukrainian exports of wheat, soybeans and other agricultural commodities. Although Latin America does not import grains from Ukraine, surging global wheat prices will have a broad effect on the region's food prices. Argentina (Ca stable), among the world's largest wheat producers, will likely benefit from the higher prices and the opening of markets far afield. But, depending on the length of the crisis and the magnitude of the price surge, food stocks may become strategic assets and exports may be capped or restricted. Food security concerns are rising globally as stocks were already at risk from recurring severe climate events as well as from animal disease, affecting pork and other products, and flat fertilizer production in the Americas.

The use of administered fuel or food prices by the governments of Argentina, Brazil and Chile will help mask the overall impact on headline inflation in those countries. These slower or lower price pass-throughs may not be fiscally significant for most countries but could add to the increased subsidies or indirect fiscal costs as fuel-related state-owned entities shoulder the burden. Higher commodity-related income may mitigate the cost of providing these subsidies. Some governments may elect to reduce taxes on petroleum products to ease the burden on households, reducing any upside to revenue from higher prices.

Fuel imports will weaken balance of payments for many Latin American countries, while benefiting commodity exporters

While rising fuel import costs will weaken balance-of-payment positions for import-dependent sovereigns, particularly in Central America, the effect on commodity exporters’ external accounts may be neutral or positive. Net hydrocarbon exporters will benefit from higher oil and gas prices, which will contribute to a narrowing of current account deficits.

Meanwhile, metals and soft commodities exporters will benefit from current high prices for these goods, which may mitigate the rise of higher fuel import costs. Year to date, the exchange rates of major economies in the region have appreciated as terms-of-trade have improved. This, in turn, should support foreign-currency buffers, which continue to allow for ample coverage of most Latin American countries' external debt payments.

Higher commodities prices will benefit producers but raise input costs for transport and agriculture

Higher oil prices will benefit the region's energy producers in countries where prices follow international parity, such as Brazil, Chile, Colombia (Baa2 stable) and Peru (Baa1 stable). For refiners, fuel prices tend to follow changes in crude prices, but in times of high inflation, governments may create mechanisms to limit fuel increases for consumers. In Mexico, limited increases in fuel prices help contain inflation, but cash generation weakens for integrated national oil company PEMEX (Ba3 negative) when it does not increase prices in line with international benchmarks. In Brazil, higher oil prices will help national oil company Petrobras (Ba1 stable) generate more revenue from fuel products in 2022, assuming no government interference.

Latin American metals and mining companies will benefit from high prices for iron ore, steel, nickel and other metals, sustaining their profitability above peak-cycle levels in 2022. Even though input costs will rise, including prices for coking coal and iron ore for steelmakers, selling prices will exceed historical levels in 2022, partially reflecting supply concerns tied to Russia and Ukraine. Exchange rates also favor Latin American exports, but less so than in 2021.

In terms of agricultural commodities, selling prices for soybeans, corn and sugar will exceed historical levels, benefiting some large Latin American agricultural producers in 2022. Agricultural commodity producers purchased fertilizers before prices peaked in the second half of 2021, which favors their margins in 2022 — especially for soybean producers. But higher fertilizer prices and tight supplies will make purchases more difficult for the 2022-23 harvest, since Brazil sources most of its fertilizers from Russia. Although a reduced supply from Russia should encourage production from other regions, fertilizer prices will remain high and farming margins will narrow in the next harvest.

Still, higher selling prices would help offset lower profitability, especially for larger farmers with more nutrient-rich soil and more efficient processes. Farmers will increase the use of alternative sources of nitrogen and potash-based plant nutrients to lower their dependence on imported fertilizers from Russia. Selling prices would ultimately rise if productivity drops, or if farmers reduce their planted area as fertilizer becomes more restricted.

Shipping and rail operators in Brazil will be able to pass through at least some of their higher transport and logistics costs to clients based on contractual terms, and because higher fuel prices will raise costs even more for the competing trucking companies. But a smaller grain harvest in 2023, in a scenario of tighter fertilizer supplies and lower agricultural yields, would strain transportation volumes for grain-focused shipping operators Rumo (Ba2 stable) and Hidrovias do Brasil (B1 stable).

Higher jet fuel prices will hurt the region’s airlines if they cannot increase airfares enough to compensate. Demand for air travel has begun to recover as travel restrictions ease and with pent-up demand that has built during the pandemic. But efforts to pass through higher fuel costs will test the elasticity of air demand. Airlines will ultimately need to reduce capacity if profitability starts to deteriorate, slowing their recovery in the process.

Infrastructure companies are generally well protected from inflationary pressures from higher commodity prices, based on contractually based indexation that allows for periodic price adjustments to pass through higher operating costs. But persistently high prices lasting into 2023 increases the risk of political interference on tariff-setting mechanisms through price caps, or delays in the contractual adjustments to address customers' affordability concerns. With higher prices, delinquency rates on electricity and water services would likely increase, weakening operating margins; however, we expect regulated companies to have more flexibility to reinstate tight credit policies that they suspended during the pandemic, which will help them mitigate the effects on their cash flow.

The high oil and gas prices will also weigh on the cash generation of unregulated utilities and power-generation companies that rely heavily on oil and gas supplies. In Mexico and Argentina, thermal power generators represent more than 60 percent of electricity production. To compensate for higher oil and gas costs, companies in these sectors will rely more on their contractual provisions to pass on costs to their counterparties, or on higher government subsidies to mitigate losses. But these avenues may prove insufficient to fully offset near-term price fluctuations.

Tight access to raw materials will have limited effects on manufacturers and infrastructure groups

A continued or worsening semiconductor shortage would slow auto production growth, with spillover for auto suppliers in Brazil and Mexico, and ultimately for producers of flat and special steel. But auto suppliers such as Iochpe-Maxion (Ba3 stable) can shift production toward less semiconductor-dependent commercial vehicles to sustain volumes and profitability if light vehicle production declines.

Aircraft manufacturer Embraer (Ba2 stable) has ample titanium inventories and no major contracts with Russia. But a drawn-out conflict with Russia that constrains the world's titanium supply at a time of inflating costs would delay build rates, cutting into earnings for aerospace companies and their supply chains.

Any supply-chain disruptions would threaten to delay project completions for infrastructure companies that are now expanding installed capacity by making power-generation investments, and in particular those depending on the sourcing of raw materials and imported equipment, in renewables for example. But fixed-price agreements for engineering, procurement and construction (EPC) that are common to project finance transactions insulate these companies from any additional cost overruns. Until supply normalizes, companies without price protections on their EPC agreements will likely delay investments to avoid cash flow pressures.

Funding costs will rise further as financial conditions tighten

Beyond the immediate effects of the Russian invasion shock, the Fed’s tightening monetary stance will likely push funding costs higher for Latin American issuers, particularly if it leads to capital outflows as a result of flight to quality. The Fed's policies in the coming months will have a more direct impact on funding conditions in Latin America than the invasion of Ukraine. If the military conflict were to spread beyond Russia and Ukraine, it is likely that global financial conditions would tighten sharply. The sovereigns that would be most affected by this scenario would be those rated below Ba and that lack developed domestic credit markets. This includes most Central American and Caribbean sovereigns. In contrast, we expect Brazil and Chile to be among the least-affected sovereigns in the region because they possess ample domestic bank and bond market availability.

Financial conditions for Latin American sovereigns started to tighten in 2021 after a more favorable economic environment following the unprecedented monetary policy response by developed market central banks at the outset of the COVID-19 pandemic. On the external front, the median EMBI Global government bond spread for Latin America is about 100 basis points higher than the lows before the pandemic began (see Exhibit 5). Although the Russia-Ukraine shock caused a spike in sovereign spreads in early March, most have declined since then because of the rise in commodities prices. However, cross-border funding costs for Latin American sovereigns are higher than the lows in 2020-21, because interest rates in developed economies have materially increased. For many governments in the region, domestic funding costs are at the highest levels in recent years. As governments serve as benchmarks for issuers in other asset classes, rising sovereign funding costs point to tightening financial conditions.

Improved terms-of-trade and the strengthening of Latin American currencies may support investor appetite for Latin American issuers’ debt, particularly for commodity producers. However, country-specific factors – for example, political risk associated with upcoming elections in Brazil and Colombia – will remain relevant.

Financial institutions have few direct ties to Russia

Latin American financial institutions are relatively insulated from financial sanctions affecting Russia because of limited trade ties with the countries engaged in the military conflict. Therefore, cybersecurity risks and sanctions compliance risks are limited.

Most effects will be indirect and materialize as macroeconomic risks, including prolonged inflationary pressure and reactive tightening of monetary policy, which will dampen economic activity at a time when asset risk is also rising, though slowly. The negative effects of inflation on asset quality will be counterbalanced by higher lending rates, which will aid margins, compensating for more moderate lending activity and increasing credit costs. However, reserves for loan losses are ample to absorb the effects of activity slowdown and tightening payment capacity of borrowers. In 2021, the five largest banking systems in the region, including Brazil, Mexico, Chile, Colombia and Peru, had levels of reserves covering more than two times nonperforming loans, as Exhibit 7 shows, in some cases well above the position held five years ago.

On the funding side, local costs should rise with policy rates while deposit trends remain strong. International resources will also price in volatility, but local banks would be less affected given the limited reliance on foreign currency funding.

Security and legal risks are medium for global banks in general, including Latin American financial systems, despite the region’s neutral stance toward the invasion. Ample investment against cyberattacks and increased coordination and regulatory measures serve as strong mitigants to cyber risk. On the legal side, risks of inadvertently violating complex sanctions have increased.

Inflation is spurring risk for consumer and utility cost recovery securitizations but will support agribusiness ABS cash flow

As the Russia-Ukraine military conflict exacerbates price pressures on a range of goods, inflation will erode the performance of consumer-debt backed securitizations in Latin America. Rising food and energy prices will weaken consumers’ ability to service debt, creating additional performance risk for residential mortgage-backed securities (RMBS) and consumer loan asset-backed securities (ABS). Such risk will be elevated for deals exposed to borrowers with weaker credit quality. Many of these borrowers have relatively low incomes, with high and rising prices further straining their already-tight finances. However, transactions in which a large percentage of the borrowers pay down their loans through payroll deductions will be better protected from inflation-driven performance deterioration. For example, about 68 percent of the pooled loans in RMBS that we rate in Mexico use payroll deductions.

For securitizations backed by corporate assets, elevated goods prices will have varying credit effects. In Chile, for example, inflation will pose performance risks to ABS backed by utility cost recovery charges if there are shortfalls in the generation of surplus electricity fee revenue to pay receivables in full. If governments refrain from passing on full energy price increases to already-strapped consumers, electricity distribution companies – the obligors in the transactions – will need to make out-of-pocket payments by the notes’ legal final maturity. By contrast, Brazilian transactions backed by agribusiness account receivables will benefit from strong demand for fertilizers and pesticides in Brazil amid the production gaps resulting from the invasion of Ukraine, supported by high commodity prices. Such transactions are a leading securitization type in Brazil.

This article is based on an analysis by Moody’s Investor Service. Republished with permission.

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