Publish in Perspectives - Wednesday, February 11, 2015
The Mexican peso is at its lowest level since early 2009, while currencies from Colombia and Chile have also weakened. (Photo: Mexico's Central Bank)
External developments have combined to weaken Latin America’s currencies.
Colombia's peso is at its lowest levels against the U.S. dollar in five years. Chile's peso is at a six-year-low against the dollar amid a plunge in the price of copper, Chile's chief export. And the Mexican peso, which lost 12 percent of its value against the greenback since the beginning of September, is at its lowest level since early 2009. What are the positive and negative effects of the weakening Latin American currencies? Do the positives outweigh the negatives? Do governments in the region need to take action to prop up their currencies against the dollar, and if so, what types? What external and internal factors are most shaping the outlook for LatAm currencies this year?
Claudio Loser, visiting senior fellow at the Inter-American Dialogue, president of Centennial Group Latin America and former head of the Western Hemisphere Department of the International Monetary Fund: The key point regarding exchange rate behavior in Latin America is that the observed decline in the value of currencies is an inevitable consequence of the decline in commodity prices, a phenomenon that will be with the region at least through 2015. Latin America is as rich in natural resources as imaginable, but a sharp decline in prices of its exports makes the countries poorer. This is exactly the reverse of what Latin America experienced during the previous decade, with amazing increases in commodity prices and prosperity. Governments and the public developed the belief that prosperity was due to a change in paradigm. It was not. A few countries, mainly Chile, had the wisdom to prepare for these events, which repeat themselves over the decades. A depreciation of the currency at least helps traditional commodity exports, while making other sectors more attractive. A flexible exchange regime makes the process, if not seamless, at least smooth. Thus, countries like Chile, Mexico, Colombia, Peru and possibly Brazil have moved quickly to protect themselves from the shock. They show that it is possible, though difficult, to sail even with unfavorable winds. Other countries are suffering more by not moving the rate, like Venezuela, Argentina and Ecuador. They seem to believe that negating the existence of these winds makes them not exist. They are wrong, and not allowing their currencies to decline makes them suffer the costs in terms of economic activity and well-being.
Juan Ruiz, chief economist for South America at BBVA in Madrid: Most countries in Latin America have managed to break almost free of the liability dollarization and currency mismatches of the 1980s. There are still some currency mismatches mostly in the corporate, non-financial sector, but they are, to a great extent, hedged one way or another. Thus, nowadays FX flexibility can truly act as a first shock absorber in the region, and that's what we have witnessed recently. Therefore, I think the positives of depreciation (a boost to the external sector) this time truly outweigh the negatives (some currency mismatches). In addition, inflation-targeting regimes have become more credible in the region, limiting the pass-through to inflation. Latin American currencies will continue to follow a depreciating trend going forward, as commodity prices will no longer rise as in the past decade, China engineers a controlled slowdown and the global liquidity that is dominated by the United States is tightened as Fed funds rates take off sometime in mid-2015. To this, you need to add that some central banks in the region, such as those in Chile, Peru and Colombia, are becoming more dovish, due to weakness of their economic activity. In countries such as Argentina, Brazil and Uruguay, persistently high inflation will also weigh on nominal exchange rates. In this sense, I think governments in the region should refrain from propping up their currencies, since the three aforementioned external shocks seem to be mostly structural in nature. However, I do think there is a case for trying to stem excessive volatility around that general depreciating trend going forward.
Carlos M. Parra, professor of marketing at Florida International University: Various factors are driving the devaluation of Latin American currencies, but I will focus on a couple of recent developments in the world's largest economies as well as in global investment trends. These developments are: the end of quantitative easing in the United States, which is related to a better economic outlook, along with reduced U.S. demand for foreign oil. Another factor is China's slowdown, which has led to reduced demand for Latin American commodities. The end of the Fed's quantitative easing has made the dollar dearer because the currency has become harder to find. Also, strong economic indicators have made investors return to positions in the United States. Meanwhile, demand for Latin American commodities (chiefly oil and construction metals) has slumped. All these external developments have combined to weaken the region's currencies. Unfortunately, these are developments that will continue to shape the 2015 outlook for Latin America and about which governments in the region can do very little. Thankfully, Latin America's recent growth years have lifted many out of poverty, strengthening the middle class, especially in Peru, Colombia and others. This enhances internal demand and will continue to attract investments related to demand in middle-income segments for housing, cars, plane rides, laptops, phones and other goods. The best way to satisfy this demand in 2015 is for businesses to leverage the availability of competitive local financing. However, importers will eventually pass exchange-rate costs to consumers, and inflation may set in, which will be somewhat tamed by low fuel costs. Thus, central banks in the region will have to discuss interest rate hikes, and because of this, governments should think of ways of handling carry traders looking for spread as they borrow in the United States at low interest rates, get much more local currency for their dollars and then lend at higher rates in the region (high enough to cover further devaluation).
Pablo Heidrich, adjunct research professor at the Institute of Political Economy of Carleton University in Ottawa: The main positive effect of weakening Latin American currencies is immediately increased export competitiveness in the U.S. market, particularly in those goods with significant labor or local content, such as textiles from Colombia, fresh fruits from Chile and auto parts or lighter manufacturing goods from Mexico. That competitiveness is also translated partially in the internal markets of Latin American countries, such as Mexico and the Central American nations, which source a significant proportion of their imports from the United States. In those cases, domestic producers might have some possibilities to expand at the cost of U.S. firms exporting there. The negative effect might be slightly higher levels of inflation, with Latin American central banks having to keep interest rates higher than otherwise needed. Still, that effect is a function of their linkages with the U.S. economy, so it varies hugely across the region. Governments in the region should continue calibrating monetary policy with interest rates and bond issuances, careful however not to use exit controls on monetary flows. That would raise unwarranted alarms and could precipitate overshooting in the devaluation process. The main policy target should be to smooth currency value changes while optimizing for the highest possible level of activity and employment. An external factor shaping the outlook for Latin American currencies is the continued currency warfare among the United States, European Union, Japan and most East Asian nations. Given a context wherein developed countries' fiscal policies to exit the global crisis were blunted by fiscal consolidation and austerity, governments are using their monetary instruments to their full power to get out of stagnation. Unfortunately, this currency warfare will get worse before some or all participants give up and try more balanced solutions instead. Internally, situations in the region vary greatly. Except for Venezuela and Argentina, most other countries do not present high chances of a drastic currency changes (devaluations). As several Latin American countries compete with each other in the U.S. market, we can expect some degree of correlation among devaluations in Central America, Mexico and perhaps Colombia.