How will the international financial crisis affect Asia and Latin America?
The turmoil in the international financial markets since mid-August initially prompted international investors to pull back from risky assets and seek the security of US Treasury bills. Second thoughts -and the promise of cuts in US interest rates, which were fulfilled first in September and then again in October- prompted investors to go back into US equities. Analysts were quick to rationalise this move: they noted that as a result of globalisation 50% of sales generated by companies who are members of the S&P 500 come from outside the US. Some analysts try to argue that this phenomenon will underpin the US dollar: companies will have to repatriate these profits and investors will buy their shares. We don't buy this argument. We believe that the dollar will fall further against most major currencies.
Indeed, on 7 November the dollar lurched horribly following a comment from Cheng Siwei, the vice chairman of the standing committee of China's National People's Congress. He said that China should diversify its reserves away from the dollar. Such a move has long been feared by US economists and policymakers but China has previously never speculated publicly about implementing it.
The tacit agreement between the US and China has been that the US will not press the Chinese too strongly on the undervaluation of the renimbi provided the Chinese continue to buy US securities and to fund the US current account deficit, which, in turn, is largely the result of China's export drive to the US.
If the Chinese break this tacit deal it is far from clear who will go on funding the US current accounts deficit. This will mean that the US will either have to pay higher interest rates to fund the deficit at its current level (still around 5% of GDP) or reduce it further.
With this background, the question is: why should investors buy the shares of US companies, which generate only half their sales outside the US when, with a bit of research, they could buy non-US companies which have a much lower US exposure.
Our view is that exposure to the US economy is not going to be a comfortable experience for most companies over the next 18 months to two years. The sub prime turmoil has already shaken two of the US's biggest financial companies: Merrill Lynch and Citigroup. In some ways the current crisis has major similarities to the Latin American debt crises of the 1980s. Then US banks swallowed the argument that countries could not go bust, just as the current generation of bankers believed that financial engineering and derivatives could protect them from the consequences of their "bigger fool" lending policies. It is also worth noting that Citigroup was the first major bank (in 1987) to accept that "The countries do not go bust" argument was wrong.
It turned this decision into a competitive advantage, providing against Latin American loans it accepted were likely to be dud. Weaker banks did not have the cash flow to afford the provisions Citigroup made, so a host of what were then known as money centre banks were forced into mergers. Citigroup's huge provisions (US$15bn so far) against sub-prime assets is likely to set off a similar reduction of the financial services industry, though this time it will not be just US banks which will suffer. Already regional banks in northern Germany and northern England have been hurt.
The big question for both Asia and Latin America is how the financial turmoil will affect the US economy. Ostensibly the US escaped more or less unscathed from the Latin American debt crisis. A disappearance of a few big US banks had little effect on US jobs and economic growth. The effect of the Latin American debt crisis on Latin America, however, was profound.
Our view is that the effect on the US economy of the sub-prime crisis could be equally profound. It could force major changes in US economic behaviour which will have considerable effects on the US's trading partners. One big effect could be a rebalancing between consumption and saving: this would reduce US demand for credit and thus demand for imports.
There were two main consequences of the Latin American debt crisis. The first, reinforced by the Mexican crisis of 1995 and the Argentine collapse of 2002, was that Latin American policy-makers formed a new consensus that foreign debt, of any sort, is dangerous. Big borrowers such as Mexico and Brazil developed their own capital markets: they allow foreign investors in, but they are much less dependent on them than when they borrowed abroad. Indeed Brazil is now so attractive to foreign investors that the New York Stock Exchange took a symbolic 1% stake in the Brazilian market, the Bovespa, when the Bovespa went public at the end of October.
The second consequence of the debt crisis was huge emigration, principally from Mexico and Central America, to the US. This vast movement of people initially had only economic benefits: the US got the cheap labour its economy needed and Latin America got remittances which, arguably, were better directed and more economically beneficial than foreign loans. Latin America's economies, however, stagnated for a decade. Only now are they reviving.
The social consequences of this mass migration are just beginning to appear. The US has failed to rationalise the immigration situation, probably because of its distractions in the Middle East. Immigration has become an economic and emotive issue in the US. In early August the Department of Homeland Security announced that it was increasing penalties for companies and executives who resorted to hiring illegal migrants. On 20 August, the US government deported Elvira Arellano, an illegal Mexican immigrant whose son was born in the US. In mid-August Arellano took the risk of leaving the sanctuary of the Chicago church where she had lived for a year to campaign in Los Angeles for immigrants' rights. Her deportation made headlines across the US and around Latin America for two reasons. Public pressure in Mexico prompted President Felipe Calderón to meet her and endorse her campaign.
Arellano embodies the hugely complicated immigration issue. To her supporters, she has been exploited. The US had needed her and used her (she worked at O'Hare International Airport) but now it needs her no longer, she is expendable. The danger of splitting her from her eight year old son comes a distant second to the needs of the US economy.
The second reason why Arellano's deportation is important is that it shows that the anti-immigrant mood in the US is strengthening. No major US politician has protested against Arellano's deportation. This suggests that anti-immigration rhetoric will increase in the run-up to next year's presidential elections.
This combination of increasing anti-immigrant rhetoric and harsher policies will affect US relations with Latin America. Already, Calderón has signalled that he wants to keep his distance from the US and is busy mending relations with the US's bête noires in the region: Venezuela and Cuba.
Anti-immigrant rhetoric in the US may be a product of the slowing economy. The apparent collapse of the US construction industry has thrown a lot of hardworking immigrants on to the US labour market. They are competing with the rest of the working class for a shrinking number of low-skilled jobs.
Some of the US economic forecasts for the long term (the next two years) effects of the sub-prime mortgage crisis are extremely gloomy. Merrill Lynch's US economist believes, for example, that the US growth rate may be only a third of what it was in 2006. So far there is little sign of a major US economic slowdown, but we are convinced it will come.
If the US goes into a consumer-led recession some of the froth will be blown off the world economy. Some commodity prices, notably copper and oil, are likely to come down. Food prices will also weaken. It is worth noting that South America is expecting a bumper harvest. This should mean that maize prices, which have been pushing up food prices around the world, will fall further.
A slowdown in the US consumer demand will hit Mexico and Central America much harder than South America. South America, however, is vulnerable to any slowdown in Chinese demand which is unlikely to change until after the Olympics next year. More of Chile's copper goes to China than to the US, while Brazil and Argentina sell the bulk of their soya to China.
The key effect, however, of a significant recession in the US's economic and political influence will be undermined. Even Mexico, which swallowed the neoliberal Washington Consensus more or less neat, has been backing away from the idea that free markets and democracy can reduce poverty significantly.
China is a prime example of successful economy that has neither free markets nor democracy. Indeed it is possibly the only example of a successful (fast growing, low inflation, poverty reducing) economy that does not have free markets.
The danger for the Chinese economy is that the lack of a free market will create destructive distortions in the economy. The most obvious sign of this is the wild overvaluation of Petro-China which, thanks to its initial public offering on the Shanghai exchange became the world's first US$1trillion company by market capitalisation. As many analysts have pointed out, taking the freer Hong Kong market as a guide, the market capitalisation is actually two-thirds lower.
Chinese investors have so few choices about where to put their savings that they are forced to chase the prices of equities they can buy to ridiculous levels. As the Latin American debt crisis and now the US subprime mortgage disaster show, eventually markets exhaust the supply of bigger fools.
What seems to appeal to Chinese policymakers is the Latin American combination of natural resources and states with stronger public sectors. China recently announced that it was setting up a fund to invest US$6bn in projects in Venezuela. This looks similar to the huge promises made by China's leader Hu Jintao on his Latin American tour of 2005. A lot of these have yet to materialise.
In Latin America, the disenchantment with neoliberal economic policies is growing. There are growing signs the President Lula da Silva in Brazil may finally be making some leftwards moves. One sign of this is his reassembling of state companies: state-owned companies have been buying rivals and bolstering their market position. President Hugo Chávez of Venezuela has made more fanfare about similar re-nationalisations, though the state oil company Petróleos de Venezuela, and the Corporación Venezolana de Guayana are nothing like as powerful as they were in their heyday.