Going down
This is our fifth effort at forecasting what will happen in the region in 2007 and our first stab at forecasting what will happen in 2008. We are making these forecasts in late-September, just after the US Federal Reserve Board cut US interest rates by half a percentage point. Our view of the global economy is bearish. We think that world growth will slow, despite the Fed's action, and the effect of higher commodity prices (oil, metals and grains) will push up inflation.
Given this overall background, South America, is, unusually, rather well placed. It is a major producer of commodities, so will benefit from higher prices. South America's exposure to the US, which is likely to be the world economy that will have to make the biggest adjustments to its current mix of economic policies, has generally been shrinking over the past decade.
Right across Latin America governments have been rebuilding their economic credibility (even, we would argue, in economies influenced by President Hugo Chávez of Venezuela) so they should be in a position to weather a rough patch, provided it does not last too long. Our view is that growth in South America over the next few years will be significantly faster than in Mexico and Central America. Mexico and Central America are much more dependent on the US than South America, especially for remittances, so their political stability may wax and wane alongside the US economy.
Our view three months ago was that Brazil and Chile would have better economic performances (ie growth of 5% or more and an inflation rate below that) in 2007 than they did in 2006. Brazil, definitely, looks on course for decent growth in 2008. The outlook for Chile is rather cloudier, given the upswing in inflation and the government's uncertain performance. Colombia, Peru, Panama and El Salvador all look as though their economies will grow fast (around or above 5%) without triggering faster inflation.
Although the outlook for South America is better than for Central America, growth in the Chávez economies (Argentina, Bolivia, perhaps Ecuador, Nicaragua and Venezuela) will slow a bit, largely because its has been so fast in the past three years. No-one really knows whether the Cuban economy is growing fast or slowly. It is clearly, however, growing.
Strategically, what happens economically in Mexico is likely to have the greatest implications for the region. Only if oil prices collapsed (unhinging Chavismo) would the geopolitical implications be greater. Mexico, though, not as dependent as Venezuela and the other Opec countries on oil is still hugely vulnerable to a collapse in oil prices. The Mexican government depends on oil for 35% of its revenues, 90% of which are committed to wages and pensions. A 50% collapse in oil prices, as happened at the end of 1990s, coupled with a weak US economy (so no jobs for Mexican emigrants and export industries) would create social tensions in Mexico that could easily erupt into something vicious. The government of President Felipe Calderón Hinojosa is playing the very difficult political hand, bequeathed him by his increasingly discredited predecessor, Vicente Fox, rather well. But with the oil running out, a guerrilla group set on a bombing campaign and a war against the drug trade, he and his government face the greatest challenges in the region.
The issue for Mexican economic policymakers is whether or not they decide to take risks with inflation to keep the domestic economy growing. Their initial answer, provided by the Banco de México's decision to raise interest rates in May, is that the battle against inflation is all-important. It is worth remembering that the Banco de México, unlike the US Fed, has only an inflation target. The Fed has to balance inflation with employment. The worry for the financial markets in Mexico should be that the Banco de México's action has not had a noticeable effect on inflation: the rate is still around 4%, significantly above the US's 2.5%.
A weakening US economy is also likely, so that means that 2008 will be another year in which local currencies are strong. Colombia, Brazil and Chile have all suffered from this phenomenon in 2007. Ecuador, El Salvador and Panama, which are dollarised, have benefited.
Our view is still that Argentina is still the region's most vulnerable economy. It looks as though, however, the government has timed things nicely. It has kept the lid on inflation to allow Cristina Fernández, wife of the current President, Néstor Kirchner, to win the presidency, almost certainly in the first round at the end of October. She has been making international connections this year (in Mexico and Europe) which may signal that she will try to propel Argentina out of its current orbit around Venezuela.
As we warned three months ago, the crisis in the US housing market has affected the financial markets. We would argue that second shoe has yet to drop: an apparent collapse in the house construction market must have implications for municipal finance and general consumption. We think that the US is on the verge of a major recession. This, we define as at least three consecutive quarters of either quarter-on-quarter or year-on-year contractions in output.
What is interesting is how well Latin American economies, with the exception of Mexico and Central America are diversifying their economies away from relying on the US. China's demand for metals and food has helped. What has been less remarked upon is the European Union's rekindled interest in South America. As we noted three months ago, the bulk of the record levels of foreign investment in Brazil is coming from Europe. The Europeans are as interested in buying into service businesses as well as manufacturing. As we noted three months ago the corollary to this increasing trans-atlantic trade has been that more cocaine is flowing northeast across the Atlantic. There are signs that the drug industry is finding the US cocaine market at near saturation point, while demand from Europe is growing.
In the Andean countries, Bolivia's economy is moving. The pick up in inflation suggests that more people are entering the economy which has put pressure on supplies. The political uncertainty has not had much effect on the economy, either way. If a rightwing government was in power, the radical Left would, almost certainly, be protesting deterring foreign investment. Around the world, investment in gas has tailed off: when gas prices recover foreign investment in Bolivia will pick up again. In Ecuador, the economy is doing ok: the constituent assembly elections at the end of September may well give the economy a leftward tilt, but the new constitution is likely to be more socially inclusive (ie specifically guaranteeing gay and indigenous people's rights, for example) than economically radical.
In Venezuela, President Hugo Chávez can go on with his heterodox economic policies for as long as oil prices stay high. It is worth noting that only one foreign oil company, ENI from Italy, has confronted the government over its policy of turning foreign investors into minority shareholders in oil projects. Even US oil companies have shied away from confronting the government. As the foreign oil companies who have settled with the Chávez government will retain management control, it is far from clear that the shift in shareholdings will make much difference on the ground.
In Colombia growth in the second quarter was 6.87% year on year. Industrial output was up by a staggering 12%, thanks to the oil-fuelled boom in Venezuela.
Colombia's trade is dominated by two countries: the US, which buys 33% of the country's exports and Venezuela, which buys 14%. The country's biggest trade surplus (US$1.2bn in the first half of 2007, three times more than in the first half of 2006) is with Venezuela. Colombia's trade surplus with the US fell by 65%, compared with the first half of 2006, to US$615m.
Now to our specific forecasts. Three months ago, we forecast that the US Federal Reserve Board would not alter interest rates, either up or down until after the summer. We were right about that. Until the Fed cut rates the Six month Libor (London Inter-Bank Offer Rate) was in line with our target of between 5.50% and 5.30%. It is now 5.09%. We expect another 25 basis point cut by the end of year bringing Six Month Libor down to around 4.8%in December. Our bearishness on crude oil prices was hopelessly wrong. Again. Three months ago we expected the price to fall back below US$60 a barrel by September. In fact crude oil traded close to its all-time high of US$84.1 a barrel in the penultimate week of September. We still expect the oil price to fall back to below US$70 a barrel by the end of the year.
On copper we expected prices to ease back to US$3 a pound by September. In fact the price fell close to that level before recovering to US$3.5. We expect copper prices to have weakened by 10% by December.
Argentina
The right-wing opposition is trying to generate a row over inflation. The
government, in the form of the prime minister,was tempted into making the
bizarre statement that there was no inflation in Argentina. The central bank
governor, Martín Redrado, annoyed President Kirchner by saying that inflation
was worrying. Despite this, the economy is still humming along at 8% plus
growth. Unemployment is falling and the fiscal position looks sustainable in the
short term. The big economic problem is investment: the economy is increasingly
becoming a satellite of Brazil. The Argentine car industry serves the much
larger Brazilian industry, while Petrobras is one of the main investors in the
energy industry.
Brazil
The government and private sector forecasters are steadily increasing their forecasts to around 5%. We still think that this is an underestimate and 6% growth is possible. What is hugely encouraging is the level of foreign direct investment. The government is now expecting over US$32bn in FDI this year. Some of this is corporate activity but the bulk is "real" investment in new factories, and machinery. The government had been forecasting US$25bn in FDI in 2007. The strength of FDI should mean that the economy will continue to grow fast in 2008. We expect 5% growth.
Exporters, even of manufactured goods, have coped with the rise in the Real against the dollar. They now seem able to live with a dollar at sub R$1.90 levels. The question is could they cope with a dollar down at R$1.70. It is worth remembering that a year ago the dollar was at R$2.20.
The other hugely positive development is the lowering of interest rates. This is leading to wider access to credit: construction and housing loans is up by 70% in the first five months of the year compared to the same period of 2006. This surge in credit means that the service sector is booming. Credit is likely to become even more widely available if the country achieves investment grade status. Several investment banks reckon that this could happen before the end of the year.
Chile
The central bank raised interest rates in August and then again in September.
Both times it increased rates by 0.25%, bringing them to 5.75%. The bank has
been disconcerted by the run up in food prices which has taken the 12 month
inflation rate up to 4.7%. This is the highest rate for six years. Growth,
though, has been strong, prompting the government to raise its forecast for 2007
to 6%. Domestic demand is running at around 6.8%. The resurgence of copper
prices will keep government revenues buoyant, though whether the bureaucrats
have the capacity to spend the money wisely is far from clear, given the
expensive mess and muddle of the Transantiago urban transport scheme which
despite having money chucked at it, is still not functioning properly.
Colombia
The peso surged against the dollar when the US cut interest rates. The strength
of the currency is taking some of the edge off inflation, which is already about
50% ahead of the government's 2007 target.
As we noted three months ago, the central bank has all but admitted that raising interest rates has not been effective in bringing inflation to heel. It, and the government, have now moved on to trying to discourage financial investors putting money into the country and Colombian companies borrowing abroad. The government's changed policies have yet to deliver.
The real economy is still benefiting from the strong growth in Venezuela. Exports to Venezuela are booming while sales to the US are showing signs of wilting, after their strong growth in 2006.
Politically, President Alvaro Uribe has trouble on several fronts. His biggest headache is the Democrats' control of the US Congress. They will thwart his free trade agreement with the US and may yet force the US to scale back the military support provided under Plan Colombia. The likely loss of the US base at Manta, Ecuador, will also have implications for US anti-drugs policy.
Another issue for Uribe is France's renewed interest in securing the release of Ingrid Betancourt, held hostage by the Farc. The Farc has ignored Uribe's first gesture, releasing Rodrigo Granda, a prominent Farc leader, gambling correctly that France's new president, Nicolas Sarkozy, will heap pressure on Uribe and force him to make more concessions.
The third problem, the controversial peace process with the paramilitaries, will come under a spotlight in the run up to the regional elections, due at the end of October.
Ecuador
President Rafael Correa's focus on reforming the constitution means that all he
wants from his economic team is no nasty surprises. He has, in fact, done rather
better. The economic sluggishness that seemed to be manifesting itself in July
has dissipated. Employment, energy usage and manufacturing output are all
increasing. The only problem is that oil production is sticky.
Businessmen are pleased by the government's decision to cut, and in some cases, eliminate import tariffs on capital goods and imported inputs.
What is interesting is that despite dollarisation inflation remains low. Only Peru has a lower inflation rate. The government is confident that it can keep the rate at the current level of below 3% for 2008. It is also forecasting that growth in 2008 will be 4.3%. This is above the long term trend rate of annual growth of 3% and the government's target for 4% growth in 2007.
Mexico
The economy has slowed down, but the strength of domestic demand, fuelled by
cheap credit, has taken the edge off the sharpness of the fall in US demand. The
short-term problem for policymakers is that cheap credit may have led to some
distortions in the domestic economy. The structural problems for the economy are
the dependence on oil, which is now running out fast and on the US. Our view of
both is bearish, so we are gloomy about the long run prospects.
The main bull point for the economy is the practical outlook of the government of President Felipe Calderón. Business does not like his fiscal reform, as adjusted by congress, but it is a significant start. The electoral reform is far more radical and would switch the emphasis in election campaigns away from money and back to organisation. The reform will clearly benefit the Partido Revolucionario Institucional, which lost the presidency in 2000, but has retained control of a majority of Mexican states. The electoral reform will also weaken Elba Esther Gordillo, the hugely powerful leader of the teachers' union, Latin America's biggest trade union. Gordillo has controlled education policy in Mexico since the early 1990s and extended her power into politics under President Vicente Fox: she was probably decisive in the 2006 election in tilting the result Calderón's way. Yet Calderón has not become beholden to her. With Agustín Carstens at the finance ministry it is quite possible that Calderón's administration will develop into the technocratic, but reforming, administration that Mexico needs.
Peru
President Alan García's impressive response to the Ica earthquake in mid August
has transformed the commentariat's view of his administration. His big challenge
now is to manage the prosecution, and conviction, of a former president, Alberto
Fujimori. Fujimori was extradited to Peru, from Chile, on 22 September. The
problem for García is that he depends on the Fujimoristas for his majority in
congress.
The economy looks well set. Growth will be around 7% this year and there is little reason for the rate to slow in 2008. Retailing and construction are booming. The Camisea gas project will underpin exports and keep the economy moving. Inflation is negligible, in international terms, running at less than 2.5% a year. This low rate did not stop the central bank from raising rates to show that it was not happy. In 2006 inflation was only 1.1%.
Venezuela
President Hugo Chávez 's anti-capitalist rhetoric disguises some pretty
impressive orthodox economic achievements. The most important is probably the
reduction in the foreign debt burden from 37% of GDP three years ago to 17% now.
Some of this achievement is the result of strong economic growth; the rest is
down to using the oil surpluses to pay off expensive debt.
The economy is running into capacity constraints. Investment has been stuck at 19% of GDP even though the economy has grown by an average of 13% a year over the past three years. Orthodox economists argue that something must change: either the growth rate will wilt or investment will have to go up. The surge in inflation is one indication that demand is exceeding supply.
We would argue that it is more sensible to see Venezuela and Colombia as complementary economies. Business investment in Colombia has been huge as its export trade with Venezuela has soared. What Chávez has done is to increase spending on health, education (and defence). He has also bought political influence in both South America and the Caribbean by either lending money (Argentina) or providing potential allies with cheap oil.
Chávez 's critics claim that the imbalances in the economy will lead to a devaluation. Chávez 's advisers will probably camouflage any devaluation in the currency reordering scheduled for the beginning of 2008 when the government lops three zeroes off the dollar exchange rate. A devaluation will boost government revenues (and thus reduce the budget deficit) because half the government's revenues come from oil exports, which are denominated in dollars. The budget deficit is anyway pretty notional because the government is budgeting on an average price of US$29 a barrel in 2008. Venezuela is currently selling its oil for two and half times that figure.