Latin America economic risk from European debt
International financial markets are worried about a resurgence of the euro zone debt crisis, with eyes squarely on Spain and whether it could become the fourth country to require a financial rescue. While Latin America has thus far weathered Europe’s troubles relatively well, it has not been immune. Growth in the region has slowed, although we expect it to remain stronger than the global average. Still, under a scenario where conditions in Europe worsen—or there is another shock, like a spike in oil prices—there could be more fallout on Latin America’s economies, asset prices and financial flows.
Following a strong rebound in 2010 to 6% on the back of a surge in global stimulus, growth in the Latin American region as a whole slowed to 4.4% in 2011. The Economist Intelligence Unit forecasts a further deceleration to 3.7% in 2012, in a context of outright contraction in the euro zone (we expect shrinkage of 0.7%) and below-par growth in the US (of 2.2%).
Growth in the region’s largest economy, Brazil, is off to a sluggish start this year after plummeting to 2.7% in 2011 from 7.5% the year before. On the positive side, commodity exporters in South America will continue to benefit from strong Chinese demand. Several factors—such as sound macroeconomic policies, resilient domestic demand and recovery in growth in the OECD—will boost Latin American growth from 2013 (with average growth of 4.2% in 2013-16). However, many countries in the region will remain vulnerable to shifts in market sentiment and rising inflationary pressures.
The region’s external balance sheet has become stronger over recent years, which will help provide a cushion against external shocks. External debt is lower relative to GDP and exports and foreign-exchange reserves are at record levels. Nevertheless, growth in import bills, fuelled by domestic demand and by strong local currencies, will exceed export revenue growth, resulting in large current-account deficits in the region—even for commodities exporters. This situation is particularly problematic for Argentina, for which current-account surpluses have been a pillar of stability in the last decade, given the government’s limited access to international capital markets, use of foreign reserves to repay its external debts and vulnerability to capital flight.
Swings in sentiment
Given the close integration of the major Latin American economies in global financial markets, local currencies and asset prices have been hit by swings in investor sentiment. But thanks to flexible policies these shocks have been absorbed relatively well. In September 2011 the region suffered an increase in risk aversion associated with Europe’s woes (with the Brazilian Real and Mexican peso down by 16.6% and 12.3% respectively against the US dollar in that month). Since the start of 2012, risky asset markets have registered large gains, as risk aversion abated, thanks to the liquidity operations of the European Central Bank. As the effects of these have worn off, however, risk aversion has returned.
In addition to fluctuations in investor sentiment, Latin American policymakers face other challenges. In monetary and credit policy they are striving to strike a balance between supporting domestic demand (to offset weak export markets in the OECD) while keeping inflation under control amid price pressures stemming from high food and oil prices. Brazil’s aggressive string of interest-rate cuts (with its latest reduction of 75 basis points on April 18th putting the policy rate at 9%, close to a record low of 8.75%), attests to the government’s aim of supporting growth. This has raised concerns over the Central Bank’s commitment to achieving the central inflation target (4.5%), and inflationary expectations for 2012 and 2013 have continued to drift upwards.
A worsening of the European debt crisis, which would damage both sovereigns and European banks (which are heavily invested in sovereign debt and are already showing higher rates of non-performing loans in their other portfolios) would complicate matters. The Economist Intelligence Unit currently assigns a moderate (40%) probability to the exit of Greece from the euro zone within the next two years, and a lower, though not insignificant chance, of a break-up of the currency zone (which we define as the withdrawal of several countries, including at least one of the major economies).
But even without dissolution of the euro zone, a full-blown financial crisis engulfing Spain or Italy, the weakest of the larger European economies, would hurt. Spanish banks, for example, have been very heavy buyers of government debt since the European Central Bank gave them access to cheap three-year loans, designed to boost liquidity across the euro zone. The government cannot let the banks fail, any more than the banks can survive a run on government bonds. Even if the country can avoid a bailout its banks might need one soon.
If the banks did weaken, credit lines to Latin America (including trade finance, which has already been affected by euro zone woes so far) from European entities and their subsidiaries in Latin America could shrink, as a first step. The impact on international credit lines would also be felt more broadly, given that a new euro zone credit “event” would cause global financial stresses and cause investor risk aversion to surge.
Besides tighter international credit conditions, other transmission channels would include weaker demand and prices for Latin America’s exports, and there would be a knock-on impact on business and consumer sentiment in the region. A deeper debt crisis would also damage foreign direct investment (FDI) flows to Latin America, as Europe is an important source of FDI to the region. In the event that China’s economic growth were to slow more sharply than expected (currently we envisage GDP growth of 8.3% this year), demand and prices for South American commodity exporters would suffer even more.
European banks retrench
Pressures on European banks since mid-2011 have already caused a few to sell some of their assets in Latin America to strengthen their balance sheets. These local assets have been acquired by Latin American financial institutions, so the impact on regional credit has so far been muted. Further deleveraging by European banks would lead to further asset sales. Where buyers step in, the impact on credit in the Latin America would be limited. But there is a risk of disruptions to credit should purchases not materialise in a timely way.
European banks in the periphery countries would be most adversely affected by a European debt shock. Spanish banks account for just over 40% of total foreign claims on Latin America. Loans to regional banks from Greece, Ireland, Italy and Portugal are less significant. There may also be indirect channels, namely non-European banks which are exposed to a European debt event and also lend to Latin America. These credit lines might also suffer.
Local banking systems should hold up
The impact on local banking systems would vary in relation to the shares in total assets of affected European banks in each market. The impact would be mitigated because many of the European (and other foreign) banks operating in Latin America get most of their funding locally.
Moreover, banking-sector indicators suggest that most Latin American financial institutions would be relatively resilient to a European credit event. Local banks are fairly well capitalised and liquid. Credit growth, buoyed by expansionary policies after the 2008-09 global financial crisis, is now mostly decelerating. Policymakers in most countries would be able to loosen monetary policy (including lowering reserve requirements) to help ease financial stresses.
There would also be some room for counter-cyclical fiscal policies in order to support economic growth during the crisis period, although there would be less capacity for stimulus policies this time around, since not all the prior stimulus has been withdrawn and structural fiscal deficits are slightly higher now. Some countries (Mexico and Colombia) have contingency credit lines from the IMF, and other countries (in the Caribbean and Central America, for example) would probably approach the Fund successfully for contingency credit.
However, the region would still suffer, much in the same way it did in the aftermath of the Lehman Brothers collapse of late 2008. A more severe European recession triggered by a worsening financial crisis there would probably be longer-lasting than was the US recession after the Lehman collapse, and this would have adverse effects on European-Latin America trade and investment flows. In the event, Latin America might suffer a loss of up to three percentage points in GDP in the first year or fall into a mild recession. It would recover gradually thereafter, but more slowly than its rebound of 2010 that followed the 2008-09 global financial crisis.