The “right” Latin America will thrive in the New Year, fueled by ts own growth – with an assist from the continued hot growth from China – while the “wrong” Latin America will get left behind.
The second phase of emerging markets expansion is well on its way – a period of self-sustaining growth, driven by consumer growth and infrastructure spending. And Latin America, following China and other Asian economies, is one of the key global pillars of growth that will save the global economy and the U.S. financial system from total collapse. But not all the countries in Latin America will go on to prosper. There is a wide gulf in the policies that will continue to separate the winners from the losers.
Let me explain.
In a recent article in our affiliated monthly newsletter, The Money Map Report, Money Morning Investment Director Keith Fitz-Gerald made three important points:
* The emerging markets (of which Latin America is the second-most-important leg) will play a growing role in the continued long-term growth of the world economy.
* The U.S. economy will continue to grow long-term, but its relative importance in the world economy will continue to decline.
* In the near term, the emerging markets could well play a determining role in keeping the overall global economy – and the U.S. financial system – from dropping into a depression-like funk that we won’t be free of for years. Emerging economies in Asia and parts of Latin America have huge cash reserves, much of which will be invested in infrastructure projects over the next 20 years.
In the next three years, China, alone will invest as much as $725 billion in infrastructure, while Brazil will invest $225 billion for the same purpose.
This is important to remember, given that the dramatic sell-off the emerging markets have experienced has many investors doubting the ability of these countries to “decouple” from the global economy. The reality of the situation is that most investors and pundits are failing to differentiate between economic decoupling and market decoupling.
The Gloomy Present
While growth in emerging economies has dropped slightly, the prices of securities and currencies in emerging markets has fallen drastically. Many investors think that the U.S. economic crash will lead to a dramatic drop in U.S. orders of emerging-market products, which will cause those economies to drop off. That, in turn, would squeeze the profits and market valuations of the companies that operate in these economies.
But that’s a mistaken assumption. And here’s why.
In Brazil, for instance, exports account for a mere 13% of gross domestic product (GDP). In China, exports are just 10% of GDP. So some contraction in U.S. and European orders can easily be counterbalanced by fiscal and monetary stimulus in these countries.
On Oct. 27, in the depths of a rabid, indiscriminate sell-off, I published an extremely bullish piece on Brazil. Since that article was published, Brazil went on to rally as much as 47%. As of Friday’s close – even after some subsequent profit-taking – the exchange traded fund (ETF) that represents the Brazilian market (EWZ) is still up 21% (and has risen as much as 42% since my recommendation).
And most emerging markets economies have plenty of fiscal and monetary maneuvering room. Leading the pack is China, which accounted for some 27% of global growth last year, and which has continued to use both fiscal and monetary tools to keep itself on a solid growth path.
It recently slashed interest rates again, down to 6.66% (a lucky number in the Chinese culture, meaning “things (are) going smoothly”). With record foreign reserves of $1.9 trillion, China also approved a “fast and heavy-handed” $586 billion stimulus, mainly in housing and infrastructure, to be implemented through 2010. And the Chinese yuan will drop almost 7% vis-a-vis the U.S. dollar to cushion losses in trade. It has also lowered taxes on investments in capital goods. And in a key move that’s been almost totally overlooked by the media, China has made huge market-oriented reforms in agriculture.
China has just allowed its 780 million farmers to rent, transfer or utilize as collateral their rights to their lands and eliminated all taxes on agricultural production and to farmers. This will allow for a massive increase in the scale of production by consolidating companies. In this way, China will keep its 120 million hectares dedicated to agriculture exclusively, with no possibility of urbanization, while at the same time allowing the millions of small farmers to sell out, and get capital to move to the cities. This will not only increase the productivity of Chinese farming dramatically by allowing for economies of scale to work and attracting billions in investments, it also will create a huge incentive for these millions of farmers to move to the cities, boosting housing and infrastructure demand.
Brazil’s plans are very similar to those of China. There’s a:
* Strong fiscal stimulus, allowing a drop in the value of the real currency (a decline that’s already been substantial) in order to cushion exports.
* An easing of capital requirements to Brazil’s strong banking system, which will incentivize housing and car loans.
* Export financing.
* And huge local infrastructure projects.
There is another little-understood phenomenon that cushions the blows for emerging economies: Intra-emerging market trade has become increasingly important. By now everybody understands that iron ore from Brazil and coal and oil from other emerging markets is flowing into China in order to fuel China’s massive infrastructure buildup and growing consumer demand.
The Breakdown on Brazil
Increasingly, a growing proportion of the infrastructure needs of industrial goods being bought by emerging economies are goods produced by other emerging economies. Trade between Latin America and China has increased by 13 times since 1995, from $8.4 billion to $100 billion. And China, now the second-most-important commercial partner to the region after the United States, has finally been accepted as a member of the Inter-American Development Bank, committing itself to contribute $350 million to the bank. As an example of this growth in industrial trade, Argentina just bought 279 subway cars from China’s CITIC Group.
However, not all trade with China has been successful, due to China’s notable deficiencies in quality control, especially in health standards. For example, Latin American imports of medicines manufactured in China had catastrophic results in Panama two years ago, where more than 100 people died and hundreds more became ill from medications containing toxic Chinese glycerine. Recently, Panama detected toxic chemicals in imported Chinese sweets and crackers and Argentina’s customs recently seized Chinese 20,000 thermos containers for having elevated content of toxic chemicals.
And all of this means that there is a market disconnect between the prices of Brazilian shares and those elsewhere in Latin American equities and the fundamentals of the underlying companies, that we will see played out in the next and subsequent years. Why?
Just because huge financial losses by banks precipitated a massive de-leveraging cycle, which means they had to sell their holdings, regardless of merit. And that included big sell-offs in preferred investments, including the hugely promising and profitable Petroleo Brasileiro SA (Petrobras) (ADR: PBR), Vale (ADR: RIO), and many others.
And what is worse, their sales hit the stop losses of major hedge funds, who were also leveraged in such favorite plays as commodities, steel, coal, agro, emerging markets and even defensive stocks such as the U.S.-based Pepsico Inc. (PEP).
When you have the proprietary positions of banks and hedge funds all trying to get out of the same door at the same time because of risk management issues, you get the current disconnect between market fundamentals and pricing.
Another impact that we have to understand is that the ongoing dramatic interest rate drops in all major G7 economies and the more than $3 trillion in G7 fiscal programs will have a marked impact on growth next year, containing what would have been a much nastier economic contraction. But while G7 countries will barely grow between negative 0.5% and a positive 1% in 2009, with the worst contraction front-loaded and recovering in the second half, emerging economies will grow at a minimum of 4%, and in the case of China maybe as high as 10%.
In my October Brazil analysis, I detailed the massive stress that Brazil came under in 1995 because of another exogenous shock: The Mexican devaluation, the so-called “Tequila effect,” which ricocheted around the world, and which caught Brazil in 1995 in a much weaker position than it is in today. Back then, Brazil had a much higher level of debt, much lower reserves, a fiscal sector that needed huge reform, and a much lower capacity for exports. Brazil dealt with this massive stress effectively and went on to work at each one of its weaknesses in the next 13 years, getting itself into a position of strength today.
While having the temptation and the perfect excuse for a default right at hand, Brazil proved its seriousness back then by taking the hard, but certain road to progress, keeping its international commitments and gradually affecting strong structural reforms. Since then, it has become a net creditor to the world; it controlled inflation, and avoided an overheating of its economy with tight fiscal and monetary policies during the recent run-up in commodity prices.
This is paying off strongly today. The policies, run day to day by a sophisticated technocracy led by top economists and international bankers, many of which held top positions in leading international banks, has allowed Brazil to move forward and to anticipate GDP growth of 4% to 5% for the New Year.
Hence, Brazil is by far my favorite Latin American play for 2009.
Checking Out Chile
Following closely behind, and hindered only by its small size, is the poster child of fiscal and monetary prudence: Chile.
Chile, which came out of its 1970s default by eliminating its foreign debt and successfully restructuring its banking system, has made every effort to maintain very prudent fiscal and monetary policies and to diversify its exports away from copper, which, being the largest exporter of the metal in the world, still accounted for 38% of its GDP.
Today, Chile exports many diversified products, including agricultural products, wine, fertilizers and industrial wares. And because it’s situated on the Pacific Coast, it is geographically well positioned to trade with the fastest-growing markets in the world – China and the other emerging Asian tigers.
But Chile, in order to minimize the cyclical nature of its economy due to the wide fluctuation in the price of copper, decided years ago to start a “rainy-day” fund, which would accumulate wealth in the good years and be used to soften the blow in the bad ones. Now, Chile boasts a $28 billion sovereign wealth fund, accumulated almost completely from its copper profits. That’s almost equal to a staggering 14% of the country’s GDP in cash savings! This will enable Chile to implement counter-cyclical policies to keep growing at 3.5% to 4% next year – or about the current rate of growth, even with the worldwide meltdown.
Chile already has started to deploy this capital, having passed a $1.15 billion government plan on top of last month’s $850 million to stimulate housing and small-business lending, injecting that capital into a government bank that will make available loans for small businesses.
Chile’s fiscal prudence is in direct contrast to Argentina’s lack of discipline. Argentina’s Peronist government, which squandered the agricultural commodities bonanza in fiscal spending, is now is trying to use its majority in both houses in Congress to pass the nationalization of the privatized pension funds under the excuse of “protecting them from market volatility.”
These funds, which now have successfully grown to more than $30 billion in size, or 73% of the government’s budget and have returned an average of more than 13% a year since inception will allow the government to cover its fiscal gap and debt maturities next year and to financed public works and consumption projects. The government, at the same time, is suffering from an important loss of confidence, as evidenced by its need to resort to police controls in order to prevent the illegal purchase of U.S. Dollars. Argentina might end 2009 with growth of negative 2% and unemployment of 10%. Stay away.
A “Maybe” for Mexico
Mexico, given its strong links to the United States, is receiving a heavy dose of external shocks on many economic and financial fronts – especially where the United States is concerned: It’s being hit by a drop in exports (the United States is the main component), the drop in oil prices, lower tourism (its largest proportion of travelers is from the United States), falling U.S. investments in Mexico, and reduced remittances from Mexicans working in the United States back to their Mexican relatives.
In addition, many companies suffered strong losses in their derivatives hedges, banks have had to reduce lending due to reduced liquidity and the Mexican peso has lost some 22% of its value against the U.S. dollar. Mexico’s growth in the New Year may fall to about 1% from 2008’s 2.4% pace, and the country is on its way to approving the first budget with a fiscal deficit in four years. The government’s target will be negative 1.8% of GDP, in order to stimulate the economy. Mexico, seeing its oil production declining, is seen moving soon towards opening some oil areas for exploration and development, which some estimate could add another 1% to GDP.
Once the U.S. markets have stabilized, Mexico’s stocks will be an incredible buy once more, since they discount a very bad scenario at these prices.
A Case Against Colombia
Colombia, another country that has merited a lot of attention, given its staunch support of U.S. anti-drug and anti-money-laundering efforts, has seen its free trade agreement with the United States inexplicably delayed.
The country foresees a tightening of credit conditions, so it is moving up its peso-based borrowing to this year. Next year it will issue only $1 billion in foreign bonds and tap $1.4 billion from multi-lateral lenders. So the refinancing risk for Colombia is muted, given the small amounts involved, and the country’s economy should expand a minimum of 1% in the New Year, even in the worst economic scenario. However, Colombia could grow as much as 4% under a moderate scenario.
That would represent a big drop from the 8% growth recorded this year.
The story in Colombia has been the curbing of inflation, and how far behind the curve the central bank has been, at least as recently as July, when it boosted rates up to 10% and then kept them there.
These ultra-high interest rates, combined with the global slowdown, have blunted demand for consumer products in Colombia. Since the passage of the trade pact is a situation in flux, I want to wait and see right now.
I will not go into the economies of Venezuela, Bolivia and Ecuador, which, with massive intervention by their governments and advances against property rights, are experiencing severe economic and political stress, and which do not offer the guarantees needed for foreign investment.
Source: Money Morning, by Horacio Marquez, 15.12.2008
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