What’s To Blame for the Latin America Investment Slowdown? Forget the Economy, Says Michael Wilson. It’s the Federal Reserve:

 

If there’s one thing we all think we know about South America at the moment, it’s that the markets are taking fright because economic discomfort is spilling over into political dissent just about everywhere you look. And that the uncertainty is troubling the world’s financial markets as they turn away from emerging markets and refocus their gaze on a resurgent United States.

Brazil, we hear, has been exploding into street demonstrations that might yet place a question mark over the country’s ability to host the World Cup in 2014 and even the Olympics in 2016. Argentina has descended into farce as an increasingly embattled President Cristina Fernandez is reduced to lying about inflation while trying to nobble the judiciary. And although Mexico’s economy is gaining strength with every passing month, the last month has seen a terrifying plunge in the value of the peso as international investors have turned and run.

Then there’s Venezuela, where the deceased President Hugo Chavez’s sideman has just won another easy election victory for his leftist administration. And Peru and Bolivia, both of which have been escalating their invective against the west over America’s attempts to intercept the US secrets whistle-blower Edward Snowden: Venezuela, Nicaragua and Bolivia have now formally offered him asylum

And so on, and so on. The news just looks so bleak. And yet most of these perceptions are just wrong.

A Wealthy, Successful Region….

Wrong not so much in the detail, but in the interpretation. The stumbling growth rates in Brazil and Argentina aren’t up for discussion. But how easily we forget that Argentina’s GDP grew by 6.3% in the first quarter of 2013, and that this year’s growth projection of 3.5% is twice what America can expect and nearly four times our own. Or that Chile, Mexico and Colombia will be up around the same levels. These days you’d have to go to India or East Asia to find anything like that.

Or that Mexico and Argentina are growing their industrial output by 3.5% a year, as booming demand from the United States creates enormous opportunities for domestic producers. And that growing Chinese demand for foodstuffs such as soya, wheat and beef is at least partially compensating for the undeniable plunge in mining industry prices.

Or, for that matter, that even in Brazil, the weakest of the Latin American economies (excluding Venezuela), the stumbling growth rate isn’t quite what it seems because the poor people are getting more affluent while the wealthier middle and upper classes are taking all the pain. That’s another way of saying that the country’s appalling wealth inequalities are starting to flatten out, in exactly the way that the country’s social-democratic leadership has always intended.

…..With Affluent Consumers….

Since we’ve got into this vein, let’s throw in a few more consumer statistics. Brazil is the world’s fourth largest car market with 4 million cars sold every year – more than Germany – and what’s more, its vehicle sales in April were a full 29.6% higher than a year earlier.

Mexico’s vehicle sales in May were up by 9% year-on-year – but, more tellingly, the country’s production was up 12%, with strong sales of both cars and components to the United States. Overall, according to AutomotiveCompass, overall South American car production is due to rise by 8.1% in 2013 to 4.43 million units, with Brazil raising its own output by 7.6% to 3.28 million.

Then there’s the Latin American telecoms market, which is worth around $150 billion a year, and which is set to reach $167 billion by 2017 (source: Analysis Mason). Brazil alone is worth $60 billion a year, which makes it the world’s fourth largest telecoms market after the USA, China and Japan. Mexico’s rather slow telecoms infrastructure, meanwhile, is being revolutionised by political reforms that will shortly break the pseudo-monopoly by America Movil that has been holding the country’s rural development back. Indeed, the Mexican changes reflect a bold commitment from the government to break up several of the destructive cartels and monopolies that have dogged the economy for decades.

Put it all together, and it isn’t exactly what you’d call a disaster scenario. And if we exclude oil-dependent Venezuela, which is genuinely going downhill fast with a 10-12% annual fall in output at the moment, the outlook really isn’t that bad at all.

….But in Bond To Foreigners

But it still isn’t enough to convince the foreign investors. The Latin American bond markets have been taking a battering during the last six months, as investors have started reining in their risk exposures because of worries that China might slow. The MSCI Emerging Market index plummeted by 10% in the second quarter, bringing the first half’s losses to 11.7%. And it was much worse than that in Brazil, where the The Bovespa index fell by 15.8% in the second quarter to bring its first half losses to a terrible 24.1%.

More importantly, the recent worries have centred on fears that the US Federal Reserve chairman Ben Bernanke might really be serious about reducing the quantitative easing programme later this year. But where, you might ask, is the connection between Washington and Rio?

Very simply, less QE from Washington will almost certainly translate into higher interest rates and higher treasury bond yields before very long. Indeed, that’s already happening. Ten year paper is now fetching a yield in excess of 2.75%, compared with 1.7% back in February .

The reason that small shift in the bond yield matters is that it takes some of the wind out of the ‘carry trade’. Plenty of American investors have discovered over the last 15 years or so that they can make huge profits by buying Brazilian or Mexican government bonds in preference to dollar-denominated ones from Washington. As long as their locally-denominated Brazilian bonds are fetching 6-8% more than they could get from US treasuries, all they have to do is hope that the Brazilian real won’t suddenly lose a lot of its value.

Unfortunately that’s what has just happened. The real dropped by 9.4% in Q2 – reversing a slight first-quarter improvement and taking the first-half losses to 8.7%. And that in turn meant that the carry trade wasn’t worth the candle any more.

Then it got worse. Just as American investors were thinking about pulling their money out of Brazil and all points south of Texas, the news of a rapidly slowing economy coinciding with anti-government protests brought the unwelcome – if remote – prospect, that the Brazilian government of Mrs Dilma Rousseff could find itself in deadlock.

Long Memories

And that’s where the ghost of the 1990s starts to rattle its chains. Anyone older than 40 will remember all too clearly that the currencies of both Brazil and Mexico were very nearly trashed by a sudden exodus of exactly the same kind of foreign money that we’ve just been talking about. Money that had no real interest at all in Latin America itself, but which had been attracted simply by the higher bond yields. It was hot money. It came, and overnight it went. It was all very destabilising.

What made it more difficult was that, as soon as the foreign money started to leave Brazil or Mexico, so did the government’s ability to pay its debts. The outflows soon sent the credit ratings down, and that in turn started a vicious cycle of panicking with didn’t end until a certain Fernando Henrique Cardoso was appointed Brazil’s finance minister in 1993 with a brief to sort it out. Cardoso set up a so-called “Real Plan”, which soon tamed Brazil’s inflation and reassured enough of the foreign investors to bring them back into the fold.

But it was a close-run thing at the time, and many Latin American countries – Brazil, Argentina, Mexico – came close to defaulting on their bond debts. That’s why the markets are still twitchy today about any big shift in Latin bond yields. And why Mr Bernanke’s quantitative easing decisions in faraway Washington can still undermine the region’s confidence in an instant.

Latin America has long been well aware of the dangers of attracting so much hot money that might not stay for long. Not least, because it can strengthen a country’s currency in a quite unreasonable way. And so it came about that in 2010, as a wave of unwanted new money descended on Brazil, President Rousseff tried to stem the influx by the rather bizarre tactic of charging a 6% levy on local debt, in an effort to curb the Real’s appreciation. The term “currency war” had entered the vocabulary.

And This Year?

The 6% levy was finally scrapped in early June this year. And that wasn’t a coincidence either! The prospect of a stronger Treasury bond yield hadn’t just reduced the relative attractions of Real bonds – it had switched the pump from suck to blow.

Which is how we got to this point. When we look at how Brazil’s currency weakened by very nearly 50% against the dollar between July 2011 and July 2013 – and how very much worse the last three months have been – there’s a very real risk that the situation may overreach itself again and go into overdrive.

Is that likely? Not especially, because Brazil’s economy is substantial enough, and diversified enough, to offer a good degree of protection. But unless we appreciate that Brazil, Argentina, Chile and many other Latin countries are now ‘deleveraging’ after years of overheated expectation, we won’t have understood the whole picture. In a real sense, Ben Bernanke, QE programme put Latin America’s currencies on an unrealistic pedestal, and now it’s knocking them off it again.