Global Financial Crisis and Recession: How will Latin America Perform? LILIANA ROJAS-SUÁREZ October 2008

Global Financial Crisis and Recession: How will Latin America Perform?

LILIANA ROJAS-SUÁREZ

October 2008

Four Major Features of the Crisis with Potential Impact on Latin America1. It is Now a Full-Blown Credit Crisis

• The crisis has spread from a sub-prime mortgage crisis to an overall credit crisis, involving consumer and corporate loans.

• The US$ 1,600 billion commercial paper market has shrunk severely as money market funds have curtailed lending to both banks and companies.

The “TED” spread, a measure of credit risk for interbank lending has increased sharply in the last six weeks.

00.5

11.5

22.5

33.5

44.5

5

Jan-08 Apr-08 Jul-08 Oct-08

TED Spreads, Treasury Bill and Libor (%)

T-bill (3 mo.)

Libor (3 mo.)

TED Spread

Source: JP Morgan

Four Major Features of the Crisis with Potential Impact on Latin America2. The Crisis has Gone Global

and is affecting European financial systems severely.

0 20 40 60 80 100 120 140 160 180 200 220

HSBC (UK)

Santander (Spain)

Un iCredit (Italy)

In tesa Sanpaolo (Italy)

BNP Paribas (France)

BBVA (Spain )

UBS (Switzerland)

Société Générale (France)

Barclays (UK)

Market Capitalization ($bn)

Jan-07 Sep-08Source: Thomson Datastream

Four Major Features of the Crisis with Potential Impact on Latin America

2. The Crisis has Gone Global … and so have the rescue packages.

Some Examples:Liquidity Injections by Central Banks• Reductions in interests rates (most recently in a coordinated fashion: US-

Europe-China)• Provision of liquidity: US, Japan, Australia, UK• Federal Reserve Term Auction Facility (TAF): banks could borrow against a

wider range of assets used as collateral

Four Major Features of the Crisis with Potential Impact on Latin America2. The Crisis has Gone Global

Public Sector Bailouts and Guarantees• Fannie Mae / Freddie Mac, with the US becoming a stakeholder (US$ 200 billion)• IAG rescue (US$ 85 billion 2-year credit line – US$ 38 billion on October 9)• TARP (Troubled Asset Relief Program) US$ 700 billion plan• US deposit insurance expanded limits; Ireland blanket guarantee of deposits,

covered bonds, subordinated debt• Fortis partly taken over by governments of Belgium, Netherlands and Luxemburg• Emergency Funds. Ex: Spain’s offer to buy assets from banks (40-70 billion

dollars)• Banks recapitalization in the UK (60-80 billion dollars)

Change in Market Structure• US investment banks not longer allowed to be independent institutions (without a

commercial bank)

Four Major Features of the Crisis with Potential Impact on Latin America3. The Financial Crisis has Expanded into the Real

Sector

The Credit Crunch is now squeezing corporates’ and consumers’ financing availability and a recession is forecasted in the industrialized world.

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08Q1 08Q2 08Q3 08Q4 09Q1 09Q2 09Q3 09Q4

Real GDP Growth (%) - quarter on quarter

Euroland Japan USSource: National sources and market projections

Four Major Features of the Crisis with Potential Impact on Latin America3. The Financial Crisis has Expanded into the Real SectorIn previous downturns, consumption has saved the day, offsetting declines in investment.

NOT THIS TIME. Consumers have been hit by a triple whammy:• Decline in the value of their houses (wealth effect)• Decline in the value of their savings (through the stock market; other wealth effect)• Increased unemployment

Since consumption accounts for about 70 percent of GDP, the recession will be deeper than in other recent episodes.

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25

35

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

GDP, Consumption and Investment Growth (%) -quarter on quarter

Consum ption Investm entSource: Bureau of Econom ic Analysis and Market Forecasts

Forecast08Q

408Q

3

Four Major Features of the Crisis with Potential Impact on Latin America3. The Financial Crisis has Expanded into the Real Sector

• Net exports have been the driver of growth recently and will continue to do so, but at a slower pace in the face of a decreased global activity.

• However, the recession will only be over when the consumer recovers.

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2000 2001 2002 2003 2004 2005 2006 2007 2008

Contribution of Net Exports to Real GDP Growth (%)

Source: Bureau o f Economic Analysis

Four Major Features of the Crisis with Potential Impact on Latin America4. The Depth and Length of the Crisis is Uncertain

And this is due to a number of reasons:• Industrial country authorities have taken too long in recognizing

that this is a systemic crisis that needs a comprehensive (and global) resolution plan, rather than a case-by-case approach.

• The only way to solve a systemic crisis is to use public funds for the recapitalization of institutions assessed as solvent in the long run.

• Political interference has prevented the approval of “clean” fiscal packages for “recapitalization-purposes only”. The problems with TARP (tranches, added tax exceptions, purchase of assets rather than recapitalization) is the best example.

How will Latin America Perform?Main Message: In spite of significant improvements

in macroeconomic management over the last few years, Latin America will be strongly affected by the crisis.

And:• Together with Eastern Europe, Latin America will be the region of the

developing world with the slowest rate of growth (although positive) in 2009.• The effects of the crisis will be felt in “stages”.• There will be important differences among countries in the region.But:• Policy reaction in some countries, although insufficient, is helping to

ameliorate the adverse impact of the crisis.• Although important concerns in the social/political areas are re-emerging.

How will Latin America Perform?As a region, Latin America growth will be strongly affected.

Although at this time, no recession is expected, the significant slowdown reflects the impact of the crisis on some large countries in the region.

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Developing Asia Africa Commonwealth of Independent

States

Middle East Central and Eastern Europe

Lati n America and The

Caribbean

Real GDP Growth (%)

2006 2007 2008 2009Source: WEO-IMF.

How will Latin America Perform?

• Growth will slowdown in all countries in the region.• While the external shock is the common factor, idiosyncratic

vulnerabilities (to be discussed later on) explain differences in performance. For example, while Argentina’s growth will sharply decline by almost 6 percentage points in the period 2007-2009, Chile is forecasted to decline only 1.5 percentage points in the same period.

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Argentina Brazil Chile Colombia Mexico Peru Venezuela

Real GDP Growth (% )

2007

2008F

2009F

Source: WEO-IMF

How will Latin America Perform?The Effects of the Crisis is being Felt in overlapping stages

Stage 1: First started.

• Increased risk aversion has resulted in a “flight to quality” by global investors that is affecting the emerging markets asset class.

Perceptions of risk as reflected in the EMBI+ is affecting all emerging markets, with Asia being the least affected.

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100120140160180200220240260280

Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

US High Yield and EMBI+ Spreads (Jan2005=100)

JP Morgan US HY Spread

EMBI+ Asia

EMBI+ Eastern Europe

EMBI+ Latin America

Source: JP Morgan

At this time, the global credit crunch is mainly affecting financial variables:

How will Latin America Perform?Stage 1:

And the deteriorated perceptions of risk is affecting all Latin American countries but especially those with more restrictions to the capital account: Argentina and Venezuela.

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Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

EMBI+ Spreads in Latin America (Jul2005=100)

Argentina

Colombia

Mexico

Source: JP Morgan

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Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

EMBI+ Spreads in Latin America (Jul2005=100)

Brazil

Ecuador

Peru

Venezuela

Source: JP Morgan

How will Latin America Perform?Stage 1:In terms of local stock markets, all emerging market regions have been affected (this is the

market where international arbitrage occurs the fastest).

• Eastern Europe has experienced the largest percentage decline since the beginning of the sub-prime crisis (51%). In the last four months, the decline in Latin America has accelerated.

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Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08

MSCI Emerging Markets Index and US S&P 500(Jan2007=100)

MSCI Emerging Asia

MSCI Eastern Europe

MSCI Latin America

US S&P 500

Source: Bloomberg

Start Sub-prime Crisis


The local equity markets most affected have been: Argentina, Brazil, Mexico and Peru.• In Brazil and Mexico, foreign investors are the largest investor base for local equities (in Mexico they

account for about 50 percent of market capitalization).• In Peru, foreigners account for about 90% of overall trading; but market liquidity is extremely concentrated:

3 stocks (Southern Copper, Buenaventura and Credicorp account for more than 95% of the overall volume).• In Argentina, where local investors totally dominate, concentration in Energy and weakening fundamentals

are at play.

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Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08

Stocks Exchange Indexes in Latin America (Jan2007=100)

Brazil BOVESPA Colombia IGBC Peru IGBVLSource: Securities Exchanges


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Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08

Stocks Exchange Indexes in Latin America (Jan2007=100)

Argen tina MERVAL Chile IGPA Mexico IPC Venezuela IBCSource: Securities Exchanges


How will Latin America Perform?Stage 1:The increase in risk perceptions and the associated decline in capital

inflows to the region is also being reflected in depreciation of the local currencies against the US dollar.

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Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08

Exchange Rate in Argentina(ARS per USD)

Source: JP Morgan

1.3

1.5

1.7

1.9

2.1

2.3

2.5


Exchange Rate in Brasil(BRL per USD)

Source: JP Morgan

400425450475500525550575600625


Exchange Rate in Chile(CLP per USD)

Source: JP Morgan

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2800


Exchange Rate in Colombia(COP per USD)

Source: JP Morgan

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Exchange Rate in Mexico(MXN per USD)

Source: JP Morgan

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2.9

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3.5


Exchange Rate in Peru(PEN per USD)

Source: JP Morgan

How will Latin America Perform?Stage 2: Overlapping with Stage 1, it will Deepen through

year-end and through 2009

• All types of capital flows: bank loans, portfolio flows, FDI and remittances have started to decrease.For example: Syndicated net lending to banks from emerging markets is entering into negative territory.

Global deleveraging implies that there will be less net capital flows to meet the financing needs of the region.

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2005 2006 2007 2008

Quarterly Net Syndicated Loans (US$bn)

Source: Deutsche Bank

How will Latin America Perform?Stage 2:For Latin America as a whole, external financing needs, as reflected by the

overall current account balances are not large, but deteriorating.

While in much better position than Eastern Europe, Latin America is not as financially strong as Emerging Asia.

Source: WEO-IMF

How will Latin America Perform?Stage 2:But aggregates disguise significant differences between Latin American

countries.

Although in contrast to previous periods of external shocks, accumulation of international reserves can easily cover payments on short-term external debt in all countries…

Country 2007 2008Argentina 85.33 85.32Brazil 21.57 23.96Chile 66.08 40.93Colombia 26.39 25.44Ecuador 59.89 32.10Mexico 45.08 38.29Peru 20.97 26.89Venezuela 27.29 28.85Source: Central Banks and Market Forecasts

Short-term External Debt / International Reserves (%)


…Vulnerabilities remain in countries with twin deficits: current account and fiscal balances (actual and forecasted): Colombia, followed by Brazil and Mexico.

Ex: Brazil is facing problems in the roll-over of credit lines –largely trade finance--. Interest rates have increased and maturity has declined.

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Argentina Brazil Chile Colombia Ecuador Mexico Peru Venezuela

Current Acount Balance (% GDP)

2007

2008F

2009F

Source: WEO-IMF

How will Latin America Perform?Stage 2:In the current environment, current account deficits are extremely dangerous

since even FDI, the most important source of external finance in Latin America tends to be pro-cyclical in the face of global slowdowns.

In the 2001 US recession, global FDI dropped sharply.-2%

3%

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18%

23%

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Foreign Direct Investment(as % of GDP)

Source: IFS - IMF.


In Colombia, Brazil and Mexico, overall fiscal deficits are fueling the current account imbalance, calling for prompt fiscal adjustments, if the effects of the global credit crunch is to be minimized.

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Argentina Brazil Chile Colombia Mexico Peru Venezuela

Overall Fiscal Balance (% GDP)

2007

2008F

2009F

Source: Market Forecasts

How will Latin America Perform?Stage 2:As reflected in the EMBI+ spreads, Argentina and Venezuela,

countries with very high, and increasing, rates of inflation are facing a deteriorated perception of risk, even in the context of significant reserve accumulation.

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Argentina Brazil Chile Colombia Ecuador Mexico Peru Venezuela

Inflation (%)

2007

2008F

2009F

Source: WEO-IMF and Market Forecasts

How will Latin America Perform?Stage 3: Overlapping with Stages 1 and 2, but perhaps with longer-term duration (due to lags)

Export growth has suffered the most in periods of slowdowns. The decline in the growth of export volume is already forecasted.

The global recession implies a decrease in aggregate demand for goods and services exported by the region. This might affect both volumes and prices.

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1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Global Real GDP and Merchandise Export Volume (Annual % change)

Real GDP Merchandise Export VolumeSource: WEO - IMF.

2009

How will Latin America Perform?Stage 3:Although the continuous growth of China will help to mitigate the impact of reduced aggregate

demand from industrial countries, the price of some important commodities are forecasted to decline.

• There is an inverse correlation between the value of the dollar and the prices of commodities.• The recent “flight to quality” has increased the demand for US-Treasury bills and reduced

the demand for many commodities.

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Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08

Nominal Dollar Broad Index (traded weighted) and CRB Commodities Index

Dollar Index CRB IndexSource: FED and CRB.

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CR

B In

dex


• Particularly important is the decline in the price of oil. However, future markets call for an oil price still well above the levels of 2005. This is partly because there is an expectation of a production cut by OPEC.

• Forecasts on oil prices, however, tend to not be very accurate.

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2002 2003 2004 2005 2006 2007 2008 2009 2010

US

D p

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arre

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Oil Prices: Spots and Futures

Spot Future Oct-08Source: IFS-IMF and NYMEX

Futures

How will Latin America Perform?Stage 3:Prices of non-oil commodities such as copper, silver and food

commodities are also expected to decline further.

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Copper prices: Spots and Futures

Source: IFS-IMF and LME

Futures

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2002 2003 2004 2005 2006 2007 2008 2009 2010

US

D p

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Soybean Meal Prices: Spots and Futures

Source: IFS-IMF and CBOT.

Futures

How will Latin America Perform?Stage 3:The clear exception is gold, which together with US-Treasury

bills is demanded as a save haven.

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2002 2003 2004 2005 2006 2007 2008 2009 2010

US

D p

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ou

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Gold prices: Spots and Futures

Source: IFS-IMF and NYMEX

Futures

How will Latin America Perform?Stage 3:• But the external developments and the current economic stance

only tell part of the story.• There are two additional factors:On the positive side:A number of countries are implementing some policies to deal with a more adverse

environment. Examples:• In Brazil, the Central Bank is lowering reserves requirements for banks that

purchase loans from small financial entities, and providing liquidity through dollar repos.

• In Mexico, the Central Bank is auctioning up to 400 million dollars daily every time that the peso depreciates at least 2% in a day.

• Most other Latin American countries are also providing dollar liquidity.

How will Latin America Perform?

On the negative side:• More action is needed on the fiscal side, including incorporating

the new commodity prices in the budget.• As fiscal tightening is needed, social programs need to be

protected to avoid political disruptions associated with lower growth.

• Anti-market forces led by the Venezuelan government run the risk to spread even further over the region in the context of slower growth.

• Political crises, such as the one just started in Peru (a good performer, in terms of economic fundamentals) might fuel credit concerns about the region.

In a nutshell:

• The crisis will adversely affect the region as a whole.• Macroeconomic disequilibria built up over several

years, like very high inflation, is affecting the creditworthiness of Venezuela and Argentina.

• Countries with twin-deficits: Brazil, Colombia and Mexico need prompt fiscal adjustments to mitigate the adverse effect of the global credit crunch.

• Social programs need to be protected in the region to avoid political disruptions.

Documents

Global Financial Crisis and Recession: How will Latin America Perform? LILIANA ROJAS-SUÁREZ October 2008