World Economic Imbalances and their Impact in Latin America LILIANA ROJAS-SUÁREZ Center for Global Development Mexico, June 2005

Summary In contrast with 2004, 2005 is a year of very varied economic growth among industrial nations. While economic recovery is expected to continue in the US, and Latin America is expected to benefit in general from this recovery, European and Japanese growth appears weak. The extremely high prices of non-agricultural commodities benefit the fiscal accounts and balance of payments of many nations in the region. Latin America has also benefited from very low international interest rates. But 2005 results are very fragile, and the Latin American region faces significant risks stemming from the need to correct macroeconomic imbalances in industrialized nations and China, aside from the vulnerabilities specific to each country in the region.

More macroeconomic imbalances are created in international markets. This due to the following: –The need for monetary policy adjustments in industrial nations to prevent inflationary episodes and/or disorderly exchange rate movements. –Fiscal imbalances in many industrialized nations, especially the United States and Japan, which are unsustainable for the medium term. –The enormous US current accounts deficit, correction of which requires exchange rate adjustments. –An overheated Chinese economy. –Conflicts with the Arab world and possible terrorist attacks. Given the need for global level adjustments, the greatest risk faced by Latin America is that 2004 – 2005 growth results are regarded as permanent and the relatively favorable international context for necessary reforms is overlooked.

The need for global macroeconomic adjustments will reduce growth in 2005 and Real GDP Growth for the World and for Latin America: (percentages) World United States JapanEuro Area Latin AmericaEmerging Asia China F 2006F Sources: IMF, Market Estimates The Unusual Global Economic Growth of 2004 will not be repeated in

Latin America also reflects the global outlook. Although 2005 still looks favorable, estimates point to slower growth in , especially in Argentina and Ecuador. Real GDP Growth for Latin American Nations: ArgentinaBrazilChileColombiaMexicoVenezuelaPeruEcuador F 2006F Source: Market Estimates The Unusual Global Economic Growth of 2004 will not be repeated in

Most Central American nations reflect the world economic outlook. Real GDP Growth in Central American Countries: Costa RicaEl SalvadorGuatemalaHondurasNicaraguaPanamaDominican R F Source:CEPAL The Unusual Global Economic Growth of 2004 will not be repeated in

I.In contrast with 2004, this year the US Federal Reserve is less worried about consolidating the economic recovery and more about inflation. That is why rates will rise continuously. What policy decisions made by the industrialized world help explain the current economic cycle? Since Japanese growth rates are still very low, the nominal interest rate will be zero in However, European rates are under pressure to rise.

I.Low interest rates allowed a significant rise in housing prices and this induced a wealth effect that kept consumption stable in the United States, in spite of the stock market drop of US authorities maintained this expansive monetary policy until investment recovered. Once investment recovered in 2004, monetary policy gradually reverted ---and will remain subject to adjustments during , introduced to contain possible inflation episodes. What policy decisions made by the industrialized world help explain the current economic cycle?

II.An expansive monetary policy was supplemented by an expansive fiscal policy in industrial nations. But, in contrast with the estimated monetary adjustment (at least in the US), no significant reduction is foreseen in the fiscal deficits of industrialized nations. The fiscal adjustment will be slower than the monetary adjustment. Fiscal Statements (% of GDP) USA Japan Europe Source: National Statistics, IMF and market estimates What policy decisions made by the industrialized world help explain the current economic cycle?

III.The export-centered growth strategy pursued by China and other Asian emerging nations has increased the global products supply. This main factor helps explain the coexistence of expansive policies with low inflation levels in the industrialized world. What Asian policy decisions help explain the current economic cycle? To a large extent the Asian current account surplus finances the high current account deficit of the United States.

III.Higher than 8% growth in China will not fall in What may be questioned is the sustainability of this growth (as will be seen ahead). The role of China as a significant world economic player is manifested in the extremely rapid growth of its trade. What Asian policy decisions help explain the current economic cycle?

The productivity effect is reflected in global economic behavior While Asia and North America stand out for their impressive productivity growth during the last decade, productivity growth in Europe and Latin America has slowed down. Global Growth of Productivity South Asia East Asia / Pacific Middle East Africa Latin America North America (NAFTA) Eastern Europe / Central Asia Southern Europe Western & Northern Europe World Average Sources: GGDC; The Conference Board

THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON LATIN AMERICA The dramatic rise in the price of non-agricultural commodities has benefited many nations in the region, but has negatively affected net oil importers. Goldman Sachs Commodity Index (January 1998 = 100) Source: Bloomberg

But a series of agricultural commodities such as sugar and coffee have also shown significant recovery. THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON LATIN AMERICA The Price of Coffee (in New York) US cents per pound Other Mild ArabicasBrazil Sources: IMF, International Financial Statistics & International Coffee Organization

Improved commodity prices influence the non-oil mining products exported by Latin America. For example the prices of gold and copper have risen significantly, and market estimates indicate the price of gold will continue to rise in 2005 and Although a moderate drop is predicted for copper forward prices, not all analysts agree and some expect the excess global demand that keeps prices high to be maintained. The combination of low interest rates in industrialized nations, a weak dollar and volatile stock markets has supported rising prices in precious metals in recent years. THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON LATIN AMERICA Gold Prices: Spots and Futures Dec-90Dec-91Dec-92Dec-93Dec-94Dec-95Dec-96Dec-97Dec-98Dec-99Dec-00Dec-01Dec-02 Dec-03Dec-04Dec-05Dec-06Dec-07Dec-08 US Dólares/Onza Source: World Gold Council y NYMEX Futures Copper Prices: Spots and Futures US Dólares/Tonelada Métrica Futuros Fuente: Bloomberg and NYMEX

Capital inflows in emerging nations will continue in 2005 and Latin America will benefit from this. Net Private Inflows into Emerging Markets, by Region (in billions of dollars) e2005p Total Latin America Europe Africa/Middle East Asia/Pacific Source IIF, 2005 THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON LATIN AMERICA

The larger volume of capital inflows is due to a combination of factors, including the following: -Still ample liquidity at the global level (although diminishing) -A weakening dollar creates incentives for capital outflows to other countries, including emerging nations. -A greater interest in funds dedicated to emerging nations counters a reduction in international bank loans. -Increased foreign direct investment motivated by the US economic recovery and the favorable macroeconomic figures of many nations in the region, including current account statements that still show a surplus (although diminishing). Brazil and Mexico will receive the largest portion of direct foreign investment in the region. -Improved foreign debt sustainability indicators, since various regional nations took advantage of low interest rates to place relatively cheap longer-term bonds in order to repurchase expensive debt. THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON LATIN AMERICA

One additional positive factor is that not only has Foreign Direct Investment increased; the Latin American share of total Foreign Direct Investment in developing nations has remained stable, and seems to be more resistant to international interest rate variations as well. THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON LATIN AMERICA Latin American Share of Total Net Private Direct Foreign Investment in Emerging and Developing Nations (in billions of US dollars) F2005F Latin AmericaOthers Source: IMF, WEO (September 2004)

The improved international situation is reflected in a higher EMBI (bond prices), with the exception of Argentina. THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON LATIN AMERICA

However, the projected reduction in global liquidity generated by expectations surrounding US interest rate adjustments has led to greater variability in the price of bonds, and considerably lower returns for investors, for the period 2004-May 2005 compared with THE INTERNATIONAL CONTEXT AND ITS EFFECTS ON LATIN AMERICA

THE RISKS The greatest risk to global economic stability is that the governments of key nations (the United States, Europe and China) fail to adopt the necessary measures to correct major macroeconomic imbalances. Europeans and Asians believe the principal imbalance is the low level of savings (especially fiscal savings) and excessive imports from the US. The US government says the opposite, that is, the problem is excessive Asian and European savings and very low levels of imports by those nations. Europeans and Asians believe the most important solution is the revaluation of the Chinese currency and thus more Chinese imports and less exports. What is ironic about this proposal is that a revaluation of the yuan would mean that China would reduce its purchases of US Treasury Bonds! All of them are right. No single measure (fiscal and/or monetary/exchange) would in itself suffice.

I.THE TIMING AND MAGNITUDE OF INTEREST RATE HIKES IN THE UNITED STATES 1.Expectations International financial markets expect the Fed to rise interest rates to a neutral position, that is, to a rate compatible with the return to full employment growth and a stable inflation rate (of about 2%). Market estimates suggest a neutral rate of about 4%, but also including overshooting to curtail inflation episodes and/or excessive depreciation of the dollar. This expected path has allowed investors to adjust their positions and prevented distortions in international financial markets. THE RISKS Fed Funds Rate Market Estimate (percentages) T12004T22004T32004T42005T12005T22005T32005T42006T12006T22006T3 Source: Market estimates

2.Uncertainty Although the long term focus of US interest rates is known, there is great short term uncertainty due to the following: The Federal Reserve may accelerate interest hikes if : – Inflation rises rapidly beyond expectations – The depreciation of the dollar leads to financial instability – Very slowly rising interest rates produce a mortgage market bubble … …And already some significant signs point to an overheated mortgage market… THE RISKS I.THE TIMING AND MAGNITUDE OF INTEREST RATE HIKES IN THE UNITED STATES

2.Uncertainty Besides, the Federal Reserve gives great significance to unit labor costs as an inflation indicator, and these costs have been rising significantly while productivity growth has slowed down. THE RISKS I.THE TIMING AND MAGNITUDE OF INTEREST RATE HIKES IN THE UNITED STATES Unit Labor Costs and Productivity in the US cambio % anual ProductivityUnit Labor Costs Source: Bureau of Labor Statistics, Deutsche Bank

An excessive interest rate hike may revert capital flows into the region. The greatest problem is the rebirth of the debt sustainability problems of several Latin American nations. THE RISKS I.THE TIMING AND MAGNITUDE OF INTEREST RATE HIKES IN THE UNITED STATES

The General Motors and Ford downgrades led to significant losses in financial institutions (including hedge funds) that had collateral in the stocks and bonds of those companies. This has raised risk aversion among investors and is increasing the cost for companies of obtaining financing through bonds. II.INTERNATIONAL LIQUIDITY IS ALSO AFFECTED BY THE DOWNGRADING OF MAJOR INTERNATIONAL COMPANIES THE RISKS

III.FISCAL DEFICITS IN THE INDUSTRIALIZED WORLD, ESPECIALLY IN THE UNITED STATES, CAN PRODUCE UNCERTAINTY IN INTERNATIONAL MARKETS. Due to medium term fiscal pressures originated in social security and Medicare in the US (stemming from the relative increase in the retirement age population), short term fiscal correctives are required. Otherwise the fiscal position runs the risk of becoming unsustainable, which would then require an excessively strong and prolonged adjustment. The negative effects produced in Latin America by a strong adjustment related to economic contraction in the US are obvious, especially in the context of new free trade treaties. THE RISKS

Given the new Bush administrations intent of making the 2001 tax breaks permanent, there is greater risk that the fiscal deficit may increase in the coming years. If a higher fiscal deficit materializes, additional pressure may be generated for a strong interest rate hike, with the resulting negative effects on Latin America. THE RISKS III.FISCAL DEFICITS IN THE INDUSTRIAL WORLD, ESPECIALLY IN THE UNITED STATES, CAN PRODUCE UNCERTAINTY IN INTERNATIONAL MARKETS.

IV.THE ENORMOUS US CURRENT ACCOUNT DEFICIT REQUIERES GREATER DEPRECIATION OF THE DOLLAR WITH RESPECT TO THE EURO AND ASIAN CURRENCIES Correcting this imbalance is believed to require close to a 20% depreciation in the effective real exchange rate of the US. THE RISKS

… and forward markets reflect the long term trend, especially regarding the yen. In spite of the recent slight appreciation of the dollar, long term equilibrium is expected to require a more depreciated dollar. THE RISKS IV.THE ENORMOUS US CURRENT ACCOUNT DEFICIT REQUIERES GREATER DEPRECIATION OF THE DOLLAR WITH RESPECT TO THE EURO AND ASIAN CURRENCIES

IV.WHAT ARE THE RISKS FACED BY LATIN AMERICA DUE TO THE US BALANCE OF PAYMENTS IMBALANCE? The first one is that a strong depreciation of the dollar would raise production costs for US companies (due to more expensive imports) and lead to a generalized reduction in imported inputs. An attenuating factor, however, is the possibility of substituting US imports from markets with appreciated currencies by markets whose export products are denominated in dollars. The second one is that a severe depreciation of the US dollar would raise the US inflation rate, leading the Fed to sharply raise interest rates. The third one is that a severe depreciation of the US dollar would reduce the real value of the international reserves kept in Latin American nations. This is why certain sales of dollars by the central banks of both emerging and industrial nations (such as Norway, for example) have been recently observed. THE RISKS

V.THE POSSIBLE OVERHEATING OF THE CHINESE ECONOMY INVOLVES SYSTEMIC RISKS DUE TO CHINAS GROWING IMPORTANCE IN INTERNATIONAL COMMERCIAL AND FINANCIAL MARKETS. China is the worlds largest consumer of copper, zinc, iron and steel, and the worlds second oil importer (after Japan). It is therefore relevant in determining the prices of commodities. T The tremendous expansion of investment in China, financed with sharp growth in domestic credit (achieved especially through government banks) is not sustainable. Although some analysts argue that the Chinese economy will gradually cool down, crisis risks are still present because current policies implemented by authorities to curtail excessive growth in money and credit are still very limited. China already had this experience in the early 1990s, but then it lacked the international importance it now has. THE RISKS

Although international reserves have increased significantly, domestic credit has been growing at excessively high rates, increasing potential financial fragility. The good news is that the probability of a financial crisis in China is still modest –but it will continue to increase of efforts are not made to cool the economy. Another fragility indicator is the accelerated growth seen in mortgage market prices. THE RISKS China: Residential Property Sales Price Index (annual change in percentages) Mar-00 Jun-00 Sep-00Dec-00 Mar-01 Jun-01 Sep-01Dec-01 Mar-02 Jun-02 Sep-02Dec-02 Mar-03 Jun-03 Sep-03Dec-03 Mar-04 Jun-04 Fuente: CEIC, datos oficiales V.THE POSSIBLE OVERHEATING OF THE CHINESE ECONOMY INVOLVES SYSTEMIC RISKS DUE TO CHINAS GROWING IMPORTANCE IN INTERNATIONAL COMMERCIAL AND FINANCIAL MARKETS.

The risks originate in the possible effects in international markets of a hard landing of the Chinese economy. Pressure for a drop in the price of export commodities from many Latin American nations, not only due to reduced direct demand from China, but also to the indirect effect produced on aggregate demand from the rest of Asia. Global recessive pressures stemming from the fact that China accounts for more than 20% of the growth in global trade in recent years. Pressures that reduce demand for US Treasury Bonds, which further exposes the balance of payments imbalances of the US. Increased volatility in international financial markets. Experience demonstrates that this volatility tends to increase risk aversion and reduce the financing available to emerging nations. Given the large accumulation of international reserves, no devaluation of the yuan is foreseen, nor any short term improvement in Chinese international competitiveness that could harm Latin American nations that compete with Chinese exports. THE RISKS V.THE POSSIBLE OVERHEATING OF THE CHINESE ECONOMY INVOLVES SYSTEMIC RISKS DUE TO CHINAS GROWING IMPORTANCE IN INTERNATIONAL COMMERCIAL AND FINANCIAL MARKETS.

V.AN ADDITIONAL RISK ORIGINATED IN CHINA The expiration of the textile trade quotas that took place towards the end of 2004 (for WTO member nations) may produce additional pressure in favor of textile price reductions (and these products are also exported by some Latin American nations). Nevertheless international analysts dont think this represents a major risk, because US importers prefer not to concentrate their trade on China, especially after the temporary imposition of import quotas on Chinese products headed for the US and given that Europe is also considering restrictions on Chinese imports. THE RISKS

VI.CONTINUED HIGH OIL PRICES POSE A MAJOR GLOBAL RISK This is due to already mentioned factors (economic recovery in the United States, overheating in China), the high frequency of weather shocks that raise demand for energy products, and supply factors, including those derived from the Irak conflict. Although estimates point downward, prices in the futures market are extremely high. This is because the price of oil has experienced a permanent increase due to a substantial increase in global demand. THE RISKS Oil Prices (West Texas Intermediate): Spot and Futures Feb-99 Aug-99 Feb-00 Aug-00 Feb-01 Aug-01 Feb-02 Aug-02 Feb-03 Aug-03 Feb-04 Aug-04 Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 US Dllars per barrel Futures Source: Bloomberg and NYMEX

VI.BESIDES, THE PROBLEM WITH ESTIMATES IS THAT ANALYSTS SYSTEMATICALLY SUBESTIMATE THE OBSERVED PRICE OF OIL. And this happened again in THE RISKS Price of Brent Oil: Estimates and Observed Price US Dollars per barrel Estimated price at start of yearObserved price Source: Deutsche Bank, Reuters, Bloomberg

VI.THE RISKS THAT HIGH OIL PRICES RAISE FOR LATIN AMERICA: One risk basically consists of pressure exerted to accommodate oil price increases by relaxing monetary policy. Fortunately this risk has not materialized because most Latin American nations have implemented a restrictive monetary policy. Another important risk is the fact that recent estimates calculate that each sustained increase of US $10 per barrel in the price of oil reduces global growth by about ½ percent per year. THE RISKS

VII.A LATIN AMERICAN EXPORT RISK: DISSATISFACTION WITH THE RESULTS OF DEMOCRACY AND THE MARKET ECONOMY. Recent surveys point to a high level of dissatisfaction with democracy and the results of reform in the population. The percentage of dissatisfied respondents is higher than 50% in all nations. This poses a serious risk to the continuation of the reform processes that the region requires, and must be addressed to prevent reform reversals. THE RISKS Source: Latinobarómetro Percentage of respondents who are barely satisfied" or "not satisfied" with democracy and its results.

A RISK SUMMARY The greatest risk for Latin America is a reduction in global liquidity, given that the Federal Reserve will continue to raise interest rates in order to correct, at least in part, global macroeconomic imbalances.

A SUMMARY OF OPPORTUNITIES Since the resolution of macroeconomic imbalances in leading nations in 2006 will imply a reduction in global growth, higher international interest rates and reduced capital flows into the region, 2005 looks like a window of opportunities for Latin America. This is the best time to consolidate fiscal accounts, avoid debt problems and accelerate institutional reforms. Delaying these efforts may be very costly for the region. However, given the level of discontent among the population with the results of reforms already implemented, the inclusion of different social segments and the search for a consensus are essential.