Foreign Emerging

From the Economic Forum of the Americas: The Latin American Decade - Assessing Opportunities and Risk

June 10th, 2011 | By Nick Sargen

Note: The comments below are remarks I delivered at the Economic Forum of the Americas at the 17th Conference de Montreal on June 8 for a panel on the Prospects for Latin America.

Thank you very much for the opportunity to address this forum and to share some insights on prospects for Latin America. My perspective is as a Chief Investment Officer for an asset management firm that is U.S. oriented, but which is exploring opportunities globally. The primary opportunity we are currently considering is in China. But we are also looking to invest in other regions including Latin America, where we are focusing on Brazil.

What stands out when I look at Latin America today? Two things. The first is the economic stability the region has exhibited over the past eight years. The second is Brazil’s emergence as a leading engine for South America, which is closely tied to China’s ascent in Asia.

Is Latin America’s Transformation for Real?

In assessing Latin America’s prospects, one should first be mindful of the boom-bust conditions that prevailed until the past decade. When I began my career as an international economist in the early 1970s, for example, international bankers were very optimistic about the region’s prospects based on its abundance of resources and soaring commodity prices. Accordingly, Mexico, Brazil and Argentina – the so-called MBAs -- became prime recipients of syndicated bank loans.

The 1980s, however, proved to be very turbulent, when inflation and interest rates soared, commodity prices plummeted and the major borrowers had to tighten policies to restore their creditworthiness. In the 1990s, there were renewed hopes for greater stability in response to a series of economic reforms. Nonetheless, the region was subjected to contagion in the middle of the decade during the Mexican peso crisis, and also in the early part of the last decade during the Brazilian and Argentine crises.

Fortunately, Latin America has undergone a remarkable transformation in the past eight years including the following developments:

  • Real GDP growth has averaged more than 4.0% per annum, up from 2.7% in the previous decade.
  • Consumer price inflation has fallen to about 6% from nearly 40% per annum in the prior decade.
  • Current account positions have been close to balanced, while aggregate FX reserves have increased more than three-fold and are nearing $700 billion.
  • Brazil has seen its external debt decline from over 40% of GDP in 2002 to less than 15%, and its government debt was upgraded to investment grade status in 2008.

Amid these developments, the major Latin countries have benefited from declining bond yields, buoyant equity markets and strong-to-stable currencies.

This begs a key question: Will the improved economic and financial performance persist, or will it prove to be temporary?

For the most part, I am encouraged by what has transpired. Policymakers have learned valuable lessons about the need to pursue sound fiscal, monetary and exchange rate policies. Collectively, these policy reforms have enabled countries in the region to reduce their dependence on foreign capital. Moreover, Latin countries no longer are content to “live with inflation”; they are striving now to keep inflation in check.

At the same time, Latin American countries are transitioning away from development strategies based on “import substitution,” in which countries utilized trade barriers to shelter domestic industries from foreign competition. Too often, the infant industries did not evolve and become competitive internationally. Fortunately, this is less true today, and Latin America is becoming more export conscious and competitive.

A third factor at play is that Brazil and other resource-rich economies have benefited from China’s emergence as a global economic power. One of the main drivers of the huge run-up in commodity prices over the past decade has been the strong demand from China for raw materials to meet its development objectives. This has translated into favorable terms of trade (ratio of prices of exports to imports) for commodity exporting countries. In the case of Brazil, for example, the country’s terms of trade are nearly 35% higher than they were eight years ago. However, while this has provided a lift to Brazil’s economy, I will also point out some of the inherent risks of becoming over-reliant on commodity exports.

Challenges Ahead

While these factors should support ongoing development in Latin America, there are also challenges that need to be overcome. The most pressing challenge is that inflation in the region has accelerated, and there is a risk of over-heating: Economic growth in the region is now in excess of 6%, while inflation has climbed above that level. Central banks have responded by tightening monetary policies, but interest rates appear too low to dampen economic growth and to curb inflation. Therefore, we are closely monitoring how vigilant the authorities will be in containing inflation.

We are also cognizant that the situation is exacerbated by an influx of foreign capital, which has made it more difficult for the authorities to control their currencies. These inflows, for example, have contributed to about a 30% appreciation of Latin American currencies in the past two years, while Brazil’s currency has appreciated by about 60%.

This situation poses two types of risks. One possibility is that Brazil could fall victim to the “Dutch disease,” if commodity driven currency appreciation crushes local manufacturing. Another possibility is that its current account position could deteriorate very quickly if commodity prices were to plummet. The IMF, for example, has calculated that if commodity prices were to weaken to 2005 levels, Brazil’s current account deficit could double and approach 5% of GDP.

In these circumstances, international investors must weigh the potential benefit of investing in the region versus the risk of currency depreciation. In our own case, for example, we considered investing in Brazilian government paper which would have yielded 8% in local currency terms versus 2% in comparable U.S. government debt. We ultimately decided against doing so, as we believed the risk of depreciation of the real was too great.

The Allure of Brazil

Finally, I will conclude by offering some observations about what has attracted us to consider investing in private equity in Brazil:

  1. Size: It is the largest economy in Latin America, accounting for one third of economic output in the region, while Mexico ranks second at 25%. Equally important, Brazil has emerged as a leading engine for the Southern cone and other parts of South America in recent years.
  2. Balance: It has lower growth potential than China, but it is a more balanced economy. That is, domestic demand (and consumption) is the main driver of the economy, as compared with China, where investment spending and exports dominate. A potential concern, however, is that rising commodity prices and a strong currency increase the risk that Brazil could lose competitiveness in manufacturing.
  3. Stability: Prospects for stability are favorable, owing to Brazil’s advanced stage of development, political system and environmental sustainability. The newly elected government is also committed to continue the reform process.
  4. Resources: It’s wealth of natural resources offer a strong competitive advantage, and its resource-based companies are acknowledged world leaders.
  5. Valuation: Equity values are reasonably priced relative to China and India. Furthermore, the private equity market is less competitive than China’s

In sum, while Brazil faces some formidable challenges in becoming a leading global economy, we believe it has emerged as a regional power. In some respects, Brazil’s prospects today are as favorable as any time in post-war history. The caveat, however, is that it must continue the reform process and demonstrate an ability to thrive even when external conditions are less favorable.