Decoupling?

The recent credit turmoil has had to date only relatively subdued effects on Latin American markets1. While there were some effects largely as a result of rising risk aversion with a larger impact on emerging country assets with lower credit ratings, the region appears to have escaped relatively lightly. We have not seen the liquidity-driven sales of the Russian default episode, Latin American financial institutions have not posted significant losses and, perhaps as a result, inter-bank markets in the region have not been affected to the same degree as in other regions; especially Europe. Moreover, while the epicenter of the turmoil has been the market for securitized mortgage assets in the US, Latin American markets for securitized instruments have been relatively unscathed. Perhaps this is because Latin securitization has tended to be prime and far from sub prime, with much stricter documentation standards, because there are few visible underlying problems today in housing or other markets in the region and Latin instrument-design has tended to favor standard in a quest for liquidity over complex structures for buy and hold investment vehicles increasing valuation problems.

However, a further remarkable feature of this episode has been that as US growth has slowed, and US growth expectations have fallen, growth forecasts for Latin America have been extremely resilient. In June, the median forecast for US growth from a sample of private analysts was 3% for 4Q 2007 and 2.95% for 1Q 2008. More recently, for the same sample of analysts the corresponding forecasts are 1.9% and 2.3% respectively. Average growth for the US for 2007 again using the same sample is now expected to be 2.0% for 2007 rising to 2.5% for 20082. The IMF’s WEO predictions for 2008 US growth have fallen from 2.8% in June to a more pessimistic 1.9% as of October of this year.

The Research Department of the Inter-American Development Bank tracks the surveys of market expectations of Central Banks in the Latin American region and publishes them monthly in a product named Revela (Revelation of Expectations in Latin America)3 . The October survey suggests growth (simple average across countries) will be 5.3% in 2007 and 4.7% in 2008. Remarkably, the first figure implies a 0.2% increase in expected growth for 2007 since the June survey. Marginal declines were seen in Mexico and Chile and a slightly stronger decline in Bolivia but in the other nine countries surveyed, 2007 growth expectations increased, and particularly strongly in Honduras, Colombia and Brazil. Expected growth for 2008 has been quite stable on average, although again this hides some winners and some losers. The following two graphs show how growth expectations for 2007 and 2008 have been changing over time and across countries. image002_400_15.gifimage004_400_06.gif

Moreover, in countries that report the standard deviation across forecasters there is little evidence of increased uncertainty as there is no systematic increase in the variation across the individual predictions. For Brazil, that has the largest number of analysts in its “real-time” survey, the standard deviation across forecasters for 2008 growth has, if anything, declined somewhat over the last few months.

Indeed perhaps of more concern today in this survey of surveys, is the rise in inflation expectations. Inflation is now expected to be 6.87% for 2007 (simple average across countries surveyed), almost 0.5% higher than the expectation last month. Inflation is also expected to be higher at 7.2% in 2008. However, this last figure hides a set of interesting features. Inflation expectations for 2007 shot up in Chile to 6.3% but are anchored at 3.3% for 2008. The increases in inflation expectations for 2008 over the last months are accounted for by a significant rise in Bolivia and smaller increases in Guatemala, Mexico and Uruguay. The next two graphs illustrate changing inflation expectations for 2007 and 20084.

image002_400_16.gif

image008_400_02.gif

These forecasts suggest that as the US slows, Latin America is expected to escape any serious harm and indeed appears largely decoupled from the US. One may conjecture that these forecasts are built on the hypothesis that the rest of the world continues to grow and that demand for commodities from the East remains strong enough to maintain the current boom in export prices. This is also suggestive of the main risks that may stem less from the US itself but rather what happens elsewhere.

The main challenge for the region may then to be to ensure that this remarkable period of world growth, high export prices and price stability is harnessed to best effect. Containing creeping inflation will certainly be one issue and there should be careful monitoring of the build-up of quasi fiscal debt on central banks’ balance sheets as central banks sterilize capital inflows in an attempt to curb money growth. This is also surely the time to take those difficult political decisions to improve the efficiency of public spending and to invest to truly enhance long-term sustainable growth. It is also the time to improve regulations; especially as heightened competition may weaken risk management in financial institutions as credit growth accelerates. History suggests that one day the commodity boom will end as supply catches up with demand, China miniturizes and/or China slows5. It really would be a shame if the lessons of the past are forgotten and the “great moderation” becomes known as the “great complacency” as we look back at what the region achieved over this particularly benign period6.


[1] This article represents strictly the opinions of the author and they are not necessarily the opinions of the Inter American Development Bank, the Directors of that institution or the countries that they represent. I wish to thank Mariana Salazni for excellent assistance, all mistakes are of course my own.[2] The sample is the common set of 35 private forecasters available on Bloomberg for June and October of this year. The statistic quoted is the median, the mean is 2.44% for 2008 growth and the standard deviation across the forecasts is 0.5%. Interestingly none of the 25 are predicting a recession for the US economy with the minimum being 0.4% average growth for the year.

[3]See http://www.iadb.org/RES/pub_List.cfm?&pub_type_id=REV where the data and short descriptions of the surveys are available.

[4] The figures for 2008 for Colombia refer to a 12 month horizon from the date of the forecast rather than end of 2008 as in the other countries.

[5] China’s growth is estimated to have accounted for a substantial part of the increase in commodity prices. Perhaps the closest analogy to the current commodity price boom is the price boom of the 1960’s and early 1970’s on the back of the economic growth in Japan. Commodity prices fell sharply in the mid 1970’s in part spurred by slower Japanese growth and miniaturization particularly affecting metals. See the presentation by Christopher Gilbert available at http://www.iadb.org/res/centralBanks/publications/cbm45_385.ppt for a discussion.

[6] Many of these issues were discussed at the XXVI Meeting of the Network of Central Banks and Finance Ministries, known as the Chief EconomistsTM Network. See in particular the presentations by Ernesto Talvi http://www.iadb.org/res/centralBanks/publications/cbm49_490.ppt and Claudio Loser http://www.iadb.org/res/centralBanks/publications/cbm49_487.ppt

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33 Responses to "Decoupling?"

  1. Guest   November 3, 2007 at 5:31 pm

    This is a most excellent analysis. But what happens to Latin American decoupling if the US experiences a recession and this leads to a global slowdown?

  2. Guest   November 3, 2007 at 5:32 pm

    The April 2007 IMF WEO suggested that trade and other links between the US and Latin America would imply large effects of a sharp US slowdown on the Latin economies.

  3. Guest   November 3, 2007 at 6:15 pm

    US Inflation scares – like the one in the spring of 2006 – lead to financial contagion to emerging markets as the Fed is expected to tighten rates. While growth scares – like the one of this summer – lead to lower contagion as the Fed eases rates.

  4. Anonymous   November 3, 2007 at 6:16 pm

    Indeed there is a risk of “great complacency” in Latin America these days; the commodity boom may not last

  5. Vitoria Saddi   November 4, 2007 at 11:05 am

    Andy, In your decoupling scenario is it possible that some Latin countries to decouple more than others? Besides trade linkages, if one consider the leading stock markets (Ibovespa, Merval and S&P) we note an increase in the implied vol in 2007 not a decrease. Does the greater vol and sugggests that there is more ‘contagion’ than decoupling?

  6. Otaviano Canuto   November 4, 2007 at 5:41 pm

    Excellent analysis. Just one remark: there must be a typing mistake with the figure in the phrase “In Brazil too, 2007 inflation expectations have risen to 5.6%”.

  7. Andrew Powell   November 5, 2007 at 1:02 pm

    Thanks to everyone for the great comments.I wrote this piece as I thought the lack of any apparent correlation between the lowering of US growth forecasts and growth forecasts for LAC – as revealed in the monthly REVELA – interesting. Of course if the US does enter into recession (or recession is forecast) rather than there being just a slow down, then perhaps a correlation might suddenly appear. However, the most recent analysis I have seen coming out of the IMF suggests that the effect of a US recession by iteslf would not be very significant for LAC – I am particularly thinking of recent presentations by Jeromin Zettelmeyer at the Lacea conference in Bogota and more recently here at the IDB.Barring any catastophe in financial markets, the critical linkage is the effect of US growth on the rest of the world, China and commodity prices. If a US recession affects China and the rest of the world to the extent that commodity demand is lowered substantially then a US recession must impact LAC and indeed I think that this is a key risk to today’s forecasts. But the fact remains that those forecasts have the US growing significantly less than a just a few months ago and LAC if anything growing a bit more.I have no great answer to Vitoria’s point that implied stock market volatilities in LAC have risen. There is no real evidence of increased dispersion in growth forecasts for LAC countries where the appropirate stats. are published; another interesting decoupling perhaps?And I wish to thank Otaviano for correcting me on Brazil. For some reason I mistakenly quoted the wholesale price expectations and not consumer price expectations, so I will definitely correct in any future blog on these themes.And of course, I agree with the anon. comment on the “great complacency”. Under the current forecasts of slower US growth, but continued growth in the East and continued high export prices for LAC, the danger of the “great complacency” is perhaps THE issue facing LAC today.Thanks again to all,Andrew Powell(all views and all mistakes are of course strictly only my own).