On the Links to a Recovery in Latin America

The business cycle of four of the largest Latin American countries is synchronized. The output gaps of Brazil, Chile, Colombia and Peru all peak before the crisis at the end of the century, go into a trough during the rise in risk aversion and the crisis of accounting practices crisis in 2002 and peak again before the Great Recession. The business cycle in Mexico is different. The output gap plummeted during the Tequila crisis and peaked in 2000. It went into a trough in 2003 and peaked again in 2007.

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The synchronicity of the business cycle in these Latin American countries is due to common external factors that affect GDP. These factors are capital flows, the real price of exports and foreign output. It is possible to add these factors together–provided they are all defined in units of GDP (I explain this in the methodological note to the article “The external factors of monetary policy in Latin America” which is in this same blog). In Brazil, Chile, Colombia and Peru, business fluctuations closely follow the first two external factors that were mentioned: capital flows and the real price of exports. In Mexico after the Tequila crisis, the business cycle is explained mostly by foreign output.

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The key to understanding where activity is heading in Latin America, and in emerging economies in general, is the evolution of these external factors. Take capital flows first. The flow of capital to emerging economies depends on the mood of Mr. Market, which may be measured many ways; the one shown in the graph below is the return on Bb bonds over and above that of Aaa bonds. Mr. Market’s changing mood is also evident in the financial account of the US, which is clearly related to that of Latin America (see graph below). Now, take the real price of exports. The graph shows that it is related to world economic activity.

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What does all of this mean for the outlook for Latin America? In the central scenario, commodity prices have rebounded perhaps a little ahead of world economic activity. This will certainly help the recovery. An upside risk is that capital flows are typically correlated with export prices so the rebound in export prices could make emerging-market economies look attractive to investors. If this risk materializes, it would be two, not one external factor helping the recovery. A downside risk for all three external factors and hence for activity in Latin America is that of a double dip recession in advanced countries.

All the above helps explain fluctuations around potential. Potential output in emerging economies may not go through a downward level effect as it is expected in advanced economies. Among the factors that explain the downward shift in potential output in the advanced world are a drop in net investment and hence in the stock of capital and a permanent shift in consumption habits. These are not developments that should be expected to take place in the emerging world.