The notion that a US recession would somehow be less painful for the real economies of Latin America has gained considerable credence in recent years. But a close look at the links between LatAm and the US – and other economies tied to the US – tells a different story.
Over the last five years, all Latin economies have seen a huge boom in exports. Of the seven major Latin economies, all with the exception of Mexico – which already had a relatively well-developed export sector – have seen exports at least double, and in some cases more than triple. In Peru, for example, exports have gone from a paltry 13% of GDP in 2002 to an expected 23% of GDP this year, and in absolute terms they have increased by 229% since 2002. Without exception, major Latin economies have been further integrated into the global economy with the surge in exports.
This integration has generally been heralded as an important structural improvement, and with good reason. Over the very long term, stronger ties with the global economy should yield structurally higher growth in labor productivity – and therefore higher growth in living standards – as LatAm is further exposed to the competitive pressures of greater international trade.
In theory, economic growth should also be less volatile, as integration with the rest of the world reduces the exposure of LatAm economic actors to swings in domestic consumption.
While the long-term benefits of this integration are important, negative by-product is greater vulnerability to a downturn in global growth. It may be that many Latin economies have made progress in diversifying their export markets away from North America. But closer alignment with the rest of the world undermines the benefit. If the world’s major economies are all highly correlated with one another, LatAm has not really gained anything by moving away from North America in its search for new export markets.
More than a few analysts continue to believe that the global economy should be able to isolate a housing-led slump in the US, but the data look less and less supportive of this theory. Expansion in the eurozone came in well short of expectations in the second quarter, and growth in Japan was even further into negative territory in the second quarter than expected. What’s more, Germany had some negative shocks on manufacturing and exports in July and August, pointing to further sluggishness in the eurozone in the third quarter. A full-blown global recession still seems far-fetched, but recent data are at the very least not especially encouraging.
The China Factor
The exposure of Latin America to a global economic slump is even more worrisome when China is factored into the equation. Whatever the outlook is for China in the very long-term, the massive boom in Chinese fixed investment in recent years should raise a number of red flags for anyone investing in Latin America. The boom in China has always been led in large part by fixed investment, but over the last two years fixed investment has ballooned to levels that are unprecedented for a major economy in modern times. Fixed investment as a share of GDP already stood at a relatively impressive 36% of GDP in 1999-2003. In 2004-2005, fixed investment rose to 41% of GDP, a very high level by any standard.
In 2006 and 2007, however, Chinese fixed investment has soared well into problem territory, hitting 52% of GDP and on track to reach 57% of GDP in 2007 if the first half of the year is any indication. Quite simply, China is in the middle of a fixed investment bubble of epic proportions. Whether it pops or is merely gradually deflated through policy tightening remains to be seen, but investors can hardly count on current levels of Chinese fixed investment being maintained indefinitely.
The importance of China and its fixed investment levels to Latin American economies becomes all the greater when one considers the degree to which the current global investment boom depends on the contribution from China. According to CreditSights research, total global fixed investment represented 22.9% of global GDP in 2006, well above the 21.9% long-term average. But if China’s fixed investment levels were simply to drop back to its long-term average of 33.5% of GDP, world fixed investment as a share of world GDP would fall to just 22.1%. This would still be marginally above the global long-term average of fixed investment representing 21.9% of GDP, but only by a slim margin.
If other above-normal factors in the global fixed investment equation are also smoothed out – including US and UK residential investment, and Japanese non-residential investment, all of which have been running at relatively high levels in recent years – actual global fixed investment would be well below its long-term average, closer to just 20.0% of global GDP. A slowdown in China, mixed with a cooling in US and UK residential investment and a China-led slowdown in Japanese non-residential fixed investment, could quickly take the economy from a global investment boom to a global investment bust.
The issue of global fixed investment levels are hardly academic for Latin American economies. Latin America has been a primary beneficiary of the largesse of the global investment boom, reaping gains especially from the surge in demand for commodities as well as growth in demand for certain capital goods like aircraft – for example, Embraer in Brazil – and auto and auto parts goods – especially out of Mexico. The main drivers of the global investment boom – a surge in US residential construction and the infrastructure, manufacturing, and commercial real estate bonanzas in China – have been especially hungry for LatAm commodity exports. Chilean particle board, Peruvian zinc, Brazilian steel, and everyone’s oil have all been critical components of the investment boom.
The integration of China and India into the global economy may well mean that commodities have experienced a semi-permanent increase in relative prices. But whether aluminium prices should be twice what they were just a few years ago, or whether copper prices will remain more than three times where they stood in mid-2003, is not at all obvious. Many commodities – especially the metals and energy complexes – could suffer a 50% price drop and still be well above where they stood just four years ago.
One counter-argument to the notion that Latin America is exposed to a fall in commodities prices is that many Latin economies have managed to diversify their export base into higher value-added goods. This may be the case for some economies, but the argument has the same problem of ignoring correlation as the argument that LatAm has diversified its export markets away from North America. If the Chinese and US economies are slowing enough to push down commodities prices, then the global economy will undoubtedly also be slowing enough to push down demand for non-commodity exports.
All other things being equal, a diversified export base like that of Mexico is preferable over the very long run to a single-product one like Venezuela’s, for various reasons. In the short run, however, there is no reason to believe that Mexico’s diversified export sector will not suffer a serious blow in the event of a US and China slowdown at the same time that Venezuela’s does.
Economic integration and diversification, whether of an economy’s export base or of its export markets, is generally positive. However, the recent heightened integration of Latin American economies with the global economy, and their increased diversification of export goods and export markets is no guarantee that Latin America has left external contagion behind for good. LF