Cover Story – China & LatAm: The Penalty Shot

Long a source of export revenue and financing for Latin America, China is poised for a structural slowdown. This could be bad news for Latin America. 

If China catches a cold, what will this mean for Latin America? The question has seemingly all of a sudden become a big concern for policymakers and sovereign bond investors across the region. 

There are reasons for concern. After years of booming, China’s real estate bubble has run out of steam, threatening builders, banks, and homebuyers alike there. Indeed, the world’s second-largest economy is spluttering with disappointing growth figures, the threat of deflation and more trouble brewing on the horizon in the housing market.

This could be very bad news for Latin America. The region has ridden the China wave for the last two decades, and these new travails across the Pacific come as global economic growth slows. A rise in central bank policy interest rates is helping to contain a surge in inflation, but it’s weighing on growth. Add in a raft of risks – the Ukraine war and extreme weather conditions, and growth could be slower than the 3% forecast by the International Monetary Fund for both 2023 and 2024, and inflation could take longer to decline, meaning that interest rates could very well remain higher for longer.

While some doomsayers are forecasting a financial crisis in China triggered by a bursting real estate bubble, cooler headed analysts suggest a soft-landing is much more likely, especially given the Communist Party’s tight grip on all the levers of power.

But this is not just another downturn in the economic cycle for China. After a growth spurt like no other – China poured more concrete in three years to 2014 than the United States did in a century – the Chinese economy is maturing, and this means its growth is slowing.

“The sky is not falling, but it does seem that China is growing much more slowly,” says Brad Setser, a former US Treasury economist and now a senior fellow at the Council on Foreign Relations in Washington, DC. “It will have a lot more difficulty growing than in the past.”

China’s huge population is aging rapidly, with deaths outpacing births last year for the first time since 1960, meaning that its workforce and consumer base will also soon start contracting.

This transition to slower growth was masked by tight lockdowns during the COVID-19 pandemic, but the boom that followed the lifting of most pandemic-era restrictions last November has been short-lived. After averaging 6% over the last decade, the Chinese economy is likely to grow by between 3% and 4%, according to most estimates. That’s still respectable, but it’s a big change from the previous decade.

New storm clouds

A more restrained China would bring new storm clouds to Latin America, which has over the years become a big source of the raw materials that China needs for its growth. Indeed, Latin American farmers and miners have prospered over the past two decades by producing more than they need in grains, iron ore and other raw materials to feed the maw across the Pacific.

Last year, China was the destination for 57% of Chile’s copper, 63% of Brazil’s iron ore, and 80% of Argentina’s soybeans. Booming Chinese demand kept commodity prices high, builders busy, government coffers full and voters mostly happy.

Now this model is faltering. With China’s slowing construction industry, Brazil’s iron ore miners could be among the worst hit. Iron ore prices are expected to fall as steel output is curbed. The trouble is that the volume of commodities flowing across the Pacific means that miners cannot simply divert shipments to third markets. None are big enough to absorb what China has been buying.

“We are more or less dependent on Chinese markets and will be for the foreseeable future,” says Leonardo Paz Neves, a researcher at the Getulio Vargas Foundation in Rio de Janeiro.

Luckily for Brazil, a slowdown in China is unlikely to hit its agricultural exports, as demand for beef, soybeans and wheat is less fickle than other commodities. It’s Chile and Peru that are perhaps the most exposed to China’s slump because of their dependence on copper exports. So far, copper prices, normally a reliable predictor of the economic weather, have not fallen far because they’ve been kept afloat by demand for the mineral’s use in clean energy technologies, which are booming around the world in the energy transition to net-zero carbon emissions by 2050. But lower prices will slow investment and limit government largesse.

The fallout from China could take other forms, more subtle but as detrimental. As Beijing feels its way to a new growth model, investors could become more risk averse, thus limiting their lending to other emerging markets such as Latin America. And in more straitened times, China will also have less of a cash surplus, slowing its investments in Chilean vineyards, Peruvian power grids and Brazilian ports.

“LatAm still depends critically on commodity prices and cheap, abundant global liquidity to grow and develop. A negative shock to China could actually impact both,” warns Alberto Ramos, the chief economist for Latin America at Goldman Sachs in New York.

Perhaps the most likely strategy is a new emphasis on exports. A weaker Chinese yuan – it fell to its lowest level in 16 years in September – will further boost their competitiveness. Chinese vehicle exports have risen threefold since 2020. That could brew trouble for Latin America’s manufacturers.

“If I were making cars in Brazil, I'd be a little worried,” says Setser.

Who's prepared?

Many countries are little prepared for the turbulence ahead.

Brazil, the region’s biggest economy, is finally launching a reform of its labyrinthine fiscal system, but its impact will not be felt for at least a decade, says Paz Neves. He adds that byzantine trade and labor laws means the cost of doing business in the country remains as high as ever.

Ecuador and Peru are sinking into drug violence, Argentina will take years to resolve recent economic mismanagement, while left-wing leaders in Chile and Colombia are not providing the reassurances investors need to put more money into those countries.

Andrés Abadía, chief Latin American economist at Pantheon Macroeconomics in Newcastle, UK, says that Colombian President Gustavo Petro has struggled to attract fresh investment. To do that, “uncertainty needs to be out of the picture and I'm afraid that that won't be the case with Petro at the helm,” Abadía argues.

Massive protests from Santiago to São Paulo have shown voters are growing impatient and prepared to back off-the-wall policies, spelling more trouble ahead.

The weather could also weigh on the region, as it has with droughts in key markets over the past year because of El Niño.

“The below-than-average rainfall in Central America and the northern part of South America can translate into higher inflation and larger fiscal spending for countries in those regions,” says Bruno Rovai, a sovereign strategist at Macquarie Asset Management. “At the same time, food and energy commodities exporters can benefit from higher global prices on the back of this weather phenomenon.”

A few tailwinds

Fortunately, this is a tailwind for at least parts of Latin America. And there are others. Thanks to a swift response from central banks, inflation is in retreat in most major economies (Argentina, as ever, is on a different page with 124% annual inflation), allowing interest rates to fall.

Ilan Goldfajn, president of the Inter-American Development Bank, says that the region can start easing sooner than others in the world.

“It looks like they are going to leave the tightening period before the rest. Chile, Brazil and others are already in the process. If the region leaves earlier than the rest, it usually means capital flows will come to take advantage of the momentum.”

At the same time, Latin America holds a lot of what the world needs in its massive mineral resources and potential for renewable energy. The region is uniquely positioned to benefit for the global drive to clean energy. Brazil’s offshore wind resources could triple the country’s generation capacity, turning into a clean energy superpower.

“In Central America, 80% of the energy is clean. If you continue to invest in renewable energy, at the end of the day you can export clean energy,” Goldfajn says “We have the Amazon and we can build on this by providing nature conservation. And two-thirds of the lithium and a good chunk of copper that come from the region are needed for mobility.”

The widening split between China and the United States is also bringing new opportunities in manufacturing as multinationals strive to make things closer to home. Witness Tesla’s commitment to build a $5 billion “gigafactory” in Monterrey, Mexico to supply the United States. This nearshoring wave could spread to other Washington allies, such as Chile and Colombia.

Nouriel Roubini, chairman and CEO of Roubini Macro Associates, says that this nearshoring trend could become a sort-of friend-shoring that benefits “those countries that can be part of a new supply chain that is less reliant on China and more on the friends and allies of the United States”

He adds that commodity prices might stay high even if they dip somewhat because of China’s economic slowdown. “I would say demand for renewable energy is going to continue as there is a transition from fossil fuels to the new normal of clean energy,” Roubini says. “Overall, with some caveats, demand for commodities will outstrip supply, and therefore the prices may be higher and that may be a positive in terms of the trade impact for those countries that are overall commodity producers and exporters. And Latin America has a comparative advantage in a wide range of commodities.”

Local financing

Julio Mariscal, head of debt capital markets for Latin America at Natixis, says that Latin America’s early start in reducing interest rates should help sovereigns find funding in the local market as well, shielding them from the high rates of 5% to 5.5% abroad, at least for a time.

“That should make the local markets a little bit more attractive in terms of funding for sovereigns,” he says. “You see that a little bit in Mexico with how they have been issuing more locally rather than in the international specter.”

The challenge for sovereigns will be to balance the attractiveness of the local market with “the need to re-tap the international markets to continue to provide liquidity for investors,” Mariscal says. “You have to continue to reach out to international markets for the debt and the size. But it's going to be a hefty carry for sovereigns to start paying. Brazil has taken on debt at 7%, 6%, and Mexico at 6%. I think that's going to be a challenge for them to continue to extend maturity with these current rates. The rate cycle is intended to go down, but that's still not very clear. I think it’s still going to be a long period of high interest rates.”

But while countries focus on finding more financing at lower rates and resolving their internal disputes, the region risks missing another blow to its long-stumbling efforts to achieve sustainable development for many decades.

“If we lose another decade,” Ramos warns, “you’re going to be losing half a century.” LF