| | |  Business News | October 2008 
The Financial Crisis In Latin America - Part 1
 Stratfor
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While the effects of the financial crisis ripple across the globe, we turn our sights to Latin America. As a region that has been relatively isolated from the immediate effects of the collapse of international financial sectors, Latin America will not necessarily face the kinds of bank failures that currently ravage Europe. But the region can certainly expect a significant slowdown. The World Bank has already sharply revised its estimates for Latin America’s 2009 growth potential, from 4.2 percent to between 2.5 percent and 3.5 percent — and that projection assumes that the financial crisis does not deteriorate further. The fundamental effect the global financial crisis will have on Latin America boils down to two basic factors: the shrinking credit market and falling commodity prices. Both of these affect access to capital, which is the issue at hand in every single Latin American country.
Since Latin America depends on supplying the rest of the world with commodities, the current economic downturn is not the end of the world. Demand for commodities will eventually recover from the financial meltdown, and credit will undoubtedly flow once again — it is only a matter of waiting out the crisis.
One of Latin America’s critical weaknesses is its failure to develop and retain its own pools of credit. In part, this is a fundamental product of the region’s highly diverse geography. South America contains vast mountain chains and very few navigable rivers; developing the continent was destined to be difficult. Unlike the United States, Latin America has no obvious transport corridors, and much of the region can be thought of as “islands” divided by “seas” of jungles and peaks. This geography makes forming intracontinental transportation networks extremely difficult. As a result, Latin America has from the start relied on external credit to build the roads, railroads and tunnels necessary to navigate its terrain and industrialize.
This has made Latin America a debtor region from the beginning. Furthermore, the region’s highly divisive geography has made it difficult to create large enough markets to sustain diversified productive sectors, so industrialization has been slow. These problems have been exacerbated over the years by a focus on populist measures, which have periodically pressured countries into sacrificing financial stability in favor of political support. Thus, Latin America remains a source of raw and primary materials for the rest of the world.
To some extent, Latin America is still recovering from the 1982 debt crisis caused by the rapid increase in external debt. In the early 1970s and early 1980s, European banks flush with cash from Middle Eastern oil profits made a series of loans to third-world countries at profitable interest rates. At that point, Latin America appeared to be a particularly promising market. These loans brought the region’s external debt from $27 billion in 1970 to $231 billion in 1980. Increasingly ponderous debt payments began to drag the countries down as the development strategy of import substitution industrialization (trying to manufacture everything the countries would otherwise import) began to falter. In 1981, the price of oil plummeted, causing a sudden devaluation of the Mexican peso in 1982 and prompting Mexico to declare that it could not make its debt payments. Though the International Monetary Fund (IMF) and the United States subsidized its payments, Mexico’s dec laration rippled through the region as investors lost confidence.
As a result, Latin America suffered a decades-long economic crisis that forced a complete restructuring of the region’s economic strategies. The failures of import substitution industrialization (including an unreasonably high reliance on foreign capital, limited domestic demand and inadequate job creation) had become clear, and the region began to adopt a series of liberalization and austerity measures under the guidance of the IMF.
The new policies brought a sort of stability to Latin American economies by the early 1990s. International capital inflows rose from $13.4 billion in 1990 to $57 billion in 1994, thanks to investors from the developed world. But the problem with these investments was that most were concentrated in highly liquid assets such as local equity markets, so when the U.S. Federal Reserve raised interest rates in 1994, there was a 14 percent decline in capital investments in Latin America almost overnight. This capital flight triggered the Tequila Crisis. Once again, a massive devaluation of the peso set off a region-wide economic crisis as investors fled Latin America.
Latin America’s recent economic history shows that international financial instability characterized by nervous investors can throw the region into chaos. And at this juncture, there is a real possibility that the global slowdown could tip the balance in several countries.
The Credit Market
With financial giants collapsing and investors running scared, the world credit pool is shrinking rapidly as lenders drop risky portfolios and put money into safe bets. For Latin America, a region that has historically been plagued with bad credit, this means moving to near the end of the queue of hopeful borrowers. (Some states, like Pakistan, still beat Latin America for the “worst borrower” prize.) As a result of these global conditions, the region is facing a shortage of capital. This shortage will take the form of a reduction in credit, which is taking place globally, and a reduction of capital inflows in the form of foreign direct investment (FDI) and stock/bond purchases.
With the capital pool shrinking, states that run deficits or fund social programs through borrowing will have a much more difficult time coming through on their promises. Chief among these states is Argentina. Although Argentina has remained relatively isolated from international capital markets since its dramatic 2002 debt default, the country has again managed to build up a growing pile of debt. President Cristina Fernandez de Kirchner’s administration relies on high government spending to fund its social agenda — which Fernandez needs to maintain public support.
Another important distinction in the credit markets is to what extent a country is reliant on foreign credit for domestic loans. This can be indicated by how much of the banking industry is controlled by foreign firms. For the most part, Latin American banking sectors are dominated at between 20 percent and 50 percent by foreign firms. Mexico is a startling outlier; 80 percent of the Mexican banking sector is owned by foreign entities. This leaves Mexico’s local credit market highly exposed to shaky international credit.
But limited availability of loans is not the only downside of shriveling capital markets. For many countries, FDI has become an increasingly important percentage of gross domestic product (GDP), not to mention an important source of employment. This foreign investment is also a source of technological and infrastructural development that can be difficult, if not impossible, to create with domestic capital. Though no country stands out in the region as having unusually high FDI as a percentage of GDP, the decline of FDI as multinational investors sit out the financial crisis will be felt region-wide.
This can be particularly problematic for the commodities sectors. Most Latin American countries depend on physical FDI to develop commodity sectors, particularly in mineral extraction. Commodity FDI, from oil projects in Venezuela to natural gas pipelines in Peru and copper mines in Chile, boosts overall GDP and government tax revenue.
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