InsightsMacro risks in Latin America

Macro risks in Latin America

Latin America is trapped in a cage of external and regional risks.

Latin America is trapped in a cage of external risks arising from shifts in the behaviour of the global economy and also faces persistent risks specific to the region.

Following the financial crisis of 2007, the Federal Reserve went on a rampage of monetary expansion that increased the supply of central banks’ money fivefold in the twenty years to 2019 and then double it again by early 2022. One primary aim of the binge was to increase American production. As seen in Graph 1, it was not successful. It did, however, create immense liquidity and drive down interest rates to such a point that made it profitable to borrow money to finance the purchase of almost any asset. Accordingly, share prices went through the roof.

Figure 1: Normalised US monetary base and industrial production. The Federal Reserve’s expansionary monetary policy failed to stimulate US industrial production. Source: International Monetary Fund, International Financial Statistics.

This should have triggered very high inflation rates, but it did not because the excess demand in the United States (that is, excess over the growth of American production, also in the graph) was not tamed by increased prices but through increased imports, mainly from China. What policymakers underestimated was that China could satisfy this demand without increasing costs because it was drawing on its seemingly infinite ability to transfer low-wage peasants from rural to urban areas and there was no need to improve their wages to attract them.

Suddenly, this process was interrupted by three external events: President Trump’s restrictions on imports from China, the pandemic, and the war in Ukraine. With demand still going up very fast (and both the Treasury and the Fed injecting money) and China not dispatching, the prices of raw materials, intermediate products, and transportation went through the ceiling and these high prices trickled down to consumer goods. That is the first global problem and Latin America is sharing it with the rest of the world.

The second global problem is the effects of stopping this inflation. Just stopping monetary creation will not do. The Federal Reserve needs to reduce actively the amount of money in circulation. The outcome will be a reduction in credit and a substantial rise in lending interest rates, which will reduce the amount of credit available to the private sector and cause a restructuring of production and consumption to accommodate the higher interest rates. People worldwide are hoping against all hope that this process will not lead to a global recession but as all the presidents of central banks know, it will. And it will be long and deep. This is introducing uncertainty into the markets and consequently the prices of shares are coming down. Then, as tends to happen in moments of tension, money flows into dollars, and the dollar appreciates. This negatively affects Latin America, which is already starting to experience capital flight toward the United States.

A third global problem, a longer-term one that will likely produce severe effects is a global recession. A technological revolution is going on, and it is moving the world economy into new consumption and production patterns, benefitting some people and products more than others. Recessions, like the one that is coming, accelerate structural changes in markets. The current transformation is towards the knowledge economy which took a giant leap during the Great Recession. From 2008 to 2016, people with at least some college education moved into 9.9 million jobs, while there was a loss of 5.5 million positions for people with a high school education or less.

This restructuring continued a trend that was already underway. Data produced by the Hamilton Project shows how income in the United States changed for different educational groups from 1990 to 2013 in direct relationship to education. Men with no high school diploma lost 20 percent of their salaries while women with higher education gained 21 percent. All other categories were in between these numbers, improving in proportion to the level of education. In the OECD, the share of workers with higher education increased from 22 percent in 2000 to 40 percent today. The incoming recession will continue this process, albeit at a higher speed. In the longer term, the relative price of knowledge-intensive activities will increase over that of commodities and less knowledge-intensive products.

This process will negatively affect Latin America because the region lacks highly educated human capital. In the long term, the price of its main products will decline relative to those of developed countries, while investment flees the region in search of security.

The rapid increase in commodity prices could counteract these risks. As shown in Graph 2, Latin America’s GDP fluctuates according to the rhythm of non-fuel commodity prices. Right now, those prices are increasing as the high demand for consumer goods has led to inflation that has also increased the demand for raw materials. This would benefit Latin America for a while. Yet, this could change fast. A severe recession in the United States would substantially reduce the price of commodities.

Figure 2: Annual rate of change in non-fuel commodity prices and GDP Latin America & Caribbean. The region’s GDP fluctuates in line with non-fuel commodity prices. Source: World Bank Databank World Development Indicators.

As such, Graph 3 demonstrates that commodity prices move roughly in line with the United States’ value of goods imports. The performance of the American economy affects all regions, but the connection with Latin America is direct and deep. Notice in the graph that the worst falls in the value of American imports coincide with the recessions at the turn of the century and in 2009- 2010. Since we can be sure that the American economy will go through a severe recession in the immediate future, we can also expect a recession in Latin America. In the two previous recessions, recovery in Latin America was relatively fast because in those years the Federal Reserve injected huge amounts of money in the system, which pushed up the prices of commodities. This remedy will not be there this time as the priority of central banks should be to reduce inflation, not support asset prices.

Figure 3: Annual rate of change in non-fuel commodity prices and US goods imports. Non-commodity fuel prices move roughly in line with US goods imports. Source: World Bank Databank World Development Indicators.

This extreme dependence on external economic trends is the first regional Latin American risk. The second is its long-standing dependence on populist rulers rather than the rule of law to attain stability and development, which has led it to protracted instability and stagnation through the centuries, a trend that seems to be worsening in the last several years. The two regional risk factors are related. Waiting to be saved by populist leaders, most Latin- American countries have ignored the impact of education and health in generating value added. Therefore, they have remained tied to the lower-value-added activities, the production of primary commodities. For this reason, they missed the transition to the industrial society and are about to miss the transition to the knowledge economy. Latin America has condemned itself to be linked to the ups and downs of the commodity prices by thinking that wealth cannot be created, only distributed, and that their salvation is with populists, all of them alike, who will distribute it better. This problem is becoming worse today. The fall in GDP from 2017 to 2020, caused by a parallel fall in commodity prices, has triggered an explosion of populism over the entire region. Even Chile, which had experienced very high increases in GDP per capita in the previous years, suffered a radical convulsion. Most other countries have elected populists in those years.

This flaw is fatal for the region. Missing the Industrial Revolution was a tragedy. Missing the Knowledge Revolution would be much worse. At its independence two centuries ago, Latin America seemed ideally poised for rapid political and economic development but never met its supposed destiny. Two Swiss physicians, who visited Paraguay in the early 1820s, summarised the obstacles Latin America had to overcome to develop. They wrote in 1825 when Paraguay was under the terrible tyranny of the sinister dictator, Doctor José Gaspar Rodríguez de Francia. They could have written the same today in many Latin American countries.

At no remote era, perhaps, the republics of South America may expect to enjoy a high degree of prosperity, and be enabled to exercise a salutary influence over the governments of Europe…Hence, the importance of Paraguay is not to be estimated by its present condition, so much as by that higher state to which it will, in all probability, ultimately arrive…Once settled, it will go on progressing by freedom of trade, and the progress of civilization…When the population of South America shall experience that natural growth, which vicious institutions have hitherto hindered; and when its foreign connections shall be multiplied—then will this province [Paraguay] attain fresh importance, becoming, in consequence of  the convenience of its rivers (the Parana, the Paraguay and the Vermejo), the centre of commerce with Matogrosso and Upper Peru [Bolivia]. All these advantages will give to Paraguay a leading rank amongst the rising states of South America—. May they, in their turn, be taught from the experience of their misfortunes to appreciate the fruits of Dictatorships and Presidencies for life!

Messrs. Rengger and Longchamps would be unpleasantly surprised to learn that Paraguay and Latin America remain poor and underdeveloped almost two hundred years after their trip. Free trade is not yet a reality in the region. Latin Americans have not yet learned from the experience of their misfortunes to appreciate how bitter the fruits of Dictatorships and Presidencies for life are. They would feel dismayed when finding that the dictators of the early 21st century, like Fidel Castro, Hugo Chavez, Nicolás Maduro, Daniel Ortega, and now Nayib Bukele in El Salvador are not that different from the creepy caudillos they saw in the early nineteenth century. The trend to go back to the authoritarian state is visible in Mexico, Honduras, Colombia, Peru, Bolivia, Brazil, Chile, and Argentina. Ecuador and Guatemala are tottering on the edge. This is the worst of the risks in Latin America.

About the Author

Manuel Hinds
Manuel Hinds
Manuel Hinds has served as minister of the economy (in 1979) and of finance (in 1995-1999) in El Salvador, as division chief at the World Bank (in the 1980s and early 1990s), working with more than thirty countries, and as the Whitney H. Shepardson fellow at the Council on Foreign Relations in New York (in 2004-2005). He is the author of The Triumph of the Flexible Society: The Connectivity Revolution and Resistance to Change, Playing Monopoly with the Devil: Dollarization and Domestic Currencies in Developing Countries, and In Defense of Liberal Democracy: What We Need to Do to Heal a Divided America, and co-author of Money, Markets, and Sovereignty, with Benn Steil. He shared with him the 2010 Manhattan Institute´s Hayek Prize.
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