China Sneezes, Latin America Catches a Cold

The old axiom goes that when the United States sneezes, Latin America catches a cold. The saying, a not so polite but clear way of describing the overwhelming dependency of the economies of Latin America on the United States economy, may deserve modifying.

In the last few years Latin America has diversified its trade, broadened its economies and demonstrated that it is positioned better than ever before to withstand an economic downturn in the United States. Much of the region’s growth and consolidation can be explained by China and its impact on global demand and commodity prices.

DUAL SHOCK

China’s role is why the old axiom needs some adjusting. Indeed, Latin America’s economic story is remarkably different if China slows. Now this is not to suggest that China is nearing a recession. However, just a modest slowdown, in addition to the financial crisis gripping the United States, surely will have an increasing impact on already shaky commodity prices and with it wreak havoc on many a government budget in Latin America. Furthermore, under this increasingly plausible scenario, a dual shock may occur.

First, the rate of already-declining remittances would accelerate. Second, a lower rate of growth in China, resulting in a lower rate of investment in infrastructure, would greatly reduce the demand for commodities and have a downward pressure on prices.

What does this really mean for Latin America? Most notable and most vulnerable would be those countries that have maintained a “rentist model” – Venezuela and Ecuador – and have used the commodity boom to expand current consumption through a higher level of public spending. It does not seem unreasonable to expect the dual shock to cause severe problems for populist regimes that rely on spending to maintain their high level of domestic political support. Indeed, governments, forced to reduce spending will – once again – be tempted to postpone badly needed investment in infrastructure. By robbing both Peter and Paul, this could again potentially mortgage the region’s prospects for sustained long-term growth.

ENERGY MOST PERILOUS

Yet it may be Latin America’s energy sector that is placed in the most perilous position. The cold that the energy sector might catch could translate into increasingly hampered efforts by national oil companies (NOC’s) across the region to access capital for their exploration ventures and other critical infrastructure developments. Only NOC’s that have developed mechanisms to finance their operations outside government budgets stand a better chance; but they too will encounter contraction in the international credit market. Look no further than Brazil’s Petrobras and the dynamic challenges they face to commercialize their recent oil & gas discoveries to understand the hurdles even well-positioned firms face. To wit, their CEO has said that they will need to develop a new model to fully exploit the tremendous potential of their discoveries; a new model that will require important financial and human capital, and logistical capabilities that exceed those at their disposal today.

Under such a scenario, the region will face mounting pressure to revise its energy policies, in particular those defined as “resource nationalism,” or increased taxes and royalties and crowding out private investment. However, private companies will expect substantial improvement on the fiscal and regulatory environment in order to compensate for the risk of investing in the region. The proverbial past sins will come due.

PRAGMATIC MIDDLE GROUND?

It would be unwise to expect the shock therapy of a cooling China – and financial meltdown in the U.S. – to force a return to the glory liberalization days of the 1990’s, but it could perhaps nudge governments to accommodate expectations in terms of rates of return while partnering firms would be expected to be more flexible in terms of operating control.

In short, with the pendulum swinging from the extreme of privatization and deregulation to the renationalization and hefty tax increases of the recent “resource nationalism,” a more pragmatic and flexible Latin America may emerge if this economic scenario plays out. Politically this could also imply a change in tone or even a change in the current leadership in some of the more fiscally exposed economies.

While it seems pretty clear that the phraseology of whose sneeze affects who may have changed, the ultimate impact on several key countries in Latin America may not look too different.

Pass the Kleenex.