Recovery efforts to take a three-fold approach in the wake of coronavirus-induced contraction.
Our key word for Latin America in 2021 will be ‘recovery’. In our view, the region’s governments need to recover from the contraction induced by Covid-19, recover control over their public finances and recover the trust of populations that have suffered from both the pandemic and inconsistent measures to contain it.
The International Monetary Fund (IMF) expects Latin America’s GDP growth to rebound to 3.5% next year, after declining 8% in 2020. In our view, this means that economic activity will only recover to its 2019 level well into 2022, or even later. Furthermore, that regional aggregate masks individual performances that are even more challenging. Argentina, for example, is going through a ‘lost decade’ that will likely see 2025 per capita output stuck at the same level as in 2017.
The leaders of the two regional heavyweights – Brazil and Mexico – were united in their populist disregard for the virus, leaving the heavy lifting to state and municipal authorities. But their policy responses were very different.
Brazil boosted spending on welfare, which helped to limit the GDP decline to less than 5% this year. Conversely, Mexico held fast to fiscal conservatism and likely saw the economy contract by 9-10%.
Brazil’s generous support for the unemployed combined with falling tax revenues to push the fiscal deficit out to around 15% of GDP, and the debt/GDP ratio up close to 100%.
We estimate increases of a similar 10-15% points in the debt burden since March in Colombia and Peru, albeit from much lower levels.
Ironically, Mexico’s debt burden will climb by the same magnitude, because the more modest nominal increase in the numerator of 5% (due to the conservative fiscal deficit) will be offset by that 10% decline in GDP, which is the denominator.
So, against a backdrop of sluggish recovery, we believe Latin America needs to put in place measures to at least stabilise, and ideally push back down, debt ratios. These will require fiscal adjustment, which is unpopular at the best of times – and the aftermath of a pandemic that has already claimed at least half a million lives in the region is definitely not the best of times.
In fact, even pre-Covid, social tensions were rising and governments were largely unpopular. In the most obvious example, street protests in Chile in late 2019 forced the Piñera administration into additional social spending and a commitment to offer a referendum on a new constitution that now looks set to institutionalise a bigger role for the public sector.
As fixed income investors, we will be watching the 2021 budget approval cycle and subsequent implementation carefully to see if spending can be brought under control. In most cases, it seems that income support measures can be removed.
We note, however, that politicians in several countries have already voted to allow early withdrawals from private pension funds and even, in Peru’s case, from the unfunded public system. Such populist instincts may remain hard to resist as the economic pain persists, but they risk storing up pressure for future public spending when the remaining pension pots prove even more inadequate.
In our view, eliminating emergency Covid spending will not be enough to put the public finances back on a sustainable path in many countries. If fiscal rules were in place to limit budget deficits, such as in Brazil, Costa Rica and Panama, they understandably had to be suspended in 2020 to address the pandemic. Respecting them again off a smaller tax base and in the face of higher social needs will be tough, and they may need to be reintroduced gradually, but meanwhile the financing of those wider deficits risks pushing interest costs higher.
Overall, Bank of America estimates that the region needs a structural fiscal adjustment of around 3.5% of GDP after 2021 to stabilise the debt burden.
Large fiscal adjustments are needed
Source: Bank of America Global Research; BlueBay Asset Management
There is some good news to brighten the outlook though. In our view, the global recovery will boost demand for the region’s exports. In the last six months, prices for Latin America’s main commodities (oil, coffee, iron ore, copper and soybeans) have risen between 20% and 40%. The last two will end 2020 30% higher than a year ago and iron ore prices have climbed a remarkable 55% since the end of 2019.
We believe that interest rates will also remain low as central banks in core markets continue to stimulate their economies. That should continue to support the recovery of capital flows to Latin America, both in direct investment and in portfolios. And where private investors are nervous, the international community stands ready to contribute financing through the IMF and multilateral development banks. But that assistance is not unconditional.
Loan were disbursed quickly in the early days of the pandemic under the IMF’s Rapid Financing Instrument, with few questions asked. Follow-on programmes such as Stand-By Arrangements and Extended Financing Facilities need to be underpinned by commitments to structural reform, and particularly fiscal adjustment. So, we still need to keep a close eye on those budget discussions and social tensions.