Macro Vision Thursday, January 23, 2014 Uncertain Recoupling Road for Latin America From 2010 to 2013, emerging markets (EM) became the main engine of global growth, decoupling from advanced nations. Apparently, though, the roles are about to be reversed, as some G7 countries particularly the U.S. are picking up while emerging markets are slowing down. The new scenario creates many questions, the answers to which will be crucial in outlining a new pattern of global growth. Will the G7 recovery be strong enough to carry all EM economies? We believe not, at least not for some EM countries. The effects of recovery among advanced nations on EM economies would likely be mixed, determined by particular fundamentals and economic policies. With less abundant liquidity for emerging economies, two factors will help define their performance: their dependence on external savings and the proper use of these now-scarcer funds. In the case of Brazil, macroeconomic-policy adjustment is needed, particularly on the fiscal side. External debt relatively low and the size of the domestic market are the positive aspects. Brazil has tools at its disposal to correct and tune up its economic strategy, with relatively manageable political costs. The economic policy choices made in the coming years will likely determine Brazil's performance at least until the end of this decade. A tale of decouplings and recouplings: what now? In recent decades, advanced and emerging economies alternated economic performances, sometimes complementing each other, at times differing significantly. What to expect now? History could be of some guide. In the 1990s, the developed world led the global economy, while emerging countries faced a sequence of crises. From 1990 to 1999, developed nations contributed 2.0% per year to the global growth, while the emerging nations contributed with only 0.8% (see graph). In 1999, the developed economies share of global GDP was 78%, against 22.3% for emerging markets. In the following decade, growth became more balanced. Both groups grew at good pace. Led by China and its demand for commodities, and benefiting from reforms made in the decade before, many emerging nations saw a pickup in their growth rates. Both the developed and developing countries contributed to the boom. From 2000 to 2007, the G7 grew on average by 2.3%, and the developing world by 6.6%. During this period, the share of emerging economies in global GDP widened to 33.9% from 22.3%. Both groups were important for the global economy to reach a fast growth pace of 4.3% between 2000 and 2007. The 2008/2009 crisis dramatically changed this scenario, with extreme effects in the developed world, which interrupted the long phase of strong growth started in the mid-1980s, with relatively short pauses. The U.S. economy landed hard in 2009, and unemployment rose to the highest levels since 1982. Large household debt and the collapse and subsequent slow recovery of the housing market prevented a quick rebound, as in usual economic cycles. In Europe, instability among peripheral nations in the euro zone, including large economies like Spain and Italy, threatened the single currency. Though measures taken by the European Central Bank (ECB) under Mario Draghi averted imminent danger, the turmoil was enough to undermine Please refer to the last page of this report for important disclosures, analyst and additional information. Itaú Unibanco or its subsidiaries may do or seek to do business with companies covered in this research report. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should not consider this report as the single factor in making their investment decision.
the continent s economic performance, which was even more discouraging than the so-called eurosclerosis diagnosed before the crisis. Hence, the two large, advanced economies of the Northern Atlantic joined Japan, a country in low-growth mode since the crisis in the late 1980s and early1990s, to form a virtually-stagnant developed world. Deflationary risks caused fears that the Japanese disease could spread to other major economies. The average growth pace of the G7 from 2009 to 2013 slowed to just 0.7%. More recently, from 2011 to 2013, average growth in the developed world stayed at 1.5%. 4.0 3.0 2.0 1.0 0.0-1.0-2.0 Decouling, Recoupling, Decoupling... Developed and Emerging economies contribution to Global Growth p.p. Developed economies Emerging markets From 2010 to 2013, the developing world expanded at an annual average of 5.8%. Disregarding the exceptional year of 2010, marked by a rebound from a steep drop, the average was 5.2%. The share of developing nations in global GDP widened to 45.1% in 2013 from 40.5% in 2010. These countries became the main engine of global growth, decoupling from advanced nations. Interestingly, we may be entering a new -3.0 phase. Emerging economies are losing 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: IMF, Itaú ground. Growth in Brazil, China and India, for instance, fell from 2008-2011 average of 3.7%, 9.6% and 7.3%, respectively, to around 2.2%, 7.7% and 3.8% in 2013. In contrast, we see encouraging signs in advanced economies. Growth in the U.S. in 2013 is estimated at around 2%, despite a sharp fiscal adjustment, and should approach 3% in 2014. Europe exited recession, and should expand 0.9% this year. In Japan, there are still questions lingering about the sustainability of the more aggressive incentive policy of Prime Minister Shinzo Abe, but at least there is a larger-than-ever effort to prop up the economy. Apparently, the roles of advanced and emerging nations are about to be reversed, as some of the former pick up and many countries in latter group slow down. The new scenario creates many questions, the answers to which will be crucial in outlining a new pattern of global growth. The key question is whether the recovery in advanced nations (still accounting for more than half of global demand) will rekindle the largest economies of the emerging world at a time when they are decelerating. One concern is the repetition of the pattern seen after the U.S. recession at the beginning of the last decade, when international interest rates climbed continuously starting in 2004, after an extended period of low rates. The move caused market turmoil and, if repeated in the current environment of greater financial frailty in many emerging nations, could have an inverse effect compared with the positive momentum that a rebound in the advanced world would theoretically cause. G7 recovery ahead: lifting all boats? It could be useful to outline some scenarios for the global economy. The first scenario assumes that the U.S. will post a strong recovery and that Europe will definitely get out of recession, although grow less than the U.S. In this first "strong recovery" scenario, deceleration in China, India and Brazil would be partially reversed. Economic imbalances accumulated in many developing nations would likely be solved gradually and not traumatically, in a context in which commodity prices would pick up again. Page 2
Another condition for this bullish forecast is that the increase in interest rates in the U.S. takes place gradually and orderly, so as not to shake global markets. The second is a "double dip" scenario: a new sharp deceleration in advanced economies lies ahead of us, with a possible new round of deterioration in the troubled euro nations, whose situation was stabilized but not structurally resolved. The Japanese rebound would be aborted, reflecting a legacy of excessive leverage, similar to the financial crisis that took place in 2008. A third "muddle through" scenario is the most likely, in our view. The scenario is one with a modest recovery in the developed world, with average growth higher than in the recent past, but materially below the pre-crisis period. On the one hand, the strong recovery scenario runs up against indications of a "new normal" in the advanced world. Because the exceptionally favorable conditions seen in years prior to the crisis (such as the first and largest productivity gains attained via information technology and the internet) are no longer present, it seems difficult to repeat the growth performance of the 90s without entering bubble territory. On the other hand, new innovations may produce unexpected productivity shocks (shale gas discoveries, for example) and generate surprisingly strong growth. Currently, the performance of the U.S. in 2013 was encouraging and there are signs that 2014 could be a year of sound and broad-based recovery, at least reducing the chances of the "double dip" scenario. A point shared in both the strong recovery and double dip scenarios is a wave that lifts or drags down all economies. A world in full recovery mode, with developed nations growing close to their pre-crisis pace and emerging countries with renewed momentum, would recall the easy times of the first decade of the 21st century, when not making too many mistakes was enough to grow briskly. A double dip would cause difficulties in almost every nation, regardless of its peculiarities and the quality of its economic policies. In the most likely scenario, the rebound would not be strong enough to produce a wave. In the emerging world, where large economies are slowing down, the effects of a just-moderate recovery in advanced nations would likely be different from country to country, defined by distinct situations, fundamentals and economic policies. A beauty contest among emerging markets In order to examine how a moderate rebound in the advanced world would affect emerging countries, we should analyze the global linkages since the crisis of 2008. As late as 2013, financial conditions were still favorable for emerging nations, with plentiful liquidity and very low international interest rates. For some analysts, such financial abundance was actually excessive, as currencies of developing nations and commodity exporters soared, leading to reserve accumulation and even capital controls, as was the case in Brazil. Growth in the U.S. and Europe fell to a very weak pace in the aftermath of the global crisis. China also slowed down, but given its robust pace before and its widening share in the global economy, the country continued to contribute to global growth and to sustain high commodity prices. A large number of major emerging countries, including Brazil and India, recovered very quickly from the crisis and accelerated. For the period ranging from 2014 to 2018, as already mentioned, the most likely scenario is acceleration of advanced economies in the G7 but at a slower pace than before the crisis. On the financial front, U.S. interest rates will be normalized, leaving behind the extremely low levels of the first post-crisis phase. Commodity prices should be somewhat lower. International capital flows will be more selective, specially for countries with deficits in their current accounts. Page 3
In Latin America economies, moderate recovery in advanced economies may be a differentiating moment, as there will no longer be the general strong momentum of the last decade (until 2008), which prompted a widespread pickup in growth and also important social achievements in terms of reducing poverty and inequality. The economic ties of each Latin American nation with major global economies such as the U.S., Europe and China will be vital. For instance, Mexico stands to gain from the U.S. recovery, while Brazil, Peru and Chile depend on China. With less abundant liquidity to Latin America, two factors will help define their performance: the dependence on external savings and the proper use of these now-scarcer funds. The presence and size of a current-account deficit are important, as well as the investment rate. External savings funneled to increase production capacity are clearly more sustainable and useful in the medium and long term than when used to finance consumption. Many Latin American countries ran current account deficit in recent years. We note, however, that Brazil s domestic savings are much lower than those of its Latin American peers, at 14.6% of GDP in 2012, versus more than 22% in Chile and Mexico, for instance. This difference explains why Brazil s current-account deficit (or absorption of external savings) is close to levels posted by others in the region, despite the fact that Brazil invests considerably less than other Latin American countries. Gross fixed-capital formation (GFCF) in Brazil stood at around 18% in 2013, vs. almost 25% on average for the group including Argentina, Chile, Colombia, Mexico, Peru and Venezuela. Current-account deficits widened in recent years in Chile and Peru, for instance, but GFCF increased to 25.7% of GDP in 2013 from 20.6% in 2007 and to 27.9% from 22.8%, respectively. In Brazil, the deficit moved to 3.6% of GDP from around zero in the same period, while investment stood at around 18% of GDP. Average growth in Brazil stands at 2% since 2011 (incorporating a 2.2% forecast for 2013), less than half of the 4.6% non-weighted average for the so-called Pacific Group (Chile, Colombia, Mexico and Peru). Our forecasts suggest that this picture will continue in 2014/15. Still, Brazil s inflation, at 5.9% in 2013, is higher than the 2.9% non-weighted average for that group. This worse trade-off leaves less room for countercyclical policies in Brazil than in the Pacific Group. High inflation makes corrective exchange rate depreciation less desirable as the passthrough of exchange rate to inflation becomes a major issue. As a consequence, the benchmark interest rate in Brazil hit 10% by the end of 2013 (and continued to rise in 2014); compared with, for example, 4.5% (with a downward bias for 2014) in Chile, the country with the highest basic interest rates among the Pacific Group. Additionally, Brazil s gross general-government debt, at 68% of GDP, stands above the (nonweighted) average of 27% for the Pacific Group. Mexico has the largest gross debt for this group, at 43% of GDP, almost 25 pp below Brazil. Last available data Brazil Chile Colombia Mexico Peru GDP (last 5 years) i 2.6% 3.9% 4.0% 1.9% 6.5% Inflation 5.9% 3.0% 1.9% 4.0% 2.9% Interest rate 10.0% 4.5% 3.3% 3.5% 4.0% Openness ii 20.7% 57.0% 32.2% 62.6% 43.6% Current account deficit (% GDP) iii 3.6% 3.4% 3.4% 2.0% 5.0% Domestic Savings (%GDP) iv 14.6% 22.3% 18.2% 22.1% 24.3% Share of commodities in exports iv 50.0% 66.0% 81.2% 18.5% 75.2% Gross fixed capital formation (% GDP) i v 18.3% 24.8% 23.7% 21.5% 27.4% Gross public debt (% GDP) v 68.0% 11.9% 32.6% 43.5% 20.5% i 2013 estimated; ii (exports+imports)/gdp (2012 data); iii Rolling 4 quarters to 3Q13; iv 2012; v Rolling 4 quarters to 3Q13; vi Central Government Page 4
On the positive side, reliance on basic materials, which may be dangerous in this new phase, is much greater in nearly the entire Pacific Group than in Brazil. Commodities account for 50% of exports for Brazil, less than the 74% average for Chile, Colombia and Peru. This share is much lower for Mexico, at 18.5%. Brazil s external sustainability indicators are also positive highlights, with external debt being much lower than it is in other countries with the same sovereign rating. International reserves as a share of GDP are in line with the average. In the institutional sphere, Brazil considered a free country by Freedom House, which gauges civil liberties and political rights for different countries ranks better than other nations with the same risk rating, such as Russia, Thailand and Mexico. Another Brazilian comparative advantage is market size. With a population 200 million, 75% of that in the middle class or higher, the domestic-consumption market is very attractive. In the absence of a major shock, this should ensure a fairly good inflow of FDI in coming years. The challenge for Brazil is to think about performance in a longer period of four to five years, in a likely scenario of moderate growth in advanced economies and heterogeneous performance among emerging nations. Macroeconomic policy needs adjustment, particularly on the fiscal side. Opening-up, with new free-trade agreements, would be very welcome. The choices and quality of economic policy in a world of weaker waves will be essential to the performance of emerging countries in the medium term. Brazil still has tools at its disposal to correct and tune up its economic strategy, with relatively manageable political costs. The economic policy choices made during the coming years will likely define Brazil's performance at least until the end of this decade. Itaú Macro Team Macro Research Itaú Ilan Goldfajn Chief Economist Tel: +5511 3708-2696 E-mail: macroeconomia@itaubba-economia.com Click here to visit our digital research library. Page 5
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