Fall-out Fears Ferment in Latin America

This year’s World Bank/International Monetary Fund shindig in Washington DC saw most attention focused on the plight of banks in the developed world.

Yet, it is becoming increasingly evident that the crisis in infecting both the global real economy and that ripple effects on emerging markets will be severe. Almost unnoticed in the wider news, the World Bank slashed growth expectations for Latin America to 2.5%-3.5% for next year, down from 4.6% this year and 5.6% in 2007. Those figures look provisional and could well be lowered again. Foreign-owned banks are holding back credit while domestic banks are facing tougher credit conditions from correspondent banks, are having to postpone capital raising plans, and have seen shares swoon.


The beginning of the sub-prime crisis witnessed a touch of schadenfreude from Latin American pundits directed at the developed world, a sentiment which is only now fully dying out. It was rich countries’ over-exposure to risky assets, a business area which Latin American banks were thankfully not involved in, that triggered the crisis and that would exempt Latin America from its after-effects went the argument. The attractiveness of that line of reasoning has faded as the focus of attention has turned from the banking system to the real economy.

Indeed, many are more pessimistic than the World Bank on Latin America. JPMorgan Chase & Co. forecasts the Mexican economy will expand just 0.3% next year, down from 1.4% in 2008 and pegs Brazilian growth at 2.8% in 2009, down from 5.2% this year.

The crisis is being transmitted to Latin America in three ways, according to the chief economist for Latin America’s office at the Wold Bank. The first is financial contagion with a slowdown in portfolio flows, large declines in stock price indexes and significant currency adjustments. The second is a drop in demand that includes demand for exports, particularly commodities, and drops in remittances as well as higher borrowing costs and the impact of tight monetary policies. The last is changes in relative prices, especially in commodities. That is particularly key as over 90% of the region’s GDP and population reside in commodity exporting countries.

The effects of this triple whammy are already coming home to roost. Much of Latin America’s boom of the last five years has stemmed from increases in commodity prices, attracting in FDI and portfolio flows, cutting unemployment, driving up wages, and filling government coffers. Currencies appreciated against the dollar as balance of payments turned positive.

The downturn in commodity prices has smashed those trends and hit currencies hard. The unwinding has been all the more brutal both because performance of commodities was so strong and thanks to a flight to US dollar assets.

Chile, Brazil, Peru and Mexico have been hit hard. But it is the effect on Venezuela in particular, with its heavy oil dependence and hollowed out agro-industrial economy, that threatens to be most severe.

Venezuela remains an isolated case because of its dependence on one commodity, oil, and its unorthodox economic policies, largely supported on the back of these very oil revenues. It was only back in late summer that Venezuela’s oil giant PDVSA reported spectacular numbers: a 958% increase in net profits and revenues that had reached $72.42 billion compared to $42.86 billion compared to the same period last year. These huge increases were reached with just a 3.5% increase in production. PDVSA claimed that it would boost production substantially -- to over 4.9 million barrels per day by 2013 and 6.5 million by 2021. Many analysts were optimistic about the firm’s future.

The situation has since changed dramatically as oil prices have tumbled nearly 50%. In a country with few other resources, the effect is magnified. JPMorgan Chase has cut its 2009 economic growth forecast for Venezuela next year to 2.5% from 3.5% on lower oil prices and expectations of a global recession. If oil prices remain below $90 in 2009, the current account surplus will be hit hard, according to analyst Ben Ramsey. It could even move into a deficit, compared to expectations of 14% of GDP, he predicts.

That is likely to trigger a currency devaluation and Ramsey predicts that the bolivar will be moved down 30% from its current level of 2.15 to the US dollar. That will hurt in a country that imports some 60% of its goods and pays US dollars for them. Venezuela, which has long lived on the largesse of oil to fund extensive social programs and more recently to embark on a comprehensive nationalisation programme, looks shaky. The country will pay close to $11.6 billion for the nationalisations agreed to date, including those in the petroleum sector, according to paper Ecoanalitica. In a sign that the government is anxious, ministers have said that they will look to pass an austere budget.

Countries with more orthodox policies are suffering greatly too. In October, Chile saw its currency plunge the most in 19 years as copper prices stumbled. The Brazilian stock market has plunged by more than 40% since a peak in May, with darlings of the market, such as Petrobras and Vale, particularly hard hit. Currencies across the board have slid and economic forecasts have been slashed.

The severity of the crisis has, however, been mitigated thanks to at least some prudent policies. Across the region, debt levels have been falling and there have been moves to develop a local bond market. Total debt as a percentage of GDP in Western Hemisphere emerging market countries fell to 22.8% last year from 42% in 2003, according to the IMF. And many countries have chosen to invest rather than spend all the revenues from commodities. Chile has built up some $21 billion in reserves from selling copper. Brazil's international reserves are at record levels of $208 billion.

That will help soften the shocks in the short-term. Furthermore, support from an array of multilaterals has been forthcoming, concerted and rapid and should help to combat the liquidity crunch.

Four multilaterals have pledged significant funds, including the Inter-American Development Bank (IDB) and the Andean Development Bank, CAF. They accounted for close to $10 billion in fresh credit and the IDB alone will provide $6 billion in liquidity as well as accelerating specific loans next year.

Bank Policies

The crisis has brought into focus the monetary policies of the region. Until it struck, the main preoccupation had been with fighting resurgent inflation. That had seen almost all the major economies increase interest rates. Brazil’s Selic rate stands at a hefty 13.75% and Mexico’s at 8.25%.

The dilemma is now how monetary policy can be handled at a time that offers great uncertainty and conflicting policy priorities. The rapid rise in inflation in the first half of the year may slow as commodity prices tumble, yet the recent sharp falls in currencies suggest that import prices will rise. Governments want greater scope to loosen monetary policy to stimulate credit, but are nervous about looser policies in case it exacerbates the run on currencies.

The crisis also calls into question just how enduring reserves will prove as countries fight to protect their currency amid a massive flight to safety in US dollars. High levels of reserves are being eroded and the short-term policy of selling dollars has had only limited success. Mexico's central bank sold over 10% of its $84 billion foreign reserves in one week in October as the peso plunged 16.3% against the dollar. Peru's central bank sold $2.4 billion in reserves in one day at the end of September to support the sol. Chile's central bank stepped up its offer of currency swaps to combat a sharp decline in its currency.

In general, conservative bank regulations, imposed thanks to previous crises that destabilised Latin banking systems, have helped weather the storm. Strict rules, once seen as a straitjacket, have turned out to be a lifejacket. Stringent reserve requirements have particularly helped protect banks and furthermore given regulators the scope to ease such restrictions in a bid to defray the credit crunch. In Brazil, for example, Caixa Econômica Federal, the bank owned by the Brazilian government, announced plans in October to buy at least 20 credit portfolios from smaller lenders in a month after the central bank eased rules on reserve requirements.

And Latin banks tend to be conservatively managed as well. That has spared them from exposure to sub-prime assets and CDOs, points out Jeanne del Casino, vice president, regional credit officer for Latin American banks, at Moody’s.

Even though Latin banks this time round look stronger and more prudent that developed market banks, they may yet lose a chunk of the deposit base. Local wealthy individuals have been selling local assets to buy the greenback, a reaction honed over years of dealing with crises. That looks astute given recent currency turbulence. “Their risk appetite for investment in their own home country has been reduced,” said Javier Arus Castillo, general manager of Santander Private Banking International, which works in nine Latin American countries.

Furthermore, the credit boom, that has been such a strong and region-wide phenomenon, looks over-stretched.

The impact will be different in different countries. In Brazil, which has one of the region’s last mostly locally-owned banking systems, questions revolve around how banks will raise funds and what will happen to credit lines between Brazilian banks and their correspondents.

Larger banks have already seen significant drops in their share prices. Itaú was down close to 40% over the 12 months to October 16 and Bradesco was down by just over this amount over the same period. Although bad, it is the smaller banks that have been most hurt. Banco Daycoval is down by over 70% over the same period, for example.

These smaller banks had been seeking out niche areas in which to invest where they felt more shielded from competition. One area that may cause difficulties is US dollar-denominated agro loans, a hugely popular area in the last couple of years. Smaller banks are likely to face difficulties now in borrowing in dollars and with the sharp decline in the value of the real, the inability to roll over dollar debt by their customers could lead default rates to spike.

Banks’ inability to tap markets is already starting to be seen with cancellations of debt and equity deals common. That means that local deposit capture will be the only way for many banks to raise capital in the short-term, for example, though emerging pension funds, says del Casino.

All this has pressured ratings downwards. S&P revised the outlooks on Daycoval (BB-) and Banco Indusval (B+) to stable from positive on October 8 while Fitch trimmed positive outlooks for five banks too. S&P cited limited funding options as the largest challenge to banks rather than a fundamental weakening of operations while Fitch said its cuts came thanks to a fundamental change in the expectations for loan growth and business expansion, given the deteriorated world outlook.

Most of the rest of Latin America, where international banks dominate the scene, faces different dilemmas. The question there is how much interest banks, that are facing severe turbulence at home, will have in funding continued growth in Latin America. Leaders in the region include Citigroup, HSBC and Santander.

Moody’s has warned that Mexico faces some stress, for example. Foreign players have aggressively expanded loan books, both to individuals and companies with private lending up by as much as 50% in both 2005 and 2006. That growth has dropped precipitously to stand at some 11% annually today, but the risk is clearly strongly to the downside. Non-performing loans on credit card debt in Mexico have jumped to about 8% in recent months.

Citigroup has been particularly badly affected by global conditions with third quarter results showed a quarterly loss of $2.82 billion after write-downs (amazingly enough, that was actually better than many had feared). Key Latin markets were identified as showing weakening credit characteristics and Chief Financial Officer Gary Crittenden saying there is broad deterioration in consumer credit worldwide, particularly in Brazil, India and Mexico.

The trouble for Latin banks has had little to do with the miscalculation of risk and aggressive lending to the unwashed of the credit era that banks in the developed world indulged in. Nonetheless, they are feeling the effects of these problems.

Foreign-owned banks are already retrenching in Latin America, particularly in credit, the boom area of recent years. Their reticence will be encouraged as a slower macro scenario boosts delinquency rates. Sales by these banks of some Latin assets cannot be ruled out. Local banks, particularly those without big balance sheets to fund their business, face a huge funding drought that will oblige them to pick carefully what areas to emphasise. They will have to re-adjust to funding most of their business through deposits. The easy days for borrowers and bankers is over.

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