Latin America Trip

I have been in Latin America in the past two weeks. My first destination was Chile, followed by Argentina, Brazil, Peru and Colombia. The trip is very fruitful, but very exhausted. Two weeks have passed in a flash. I am now on the way back home.

Different countries have different economic development. The impression from the trip is that all countries are booming. All countries, to a different extent, are able to maintain their fiscal discipline. Argentina, Brazil, Peru and Chile all have primary fiscal surplus. Colombia is a bit behind with manageable deficit. This is a big contrast in the 1980s when the government spending is highly correlated with external environment.

Another important observation is that the growth is not limited to a small subset of economic sectors. Chile, Peru and Colombia, for example, the growth is quite diversified, from their traditional commodity export to retail, manufacturing, telecommunication, etc. This seems the current favorable external environment somehow passes through into domestic economy. One explanation is that the world really has a lot of liquidity. With economies are driven largely by private sector, high liquidity is channeled to the productive sectors. The government spending restraint also minimizes the crowding out effect.

This does not mean the countries are totally insulated from shock. One very clear problem in my mind is all their currencies are undervalued. Government intervention is the norm everywhere. There are two problems. One is sterilization is not complete, which means sooner or later, inflation will show up in the domestic economy. If this happens, the most affected group will be the poor, as most of them are not able to hedge the inflation risk. This is particularly important as history tells us that social unrest has been a hidden bomb in the Latin region. Last year’s Peru experience is still in our mind.

On the other side of the same coin, huge rise in international reserve expose the central bank on exchange rate valuation effect. If the world continues to be smooth and if the US continues to be fiscally irresponsible, the continuation of dollar depreciation is inevitable. If dollar in one day lost its attractiveness as a vehicle currency, these countries’ assets will be greatly affected. In some sense, the US now having a free lunch; or precisely the cost of the free lunch is paid by other countries.

The second problem I think is even more worrisome is all countries is very protective to their export sector. This suggests that they are not confident on the domestic economy. Every developing country wants to move to the developed world. Every developed economy is driven by domestic component, and most likely letting its currency floats freely. I don’t see this is the case in any of the Latin economy. The typical argument from the central bank or the ministry of finance is they concern their export sectors, or in short the Dutch Disease. Theoretically sound, but seems not practically right. The Dutch Disease argument relies on high entry barrier. This seems not too important for Latin’s manufacturing industries. But the end, the undervalued currency hinders the transformation to a high value added sectors. This is quite a bad thing in the long run.

In the sense, the government should spell a clear message that FX intervention is transitional, including the intervention magnitude over time. It seems so far there is no clear message out there. The market may think that is transitional not because of the government commitment, but the government capacity. Although the eventual outcome may be FX appreciation, the dynamic is very different. Under the first case, the market will have full information on the FX trend, and export sector are able to plan its transformation in an orderly fashion. Rational expectation suggests that volatility will tend to low. In the second case, market needs to estimate the capacity of the central bank, from inflation data, from interest rate data, etc. export sector will put more efforts on lobbying the government. Speculation will be high, and so is the FX volatility.

I recalled there are a number of countries in the past are able to move from pegged regime to floating regime without triggering a crisis. More importantly, all of them switched their regimes under the good time. This is the time for the Latin America. Making it overvalued or undervalued will eventually be problematic. It is important to let the FX go before the end of the good times. Today, with the exception of Argentina, all countries are doing well. Private sector is moving forward, and business confidence is high. Hyperinflation is a history.

With high international reserves, with fiscal balance and with favorable monetary condition, it is time to let it float. Let the market determine which industry should stay, which should let go. Let the financial market develops under the market condition. Most of those countries are not small open economy, they need their domestic demand determines the economy, not the export sector.