As central banks worldwide are scrambling to keep inflation under control, it looks like Latin America has a lesson for the rest of the world. Its monetary authorities have taken the unorthodox route of reducing interest rates, instead of continuing to hike them.
In March, Costa Rica’s central bank became the first in the region to cut interest rates, followed by Chile, Brazil, Peru, Uruguay, Paraguay and the Dominican Republic. The region was also quicker in tightening monetary policy in the first place.
“When, in 2021, the Federal Reserve made the mistake of thinking that inflation was going to fade very quickly, Latin American central bankers — emboldened by their experience dealing with inflation — started hiking aggressively to fight inflation,” says Ernesto Revilla, chief economist for Latin America at Citi.
Most of the regional central banks drove up interest rates quickly, pushing them as high as 13.75% in Brazil, 13.25% in Colombia and 11.25% in Mexico.
Now is probably the first time that rates in developed markets are rising higher than emerging markets. But Gustavo Arruda, head of Latin America research at BNP Paribas, for one, wonders how much this will affect the business sentiment in the region.
It is difficult for central banks in emerging markets to decouple from US Federal Reserve policy, or other central banks in advanced economies, as this puts extra pressure on local currencies and capital outflows. However, Latin American central banks now have the chance to do something quite difficult for emerging markets: implement a countercyclical monetary policy.
“As the regional economy slows down, going into 2024, Latin American central banks are able to expand monetary policy by cutting interest rates to smooth the cycle,” Mr Revilla explains. “It’s an important milestone for Latin America.”
Their success is also linked to the evolution these institutions have undergone. In the past 20 years, many Latin American central banks have gained independence and moved to an inflation-targeting regime, which is considered state-of-the-art monetary policy by experts.
A great deal will depend on how much inflation remains under control, in the region and elsewhere. If the Fed is forced to hike again and US rates continue to rise, then this will create volatility in Latin American currencies which will halt central banks’ efforts in continuing their easing cycle. They might, in some scenarios, have to hike to defend their currencies.
Countries that have started their loosening journey might have to wait before proceeding, or at least slow down. Chile, for example, reduced its rate by 100 basis points (bps) at the end of July, from 11.25% to 10.25%; but its next cut in September was just 75bps, to 9.50%. “Chile has seen a massive depreciation of the peso — such volatility is quite unusual,” remarks Sergio Urzua, professor of economics at the University of Maryland in the US. “The spread with the US emerges as a driver. Long-term foreign investments kept the exchange rate stable in the past. This does not seem to be the case anymore.”
Stay the course
The two biggest economies, Mexico and Brazil, remain very strong, despite the risk that inflation is not going to come down easily.
“Central banks in the region should move carefully. Assuming the risks of rising prices are over would be a mistake,” Mr Urzua says. “There is uncertainty regarding the oil price and whether the US and Europe are keeping rates high for longer than expected. The spreads with the US Treasury are another factor in the region.”
Nobody has a clear understanding of when and at which level US rates will stabilise, agrees Mr Arruda. For this reason, some central banks, including Colombia and Mexico, are proceeding with caution.
“For Mexico, although fundamentals would probably justify a discussion to start normalising monetary policy, they are being more cautious — especially as the economy is strongly linked to the US,” says Mr Arruda. “We were expecting them to start cutting rates in the fourth quarter, but we then decided to push that to next year.”
Brazil is also being prudent in cutting interest rates. “The discussion is whether to move forward, or wait and see the Fed’s next move,” according to Mr Urzua.
Therefore, central banks are at a crossroads, as the desire to reduce interest rates to activate economic growth will also have an impact on other economic variables. “At the moment, it’s an open question whether 2024 is going to be graduation or back to history for central banks in the region,” Mr Revilla says.
Slow growth
Latin America and the Caribbean is expected to see growth decline from 4.1% in 2022 to 2.3% this year — below the world average of 3%, according to the International Monetary Fund (IMF). The decline reflects a normalisation of growth, but also a tightening of monetary policies, a weaker external environment and lower commodity prices.
As such, it is unlikely that any country in the region will grow significantly, with forecasts of growth ranging between 2.4% and 1.4%. “The region is going to struggle,” explains Diego Sánchez-Ancochea, professor of political economy of development at the University of Oxford. “I’m not particularly optimistic, unless global conditions improve in ways that we are not expecting at the moment. The lost decade may become the lost three decades.”
Mr Urzua agrees: “I don’t think the region has fully recovered from what it experienced during the Covid-19 pandemic. This is clear in countries like Colombia, Peru, Chile, Argentina and Ecuador.”
The debt-to-gross-domestic-product (GDP) ratios have increased after the pandemic, with the average public debt of 16 Latin American countries at 49.5% of GDP in March 2023. Although there were improvements, public debt remains at a high level, both historically and compared to other regions, according to the UN Economic Commission for Latin America and the Caribbean.
A more pronounced slowdown in China and a worldwide decline in the demand for commodities represent major risks for the region. “We saw this back in 2014 when the commodity boom came to a halt. The tension between the West and China, the war in Ukraine and the Israel–Hamas conflict are sources of uncertainty. These might have unexpected economic and geopolitical consequences,” adds Mr Urzua.
Stronger than expected
In its October 2023 World Economic Outlook, the IMF revised growth projections for Brazil upward by one percentage point to 3.1%, driven by buoyant agriculture and resilient services and strong consumption. Mexico’s growth has also been upgraded by 0.6 percentage points to 3.2%.
The two biggest markets are interesting cases, albeit for different reasons. In the case of Mexico, it will be interesting to see how much the changes that are taking place in US manufacturing will bring some production facilities to the country.
Everybody talks about nearshoring, but it has been very difficult to find in numbers.
In Mexico, growth has been driven by private consumption and investment, the service sectors and auto production. This has led to record-low unemployment rates and record-high manufacturing capacity, according to the IMF.
“Everybody talks about nearshoring, but it has been very difficult to find in numbers. Yet it’s also very difficult to deny this story. We see some very good performances on the construction side,” says Mr Arruda.
In Brazil, economic dynamics are better than many would assume given its monetary position. Mr Arruda says, “Growth next year will likely be supported by some fiscal policies. We assume 1.8% growth next year, a fair performance for the country compared to historical terms.”
Until now, Brazilian president Luiz Inácio Lula da Silva (Lula) has managed the economy well, and the nation’s independent central bank has been a pillar of the efforts to reduce inflation, Mr Urzua explains.
The question is how much effort the Lula administration is putting into a new industrial strategy. “The only way that growth will take place is if they move away from commodities — or they are able to add value on commodities — and that will require more active industrial policy,” adds Mr Sánchez-Ancochea.
The Brazilian government has managed to approve a new fiscal rule which has been well received by the market, according to Mr Revilla. “They are now discussing a very important tax reform that aims to simplify the Brazilian tax system,” he adds.
Relevance of commodities
Several countries are receiving a great deal of attention from investors to see how they take advantage of their raw materials. In one way or another, commodities are at the centre of the political discussion.
What Bolivia and Ecuador might do with the management of natural resources such as lithium, including the degree of public sector involvement, is under consideration, according to Mr Sánchez-Ancochea.
In August, Ecuadorians voted to halt oil drilling in a biodiverse Amazonian national park, while in a second referendum citizens in Quito voted to block gold mining in the Chocó Andino region. Bolivia, on the other hand, has expressed its willingness to collaborate with global companies for lithium exploration and extraction.
Meanwhile, Chile has announced plans to bring lithium mines under state control, while Colombia is trying to attract foreign investment to support a transition away from fossil fuel extraction.
For countries such as Argentina and Venezuela, macro stability will be at the heart of discussions in the next few months. Guatemala, despite the politics, is a bit like Peru — a smaller country where the economic fundamentals are relatively good and growth seems to be independent from political noise, Mr Revilla says.
Effects on banks
Due to central bank actions, Latin American banks are ahead of the cycle compared to the US and other advanced economies. As interest rates come down, the effect on balance sheet dynamics is going to be more positive for profitability, according to Ceres Lisboa, associate managing director of financial institutions at Moody’s Investors Service.
In most markets, the net interest margin (NIM) is clearly affected by monetary policy. But there’s still a lot of heterogeneity in the region. “In some places, such as Mexico, an important part of banking profits is not that much related to the NIM, but more to other types of fees and commissions,” Mr Revilla says.
Ms Lisboa explains that credit costs should come down very gradually over the next few quarters as funding, mostly floating and made up of granular deposits, will reprice faster than the loan book, which are in most cases longer tenor and fixed rate.
In the first half of this year, non-performing loans peaked in most countries. “We now expect delinquencies to come down very gradually over the next year,” Ms Lisboa says.
Moody’s has a favourable opinion on asset quality in Brazil, Mexico and Chile, but less so in Colombia and Peru, where there is still persistent inflation.
Banks will need to do some heavy lifting to increase appetite for lending or mergers and acquisitions in low growth potential economies.
Also on the positive side, many banks in the region face less liquidity issues than those in more mature markets. They rely on a much more granular deposit base, while countries like Brazil and Chile rely on very large capital markets which help to mitigate risks of refinancing in the banking systems.
In 2024, banks are forecast to grow their business at a lesser rate, but will maintain very conservative levels of reserves. As interest rates come down, banks are going to have to reprice their loan book. “We’re gradually and carefully leaving the risk periods to a more favourable but low growth scenario. Banks will need to do some heavy lifting to increase appetite for lending or mergers and acquisitions in low growth potential economies,” Ms Lisboa says.
Regardless of whether central banks are able to declare victory over inflation next year, monetary policy has contributed to a deepening of the financial sector in the region. A region with historically unstable macroeconomic environments now seems able to offer more stability — a necessity for the banking sector to grow.
