Who will survive Latin America's ‘year of political risk’?

Elijah Oliveros-Rosen

Rising US interest rates are rocking emerging market currencies – most notably in Argentina, where the central bank has been forced to intervene to prop up the peso. The sharp interest rate rises that followed are threatening the country’s economy. With external factors compounding political uncertainty across the region, which Latin American central banks will face the harsher tests, and which are best placed to absorb the turmoil? The Banker has asked a number of well-placed analysts, who do not always agree on the outcomes.

Q: Will Argentina’s central bank be able to support the peso without damaging economic growth?

Elijah Oliveros-Rosen: The short answer is no, not sustainably, not alone. There is a trade-off between having an overvalued, effective real exchange rate and achieving sustainable long-term economic growth. Argentina has suffered from an overvalued exchange rate for many years, which has incentivised consumption and imports at the cost of losing competitiveness.

The long-term picture for Argentina would improve if the government temporarily abandoned its disinflation efforts and instead facilitated a controlled real depreciation of the peso to boost competitiveness, attract foreign direct investment and reduce the fiscal deficit, at the cost of lower economic growth in the short term. However, with a general election in October 2019, this might be politically unfeasible.

Authorities have instead taken a second-best approach: defending the currency with higher interest rates while moderately accelerating the fiscal adjustment by reducing the 2018 primary budget deficit target to 2.7% of gross domestic product from 3.2% previously. This strategy can work as long as investors are patient.

Gabriel Casillas: [Argentina being able to support the peso without damaging economic growth is] very unlikely, as options available to fight currency pressures are limited. The central bank hiked its benchmark interest rate by a whopping 1275 basis points in May, from 27.25% to 40%, but has not been able to stabilise the peso, accumulating a 25.5% year-to-date loss [as of May 16, 2018]. This alone will impact activity as consumer confidence, credit availability and investment are all hit.

Moreover, the government has announced hefty spending cuts and increases in utility prices. An agreement with the International Monetary Fund [IMF] could help Argentina weather the storm, but will likely come with adjustment measures that would take their toll on growth.

Axel Christensen: Argentina’s central bank is running out of time to avoid seeing the significant rate hike it enacted to support the peso not causing permanent damage to the country’s economic growth. With its policy rate at 40%, the negative impact over funding for companies (mostly small and medium-sized enterprises) as well as households is significant. If it is not able to reach foreign exchange stability, the central bank will have to leave rates higher for longer, [resulting] in extended damage to Argentina’s economic growth.

Martin Castellano: The central bank has been burdened with multiple objectives despite its limited toolkit. For instance, its dollar firepower is relatively low compared with other central banks in the region. Efforts have been recently made by [president Mauricio] Macri’s administration to bolster the country’s external liquidity position, which should make the central bank’s life easier.

An adverse impact on growth, however, is unavoidable given tighter policies and global headwinds. The magnitude of the impact would largely depend on the duration of the stabilisation process. Achieving a rapid stabilisation is critical because the current policy framework requires decent growth to be sustainable.

Ernesto Revilla: It should be able to [support the peso without damaging the economy]. So far, the situation in Argentina looks like a liquidity story rather than a solvency problem. It’s true that there are traditional vulnerabilities associated with distress, namely a large fiscal deficit that [translates into] significant dependency on external financing. This shows that there is added urgency in finishing important reforms faster.

Nevertheless, the increase in rates by the central bank, the availability of reserves (plus maybe some support from the IMF), the resiliency of growth, the delivery of fiscal targets, and the adjustment that we have seen in assets prices should be enough to give Argentina some breathing space. Going forward, the economic team must show scrupulous skills to communicate with the market and to be proactive rather than reactive.

Q: Which Latin American countries are at higher risk of sharp currency devaluation and capital outflows? Do their central banks have enough leeway to ease external pressures?

Mr Christensen: Argentina faces the highest risks of currency devaluation and capital outflows (leaving Venezuela out of consideration). In the case of Mexico, despite political concerns, [concerns over] high inflation levels seem to have been left behind. A healthier fiscal situation also allows for more leeway for the Mexican central bank to act if needed.

Although Brazil's fiscal situation continues to be challenging and requires further adjustments, the combination of more favourable inflationary conditions, which in turn led to a significant reduction in interest rates, have provided the central bank with a higher degree of policy flexibility. Similar, if not greater, [flexibility] is available for monetary authorities in Colombia, Peru and Chile.  

Mr Revilla: In Latin America, most countries’ fundamentals are now stronger than they were in 2013 when they faced the shock of the [US] taper tantrum. While not at significant risk, given strong fundamentals, the behaviour of the currencies shows that markets are now focusing again on the Brazilian fiscal situation – with an urgent need for pension reform – and Mexico’s prospects under a [left-wing Andrés Manuel] López Obrador presidency, not to mention the fate of the North American Free Trade Agreement [Nafta].

Mr Oliveros-Rosen: Two Latin American economies stand out as being the most at risk of capital flight at the moment: Argentina and Brazil. The Argentine peso is overvalued in real effective terms and there is a great deal of uncertainty over the trajectory of the economy. In Brazil, two trends put the economy at risk of abrupt capital outflow pressures: the carry trade on offer is not as attractive as it used to be, and the fiscal picture is still highly uncertain.

The one-year interest rate spread between Brazil and the US has fallen by nearly 7 percentage points since the end of 2016, which reduces the attractiveness of holding real-denominated assets. Meanwhile, the pending pension reform is key in closing the primary deficit and stopping the rapid growth in debt ratios, but it is subject to the result of the October general election, which is far from certain.

Mr Casillas: As the US Federal Reserve and other major central banks lift interest rates, countries with higher current account deficits and external debt levels are at higher risk of a reversal in capital flows, which have been strong in recent years. In our view, structural fiscal challenges should be addressed in countries such as Brazil, Colombia and Peru, which look relatively more vulnerable to a stark devaluation.

Nevertheless, most seem well prepared for containing any potential contagion from Argentina – in particular Mexico, as it is more sensitive to the US economy, which remains robust, and maintains a very strong institutional framework in terms of macroeconomic management.

Q: Which Latin American currencies are likely to perform better over the next six months, and why?

Mr Oliveros-Rosen: Accurately forecasting spot exchange rates, even over a six-month period, requires something close to divine intervention. But from a purely analytical angle, I find it useful to focus on three variables that have been drivers of exchange rate performance in Latin America in recent years: risk premia, interest rate differentials and growth expectations. When risk premia are low, interest rates can be cut without risking a major depreciation of your currency, even if growth is expected to be relatively subdued.

This has been the case since late 2016, mainly because a flat US yield curve and soft US dollar depressed risk premia, not necessarily because domestic political dynamics improved much. If we continue to see episodes of broad US dollar strength, domestic political dynamics will be key in preventing a sharp increase in risk premia, and by extension a weaker exchange rate.

This is why the Chilean and Colombian pesos seem to be in a more comfortable position than their regional peers. In Chile, the improvement in business confidence since president Sebastian Piñera took office is very noticeable. In Colombia, polls suggest that the result of the general election [on May 27] will be one in which fiscal prudence and business-friendly economic policy will dominate.

In both countries interest rates have likely bottomed, and growth expectations are picking up. The recent uptick in copper and oil prices hasn’t hurt either.

Mr Christensen: The currencies in those countries in Latin America that [have] more robust macroeconomic conditions, such as Peru and Chile, should likely perform better. In addition, should the electoral results in Mexico and Brazil be more favourable in the eyes of investors, there could be room for an over-performance of their currency, as the current levels reflect a certain degree of a more concerning [electoral] outcome.

Mr Revilla: Over the next six-month period, the Mexican peso should perform well, as the uncertainty over Nafta and the election would have passed and [the currency is] still significantly undervalued according to long-run valuations. The Brazilian real should also do well after the election, given very strong external accounts and increasing growth. The recent behaviour in the oil price would also support the Colombian peso in this window of time.

Mr Catellano: Performance will be closely related to the outcome of the still-open presidential races in several countries. Widespread fragmentation, dissatisfaction with traditional political factions and strong public support for left-leaning candidates have raised doubts about the continuity of current macroeconomic policy frameworks in the region.

Global conditions have also recently deteriorated – affecting the countries that are more vulnerable to swings in investor sentiment the most. Against this backdrop, the Chilean economy is poised to strengthen further in the next six months as the new administration is implementing policies aimed at improving the macroeconomic framework and lifting business and consumer confidence.

Q: How do you think elections in Mexico and Brazil will play out and potentially impact local central banks?

Mr Oliveros-Rosen: The heavy election agenda has made 2018 the year of political risk in Latin America. But in the case of both Mexico and Brazil, political uncertainty is mainly associated with fiscal policy, not monetary policy. In Mexico, it is true that there is a general perception of uncertainty towards Mr López Obrador’s economic policies. However, Banxico enjoys broad political support based on its inflation-targeting framework. I do not find strong incentives for Mr López Obrador to take steps to challenge Banxico’s autonomy and credibility if he gets elected.

The Brazilian central bank’s autonomy survived the impeachment of former president Dilma Rousseff and the impeachment [proposal] of current president Michel Temer. The central bank has improved its credibility in recent years, at a time when fiscal credentials have deteriorated, by succeeding in bringing inflation down from almost 11% at the beginning of 2016 to below 3% since the middle of 2017.

In fact, in 2017 the national monetary council established a lower inflation target of 4.25% and 4% for 2019 and 2020, respectively, from 4.5% for 2018. Therefore, as in the case of Mexico, I don’t find a strong incentive for any incoming administration to challenge the Brazilian central bank’s autonomy and credibility.

Mr Castellano: In Mexico, Mr López Obrador is well positioned to make it this time due to several reasons: a weak economy, heightened tension with the US, the combination of the single round of voting and significant political fragmentation, the low public support for traditional political parties, and intense confrontation between the PAN and the PRI [parties].

Regarding the implications of a López Obrador win, the private sector would look at signs of pragmatism. In the absence of meaningful signals, the main risk is to see a gradual erosion of the macroeconomic position amid challenges to garner business confidence.

In Brazil, there are reasons to believe that the next administration will pursue relatively moderate policies. The country’s two-round voting system favours prudent proposals. Fragile public finances, a rule-based framework and the need to sustain investor confidence provide a limited scope for fiscal slippage. Also, politicians are under pressure to deliver on the macro front amid still-unfolding corruption probes and the failure of past populist measures.

Mr Casillas: This year’s global geopolitical agenda is very active and key to making sense of the current social and market developments. Among a number of political events taking place in Italy, Germany, Brazil and Venezuela, the Mexican electoral process stands out due to its historic scale. More than 3400 posts will be elected, including the president’s office. Mr López Obrador is currently leading the polls. Despite representing an anti-establishment standpoint, Mexico’s strong institutional structure would support the macro stability – [this includes] an autonomous central bank.

Brazil’s process will also be very relevant in a context where the economy is recovering from recession. However, following a sharp decline since 2014, the Brazilian [economic] backdrop has become more stable. We expect the [benchmark interest rate] Selic to hold at 6.5%, following [monetary committee] Copom’s easing cycle, which started in 2017. Nevertheless, any adverse reaction in the result of the electoral outcome could easily be tackled through rates, [currently at] the lowest levels registered [in the central bank’s most recent history].

Q: Which Latam central bank has impressed you the most over the past six months?

Mr Christensen: The Central Bank of Argentina has had an impressive performance in the past six months. First, as experienced in late December 2017, in a rather awkward press conference with senior government officials, the central bank seemed to have abdicated in its autonomy as it announced an adjustment on its inflation-targeting objectives. This was read by the market as a negative development, in terms of a loss of the central bank’s independence. Therefore, the recent decision of the central bank to increase rates 'as much as needed' to stabilise the currency – which received the explicit support from the finance and treasury ministries – can be seen as significant progress in it regaining its reputation as an independent entity.

Mr Oliveros-Rosen: Stepping away from the difficult monetary policy decisions that Argentina’s central bank has had to take this year under intense pressure, [Mexico’s] Banxico has impressed me the most in recent months. It had to go through a change of leadership at the end of 2017, when Agustín Carstens left the governorship to lead the Bank for International Settlements.

The timing for a change of baton was not ideal, in the midst of the uncertainty that the Nafta renegotiations and the July 2018 election create over Mexico’s long-term macroeconomic trajectory. However, the transition from Mr Carstens to now-governor of Banxico Alejandro Díaz de León was seamless.

Banxico hiked its policy rate by 25 basis points in each of the first two meetings the bank held under Mr Díaz de León’s governorship (in December 2017 and February 2018), and the implementation could not have been smoother. The process of disinflation that started at the end of 2017 has continued uninterrupted, and importantly, inflation expectations have remained relatively stable since Mr Díaz de León became governor.

Mr Casillas: Banxico’s performance has kept fairly in line with monetary orthodoxy. It is worth noting that the central bank has undergone important structural changes to its monetary policy communication strategy; in particular, Banxico will now identify the direction of the vote as well as the rationale of each member of the board in the meeting minutes.

Moreover, the complete transcripts of monetary policy meetings will now be released three years after the meeting, and the post-meeting communiqué along with the minutes of each meeting will be published both in Spanish and English simultaneously, among other modifications.

Mr Castellano: The Central Bank of Brazil has quickly bolstered its credibility by forcefully reducing interest rates in a context of remarkably low inflation. Aggressive monetary easing has helped the economy rebound following a painful and protracted recession. Increased credibility comes in handy to protect financial stability at the current times of heightened global financial volatility linked to monetary policy normalisation in the US.