Latin America: An end to boom and bust?
Argentina is on a precipice, Venezuela has a humanitarian crisis and Brazil is just exiting its worst-ever recession – so far, so Latin America. But some countries have shown a path to sustainable growth and others are now grasping the nettle of reform. In a series of articles to commemorate 50 years of Euromoney, we speak to architects of previous recovery plans and to today's heads of the region's top banks and investment banks and ask: could an end to Latin America's long history of boom and bust finally be in sight?
Illustration: Andrew Archer
"You have to remember the overall climate was very optimistic in the 1990s, there had been the fall of the Berlin Wall… Francis Fukuyama’s book ‘The end of history’ predicted that most countries would converge to democratic market economies. This climate helped to convince a lot of Latin American leaders that they had to engage with the Washington consensus reforms,” says Domingo Cavallo, Argentina’s reformist finance minister between February 1991 and August 1996.
Latin America’s history of crises in the 1990s and early 2000s proved that such a positive outlook was misplaced.
Today there is a similar optimism about Latin America’s financial resilience. The continent, which has done boom and bust like no other, has been remarkably steady. The region shrugged off the economic crisis of 2008 that plunged many other parts of the world into financial paralysis.
Latin America, which had previously caught every contagious shock going – whether from inside the region (the 1994 Tequila crisis) or outside (from Russia or Asia) – now shrugged off one of the greatest financial crises. Growth rebounded.
Then came the end of the commodity boom. Growth slowed but didn’t stall. Then came the taper tantrum: Latin American currencies, like others in the emerging markets, plunged, but free-floating currency regimes rode the wave without GDP growth falling into negative territory. Then came the real event – interest rate rises in the US and the end of quantitative easing.
Even those countries that did have recessions – Brazil had its longest and deepest ever economic contraction – passed the test. There was no banking or financial crisis. Banks continued to increase profits – never mind absorb losses. The sovereign lost its investment grade rating, but foreign direct investment more than financed the (shrinking) current account.
“We haven’t suffered a banking crisis in Brazil for more than 20 years, even though there have been many EM banking crises during that time – such as in Russia and Asia,” says Roberto Setubal, co-chairman of the board of directors at Itaú Unibanco. “Not many countries could see their GDP fall by 7% in two years and still have a solid banking system.”
There are even increasingly buoyant expectations about the perennial Latin American exceptions that “prove the rule” – Venezuela and Argentina.
But if we leave those two countries outside the hypothesis of resilience, is this swelling confidence any less misplaced than Fukuyama’s proved to be?
The region’s response to 2008 was a watershed. While the developed markets’ financial systems remained frozen, Latin America’s economies and domestic capital markets rebounded with vigour. Chinese demand meant those commodity revenues continued. Banking systems across the region were strong, well-capitalized and de-risked ,and so stood isolated from the turmoil wrecking others.
“The region suffered a blip in 2009 when commodity prices fell, but they recovered in the short term,” says Felipe Larraín, Chile’s finance minister. The country had been the role model for the Pacific Alliance countries and it had built reserves, sovereign wealth funds and strong fundamentals during the good years that made it – and its followers – respond well to the crisis.
“Some of the countries – particularly Pacific Alliance countries like Mexico, Chile, Peru and Colombia – had learned from their earlier crises, and in this century they have had much better policies,” says Julio Velarde, president of Peru’s central bank since September 2006.
“Specifically, sustainable macro policies and flexible exchange rates that act as a buffer. These countries are also concerned about the yields of their bonds, so they have been more responsible in fiscal terms, and in monetary policy most have become inflation targeters.”
Also, very simply, there was less debt in the region in 2008.
Former Colombia finance minister Juan Carlos Echeverry
“First, [Latin American countries] were not over-indebted,” says Juan Carlos Echeverry, who was finance minister of Colombia between August 2010 and September 2012.
“Second, if there was debt it was in local currency, so the exchange rate didn’t kill firms and governments. There had also been a build-up of countries’ international reserves, so the attack on the currencies was not that large. And there were at that time some countries already floating exchange rates.
“And, of course, China,” Echeverry continues. “The Chinese economy kept growing and the price of commodities increased in 2009 and 2010 and 2011. So, we had domestic reasons but also the fact of that a bipolar world, where China was the rising star in the global economy and being a large vacuum of demand for commodities for Latin America, helped the region weather this crisis much better.”
Echeverry also says that the quality of policymaking improved throughout Latin America and most central banks are now managed by very competent people.
“The Latin America of this century is quite different from last century, and you have to give credit to many people that made that the case,” he says.
Pedro Pablo Kuczynski, a financier in New York during these years, who would later become president of Peru, agrees: “The Washington consensus meant that the Latin American countries hadn’t borrowed so much, and, second, debt default memories were still relatively fresh. Banks didn’t want to lend them that much.
“And the credit rating agencies’ focus on exchange rate risk had led it to become very fashionable to lend domestically, in local currencies.”
The lack of fiscal discipline in countries like Brazil and Argentina is related to populist governments being in power when there are very favourable terms of trade for the country - Domingo Cavallo, Argentina
For the first time the Washington consensus saw many of the economies – Peru, Mexico and Colombia – embrace free-floating exchange rates that handled the stress of falling demand. The governments and their private sectors had most of their outstanding debt in domestic currency; therefore, there was no run of defaults. Banking systems registered some uptick in non-performing loans and rating agencies produced rather dry reports pointing to slightly lower credit quality and increased provisions. There was no crisis.
“The main reason that Latin America could survive in that manner [in 2008] was because the macro environment in the Latin American countries was very good,” says Luis Enrique Garcia, former executive president of Latin American development bank CAF. “Most countries had low public deficits and, on the external side, the level of international reserves was high compared to the past and there was not a debt issue like we had in the past.
“The fact is now we are having lower rates of growth – so the big challenge is how you restore reasonable rates of growth, above 4% or 5%. And at the same time, that needs not only to be growth because of the increase of the external markets in terms of the price of commodities and demand from China. But to really move to a competitive advantage the questions are: how you improve technology? How you have higher levels of productivity? How you invest in areas that are critical, such as education and institutions? And how you attract direct investment precisely to move in that direction?”
The region’s strong response to 2008 is expected to be repeated in today’s challenging economic environment.
Velarde says of the Peruvian economy: “It sounds presumptuous to say we’re not going to be affected, but the impact is not going to be as strong [as in past US rate increases], because the Fed has improved communication, and we have been growing for 20 years now without a recession.”
Cavallo argues that the basis for many of these reforms, the so-called Washington consensus, was in reality a “Latin America consensus”. In his book, ‘Argentina’s economic reforms of the 1990s in contemporary and historical perspective’, he argues it differs from the “so-called ‘Washington consensus’, it did not originate in Washington, but in the political and economic centres of the countries that suffered from stagflation and hyperinflation”.
Perhaps more tellingly, as he points out to Euromoney in his Buenos Aires office, that consensus was easily broken.
“First the Mexican crisis, then the crisis in Venezuela and then Argentina’s in 2001 and 2002 discouraged many reformers,” he says. “Some countries continued to do the reforms, but others started to reverse.”
He argues that the commodity-boom decade would come and help all countries grow, but those that had abandoned the reform agenda lost ground and, crucially, time, which poses a real risk for the rebirth of financial crisis in the future.
All this talk of resilience unquestionably relies on the agreement that the crisis ravaging Venezuela is placed outside this discussion, although there are many who are optimistic about the speed of the country’s recuperation should president Nicolás Maduro exit the stage and allow the international community to bring in aid and financial support for a new regime.
However, it is less of a given that Argentina should be granted such an automatic exemption. And having a country that just signed the IMF’s biggest-ever rescue package ($57 billion) last year doesn’t boost the “end of debt crises” hypothesis. Let’s not also forget that in February the IMF agreed a $4.2 billion fund to stabilize Ecuador’s financial position.
So just the one humanitarian crisis and two IMF interventions in Latin America at the moment; but the rest of the region has been transformed. Hasn’t it?
Engine of expansion
As Setubal points out, there has been no financial or banking crisis in Brazil since the adoption of the Plano Real in 1994. The country is emerging from a deep recession with a new government that has a very liberal economic agenda, driven by a Chicago-trained economics minister, Paulo Guedes.
Forecasts for growth are sound if unspectacular, but there is growing excitement that Brazil will be the region’s engine of expansion in the coming years – both economic and financial.
Investment bankers in New York express confidence in the capital markets pipeline that will boost regional fees in DCM, M&A and ECM. Bankers in the country expect growth will feed into development in private banking wealth, while asset managers see a wall of money coming from fixed income investments to unleash cheaper financing for investment. The pain has been endured, the future is bright.
But not all are convinced. Cavallo casts a sceptical eye to his neighbour.
“The difficulty is how you get the political support to implement the reforms that will bring expenditure down,” he says.
Domingo Cavallo, Argentina’s reformist finance minister between February 1991 and August 1996
Cavallo’s assessment is not unique by any means. Setubal also expresses doubts.
“I am cautiously optimistic about the reforms,” he says, “which means we will probably have OK reforms that will be enough to keep going fiscally for the next four or five years. They won’t solve the problem for ever; there will need to be more in the future.”
Ricardo Lacerda, founder and chief executive of BR Partners, is less optimistic.
“Something will get done, but it is going to be the usual Brazilian compromise,” he says. “It won’t be perfect because they won’t get the vote ,so it will be something right at the level to avoid bankruptcy.”
The interesting thing about Cavallo’s scepticism is that it is based on a reading of Latin American history rather than any specific interpretation of the current dynamics of Brazil’s politics.
His view, formed from his first-hand attempt to reform Argentina’s economy away from a populist towards a more orthodox footing, is that it is almost impossible to cut social security programmes that have become entrenched.
“The lack of fiscal discipline in countries like Brazil and Argentina is related to populist governments being in power when there are very favourable terms of trade for the country,” he says. “Once expenditure increases, it is very difficult to bring it back down. You can only do that with very difficult reforms like the one we did in the 1990s, with privatization, de-regulation and reducing public employment.”
At the time Cavallo privatized more than 200 state enterprises. He says that he was only able to implement such radical reforms because of the success of the convertibility plan that he introduced in 1991. It brought down inflation from more than 3,000% in 1989 to 3.4% in 1994.
That stability created the political capital to push through those reforms.
“We could only pursue these policies because of the stability – we went from hyperinflation – and so the people were supportive of any kind of reform that was presented as a reform that was needed to continue stability,” he says.
And even then the political capital expired. The high unemployment created by the plan (the rate rose from 6.1% in 1991 to 15% in 2000 as the fixed exchange rate increased foreign price competition and local firms laid-off workers) began to feed into a crime wave (income distribution worsened) and Argentine society tired of the side-effects.
The Volcker shock was the spark, but you had all the explosives set throughout Latin America as countries over-borrowed in eurodollars because there was a boom in commodities and oil - Juan Carlos Echeverry, Colombia
Cavallo was replaced in 1996. The convertibility plan, which was always meant to be a temporary measure, continued until its rigidity led to collapse in 2001.
Ironically, Cavallo says that he would have ended the convertibility plan in 1997 had he remained in power.
“The Asian crisis brought in huge capital flows to Argentina – our risk premium was lower than Brazil’s and as low as Chile’s. If the peso had been floated then, it would have appreciated and then that would have had the effect of reducing some of that liquidity, which ended up being a problem because the lending encouraged risks that should not have been taken – particularly at the provincial level.”
However, Cavallo’s wider point is that without a crisis – and then the introduction of stability – there isn’t the imperative to embrace painful reforms that will ultimately prevent a crisis. He also points to the painful attempts by Argentina’s president Mauricio Macri to cut the country’s fiscal deficits as part of this structural problem.
“During Kirchnerism they expanded the number of people eligible for retirement payments to six million from 3.5 million and the cost of social security went from 6% of GDP to 10%,” he says. “How do you then reduce that 4% of GDP?”
Argentina also had huge subsidies that Cavallo argues had become almost accepted as entitlements. And when Macri’s policy of gradualism failed and international investors lost faith in the reforms, the peso collapsed and inflation spiked again. With an election looming, Cavallo believes there is a real danger the population might see recession and inflation under Macri as worse than inflation and subsidies and vote for the opposition, which would undermine the attempt to move the country away from populism.
Unable to cut government spending, Macri has raised taxes. Cavallo argues these are distortive, hit the economy’s efficiency and prevent investment and growth. It is a hellishly difficult problem to unpick and, crucially, Macri didn’t have the backdrop of a crisis to win political capital by ushering in stability. On the contrary, he managed to avoid a total collapse of an economy teetering on the brink and saved the previous government from being branded as responsible for the economic damage it had wrought on the economy.
“Once an economy is disorganized by governments spending too much and financing that spending with distortive taxes, it is a very difficult political act to move towards the reasonable fiscal policy that is necessary in order to implement a monetary policy that will help to reduce inflation,” summarizes Cavallo.
While Brazil’s banking system is solid, the country’s finances are not. The government’s debt burden rose quickly in the last decade – and particularly in the second administration of Dilma Rousseff.
The country’s debt-to-GDP ratio is now 77%. And although the fiscal deficit has been shrinking, there it is still a deficit. Goldman Sach’s Brazil economist, Alberto Ramos, expects that the country’s debt level will exceed the “disquieting” level 80% of GDP before stabilizing.
“This leaves the fiscal picture and the economy at large vulnerable to adverse domestic and external shocks,” he says, adding that “at the end of the fiscal consolidation process we estimate that Brazil needs to end up with a primary surplus of 3% to 3.5% of GDP. This would be the level of primary surplus that would put gross public debt on a clear declining trajectory, something that is required for Brazil to rebuild fiscal buffers and regain room to use fiscal policy counter-cyclically, whenever needed and appropriate.”
There is little expectation of reforms that will lead to such a huge fiscal surplus anytime soon and so the situation continues to be precarious.
Ultimately all crises are debt crises. The LDC crisis of the 1980s is the region’s most famous example.
“All the petrodollars of the 1970s were being recycled through the banks, and the banks were basically being told by the US and other G7 governments to lend to the emerging markets,” says Bill Rhodes, who became one of the central figures of the Latin American debt crisis in the 1980s and who chaired most of the bank restructuring committees while working for Citibank.
“Of course what you got was a lot of over-borrowing by the countries and over-lending by the banks that contributed to this tremendous inflationary spiral, particularly in the US. When interest rates increased, it hit all those countries that had borrowed heavily.”
According to the Institute of Latin American studies, between 1975 and 1982 Latin American debt to commercial banks increased at a cumulative rate of 20.4%. This level of expansion led Latin America to quadruple its external debt from $75 billion to more than $315 billion in 1983 – equivalent to 50% of the region’s GDP.
That build up was, of course, unsustainable. But then Paul Volcker, as chairman of the US Fed, raised US interest rates to combat domestic inflation – nearly doubling the US rate to 20% in March 1980.
Debt servicing for the region surged – reaching $66 billion for the region by 1982, up from $12 billion in 1975. The commercial banks turned off the taps and in 1982 Mexico was the first domino to fall.
Mexico was first because large oil discoveries in the 1970s increased Mexico’s ability to borrow and so its problems servicing its debt were more pronounced than in other Latin American countries.
“Mexico was the one that blew the top off,” says Rhodes. “It couldn’t service its debt but the contagion spread throughout Latin America – as well as parts of Asia, eastern Europe and Africa.”
Echeverry says: “The Volcker shock was the spark, but you had all the explosives set throughout Latin America as countries over-borrowed in eurodollars because there was a boom in commodities and oil. Mexico was overinvesting in infrastructure, Brazil as well, Argentina too. They were the roaring 1970s. So Volcker was the spark, but you needed both: the spark and the explosive levels of debt.”
Could Brazil be heading to such levels of unsustainable debt?
Setubal points to the fiscal ceiling that the previous Michel Temer administration brought in as a reason to be confident that a fiscal and debt crisis will be avoided.
“An important thing was done by [previous finance minister Henrique] Meirelles when he introduced the government spending ceiling,” he says. “That is basically leading everything. You have the country’s constitution saying that the federal government can’t increase spending above inflation. That’s a huge change, and it would be harder to change that constitutional ceiling than it would to do pension reform. So that creates legal pressure to do the pension reform and for privatizations.”
It is certainly true that the Jair Bolsonaro government will need to be disciplined to meet this spending cap in the near term. While compliance in 2019 looks straightforward, the straight jacket it places on the government in the following years will require success in pensions and minimum wage reform – and still further cuts to discretionary spending as soon as 2020.
It will also constrain the government’s ability to invest in areas that need capital, such as infrastructure, health, education, sewage – the list is huge.
Guedes’ aim is a Cavallo-esque programme of privatizations. But it is far from clear that the coalition in government has the appetite for wholesale disposals of state assets. It would likely require a reduction in public employment at both the federal and the state level. And it also presumes that state development bank BNDES can step back and leave the private sector to provide longer-term finance.
These are all precarious assumptions. Which leads to the question of what happens if that cap is breached?
Perhaps it is instructive to look at the episode of the Plano Real. The plan was a solution that had never been tried before – either in Brazil or anywhere else in the world. Pérsio Arida, one of the architects of the plan that was implemented by finance minister Fernando Henrique Cardoso, went on to become the president of the central bank under Cardoso’s subsequent presidency.
“It was a paper I had written in 1983 with economist André Resende 10 years before we would have a chance to implement it,” says Arida. “It was a uniquely Brazilian solution to a situation we had in Brazil that was in many ways unique. In all hyperinflation situations you have fiscal imbalances, but we had very specific issues such as the computational capacity of the banking system that needed to be taken into account.”
Rather than saying we are a model for Latin America, I would say that we have some economic rules and institutions that are respected throughout the region - Felipe Larraín, Chile
At the heart of the Plano Real was the creation of a parallel currency, the URV, which was always worth $1 and conversion with the existing currency was provided daily. Contracts were denominated in this virtual currency. Bonds were indexed to the URV.
The Brazilian population and businesses became accustomed to this URV being worth $1 so that when the real was finally introduced to replace the cruzeiro there was a sense of valuation stability.
The plan’s success was amazing. Arida’s initial paper had foreseen a need for the URV for two years prior to the implementation of the real. After three months, the economy had moved to all contracts using this virtual currency.
“Clearly the idea was embraced by the people,” says Arida. “No one really understood the trick – how can inflation go down to zero straight away? It worked like a miracle and people still don’t really understand it.”
But as successful as it was, the chance to complete the structural platform of the economy was lost. Monetary policy was doing too much work (a constant to this day) and the financial team knew this.
They tried to implement social security reform that would have kept fiscal spending in line with GDP growth. It lost by one vote. So even with Cavallo’s ‘stability honeymoon’, Brazil failed to adopt the necessary reforms.
“The ideal economic combination is a very simple one: loose monetary and very tight fiscal policy,” argues Arida. “Most of the time we have it the other way around.”
Had Brazil made those reforms, the steady debt build-up that is now a weight around its neck would probably have been avoided. Brazil would be like Chile today. Guedes was open in his admiration for Chile’s economic model during the Brazilian presidential election campaign. He even, somewhat confusingly, endorsed the adoption of a capitalization pension scheme as the solution for Brazil’s huge pension liabilities.
There has been lots of talk about Brazil’s new pension laws, but perhaps no conversation as important as the one that Chile’s finance minister, Larraín, had with Bolsonaro in Davos in January.
Felipe Larraín, Chile’s finance minister
“I had the opportunity to speak with him and he clearly realizes that the problem in Brazil is fiscal, and that the fiscal deficit will not be addressed unless structural reforms are done, and part of that means pensions reform,” says Larraín.
The Brazilian delegation to Davos was very interested in the Chilean model, including its most recent reforms. Chile has adopted a capitalization model, essentially a defined contribution (DC) system where individuals have individual accounts. That could be a future model for Brazil, but as Larraín points out, transitioning to such a system does not address the fiscal liabilities inherited from the unfunded defined benefit system. Without addressing this issue, Brazil will continue to build up its debt-to-GDP ratio and it may lead to a crisis of confidence in the currency.
“We could move to this system because we have a fiscal surplus in Chile,” he says. “This has lots of benefits for the financial sector in terms of deepening the financial markets and the roles of institutional investors. There are many good benefits in having a DC, but how would Brazil fund the transition because if you take away the contributions of people who are currently working [from paying current retirees], you are going to increase the fiscal deficit in the long term.”
That is just one example of why the Chilean model is an aspiration rather than a template. Chile never had to tackle a stock or flow debt problem like Brazil and its other Latin American neighbours. It is easy to be disciplined fiscally if you aren’t paying interest on a mountain of debt equal to 70% of GDP.
Chile’s new pension reform does not include minimum ages for retirement – a key expectation of the markets for Brazil’s – because it is designed not to need it. Instead it incentivizes Chileans to remain in the workforce with additional government pension contributions for those delaying retirement.
In short, Brazil will need to ape Chile’s discipline, not its rules, but it sounds like Larraín helped to move Bolsonaro to that understanding.
“Rather than saying we are a model for Latin America, I would say that we have some economic rules and institutions that are respected throughout the region,” says Larraín. “I think that’s clear from the way we were received in Davos.”
Chile also shows the counter-intuitive logic that headwinds can be more favourable than tailwinds.
“Chile suffered a very significant deceleration between 2014 and 2017 – growth was barely 1.7% during that period,” says Larraín. “Our analysis was that two-thirds of that deceleration was caused by local factors and only one-third from international factors. Tailwinds help you ride your economy and headwinds make it more complicated, but although a favourable external economy makes life easier, success depends on preparing the economy for when things don’t go so well.”
We’re not out of the woods yet, but I think we are laying the groundwork for a boom that could last for years. The main challenge isn’t surviving this bust, it’s administering the next boom - Argentine official
Chile did this. It is diversifying its economy. It is developing very deep local markets – more than 80% of debt is local, it has hedged some hard currency exposure and it is extending its debt maturity profile. It is integrating its economy with local blocs (the Pacific Alliance) and international alliances (the Trans Pacific Alliance). It is controlling public debt and making reforms to fiscal programmes to make them affordable.
Contrast this with periods of easy money. The first in Euromoney’s history was the LDC crisis that was preceded by the easy money of the 1970s. Oil shocks and petrodollars were washing around the international banking system. Emerging markets – and Latin America in particular – were suddenly awash with this liquidity.
CAF’s Garcia was an official in the government of Bolivia at the time.
“Petrodollars played a key role in the 1970s,” he says. “It was very easy for countries to go through the commercial banks to borrow money. Bankers were coming to Bolivia and saying to us: ‘Why do you bother going to the World Bank, the IDB? They ask for too many things. We can provide you with a lot of money in a way that is much more flexible,’ and that was the way countries did it.”
Those things that the commercial banks didn’t pay much attention to at the time were credit analysis and cash-flow projections regarding the ability of the lender to repay principal and interest. The money flowed despite low interest rates and high inflation. In many cases real interest rates were negative, so the nominal debt ballooned, with many countries increasing their hard currency debt by around 25% to 30% a year.
“In those times banks would syndicate loans and many banks participated,” says Guillermo Ortiz, partner and board member of BTG Pactual in Mexico, who at the time was an economist at Mexico’s central bank and would become governor of the Bank of Mexico between January 1998 and December 2009. “There were small banks – even regional US and European banks – and they didn’t really know to whom they were lending.”
Another time of easy money was the commodities boom, boosted by very low interest rates and quantitative easing programmes adopted by the developed markets’ central banks after the 2008 crisis.
What else can explain the extent of the scramble for Argentina’s paper when it returned to the capital markets in 2016? Before the roadshow even kicked off, $10 billion of orders had been received. The $16.5 billion deal would eventually see a book of almost $70 billion. The sovereign would tap 100-year debt soon after.
Some argue that liquidity reinforced a belief in the Macri administration that the international markets would finance the gradualism path to fiscal consolidation. It would be a fair conclusion – after all the gradualism was never a secret – but ultimately sentiment changed and the IMF had to come in and it forced the government to move more quickly.
That is why tailwinds can be more dangerous than headwinds. One Argentine official who, although he is working to get his country out of a recession, to create sustainable macro-policies and who faces a political challenge that could derail the past three year’s work, already considers this one of the biggest threats.
“We’re not out of the woods yet, but I think we are laying the groundwork for a boom that could last for years,” he says. “The main challenge isn’t surviving this bust, it’s administering the next boom.
If Brazil’s late embrace of reform caused it to have a dangerously high structural debt, then surely the rest of the Pacific Alliance, which has followed Chile down the orthodox path much sooner, are strong enough to avoid any crises.
Instead of talking about Latin America being immune to crises can we talk about the Pacific Alliance countries?
Perhaps not. There is already some unease about Mexico under its new president Andrés Manuel López Obrador (Amlo). Despite strong economic fundamentals and a well-regarded central bank, the fear about the one-way nature of fiscal expenditures is evident.
As one chief executive of a large Latin American bank tells Euromoney: “I think everybody is a bit apprehensive because the government is talking about changing policy. And we saw what happened with Brazil, right? It’s the problem of the frog in hot water. It changes slowly, slowly, slowly – and then you realize you have a problem and it’s too late.”
Another senior banker claims he has already heard disquiet from sources at the IMF – which has an $88 billion flexible credit line extended to the country – about the Fund’s exposure to Mexico given the policy direction of Amlo’s government in recent months.
“There is real concern,” he says.
Mexico is probably the best example today of the reason why no one confidently calls the end of debt crises in the region, even for the best performing Pacific Alliance countries. Because it isn’t economics that is particularly difficult, it is the intersection of economics with politics. And why is politics particularly difficult in Latin America? Inequality.
One of the reasons that populism flared in Latin America was because of the high levels of income disparity. The rich are surrounded by favelas. The best hospitals are for the few, with pitiful healthcare for the rest of its citizens. In Brazil, even the left-wing PT government misjudged the people’s desire for better services when it spent billions putting on a football tournament. The supposedly football-mad country protested.
The inequalities of virtually all Latin American countries create a structural weakness across the region that needs to be addressed just as much as the economic reforms that were ushered in with the Washington consensus.
The benign macro-environment for emerging markets that was created by the developed markets’ central banks is now turning. With zero or negative interest rates on offer in developed markets, investors searched abroad for yield. That search was amplified by the use of quantitative easing that increased the amount of money spilling into the emerging markets in search of positive returns.
This had a massive impact. For those that could use the capital productively it was a great source of cheap finance. For those like Brazil that still had structural inefficiencies, it exacerbated those problems. Brazil’s high interest rates were a magnet for a wall of inflows that pushed the real to R$1.5 to the dollar. It might have eased inflation pressures, but the country was uncompetitive.
It wasn’t just Brazil. All emerging markets currencies rallied, only to have sharp depreciations in the taper tantrum. Those flexible exchange rates helped again, but that liquidity is turning. Rising Fed rates and the reversal of QE have increased the financing costs for Latin American countries and companies.
With the US Fed suggesting to the markets that it might slow its interest rate rises, is it time to declare that the region has withstood this shift?
“The timing of monetary policy in the US is now better understood and anticipated, and therefore the region is better prepared to deal with that,” agrees Mauricio Cárdenas, Colombia’s finance minister between September 2012 and August 2018 and now a visiting professor at New York’s Columbia University. “Few observers expected major turmoil. Of course, you can never be too sure that things will move in a smooth way – as was evidenced by the taper tantrum – but I think the region is prepared.”
The other big risk is China. Its future growth rate is a topic of much speculation these days. While some are blasé – “Even at 5% growth rate, it still creates three Argentinas every year,” says one banker – others are cautious, especially in regards to externalities of growth and trade from the US/China trade conflict.
“The first possible channel is the decline in prices,” says Cárdenas. “The other two channels are less visible, but they could be quite damaging. The first is the effect of Chinese investment, and a reduction in this could be quite damaging for some Latin American countries. The other is that China has very significant production capacity and it could use that production to increase its presence in the LatAm markets through lower product pricing if its access to the US market is reduced. That could have competitive challenges to the local manufacturing sector.”
Rhodes also warns governments to be wary of interacting with China: “Nothing comes for free, and China is saddling some Belt and Road countries with a lot of debt, and often brings in its own workers, as well as making sure their products are bought.”
Rhodes points to Ecuador as one country in the region that has borrowed a lot from China and needs to be cautious that such transactions do not lead to financial and economic problems in the future.
But for things to really be different in Latin America this time, the region needs – as far as possible – to put in place the framework for withstanding events beyond its control.
Latin America has long proven what the rest of the world is now beginning to grapple with: that economics, finance and politics have a circular inter-relationship. Inequality reduces the credibility of established economics and populist politicians can capture disillusion and turn it into radical policies.
The region’s bankers understand this, perhaps more clearly than its politicians.
“We need to talk about reducing poverty,” says one senior capital markets executive at a leading international bank. “We did a lot of structural reforms in the 1990s and then in the 2000s, but with the commodity boom the region’s governments grew complacent. Then after the global crisis complacency grew again with zero interest rate international financing. Latin America now needs to refocus on structural reforms because these countries need to take their economies to the next level in terms of education and opportunities for poor people.
“Once you achieve the macroeconomic base that will take people out of poverty, you will have a stable base for the region that will regain the trust of investors – both local and international – by showing we have a structural reform agenda to make these countries competitive.”
There will only be an end to financial crises once there is political stability. And, despite Fukuyama’s optimistic prediction, that is still a long way off.
Bill Rhodes: The Brady bond banker
“It’s the same movie but with different subtitles,” says Bill Rhodes, settling into his chair in his large Fifth Avenue office as he discusses debt crises with Euromoney. “They all have their own characteristics, but there were many lessons that should have been learned from the Latin America debt crisis.”
Rhodes believes complacency lies at the heart of the subsequent exporting of debt crises from Latin America to Asia and then on to Europe.
Pictures of him at various stages of his lengthy career at the top of Citi adorn the walls of his office. Euromoney recognizes most of the people he is pictured with, presidents and world leaders of the last 30 or 40 years.
“The Asians thought they were different – that their economies were fundamentally more stable than what happened in Latin America in the 1980s. They were wrong in 1997 and 1998,” he sighs.
Rhodes points to the similar strains in Europe during the recent European debt crisis, affecting Greece, Spain, Italy and Ireland. “You had weak banking systems and significant over-borrowing and lending.”
Rhodes also began to warn about the build-up of debt and the likelihood for a correction in 2007. In this case it was securitization that masked the risks to the end buyers, rather than the participation of commercial banks in Latin America during the 1970s. But the end result was the same, a banking crisis that, unmanaged, could have sparked a global depression rather than a global recession.
His most recent prediction is for a US recession in 2020, which will be a problem because, with still-low interest rates in both Europe and the US and a lot of liquidity sloshing around from quantitative easing, the European Central Bank and the Federal Reserve won’t have the monetary policy flexibility they had in 2008. But his biggest concern is the amount of debt in China that he thinks is unsustainable and could cause a global economic crisis in the future.
“I have been warning about China for years,” he says. “Debt-to-GDP is over 300% and there has been huge over-lending to the state-owned enterprises, municipalities and the provinces. Some of the smaller banks with a lot of past-due loans should be put out of business.”
Rhodes recently returned from a trip to Beijing, where he addressed the heads of large banks about the role of culture and conduct in risk management in their businesses. The talk was organized by the People’s Bank of China, the country’s central bank. The trip seems to have reaffirmed his views on the country’s slowing economy and China’s desire to reach a trade deal with the US.
“The central bank is trying to cut the leverage of the financial institutions, but that is harder now than it would have been a decade ago because over the last 10 years there has been the growth of a huge shadow banking sector,” he says.
Guillermo Ortiz: The tequila crisis – whatever it takes
Becoming finance minister of a country in the midst of a financial crisis is probably one of the least desirable jobs in government, but it is one that Guillermo Ortiz accepted in December 1994 at the peak of Mexico’s infamous tequila crisis.
Just days before, the country had run out of reserves and had been forced to let the currency float, causing the peso to plunge.
Those first few weeks in office were punishing as Ortiz rushed to understand the magnitude of the crisis. In early January, Ortiz took a plane to New York to meet investors in an attempt to restore market confidence.
“We really had no solid plan to present, but we outlined what was needed in terms of the domestic adjustment,” he recalls. “But we hadn’t signed anything with the IMF, it was more a way to reassure the investment community that Mexico would do whatever it takes in terms of getting finance and adjusting the economy, and that we would honour our debts.”
The initial reaction was positive, but then the following day Mexico’s banks needed money and started buying dollars, and the peso volatility kicked off again.
“I remember I flew from New York to Washington and had lunch with the IMF and then had a meeting at the Treasury in the afternoon,” he says. “Mr [Robert] Rubin, who had been appointed secretary of the treasury hadn’t been confirmed, so there was an acting treasury secretary there, Mr [Alan] Greenspan [chairman of the Federal Reserve] and [under secretary] Larry Summers. So Greenspan asked me: ‘What do you need Guillermo?’ We started talking numbers, and I said: ‘Well, we need the full faith and credit of the US.’ He said: ‘Well you have our full faith’. So I said: ‘Well, we got half way very quickly – now we just need the other part.’”
That other part looked promising after then US president Bill Clinton agreed to guarantee Mexico’s debt to the tune of $50 billion. The snag was that it required congressional approval and that would only be granted with strings attached (such as cutting ties with Cuba).
It soon became clear that that solution was politically untenable. Instead, the US Treasury agreed to lend Mexico $20 billion from a contingency fund – a measure that did not require legislators’ backing – with Ortiz cobbling the rest of the money together from a variety of sources, including the IMF, the World Bank and the Inter-American Development Bank.
“We had to reach $50 billion because that was the magic number the market had in mind,” he says. “It was a brutal shock, a huge adjustment, but it worked.”
Julio Velarde: Averting crisis – lessons from the past
Latin America’s central bankers are no strangers to crisis. That has made them experts at snuffing out problems – even when those problems come from surprising sources.
Banco Central de Reserva del Peru’s Julio Velarde is one of the region’s longest serving central bankers, having been in the top job since September 2006. He had been at the helm for about a year when something strange started to happen. The subprime mortgage crisis had ignited in the US and, with investor cash looking for a new home, there was a sudden appetite for Peruvian assets.
“There was so much money flowing in that it was a real problem because you have currency appreciation,” Velarde says, sitting in his favourite leather armchair in a windowless office at the central bank in downtown Lima (Euromoney knows it is his favourite chair because we accidentally sat in it first).
“We were growing at almost 9%, real estate was jumping and prices were really increasing dramatically. Structurally, it created a lot of distortions, so stemming that credit cycle was very hard.”
Velarde lifted rates four times in 2008 from 5.25% to a high of 6.5%. Then came the collapse of Lehman Brothers and the ensuing financial crisis.
“I remember in October of 2008 going to the IMF; everybody looked like zombies,” he recalls. “I have never seen a situation when finance ministers and central bankers were like the walking dead, it was surprising. We didn’t need any money from the fund, but I thought we might have to ask; nobody knew what was going to happen. You knew what happened in the 1930s, and you didn’t know if it was going to be like that again.”
Velarde cut rates seven times in the first eight months of 2009, down to a low of 1.25% in August of that year, and Peru soon returned to growth.
So why does he think Latin America’s central bankers have become so adept at averting crises?
Velarde recalls Peru’s economic woes that started in the 1970s and continued into a period of hyperinflation in the 1990s when the then president, Alan García, cranked up the printing presses in a desperate bid to spend his way out of recession.
“GDP per capita fell more than 30% and it took more than three decades to recover to the levels of 1975,” he says. “People became poor; so after that you have a social consensus that you don’t want that situation to return again. So probably that is more important than the instruments – you need the consensus for good, stable macro policies.”
Pedro Pablo Kuczynski: The debt crisis – the view from Wall Street
Sometime towards the end of the 1970s, Pedro Pablo Kuczynski was sitting at a desk in the US writing one of his several editorials for Euromoney, “written out in longhand and sent via telex machine – those were in the days even before fax,” he says.
The theme was one of concern about the debt problem in his native Peru, from where he had fled in the late 1960s after a military coup. Borrowing in the Euromarket had dried up, he wrote, and about 65% of Peru’s roughly $5 billion of long-term debt was falling due over the next five years.
It was an ominous sign of what was about to unravel across Latin America.
“The crisis came with the rise in oil prices that began around 1979 or 1980. The banks found a way around IMF restrictions by creating something called an oil acceptance facility, which was a short-term loan that wasn’t counted in the debt,” recalls Kuczynski, sitting in the study at his home in Lima, surrounded by a lifetime’s collection of books.
Those oil acceptance facilities were renewable 180-day paper, he says wryly, and nobody really had a handle on how much was lurking out there.
“I remember being at a meeting in New York at the UN after Mexico had defaulted in 1982 and the World Bank said the debt of Latin America is really quite small. I said: ‘No, no, no. It’s $325 billion’. They said: ‘You’re wrong’, and I said: ‘No, I’m right, and the reason is you’re not counting all this short-term debt.’ A few days later the Federal Reserve counted the loans that all the banks around the table had made and it came to $325 billion,” he says. “It was just like in Greece, there was ignorance about how much the total debt really was.”
At the time of Mexico’s default in 1982, Kuczynski was back in Peru working in Fernando Belaúnde Terry’s government. The president wanted Kuczynski to be finance minister, but he could see the situation was going to be unmanageable. Instead Kuczynski took a job at First Boston in New York and watched the drama unfold from Wall Street.
“I knew things were really, really wrong when one of my former assistants at the World Bank, who had become a senior vice-president at Bank of America, announced a multi-billion-dollar oil acceptance facility for Mexico. I said: ‘Oh my god, now it’s going to blow up’ – and it did.”
Martin Schubert: Waiting on Venezuela
Before Hugo Chavez came to power in 1999, Martin Schubert was a regular visitor to Venezuela and one of the leading financiers to the country, structuring export finance transactions, bond deals, privatizations and other asset-based and swap financings. Schubert’s firm, Eurinam, worked with various Venezuelan administrations prior to the Chavez government, with which he refused to be involved.
Schubert is now a fascinated observer of the political situation in Venezuela. On the day he is talking to Euromoney, Juan Guaido has taken the presidential oath of office in a direct challenge to Nicolás Maduro. Schubert keeps breaking off the conversation to take phone calls from contacts on the ground.
Schubert’s interest is more than political. He represents a group of retail bond holders of defaulted Venezuelan bonds. Law firm Clifford Chance is the legal partner and the group proposes to use debt swap mechanisms similar to those Schubert was so involved with in the 1980s and 1990s to allow the country to re-access financing in the envisaged post-Maduro era.
He hopes to participate in the final restructuring with privatization bonds, oil bonds and other unique vehicles adding to the final settlement.
Schubert’s aim is to get a seat on the negotiating committee because of the volume of debt his group represents.
“We believe our knowledge of Venezuela and the ability to create new debt settlement instruments will improve the return to the investors,” he says.
Estimates of the outstanding debt usually hover around $65 billion, of which $28 billion is state oil company PDVSA debt and the balance is from the sovereign.
“There are people, like myself, who say this is very underestimated because there are substantial other notes and bonds, plus debt owed to Russia, China and Turkey, which brings the total debt closer to $140 billion.”
A Capital Economics note says that if Venezuelan debt relief follows normal rules, the debt write-off should be between 60% and 80% as its debt is 140% of GDP. Schubert will not comment on expected levels of debt relief but points to the large oil reserves and the extent of the potential for privatizations of state enterprises as a reason why an Argentina-style debt relief formula may not apply.
Schubert adds that he believes that there is a substantial amount of fresh money sitting on the sidelines ready to invest in a Venezuela after Maduro, which makes him optimistic about the speed of settlement and the value of the final settlement with creditors.
Pérsio Arida: The economic radical
Pérsio Arida understands all too well the difficulty of getting the Brazilian congress to pass social security reform.
Fernando Henrique Cardoso made Arida president of the central bank when he won the presidency at the end of 1994. The appointment was part recognition of Arida’s role in Cardoso’s victory – as architect of the ‘Plano Real’ that had dramatically cut the country’s hyper-inflationary economic environment – and part to ensure the next stage of the plan was properly implemented.
The Plano Real was a monetary shock, but Arida always knew that the country needed to grasp the fiscal nettle if the stability created initially by the plan was to be sustainable. Cardoso came close but, even with the momentum of the financial reform that had brought him to power, he ultimately couldn’t get his proposed pensions reform through the legislature.
So Arida’s cautious optimism about the chances of Brazil’s new administration is notable.
“You have a new government, a new congress and they should enjoy a certain honeymoon period,” he says. “The new government has been very surprisingly positive on its privatization proposal, so that is a good sign. The key issue though is, of course, social security reform. Will they come with a good proposal and what is the administration’s political capacity?”
Even without large-scale reform, Arida thinks Brazil should grow in the coming years.
“Brazil is in a cyclical recovery,” he says. “I think the economy will grow about 2.5%, everything being constant, which is the sustainable rate of growth. There may be more growth if [president Jair] Bolsonaro surprises on the upside, and less growth if the external environment deteriorates.”
With reforms, he thinks the sustainable rate – one which does not reignite inflation – is around 4%. But a lot would need to be done to get there: a commercial opening of the economy; widespread tax reform; and even immigration reform to counter the deteriorating demographics of the country.
The appetite of the new administration to tackle the first two issues is uncertain and the government is positively against immigration.
Arida is sanguine about the banking sector. His Plano Real caused a huge shock when it was implemented and the government and central bank pursued a careful policy of consolidation – encouraging foreign entrants and domestic mergers.
The banking system is now one of the most consolidated and profitable in the world, but Arida thinks that recent micro reforms (such as the financing rate of the country’s state development bank BNDES) are more important for encouraging credit growth than any regulation aimed at changing the macro dynamics of the financial system.
“Banking is a multi-dimensional problem,” he says. “The fact that you have five big banks is not bad nor points to excessive concentration as such, but clearly I think that the new fintechs that are creating competition in the financial industry will be very helpful.”