The last few weeks of 2015 are shaping up to be quite eventful for Latin America. On Wednesday, Dec. 16, the U.S. Federal Reserve announced that it would finally begin its much anticipated tightening cycle, placing greater pressure on Latin American monetary authorities to follow suit. On the same day, Brazil lost its investment grade rating from a second ratings agency (Fitch) and Argentina announced the removal of capital controls that had been in place since 2011. Meanwhile, other markets such as Venezuela and Ecuador are also facing down potentially destabilizing economic events that are likely to be exasperated by a prolonged tightening cycle in the U.S.
U.S. Federal Reserve raises rates, puts greater pressure on LATAM monetary authorities
Citing an improved labor market and inflation projections moving back toward its target level, the Federal Open Markets Committee (FOMC), the monetary policy arm of the Federal Reserve, made a unanimous decision this week to begin raising its target interest rate. The FOMC also signaled its intention to enact additional rate increases in 2016 totaling approximately one percent, with further increases totaling between 0.75 percent and one percent anticipated for 2017.
Movements in LATAM currencies following the announcement were subdued, as market actors had long anticipated the move by the Fed and were thus positioned accordingly. That said, moving forward it will be important for companies to understand the projected direction and speed of changes to Fed policy. FSG expects a continued tightening cycle in the U.S. to force Latin American monetary authorities to react in kind, therefore squeezing credit availability in these markets and putting greater pressure on the finances of consumers and business that are currently struggling in a down market. This effect can already be seen in Mexico, where the central bank raised its target interest rate on Thursday (Dec. 17) even though inflation is currently below the institution’s target range. The argument by Bank economists is that a mirror reaction to the Fed rate hike is necessary in order to smooth sustained currency volatility that has been afflicting the Mexican peso, which is the most traded emerging market currency in the world.
FSG will continue to monitor this situation, specifically its impact on consumer demand and business activity across the region, in addition to any potential effect on financial stability in more vulnerable markets.
Brazil loses investment grade rating from second ratings agency
On the same day that the Fed announced the beginning of its first tightening cycle in nearly ten years, the ratings agency Fitch divulged its decision to downgrade Brazil’s sovereign rating to junk status. Fitch is the second ratings agency to make such a move, following S&P’s downgrade of Brazil in September. The downgrade initially pushed the real down by two percent against the dollar. Fitch cited a deeper economic contraction than previously expected, in addition to elevated uncertainty regarding the country’s ability to reverse the deterioration of its fiscal accounts, as the drivers of its decision.
Much of the continued uncertainty surrounding Brazil can be traced back to the current political turmoil that has taken the country hostage. President Rousseff, who has been unable to pull together a sufficiently strong coalition to pass necessary fiscal reform, is now facing a potential impeachment that could push political paralysis well into 2016. Meanwhile, the president’s favored finance minister, Joaquim Levy, has just resigned following the government’s decision to further reduce its targeted primary fiscal surplus for 2016.
To make matters worse, the most recent downgrade, in addition to the beginning of a monetary tightening cycle in the U.S., will only serve to put further pressure on Brazil’s Central Bank to enact an additional rate rise in the beginning of 2016 as inflation expectations continue to shift upward. With Brazil already facing its longest recession in over 80 years, further monetary tightening would be particularly punishing for the overall economic outlook.
Argentina releases capital controls, Peso depreciates by 30 percent
In case the Fed’s rate hike and Brazil’s downgrade were not enough, on the very same day Argentina’s finance minister, Alfonso Prat-Gay, revealed the decision to release the country’s complex system of capital controls. The intention of the government, according to Minister Prat-Gay, is to administer a ‘dirty float,’ possibly intervening should devaluation of the Peso reach an extreme value, which would supposedly be defined by the government. The Peso opened Thursday (Dec. 17) trading down 30 percent against the dollar.
With Argentines now able to access dollars at will, FSG foresees increased pressure on the Argentine central bank to maintain an adequate level of reserves. However, Argentina expects US$ 15-25 billion in inflows over the next month to bolster its international liquidity position. The Argentine government is said to have negotiated a new loan worth between US$ 7-10 billion from U.S. lenders, which should be finalized within the coming days. Furthermore, the recent elimination of most export tariffs is expected to lift agriculture exports and help the government to bring in nearly US$ 6 billion in new tax revenue. Finally, the central bank has signaled its intention to convert the equivalent of US$ 3.1 billion in Chinese yuan into U.S. dollars in order to further boost its dollar liquidity. These initiatives, in addition to ongoing negotiations with business leaders to limit potential price increases, should help Argentina to prevent an exorbitant devaluation of its currency. That said, the various moves will have an economic cost as producers and consumer alike adjust to their new reality. While FSG expects a slowdown in the short-term, the elimination of trade tariffs and the end of capital controls should help to set the country on a path for a strong medium-term recovery.
Venezuela and Ecuador remain wildcards
Elsewhere, both Venezuela and Ecuador will require especially close attention moving forward. With the Venezuelan economy already expected to contract by nine percent in 2015, the country seems likely to confront significant political discord between the opposition and the government following an overwhelming mid-term electoral victory by the opposition coalition. In the case of Ecuador, while de-dollarization seems to be less likely now that President Correa is eschewing reelection, companies should remain on the lookout for growing economic imbalances in the lead up to elections in early 2017. Multinationals are advised to closely monitor the political situations in both countries carefully over the next year, as politics will dictate the direction of both economies as much as the state of oil prices.
Actions to take
Latin America is likely to experience yet another turbulent year in 2016 with economic growth remaining constrained by recession in Brazil and the pullback of the “three Cs” across the region: Chinese demand, commodity prices and cheap money. As companies go through their strategic planning process, it will be more important than ever to ensure high alignment between corporate, regional and country leaders while also building resilience against external surprises through sound scenario and contingency planning. FSG has developed deep expertise in both of these areas and stands ready to support. According to our own research, which our clients can access here, regional organizations with high alignment and resilience are more likely to exceed expectations for profitability and market share (99 percent confidence level).
Finally, companies should be aware of the changes that economic slowdown and volatility are provoking with regards to the market landscape, customer demands and operating environment across the region’s different markets. If you want to learn more about how leading multinationals are preparing for Latin America’s new business reality click here.
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