The turmoil in emerging markets seems all too familiar. In the late 1990s Russia and several Asian countries suffered a series of interlinked crises that stemmed from high fiscal deficits, large current-account deficits, and dollar-denominated debt. In 1994 Mexico got into trouble after it built up unsustainable dollar debts, and during the 1980s several Latin American countries were forced to default when rising US interest rates made it impossible to pay back their loans. No wonder, then, that when US interest rates rise and the dollar strengthens, investors are quick to ditch emerging-market assets. They are particularly wary about developing countries that combine high current-account and fiscal deficits – funded by dollar-denominated debt – with a dearth of defence mechanisms, such as a big pile of foreign-exchange reserves. That’s why Turkey and Argentina have been the principal victims of the sell-off.
But the rush for the exit has created interesting buying opportunities. Investors have tarred all the emerging markets with the same brush, yet their individual situations differ widely. In a moment of panic, all emerging markets move the same way, but over time capital will return to the solid, well-managed, growing economies. Prime examples are the four members of Latin America’s Pacific Alliance. This outward-looking trade bloc comprising Mexico, Colombia, Peru and Chile will reward long-term investors over the next few years.
A new Latin American trade bloc
With a combined population of around 200 million the Pacific Alliance represents almost 40% of Latin America’s GDP and accounts for more than half the region’s exports. Founded in 2011, the goal is to give member-country businesses access to a greater pool of resources, capital, customers and workers to build the scale they need to trade successfully with Asia. As the name suggests, the Pacific Alliance is intended to take advantage of the massive opportunities created by the “Asian Century”.
The majority of the world’s wealth and economic growth in the 21st century will come from Asia, and the Pacific Alliance is a way for these mid-sized Latin American economies to benefit collectively from this structural shift. Over the coming years closer integration between Alliance members will help drive growth. Since 2011 a succession of infrastructure projects, visa agreements and tariff reductions have boosted the movement of people and goods within the bloc. The creation of a shared stockmarket and standardised financial-sector regulation should increase inter-Alliance capital flows.
They survived the perfect storm
Laudable as the bloc’s joint efforts and achievements are, it’s the strong state of the member economies that will tempt investors. All four benefit from prudent macroeconomic management that ensures they are far more resilient to US monetary tightening than the likes of Turkey or Argentina – they’ve already been through worse and come through unscathed. Beginning in 2013, Peru, Chile and Colombia saw the prices for their major exports fall. First to go was copper, which at the time made up more than 60% of exports in Chile. Copper is also Peru’s top export and the pain was compounded when gold, its second-most important metal, fell too: more than 50% of the country’s exports suffered a double-whammy. Then in 2014 oil and coal prices tumbled, hitting Colombia’s two main exports.
[quote]they’ve already been through worse and come through unscathed…[/quote]
The plunging commodity prices were too much for Venezuela. But, in a testament to their macroeconomic strengths, the Pacific Alliance countries avoided recession. During the good times their governments had paid down debt, which meant they could comfortably run larger fiscal deficits to sustain growth during the commodity downturn. Years of prudent monetary policy, meanwhile, gave the Pacific Alliance’s central banks the firepower to combat the downturn. Unlike most of the developed world, the Pacific Alliance countries raised interest rates back to normal levels soon after the global crisis of 2008-2009. That meant they had room to cut rates when commodity prices tanked a few years later.
During the commodity downturn the Pacific Alliance members’ floating currencies devalued in line with the prices of the key raw material of each. That boosted the competitiveness of non-commodity exports and made imports more expensive – thereby acting as an automatic control on current-account deficits. What’s more, the Pacific Alliance countries had accumulated healthy foreign-exchange reserves. These can be used to repay foreign debts and prop up the local currency, precluding a rout. In Peru, where dollarised debt was relatively high, the central bank managed to control the depreciation, slowly bringing down the value of the currency and giving banks time to adjust to the new reality.
Why the Pacific Alliance is resilient today
Compared with the commodities downturn, this current “crisis” is a walk in the park. One key point is that none of the Pacific Alliance countries have dangerously high combinations of fiscal and current-account deficits. Based on 2018 forecasts, the combined fiscal and current-account deficits as a percentage of the Pacific Alliance members’ countries’ GDP are: Mexico 3.5%, Chile 4%, Colombia 6.3% and Peru 4.6%. Compare that with 8.1% for Argentina and 10% for Turkey. What’s more, in Peru, Chile, Colombia and Mexico, foreign direct investment is much higher than in Argentina or Turkey. That means a higher proportion of the current-account deficit is financed by foreign direct investment, or “real economy” projects, such as mines or infrastructure, rather than financial flows (“hot money”) that tend to retreat rapidly when spooked.
Another important factor is foreign-exchange (forex) reserves. When Marc Jones at Reuters crunched the numbers, he found that Peru’s forex reserves are worth more than 700% of its short-term debt obligations, Colombia and Mexico’s reserves are worth around 350%, and Chile’s more than 200%. However, Argentina’s and Turkey’s forex reserves stand at less than 100%. In other words, if the latter two countries were unable to raise more loans they wouldn’t be able to cover their short-term repayments with their existing reserves.
Finally, you have the private sector. One of the key factors in the Turkish crisis is that its banks have gorged on cheap foreign debt, which investors worry they will struggle to pay back with a devalued lira. But the Pacific Alliance members – indeed, most of Latin America – already had to deal with that challenge in the commodity downturn. As a result, it now has a deleveraged private sector. Edward Glossop, the Latin America economist at economic consultancy Capital Economics, notes that across Latin America “banks’ short-term external debt burdens are small, at less than 3% of GDP. That compares with rates of 10%-20% in much of emerging Europe prior to the 2008-2009 global financial crisis and 11% of GDP in Turkey today.”
Diverse and growing economies
Argentina and Turkey have good long-term growth prospects. But both need easy money to survive in the short term. And with global monetary policy tightening as the dollar strengthens, both will have more difficulties ahead. The Pacific Alliance members also have good long-term growth prospects. But the difference is that tighter monetary policy won’t cause them any major trouble in the short term. That’s why the current emerging-market sell-off is a great chance to buy into these economies on the cheap. For the Andean three of Peru, Chile and Colombia, rising commodity prices are the most positive factor. Copper, oil and coal may not have returned to the heights of the commodity super-cycle, but they have recovered strongly from their lows. Gold is up 14% from its 2015 trough, while copper has gained 30% and coal 100% since bottoming out in 2016. That’s powering expected 2018 annual GDP growth of 4.5% in Peru and Chile and 3% in Colombia. The commodity-price slide also prompted these economies to diversify, helping boost manufacturing and agroindustry.
[quote]the current emerging-market sell-off is a great chance to buy into these economies on the cheap…[/quote]
For example, in Peru the export of non-traditional crops – grapes, avocados and mangoes were the top three last year – is now worth almost $8bn per year, up from around $300m ten years ago. In Colombia a $70bn counter-cyclical transport infrastructure programme launched in the commodities slowdown is bolstering productivity. In Chile, a country that paid double the world average electricity price in 2011, a renewable energy revolution has brought down the cost of power from new projects by 75%.
Mexico has long had a diversified economy. It’s an industrial powerhouse that exports more manufactured goods than the rest of Latin America combined, while its oil and mining sectors have an abundance of world-class assets. This diversification meant it didn’t suffer as sharply from the commodity downturn. Instead, its main recent headache has been its northern neighbour’s protectionism, especially Donald Trump’s threats to unravel the North American Free Trade Agreement (Nafta). That potentially grievous blow has now been avoided with the recent Nafta renegotiation agreement between the US and Mexico.
Trump has claimed a victory on the deal, but it’s also good for Mexico. The stipulation that Nafta goods should contain more North American content helps Mexico in its battle against its key manufacturing rival in the US market – China. Moreover, the agreement ends months of uncertainty that were forcing Mexico’s central bank to maintain high interest rates in case of a run on the peso. It can now loosen monetary policy, giving a short-term boost to GDP that’s already expected to grow by 3% this year. More importantly, its energy reform, which is encouraging massive investment across the oil and gas and electricity sectors, will continue to drive growth in the medium to long term.
Long-term growth at a reasonable price
Critics of the Pacific Alliance often complain that little links the “Andean 3” to Mexico. Yet they share several characteristics that should drive economic growth across the Pacific Alliance. Peru, Colombia and Mexico are enjoying demographic boons; their labour forces will continue to expand over the next decade. They’re also still reaping the fruits of improving education systems, rising bank penetration, expanding capital markets and more efficient institutions.
Meanwhile, all four countries are ranked “investment grade” by the rating agencies and officially classed as emerging markets. That matters – just ask Argentina – as it means they can access a wider pool of investment capital. Many funds are not allowed to invest in frontier markets, Argentina’s official category until it regained emerging-market status earlier this year. Finally, as Alliance initiatives continue to improve economic links between members, increased integration will drive growth.
The Pacific Alliance is not perfect. There is a web of local regulation that tends to impede integration. For example, trading volumes on the new stockmarket, Mila, are stunted because of the different tax treatment of investors in each country. However, the rapid success in the last seven years shows the Alliance is moving in the right direction.
This compelling structural growth story, moreover, looks reasonably priced. The forward price-earnings ratios of key indices in the four markets range from 13 for Peru and Colombia to 17 in Mexico and 21 in Chile. At the end of July, the cyclically adjusted price-earnings (Cape) ratio for Colombia was 16.4. Chile and Peru’s were below 20, while Mexico was 22. As these markets have sold off since the research was published those scores will be even lower now. As a bloc they are far cheaper than the average Cape of 26 across developed markets. Put it this way: the combined GDP of the Pacific Alliance is roughly the same size as France’s economy, but with cheaper stockmarkets. Who do you expect to grow more quickly over the next decade?
A version of this article first appeared in MoneyWeek on the 21st of September.