Another Lost Decade?

August 18, 2020

The first in a series of articles that explore if Latin America is heading for a debt crisis…

In recent months Latin American governments have done whatever it takes to control coronavirus. And, despite some particularly fatal outbreaks in Ecuador, Peru, Brazil and Mexico, the public health threat is now receding in the region. But in its wake Covid-19 has left rising public debt. Every aspect of dealing with the pandemic, from building new hospitals to enforcing lockdowns, costs money.

The financial hit looks set to be particularly severe in Latin America. The IMF’s recent World Economic Outlook, pencils in a 9.4% economic contraction for the region in 2020 – its worst recession on record. Given that state lockdowns caused the recession, citizens naturally expect their governments to get economies moving again. And that means money. Job protections schemes, compensation programmes, new investment projects – governments across Latin America are spending heavily to counteract the economic crisis. But with fiscal receipts also hit by the lockdown – for example the half a million businesses that have gone bust in Brazil this year won’t be paying any more tax – governments have been forced to borrow.

The extra borrowing is pushing up debt-to-GDP ratios that were already too high and setting off alarm bells. After all the region’s last experiment with high debt ended with the disastrous ‘lost decade’ of the 1980s. In this sector special we explore if Latin America is heading towards another debt crisis.

Back to the future

When Mexico suspended payments on its debt in 1982, it triggered a wave of payment crises across Latin America. The biggest debtors were Brazil, Mexico, Argentina, Venezuela and Chile but smaller countries were also overextended and the region’s total debt pile, of around $315billion accounted for roughly 50% of GDP.

The defaults were triggered by rising US interest rates – between 1979 to 1980 the then Chair of the Federal Reserve, Paul Volcker, cranked up the benchmark rate to 20%. Unfortunately for Latin America most of the loans had been issued with floating interest that meant payments increased every time Volker pushed up US rates. But while US monetary policy may have been the immediate cause, the real problems began several decades earlier. By understanding the true causes of the 1980s debt crisis we can better evaluate Latin America’s position today.

The fundamental problem was Latin America’s lack of productivity. Since the 1920s it was obvious that despite patches of industrialisation Latin American countries couldn’t compete with international goods. A wave of post-war Latin American leaders responded with a new development model – import substitution industrialisation. The idea was that government support would help local factories produce consumer goods, so that Latin America wouldn’t continue trading raw commodities for developed goods from the developed world.

When Mexico suspended payments on its debt in 1982, it triggered a wave of payment crises across Latin America…

In the 1950s ISI appeared to be working, partly because it began with non-durable consumer goods, like textiles or shoes, that were relatively easy to produce. That success encouraged governments to proceed to more complex durable consumer goods. The flaws of ISI were masked by the buoyant world economy of the 1960s but the pressures were building. To protect locally-produced goods, governments placed high-tariffs in imported competition. This increased costs in the local market which spurred inflation as workers demanded higher wages. Meanwhile, protected local industry became less competitive as it no longer had to fight imported rivals. Finally, the push to produce more complex goods locally was counter-productive as it meant importing capital-intensive machine tools and plant.

By the 1970s the flaws were obvious but no government wanted to take on vested interests, such as the owners and workers of local subsidised manufacturers. Moreover, any correction would have involved short-term pain, which politicians are notoriously keen to avoid. Higher oil prices allowed exporters, like Venezuela and Mexico to carry on the party. Indeed, the high oil price meant Opec countries had more dollars than they could deal with domestically, forcing them to deposit cash with Western banks that promptly recycled the money into loans for Latin America. That cheap credit meant that even countries without oil were allowed to avoid a reckoning. Government spending grew and debt ballooned as the 70s drew to a close.

But when Opec overplayed its hand in 1979 with the second oil price rise in a decade, it forced the Fed to finally tackle US inflation. Interest rates were raised, causing a recession that sent oil prices tumbling. The strong dollar meant Latin American countries debts were worth more, while a commodity bear market hit their export earnings. By the end of the 1982 all major Latin American economies, bar Colombia, were negotiating new terms with their creditors.

Worse than the 1980s?

There are a lot of worrying similarities. The first is that, yet again, Latin America has headed into a crisis carrying lots of debt. The region runs consistent fiscal deficits, even during the commodity super-cycle at the start of the century. After the first quarter of 2019 the debt of the governments of Argentina and Brazil were worth 91.8% and 89.5% of their respective GDPs. Far higher than in the 1980s. Colombia’s debt was worth 51% of its economy, even worse than Mexico’s in 1982. With government debt totalling 53% of GDP in 2019 Mexico also in worse shape than it was back then. Indeed, the regional average of debt worth 70% of GDP in 2019, shows that Latin America went into the pandemic in poor financial shape.

The pandemic is rapidly adding more debt. The IMF predicts that 2020 will see Latin America debt rise to 81% of GDP. That will be led by Brazil, where debt will reach 100% of GDP, followed by big jumps in Colombia and Mexico. The growth outlook is equally depressing. In 2020 region’s two largest economies, Brazil and Mexico, are expected to contract by 9.1% and 10.4% respectively, creating a deeper recession than in 1982, when regional GDP fell by less than 2%.

The IMF predicts that 2020 will see Latin America debt rise to 81% of GDP…

“This time it’s different” is probably the most dangerous phrase in investment but there are some crucial differences this time. The most important is that Latin America is more democratic this time around. The last debt crisis was handled by out-of-touch dictatorships in Brazil, Argentina, Chile and Mexico, now they have all been replaced by elected governments. Another difference, perhaps linked to that accountability, is that barring notable exceptions such as Venezuela and Argentina, most Latin American economies are better managed than they were in the 1980s. They are open economies, with floating exchange rates that allow them to react to external shocks. Local capital markets are deeper and more sophisticated, which means that most of the state debt has been issued locally. That removes the danger of depreciating against the US dollar. They have also built up high reserves of foreign currency to cover external debt obligations.

External factors also look more positive. The trigger for the 1982 crisis was rising US interest rates. Yet with trillions of dollars of liquidity being pumped into the global economy that threat is not on the horizon. It also helps that most of Latin America’s sovereign bonds now have fixed interest rates. Another crucial difference are international commodity markets. In the 1980s both oil and non-energy commodities fell sharply and didn’t recover for a decade. During this pandemic key metals, such as copper where Latin America is the largest producer, and gold have risen. After an early scare, even oil has recovered and is back above the $40 mark.

The final cause for optimism is that even crises can bring positive changes. The debt problems of the 1980s ushered in a period of democracy. Nothing so dramatic is needed this time – apart from in Venezuela and Nicaragua – but there are already signs that the financial pressures will lead to reforms, such as tax changes in Brazil. In coming articles we will explore if Latin America is on the verge of another debt crisis or if it really is different this time.