Friday, 18 January 2019

When a boom turns to bust

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  • An aerial view of Anglo American’s Los Bronces copper mine with several glaciers in the background at Los Andes Mountain range, near Santiago city

The Andean nations of Colombia, Peru, Chile, Bolivia, Ecuador and Venezuela have many similarities, not least their economic dependence on commodities. Yet there are equally important differences, ensuring some will fare better than others if prices remain at low levels

While the collapse of the commodities markets has not yet tipped the Andean region into all-out crisis, the resulting loss of earnings has left it with an economic mountain to climb. The region has made great strides on the macroeconomic front, but has much to do to diversify away from commodities and increase productivity and growth.

Falling prices in the commodity markets have taken their toll on all the nations of the Andes, undermining their export revenues and weakening their external accounts.

Peru derived 69% of its external revenues from commodities in 2014; for Colombia it was 64%; for Bolivia 79%; for Ecuador 78%; and for Venezuela 94%, according to Fitch.

With less money coming in, governments of these countries have all have felt a pinch in their ability to invest domestically, be that in infrastructure projects or providing social safety nets for their citizens. With around 2% growth, countries such as Peru and Colombia are feeling the squeeze, with lower job creation and a gradual erosion of their finances.

Yet the region as a whole has proved relatively resilient in the face of this pressure.

“Falling prices have not created a crisis for the Andean region yet. Only Venezuela has been downgraded, Peru, Ecuador and Colombia are all stable and Bolivia was only upgraded recently. African commodity exporters have seen more negative actions due to the commodity price shock,” said Erich Arispe, an analyst at Fitch.

Indeed, Colombia, Peru, Chile and Bolivia can all be described as economic success stories to differing extents. All have overseen falling inflation and managed debt well, with broadly positive fiscal and monetary policies in recent years.

The key to the success of at least some of the Andean nations has been fiscal responsibility. As with many emerging markets with memories of the crises of the 1980s and 1990s, some have built up reserves of cash that are serving them well in a year of falling commodity prices.

Poster child: Chile

Chile is the poster child for this approach. Its Economic and Social Stabilization Fund was created in March 2007 and is highly institutionalised, with rules governing when and how the money can be used. Successive governments have respected the rules around the ESSF.

Last year, Colombia followed Chile’s lead and created new fiscal rules requiring it to run a tighter policy in boom years, allowing it to loosen the purse strings in leaner years, balancing over the cycle.

It has not yet managed to create a significant war chest, but is already winning praise from rating agencies such as S&P for its commitment to economic prudence. And the countercyclical nature of the fiscal rules mean falling commodity prices unlock greater resources for investment, smoothing the deficit from falling oil sales.

Jan Dehn, head of research at Ashmore, said: “Colombia is the most sophisticated economy in the region in terms of the development of its manufacturing, services and banking sectors. It has high literacy and higher newspaper sales per capita than its neighbours. It has excellent policies and a strong central bank – and it has done for years. Its problem was having to live down a terrible reputation it earned in the 1980s.”

Bolivia, a country unlike Chile in many ways, has sought to replicate Chile’s commitment to saving in a more informal way, setting aside around 15% of its GDP, though not in a formal fund, and with no rules dictating how the money can be used.

And with a savings rate of 12% of GDP, Peru has also been in a relatively strong position to weather the storm in the copper market.

“The copper shock came earlier than the oil shock, but Peru has had no problem accessing markets,” said Juan Lorenzo Maldonado, LatAm economist at Credit Suisse.

“Chile and Peru managed their finances well during the boom years and are good examples of how to implement sound, countercyclical policies. They could not avoid the pain of the adjustment entirely but it has had less impact on their ability to finance themselves,” Maldonado said.

Joydeep Mukherji, managing director for sovereign ratings at Standard & Poor’s, said: “Countries like Chile, Bolivia and Colombia demonstrate that governments have the capacity to change their situations. Big commodity exporters can protect themselves from volatility and change their future. Chile’s success is no accident. Copper prices are down but the country is still in good shape.”

The great divide

All stand in marked contrast to countries such as Ecuador and Venezuela, which neglected to save money when commodity prices were high.

“In South America there is still a big divide between capitalists and socialists, it’s like the Cold War is still going on. It’s the result of severe income inequality,” said Dehn. Among the Andean nations, Colombia, Chile and Peru fall on the capitalist side of the divide, while Bolivia, Ecuador and Venezuela lean more towards socialism.

Venezuela’s case is the most extreme, the country having experienced shortages of food and household items even when the oil price was high.

“Venezuela is a real tragedy,” said Dehn. “It ought to be as wealthy as Norway, but it has nothing to show for its oil boom. The windfall was all stolen or wasted on consumption. There was no investment. Maduro does not have the charisma or political skill of Chavez, he will lose the upcoming election and Venezuela is in for a painful adjustment.”

Things are a little less clear cut in the other Andean countries. Ecuador ’s use of the US dollar gives it no exchange rate or monetary flexibility, in stark contrast to neighbours such as Chile, Peru and Colombia. The considerable depreciation of those countries’ currencies this year, especially against the dollar, has acted as an economic shock absorber, which has been markedly absent in Ecuador’s case.

However, in Rafael Correa, Ecuador does have a successful president, who has kept markets broadly on-side. It had been a difficult start to their relationship, with one of the first acts of his presidency being to default on two sets of government bonds, issued in the 1980s. However, markets soon warmed to him, as he proved to be an effective leader in a country – and a region – where it can be difficult to get things done.

Dehn said: “Ecuador was essentially run by two interest groups on opposite sides of the political spectrum: the export lobby and the public sector unions, especially teachers’ unions. Between them they made public finances unsustainable. Correa is the authoritarian leader who neutralised these interest groups.”

“Venezuela is a real tragedy. It ought to be as wealthy as Norway, but it has nothing to show for its oil boom. The windfall was all stolen or wasted on consumption. There was no investment”

Correa has been successful in attracting financing from China, from which it secured a US$7.5bn line of credit earlier this year. And Ecuador has also come up with creative ideas to raise capital, for example a tax amnesty in May, forgiving all interest, fines and additional charges for those that paid their tax. This raised a lot of revenue for the government and increased Correa’s credibility with investors.

Neither is Bolivia’s case black and white. While it has not traditionally been synonymous with speedy growth, it has been the second-fastest growing economy in Latin America this year – after Panama – at around 4%.

As in Ecuador, part of the credit goes to the personal quality of its president. “Evo Morales has also done a good job, building up a big cushion of FX reserves and keeping debt low relative to GDP,” said Dehn.

However, the fear is that while Ecuador and Bolivia have relatively good leaders now, nobody knows who will ultimately replace them, or how competent and market-friendly they will be. This gives longer-term investors pause, and illustrates a broader problem in the region.

Dehn said: “The tragedy of the region is that since securing freedom from the Spanish, its attempts at creating political pluralism have usually resulted in weak governments and political and economic chaos.”

”Colombia and Peru have managed to overcome this democratic deficit,” said Dehn, because they “had drug-financed oppositions that had to be defeated militarily, which then created the space for modern political parties to emerge”.

Ecuador, Bolivia and Venezuela, by contrast, never had that, and hence have been left to be ruled by strong, populist, authoritarian leaders.

“Their fate is therefore tied to the quality of these leaders rather than the quality of institutions,” said Dehn.

An institutional deficit

The region badly needs reforms to strengthen its institutions.

“Institutional weakness is a theme for the region, undermining its capacity to respond to crises and implement reform,” said Arispe. “You can have a five-star economy, but reform will not be possible if there is no institutional framework to facilitate the process.”

This is even true in Peru. “Peruvians have zero loyalty to politicians or parties, and that means there is constant change which makes it hard to implement structural reforms,” said Dehn.

For example, Ollanta Humala and the Finance Ministry tried to push through structural reforms aimed at tackling high youth unemployment, but saw the laws repealed earlier this year. The reform would have cut benefits for younger workers, for example halving holiday entitlement for 18 to 24-year olds and freeing companies from paying them bonuses twice per year.

Such problems are echoed across the region, which “needs to move from resilience to dynamism”, said Mukherji.

“The region has more to do in terms of microeconomic policy. Each country has tried to push through some structural reforms but none have really shown up in productivity growth. The region needs to focus on these internal measures such as labour market and educational reform that can be the engine for growth,” he said.

Every country has increased spending on education, for example, but none has seen any significant return on this investment, as yet, said Mukherji. “This must be the priority for the future,” he said.

Similarly, on labour market reform, where there remains much to do to tackle mass economic informality.

“Colombia implemented fiscal reforms in 2012 [it reduced tax charges to encourage employment in the formal sector], which helped drive unemployment down by creating more formal jobs, which has made a difference in the last year or two. It is a good first step,” said Maldonado. But much more needs to be done – here, and across the region.

Pressure for more reform is building up from within. Sustained growth has transformed Latin American electorates, making the upper working class larger than the middle class above them or the poverty class below.

“The growth of the upper working class and middle class means electorates are wealthier, better educated and more long-term in their outlook. But they are better organised and more powerful than they used to be, with more influence over the media. And they can be impatient,” said Mukherji. “It will be a huge political challenge for the region’s government’s to manage the expectations of this class as growth slows.”

“Commodities are important in the region, and it is important to take advantage of what you have now, while also looking for new ways to grow. Peru, for example, is competitive in mining and it should continue to increase its output, as it is projected to do in copper over the next three years, while it looks to develop new growth engines for the future”

The region’s governments understand this and are looking for new sources of growth to make up for declining commodity revenues.

“The region wants domestic infrastructure to become a new engine for growth,” said Maldonado. “Peru and Colombia have investment pipelines that have the potential to boost economic activity, while Ecuador has invested aggressively in roads and hydroelectric power – which is one of the reasons its finances are perhaps weaker than its neighbours.”

The correct approach will see Andean nations look to protect their existing strengths while building up alternative income streams. Chile leads the region in terms of infrastructure, having invested in things such as roads years ago, but countries such as Colombia and Bolivia still have poor roads, undermining growth.

Maldonado said: “Commodities are important in the region, and it is important to take advantage of what you have now, while also looking for new ways to grow. Peru, for example, is competitive in mining and it should continue to increase its output, as it is projected to do in copper over the next three years, while it looks to develop new growth engines for the future.”

This will be easier for those countries that have already cultivated good relationships with investors.

“Peru wants to attract more FDI into its mines despite low prices and, given it already has a good relationship with investors, it has a chance,” said Arispe. “But other countries looking to attract new investors into the sector while prices are so low face a more difficult challenge.”

The region’s infrastructure investment is principally financed by development institutions such as the Andean Development Corporation, the Inter-American Development Bank and the World Bank. But private fund managers are active too, and attracting them will be key if Andean countries are to succeed in their plans to diversify.

Dehn said: “We invest across the region, especially in government bonds, which trade offshore and provide a good spread over US Treasuries. But we also invest in the real economy. We are on the ground in Colombia, investing in infrastructure, because the government has demonstrated good will towards foreign investment and willingness to service debt.”

Ashmore wants to invest in infrastructure across the region, in Peru and maybe Ecuador too, said Dehn.

“The problem is contract interference and the threat of nationalisation, not in Colombia and Peru, but elsewhere. Managers can make profit margins of 5%–6%, or higher, but these can be wiped out at a stroke by government interference. That scares investors and makes it hard to attract FDI.”

“We are not likely going to see a return to the growth rates we saw during the years of the commodity price boom, so it is important governments tackle structural reforms aimed at boosting productivity in other sectors”

Andean countries will continue to try and attract investment, and if they succeed – and put the money to good use – it should over time make the region more dynamic.

“Investments in infrastructure, education and human capital can make a real difference to productivity but it takes time, sometimes years. Some of these investments could have been made a bit earlier, in the boom years, which would have made the current adjustment easier,” said Maldonado.

“The Andean nations are, in general, better run economies than they used to be, but they are growing slower now that the prices of commodities have fallen,” he concluded. “We are not likely going to see a return to the growth rates we saw during the years of the commodity price boom, so it is important governments tackle structural reforms aimed at boosting productivity in other sectors.”

The outlook for the coming years depends very much on their ability to push through such reforms, and add dynamism to their hard-earned resilience.

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