Since Latin America depends on supplying the rest of the world with commodities, the current economic downturn is not the end of the world. Demand for commodities will eventually recover from the financial meltdown, and credit will undoubtedly flow once again, it is only a matter of waiting out the crisis.

One of Latin America’s critical weaknesses is its failure to develop and retain its own pools of credit. In part, this is a fundamental product of the region’s highly diverse geography. South America contains vast mountain chains and very few navigable rivers; developing the continent was destined to be difficult. Unlike the United States, Latin America has no obvious transport corridors, and much of the region can be thought of as “islands” divided by “seas” of jungles and peaks. This geography makes forming intracontinental transportation networks extremely difficult. As a result, Latin America has from the start relied on external credit to build the roads, railroads and tunnels necessary to navigate its terrain and industrialize.

This has made Latin America a debtor region from the beginning. Furthermore, the region’s highly divisive geography has made it difficult to create large enough markets to sustain diversified productive sectors, so industrialization has been slow. These problems have been exacerbated over the years by a focus on populist measures, which have periodically pressured countries into sacrificing financial stability in favor of political support. Thus, Latin America remains a source of raw and primary materials for the rest of the world.

To some extent, Latin America is still recovering from the 1982 debt crisis caused by the rapid increase in external debt. In the early 1970s and early 1980s, European banks flush with cash from Middle Eastern oil profits made a series of loans to third-world countries at profitable interest rates. At that point, Latin America appeared to be a particularly promising market. These loans brought the region’s external debt from $27 billion in 1970 to $231 billion in 1980. Increasingly ponderous debt payments began to drag the countries down as the development strategy of import substitution industrialization (trying to manufacture everything the countries would otherwise import) began to falter. In 1981, the price of oil plummeted, causing a sudden devaluation of the Mexican peso in 1982 and prompting Mexico to declare that it could not make its debt payments. Though the International Monetary Fund (IMF) and the United States subsidized its payments, Mexico’s declaration rippled through the region as investors lost confidence.

As a result, Latin America suffered a decades-long economic crisis that forced a complete restructuring of the region’s economic strategies. The failures of import substitution industrialization (including an unreasonably high reliance on foreign capital, limited domestic demand and inadequate job creation) had become clear, and the region began to adopt a series of liberalization and austerity measures under the guidance of the IMF.

The new policies brought a sort of stability to Latin American economies by the early 1990s. International capital inflows rose from $13.4 billion in 1990 to $57 billion in 1994, thanks to investors from the developed world. But the problem with these investments was that most were concentrated in highly liquid assets such as local equity markets, so when the U.S. Federal Reserve raised interest rates in 1994, there was a 14 percent decline in capital investments in Latin America almost overnight. This capital flight triggered the Tequila Crisis. Once again, a massive devaluation of the peso set off a region-wide economic crisis as investors fled Latin America.

Latin America’s recent economic history shows that international financial instability characterized by nervous investors can throw the region into chaos. And at this juncture, there is a real possibility that the global slowdown could tip the balance in several countries.

With financial giants collapsing and investors running scared, the world credit pool is shrinking rapidly as lenders drop risky portfolios and put money into safe bets. For Latin America, a region that has historically been plagued with bad credit, this means moving to near the end of the queue of hopeful borrowers. (Some states, like Pakistan, still beat Latin America for the “worst borrower” prize.) As a result of these global conditions, the region is facing a shortage of capital. This shortage will take the form of a reduction in credit, which is taking place globally, and a reduction of capital inflows in the form of foreign direct investment (FDI) and stock/bond purchases.

With the capital pool shrinking, states that run deficits or fund social programs through borrowing will have a much more difficult time coming through on their promises. Chief among these states is Argentina. Although Argentina has remained relatively isolated from international capital markets since its dramatic 2002 debt default, the country has again managed to build up a growing pile of debt. President Cristina Fernandez de Kirchner’s administration relies on high government spending to fund its social agenda, which Fernandez needs to maintain public support.

Another important distinction in the credit markets is to what extent a country is reliant on foreign credit for domestic loans. This can be indicated by how much of the banking industry is controlled by foreign firms. For the most part, Latin American banking sectors are dominated at between 20 percent and 50 percent by foreign firms. Mexico is a startling outlier; 80 percent of the Mexican banking sector is owned by foreign entities. This leaves Mexico’s local credit market highly exposed to shaky international credit.

But limited availability of loans is not the only downside of shriveling capital markets. For many countries, FDI has become an increasingly important percentage of gross domestic product (GDP), not to mention an important source of employment. This foreign investment is also a source of technological and infrastructural development that can be difficult, if not impossible, to create with domestic capital. Though no country stands out in the region as having unusually high FDI as a percentage of GDP, the decline of FDI as multinational investors sit out the financial crisis will be felt region-wide.

This can be particularly problematic for the commodities sectors. Most Latin American countries depend on physical FDI to develop commodity sectors, particularly in mineral extraction. Commodity FDI, from oil projects in Venezuela to natural gas pipelines in Peru and copper mines in Chile, boosts overall GDP and government tax revenue.

 

Commodities

As a region, Latin America is largely dependent on the export of primary materials for income. Latin American economies have ridden high over the past decade as rising industrial production (mostly in other countries, and particularly in China) ramped up demand for copper, iron and oil. Higher standards of living accompanied the global boom, spurring greater demand for food as people the world over began to demand more resource-intensive foods, such as meat. This has been great news for countries whose economies are dominated by agriculture, such as Argentina. In addition to these “real” economic factors, a massive pool of global capital prompted increased speculation, and traders began to bid up the price of basic goods traded on the international markets.

We expect that the shakeup of financial markets will reduce trader speculation on food commodities, bringing prices down even further from their recent highs, though it is difficult to determine how much of the price increases are attributable to this factor. In food commodities, such as rice, wheat, corn and soybeans, there will be some amelioration in demand as lowered incomes lead to a shift in consumption patterns. However, there are some structural constraints, including increasing demand from a rising global population and limited room for the expansion of production, that will likely prevent food prices from falling to the lows of three years ago.

Falling commodity prices will have mixed results in Latin America. On one hand, the region has suffered severely under rising inflation driven by rising costs. High prices of some foods have caused great economic distress and, in some cases, civic unrest. Thus, a drop in the cost of food will be a relief to many. On the other hand, major agricultural states, Argentina in particular, will suffer from a rapid loss of income. This will affect not only local industry, but also the governments that depend on that industry for tax revenues.

In the real economy, there will be lowered demand for primary minerals as industrial production slows. This will depress extractive sectors, including Chile’s copper industry, one of the largest in the world. As oil markets sink on a global industrial slowdown, there will be similarly mixed results. For oil-poor countries that rely on the international market (or Venezuelan generosity) for oil supplies, the falling price of oil is a godsend. Countries like Chile, or Central American states that have to import nearly 100 percent of their oil consumption, will finally have some breathing room as costs fall for their industry and transportation sectors. This will be an economic boon, and it will also help to resolve civic unrest at a time when unions across the region have been pressuring governments through strikes.

But in states for which oil is a driving political and economic force, namely Venezuela and Mexico, where petroleum taxes make up 40 percent of government revenue, and Ecuador, where they amount to 30 percent of government revenue, the fall in the price of oil is a disaster. Venezuelan President Hugo Chavez has unabashedly bet his entire administration (and foreign policy) on the ability to translate oil into a higher standard of living for his constituents, who view Venezuela’s oil wealth as a national birthright.

Even in Brazil, Latin America’s rising star, there is danger in the falling oil markets, a danger that is exacerbated by the credit crunch. In the past year, Brazil has discovered vast reserves of oil that will make it one of the world’s top 10 oil producers. But Brazil’s deposits are only just accessible with current technology, and Brazil’s state-owned oil company Petroleos Brasileiros (Petrobras) is counting on substantial technological developments in order to efficiently extract the oil. This extremely capital-intensive process will depend on both the availability of funds and the forecast price of the extracted oil. Current conditions indicate that Brazil’s plans to tap its massive reserves will be delayed.

 

Who is at Risk?

Many states, Chile chief among them, have taken the opportunity afforded by prosperous times to pay down substantial portions of their debt and have fostered diversified economies with limited government intrusion. Countries with well-developed commodity markets that are also well-managed, such as Chile’s copper industry, have a buffer that will give them breathing room in situations where massive cash outlays are the only way to stave off crisis.

Other economies, such as Bolivia and Paraguay, are so well-insulated from the international system by the dubious virtue of underdevelopment that the financial crisis will have much less of an impact.

But several states walk a fine line, particularly Brazil. Brazil is generally characterized by a good and improving investment climate, a growing and increasingly efficient industrial base, and a promising array of natural resources at its fingertips. But Brazil’s well-developed financial industry has left the country exposed to reeling global financial markets reacting to the U.S. financial crisis. Brazil’s currency, the real, has taken a 16 percent hit so far. As a result of this devaluation, the private sector has already reported expected losses of about US$28 billion, or 2 percent of GDP. But news of the devaluation is not all bad, as it will give a kick to the Brazilian export sector, and although Brazil’s debt is high (about 45 percent of GDP), its external debt is only fraction of that, about 5 percent of GDP. This reduces its vulnerability to external creditors and gives it more ability to borrow externally. Brazil also has a nest egg of some $200 billion, which has helped to halt the free fall of the real and will come in handy as the country reacts to the slowdown.

 

Some states do not walk a fine line so much as stare down the gullet of the beast.

Small states, including Nicaragua and its Central American neighbors, have found themselves burdened with high debt-to-GDP ratios, large budget and current account deficits and weak, limited private sectors. High reliance on remittances from the United States will inevitably hurt these economies as the U.S. economy slows. These states run serious risks of economic crisis with little institutional capability to control or respond to the situation. However, if Nicaragua suffers a meltdown, its small size precludes any serious contamination of other economies.

This is not true of Argentina, Venezuela and Mexico, all of which have deeply worrying vulnerabilities to the current economic crisis. Argentina’s penchant to increase government spending as the answer to any problem has led the country into a situation where public debt is rising to near pre-2002 default levels, and the private sector is being crowded out as the government takes a increasingly strong hand in regulating and nationalizing important sectors of the economy. The net effect of this phenomenon is a reduction in the amount of credit available to the private sector and a stifling of the economy’s ability to grow on its own or recover from slowdowns. The long-term effect of a heavier government hand is a slowdown in Argentina’s overall development. Add to that the fact that the government routinely manipulates its economic statistics and seems to have no clear plan of action, and it is apparent that Argentina is an increasingly unstable country with little room to respond to looming challenges.

In Venezuela, increased reliance on oil for funding massive social programs has put the country at risk of shortfalls as oil prices fall. Venezuela’s 2009 budget will bank on an oil price of $60 per barrel of its heavy, sour crude. With the higher-quality Brent blend crude futures trading at nearly $61 per barrel, Venezuela’s projection is uncomfortably close to the real price of crude. Though Venezuela does not run the same debt risks as its Latin American neighbors, it might find itself in need of a loan at a time when international credit is nigh impossible to secure, particularly for such an unreliable state. At minimum, the Chavez government will need to decide which of its expensive pet projects to cut.

Finally, Mexico, the source of the last two regional crises, poses grave concerns. Mexico is not only reliant on the United States for remittances, but it is also deeply enmeshed in the U.S. economy through trade. As the United States falls, so does Mexico. On the upside, as the United States pulls out of its upcoming recession, Mexico will follow. However, Mexico does not have the same capacity for recovery that the United States enjoys. With 80 percent of Mexico’s banking system owned by foreign interests, the country is highly exposed to international credit markets at a very fundamental level, far more than any other Latin American state. Any threat to that sector could cause a banking collapse in addition to a capital shortage. Finally, at the same time that Mexico is pouring billions of dollars into bailing out the peso and propping up Mexican businesses, the government is waging an expensive war against some of the best-funded and most highly organized criminal groups in the world.

 

Political Endurance

This brings us to the final piece of the puzzle: political endurance. For all of Latin America, there are two critical political factors to consider as we look ahead to the region’s adaptation to the global slowdown: the role of the military and the role of the people.

In the economic downturn of the 1960s, Latin American militaries staged a series of coups, Brazil’s in 1964, Argentina’s in 1966 and Chile’s in 1973, designed to establish autocratic control over deteriorating economic situations. In more recent decades, popular movements have come to the fore and brought to power leaders like Venezuela’s Chavez and Bolivian President Evo Morales. This was aided in no small part by a resounding rejection of the human devastation wreaked by the military regimes as they sought to quash (often leftist) opposition movements. It was also aided by the fact that these earlier military regimes failed to solve the economic problems that led to their original rise, so movements toward civilian governments began to gain traction.

With this history in mind, we must watch carefully both for rising public discontent that could throw countries into chaos and trigger their governments’ downfalls, and for movements on the part of the military to consolidate control. In many cases (such as in the downfalls of three of the past four Ecuadorian presidents), Latin American militaries will step in to control the government once rising public discontent has made the civilian government irrelevant, then turn the government over to a new civilian administration.

It is fair to say that there is not a single Latin American country that is immune from civic unrest. It is a defining characteristic of politics in the region. Poor income distribution, coupled with ethnically divided economic classes and a widespread approbation of public participation in government, provides a wealth of motivation for the public to censure the government via civic unrest. But unless sparked by truly massive grievances, high levels of organization or outside financial support (or all of these factors), these protests usually do not threaten the stability of the state.

That said, it will be particularly important to watch the economically endangered countries for signs of destabilizing civic unrest. In Argentina, a sincere devotion to the art of protesting led the entire agricultural sector to shut down the country for brief periods of 2008. With trouble ahead and a shaky government hand, should the country’s economic situation decline radically, Argentina could see a replay of the bloody riots of 2002 in the wake of the economic crisis and the debt default. In Venezuela, the opposition is becoming increasingly organized and more popular among the country’s poor, who have begun to suffer under Chavez’s economic mismanagement. In Mexico, protesting is something of a national sport. With an ongoing war on drug cartels, rising crime, an energy industry that is nervously approaching total failure and an increasingly strained government budget, the situation in Mexico is precariously close to an economic disaster that would unquestionably spark massive civic unrest.

Falling commodity prices and shrinking international credit will impact all of Latin America. The conditions for social unrest will become more prevalent, and those wishing to influence the status quo will have their chance. This could happen through a number of domestic actors, but we must also remember to look for signs of instability from outside. As Russia seeks to increase its influence in the region, the economic downturn will create opportunities for greater partnerships with Latin American states, as well as more potential discontent that could be exploited to produce greater instability. In the end, the impact of the financial crisis on Latin America will be determined by the degree to which Latin American states can maintain stability until the global economy begins to recover.

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