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Investment outlook When the dust settles

Sep 1, 2013

Country differentiation will prove key for investors navigating Latin America’s darkening economic landscape. By Nouriel Roubini

Following years of successful economic performance, Latin America, like many other emerging markets, is now facing significant domestic and external pressures that have already begun to dampen economic growth.

Economies that had benefited from institutional development and sound macro policies face the prospect of becoming stuck in a middle-income trap: having already picked the "low hanging fruit" of domestic factors including expanding labor forces, they now risk being unable to achieve high-income status as external sources of growth dissipate.

Meanwhile, those countries that failed to undertake sound macro reforms, but which were nevertheless able to sustain rapid growth on the back of strong external demand and high commodity prices, must now significantly alter their strategies.

Against an increasingly challenging backdrop of weaker global growth, the diverging paths of the region’s economies will be determined by several factors: the nature of countries’ trade and economic linkages with larger emerging and developed economies, especially if China’s economy slows sharply or if the commodities super-cycle comes to an end; the macro policy framework countries choose to adopt, whether state capitalism or more market-oriented policies; and, political stability, which will be key for countries looking to attract international investment as liquidity tighten across global financial markets.

Latin America’s bigger economies can be divided into the following four groups:

Argentina and Venezuela: After several years of heavy government intervention and state-oriented policy making, growth models in both countries are faltering, exposing falling productivity and rising political turmoil. The tail risks associated with the possibility of a volatile regime change are especially large in Venezuela, but the emergence of a market-friendly government could lead to a significant pick-up in oil-related investment.

Chile and Peru: These economies are mining-intensive and, as a result, are highly exposed to China’s investment boom. Thanks to their impressive economic expansion, strong investment flows and solid institutions, both countries have built up robust reserve buffers, which could make them less vulnerable to a scenario of widening current account deficits and reduced international liquidity, although conditions will be more challenging than in recent years.

Mexico and Colombia: Both economies are more affected by fluctuations in the oil market and the US economy than by China. As a result, they stand to benefit from rising growth in the US and a shift toward a consumption-led development model in China, both of which should boost exports from these countries. Additionally, both countries have embarked on a series of ambitious reforms.

Brazil: Potential output is falling as its demand-driven growth model, sustained for several years by an expansion of the labor market, runs out of steam. A failure to address supply-side bottlenecks through structural reforms, coupled with stimulus measures aimed at boosting growth by spurring demand, has led to above-target inflation and monetary tightening, further hampering the country’s growth prospects. With the lowest investment-to-GDP ratio in the region and few pockets of untapped labor, productivity – a very important component of growth in the first decade of the 2000s –will be key, but the lack of reforms in recent years has held back gains in this area.

Some bright spots remain, however. Chief among them is Mexico, whose ambitious reform agenda has the potential to significantly improve the country’s appeal to international investment. Meanwhile, political change in Venezuela could spur investment in projects to explore the country’s massive heavy oil reserves (estimated to be the world’s largest but in need of foreign expertise). And Brazil’s 2014 presidential elections could usher in a new economic approach that prioritizes structural reforms that boost, rather than sap, investor confidence.

All told, however, the bad currently outweighs the good for Latin America. Over the next five years, the region is likely to face slower growth than pre-crisis levels. While some of the better prepared economies, including Chile, will have to cope with the challenges of weaker external demand, positive developments in Mexico and Colombia are counterbalanced by a high degree of uncertainty over the future of policymaking in Brazil, Venezuela and Argentina.

Even if some of the factors limiting the region’s growth are cyclical, there are important structural forces also at play. For investors, country differentiation will be key. LF

Nouriel Roubini is co-founder and chairman of Roubini Global Economics and professor of economics at New York University’s Stern School of Business.

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