I was only in Europe for a week orso in early July, but when I returned to Latin America the extent to which China had moved up the financial agenda was striking.
Latin America can never afford to be insular, but there has been a certain amount of navel gazing this year – an understandable impact of so many presidential elections in the region at more or less the same time.
But China too has moved front of mind for the first time in years, especially the risks from an economic slowdown. That country’s trade dispute with the US is the catalyst, but it is also helping throw into sharp relief the vulnerability that some Latin American countries have to the state of the Chinese economy.
The main transmission mechanism is trade, both in nominal trade amounts and the effects of Chinese demand on certain commodities – and, through them, some Latin American currencies.
These currencies are showing the first signs of a China crisis. As the renminbi has declined, so too have the currencies of Brazil, Chile and – to a lesser extent because it is managed in a tight band – Peru.
All these countries sell more than 20% of their total exports to China; Chile’s share of exports to China is the highest, at just over 30%. And nearly all of these exports are some form of commodity.
Standard Chartered’s macro strategist Ilya Gofshteyn points out that such heavy reliance in exports on dollar-denominated commodities negates any competitive gains from currency weakening.
In Latin America, Brazil’s real and Colombia’s peso have seen the biggest depreciations against the renminbi since the start of the year (if we exclude Argentina’s unique story of currency weakness), but the benefit from this to their respective export sectors has been marginal.
These currencies are showing the first signs of a China crisis. As the renminbi has declined, so too have the currencies of Brazil, Chile and – to a lesser extent because it is managed in a tight band – Peru
Also, the specific commodity drivers of these economies have been hit hard. In Brazil, sugar prices are down by around 25% since the start of 2018, iron ore is down by approximately 15% and soybean about 10%. (Although Brazilian soy farmers will benefit from now being able to charge a premium to China, as the tariffs on US soy give Brazil an effective monopoly in this commodity.)
In Peru and Chile, lower prices for copper, iron and gold are a drag on exporters that will not be offset by lower currency valuations in the short term. Indeed, the risk is to the downside – a further slowdown in China would lessen demand and lead to even lower commodity prices – which would be a big shock to these economies.
It is probably for this reason – the growing awareness of these economies’ vulnerability to China – that there has been an increased correlation between stock markets in these countries and the Shanghai stock exchange.
Gofshteyn points out that the correlation of the indices in Peru and Chile is approaching 1 – with the Bovespa not far behind. Meanwhile, the stock exchanges in Mexico and Colombia have become more negative in recent weeks – logical given these countries’ lack of exposure to China, which accounts for less than 10% of their exports.
There is, then, growing nervousness in the region about a hit from a Chinese slowdown. But the biggest danger in the region is faced by Peru.
It not only has the trade issue, but China also accounts for nearly one-fifth of all foreign direct investment. In addition, its central bank manages its currency, the sol, in a relatively tight band (the economy still has relatively high levels of dollarization), which means foreign exchange rates don’t serve as an adjustment mechanism as elsewhere.
For much of the first half of this year the currency was undervalued relative to Peru’s terms of trade, but, with the US dollar rally, the currency has seen a rapid appreciation against regional peers.
At the same time, the drop in Peru’s key commodity prices has dented its terms of trade, to the point where the lack of an FX release valve, coupled with growing fears about China, leave Peruvian assets at risk of further weakness.
Even if this short-term danger passes uneventfully – with either trade tensions lessening or the impact on GDP growth being mitigated through a pivot by China to other markets – this will remain a longer-term risk for all of Latin America. Capital Economics predicts a structural slowdown in the Chinese economy, with growth down to just 2% by 2030.
As China consumes 47% of the global demand for metals, such a slowdown will also pose difficult questions for those Latin American economies that are dominated by mining.
In the longer term, the need for the greater diversification of Latin American business and trade is clear. So if a short-term scare focuses minds about the need to rebalance and invest in other sectors, boost productivity and improve education, it could turn out to be a very valuable warning.