Chronicle of a Bust Foretold
Latin America cannot achieve sustainable development without recognizing that wealth is made, not found.
July 2006
by John G. Murphy
John G. Murphy is Vice President for International Affairs at the U.S. Chamber of Commerce. He also serves as Executive Vice President of the Association of American Chambers of Commerce in Latin America (AACCLA).
Setting aside the headlines from Bolivia and Ecuador for the moment, these appear to be good times for Latin America and the Caribbean. For 2006, the UN's Economic Commission for Latin America and the Caribbean forecasts a fourth consecutive year of 4% economic growth for the region, with a cumulative rise in per capita GDP of 11% over the 2003-2006 period. Latin America has also experienced a seminal shift toward current account surpluses that ECLAC describes as "unprecedented in the region's economic history for the past 50 years."
But are the seeds of the next bust being sown in today's boom? Arguably, the very trends that are lending prosperity to the region are driving policies and perspectives down the same "boom and bust" trajectory of the past century. Today's moment of prosperity may be enticing policymakers to defer needed reforms; it may also lull businesses into deferring the arduous climb up the value ladder now being scaled by Asian rivals. Worst of all, it may foment a return to the mistaken economic thinking of the 1960s and 1970s and usher in an era of expropriations, lack of respect for the rule of law, and investment flight.
Better Lucky Than Good?
Today's boom has its origin in two undisputable facts, neither of which arise from virtuous economic policies. First, commodity prices have soared. Even setting aside oil, BBVA's index of key Latin American commodities shows that prices have surged by 40% over the past three years.
Second, commodities still dominate Latin America's exports. As a share of exports, commodities (including hydrocarbons) account for a massive 83% of exports for Venezuela, 71% for Peru, 59% for Chile, 38% for Argentina, and 30% for Brazil. Only Mexico, whose participation in world trade dwarfs that of its neighbors, registers a relatively low 15%.
In this context, it's no miracle that Latin America has managed to eke out 4% growth in recent years. It's useful to consider the global context here. The engine driving commodity prices skyward is China, where economic growth has averaged nearly 10% over the past quarter century. China's rise is increasingly fueled by Argentine soybeans and wheat, Brazilian iron ore and steel, and metals from Chile and Peru. Brazil, Argentina, Chile, and Peru are sending roughly 10% of their total exports to the rising giant - up from nearly nothing a decade ago.
Why Fix the Roof When It Isn't Raining?
Two questions loom. First, how are these developments shaping economic policy and business strategy in the Americas today? And second, how are they shaping the thinking of policymakers and business people?
One major effect of the commodity export boom on economic policy has been to allow governments to defer hard choices. Certainly, many countries have seen progress in fighting inflation, controlling fiscal deficits, and paying down external debt - including Brazil and Mexico, the region's two mega-economies. Elected leaders across the region can take credit for rising tax revenues and falling unemployment.
However, badly-needed microeconomic reforms are being shelved for another day. For instance, a consensus has emerged on the need to ease the bureaucratic burdens placed on small business, as detailed so masterfully in the World Bank's annual "Doing Business" reports, but many countries have yet to tackle the problem. Business leaders agree on the need for labor market liberalization and trade facilitation measures to make ports and customs faster and cheaper, but action is wanting in most countries. (See the report issued at the IV Summit of the Americas in November 2005 by AACCLA and the U.S. Chamber of Commerce entitled "Three Simple Things [that governments can do to create jobs, fight poverty, and enhance the competitiveness of the Americas].") Critically, the region's dismal record on basic education makes it more difficult for political leaders to "sell" sensible, market-friendly economic policies.
Inertia is an understandable by-product of the prosperity afforded by the commodity boom and the reform fatigue that followed the incomplete economic reforms of the 1985-2000 period. Inaction on the reform agenda is abetted by real progress in taming inflation and fiscal deficits. But the bar for measuring success is raised each year by global competitors from Malaysia to Ireland, and merely abandoning disastrous policies is insufficient in today's competitive world.
Clearly, countries such as Venezuela, where poverty and crime indices have risen along with the nation's surging oil revenue, are missing an opportunity. Moreover, government officials and business leaders may mistake their luck for the rewards of good policy and hard work. Only Chile, with its Copper Stabilization Fund, is taking advantage of today's high prices by saving a significant share of copper export revenues for a rainy day.
Climb the Value Chain? Mañana
Most dangerously, too many Latin American officials seem happy to accept the lot of a commodity-based economy. No one should be nostalgic for the socialist thinking of the 1960s and 1970s, when bad ideas like import substitution industrialization and state ownership of industry did so much harm. Nonetheless, those leaders did profess a vision for helping their citizens and their economies move up the value chain from natural-resource extraction to higher value-added activities in manufacturing and services. Today, the Chinese are ascending the value ladder, but a large majority of Latin Americans seem to be stuck on its lower rungs.
To understand the challenge of climbing the value chain, it's worthwhile to note China's role as a customer for Brazil and a competitor for Mexico. At first blush, this has meant gains for former and headaches for the latter, but what about the long run? In terms of its international trade profile, Mexico has indeed become a world-class manufacturing power, with over 80% of its exports coming from that sector. Mexico certainly faces Chinese competition in many more export sectors than the larger South American nations, where commodity exports loom larger in the national accounts.
But if today's commodity boom should end - and every preceding boom has eventually come to an end - won't Mexico's advantage be more obvious? Mexico today is at least in the fray of global competition, and no country ever became competitive without competing. Recent statistics show Mexicans faring better in their fight with fierce Chinese competitors, with jobs, investment, and growth up. By contrast, firms in the resource-blessed South American economies have fewer incentives to move up the value chain. The commodity boom also drives local currencies to appreciate and thereby raises the competitive challenges facing manufacturers in a dynamic economics textbooks call "Dutch disease."
The Politics of Envy
If the only negative repercussions of the commodity boom were missed opportunities and deferred reforms, that would be bad enough. But the most pernicious effects of the boom are now being seen in how leaders in government are thinking about growth, development, and property.
In a region riven by sharp economic inequalities, the politics of envy have come to the fore once again. With the oil business and some mining sectors reaping high profits, this is perhaps not surprising, but a longstanding sense of ambiguity about private property in some corners of Latin America is clearly also a factor. As Hernando de Soto pointed out in his 1986 book The Other Path, ill-defined property rights are one of the key elements to explain Latin America's underwhelming record on economic development.
This lack of respect for property rights may now be morphing into something more dangerous. The government of Ecuador on May 15 expropriated the assets of Occidental Petroleum Corporation, which had invested over $1 billion in the country since 1999 as part of its concession in the east of the country. Coming just two weeks after Bolivia's nationalization of hydrocarbon assets, the move in Ecuador represents further erosion in some Latin American governments' respect for the sanctity of contracts and property. It is, in fact, the largest expropriation of any U.S. firm's assets anywhere in the world in a generation.
This latest episode in Ecuador's turbulent modern history will surely end in tears. Production in the seized oil fields will plummet (the state-owned oil company's engineers are not prepared to simply walk in and take over Occidental's high-tech operations), revenue will fall, and new investment in Ecuador will be off the table indefinitely. In addition, Washington is bound by its own laws to terminate Ecuador's preferential access to the U.S. market under the Andean Trade Preference Act, a remarkably generous program that has helped Ecuador's exports to double over the past two years.
An ambiguous attitude toward property and contracts, coupled with the sudden wealth arising from oil, gas, and commodities in the region, makes for a volatile mix. More and more governments face the temptation to reach out and seize assets, to discard contracts, and to change the rules of the game under which foreigners have made investments. Some will likely see benefits from such actions - at least for the moment.
Capital is a Coward
But not in the long run. As former Secretary of State Colin Powell said, "Capital is a coward; money flees uncertainty and corruption. To entice capital in and then keep it in, governments must recognize private property rights, deeds of trust, and the sanctity of contract, and they must enforce these rights transparently and fairly." Absent these conditions, capital will flee to other regions - to dynamic China and India, or, for that matter, to the United States, where economic growth has lately been higher than in Latin America and where the risk of expropriation is zero.
If investors shunned Latin America, what would be lost? The World Bank has reported that private investors poured $94 billion into Latin American stocks, bonds, factories and other assets in 2005, up from $59 billion the previous year. This is a level not seen since the late 1990s, and it compares fairly well with private investment flows into East Asia ($138 billion).
The bust - or at least the end of the boom - may be already beginning. There are many reasons for the sell-off in emerging market stock markets in recent weeks, but the rise of ebullient populism in Latin America is surely part of investors' calculations. Earlier this year, Latin American bonds were paying a risk premium over U.S. Treasury bills of just a couple of percentage points; that premium is now rising quickly. The cost to insure Latin American sovereign bonds by means of credit default swaps, a kind of insurance that pays in the event of default, has risen by more than 50% in just a couple of months. Developments in Bolivia, Ecuador, and elsewhere have plainly spooked the markets; how high risk premiums will rise has yet to be seen.
Foreign capital would surely be missed in Latin America. Even the state-owned oil monopolies in Venezuela and Mexico are unable to muster the huge sums of capital and cutting-edge technologies needed to raise output - and in some cases, just to keep it from falling - despite high oil prices and record revenues. If these two giants can't do it, how can their counterparts in Bolivia and Ecuador? And if countries blessed with rich natural resources can't attract the investment they need to leverage them into true development, how can they attract the capital needed to develop the innovative manufacturing and service sectors that are the hallmarks of competitiveness?
Today, the message for Latin America's elected leaders and business executives is simple. This moment of prosperity is the result of good luck, not good policy. To avert the bust that seems always to follow Latin America's booms, reform can no longer be deferred. Most importantly, the region must recommit to respect for property, contracts, and the rule of law. Otherwise, capital - the coward Colin Powell described - will flee for the greener pastures of Asia, Europe, and North America.