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LATAM: COVID-19 to inflict heavy collateral damage

Table of Contents

  • Latin America is caught in a negative shock to both supply and demand resulting from the COVID-19 outbreak, though the spread of the virus in the region remains minor for now.

 

  • The region is facing a considerable “China shock” as well as a related oil shock and knock-on effects.

 

  • Response capacities differ across the region, but there would be limitations in the scope for fiscal and monetary stimulus, while low public confidence in governments could emerge as a problem in containing the spread of the virus.


As of today, 10 March, there are just over 100 confirmed Coronavirus cases in Latin America and the Caribbean. Most of them are seemingly imported from existing outbreak epicenters rather than from community transmission. While this is low in global terms, COVID-19 is continually evolving, and there may be more undetected cases in the region. Although the duration and intensity of the outbreak remain unclear, the economic effects on the region are already crystallizing.

China shock

Over the last two decades, China has become deeply integrated into the regional economy, in part a reflection of a neat match-up in demand and supply. For instance, China is responsible for half of global copper consumption, while Chile and Peru together account for 40% of global copper output. As a result, China is the number one trade partner for Brazil, Chile, Peru, and Uruguay, while it is the number two trade partner for Mexico, Argentina, Colombia, and Ecuador.

On the demand side, commodity exporters – principally in South America – are likely to take a double hit from a self-reinforcing drop in demand and falling prices. Oil was already facing a triple, inter-related challenge encompassing a price slide, operational disruption, and oversupply before the recent collapse of Saudi-Russian cooperation on supply and pricing. Over-reliance on single commodities and a single market – in this case China – magnifies the problem. Take two agricultural exports: over 75% of Brazilian soybeans go to China, while in Ecuador, shrimp accounts for well over 70% of non-oil exports to China.

The supply side is just as worrisome. Factory closures in China have disrupted the supply of intermediate manufacturing inputs, which are essential for sectors as diverse as the auto industry in Mexico to apparel assembly in Central America. Normalization in China would of course help these sectors, with a short, sharp, v-shaped recovery the best-case scenario – assuming extensive outbreaks and aggressive containment measures are not required in Latin America. Whatever the shape of the recovery, there will be a debate ahead about the need for diversification and alternate supplies.

Oil shock

If they are sustained, the drop in oil demand and the extra-regional dynamics resulting in market oversupply represent parallel issues for much of the region. Oil market dynamics are not isolated but will have significant effects on local currencies, inflation, debt metrics, and of course growth. Venezuela, Ecuador, and Colombia are most exposed should there be a protracted period of oil prices under USD 40/b. Venezuela’s reliance on oil can hardly be overstated. Production was already in virtual freefall. The cash-generating proportion of exports will now shrink further. Crucially, revenues are needed for imports of almost everything the country needs. In this context, the IMF’s original forecast of a 10% contraction in growth this year looks too mild.

Colombia is vulnerable given its current account deficit of 4.3% of GDP in 2019; the situation is sustainable for as long as exports increase and FDI keeps flowing, which a sustained oil price shock would make significantly more difficult. Dollarized Ecuador may not face the same currency risk as its neighbor Colombia but is still highly dependent on oil revenues. However, external financing just became prohibitively costly, while public opposition to fiscal adjustment – most obviously via the elimination of fuel subsidies – is deep set. Beyond these cases, the future of a variety of region-wide oil projects from shale to pre-salt looks uncertain, while Mexico’s Pemex’s fragility is exposed.

Response capacities

On the fiscal side, there are limits to the space available to deliver fiscal stimulus. Growth was already stuttering before the current crisis. The likes of Argentina, Ecuador, and Costa Rica are already struggling to reduce fiscal deficits or – in the case of Colombia – keep to fiscal consolidation targets. Chile already launched a fiscal stimulus late last year in response to massive public unrest. There is also an issue around governments’ capacity to deliver timely and targeted support – including measures such as tax forbearance, loan guarantees, or direct cash transfers – for worst-hit sectors, such as SME’s in the tourism sector experiencing liquidity problems, let alone the large informal labor segment that exists across most of the region.

Monetary stimulus, while an important part of authorities’ toolkit, can only go so far in helping authorities cope with the fallout of COVID-19 given the nature of the crisis. Compared to most developed markets, there is scope to bring rates down in certain countries; Mexico’s benchmark rate is currently 7%, while Argentina’s is 38%. However, currency depreciation against the USD and the risk of higher inflation (most relevant in Argentina), combined with the fact that in some countries (e.g., Chile) rates have been on an easing path for some time already – and in Brazil’s case are at a historic low of 4.25% – somewhat blunt the monetary tool.

Public confidence

At the same time, there is a public trust and transparency challenge in Latin America. Public confidence in regional governments – most notably in Venezuela, Chile, and Colombia – is already low, as reflected in recent bouts of unrest. This poses risks for the effectiveness of official public health protection measures, which could be undermined if public compliance is poor should more disruptive measures such as restrictions on free movement become necessary. Mexico is a case in point given that the government has refused to acknowledge existing, non-Coronavirus-related problems in the public health system. Similarly, it is difficult to see Venezuela’s regime acknowledging problems and/or communicating transparently.

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LATAM: COVID-19 to inflict heavy collateral damage

Latin America is caught in a negative shock to both supply and demand resulting from the COVID-19 outbreak, though the spread of the virus