Update Country Report Curaçao 18 Jun 2019

After having faltered in 2018-owing in no small part to weaknesses in Argentina and Brazil-Latin America was slated for a mild cyclical upturn in 2019. However, early economic indicators suggest that the improvement is likely to be significantly weaker than initially anticipated. A combination of decelerating global growth, weak cross-border investment and high levels of political uncertainty has contributed to flagging economic activity, and policymakers have little scope to provide an economic reprieve if headwinds strengthen. Faced with a multitude of growing challenges, Latin America is set for another year of lacklustre growth.

Since the beginning of the year, The Economist Intelligence Unit has made significant downgrades to its growth forecasts for Latin America in 2019. Indicators of economic activity suggest that, without exception, GDP either stagnated or contracted (in sequential terms) in the seven largest economies in the region in Q1 2019. A moderation in industrial confidence is seeping into other sectors, contributing to growing economic uncertainty. All the while, the outlook for Latin America's external sector is growing increasingly dim amid a slowdown in global trade growth.

External headwinds

Latin America's integration into the global economy, along with its dependence on a narrow band of commodities exports, leaves the region especially exposed to downturns in the global business cycle. Global trade has already begun to slow sharply, amplified by the spillover effects of a bilateral US-China trade war. Domestic demand in the world's two largest economies is clearly weakening, reflected in growing inventories stockpiling and contracting imports in both countries. The Sino-US conflict has natural repercussions for Latin America and the Caribbean (LAC), insofar as it weighs on the contribution of net exports to growth in the region. While LAC countries, particularly those on the Pacific Rim, have made strides in expanding trade ties in recent years, China and the US remain among the largest export destinations for most countries in the region.

Another important consequence of the weaker external environment is its deleterious impact on cross-border investment flows. According to a newly released report by the UN Conference on Trade and Development (UNCTAD), inward foreign direct investment (FDI) to LAC fell by US$148bn in 2018, a 6% year-on-year decline compared with 2017. Although FDI flows to the primary sector grew strongly-the value of primary-sector greenfield FDI projects nearly tripled in year-on-year terms amid resurgent commodities prices-this was more than offset by a decline in foreign investment in higher-value-added sectors such as manufacturing. Indeed, given the generalised weakness of commodities prices this year, prospects for foreign investment remain poor. In fact, UNCTAD expects FDI inflows to the region to fall by another 5% in 2019. Given that FDI is a significant contributor to total gross fixed capital formation in LAC, this is likely to create further downwards pressures on economic growth in the region.

Domestic concerns complicate matters

Trade woes and weaker commodities prices, however, only explain one part of the puzzle. The more fundamental problems in attracting investment arise from high levels of political uncertainty and a lack of faith in policymaking.

In Brazil, for example, investors appear unwilling to give the administration of Jair Bolsonaro the benefit of the doubt when it comes to a much-needed pension reform. Consequently, a significant pick-up in growth is likely to be delayed until the pension reform is approved, most likely in Q3 2019. Argentina has also struggled to recover from last year's recession, as policymakers were forced to adopt pro-cyclical tightening to assuage investors' concerns about the country's large twin deficits. Also weighing on business sentiment in Argentina is the high level of political risk, with the country's liberalisation programme at stake in the general election in October this year.

Mexico has also not been exempt from souring investor sentiment: the administration of the Mexican president, Andrés Manuel López Obrador, has turned off the private sector by rejecting competitive bidding for more than two-thirds of the contracts it has awarded to date. In addition, concerns are rising about the finances of Pemex, the state-owned oil company, which now claims the title of the most heavily indebted oil company in the world. Other major economies such as Chile, Colombia and Peru have also struggled with vacillating consumer and investor confidence as political frictions have raised concerns about governability.

Policy responses to slowing growth

In the face of growing challenges, there are serious concerns about the ability and willingness of governments to provide much-needed economic stimulus. Many governments across the region-notably, Argentina, Brazil and Ecuador-lifted public spending dramatically in the 2000s, bankrolled by the windfall from booming demand and prices for their commodity exports. However, the unsustainable growth in public expenditure meant that, when commodities-related revenue ultimately slumped in 2014-16, the fiscal deficits and public-debt ratios in these countries surged to new highs. This forced governments to begin austerity programmes, which are continuing to date. Moreover, as a result of budgetary rigidities in these countries, the burden of fiscal adjustment has often fallen on capital spending (which is typically more flexible), serving to further dampen overall growth.

Even countries in the region that have maintained prudent fiscal policy, giving them more room for countercyclical spending, face challenges. In Peru, for instance, an ambitious US$8bn public works programme introduced in 2017 has struggled to gain steam as a result of budget under-execution. Similarly, a recently announced US$1.5bn fiscal stimulus package in Paraguay is expected to underwhelm as weak technical and institutional capacities impede project implementation.

In this context, any impetus to economic activity is more likely to come from the monetary side. The majority of Latin American economies have moderately positive real interest rates and, with a few exceptions, inflation expectations are reasonably well anchored. As a result, central banks within the region will be well positioned to cut interest rates slightly if economic growth continues to disappoint. On June 7th the Banco Central de Chile (the Chilean central bank) did exactly this, surprising markets with a 50-basis-point rate cut to dynamise lacklustre industrial and investment activity.

We already expect the Banco de México (the Mexican central bank) to follow suit and cut interest rates in the second half of the year, given that real rates are unusually high for Mexico. There is also a rising possibility that Brazil's central bank will cut rates once pension reform approval becomes clearer. Monetary authorities in Argentina, however, will have less room to manoeuvre-given the Argentinean central bank's strict money-supply targets and its focus on exchange-rate stability-meaning that significant monetary easing in that country is unlikely to materialise before 2020.

Meanwhile, an unintended consequence of renewed trade tensions between the US and China is that it has considerably raised the risk of looser policy on the part of the Federal Reserve (Fed, the US central bank). Indeed, bond markets have to some extent already begun pricing in rate cuts for later in the year. However, this is not our view. We expect the US and Chinese governments to reach an informal "gentlemen's agreement" to freeze further tariff escalation, which should ease economic concerns somewhat and allow the Fed Funds rate to remain on hold. Nonetheless, risks to our benign US-China trade outlook are high, and an easing cycle could well begin earlier than we currently anticipate. More accommodative policy on the part of the Fed could provide the monetary authorities within LAC with further breathing room to support domestic activity.

The bottom line

All this said, downside risks to our forecasts for Latin American growth remain significant. Easier financial conditions, both domestically and globally, are likely to help only at the margins as global liquidity will remain well below the post-financial crisis quantitative-easing era. Latin America's relatively under-developed financial system will also impede monetary transmission. Indeed, the latest World Bank data show that domestic credit to the private sector as a share of GDP is extremely low in LAC (48.9%), even compared with other developing regions such as the Middle East and North Africa (58.9%) and East Asia and the Pacific (148.7%). Although policymakers are increasingly shifting their focus to structural reforms to address the region's myriad economic deficiencies, improvements are unlikely to materialise in the very near term.