Update Country Report Curaçao 04 Jan 2022

For Latin America, 2021 was a year of some well-signalled developments-such as an anti-incumbent wave at the ballot box-and some surprises-such as a much more robust than expected economic recovery, supercharged by US stimulus and a mini commodity boom. Looking ahead to 2022, EIU highlights some of the key trends-and key risks-to watch in Latin America, including a leftward shift in politics and policy, the increasing importance of environmental, social and governance (ESG) criteria in policy formulation, opportunities in the financial technology (fintech) sector, the risk of a "taper tantrum 2.0", and obstacles to economic recovery.

Latin America's leftward drift

The leftward drift in policy is likely to persist in 2022. Amid deep disillusionment with crime, corruption, poverty and inequality-and against a backdrop of economic stagnation following the commodity boom of the early 2000s-incumbents were in trouble at the ballot box well before the pandemic began. This trend continued in 2021. Although most incumbents were not eligible to run last year, presidential races featured sizeable party shifts and strong challenges from political outsiders. Before the pandemic we noted that this anti-incumbency wave did not necessarily benefit one side or the other on the traditional left-right economic divide. Since the pandemic, however, that story has been different. The crisis has laid bare the weak social safety net in much of the region, and voters are clamouring for more fiscal support and a bigger role for the state in the economy-a position best represented by candidates on the left of the political spectrum.

In our view, therefore, the shift to the left in the region's leadership is not merely the effect of an anti-incumbency wave. It is worth noting that not all left-wing governments are the same. Gabriel Boric, Chile's president-elect, is considered to represent the growth of a "new left" in Chile, focused more on the environment and social equality, and critical of authoritarian regimes in Nicaragua and Venezuela. However, Luiz Inácio Lula da Silva and Gustavo Petro, the left-wing front-runners in the big 2022 presidential races in Brazil and Colombia, clearly do not represent a "new left"-Lula has already held the presidency twice and is busy making pragmatic centrist alliances in a bid to topple the current president, Jair Bolsonaro. Mr Petro, meanwhile, has run unsuccessfully for the Colombian presidency twice but is by far the more worrying candidate for markets. In Brazil, the race is Lula's to lose; in Colombia, if the centrist parties can get their act together, we still believe that they have a good shot at a second-round victory. In a polarised left versus right run-off, however, Mr Petro would be the likely victor, which would presage more fundamental changes to policymaking in Colombia.

The economic recovery will stall

Latin America's economic recovery will stumble in 2022 as external conditions deteriorate, creating serious policymaking dilemmas. Many factors supported Latin America's economic recovery in 2021. For one, US demand rocketed amid substantial stimulus (some of which went directly into Latin American consumers' pockets in the form of workers' remittances), and strong import demand from China helped to spur a mini commodity boom. At the same time, fiscal policy remained looser than before the pandemic, and there were clear signs of economies adapting to the reality of covid-19 restrictions. In view of these factors, we estimate that, having posted the biggest coronavirus-related contraction in the world in 2020, Latin America will have expanded faster than any other region in 2021, growing by 6.5%.

In 2022, however, we expect Latin America to once again be the slowest-growing region in the world, with real GDP expanding by just 2.6%. Of course, this will partly reflect the high base of comparison, but for many economies in the region, we project very little or even zero sequential growth in 2022. The withdrawal of macroeconomic stimulus is now well under way, and more monetary and fiscal tightening is forthcoming as economies in the region tackle growing creditworthiness concerns and the upward drift of inflationary expectations. Barring a lasting shock from Omicron or another new covid-19 variant, the commodity price picture should remain supportive, but the prospect of monetary tightening in the US and other developed markets will constrain growth. On top of all this, continued political and policy uncertainty amid a hectic election calendar will weigh on the investment outlook. Assuming that Latin America can navigate around all these obstacles relatively smoothly, we expect growth to pick up in 2023, but 2022 will be a challenging year.

Taper tantrum 2.0 will be a big risk

In November Jerome Powell, chair of the Federal Reserve (Fed, the US central bank), finally "retired" the use of the word "transitory" to describe US inflation; this recognition of the persistence of inflationary pressures sets the stage for what will now be a fairly rapid monetary policy normalisation in the US in 2022, bringing with it the risk of a "taper tantrum 2.0" for emerging markets, including Latin America. The last taper tantrum, which took place back in mid-2013, when the Fed signalled that it would start to unwind extraordinary stimulus extended amid the global financial crisis, wreaked havoc on emerging markets, producing sharp currency depreciation pressure and prompting a cycle of emerging-market monetary policy tightening.

This time around, Latin America is ahead of the game. Brazil led the way among emerging markets in 2021 by raising rates in March; other regional central banks quickly followed suit as inflation expectations started to drift upwards. Latin America's central bankers will of course have been aware that US monetary normalisation is on the cards, and they are now in a better position to withstand depreciation pressure that would, in the current economic environment, prove damaging by passing through into inflation, forcing even sharper spikes in domestic interest rates that would cripple the (already weak) 2022 growth outlook and raise debt-service costs.

An increase in debt-service costs would ultimately raise the risk of a liquidity crisis that triggers sovereign defaults in the region. This is not our baseline forecast: we are cautiously optimistic that, for the most part, the region will be able to traverse this difficult period without sustaining lasting damage, but a taper tantrum 2.0 is a significant risk to our forecasts for 2022. Already, some of the most at-risk countries, including Ecuador and Costa Rica, have sought and received a boost from the IMF in the form of a long-term lending arrangement. For others, like El Salvador and Argentina, the question of IMF support in a difficult economic environment will dominate the outlook for 2022.

ESG will increasingly feature in the policy debate

Pressure for Latin American governments to focus more keenly on ESG criteria in policymaking and in business operations is building, from both inside and outside the region. The pandemic has exposed weaknesses in social safety nets and in health and education policy, and voters are clamouring for advances in social policy. With some exceptions, governments are looking to forge ahead with climate commitments by investing in climate-friendly infrastructure. Concurrently, foreign investors are increasingly looking for assurances in both social and climate policy, and in governance metrics.

There are opportunities and challenges here for Latin America. Opportunities come in the form of rapidly growing demand by portfolio investors for ESG investment vehicles. Although Latin America still makes up only a small fraction of global ESG bond issuance (about 3% in 2020), growth looks set to be rapid. Within the region, sovereigns are leading the way-driven particularly by Chile-in issuance that has been dominated by green bonds linked to specific projects in areas such as transport and energy. However, in the past year social bonds linked to particular projects and sustainability bonds (which combine both green and social projects) have gained ground. Sustainability-linked bonds that have broader targets (related to the sort of objectives found in the UN's sustainable development goals), rather than a project focus, are developing too. Governments that can credibly commit to targets in these areas are likely to increasingly issue in this format in 2022 (and beyond).

The main risk to this picture in 2022 is the potential for investor appetite towards emerging markets to seize up temporarily in response to US monetary tightening. The broader challenge for Latin America on the ESG front is the risk of lost investment commitments for governments that cannot meet the targets that portfolio and direct investors will increasingly demand. This is clearest in Brazil, where Amazon deforestation has not only scuppered the implementation of a free-trade agreement (FTA) between the EU and Mercosur (the Southern Cone customs union comprising Argentina, Brazil, Paraguay and Uruguay), but also led to threats by a group of global investors to divest from the country. Brazil's presidential election seems likely to bring a change of government and a change of policy on climate, which could dissuade investors from taking those measures, but if the government does not act, the threat of investment outflows will be substantial.

Fintech holds considerable promise

Despite the challenges that it faces on various fronts, Latin America is attracting substantial investment in its fintech sector. The industry was most recently thrust into the spotlight in December, when Nubank, a Brazilian fintech company, became the region's largest bank by market capitalisation. There has been an explosion of fintech activity in recent years, as more and more firms have sought to capitalise on a large consumer market that is either unbanked or underbanked. The underutilisation of traditional financial services is explained by several factors including a high level of bank concentration, costly transaction fees and cumbersome regulatory procedures, and stringent underwriting requirements that limit access to credit. Furthermore, a lack of competition has allowed Latin American banks to enjoy some of the healthiest profit margins of any financial institutions across the world. As a result, the region has proven fertile ground for disruption by fintech companies.

Fintech investment in Latin America reached an estimated US$9.7bn in the first three quarters of 2021-more than triple the figure recorded the year before and 16 times the comparative figure for 2017. Consequently, Latin America now accounts for about 10% of global fintech investment, compared with just 1% in 2017. There are reasons to be upbeat about prospects for continued fintech expansion. First, rising rates of internet penetration and smartphone adoption-trends that have been accelerated by the covid-19 pandemic-are boosting demand for digital financial products across the region. Secondly, new areas of opportunity are beginning to emerge. Fintech growth has so far largely been focused in payment services and alternative finance, but there is considerable scope for expansion in real-estate, e-commerce and payroll services. Thirdly, governments across the region are in the process of rolling out comprehensive fintech regulatory frameworks, which should give fintech providers policy certainty and allow them to compete better with legacy financial institutions. Although Latin America's fintech industry will still have to contend with myriad other challenges-including low levels of financial literacy and substantial deficits in digital infrastructure-it is nonetheless likely to remain one of the bright spots in the regional economy.