Update Country Report Curaçao 03 Mar 2022

• The reverberations of the Russia-Ukraine crisis are already being felt across the world-in commodity markets, financial markets and supply chains. These developments will have important ramifications for Latin America's economy this year.
• The crisis is driving international prices of both hard and soft commodities to new highs, while also raising risks of a flight to safety that generates capital flight from emerging markets and exerts depreciation pressures on Latin American currencies. The confluence of these factors will aggravate price pressures in a region that has perennially struggled to keep inflation at bay.
• On the positive side, however, markets are increasingly pricing in a less aggressive pace of monetary tightening in the US and other developed economies. This should lessen the risk of a "taper tantrum" episode.
• There will be opportunities amid the crisis. One is that the region's commodity producers will benefit from higher fiscal and external revenue. Another is that Latin American businesses may be able to use global supply-chain disruptions as leverage to expand their footprint in overseas markets. However, for some countries-particularly in Central America and the Caribbean-high commodity prices will exert more pressure on the fiscal and external accounts.
• Overall, the outlook for Latin America is far from sanguine, not least because of restrictive macroeconomic policy domestically and heightened uncertainty around the global growth outlook. In this context, we do not expect a commodity windfall to prevent a sharp slowdown in regional growth this year.

Latin America's direct economic exposure to Russia is limited. According to the IMF's Direction of Trade Statistics (DOTS), only 0.5% of Latin American exports are destined for the Russian market, and the region relies on Russia for just 0.9% of its total imports. No economy in the region sends more than 5% of its exports to Russia or receives more than 5% of its imports from that country. That said, there are deeper ties to Russia in certain sectors; for example, Russia is a major buyer of meat products from Argentina and Paraguay, and an important supplier of fertilisers to Brazil, Colombia, Mexico and Peru. Sanctions on Russia are therefore likely to cause a few (at least temporary) sector-specific disruptions in the region.

Russian foreign direct investment (FDI) into Latin America has also been limited in recent years. Once tax havens in the Caribbean are excluded, official Russian FDI to Latin America amounted to less than US$3bn between 2000 and 2019. That said, Russia's modus operandi has been to facilitate its investments through subsidiaries and shell corporations in other countries, meaning that the actual sum is probably higher. Indeed, independent investigations and media reporting indicate significant Russian investment in recent decades in the hydrocarbons sector in various Latin American countries including Bolivia, Mexico and Venezuela. However, the pace of new investments has fallen sharply in recent years, in line with Russia's economic stagnation.

Price pressures to persist in the near term

Although Latin America's direct engagement with Russia is limited, the region will not be insulated from the fallout from Russia's invasion of Ukraine. The most immediate impact will come in the form of stronger inflationary pressures. The Russia-Ukraine crisis has sent crude oil prices soaring to above US$100/barrel. Oil prices will remain elevated for as long as the conflict in Ukraine rages, especially given the extant tightness of the global oil market. Against this backdrop, we now expect the price of Brent crude to average at least US$90/b in 2022-more than a third higher than in 2021. Along similar lines, gas prices have spiked in recent days, will not recede much in the near term and will therefore post strong double-digit increments relative to last year.

The crisis will also exert strong upward pressures on food prices, as both Russia and Ukraine are among the world's largest exporters of food grains-notably wheat and maize-as well as fertilisers. Meanwhile, the price of sunflower seed oil is on track to reach record highs, given that Russia and Ukraine combined account for more than three-quarters of the world's sunflower seed oil exports. This is in turn lifting prices of palm oil and soy oil, which are relatively good substitutes. Finally, an ongoing spike in prices of base metals is likely to feed through into higher prices for industrial goods and consumer durables.

Bearing these factors in mind, prospects for disinflation across Latin America are growing increasingly bleak. Food and fuel prices tend to have an outsized impact on headline inflation, reflecting their large weights in consumer price baskets across the region. Even assuming only partial pass-through from producer prices to consumer prices, the ongoing surge in food and fuel prices is likely to contribute to keeping inflation high across Latin America.

The extent to which these commodity price shocks translate into stronger inflationary pressures will vary across the region, depending on factors such as the credibility and efficacy of monetary policymakers and the scale of existing macroeconomic imbalances in a given country. Our preliminary calculations suggest that the price shocks could leave a drag on annual average inflation-relative to our existing baseline forecast for 2022-ranging from a moderate 0.6 percentage points in Peru to a relatively significant 1.9 percentage points in Brazil. In outliers like Argentina, Haiti and Venezuela, price pressures will be even stronger. All of this suggests that Latin America's inflation problem could get worse before it gets better.

Increased currency volatility on the cards

To complicate matters further, the Russia-Ukraine crisis has put international investors in risk-off mode, prompting them to pare back their exposure to emerging markets. This has led to a renewed sell-off of Latin American stocks and bonds, following a brief rally at the beginning of the year that reflected purchases of undervalued stocks, as well as carry trade in sovereign bonds. The resulting capital outflow has been evident in some modest currency depreciation, although depreciation pressure has so far been contained by two main factors. First, markets are accounting for the fact that higher commodity prices will have a positive impact on several commodity-rich Latin American economies. Secondly, markets are changing their expectations for US monetary tightening and betting that the region will maintain relatively wide real interest-rate differentials with the US (notwithstanding an expected 25-basis-point rate rise in the US later this month).

However, given the elevated uncertainty surrounding the crisis, we cannot rule out the possibility that Latin American currencies will succumb to renewed depreciation pressures as events develop over the next few weeks. This would only aggravate the region's inflation outlook, weaken consumers' purchasing power and lift input costs for businesses. Nonetheless, we believe that investor risk aversion to Latin America-and to emerging markets more broadly-will not be a long-term phenomenon. Although asset sell-offs are common during periods of heightened geopolitical tensions, history suggests that markets around the world usually recover from their crisis-induced trough within five months. As international investors resume their search for yield later in the year, Latin American assets and currencies could receive a boost.

Recalibrating economic policy

In the context of sustained inflationary pressures, there are looming questions about how the region's monetary authorities will respond. Given that Latin American central banks led the way in aggressively tightening monetary policy in 2021, real ex-ante interest rates in most countries have already returned to positive territory, or are on track to do so in the next few months. At present we are unlikely to make substantive revisions to our monetary policy forecasts, which assume that interest rates in most countries will reach their terminal levels by the second half of the year.

There are two main considerations that underpin our view. First, although most Latin American central banks do not have explicit mandates to maximise employment or growth, they will nonetheless be wary of tightening policy to the point where it becomes recession-inducing. Secondly, with the Russia-Ukraine crisis darkening the outlook for the global economy, markets are paring back their expectations for interest-rate rises by the US Federal Reserve (the US central bank); this should reduce the risk of a taper tantrum event and provide Latin American central banks with some breathing room.

The impact of the Russia-Ukraine crisis on the public finances will be uneven across the region. Broadly speaking, a rise in headline inflation is likely to lift government revenue, reflecting unindexed provisions and/or lags in updating countries' tax codes. In other areas, there will be a marked regional divide: South America's big commodity exporters will gain from increased fiscal revenue, but commodity importers in Central America and the Caribbean will struggle with the burden of increased subsidies and generalised demands for more fiscal support from struggling consumers.

Latin America's big oil and gas exporters-including Colombia, Venezuela, Bolivia, and Ecuador-will all benefit (Mexico and Brazil are also big oil producers but have more diversified economies). The gains to be made from booming commodity prices have already been evident to a greater or lesser degree for these economies; in Bolivia, for example, the gas price boom of the past year has postponed the need for deep fiscal and currency adjustments for two years at least. For grain and oilseeds producers like Brazil, Paraguay and Argentina, there will also be some benefit (although in Argentina's case, export restrictions will limit the upside). For commodity importers like El Salvador and Costa Rica, however, pressure on the fiscal accounts will rise and fiscal deficits will widen (or at the very least, planned post-pandemic fiscal consolidation will be slow to materialise, raising creditworthiness concerns in some markets).

The upshot for the region's economic prospects

The growth outlook

Taking all of these factors into account-and although there will be some moderate upward or downward revisions to particular country forecasts-we believe that our current growth outlook for Latin America, which foresees a sharp deceleration in regional GDP growth, to 2.1% in 2022 (from 6.5% in 2021), remains appropriate. In theory, booming commodity prices should provide a fillip to growth in several key markets, by incentivising both investment and exports. There will also be opportunities for the region's agro-exporters and hard-commodity producers to capture (or expand) market share abroad. However, we think that these upsides will largely be offset by subdued consumer and business confidence and by highly restrictive macroeconomic policy. Moreover, there are downside risks to this outlook. Our current forecasts assume that the Russia-Ukraine crisis will not dent growth prospects in either China or the US-the region's largest trade partners. If the outlook for either of the world's largest economies were to worsen, Latin America's economic prospects would do so too.

The aggregate growth outlook for Latin America masks considerable differences across countries. Although the region's commodity producers may emerge relatively unscathed from the crisis, the same cannot be said of several countries in Central America and the Caribbean, which will face an extremely challenging external environment. Countries with large twin deficits, like Costa Rica and El Salvador, will face an expanding financing requirement, growing creditworthiness concerns and increased risk of a liquidity crunch.