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Walter Molano | What lies ahead not all doom and gloom

Published:Friday | January 15, 2016 | 1:00 AMWalter Molano

Capital is the essence of capitalism. Along with land and labour, it comprises the three factors of production.

While the latter two contribute linearly to a nation's output, capital's contribution to growth, through the process of com-pounding, can be geometrical.

This is a tenet that is well accepted throughout the developed world. It is the reason developed countries decided to forego political repercussions by indirectly recapitalising their banking systems through heterodox programmes, such as quantitative easing.

Indeed, the reason the Great Depression lasted as long as it did was due to government's delay in recapitalising the financial sector. This left an indelible mark in the psyche of policymakers across Europe and North America.

With balance sheets repaired, United States banks are driving the current economic recovery. It is only a matter of time until the same happens on the other side of the Atlantic.

However, that is not the case in the developing world. These economies are either labour or commodity-intensive. They require external economic conditions to be strong in order to mobilise their domestic resources.

For the past decade, China was the great engine of global growth. Using capital from the developed world, it added significantly to global demand. This triggered a corresponding increase in the demand for commodities.

Given the enormous lag between initial investment and production, and the lack of coordination between commodity producers, supply eventually outstripped demand when China's economic activity began to plateau two years ago. This is what led to the subsequent collapse in commodity prices and the environment that is currently affecting the emerging world.

This is the landscape that sits before us. Global growth is on the mend, as US and European economic apparatus slowly recover. However, it will not be expanding as fast as many commodity producers hope, given that the Chinese behemoth will be growing at a moderate pace. This means that capital expenditures and income levels across most of the developing world will moderate.

After growing for more than three decades, economic growth in Latin America dropped one per cent y/y in 2015. It will be close to flat in 2016. The biggest risks are in the financial sector. Non-performing loans are on the rise across the emerging markets, and almost all of Latin America.

Mexico was the exception in 2015, but it may soon join the lot. Consumer and corporate credit soared last year, with much of the expansion concentrated in the form of non-secured lending.

Unfortunately, the region has a checkered past in dealing with financial sector crises. It has been almost two decades since the emerging markets had a major financial sector crisis.

Most of the rescues have been led from abroad, with the International Monetary Fund, World Bank and Inter-American Development Bank leading the charge.

Household debtors in Brazil have already been on the ropes for a couple of years, now Colombian and Peruvian households are starting to feel the pain. The problems could soon spread to Chile, Panama, Russia, Turkey and Indonesia, which also experienced big increases in consumer spending.

Fortunately, not everything is gloom and doom. The political pendulum, particularly in Latin America, is swinging in the opposite direction. While many commentators have noticed the shift, there has been very little discussion about the cause.

There have been some acknowledgments about the political left's mismanagement and rampant corruption. However, these are not traits that are unique to the left. The political right has had its share of missteps. I believe that it is more related to the end of the commodity supercycle.

Most emerging market governments, particularly in Latin America, play a major role in the commodity sector. From direct ownership of the largest producers, such as Pemex and PDVSA, to the heavy taxation of exporters, as in the case of Argentina's grain sector, commodities represent an important part of government revenues. Even Chile, the paradigm of free-market capitalism, depends heavily on its two state-owned copper mining and smelting companies, CODELCO and ENAMI, to fill its government coffers.

The commodity boom created a rich prize for politicians seeking to distribute the spoils. Given that the platform of the political left is one of redistribution, they were the ones best positioned to take advantage of the situation. Now that the supercycle is over, there is nothing left to give away, thus giving an opportunity for the political right to move in.

There was no ideological shift in Latin America; it was a simple shift in economic realities. Nevertheless, it will lead to the policies that should lay the foundation for an eventual recovery in Latin America.

It will be a difficult year, but one where we will identify winners and losers. So, it could be a year with interesting opportunities.

 

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com