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Latin Dominos Falling?

Could an economic domino theory prove true for Latin America in the wake of Argentina’s crisis?

July 2, 2002

Could an economic domino theory prove true for Latin America in the wake of Argentina's crisis?

For the first half of 2002, many analysts thought that Brazil and the rest of Latin America could quietly slip away from Argentina's agony.

They figured that somehow, the rest of the region and the world could ignore the fact that an economy of 30 million people was sinking into complete breakdown.

But now, the Argentine disease seems to be slowly — but steadily — spreading to other nations in the region. Like Argentina in 2001, Brazil is suffering from falling access to foreign liquidity.

The Argentine meltdown — combined with a strong showing by the perennial left-wing presidential candidate, Luiz Inácio “Lula” da Silva — has created a stampede for the door by foreign investors.

It is some measure of the moral position of foreign investors that they fear the election of a populist candidate who dislikes the fact that Brazil spends more annually on foreign debt service than it does on internal infrastructure and health care.

Brazil's economy is larger and far more resilient than that of its neighbor. Yet, the country cannot avoid default on its total debt of $344 billion — if it loses access to the global capital markets.

At the same time, Brazil has done many things right where Argentina failed. For example, it has reduced public spending, restored solvency to the banking system — and cut inflation to single digits.

In contrast to Argentina, where the middle class contracted during the 1990s, Brazil’s middle class has thrived. Furthermore, Brazil’s social indicators improved, labor productivity surged — and Brazilians as a whole became more affluent.

Despite these successes, Brazil is now under attack. It faces a slowing economy, rising unemployment — and plummeting investor confidence.

Because of the erosion of confidence related to Argentina, Brazil — the largest country in the hemisphere after the United States — is hostage to the fickle perceptions of the global investment community.

To be sure, its cause was not helped by the glib comments of U.S. Treasury Secretary Paul O'Neill that Brazil did not merit international assistance.

If current political trends continue and Lula is victorious in the second round of Brazil's presidential elections, the country's debt problem will only worsen — despite the IMF's promises of massive aid.

They started before the election, as investors became nervous at Lula's standing in the polls. And that, in turn made Brazil's financial stability a key issue in the election itself. Now the only question seems to be how badly Brazil's credibility was damaged.

As global investors back away from the stocks and bonds of all Latin nations, the logical question to ask is: How will other nations in the region be affected by a second financial crisis in Brazil?

Already, the collapse of Argentina and the crisis in Brazil is having a negative wealth effect on Chile. It will eventually manifest itself in the form of lower investment and consumption.

"Chile may be like an island, but it is not a separate planet," says Walter Molano, a veteran Latin market observer at BCP Securities. He worries that the entire region may lose access to the capital markets as the result of Argentina's slow demise.

New credit available to Latin America is "evaporating" as investors flee the region. Mr. Molano says that the markets expect global financial institutions to reduce their lending to Brazil in 2002 by a third to a half of their current levels. Such a reduction in credit is occurring at the same time that the Brazilian economy is slowing down.

The absence of foreign capital may become prominent in the second half of the year when Brazilian firms try to finance some of their external obligations.

"Unfortunately, the situation may get worse the longer the Argentine crisis is prolonged," Mr. Molano concludes. But he notes with some irony that the Bush Administration has belatedly made overtures to end the crisis after a year of studied indifference.

In Mexico, the effect of Argentina is also being felt. Mexico's currency has fallen 10% in the first half of 2002 — from 9 pesos per dollar immediately following the Argentine devaluation to almost 10.

This follows a two-year run when the Mexican peso was the strongest currency in the world — appreciating even against the mighty dollar.

Over the last 18 months, Mexico's stock market was a stellar, double-digit gainer. This occurred even as the country dragged through six quarters of recession and saw its terms of trade deteriorate. That literally killed the country's ability to export outside of the NAFTA bloc.

For those who recall that Mexico was supposed to be a job-creating growth platform in the post-NAFTA world, the past couple of years are especially strange. The strong peso has tamed visible inflation — but at a cost.

Like the United States, corporate bankruptcies and defaults in Mexico are at record levels. This continues the process of capital destruction that has crippled the country's job creation ability since the 1970s.

And like Brazil, Mexico spends far more on foreign debt service than it does on building infrastructure and providing health services for its people.

Just what is the significance of the financial crisis in Argentina, and now Brazil, infecting heretofore solid credits like Chile and investment-grade Mexico? The answer is simple: It is put into question. The whole notion of extending the benefits of globalization to the nations of Latin America — and the rest of the developing world — is put in jeopardy.

In this context, it is fashionable to blame the Bush Administration for "allowing" the Argentine crisis to unfold. But that gives politicians too much credit — and mistakes the symptom of Argentina with other root causes.

In the ultimate analysis, it is the same vast financial and demographic forces which fueled the technology bubble in the United States that also drove Argentina's profligacy — and eventual collapse.

Despite this parallel, Washington thought it could ignore Argentina — and even use its agony as an example for other debtor nations. But a debt default by Brazil — and/or a serious financial meltdown in Mexico — is another matter entirely.

It would mark a considerable defeat for advocates of free trade and globalization.

Just as financial problems in Asia threatened the stability of markets around the world, the reduction in the supply of credit available to the Latin debtor nations may signal a larger global liquidity crisis that could spread to Asia — and beyond.

After all, if relative paragons of free-market virtue like Brazil, Chile and Mexico follow Argentina's example, a number of well-established assumptions about free trade, foreign debt and economic growth could be changed forever.

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