EconSouth (Second Quarter 2006)

Financial Volatility and Electoral Uncertainty in Latin America:
Perspectives for 2006

Latin American economies have in the past experienced increased economic upheaval during busy electoral seasons. Will the large number of elections this year pose a threat to the region’s financial stability?

At the heart of every financial transaction lies the presumption of confidence. In turn, any event that could bring about change, to the extent that the change is unpredictable, will foster uncertainty and put that confidence to the test. Political elections are an example of such an uncertain event, and in Latin America elections have typically been associated with more than their share of uncertainty.

In fact, many financial crises in Latin America have coincided with elections. For example, the largest stock market sell-offs in Brazil’s recent history occurred in the last two presidential election years of 1998 and 2002. Chart 1 illustrates the relationship between the number of elections in Latin American countries and the risk that sovereign bond buyers perceive in those governments.

campaign poster, Chile
Photos (bottom) by Jennifer Weissman
Latin American elections this year may not bring with them the volatility that has roiled the region’s markets in years past, as many countries there have strengthened their trade balances and currencies.

In the past, uncertainty about policy continuity, coupled with preexisting economic fragility, provided the catalyst for financial meltdowns in Latin America. Such cause-and-effect collapses occur during times of transition—like elections—when sensitive investors are forced to form expectations based on scarce and highly imperfect information. Therefore, a mere unfortunate comment or a change in the direction of the polls can diminish a foreign investor’s appetite for Latin American assets.

With at least 21 presidential and legislative elections scheduled, 2006 represents an unusually politically intense year in Latin America. Moreover, some of these elections are taking place in the region’s largest economies, including Brazil and Mexico. As a consequence, a great deal of speculation has occurred concerning the political cycle’s economic effect on Latin America. Will the uncertainty usually associated with the elections cause a sudden stop of financial flows into the region? Or, alternatively, will the series of political and institutional reforms implemented in the region over the last decade be enough to reassure investors that political change will not lead to a fundamental shift in economic prospects?

So far this year, the elections in Chile, Costa Rica, Haiti, El Salvador, Colombia, and Peru took place without major market disruptions, standing in stark contrast to outcomes during previous election cycles in those countries. This trend should continue throughout the remainder of 2006 because, for a number of reasons, Latin America appears better prepared to withstand the gyrations of the political cycle.

Improving trade balances
Thanks mainly to favorable external demand for the region’s commodities, most Latin American economies have been experiencing strong export performance. As a result, most countries in the region are making more money on exports than they’re spending on imports. This current account surplus clearly contrasts with the situation in the 1990s, where current accounts were for the most part running a deficit as countries spent more on imports than they made on exports. As a result, Latin America has been able to reduce its dependence on foreign financing by going from being a net borrower to a net lender of funds.

Chart 1
Latin American Election Frequency
and Government Bond Spread
Note: Bond yield calculations represent a weighted average of Latin American bond yields vs. comparable U.S. Treasury bond yields. Bond yield data are through May 5, 2005.

Source: JPMorgan Chase, Federal Reserve Bank of Atlanta

This situation has also mitigated the effects of the increased cost of borrowing. When the Fed raised interest rates in the 1990s, cash-starved Latin America suffered. Its financing costs increased every time the fed funds target rate was raised in the United States. Today, by reducing its borrowing needs, Latin America has not only reduced its vulnerability to sudden halts of foreign investment but also to higher financing costs.

Central banks gain credibility in fighting inflation
Slowly but steadily, central banks in Latin America have been able to better cope with the region’s traditional Achilles’ heel: inflation. For example, the annual average regional inflation rate for the last three years was around 8 percent while the average for 1993–2002 was closer to 53 percent.

In addition, the region’s central banks have on average shifted away from attempting to manage a particular exchange rate and have undertaken a more stringent focus on inflation. Several Latin American monetary authorities have opted for a monetary policy rule that is similar to inflation targeting. Brazil, Chile, Colombia, Mexico, and Peru gradually started to implement this sort of monetary policy throughout the 1990s.

Increased tax receipts
Given the strong growth in gross domestic product (GDP), governments have been able to boost their tax receipts, and revenues have recently grown faster than outlays. In fact, administrations in Brazil, Chile, and Argentina have created market stability through their fiscal surpluses. In turn, these fiscal surpluses also reduce the countries’ financing needs, whereas in the past, outside investment would have been a source of concern should investor sentiment go against the countries. In fact, in February 2006, JPMorgan Chase estimated that most countries in the region had already prefinanced more than 90 percent of their projected external borrowing requirements for this year. With this reduced reliance on foreign financing, Latin American governments are better prepared to absorb other types of macroeconomic shocks.

Chart 2
International Currency Reserves
of Latin American Countries
Source: Economist Intelligence Unit

Reduced leverage
A stronger fiscal position has, in addition, allowed many Latin American governments to manage their liabilities in a way that has successfully reduced their debt levels. For example, in less than two years, Brazil, Peru, and Venezuela reduced their debt-to-GDP ratios from 79 to 50 percent, 46 to 37 percent, and 53 to 34 percent, respectively, according to the Economist Intelligence Unit (EIU), an economic data firm.

Moreover, not only has the region’s average leverage situation improved, but so has the composition of its debt portfolio. Gradually, Latin American governments have either been able to sell new securities or roll over existing debt using instruments that can be paid back over a longer period. More importantly, these instruments are denominated in local currencies, thus eliminating the exchange rate risk. Therefore, not only are countries less leveraged, but they are also less exposed to variations in their exchange rates.

International reserve stock accumulation
To avoid dampening the export-led recovery, many Latin American central banks have gradually increased their holdings of international reserves. By doing so, they have been able to minimize the appreciation of their nominal exchange rates without fostering inflationary pressures.

Between 2000 and 2005 the stock of international reserves held in Latin America grew by approximately 63 percent, from $159 billion to $261 billion (see chart 2), according to the EIU. These reserves have in turn increased the countries’ net worth position.

Additionally, JPMorgan Chase estimates that the reserves’ value is well in excess of public and private external debt payments. Some analysts believe these hard-currency reserves could also allow policymakers additional options to counteract adverse economic shocks, should the situation require it.

campaign poster, Peru

Development of domestic capital markets
The development and growth of domestic capital markets in Latin American countries arguably should provide additional assurance that a major destabilizing sell-off in debt or equity markets does not occur. Sell-offs are less anticipated when domestic investors hold a greater share of their own government’s debt, and on average these investors are holding all domestic assets with longer-term horizons.

Latin America’s stock market capitalization as a percentage of GDP almost doubled between 2001 and 2004, according to the International Monetary Fund’s Global Financial Stability report. In other words, the capital markets have grown faster than the region’s economies, further providing policymakers with economic options.

A good year, so far
Entering 2006, the combination of good economic fundamentals and the perceived willingness of the main candidates to maintain macroeconomic policies were expected to anchor market expectations. To date, this has been the case.

Perhaps the greatest risk associated with the current electoral cycle is in the form of reform paralysis. Since most Latin American governments are busy with their electoral agendas, they seem to have little incentive to push forward with any of the remaining—and much-needed—reforms, such as in the fiscal and pension arenas.

Should economic conditions deteriorate, governments will find it difficult to expend the political capital needed to implement reform policies. Thus, the longer-term challenge confronting Latin America will be maintaining market confidence in the face of less favorable economic conditions and reduced enthusiasm for political and institutional reform.

This article was written by Diego Vilan, a senior economic analyst in the regional section of the Atlanta Fed’s research department.

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