Itaú BBA - Latin America slowdown: the role of external factors

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Latin America slowdown: the role of external factors

June 27, 2017

The bulk of the slowdown in Latin American can be attributed to a less supportive external scenario

Please open the attached pdf to read the full report 

Economic growth has been disappointing across the region despite well-behaved asset prices. This frustration with activity can be attributed to idiosyncratic factors or country-specific events, but we suspect that common determinants have played at least as important a role.

We have identified three external factors (global growth, China's growth and emerging economies' sovereign credit risk) that explain a large portion of growth in each of the major Latin American countries (Argentina, Brazil, Chile, Colombia, Mexico and Peru). 

In fact, the bulk of the slowdown in Latin American countries over the past few years can be attributed mainly to a less supportive external scenario relative to the terms-of-trade boom period.

In some countries (mainly Brazil, but also Chile and Colombia), however, growth is worse than would be justified by external variables, indicating that idiosyncratic factors have also been a drag on growth. 

Between 2004 and 2007 and between 2010 and 2012, with the commodity boom and high global growth, the region[1] grew by an average rate of 5.6% annually. In the most recent period (2013-2016), however, there was a considerable slowdown, with average growth receding to 1.9% per year.

This pattern was observed in all the major economies of the region, and the synchronicity in the movements suggests that this slowdown was caused by external (and not idiosyncratic) factors.

To test this hypothesis, we estimated a model for each of the Latin American countries analyzed, in which annual GDP growth is explained by a set of international variables. The value forecasted by this model determines the economic growth that would have been explained only by the external factors commonly shared by emerging economies.

In order to obtain the explanatory variables, we applied the principal component analysis (PCA) methodology. This methodology allows us to transform a large set of data into a smaller number of variables, the so-called principal components.

First, we extracted the principal components from the growth of a sample of emerging economies[2] in the period 2000-2016; i.e., we extracted the common trend of these countries’ GDP variation. We excluded the Latin American countries from this group in order to avoid an endogeneity, so that the principal components explain the common trend of several emerging economies without being biased by the growth of the Latin American region itself.

We only use the first two principal components as explanatory variables in the regressions, as they account for more than halfof the GDP variation of the emerging countries in our sample. More specifically, thefirst component explains 50%, while the second component explains 21%. The first principal component is strongly correlated with global GDP growth. The second component, however, appears to be related to China's growth weighted by the size of the Chinese economy relative to that of other emerging economies (i.e., a measure of China's impulse to emerging economies) and to the sovereign credit risk of emerging countries ex-Latin America[3] (a measure of financial conditions for emerging economies).

The charts below show the comparison between the growth rates in each country and those forecasted by the models considering only the external factors. The explanatory power of regressions (as measured by R2) is high, which is to say that global growth, the impulse provided by China and the perceived risk of emerging economies are a major influence on growth dynamics for Latin American countries.

A few interesting points arise from these charts.

•     Much of the slowdown in Latin America in recent years can be attributed to the less benign international scenario compared with the period of rising commodity prices.

•     In some countries, however, idiosyncratic factors (the error of our regressions, or the distance in the charts between observed and forecasted growth at each moment) have played a big role.

•     In particular, Brazil has suffered a deep recession in recent years, which is not explainedby external factors. The model corroborates the fact that the deterioration of the fundamentals of the Brazilian economy in recent years has played a significant role in the economic contraction. 

•     To a lesser extent, Chile has also shown a worse performance than that suggested by the external scenario (possiblya consequence of the uncertainties generated by the ongoing reform agenda). In Colombia, activity has recently been posting a weaker performance than that indicated by the external scenario. 

•     On the other hand, in Mexico, the economy has performed more robustly than the model's indication. In our view, this is partly explained by recent reforms (such as the telecommunication and labor reforms), which haveled to an improvement in real wages and a robust increase in formal employment, boosting consumption. The strong performance of the U.S. economy relative to the global economy could also explain why Mexico is growing at a pace that exceeds the forecast. 

•      Interestingly, in Argentina, the external fundamentals were consistent with the economic recession experienced last year. In fact, Argentina's growth appears to be more sensitive to external factors. In our opinion, the macro policies practiced in Argentina over most of the last two decades havehad a pro-cyclical effect, thus exacerbating the fluctuations caused by changes in the external scenario.

We note that, according to our own forecasts, external factors are consistent with an economic acceleration in Latin America this year. The global economy is likely to gain strength, and the second principal component (which combines China's impulse to EM with financial conditions for emerging markets) also points to a stronger growth rate in the region. In fact, we anticipate that Latin America will grow more in 2017 than it did last year, mainly due to Argentina's and Brazil's exit from recession. Despite the more favorable external conditions, however, we forecast a slight slowdown this year in Mexico, Peru and Colombia. Meanwhile, in Chile, we anticipate steady growth compared with 2016.


Julia Gottlieb
João Pedro Bumachar

[1] We only consider the main economies of the region for the calculation of this simple average: Argentina, Brazil, Chile, Colombia, Mexico and Peru.

[2] Czech Republic, Hungary, India, Indonesia, Poland, Russia, South Africa, Thailand and Turkey.

[3] The boost provided by China to emerging economies is measured by China's nominal GDP variation divided by the nominal GDP of emerging economies (ex-China). Appetite for or aversion to risky assets of emerging economies is measured by the EMBI of eight countries. We explain in the appendix how the econometric identification of the first and second principal components was carried out.


Please open the attached pdf to read the full report 


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