Not Much Spice in Latin America

JANUARY 6, 2003 STREET WISE By Geri Smith

Investors take note: Improvement in the region's economic picture depends largely on what happens in the U.S. and even more so in Brazil

For many in Latin America, 2002 was a year to forget. Argentina's economy shrank by 14% following a disastrous currency devaluation and a messy default on its international debt. As a result, neighboring Uruguay was forced to devalue its own currency.

Brazil had a turbulent year full of election jitters, as investors fretted that it might default on its $250 billion net public debt. And Venezuela spent the entire year in political limbo, as beleaguered President Hugo Chavez survived a military coup in April only to face an intractable, month-long civic strike and near-shutdown of the country's vital oil industry that continues today.

The region's woes weren't entirely homegrown, however. Capital flows to Latin America virtually dried up in 2002, as Enron and other corporate scandals soured investors on all but the most familiar of investments. Since the Russian crisis in 1998, capital flows have fallen from 5% of regional gross domestic product to less than 1%, according to the Inter-American Development Bank. And spreads on Latin American debt spiked upward in mid-2002, along with U.S. junk bond rates, making it difficult to issue new debt.

AS BRAZIL GOES...  Foreign direct investment (FDI) flows are just half what they were at their 1999 peak. For a region with insufficient domestic savings, the drying-up of portfolio flows and FDI put a significant damper on growth. Latin American economies shrank on average 1% in 2002. The outlook for 2003 isn't much better: growth of perhaps 2% at most.

Two big question marks could challenge even the most conservative estimates for the region's growth: the U.S. economic recovery and the new Brazilian government's policy direction. If the U.S. rebounds after the first quarter, the benefit would spread all the way to Patagonia, especially Mexico, which sends nearly 90% of its exports north of the border. A sluggish U.S. economy or continuing corporate scandals would do little to ease emerging markets' interest rate spreads.

Of even greater concern is the outlook for Brazil. During 2002, investors were worried that a victory by leftist candidate Luiz Inácio Lula da Silva would unleash a spending spree. But President da Silva, inaugurated on Jan. 1, has reassured the markets by naming respected economists and businesspeople to key government finance positions. "Lula measured the costs and benefits of breaking with the markets long ago, and he realized that he had a lot to lose by doing so," says Gray Newman, chief Latin America economist for Morgan Stanley in New York.

INFLATION PATROL.  The new administration realizes it must stay within budget and exercise great fiscal responsibility to reassure financial markets. "Although they hope at some point they can do things differently, at least initially they are committed to the idea that they can't print money to do what they want to do," says Newman.

Indeed, one of Lula's biggest challenges will be to promote economic growth without exacerbating Brazilian inflation. The cost of living rose by around 12% in 2002 -- triple the planned-for rate. But vanquishing triple-digit inflation was one of the key achievements of former President Fernando Henrique Cardoso. It not only improved the living standards of Brazil's poor but it convinced foreign investors to make the country the region's largest recipient of FDI in recent years. Lula's economic team likely will have to keep interest rates -- currently 25% -- high just to keep growth at just 2% to 2.5% this year.

Even Mexico, which along with Chile is one of region's few oases of economic stability -- and investment-grade ratings -- has to keep an eye on inflation: The Central Bank missed its target for the first time in four years, registering inflation of nearly 6%, compared to its 4.5% target. That overshooting was due mainly to the Mexican Congress' failure to approve fiscal reform. To boost revenue, the administration of President Vicente Fox hiked prices on gasoline and electricity by 16.5%. Central Bank President Guillermo Ortiz, whose six-year term ends in December, is likely to pursue a tight monetary policy so he can exit in style.

MUDDLING THROUGH?  Considering the less-than-rosy outlook, investors should venture into Latin America only if they believe in a timely U.S. recovery. Mexico is the safest bet because of its export potential and its still fairly robust consumer market. Leading retailer Wal-Mart de Mexico (WALMEXV.MX ) manages to outstrip competitors even in a slow economic environment, while dominant telecom Telmex (TMX.N ) continues to hold onto the lion's share of long-distance business.

And America Movil (AMX.N ), a spin-off of Telmex' cell-phone company that has snapped up mobile-phone operations throughout Latin America, including Brazil, offers investors a chance to get in on the still fast-expanding market for wireless telephony in the region.

If Brazil manages to avoid fireworks this year, the region should muddle through. Lots of upside can be found in Brazilian equities, which dropped 44% in dollar terms in 2002. Among the possibilities: Utilities, telecoms, and even state-run oil company Petrobras (PBR.N ), whose ADRs are now trading at around $13.50 on the New York Stock Exchange, down from around $20 a year ago.

LOW EXPECTATIONS.  The region's biggest challenge remains battling poverty. Latin America needs to grow 4% annually to make any progress at all in combating this scourge, according to most economists. Yet it has averaged only 1.7% annual growth in the past five years.

Poverty is still very much on the rise: The proportion of Latin Americans living on less than $2 a day rose from 40% to 43% from 1998 to 2001. More than 6 million people joined the ranks of the "extremely poor," subsisting on less than $1 a day. Per capita income is lower than it was in 1997, and investment is at its lowest in a decade. No wonder polls show that two of every three Latins believe economic conditions are bad or very bad, and only 25% expect improvement in the future.

That perception has soured support for free-market policies.

"Investors will be looking very closely at countries' ability to stick to pro-market reforms," says Guillermo Calvo, chief economist for the Inter-American Development Bank. "It will be difficult for politicians to explain to their constituents why it's taking so long for growth to pick up."

For investors, that's a sobering outlook for a region that thought a decade of painful economic reforms would have born fruit by now.