US deflation would rain on emerging market parade

Tue May 27, 2003 03:16 PM ET By Pedro Nicolaci da Costa

NEW YORK, May 27 (<a href=reuters.com>Reuters) - The specter of deflation in the United States has intensified Wall Street's latest obsession with Latin America as an investment destination, but a persistent global slump in prices would be no fiesta.

As financial experts scramble for alternate ways of making money while U.S. interest rates languish at rock bottom, demand for Latin America's debt has soared, with yields so much higher across the region than in the United States.

If the feared deflation monster rears its head in the United States -- still a remote possibility but a scenario increasingly on the radar screen -- Latin America's commodity-driven economies would suffer disproportionately.

While consumers in the region may be heartened by the prospect of prices tumbling at the local neighborhood store, the longer-term impact on growth would be severe, analysts warn.

Companies faced with a stubborn decline in prices are sure to pass the deflationary pain onto their workers -- either through job cuts, wage decreases or both. Large debt burdens make Latin American nations especially vulnerable.

"Deflation is particularly harmful to countries that have lots of debt, because falling prices will inflate the real debt burden," said Christian Stracke, emerging markets debt strategist at CreditSights.

Brazil, with the region's largest economy, is a classic example. With an estimated $250 billion debt load, the country's large interest payments on external debt would magnify its woes under a scenario of global deflation as export revenues fall but interest costs stay put.

Mexico's close ties to the U.S. economy, which brought tremendous benefits during the boom years of the late 1990s, would bring just as much pain in a prolonged deflationary bust. Mexico startled economists with a surprise 0.41 percent decline in consumer prices for the first two weeks of May.

Chile, Argentina and Uruguay, with their heavy reliance on commodity exports, would also suffer.

BACK ON THE ECONOMIC MAP

Deflation reclaimed its importance in the economics lexicon in April after the Federal Reserve suggested for the first time since the Great Depression that it was worried about the risk of a persistent downturn in prices.

While reaffirming that the threat of deflation is still minor, Fed Chairman Alan Greenspan expanded on the point last week, arguing that price gauges require "close scrutiny and -- maybe, maybe -- action on the part of the central bank."

At first glance, deflation might seem like a blessing to Latin America, where not long ago, several countries grappled with triple-digit hyperinflation.

"The deflationary fears that are spreading around the world, and the growing likelihood that the monetary authorities in the U.S. and Europe will be forced to cut interest rates, are increasing the demand for high-yield assets" such as emerging market debt, Walter Molano, head of research at BCP Securities, said in a report to clients.

Yet a deflationary spiral that prevents a long-sought pick-up in U.S. economic growth would have severe consequences for Latin American economies, whose success often depends on the performance of their northern counterparts.

"The principal problem in Latin America today is not inflation," said Gray Newman, chief economist for Latin America at Morgan Stanley. "Growth is what this region needs, and I'm afraid that the damage of deflation to growth prospects would outweigh the benefits."

THE VALUE OF LABOR

A bout of U.S. deflation would also put Latin American economies at a serious disadvantage in global trade.

Capital goods like heavy machinery and factory equipment, manufactured primarily in rich countries, require more labor and are thus accompanied by higher wage costs. Agricultural or lightly manufactured goods, produced mostly in the developing world, require a much smaller input from workers.

A drop in capital goods prices usually requires wage cuts, which workers are loathe to accept without a fight, so industrial costs tend to fall more slowly than commodities prices, to the detriment of emerging market exporters.

Such imbalances would be less of a problem for some of the region's oil producers, like Venezuela and Ecuador, who could ride OPEC's price-supportive supply restrictions.

But the rest of Latin America would be in a tight spot if governments had no choice but to fight economic forces largely beyond their control.