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EM turmoil rattles Latin America, but silver lining emerges for Mexico

Last week media outlets focused on Turkey’s currency crisis and the ongoing trade dispute between the United States and China, putting global markets into a tizzy.

Emerging market currencies plunged to new lows against the USD while stock markets around the world sold off. Many are speculating the situation in both countries could pierce the armor of relatively stable global economic growth and low volatility, thanks to years of accommodative central bank policies.

“The risk of contagion is pretty high,” Robert Subbaraman, an emerging market economist at Nomura in Singapore, recently told the New York Times. “Turkey is a symptom of the growing challenges for emerging markets … Due to super-low interest rates, investors have been on the hunt for yield — until this year. Now they will be blindsided by the risks.”

He attributed the risks to current account deficits, cheap dollar debt and depreciating currencies. If the US greenback continues its upward trajectory those risks will grow, although market analysts expect the USD to trade sideways in the second-half of 2018.

Between dollar-denominated bank loans and bonds, the latter may apply greater downward pressure on emerging market currencies and economies. Since 2011, emerging market issuance of dollar bonds has grown at a much faster clip than bank loans. The outstanding stock of dollar bonds has been rising at a rate of roughly 17% annually since late 2016, according to Bank of International Settlements data. Sure, the local economy gets a boost when bond proceeds are first deposited into local banks, and then invested or made into loans via the local currency. However, once monetary conditions tighten and global investors dump bonds, which drive yields up even farther, emerging market currencies lose their value at a faster pace. Domestic companies hoard dollars to pay off their dollar debts while central banks raise rates to slow their currencies’ fall, making borrowing more expensive. As the series of dominoes winds its way around the globe, investors can expect the last chip to fall will be the real economy. Emerging market economies will see declining investment RoR, growing corporate defaults and rising unemployment.

Mr. Subbaraman singled out Chile and Mexico among Latin American countries that have the most vulnerable economies. Market players have also expressed reservations about Argentina’s structural deficiencies and Brazil’s upcoming election that could add to sovereign risk.

Chile ranks among the highest of emerging markets in corporate debt issued in foreign currency as a share of GDP while Argentina’s government debt levels issued in foreign currency are the highest as a share of GDP, far surpassing Turkey’s 11%. On Monday, Banco Central De Chile announced the country’s current account deficit increased USD 1.85bn in 2Q18 from USD 1.33bn in the same period last year mainly due to higher imports of intermediate goods, namely metals and chemicals.

The Good News

Conversely, there are those that argue the Latin American market still presents opportunities for mid- and long-term investors. Writing for Forbes, MRV Associates Managing Principal Mayra Rodriguez Valladares states “there looks to be a mild recovery in most economies, which could help improve banks’ asset quality … Based on their level of GDP, there is still a lot of room for banks to extend credit to creditworthy individuals and companies … a growing middle class in many emerging markets means higher demand for mortgages, credit cards and other loans from banks.”

On Monday, Chile’s central bank announced the country’s GDP grew at its strongest rate in 6 years achieving 5.3% YoY in 2Q18, faster than an upwardly revised 4.3% in the previous period and beating market consensus of a 4% rise.

There might be even better news for Mexico.

Across the Latin American region, M2 and M3 money supply figures have reached historic highs over the last few years, especially in Brazil, Argentina and Chile - no surprise given the circumstances explained above. Interestingly, Mexico’s M3 money supply dropped from MXN 16bn at the end of 2017 to MXN 8bn in January 2018. The M2 measurement had a similar drop off while M0 and M1 declined only slightly over the same period.

Why do I bring this up? Well, because there is a school of thought that theorizes money supply growth is the actual cause of inflation – an economic phenomenon that dilutes the purchasing power of individuals and companies. While most mainstream economists – the preponderance of whom subscribe to Monetarist and/or Keynesian orthodoxy – do examine monetary growth as a possible culprit of inflation, instead, they mostly attribute it to the general growth in consumer prices. Price indexes, such as CPI, influence policy makers at the Federal Reserve and other government bodies.

However, some economists point out problems with CPI when its used as a yardstick for measuring inflation. The challenge with price indexes is which prices are to be measured and what “weights” will be assigned to what goods. Another problem is deciding what to do about changes in product quality. For example, what do you do when Apple introduces a new and improved iPhone at the same price as the previous version?

“Since increases in money supply set in motion an exchange of nothing for something, it diverts real funding away from wealth generators towards the holders of the newly created money. It is this that sets in motion the misallocation of resources and not price rises as such. Moreover, the beneficiaries of the newly created money, i.e. money ‘out of thin air,’ are always the first recipients of money. For they benefit from diverting a greater portion of wealth to themselves. Obviously, those who don’t receive any of the newly created money or get it last will find that what is left for them is a diminished portion of the real pool of wealth,” writes, Frank Shostak, Ph.D., chief economist at AAS Economics, a consulting firm that provides research services to wholesale and institutional clients.

“Furthermore, real incomes fall not because of general rises in prices but because of increases in money supply, i.e. inflation depletes the real pool of wealth thereby undermining the production of real wealth, i.e. lowering real incomes. General rises in prices, which follow rises in money supply, only points to the erosion of money's purchasing power – however general rises in prices by themselves do not undermine the formation of real wealth as such.”

If Dr. Shostak and economists that share his view of what causes inflation are correct, then it’s quite possible Mexican workers could experience real wage growth while companies might see improved margins. I don’t mean to sound noncommittal to which effect will be experienced, but it’s been argued that the effects of money creation can be felt in other channels of the economy other than CPI. For instance, asset prices and intermediate goods – products that are used as inputs into the production of other goods – can often undergo price inflation due to monetary expansion. See the current, historic bull run in the American stock market that began around the time when the Federal Reserve engaged in its quantitative easing policy. Some economic historians also point to the Great Depression as an outcome of monetary growth during the ‘20s based on inflation in intermediate good prices - CPI remained level at that time but the Index of Manufacturing Production doubled between 1921 - 1929 – and stock market bubble.

Regardless, taming M2 and M3 expansion could quite possibly give Mexico a boost of real economic growth and M&A dealmaking.  

I expect panelists at the Mergermarket’s Oct. 24 Mexico M&A and Private Equity Forum to discuss inflation expectations along with the US dollar and Mexican peso exchange rate, NAFTA renegotiations, the new presidential administration and other structural issues.

Matt O'Brien Content Editor Acuris Studios

Follow Matt on Twitter @matt_obri3n or connect with him on LinkedIn.

Matt O'Brien is content editor for Acuris Studios, the sponsored events and publications division of Acuris, overseeing the research and editorial input for events. Matt works with the editors and reporters of Acuris' various publications to ensure the company delivers industry-leading conferences. He has spent nearly 13 years in the news and finance industries. Matt has a political science and international studies BA from Rutgers University.

Matt O'Brien Content Editor Acuris Studios

Follow Matt on Twitter @matt_obri3n or connect with him on LinkedIn.

Matt O'Brien is content editor for Acuris Studios, the sponsored events and publications division of Acuris, overseeing the research and editorial input for events. Matt works with the editors and reporters of Acuris' various publications to ensure the company delivers industry-leading conferences. He has spent nearly 13 years in the news and finance industries. Matt has a political science and international studies BA from Rutgers University.

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