Latin America and the Fed Factor

The tide will go out and we will find out who was swimming naked

By Alvaro Vargas Llosa

We recently got a glimpse of what will happen to Latin America once the Federal Reserve stops printing money like crazy. Ben Bernanke’s mere suggestion, back in May, that he might begin to slow the purchase of securities (“tapering,” in financial parlance) was enough to cause $1.5 trillion to evaporate in emerging markets as money was pulled out by investors, stock exchanges took a nosedive, and local currencies lost value. In Latin America, the combined stock exchanges of Mexico, Peru, Chile and Colombia dropped 24 percent; Brazil’s currency lost 18 percent of its value in three months, prompting the central bank to sell U.S. dollars with maniacal intensity.

None of this is surprising. In recent years, the Fed’s policy of artificial money creation has generated, through the lowering of interest rates and the desperate search for yield on the part of investors, a boom in emerging capital markets. This has added to the considerable amount of money invested in regions such as Latin America where the commodities boom, itself partly a result of Fed policy, had already attracted lots of capital. The real possibility that the Fed will start to backtrack in the foreseeable future has had the opposite effect—a flight of capital out of Latin America and back into the U.S., where investors anticipate that interest rates will rise significantly.

They also anticipate the end of the commodities boom. There is every possibility that once the Fed ceases to print so much money the commodities boom will end. How sustained or deep the drop in the price of commodities is will depend on many factors, but the effect of Fed policy is usually traumatic. What will happen to Latin America then?

Well, as Manuel Hinds, the free-market former Minister of Finance in El Salvador, has said many times, economic growth will stall or be reversed in many countries that were considered the stars of the emerging firmament. Contrary to conventional wisdom, which attributes the success of Latin America’s economies in the past decade to having adopted sound policies, the truth is that much of it was directly connected to the booming exports resulting from the high prices of natural resources. The rise in exports and the expansion of domestic markets resulting from the commodities boom were powerful enough to generate GDP growth in countries that had adopted statist policies just as much as in those that had done the opposite.

As happened in the 1980s, when the commodities boom stopped once interest rates rose in the U.S., sooner or later the tide will go out and we will find out who was swimming naked. Of course, some countries (Chile, Colombia, Peru, etc.) are in a better position to withstand the end of the boom than, say, Argentina or Venezuela. However, many of the countries that adopted sound policies all these years did little to continue with the process of free-market reform. They took for granted their newfound success. They will discover how unwise this was.

There is one more thing. Will the fiscal and monetary discipline shown by some governments in good times be maintained in times of adversity? Will they continue to embrace open trade and globalization? Or will they be tempted to return to the policies of the 1980s, when the change in U.S. monetary policy and the rise in interest rates brought about the end of the commodities boom of the 1970s?