Latin America's economies

Bad bets

Currency worries in Brazil and Mexico

UNTIL the past fortnight, a crise, as Brazilians call it, had largely bypassed Latin America. No longer. In the week that began on October 6th the Brazilian real and the Mexican peso both plunged sickeningly (see chart), as did stockmarkets. This week saw modest recoveries. But confidence in the region’s new-found stability has taken a knock.

That is because the currency movements were sudden and violent. They prompted both countries’ central banks to intervene. Mexico’s had to spend 10% of its reserves in just a few hours to prop up the peso. Some foreign investors began selling Latin American assets to cover losses at home. But once it started, the currency slide seemed to provoke a collective nervous twitch that led many to seek safety in the dollar. This followed years in which Mexico had worked to create confidence in the stability of the free-floating peso. “Unfortunately you cannot just unlearn a reflex developed over decades of financial crises,” says Damian Fraser of UBS, an investment bank. The peso’s slide was exacerbated by the unwinding of derivatives contracts that had been profitable while the currency was steady. Comercial Mexicana, a big retailer, lost $4 billion on derivatives contracts and filed for protection from creditors on October 9th.

Something similar happened in Brazil. Because Brazil’s exports include a wide variety of raw materials, the real has recently come to be seen by investors as a proxy for global economic growth. When both began to fall, this triggered losses on derivatives, just as in Mexico. Grupo Votorantim, an industrial conglomerate and big exporter, used derivatives for hedging. It made profits of some 2 billion reais ($924m at the latest rate) over the past few years as the real appreciated. But earlier this month the real fell below the band specified in the contracts, triggering penalty clauses. On October 10th the company announced that it had spent 2.2 billion reais to rid itself of the troublesome contracts.

One theory is that the exchange-rate movements were so abrupt because currency dealers find it hard to raise credit, just like everyone else, and that this has cut the volume of transactions. Be that as it may, the currency turmoil will have economic effects. Until recently Brazilians worried that a rapidly strengthening real was making their exports uncompetitive. Now they have the opposite concern. Weaker currencies will mean higher inflation, because imports are more expensive.

Central bankers in both Brazil and Mexico have worked hard to establish their credibility as inflation fighters. Both have raised interest rates over the past year. Now they may have to do so again just as the gathering world recession, and the concomitant fall in commodity prices, is slowing their economies—or else abandon their inflation targets.

Until last month, most forecasters expected next year to see growth of 4.5% in Brazil and 3% in Mexico. They have since lopped about one and a half percentage points off both those figures. Even so, that points not to a bust but a slowdown. In the case of Brazil, that is healthy, since the economy cannot satisfy domestic demand (rising at 8% this year) without higher inflation, reckons Arminio Fraga, a fund manager and former central-bank president.

Even before the currency plunge, companies in both countries had started to feel the credit squeeze. Banks had stopped renewing credit lines for trade finance. Brazil’s central bank has stepped in to provide financing to exporters.

Both countries have recent experience of financial panics. As a result, their banking systems are solid and quite conservatively run. And at least this time currency weakness should not have knock-on effects on public finances, nor raise fears about the ability of governments to service their debts. That is because nowadays both governments can borrow in their own currencies. The lasting question from this bout of currency instability is how long that will remain the case.

Eastern Europe's economies

A chill wind blows east

Emerging markets in eastern Europe, battered by financial turmoil, may soon need outsiders’ help

WHICH country will be the next Iceland? The dramatic collapse of the Nordic country’s economy has concentrated international attention on other risky but obscure corners of the financial system. The stability of the Ukrainian hryvnia, the ill-regulated Kazakh banking system, and Hungarian borrowers’ penchant for loans in Swiss francs are subjects crowding on to policymakers’ desks.

Ukraine said on Friday October 17th that the IMF was about to lend it $14 billion. The fund did not immediately confirm that. Certainly the money and external reassurance would be welcome: Prominvest, the country’s sixth-largest bank, suffered a run amid speculation that it was in trouble and likely to be taken over. Earlier, the national currency, the hryvnia, hit an all time low against the dollar. The stockmarket has fallen by nearly 80% this year. Ukraine’s inflation is an alarming 25%.

Such numbers are not unusual for east European economies (Latvia’s current-account deficit is 15%, having been well over 20% last year). But they highlight the problems that emerging markets face during periods of financial turmoil. They are vulnerable first because they tend to have imbalances: they rely on high levels of foreign investment, which means that they have run up big current-account deficits, for example. Secondly because they are not rich enough to finance their own bail-outs.

The IMF is one place to turn. Its rules allow it to lend up to five times a country’s quota: the amount deposited when a member state joins. But the rules can be relaxed in a crisis. Another source is the European Central Bank. It has just lent €5billion ($6.7billion) to Hungary, which is not a member of the euro zone, but has an economy closely linked to it. Hungarians seeking to buy forints had been battling with a foreign-exchange market that had almost wholly seized up. The IMF is waiting in the wings, prepared to provide a much bigger loan if necessary, and to deliver an important public imprimatur of the government's economic policies.

Although much richer than Ukraine, with GDP per person almost four times as high, Hungary is in some senses even more vulnerable than Ukraine, because of its large foreign debts. Public borrowings amount to 60% of GDP. That is partly the legacy of a wild borrowing spree by communist rulers in the 1970s and 1980s, and also of spendthrift governments since then. In 2006 the budget deficit was over 9% of national income; the current-account deficit was 6%. A further worry is that millions of Hungarian households and firms have taken out hard-currency loans, placing personal bets (perhaps rather ill-understood) on the likelihood that the forint-euro exchange rate would stay stable.

One big question is how many such crises will flare up, and how willing outsiders will be to deal with them. In most of the small, new, member states of the European Union, foreigners own the banking systems. If their loan books go bad, the shareholders will have to stump up. What if one of those home banks is in already in trouble? Nobody knows. Perhaps it will sell a troubled subsidiary elsewhere, maybe to Russia. Even if that prospect is unlikely, it sets nerves jangling in places such as the Baltic states.

Before the crisis, Hungary showed some signs of stabilising, thanks to a tough but unpopular austerity programme. The events of the past weeks have put that in doubt. That highlights the real problem for the ex-communist countries of Europe: weak politics. Their leaders found it hard enough to govern efficiently even when times were good. If foreign investors get stingier, and if growth slows or stops all together, effective government will be all the harder.