Latin America: The (incomplete) turn to the right

The past year has seen a remarkable reversal of fortunes for the leftist regimes throughout South America. With the exception of Rafael Correa in Ecuador, all the others have experienced defeats. In Argentina and Brazil, Cristina Kirchner and Dilma Rousseff have been replaced by decidedly pro-market presidents. And in Bolivia and Venezuela, the presidents hang on, but have suffered stinging defeats – in the case of Venezuela, the Parliament is now solidly controlled by the opposition to Pres. Maduro, with efforts under way to recall him, and in Bolivia, Pres. Evo Morales was defeated in his attempt to change the Constitution in order to run for a fourth term. Finally, the peace agreement in Colombia, ending 50 years of civil conflict, is a tacit acknowledgement by the FARC rebels that they were under siege.

What does this mean for the region, in particular in terms of trade and investment, and the need for risk mitigation? It is worth examining the individual cases of the region’s three largest economies – Brazil, Mexico and Argentina – as well as the two main trading blocks of the region (the Pacific Alliance and Mercosul).

Pacific Alliance vs. Mercosul

Over the past five years, according to the WEF, the pro-market bloc of Latin America (Mexico, Chile, Peru and Colombia) has enjoyed greater GDP, export and import growth than Mercosul. Additionally, especially since Venezuela joined Mercosul, that group had become little more than a (leftleaning) political talk-shop. Currency problems in Argentina and Venezuela meant that, even within the bloc, restrictions were imposed and intra-bloc trade slid.

With the election of President Macri in Argentina and the confirmation of Pres. Temer in office, most leaders in the region are already clearly in favor of revitalizing the economic aspects of Mercosul, including in negotiations with the EU, US and others. However, protectionist sentiment continues to run high, even in some wings of the respective ruling coalitions. And, in the context of a nearly worldwide backlash against globalisation in general, and trade agreements specifically, it is difficult to imagine that the new impetus that Macri and Temer bring to Mercosul will quickly result in new agreements with Europe or the US. Talks with the EU may have restarted, but given the scrutiny in Europe of potential agreements with Canada and the US, it is unlikely that the new talks with Mercosul will have rapid results. On the other hand, the region may still see progress in three areas: within the Pacific Alliance and within Mercosul, respectively, and between the two blocs, now that the main players in Mercosul have moved ideologically closer to the Pacific Alliance. In particular, if the US were to turn more protectionist after the elections there, deeper Latin American integration may be one of the answers that would united countries from Mexico to Argentina.

It is worth noting, however, that there are both structural and political impediments to such a process. On the structural side, the predominance of commodity exports means that most countries are more inclined to be competitors than to be able to harness complementary competitive advantages. Similarly, both the volatility in commodities and the economic mismanagement in several (mostly Mercosul) countries has resulted in great currency volatility – making trade and investment flows more difficult, and concerning foreign investors and traders. On the political side, despite the now more promarket rhetoric, it is clear that politicians in the countries of both alliances are seeking to harness deeper regional integration for shortterm political gain, too – and hence will be resistant to relax their own protectionist measures.

Brazil

Expectations are that Brazil will next year finally emerge from its worst recession in a century. Early signs are that the confirmation of Temer as president will help accelerate and increase that upward potential – but much depends on the new government’s ability to get much-needed reforms passed in the next two years. Early indications are that Temer – who was previously president of the lower house of Congress – will be able to push through significant labor and pension reforms, as well as launch a wave of privatisations and concessions. (The labour reforms, in particular, are likely to result in street protests and potentially even violence – particularly if they coincide with the potential arrest of former president and leftwing hero, Luiz Ignácio “Lula” da Silva. One can expect, however, that the violence will be limited in scope and concentrated on a few large cities.)

These reforms are important, if minimal, steps toward putting Brazil back on track. Deeper reforms – of the dysfunctional political system itself and of the byzantine tax code, for example – will most likely wait until after the 2018 presidential election (and perhaps much longer…). So, the most likely scenario is that Brazil will return to its “general form”: institutionally solid but fragmented; growing, but below its potential; and resolving problems only, as Brazilians say “at the 48th minute of the second half”.

For foreign investors, the scenario is favourable – at least until the very unpredictable 2018 elections. Brazil’s current fiscal crisis means that the government is openly counting on foreign investment for the much-needed modernisation of the country’s creaking road, rail, port and airport infrastructure – and is willing to provide more favorable terms to those investors than the previous one. Investors may also look forward to a “bargain basement” moment for Brazilian corporates, on two fronts. First, while it cannot politically put through privatizing large state-owned companies like Petrobras and Eletrobras, the government has made it clear that significant parts of their empires will be privatized (and that means: probably sold to foreign investors). At the same time, local content and co-investment rules (for Petrobas, but also for airport concessions) are being relaxed. Second, private corporates are also attractive targets now, given the depreciation of the real and the precarious situation many find themselves in after three years of recession. (The telecoms giant Oi is only the most spectacular example of this.)

However, significant challenges remain – not least of which is the fact that the corruption scandals just keep widening and engulfing more companies and politicians. The federal prosecutors and police have demonstrated a striking independence from all the parties in Brasília, determined to look under more and more rocks. Given the endemic nature of the propinoduto (funneling of bribes), they are finding evidence under every rock. The Temer government will have a major challenge to try to maintain stability – and get its reforms passed by Congress – while the investigations continue to cause indictments among leading politicians of all stripes, most likely including more members of the government, too. This is also a challenge for foreign investors: careful analysis is necessary to ensure that the assets that may be on sale in the “bargain basement” are not toxic in some non-financial manner.

In sum, we expect that the region’s powerhouse will regain some of its luster but significant challenges remain – not least after the 2018 elections. This should result in an increased demand for PRI, as investors see opportunities but also risks. (It is worth remembering that in the early 2000s, Brazil was the country with the single largest PRI exposure in the world – and very scarce capacity from private insurers for it.) Trade credit is also likely to increase, particularly on the medium- and long-term side, as foreign companies come in to export more goods and services under the privatizations and concessions.

Mexico

“Pobre México – tan lejos de Dios, tan cerca de Donald Trump!”

This new adaptation of an old Mexican saying sums up well one of the major clouds hanging over Mexico’s future. Much more closely linked to the US than the other Latin American countries, the US elections will have a direct impact on Mexico, whoever is elected. And of course, in the case of a Trump administration, those impacts are expected to be much more drastic.

On the domestic front, Mexico under President Peña Nieto has demonstrated a willingness to try to reform and open up, even at a political cost. In the first two years after assuming the Presidency in late 2012, he proved to be a powerful reformer, especially by Mexico’s sclerotic standards. With the help of opposition parties in the Congress, he managed radical changes that often required constitutional changes: reforming the energy sector, including opening up drilling to foreign companies beyond Pemex; lowering taxes; taking on the teachers’ unions to improve education; and promoting promarket policies in trade and tax.

However, that honeymoon has not lasted. Peña Nieto, who cannot be reelected at the next presidential election in July 2018, now has an approval rating of only 23% – and definitely not helped by his much-maligned decision to invite Donald Trump for a visit. Personal scandals involving him and his wife have undermined his credibility – especially as he was seeking to get Congressional approval of sweeping anti-corruption laws (finally passed in July 2016). The sluggish economy – hurt by low oil prices and the tepid pace of the US recovery – has been another weak spot. But perhaps the greatest concern of many Mexicans remains the security situation: not only the wars against and among the drug traffickers, but also the apparent emergence of hit squads targeting other groups, such as teachers’ unions.

From the investment and trade perspective, it remains clear that Mexico is an attractive partner – including because of the NAFTA access to the US and Canadian markets. If the next US president were to decide to scrap or revamp that treaty (which is obviously only likely under a Trump presidency), this could spell serious trouble for investors, exporters and importers. Another threat may lie in the very “success”

of the reforms: the 2018 elections may be a referendum on Peña Nieto’s economic policies, which created more efficiency – and more unemployment and inequality. A backlash, particularly from the left is possible: Andres Manuel Lopez Obrador, who nearly won the 2006 elections and was again runner-up in 2012, may try again, and has espoused his opposition to Peña Nieto’s policies. As in Brazil, things look positive for foreign investors and exporters – but only for the next two years, until presidential elections again cloud the crystal ball.

Argentina

Few countries in Latin America have experienced as radical a policy shift in a short time as has Argentina in the transition from President Cristina Kirchner to President Macri. From exchange rates to publishing verifiable inflation statistics, Macri has wasted no time in moving toward an agenda aimed at reassuring foreign and domestic investors. The fact that Argentina’s $16.5 billion return to the international bond markets in 2016 was oversubscribed and resulted in surprisingly tight pricing for a country that has defaulted twice in the past twenty years is evidence that investors want to believe that “this time will be different.”

Yet, the situation is complex. Removing energy subsidies has caused both a massive (if mostly one-off) spike in inflation. As many people have found the price hikes unaffordable, it has also resulted in widespread demonstrations against the government. Many other necessary reforms – particularly to take on the bloated and inefficient public sector – are being postponed, not least because Macri must rely on support from the opposition-controlled Congress to push through his reforms. (He may hope that next year’s Congressional elections will strengthen his hand, but that is far from certain.) The recovery is now only expected to begin in 2017 and Macri is pleading for patience – in a country with a historically rather limited reservoir of that commodity. The Supreme Court, for example, has already ordered a partial rollback of the energy price increases.

Beyond the bond issue, which bought Macri some breathing room, Macri – like his Brazilian counterpart – is betting on foreign investors to fund many of the needed investments in infrastructure. And despite Argentina having been the “world champion” of investment insurance claims and international arbitral decisions against it, many are indeed looking at the opportunities with interest. Notwithstanding the currently drop in oil prices, there is global interest in Vaca Muerta, one of the world’s largest untapped shale gas and oil reservoirs, located in the remote Patagonia region. Exploiting it would require billions of dollars in investment, not only in the fields, but also in the ancillary infrastructure (pipelines, ports, etc.).

Finally, Macri is clearly keen on rekindling the country’s glorious exporting past, particularly in agricultural commodities. Gone are the punishing taxes and hard currency retentions that the Kirchners placed on those exports. While exports are rebounding, it is unclear how much they will help plug the hard currency hole Argentina faces. (While the bond issue provided on short-term fix, he is counting on investments and exports, as well as an amnesty programme designed to encourage Argentinians to “on-shore” their offshore assets, as longer-term solutions to the reserve crisis.)

As anyone who has been working with Argentina over the past twenty years knows, radical shifts are a common occurrence – and often foreign investors are left holding the bag. Additionally, matters are complicated by the fact that much political (but little tax) authority resides with the provinces. This means that foreigners looking at concessions will often face a double risk: federal and provincial. The question will be: will foreign insurance providers be as bold as some foreign investors and bondholders, and return to covering Argentina risk?

Keith Martin

Senior Consultant - Aon Brazil and Veracity Worldwide

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Note

1. The views expressed in this article are strictly the personal ones of the author.