AMERICAS: ECONOMIC REVIEW AUGUST 2011

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United States: Fed resists further quantitative easing, opts for low interest rate assurance instead

Despite the increased pressure to initiate further quantitative easing to counter the worse than expected decline in economic activity, the Federal Reserve has instead given an assurance that it will maintain low interest rates until mid-2013. As its earlier efforts at quantitative easing through direct purchase of bonds from the market have not succeeded in producing a sustainable recovery, though they contributed to arresting the economic decline, the Fed has preferred to be cautious. Also, readings from both the consumer and wholesale price indices climbed in July, further constraining monetary policy options. However, some members of the Federal Open Markets Committee favored the resumption of bond purchases while three members disagreed with the decision to assure rate stability for the next two years. In its policy statement, the Fed said it is willing to deploy all the available policy options, if necessary.

Meanwhile, GDP growth for the second quarter was revised lower to just 1% from an earlier estimate of 1.3%, raising fears of another downturn as both fiscal and monetary responses are likely to remain constrained. To make it worse, the estimate for the first quarter was cut substantially from 1.9% to 0.4%. During the second quarter, economic growth was helped by higher private investments and government spending, while private consumption growth slowed to just 0.4% annualized from 2.1% during the previous quarter. The contribution of exports was revised lower as the trade deficit increased unexpectedly in June, when exports declined more than imports.

However, subsequent data releases have helped allay concerns about another recession, though the pace of expansion is still expected to be below earlier forecasts. The economy added 117,000 jobs in July and the unemployment rate dipped marginally to 9.1%. Though the monthly rate of job additions was below expectations and the unemployment rate is still very high, the data provided assurance that the labor market is not weakening again. It is expected that the month of August will also see further job gains, though the net additions may fall short of the previous month. Personal consumption expenditure expanded at an annualized rate of 1.6% in July, the highest in more than a year, following a healthy 1.4% expansion during the previous month. However, net disposable incomes declined in July as inflation eroded the gains in average personal incomes.

Consumer confidence declined further this month, but it is believed that the increased anxiety created by the heated debates about the federal borrowing limit and S&P’s decision to downgrade U.S. debt added to the pessimism. Since gasoline prices have trended lower and the economy is adding jobs, though at a slow pace, it is expected that consumer sentiment will recover in subsequent months.

Canada: Weaker economic signals and inflation reduce possibility of interest rate hikes

The Canadian economy contracted 0.4% on annualized basis during the second quarter as the trade balance slipped into a deficit, mostly due to unexpected events that hampered production and demand. As the volume of crude oil exports declined, even though prices stabilized, aggregate exports during the second quarter were lower. The increase in realizations from other energy exports, including coal and natural gas, was not enough to fully offset the fall in oil shipments. Exports of automobiles were affected by disruptions in component supplies following the Japanese earthquake. The relatively strong Canadian dollar detracted further from export growth. Meanwhile, imports expanded on increased domestic demand for machinery, industrial material, and energy products. The economy had expanded at an annual pace of 3.6% during the first quarter and it is expected that the second half of the year will see a recovery in activity.

While the headline job additions of 7,100 for the month of July were well below expectations, job gains in the private sector were the highest in several years. The private sector added nearly 95,000 jobs in July, well above the average for this year, led by the construction, retail, and transportation sectors. More than 25,000 full-time positions were created during the month while temporary and part-time positions declined. In the aggregate data, most of the gains in the private sector were offset by the loss of 71,500 jobs in the public sector as schools shed 30,000 positions during the month. Also, growth in average hourly wages declined further in July.

Meanwhile, consumer price inflation declined further to 2.7% annualized in July, reducing the possibility of an interest rate hike by the Bank of Canada later this year or early next year. Inflation was below expectations and is down from the recent high of 3.7% set in May. The central bank, while retaining the benchmark rate steady last month, had indicated that it may start monetary tightening as the economy recovers during the second half of this year. However, as the economic signals and inflation have been weaker than forecasted, it is now expected that the central bank will likely keep its current accommodative policy for a longer period.

Brazil: Weaker economic growth may force interest rate cuts, despite high inflation

The outlook for the Brazilian economy has turned duller as overseas demand may be cooling off and consumer spending appears to be slowing down. Weaker economic activity growth across the large countries is expected to restrict demand for industrial commodities like iron ore, of which Brazil is one of the largest exporters. Also, after growing strongly over the last two years, credit growth has weakened this year as the central bank has tightened interest rates and the reserve requirements for banks. Further, the steady rise in consumer loan defaults will likely make the banks more cautious about their lending standards. Doubtful loans as a percentage of total bank credit rose to 5.2% in July, as the bad loan ratio for business borrowers increased to 6.4% and that for retail borrowers remained steady at 3.8%. Average borrowing costs have increased to nearly 40% from around 35% earlier this year, making it difficult for many borrowers to keep up with their scheduled repayments. Brazil’s government-owned development bank BNDES, a major source of long-term financing for large companies, is winding down the credit lines extended to businesses during the global financial crisis and has ruled out any increase in aggregate lending this year.

The slower pace of economic growth was reflected in the central bank’s economic activity index in June, as it declined for the first time in nearly three years. Recent GDP growth forecasts for the current year are below the 4% growth expected earlier this year, and in 2012, instead of gaining speed as forecasted earlier, the Brazilian economy is now expected to only maintain the current year’s pace. The majority of the large companies failed to meet their earnings forecasts for the second quarter, which may restrict business investments. Political uncertainties that have escalated in recent months may also affect business confidence. Four federal ministers have resigned since President Rousseff formed the government less than a year ago, restricting the government’s ability to pursue further reform measures.

Nevertheless, government tax revenues remain buoyant and have kept the fiscal balance fairly healthy. Total tax revenues have increased more than 22% through July when compared to last year, while the government has managed to curb public spending growth and bring down total public sector debt as a percentage of GDP. Though consumer inflation accelerated again to 7.1% annualized in August, it is widely expected that the central bank may cut its benchmark rate to support the slowing economy.

Meanwhile, as announced earlier, the Brazilian government is preparing to overhaul the regulatory and tax structure for the country’s mining industry that may lead to increased government control. The government is planning to set up a new regulator for the industry to recommend policies as well as new rules for granting mining concessions. The government is also proposing a flexible tax on mining profits, that may rise or fall according to international commodity prices and economic conditions.

Mexico: Weak mining and farm output drags down second quarter growth

Second quarter economic growth slowed to 3.3 % annualized, slower than expected and below 4.6% for the first quarter and 5.4% achieved last year, as output in mining and the farm sectors declined. However, though slower than the first quarter, the pace of expansion in manufacturing and services remained healthy. Remittances by Mexicans working abroad are expected to aggregate more than last year’s $21.2 billion, and may support domestic consumption. Despite the relatively high unemployment rate, the labor market has shown signs of improvement recently while credit growth has increased. The Mexican government expects the economy to expand between 4% and 5% this year, before slowing down in 2012.

Led by automobile manufacturers, foreign industrial investment flows into Mexico have seen steady growth since last year and are expected to total $20 billion this year. Attracted by the proximity to the large U.S. market and relatively lower costs, manufacturers have been investing in new facilities in Mexico. Most major car manufacturers, including Volkswagen, Honda, and Nissan, have Mexican operations that also cater to the U.S. Mexican automobile exports have boomed in recent years and now outpace oil, traditionally the most significant revenue earner for Mexico, in aggregate export revenues. However, revenue growth in the tourism sector is likely to be limited due to drug related violence in several parts of the country.

The robust growth in U.S. dollar inflows, including the $20 billion in portfolio investments the Mexican government expects this year, are likely to keep the Mexican peso relatively strong this year. The Bank of Mexico has repeatedly stated that the strong currency has helped in containing inflation, currently at 3.5% as compared to 4.4% at the end of last year. The central bank yet again left the benchmark rate unchanged this month, but indicated that it is prepared to cut the benchmark rate if economic signals weaken further.

Argentina: Trade surplus narrows on strong domestic consumption growth

While the favorable external trade balance has driven Argentina’s economic recovery since 2009, the trade surplus has gradually narrowed this year as import growth has accelerated. In July, the country’s imports surged more than 30% from last year as energy imports nearly doubled on increased demand. Export growth for the month was slower at around 20% and the trade surplus for the first seven months of this year has declined by more than 20%, when compared to last year. Nevertheless, sustained global demand for agricultural commodities may limit further narrowing of the trade surplus, unless domestic demand growth accelerates even more.

The country’s banking sector attracted attention this month after ICBC, one of the largest Chinese banks, took a controlling interest in the Argentinean subsidiary of South Africa’s Standard Bank. China is one of Argentina’s largest trading partners and ICBC is the first Chinese bank to enter the country. However, some of the luster brought by this deal faded after rating agency Moody’s downgraded its outlook for Argentina’s banking sector to negative. Moody’s said the country’s economy is becoming increasingly dependent on unsustainable fiscal policies, while inflation remains very high and real inflation rates are negative.

Amid rising criticism of its imprudent fiscal management, it is believed that the Argentinean government may take several steps in next year’s budget to prevent the fiscal balance from worsening further. Capping public spending growth at 20%, compared to an estimated 35% for the current year, is among the proposals being considered. These initiatives are significant as growth in government revenues is likely to weaken next as the pace of GDP expansion is expected to fall below 5%. The Argentinean economy is forecasted to grow between 8% and 8.5% this year, slower than last year’s 9.2% but faster than any other economy in the region.

Chile: Strong consumption growth to support the economy this year

Though GDP growth has moderated during the second quarter, and possibly the current quarter as well, the Chilean government remains confident that the economy will expand by 6.6% for the whole of this year. The economy grew 6.8% during the second quarter from a year ago, better than expectations, but substantially below the revised 10% pace for the first quarter. Domestic consumption growth remains strong and export earnings are healthy. However, the widespread protests and general strikes by students demanding increased government involvement in sectors like education may affect economic activity and weaken the growth pace. The IMF expects GDP growth of 6.5% for the current year, but the pace is expected to slow to around 5% next year.

Chile’s central bank held its benchmark rate steady for the second month as domestic inflation expectations and the global growth outlook have moderated. According to recent surveys, the benchmark rate is expected to remain unchanged for the rest of this year. However, the central bank said a rate cut is possible if global uncertainties worsen and domestic signals weaken further. The IMF has asked Chile to restrict public spending to boost fiscal reserves used as a buffer when the economic cycle weakens.

Despite the correction this month, copper prices are still substantially higher than they were in 2009 and will likely support Chilean economic growth this year. While demand growth in emerging economies, mostly China, remains robust, global supplies of copper have become tight due to heavy rains and bad weather in Chile, the world’s largest exporter of the metal. Codelco, the world’s biggest copper miner owned by the Chilean government, plans to invest $20 billion over the next five years to expand and upgrade its production facilities.

Peru: Business confidence revives as new mining tax is well accepted

President Ollanta Humala’s government has managed to remove the policy uncertainty about a proposed tax on mining profits, after it arrived at a deal with mining industry groups. During the campaign, Humala had repeatedly talked about a windfall tax on miners as a way to fund the government’s increased spending plans. This caused widespread disquiet about the new government’s policy approach towards the private sector in general, and was one of the reasons behind the steep fall in equity prices after Humala’s election victory. However, the government has now managed to introduce the new tax at a moderate level that would not hurt the industry as much as feared. The tax measure is expected to net an addition $1 billion over the next five years.

The positive and accommodative policy measures announced since the new government took office in June are mostly a continuation of the previous government’s policies, and have helped rebuild business confidence. Appointments to the key economic positions in the government, including the finance minister and the central bank chief, have also been received well. Rating agency Moody’s said this month that the country’s sovereign rating could be upgraded by the end of this year, if the government persists with the current path.

A weaker global economic outlook and slower growth in some of the key domestic economic indicators encouraged the central bank to maintain the benchmark rate unchanged for the third successive month. Economic growth slowed in May as business confidence had waned on fears of restrictive economic policies from the new government. Construction activity slowed in June while mining output declined for the second successive month. The government expects export revenues to drop this year as global demand growth for metals like silver and copper is expected to weaken. Though consumer price inflation remained above its target range in July, the central bank believes consumer prices will adjust lower in the coming months.

Colombia: Despite strong domestic data, interest rate held steady on heightened global uncertainties

Most economic indicators continue to suggest that the Colombian economy has retained the momentum from the first quarter, when it expanded faster than expected. Helped by the 23% credit growth in May, the fastest in the region, retail sales growth remained well above 10% in June. As domestic demand remains strong, industrial output expanded nearly 12% in June while inflation surged more than 55%. Also, despite lower volumes, June exports were more than 50% higher from a year ago as coal and oil prices are now above last year’s average.

However, as the global economic outlook has weakened, the Colombian central bank has decided to hold its benchmark rate steady this month, after successive rate hikes since the beginning of this year. Though the bank retained its GDP growth forecasts for the current year, it said the heightened global uncertainties may have a negative effect on Colombia’s economic growth. The unexpected pause by the central bank may limit further peso appreciation, but the currency is expected to remain strong on healthy investment inflows into the country.

For the past few years, Colombia has been aggressively pursuing free trade agreements with larger trading partners, including the U.S., Brazil, and Canada. Brazil is Colombia’s second largest trading partner, after the U.S., and trade between the countries is expected to touch $5 billion by 2014. Investments by Brazilian companies are also on the rise, especially in oil and coal exploration and production. The country’s new free trade agreement with Canada came into force this month, and is expected to boost trade and investment between the two countries. Total trade flows between the two countries were nearly $1.5 billion last year, with a surplus in Colombia’s favor. Energy and farm produce form the bulk of the exports to Canada, while Colombia imports machinery and cereals. Meanwhile, Colombia’s 2006 trade agreement with the U.S. is not yet operational as the treaty awaits the approval of the U.S. Congress.

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