A closer look at current account risks in Lat Am

• We expect that falls in commodity prices will cause current account positions to worsen across the region this year. While external positions will remain secure in most major Latin American economies, those in Colombia and Chile are an underappreciated cause for concern. Policy will need to tighten and currencies are likely to weaken in these economies, especially if external financing conditions tighten from here.
• Most major Latin American economies have run persistent current account deficits over the past decade. However, the combination of weak domestic demand (and therefore imports), falls in currencies and rallying commodity prices have caused a marked improvement in current account positions across the region since the onset of the pandemic. The main exceptions were Chile and Colombia where, on our seasonally-adjusted measure, deficits widened to 6-7% of GDP in Q3 2021.
• This Focus sets out our new models to forecast current account balances for each major Latin American economy. These models use our projections for key commodity prices, as well as growth in export and import volumes, to forecast trade balances.
• In general, the outlook for export growth is bleak. We expect that the prices of key commodity exports (e.g. industrial metals, oil, soybeans) will fall over the course of 2022. Weakening economic growth in the US and China this year will put a lid on Latin American exports volumes too. With regards to trade balances, this will only be partly offset by slower import growth caused by weakening domestic recoveries.
• Our models point to deteriorating current account balances in most of the region in 2022. In most cases, the moves will probably be relatively small. Indeed, unlike most analysts, we think that Mexico’s current account will remain in a small surplus as exports from the hard-hit auto sector gradually rebound, while domestic demand there stays weak. Deficits in Peru and Brazil are likely to remain relatively small.
• Where the outlook is most concerning is in Chile and Colombia. We forecast that deficits there will come in at 4.8% and 6.0% respectively this year, 1.0-1.5%-pts of GDP wider than in 2021. In contrast, the consensus expectation is that deficits will narrow in these economies this year.
• There are three key implications that emerge. First, a deterioration in the terms of trade will become a headwind to growth across Latin America, feeding into our view that the regional recovery will lag the rest of the world. Second, Mexico’s continued current account surplus is one reason why we expect it to be well placed to weather Fed tightening, and its currency to hold up better than most EM currencies this year.
• Third, policy will need to be tightened and currencies are likely to weaken in Chile and Colombia to allow their wide current account deficits to adjust. Tighter policy would dampen demand and reduce imports, while a weaker exchange rate would boost export competitiveness and encourage import substitution.
• Although fiscal policy will be tightened in both economies this year, this is unlikely to go far enough to rein in wide current account deficits. Their currencies are likely to weaken against the dollar this year (most analysts expect them to strengthen) and, given the backdrop of high inflation, central banks are likely to continue hiking interest rates aggressively (which will also help demand to weaken).
• In the meantime, the high proportion of ‘flightier’ forms of capital inflows leave Chile and Colombia especially vulnerable if external financing conditions tighten abruptly. The risks are skewed towards sharper falls in currencies and more aggressive monetary tightening.

A closer look at current account risks in Lat Am

Current account positions in Latin America generally look in decent shape compared to their recent history, but vulnerabilities are now building in parts of the region. This Focus digs into current account positions in the region’s major economies in more detail to explain where the risks lie.

It is split into three sections. First, we take stock of changes in current accounts since the start of the pandemic. Second, we evaluate the outlook for current accounts across the region and outline our new models for forecasting these. Finally, we highlight where vulnerabilities are emerging (or may emerge in the future) and the implications for the region’s economies and financial markets.

The state of play

One of the few economic positives for Latin America in recent years has been the improvement in current account positions across much of the region. Having run persistent deficits over the past decade, current account balances in Mexico, Argentina, Chile and Peru shifted to surplus a in 2020. This meant that these economies were net lenders to the rest of the world, so were less vulnerable to swings in global risk appetite. The data up until Q3 2021 suggest that this trend has at least partly unwound. But, aside from Colombia and Peru, current accounts in major Latin American economies remain in better shape than they were before the start of the pandemic. (See Chart 1.)

To take a closer look at what’s behind this shift, we have broken down the changes in current account balances since Q4 2019 into their three main components – net trade of goods and services, primary income (which relates to production and investments) and secondary income (other international transactions, including remittances). From this, a few key trends emerge.

In Brazil, Chile and Peru, net trade balances have improved, helped by the boost to their exports from the rally in industrial metals prices over the past year or so (weaker currencies have probably helped too by improving their external competitiveness). In the latter two, this has been offset by a deterioration in the primary income balance, mostly due to higher reinvested earnings by foreign direct investors.

In contrast, Colombia’s trade deficit has widened, partly due to the hit to export revenues from lower oil prices (at least until recent months). Elsewhere, strong remittances have supported Mexico’s current account, which is reflected in an improvement in the secondary income balance. (See Chart 2.)

Viewed on the conventional four-quarter sum basis, which smooths out seasonal volatility in the quarterly data, current account deficits in the region don’t look like a major cause for concern. Although Colombia’s shortfall is wide (at around 5% of GDP), others in the region remain reasonably small. However, the four quarter sum measure can mask the most recent developments. To better capture the trends in each individual quarter, we have seasonally adjusted the current account data.

Viewed on this basis, the figures in Brazil, Mexico, Argentina and Peru are broadly similar to the conventional four-quarter sum basis. However, current accounts in Colombia and Chile look much more concerning, as deficits there widened sharply over the course of last year, reaching 6-7% of GDP in Q3 2021 on our seasonally-adjusted measure. (See Chart 3.) This is perhaps surprising given that the prices of oil and copper – their key export commodities respectively – rose sharply over 2021.

The shift in Chile’s balance from a strong surplus to a big deficit over the past year is particularly eye-catching, and is largely because the turbocharged recovery in domestic demand has fuelled a surge in imports in both values and volumes terms. (See Chart 4.) Strong import growth has led to a widening of the deficit in Colombia as well, while a deterioration in the primary income balance was also a key factor.

To determine whether these recent trends are likely to continue, in the next section we explore the outlook for current account positions.

The outlook for current account positions

The place to start is by looking at what will happen to net trade. The outlook for Latin American exports in 2022 is less rosy than it was in 2021. Indeed, we expect that prices for key commodities will fall over the course of this year. We think that weakness in property construction in China will weigh on the prices of key industrial metals, such as copper and iron ore. We also expect that the price of oil and many agricultural commodities (e.g. soybeans and wheat) will drop back in the coming quarters on the back of improved supply. (See Chart 5.) Those bode ill for Colombia and Argentina respectively. Otherwise, weaker economic growth in the US and China this year will put a lid on export volumes more generally.

With respect to trade balances, the impact of weak export growth will be dampened by softer import growth. Weaker domestic demand across Latin America will keep import volumes subdued. Meanwhile, for most of the region – as net oil importers – lower oil prices will weigh on import values too (which is what ultimately matters for current account balances).

To have a better gauge about what these factors imply for overall current account positions in the six major economies in Latin America, we have created models for forecasting current account balances.

Our models use regressions to predict seasonally-adjusted, quarter-on-quarter growth in exports and imports values in US dollar terms, based on our forecasts for commodity prices (to feed into export and import prices), as well as growth in export and import volumes (from the expenditure side of GDP).

Table 1 outlines the commodities used for regressions on the import and export side for each economy. Note that Brazil and Mexico are net oil importers but oil accounts for a sizeable share of their exports too, so it is included in the calculation of both export and import values. Otherwise, we assume that primary and secondary income balances gradually converge towards their long-run trends.

Charts 6 to 11 in Box A show the model outputs for growth in export values for each major economy in the region, alongside the historical values, which the model outputs have a good relationship with.

Generally we expect that export values will stagnate or even fall slightly across the region. The main exception is Mexico, where we expect exports from the currently struggling auto sector to pick up later in the year as global goods shortages gradually ease. (See our proprietary measures of global goods shortages on CE Interactive.)

We replicated the models to forecast import values. These generally show that import growth is likely to slow from the rapid growth seen earlier in 2021. However, import growth is still likely to outpace export growth in most major economies over 2022. Brazil is the outlier on this front as weak domestic demand and measurement issues related to the Repetro tax regime (we’ll be writing more on this in forthcoming research) will probably cause import volumes to fall this year.

Bringing this together, our models point to a deterioration in current account positions across most of the region in 2022. (See Chart 12.) In most cases the moves are likely to be small. Indeed, unlike most analysts, we think that Mexico’s current account will remain in a small surplus, of 1% of GDP. That is, in part, a function of the weakness of the economic recovery. It’s a similar story for Argentina. Brazil’s deficit will narrow (for the reasons mentioned above) and we project that Peru’s current account deficit will widen marginally to just 1.5-2.0% of GDP.

The bigger risks lie in Chile and Colombia. We think that deficits will widen further, to 4.8% and 6.0% of GDP respectively in 2022.

Admittedly, the size of their deficits can in part be explained by large shortfalls on the primary income balance, which perhaps overstates vulnerabilities compared with a deficit entirely caused by the trade balance. In particular, if the primary income deficit is a result of re-invested earnings, it reflects an accounting measure in which there is no cross-border transaction. Nonetheless, this is a common feature of current account balances across EMs. And if our current account balance forecasts are correct, it would be the widest annual deficit in Colombia since 2015 when oil prices collapsed, and one of the widest in Chile since 2013. In contrast, the consensus expectation is for deficits in these economies to narrow. (See Chart 13.)

The implications for economies and markets

There are three key implications that emerge from all of this. First, terms of trade that had been a large tailwind to the recovery in 2021 will become a headwind. Falling commodity prices will hit export incomes, which will hold back domestic demand and economic recoveries. This is one reason why we expect the regional recovery to lag behind others in the emerging world.

Second, Mexico’s surplus will help the economy and currency to weather any potential storm from Fed tightening. We only expect that the currency will weaken by about 2% by the end of this year, from 20.6/$ currently to 21.0/$, which is a smaller fall than we forecast for most other EM currencies.

Third, policy will need to be tightened and currencies are likely to weaken in Chile and Colombia to allow their wide current account deficits to adjust. Tighter policy would weaken demand and reduce imports, while a weaker exchange rate would boost export competitiveness and encourage import substitution.

We expect some fiscal consolidation in both economies, although it probably will not be enough to rein in wide current account deficits significantly. In Colombia, May’s presidential election presents the risk of a lurch to the left, which could undermine current plans for austerity (which have already been watered down following mass protests last year). Meanwhile, in Chile, the incoming left-leaning government will pursue some fiscal consolidation but is unlikely to follow through with the sharp spending cuts outlined in the current 2022 Budget.

One consequence is that, even though these countries’ currencies were battered last year, we hold a non-consensus view that the Colombian peso and the Chilean peso will weaken a bit further against the US dollar over the course of 2022 (most analysts expect them to strengthen). We’re expecting depreciations of 4-6% this year, to 4,200/$ and 850/$ respectively (from 3,950/$ and 818/$ now). Given these currency falls, and the backdrop of higher inflation, we think that policy rates will rise to 7.00% in both Colombia and Chile this year (from 4.00% and 5.50% now respectively). Higher interest rates will also help demand to weaken.

Another concern is that these economies are financing their deficits with ‘flightier’ forms of capital inflows. In Colombia, the share of foreign direct investment – which is generally a more long- term and stable form of funding – has been falling and now accounts for less than 50% of net private capital inflows. This leaves the economy more dependent on volatile portfolio and ‘other’ (mainly banking) inflows. (See Chart 14.) (There has been a similar trend in Brazil, where the share of FDI inflows has fallen, although we are less concerned about the risks posed by Brazil’s current account deficit.) The picture is more alarming in Chile where net private capital inflows are largely made up of net portfolio flows. (See Chart 15.) This has mainly gone into debt securities as the Chilean government has issued more bonds to fund its wide fiscal deficit.

This leaves Chile and Colombia especially vulnerable if external financial conditions tighten abruptly (most likely due to a more hawkish turn by the Fed) and capital inflows weaken, forcing a more abrupt adjustment in their current account balances. In that situation, currencies would probably fall further than we currently expect and policy rates are likely to increase by more than we are currently anticipating.

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Olivia Cross, Assistant Economist, +44 (0) 20 7808 4089, olivia.cross@capitaleconomics.com