The abundance that the region is enjoying, however, carries some risks as material bouts of currency appreciation could be met with increasingly assertive currency measures and intervention, as policy-makers scramble to ‘protect' what they see as dwindling competitiveness. This is likely to usher in a period of greater volatility for Latin American currencies generally speaking. We discuss the specifics of intervention in the country outlooks below.
The Regional RoadmapThough the region's currencies are likely to remain well supported, the travails in the European periphery are likely to prompt a continuation of broader-based dollar strength - making for less favorable relative performance of most Latin American currencies versus the dollar earlier in the year. However, by mid-year we expect that Latin America should again retake strengthening momentum against the dollar, which should persist at least until there is a clearer indication of the timing of policy rate normalization in the US and elsewhere in developed markets. Latin America stands to gain from a relatively sanguine growth outlook for emerging markets (EM) as a whole and from what is likely to continue being a relatively supportive environment for commodities.
In this context, we expect commodity currencies like the Colombian peso and the Peruvian sol to carry over their solid performance into next year - with the clear caveat that both countries are intervening and could at some point reinstall capital controls. While the Chilean peso is likely to follow a similar trajectory, the currency's momentum may decrease towards year-end, as the tightening cycle comes to a close and the economy decelerates towards a more sustainable growth path. Though the trajectory for the Mexican peso and the real is likely to be similar in the beginning of the year - with both currencies trending stronger - the latter is likely to be materially more volatile due to the ongoing threat of a new round of capital controls or other measures designed to slow currency appreciation.
Indeed, Mexico continues to stand out as the country least likely to intervene among the large economies in the region. This fact won't be lost on investors, in our view, partially informing our positive outlook for the peso into next year.
The Wildcard
Though we expect the current status quo, characterised by resistance to further material currency strength, to be the norm into early 2011, there are important considerations that could affect the state of affairs considerably.
First, the potential for a meaningful revaluation of the renminbi by the Chinese authorities could take substantial pressure off central banks in Latin America that have been tirelessly attempting to mitigate currency strength of late. Indeed, our China economist, Qing Wang, expects the Chinese authorities to adopt a more accommodative stance vis-à-vis currency appreciation, as one tool of many deployed to contain rising inflation.
Second, inflation in EM broadly is also likely to come into play at some point later in 2011, which could affect future decisions regarding capital controls, in our view. For Latin America, though this issue may become relevant at some point, inflation seems relatively subdued in most countries and thus is unlikely to be enough to drive policy-makers towards less resistance to currency appreciation for now.
Finally, a more constructive and cooperative resolution of the current global imbalances could also relieve some of the tension that has built up over inflows into Latin American currencies over the course of this year. But given early indications thus far in different global fora, a coordinated solution continues to be elusive at best.
Brazil's ConundrumBolstered by a positive terms-of-trade shock, improving foreign direct investment flows and rising interest rate differentials, the real has all the elements in place for strengthening in 2011. However, despite these factors, our Latin American economics team expects the authorities to continue to intervene in currency markets - not only through direct intervention in the spot market, but also returning to use reverse currency swaps - and cannot rule out further hikes in the IOF tax on fixed income inflows.
After all, there is widespread concern among the authorities that the real's strength - in trade-weighted, inflation-adjusted terms now at its strongest level in more than two decades - is partially responsible for the growing disconnect between robust consumer demand (bolstered by the currency's gains) and sluggish domestic production (hit by rising imports). Indeed, we believe that this ‘growth mismatch' is likely to continue to drive the policy response in 2011 (see "Brazil: Financing Mismatch Revisited", This Week in Latin America, October 26, 2010).
The tension between strong drivers of currency strength being partially offset by policy response is likely to ultimately produce some gains in the real - at least until there is a clearer sign that the economic outlook (and policy rate path) of developed markets is beginning to normalise. But given these tensions, we expect to see a good degree of volatility in the exchange rate.
Find Strength in Numbers
For the small, open economy commodity producers - Chile, Colombia and Peru - we see several factors keeping currencies well supported during 2011. We see three broad points:
•· Strong global growth should maintain commodity prices at elevated levels. The prices of metals - both precious and industrial - are near or beyond the mid-2008 peak. And soft commodities are just shy of the peak reached pre-crisis, while oil remains at historically elevated levels. Therefore, the terms of trade - the ratio of export to import prices - for these countries have soared to near-record highs, a move usually associated with currency strength.
•· These countries should enjoy a solid macro environment, with economic expansion that remains on track while inflation pressures appear limited. While there is heterogeneity in the pace of expansion among these economies, all are expected to grow above the 4.2% average that our economists forecast for the global economy in 2011. And the strong economic growth is underpinned by domestic demand momentum. In addition to the strong growth dynamic, inflation is expected to remain on target (see "Latin America in 2011: Risks to Abundance, Risks of Abundance", This Week in Latin America, December 6, 2010).
•· Our Latin American economists expect strong foreign direct investment inflows to continue next year. The abundance of natural resource endowments should support continued investment in commodity extraction infrastructure. The strong FDI inflows should more than finance the current account deficits in Chile and Colombia, and augment the current account surplus that our economists forecast for Peru.
Colombia's MomentWe see strong currency appreciation in Colombia throughout 2011. In addition to the broad themes mentioned above, we see the country benefitting from two additional factors.
First, Colombia is likely to continue to enjoy the dividends from rising oil output and exports, and the associated very strong foreign direct investment inflow. Second, it could benefit from continued reform momentum (see "Colombia: Reform Disappointment?" This Week in Latin America, December 13, 2010).
These trends are likely to lead to another year of outperformance for the peso, despite the fact that policy-makers are likely to fight currency strength. Indeed, Daniel sees a risk of capital controls that may introduce further volatility to the FX market. But because the exchange rate tends to be driven more predominantly by the FDI dynamics outlined above, we do not feel that currency measures are likely to change the trend.
Steady Sailing for PeruWe expect the sol's slow yet steady appreciation trend to remain in place in 2011. The rationale for sol performance is fairly similar to that of the other commodity exporters we have discussed - macroeconomic stability, FDI and supportive commodity prices.
Of note, however, Peru will hold presidential elections in April, which could have a material impact on the currency if there is a surprise shift in voting intentions - something that we see as unlikely. In fact, we see scope for an upside surprise post-elections in April as a new administration could be well poised to pursue a structural reform agenda, which would clearly be currency-positive.
Positive outlook for CLP - watch for intervention in Chile and the peso is also set to benefit from a supportive global backdrop in the coming months. In addition, though the central bank has opened the door for a "transitory pause" in its tightening cycle, the authorities have also indicated their intention to continue normalizing interest rates - which remain at stimulative levels - over the course of 2011, which should also help to promote positive momentum for the peso.
But, as elsewhere in the region, outsized gains in the peso are likely to be capped by the credible risk of central bank intervention and/or other currency measures. Over the last few months, the Chilean peso has outperformed peers including the sol and the Colombian peso precisely because the government has thus far shied away from intervention (see "Chile: Intervention Concerns Overdone", This Week in Latin America, September 21, 2010). But this situation is likely to change as the currency continues to strengthen, in our view.
Moreover, given the openness of Chile's economy, with our US team expecting the Federal Reserve to start tightening in early 2012, Chilean pension funds - which are major players in the market - are likely to anticipate this reversal and add pressure to the exchange rate as early as end-2011.
Mexico an Interesting OutlierMexico continues to stand out in Latin America as being among the least likely to intervene in currency markets to stave off currency strength in the current environment. Our positive outlook for the peso is therefore predicated on our view that the authorities have little reason to intervene, given the peso's substantial relative undervaluation versus many of its Latin American peers.
Indeed, from the perspective of the Mexican authorities, in a world increasingly concerned about rising inflation, currency strength can help tighten monetary conditions at the margin, potentially allowing the central bank to remain on hold. We believe that this is their bias, given the relatively weak domestic demand dynamic observed to date.
In the current environment, the peso also stands out as being relatively more insulated from the European imbroglio, due to the currency's weak correlation to the euro and limited trade links between Mexico and Europe. And though Mexico has not enjoyed the type of positive terms-of-trade shock or domestic-led recovery seen in other major Latin American economies, there are reasons for optimism about the economic outlook - and the exchange rate - in 2011. Mexico's economy seems uniquely positioned to take advantage of our US team's call for a solid expansion in US industrial output, where the link to Mexico is strongest. In turn, the Mexican economy should see another year of good growth, with external strength gradually leading to an improvement in domestic-focused areas of the economy.
While Colombia's economic outlook has been boosted by the government's structural reform proposals, we see growing risks that the reform agenda will be delayed and could even ultimately disappoint. The centerpiece of the reform agenda is a structural fiscal rule designed to strengthen Colombia's fiscal accounts. Indeed, the prospect of a structural fiscal rule was likely one of the key drivers behind the more constructive investor sentiment for Colombia in recent months (see "Colombia: Fixing the Fiscal", This Week in Latin America, July 12, 2010). But we are concerned that the new-found optimism regarding Colombia's reform progress may be at risk during 2011.
Fruits of ReformFiscal accounts in Colombia remain the country's key macroeconomic weakness. After all, last year Colombia's central government fiscal deficit reached -4.1% of GDP and the consolidated fiscal deficit -2.8% of GDP. True, many countries around the globe saw significant fiscal deterioration last year in an attempt to counteract the global downturn. But in Colombia the fiscal deterioration reversed some very tentative progress in the preceding years. The average central government fiscal deficit over the past five years was -3.3% of GDP; over the past decade it averaged -4.1% of GDP. We believe that an explicit fiscal target - as envisioned in the fiscal rule proposal - could help to foster fiscal discipline in Colombia over the medium term.
The reform agenda has already brought some dividends by raising expectations of Colombia's upgrade to investment grade. In the aftermath of the unveiling of the reform agenda, two rating agencies - Moody's and Fitch - placed Colombia's credit rating on positive watch for an upgrade to investment grade. That, in turn, raises the prospect that Colombia's long-term cost of capital could continue to decline.
Reforms at RiskBut the reform agenda now appears to be at risk on various fronts. We have two concerns. First, the reform agenda appears to have run into difficulties with obtaining Congressional approval. Second, we are concerned that the design of the fiscal reform proposals may have significant flaws.
The structural fiscal rule is likely to be delayed. While authorities had signaled for months that Congress would approve the reform by year-end, it now looks unlikely to pass before at least April next year, pushing back implementation by at least a year. Colombia's Congress is set to adjourn after this week and the fiscal rule - which needs two more readings - does not appear to be on the agenda. That means that the earliest that Congress can take up the fiscal rule again will be when it comes back into session at the end of March. And the risk of delaying the fiscal rule may be compounded by rising oil output: by the time Congress gets around to voting on the proposal, rising oil output may boost fiscal revenues and make it more difficult to introduce fiscal austerity.
In addition to delays, there is a risk that the fiscal rule as currently designed may be circumvented with relative ease. The fiscal rule is defined only for the central government and thus could allow the authorities to use several existing decentralized funds as vehicles to continue with loose fiscal policy while formally complying with the fiscal rule at the central government level.
Finally, the structural oil and mining revenue as defined by the fiscal rule appears too generous, raising the risk that it is potentially too loose a fiscal constraint. The structural oil and mining revenue is likely to be defined as the revenue received in 2011 when the price of oil is expected to be high, raising doubts about the ‘structural' nature of that component of the fiscal rule. While the authorities expect oil output to near double over the next five years - gradually reducing the implied structural oil price - if the expected increases in oil production do not materialize, the oil price implied in the structural fiscal rule could significantly exceed long-run oil prices. That in turn could mean looser fiscal policy than currently anticipated by the markets and rating agencies.
Macro BackdropWhile we see rising risks that the reform agenda may disappoint, the good news is that the macro backdrop and outlook remain robust. The economy continues to expand at a good pace: we expect GDP growth of 4.4% in 2010 and 4.9% in 2011. At the same time, we expect inflation below the 3% target both this year and next. Indeed, the economy appears to be benefitting from a supportive external environment - elevated commodity prices and rising volume of global trade - plus a rebound in confidence and credit, rising oil production and robust domestic demand.
Bottom LineColombia surprised many when it unveiled a far-reaching reform agenda to tackle its remaining macro weakness. The administration remains in a strong position to push this agenda through Congress. And the current solid macro backdrop means reform should not come at the cost of near-term macro dislocations, a sharp contrast to the usual implementation of structural reforms in the region which come during macro crises. In this context and given the already high expectations for reform by most Colombia watchers, failure to deliver on the reform front next year could do significant damage to the long-run outlook, in our view.
Investment Case
DPJ Gets Serious about Diet Reform
Recent court cases have again brought the issue of Diet reform to the front pages. The disparity among elections districts has long been an issue in the public mind. Urban voters have resented the disparity of voter weight among election districts, which has skewed policy to the detriment of urban interests. However, in repeated legal challenges to the constitutionality of the electoral system, the courts permitted the current system to continue.
Now, however, there is judicial confusion over whether the current system for the Upper House is constitutional. In one recent case before the Tokyo High Court, the judge found the most recent Upper House election (on July 11) unconstitutional, on the basis that the differentials in voter weight between election districts had become too large. Although the judge did not invalidate the election, the size of the voter-weight differential was deemed too large, in this opinion. Ironically, on the same day, a different case at the same Tokyo High Court found that the election was constitutional.
The legal basis for selection of any given level of the voter disparity ratio as the borderline to unconstitutionality is unclear, but the political issue is simple: Voters are angry with Diet gridlock, and want change. This desire was reflected by Mr. Yuichiro Hata, the DPJ's chairman of Diet Affairs for the Upper House. In a press conference on November 17, Mr. Hata said, "There has been discussion for a very long time about reform, and we cannot keep the current system in the next election. I think a change is needed within the next year, including the period of debate."
Asahi Scoop
A few days after this statement by Mr. Hata, a leading newspaper carried a front page article, citing only "sources", that the DPJ was considering a drastic plan for Upper House reform. The article was quite detailed. It stated that the DPJ was formulating a plan to reduce the voter disparity ratio sharply, by allocating seats in the Upper House not by prefecture but rather by regional blocs of prefectures. The blocs would be the same as those used in Lower House elections.
The details mentioned by the newspaper article were very thorough, giving the report high credibility. The DPJ plan reportedly would cut the size of the Upper House from 242 seats currently to 200, and would lower the disparity ratio to 1.19. The system would award seats to the top vote-getters in each bloc, regardless of political party. The DPJ is reportedly going to finalize its plan by mid-February to March 2011, and propose the plan to a cross-party group. The new method would be used in the 2013 election, after a period for revisions of existing laws.
This DPJ plan represents a huge change from the current system. The current distribution of seats implies a maximum bloc-voter disparity rate of 1.896. The average across blocs is 1.482, with a rather large standard deviation of 0.312. In contrast, the DPJ proposal is better in three ways: Lower maximum disparity rate (1.191), lower average disparity rate (1.086), and lower standard deviation (0.053). In short, the DPJ plan would end the over-representation of the rural areas of the country, and bring Japan much closer to the one-person-one-vote ideal.
Is the DPJ Plan a Good Plan?
The DPJ plan is indeed radical, but is it the best? Of course, the criteria for ‘best' are necessarily subjective, but one benchmark is easily available. This benchmark is the allocation that would be achieved by the d'Hondt method, which is used to allocate seats to parties in the proportional districts in Lower House elections. We illustrate the voter disparity ratios for a set of d'Hondt method allocations, with differing sizes of the Diet. The d'Hondt case with 200 Upper House seats is superior to the DPJ plan in the same three ways as above. The d'Hondt 200 seat method has a lower maximum disparity rate, a lower average disparity rate, and a lower standard deviation. The d'Hondt 100 seat method is even better, by these criteria.
That said, we believe that both the DPJ plan and all of the d'Hondt plans are massive improvements, compared to the present system.
Policy Analysis
The next question is whether the change in the election district system would make any difference in policy setting. Even a cursory look at the data suggests that changes would be significant.
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