This past June 23rd, the United Kingdom voted in a referendum 52% in favor of leaving the European Union. Brexit, as has been termed this historic divorce, has already sparked market volatility and is expected to catalyze significant uncertainty in the coming months and years. While Britain is the second-largest economy in the EU, the EU is Latin America’s top investor, second-major trading partner, and main provider of development funding. Although the UK and EU will largely bear the brunt of this momentous decision, Latin America is not immune to the global effects and can expect to face both short- and long-term effects that multinationals need to consider.
- Currency volatility: The same day that Brexit results were announced, global financial markets witnessed unprecedented turmoil as emerging market stocks fell more than 3%, currencies dipped against the US dollar, and investors retreated toward safe haven assets like the US dollar, US Treasuries, and gold, which gained 4.7% on Friday. In the short-term, Latin American markets will continue to experience currency volatility as the markets respond to instability, and many central banks intervene with necessary measures to stabilize financial and currency markets. While the pound has already plunged against the USD by over 10% to a 30-year low, the Mexican peso fell by as much as 6.7% on Friday before a slight recovery on the back of central bank intervention and a $1.68 billion cut to government spending. However, Brexit will likely postpone interest rate hikes in the US by the Federal Reserve for at least a few months, with very few traders expecting further hikes this year. With the Fed adopting a more dovish stance in 2016, stronger Latin American currencies will likely regain stability over the next few weeks after volatility related to Brexit subsides. However, Latin American currencies are expected to depreciate again once the Fed resumes monetary tightening in 2017.
- Fall in commodity prices: Commodity prices will be affected around the world, which implies heightened instability for commodity exporting countries such as Mexico, Colombia and Brazil and additional currency volatility in these markets. Since Brexit, oil prices have dropped by more than 6% and industrial metal copper by 3%, and for a country like Colombia, whose crude oil comprises 40% of its exports to the EU, the impact of commodity prices will not go unperceived. This shock will affect commodities dependent on global demand, such as oil and copper, since these are denominated in US dollars.
Although the terms of Britain’s departure from the EU and the ensuing political implications are still unclear, what is clear is the heightened economic uncertainty this poses for the global economy. In fact, the IMF predicts that Brexit could negatively impact the global economy, resulting in cooling demand and a slowdown in the Chinese economy, which would be detrimental to commodity exporters to China, which include Brazil, Chile and Peru. The strongest effects will arguably be felt in markets with close ties with the UK and the EU, as trade and capital flows will be diminished and a drop in investment confidence will depress growth. Europe comprises 1/3 of global GDP and, as this region is impacted, there will be a cascading effect of global ramifications.
Latin America can expect to feel the effects of Brexit in three different ways: through reduced foreign direct investment, diminished trade with key developed markets, and cuts to the provision of development funding.
- Reduced foreign direct investment: The EU is Latin America’s top source of foreign investment, representing 35% of FDI stocks in Latin America. In fact, British investment is the second-most important foreign investment in Colombia. As the pound weakens, growth in Europe slows, and investors look to safe haven assets, emerging markets will witness diminished capital outflows from the old continent. This flight to safety could imply rising borrowing costs, as Latin American governments will have to offer higher yields in order to attract investors as they issue new sovereign bonds, crowding out funding for the private sector, and because many governments and companies significantly increased their exposure to US dollar-denominated debt during the last decade. As investors increase their aversion to riskier assets, markets with deep macroeconomic imbalances will struggle the most to attract investment. Hence, a country like Brazil, which has been struggling with economic and political uncertainty and is facing its worst contraction in a century, will be more affected than countries with a more optimistic outlook such as Peru and Chile, which will have opportunity to continue to outperform as investors look to safer markets.
- Diminished trade: Reduced trade flows could stem from lower growth in the EU and around the world, as well as from the potential delay of trade agreement negotiations. Not only could Britain take years to renegotiate trade deals with the EU and other countries (which would impact investment and place downward pressure on economic sentiment), but existing trade negotiations between Latin America and both the UK and EU could be postponed indefinitely until new terms redefining the economic and political relationship between the EU and the UK are clearly established. 19% of Costa Rica’s exports are to the EU, 17% of Colombia’s, 16% of both Brazil and Peru’s, and 14% of Argentina and Ecuador’s. While exports to the UK may be a significantly smaller proportion (average of less than 3% for the region), the uncertainty in EU markets has the potential to negatively impact trade relations and imports from Latin American markets. On the other hand, Brexit’s negative impact to China’s economy and currency could prolong decreased demand from Latin American export sectors.
- Cuts to development funding: Lastly, Central American and Caribbean markets that are recipients of EU aid would be significantly impacted as a result of the volatility in the EU and drop in the UK’s net contribution of £8.5bn to the EU. In fact, Dominican Prime Minister Skerrit warns that the EU would need to restructure its approach to financing and development assistance, which would have major impact on developing economies that rely heavily on development assistance from EU for infrastructure, social spending and catastrophe relief.
Country Risk Comparisons for Latin America’s Top Markets
Brazil only depends on the UK for 1.7% of its exports, and has decided to wait until volatility subsides to issue bonds in international markets. Thus far, the real has been among the top performers in Latin America since Brexit. However, given Brazil’s significant trade and investment ties with the EU, and the fact that it is a large commodity exporter, the already-struggling economy is particularly vulnerable as risk aversion casts doubts for future FDI in Brazil.
Mexico may see a moderate impact from Brexit on the whole. The Country has already wrapped up its foreign bond issuance and announced budget cuts to help keep borrowing costs down in light of low oil prices. Mexico is one of Latin America’s larger commodity exporters and the Mexican peso, the most traded emerging market currency, has taken the biggest nosedive (down 9.7% this year) among major currencies. As such, the country is especially vulnerable to the global effects of Brexit given the risk for a large current account deficit. Although Mexico has already drafted trade deal proposal with the UK, the trade relationship between the two countries is minimal.
Argentina will likely see a significant decline in demand for its assets as investors seek less risky stocks, which will drive up borrowing costs for companies. President Macri has been trying to spur economic growth in the country through access to capital markets, but will likely encounter rising difficulties in accessing much-needed international funding. Additionally, the Argentine peso experienced the second-largest drop among the world’s currencies since Brexit, which may favor the country’s economy as exports, particularly grain, and become more competitive without requiring government intervention. Nonetheless, Argentine Foreign Minister Malcorra has expressed serious concern over Brexit.
Colombia is the most dependent Latin American country on UK’s imports, although it only sends about 2.5% of its total exports to the UK, which mainly consists of coal. However, it is already encouraging the Pacific Alliance to initiate a trade agreement with the UK. Since Brexit, the peso has witnessed the largest decline among emerging markets, and traders are betting on large swings in the peso over the next month. Given Colombia’s high current account deficit (one of the largest among Latin American economies and forecasted to end this year near a 30-year high), the country is especially vulnerable to external turmoil and widening fiscal gap; a decline in oil export prices heightens the risk of a credit downgrade and could result in potential budget cuts later this year.
Chile, the world’s top copper exporter, is a healthy economy with strong market fundamentals and tools to intervene, if necessary. Finance Minister Valdes said the country was “well prepared” to handle any market fallout given its strong fiscal system, and its orderly economy that helps make the country resilient to external shocks.
Peru, which receives a total of 18% of its FDI from the UK (the highest of any Latin America country), may also experience a decline in British investment given the pound devaluation that could reduce the country’s capacity to invest abroad; however, Peru is one of Latin America’s more financially stable and lucrative markets for investors, and is likely to continue to see investment trickle in from investors seeking safer assets.
Ecuador is already experiencing setbacks from Brexit: President Correa has admitted that Brexit ruined an upcoming bond issue meant to help finance the oil exporter’s cash-strapped budget. Already reeling from the effects of low oil prices and a devastating earthquake, Ecuador had been planning to issue $1 billion in bonds this year, which may be at risk as investors move toward safer assets. Additionally, a stronger US dollar would be unfavorable for Ecuador’s export competitiveness in the region, which it has already been fighting in recent months with measures like import tariffs.
Venezuela is facing arguably its worst crisis in history, and its downward spiraling situation does not benefit from the potential global impacts of Brexit. The country is already unable to repay China its debt of over $65 billion, and a fall in global oil prices could increase the likelihood of default in the country this year. As it stands, oil producers and refiners are struggling to maintain output due to power outages and equipment shortages, and the combination of financial distress and lack of electricity could lead to greater declines in Venezuelan oil production.
Actions to Take
Multinationals should be prepared to manage risk via scenario and contingency planning, for which identifying and acting upon the right leading indicators of business performance will be key. Additionally, companies are encouraged to consider resilience against internal and external shocks, such as Brexit, as a key component of portfolio allocation, whether at the national, industrial or customer segment levels. FSG clients can contact their account manager for a free copy of Latin America’s Resilience Index.
Lastly, clients are encouraged to leverage FSG’s resources such as its FrontierView dashboards, including FSG’s new Brexit Dashboard, to automatically track updates in key leading indicators and FSG economic and political analysis.
For our latest updates and insights, FSG clients can visit the client portal. Not a client? Contact us to learn more.
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