Latin America: the risks of being too attractive

October 25, 2012

Ironically, an increase of capital inflows to Latin America in the last few years due to unappealing ultralow yields in industrialized countries and the region’s relative economic success is posing a threat for development, according to a recent paper that provides wider background to BRIC criticism of the latest U.S. Federal Reserve´s quantitative easing.

The article, written by Argentine economists Roberto Frenkel and Martin Rapetti for the World Economic Review – an international journal of heterodox economics –  warns about the possibility of a Latin American variant of the so-called “Dutch Disease”. This is a situation where a country suddenly finds a new source of wealth that makes its currency more expensive, hurting local exports and causing traumatic de-industrialization.

“Our concern is that massive capital inflows to Latin America may have pernicious effects via an excessive appreciation of the real exchange rates, which could lead to a contraction in output and employment in tradable activities with negative effects on long-run growth”, says the paper.

Real exchange rates in Latin America are now stronger than those required to promote economic development, reducing corporate earnings in export-oriented sectors intensive in labor, say the authors, adding: “There are in fact some hints indicating that tradable profit squeeze is negatively affecting the performance of manufacturing activities in Latin America”.

Frenkel and Rapetti focus on Brazil, where a currency appreciation trend that began in mid-2004 was followed by a relative worsening in industrial exports and value added since late 2005. “The case of the Brazilian manufacturing sector illustrates what in our view is the main threat that Latin American countries are currently facing with the sustained real exchange rate appreciation”, says the paper.

The study does not deal with U.S. monetary policy, but its findings offer deeper understanding of recent Brazilian, Chinese and Russian outcries against QE3, the latest Fed move to resurrect employment in the U.S. through acquisitions of securities. Brazil’s Finance Minister Guido Mantega this month labeled the Fed’s stimulus effort as “selfish” because it weakens the dollar, exacerbating the feared emerging currency rise.

Co-author Rapetti said Mantega is right to worry. “QE3’s implication is that, since there are not many investment alternatives in industrialized countries, additional liquidity will be channeled to emerging market economies”, he told Reuters in Buenos Aires. His paper suggests that macroeconomic policy in Latin America should aim at “a stable and competitive” real exchange rate as an intermediate target for economic development.

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