Brazil looking most vulnerable in Latam to any bursting of China’s credit bubble

March 13, 2014

Higher taxes, rising prices, political turbulence. The outlook for Brazil over the next months and years is tough, as Reuters reported on Wednesday, but it could get a lot worse if there is a banking crisis in China, according to the British firm Oxford Economics.

Brazil is the most vulnerable Latin American country if China’s credit bubble were to burst, economists Aryam Vazquez and Marcos Casarin argued, because of the potential impact on exports of soy and iron ore and the likely plunge in commodities prices overall. Despite all recent efforts by President Dilma Rousseff, Brazil would fall in a recession in 2015, shrinking 1.1 percent from this year, according to their calculations.

Impact on Brazil’s GDP would be not only sharp, but would also last long, according to their exercise. Brazil’s economy in 2018 would be 6.6 percent smaller than in the more likely scenario in which China avoids a crisis, compared to a 3.6 percent impact on the U.S. economy.

China’s huge credit expansion is one of the most important reasons behind the country’s economic miracle, especially after the world financial crisis in 2008 reduced demand for the country’s exports. But a large part of that growth happened through the so-called shadow banking system, through which non-financial institutions offered loan products with little if any supervision.

For anyone who watched the U.S. subprime mortgage crisis less than a decade ago, this also smells like trouble.

“This scenario assumes that the authorities are unable to control the credit bubble, which quickly turns into a banking crisis. Although the government is able to step in and recapitalise the banking system if needed (government debt as a share of GDP is around 45 percent), the drying up of credit would hit investment and GDP growth hard. Over the medium term the economy would have to undergo a painful adjustment process, with credit constrained for a number of years, which would limit the pace of recovery in the economy,” Casarin and Vazquez said.

The probability of a full-blown China crisis remains very low at 10 percent, according to Oxford Economics estimates. Yet their study is an interesting reminder that a severe downturn could be just around the corner for Brazil’s economy, already walking on a very thin line.

However unlikely, it is a nightmare scenario for Brazilian policymakers, who are already struggling to shore up government finances and avoid a credit downgrade by ratings agency Standard & Poor’s – something that looks far from certain, according to a Reuters poll last month.

Another Latin American country to be severely hit by a China crisis is Chile, a major copper exporter. According to Oxford’s exercise, Chile’s GDP in 2018 would be 5.6 percent smaller if China tumbles than in the base case scenario.

Unsurprisingly, Mexico stands out as the least exposed to a crisis in China, its fiercest competitor for the U.S. consumer market. Mexico’s GDP growth would slow down to 0.4 percent in 2015, but not fall, and then rebound to a 4 percent expansion in the following year thanks to a recovery in the U.S.

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