Latin America and the Commodity Crash June 2015 Latin America and the Commodity Crash Over the past year, Latin America has spiraled into economic and political turmoil, with the region expecting a GDP contraction of 0.2% for Q1-2015. At the root of this contraction is the recent crash in commodity prices, notably in oil and base metals (Aceves, 2015). The plummet in oil prices is a result of waning global demand and increased American production, which has disproportionately affected the region. The 63% drop in oil prices since 2014, coupled with weak metal and agricultural sectors, has created a dangerous formula that is putting the strength and promise of this emerging region to the test. (Energy and Oil Prices, 2015). The region is particularly sensitive to fluctuations in oil prices due to the short-sighted and socialist policies of its leaders. During prosperous years, where commodity prices were high, extensive subsidies and social programs were allotted through populist programs. However, this made the region fall into the paradox of plenty, where the short-term boom caused the region to move away from a diversified industry base, making the countries heavily reliant on commodities. A country which is particularly susceptible to price fluctuations is Chile, the largest global producer of copper. Fueled by strong Chinese demand accounting for over 50% of its copper exports, Chile enjoyed relative prosperity in the late 2000 s (Planes, Trains & Copper, 2015). However, since 2011, copper prices have dropped by over 50 percent, Queen s Global Markets A PREMIER UNDERGRADUATE THINK-TANK
which has contributed to a severe contraction in GDP, manifesting the fragility of such a reliance. (Planes, Trains & Copper, 2015). Figure 1: Chile GDP Growth Year over Year (World Bank, 2015) High commodity prices of the past allowed many Latin American governments to stave off reforms aimed at increasing worker productivity through education and other programs. Their short term prosperity was propagated by these resource revenues and the governments did not adequately invest the budget surplus towards diversifying the economy. Inevitably, the prices of commodities dropped which led the populace to increasingly focus on structural societal problems. With a high standard of living expected and a governmental failure to deliver, social instability has ensued in the past year. For example, in Brazil, large protests have consumed the streets of Rio and San Paolo, as a multi-billion dollar bribery scandal involving the state oil company Petrobras has enraged citizens. Many of President Dilma Rousseff s colleagues have been found responsible. Similarly, in Mexico, the disappearance of 43 students in Guerrero, by a drug cartel and aided by the authorities, spawned massive protests for structural reform (Miroff, 2014). Although politicians in the region may find it hard to deviate from their populist policies, they should look towards other commodity rich countries such as Canada, Norway, and Sweden which have created a robust safety net through their diversification into the service industry and investments into R&D. 2
Socialist Policies vs. the Markets The oil crash of early 2015 caused severe economic hardship within Mexico as oil related revenues make up approximately a third of the federal budget. However, key determinants of economic resilience for Mexico include its open trading policies, attractive foreign investment opportunities and adjusted fiscal policy, which has mitigated its reliance on tax revenues from PEMEX, the state-owned petrol company. Furthermore, Mexico maintains a floating exchange rate, which allows for direct adjustment to the valuation of the Mexican peso. In December 2013, Mexico ended its 75-year state oil monopoly of PEMEX by passing a bill that allowed foreign companies such as Chevron Corp. to develop untapped crude oil resource plays (Helman, 2013). With this reform, Mexico has slowly moved away from conventional socialist policies present in the region. PEMEX has been facing the prospect of declining production and the depletion of some of its oil wells as a consequence of its previous state ownership. With budgetary constraints and a lack of fresh investment, PEMEX reported a decrease in production of 192,000 barrels for the first trimester of 2015, a 7.7% decrease from 2014 in Ku-Maloob-Zaap and Cantarell, two major wells, for the first time since 1986 (Gonzáles, 2015). 3
Exports (In Millions of $) QGM 4000 Value of Crude Oil Exports in Mexico 3500 3000 2500 2000 1500 1000 500 Total Istmo (Medium Crude) Maya (Heavy Crude) Olmeca(Light Crude) 0 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Period Q2 2014 Q3 2014 Q4 2014 Q1 2015 Figure 2: Value of Crude Oil Exports in Mexico (Institute Nacional de Estadística y Geografía, 2015) In December 2013, production had already fallen by 25% from to 2.5 million bbl/d from a high of 3.3 million bbl/d in 2004 (Williams, 2013). Mexico has therefore been trying to increase tax revenues by introducing tax reforms, but tax evasion continues to be a major problem. Tax reforms in 2014 introduced a flat income tax rate of 30% for businesses, and eliminated a few of the more complicated taxes like the IETU (corporate tax at flat rate) and the IDE (tax on bank deposits), while increasing the rate from 28% and 29%. (Deloitte, 2014). While tax revenues have increased, the fiscal deficit has grown as total income has fallen by 3.4% as a result of a 43.5% decrease in oil revenues. The fiscal deficit now stands at $91.5 billion pesos or US$6.1 billion. The Finance Ministry has announced spending cuts for fiscal year 2015 in the order of 0.7% of GDP, and is expected to proceed with further adjustments should the oil prices continue to decline (Arce, 2015). Mexico has continued with its open trading policies and has benefitted from being a neighbour to the United States, one of the largest 4
consumer markets in the world. It has also benefitted greatly from the steady influx of remittances from its workers in the US. Being a part of NAFTA as well as other trade agreements with major economies has put Mexico on the world map for having a strong labour market. Mexico has also profited from its free currency markets, which has allowed a smooth adjustment to the new circumstances of lower oil prices. This has also provided certainty and stability in an economy that seeks to attract foreign investment. The impact of the Oil crash for Venezuela's economy has been amplified by policies already set in place by the current President Nicolas Maduro, and his predecessor Hugo Chavez. To main substantial economic control, Venezuela has a state-owned oil production company, PDVSA (Petroleos de Venezuela Sociedad Anónima) that holds majority control in Venezuelan oil projects. In 2007, Venezuela began forcibly seizing oil exploration assets from foreign companies that refused to restructure their holdings. This expropriation reduced drilling exploration by 80% from 2007 to 2014 and caused Venezuela to isolate itself from foreign investment opportunities (Douglas Westwood, 2015). Without the support of foreign companies, Venezuela found itself unable to fund downstream production capital for heavy crude and was forced to produce low price crude oil. This further dims onshore production expectations in the future. Venezuela has also been faced with the drastic devaluation of its currency caused by a reduction in oil revenues, since 95% of the country s exports are crude oil. The government has refused to acknowledge this by segregating the foreign exchange markets, creating distortions in the trade balance and causing a shortage of US dollars. With the implementation in February 2015 of yet another scheme of foreign exchange management, the SIMADI (Sistema Marginal de Divisas), the US dollar is traded effectively at four different rates in four different markets: (1) the official rate of 6.30 Bolivares per dollar, in which the government operates 65 to 70 percent of the US dollar market; 2) the SICAD at 12 Bolivares per dollar, for some 20 to 25 percent of the US dollar market; and (3) the SIMADI exchange rate, with a share of 5 to 10 percent of the market (McLaughlin, 2015), created in an effort to counterweight the effect of the black market, which sits at 630.21 Bolivares per dollar as of mid-july (Jaramillo, 2015). 5
This situation has exacerbated the fiscal deficit and increased the country s foreign debt. Moody's has downgraded Venezuelan debt from Caa1 to Caa3, as the default risk has increased substantially. This has compounded Venezuela's isolation on the international stage and is expected to lead to further deteriorations in its economic conditions. In Depth: Resource Curse Professor Michael L. Ross defined the resource curse as the perverse effects of a country s natural resource wealth on its economic, social, or political well-being (Ross, 2014). A case study example of a country that is suffering through the consequences of such a curse is Venezuela. Venezuela enjoyed record oil revenues in the early part of the 21 st century under the late president Hugo Chavez, who was elected in 1999 and served until his death in March 2013 (Kenny, 2013). At the time of Chavez s election, the price of oil had started to steadily increase, recovering from the previous down cycle. This resulted in increased standards of living and cash flows to the government (Plummer, 2013). The lucrative oil production reduced any incentive for Chavez to divest into infrastructure or education, leading to 95 percent of export earnings and half of government budget revenues being derived from the commodity trade (Lavelle, 2013). The increased revenues in the beginning stages of Chavez s Presidency allowed him to pursue populist policies which commonly complement the short-term boost associated with the resource curse. Through his social reforms, coined as Bolivarian Missions, he dug out many from perpetuating poverty and instituted numerous subsidies in sectors such as food and healthcare (Ismi, 2013). The costs of these socialist programs increased government social spending from 8.2 percent of GDP in 1998 to 13.6 percent in 2006 (Ross, 2014). However, as the saying goes all good things must come to an end, and this frivolous spending has left Venezuela with inflation in the triple digits and a feeble monetary system, with three official exchange rates and a rising black market (Pons, 2015). Brazil, Chile, Mexico and Venezuela have all suffered in the past year. While the degree to which their economies have suffered varies, they all share the same two core issues at the root of their struggles. The first is that current governments categorically ignored the cyclicality 6
of resource prices. The drawn out nature of the previous cycle gave them a false sense of security in that the good times would continue on indefinitely. Large portions of government revenue were commodity reliant. The extra revenue was not used properly to strengthen the economy or invest for when the commodity cycle would inevitably end. Instead, the respective government spent on social programs that the population became reliant on to make ends meet. This is the second factor that contributed to the difficult situation South America finds itself in. The left leaning governments have made their investment landscapes more unattractive by seizing assets and raising taxes to fund their social programs. Meanwhile, as revenues tumble, these same programs are becoming unsustainable. What Latin America needs are business friendly reforms that will generate investment and restore the confidence of global investors that South America is still a good environment to do business in. Daniel Yergin, a leading energy consultant, stated oil prices are what made heads of state like Hugo Chavez possible and just like the price of oil, prosperity in Venezuela seems a long way from recovery (Lavelle, 2013). 7
Bibliography Aceves, R. (May 20, 2015). Economics Snapshot for Latin America. Focus Economics. Retrieved from: http://www.focuseconomics.com/regions/latin-america Arce, J (2015, March 2). UPDATE 1-Mexico's deficit widens on drop in oil price, output. Retrieved from http://www.reuters.com/article/2015/03/02/mexico-economyfiscal-idusl1n0w42ur20150302 Deloitte. Mexico (2014) Reforma Fiscal 2014. Retrieved from: http://www2.deloitte.com/content/dam/deloitte/mx/documents/t ax/reforma2014/reforma_fiscal2014_flash.pdf Douglas Westwood. (April 29 2015). Oil production weighs heavy on Venezuela, DW says. Retrieved from: http://www.worldoil.com/news/2015/4/29/oil-productionweighs-heavy-on-venezuela-dw-says Energy and Oil Prices. (2015). Retrieved from Bloomberg: http://www.bloomberg.com/energy Gonzalez, N. (April 2015). Pemex reporta baja histórica en la producción de petróleo. Retrieved from: http://www.dineroenimagen.com/2015-04-14/53919 Helman, C. (2013). Mexico's Enrique Pena Nieto Is Leading An Oil Revolution Worth Billions. Retrieved from: http://www.forbes.com/sites/christopherhelman/2013/10/30/me xicos-enrique-pena-nieto-is-leading-an-oil-revolution-worthbillions/ Ismi, A. (2013). Huge Chaves leaves a prodigious legacy that will never die. Global Research. Retrieved from http://www.globalresearch.ca/hugo-chavez-leaves-a-prodigiouslegacy-that-will-never-die/5329706 Jaramillo, A. (July 15 2015). Venezuela's Black-Market Bolivar Tumbles to 1% of Official Rate. Retrieved from: http://www.bloomberg.com/news/articles/2015-07-14/venezuelas-black-market-bolivar-tumbles-to-1-of-official-rate Kenny, C. (2013). After Chavez: A Better Way to Help Venezuela s Poor. Bloomberg Business. Retrieved from 8
http://www.bloomberg.com/bw/articles/2013-03-07/after-ch-veza-better-way-to-help-venezuelas-poor Lavelle, M. (2013). Huge Chavez Leaves Venezuela Rich in Oil, but Ailing. National Geographic. Retrieved from: http://news.nationalgeographic.com/news/energy/2013/03/13030 6-hugo-chavez-venezuela-oil/ McLaughlin, T. (February 2 2015). U.S. companies face billions in Venezuela currency losses. Retrieved from http://www.reuters.com/article/2015/02/02/us-venezuela-usacorporations-insight-iduskbn0l60ct20150202 Miroff, N. (2014). Mass Kidnappings and Slaying of Students. Retrieved from Washington Post: https://www.washingtonpost.com/news/worldviews/wp/2014/10 /11/in-mexico-mass-kidnapping-and-slaying-of-students-in-igualabrings-outrage-and-protests-against-gangs-and-government/ Planes, Trains & Copper. (2015, May 17). Retrieved from Bloomberg Business: http://www.bloomberg.com/news/articles/2015-05- 18/planes-trains-copper-china-s-premier-goes-to-latin-america Plummer, R. (2013). Hugo Chavez leaves Venezueala in economic muddle. BBC News. Retrieved from: http://www.bbc.com/news/business-20795781 Pons, C. (2015). Venezula inflation seen hitting triple-digit levels as crisis deepens. Reuters. Retrieved from http://www.reuters.com/article/2015/07/08/venezuela-inflationidusl1n0zo1nf20150708 Ross, M. (2014). What have we learned about the Resource Curse? UCLA Department of Political Science. Retrieved from: http://www.sscnet.ucla.edu/polisci/faculty/ross/ross%20-%20wh at%20have%20we%20learned%20about%20the%20resource%20c urse.pdf Schipani, A. (2015). Venezuela s foreign reserves take a hit. The Financial Times. Retrieved from: http://www.ft.com/intl/cms/s/0/1de01d14-fb67-11e4-9fe6-00144feab7de.html?siteedition=intl#axzz3dccjybdq Williams, Adam (2013) End of Mexico 75-Year Oil Monopoly Looms With Senate Deal Bloomberg.com Retrieved from: 9
http://www.bloomberg.com/news/articles/2013-12-08/end-of-95- billion-mexico-oil-monopoly-nears-with-senate-deal World Bank. (2015). Retrieved from Chile Data: http://data.worldbank.org/country/chile 10
Contributors Henno Einola Senior Director, Latin America heinola@qgm.ca David Kamenetsky Junior Director, Latin America dkamenetsky@qgm.ca Sawyer Marsh Analyst, North America smarsh@qgm.ca Nicole Perez Analyst, North America nperez@qgm.ca Queen s Global Markets Queen s University 143 Union St. Kingston, ON, Canada K7L 3N6 www.qgm.ca 11