The Pacific Alliance Path to Profits

The turmoil in emerging markets seems all too familiar. In the late 1990s Russia and several Asian countries suffered a series of interlinked crises that stemmed from high fiscal deficits, large current-account deficits, and dollar-denominated debt. In 1994 Mexico got into trouble after it built up unsustainable dollar debts, and during the 1980s several Latin American countries were forced to default when rising US interest rates made it impossible to pay back their loans. No wonder, then, that when US interest rates rise and the dollar strengthens, investors are quick to ditch emerging-market assets. They are particularly wary about developing countries that combine high current-account and fiscal deficits – funded by dollar-denominated debt – with a dearth of defence mechanisms, such as a big pile of foreign-exchange reserves. That’s why Turkey and Argentina have been the principal victims of the sell-off.

But the rush for the exit has created interesting buying opportunities. Investors have tarred all the emerging markets with the same brush, yet their individual situations differ widely. In a moment of panic, all emerging markets move the same way, but over time capital will return to the solid, well-managed, growing economies. Prime examples are the four members of Latin America’s Pacific Alliance. This outward-looking trade bloc comprising Mexico, Colombia, Peru and Chile will reward long-term investors over the next few years.

A new Latin American trade bloc

With a combined population of around 200 million the Pacific Alliance represents almost 40% of Latin America’s GDP and accounts for more than half the region’s exports. Founded in 2011, the goal is to give member-country businesses access to a greater pool of resources, capital, customers and workers to build the scale they need to trade successfully with Asia. As the name suggests, the Pacific Alliance is intended to take advantage of the massive opportunities created by the “Asian Century”.

The majority of the world’s wealth and economic growth in the 21st century will come from Asia, and the Pacific Alliance is a way for these mid-sized Latin American economies to benefit collectively from this structural shift. Over the coming years closer integration between Alliance members will help drive growth. Since 2011 a succession of infrastructure projects, visa agreements and tariff reductions have boosted the movement of people and goods within the bloc. The creation of a shared stockmarket and standardised financial-sector regulation should increase inter-Alliance capital flows.

They survived the perfect storm

Laudable as the bloc’s joint efforts and achievements are, it’s the strong state of the member economies that will temp investors. All four benefit from prudent macroeconomic management that ensures they are far more resilient to US monetary tightening than the likes of Turkey or Argentina – they’ve already been through worse and come through unscathed. Beginning in 2013, Peru, Chile and Colombia saw the prices for their major exports fall. First to go was copper, which at the time made up more than 60% of exports in Chile. Copper is also Peru’s top export and the pain was compounded when gold, its second-most important metal, fell too: more than 50% of the country’s exports suffered a double-whammy. Then in 2014 oil and coal prices tumbled, hitting Colombia’s two main exports.

The plunging commodity prices were too much for Venezuela. But, in a testament to their macroeconomic strengths, the Pacific Alliance countries avoided recession. During the good times their governments had paid down debt, which meant they could comfortably run larger fiscal deficits to sustain growth during the commodity downturn. Years of prudent monetary policy, meanwhile, gave the Pacific Alliance’s central banks the firepower to combat the downturn. Unlike most of the developed world, the Pacific Alliance countries raised interest rates back to normal levels soon after the global crisis of 2008-2009. That meant they had room to cut rates when commodity prices tanked a few years later.

During the commodity downturn the Pacific Alliance members’ floating currencies devalued in line with the prices of the key raw material of each. That boosted the competitiveness of non-commodity exports and made imports more expensive – thereby acting as an automatic control on current-account deficits. What’s more, the Pacific Alliance countries had accumulated healthy foreign-exchange reserves. These can be used to repay foreign debts and prop up the local currency, precluding a rout. In Peru, where dollarised debt was relatively high, the central bank managed to control the depreciation, slowly bringing down the value of the currency and giving banks time to adjust to the new reality.

Why the Pacific Alliance is resilient today

Compared with the commodities downturn, this current “crisis” is a walk in the park. One key point is that none of the Pacific Alliance countries have dangerously high combinations of fiscal and current-account deficits. Based on 2018 forecasts, the combined fiscal and current-account deficits as a percentage of the Pacific Alliance members’ countries’ GDP are: Mexico 3.5%, Chile 4%, Colombia 6.3% and Peru 4.6%. Compare that with 8.1% for Argentina and 10% for Turkey. What’s more, in Peru, Chile, Colombia and Mexico, foreign direct investment is much higher than in Argentina or Turkey. That means a higher proportion of the current-account deficit is financed by foreign direct investment, or “real economy” projects, such as mines or infrastructure, rather than financial flows (“hot money”) that tend to retreat rapidly when spooked.

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