Since September, two notable dynamics have changed for the Latin American economy. First, inflation has been higher and less transitory than expected, in large part due to the recent and rapid increase in energy prices. In turn, inflation expectations have risen, which means central banks in the region will speed up monetary tighten to anchor inflation expectations. Second, supply-chain bottlenecks have disrupted manufacturing production more than anticipated. This will take a toll on near-term growth in countries with large manufacturing hubs, such as Mexico and Brazil. As a result, we lowered our 2022 GDP growth average for the six major Latin American economies (Argentina, Brazil, Chile, Colombia, Mexico, and Peru) by roughly half a percentage point to 2%, which implies a significant slowdown from 6.6% expected in 2021.

S&P Global Ratings believes the new Omicron variant is a stark reminder that the COVID-19 pandemic is far from over. Although already declared a variant of concern by the World Health Organization, uncertainty still surrounds its transmissibility, severity, and the effectiveness of existing vaccines against it. Early evidence points toward faster transmissibility, which has led many countries to close their borders with Southern Africa or reimpose international travel restrictions. Over coming weeks, we expect additional evidence and testing will show the extent of the danger it poses to enable us to make a more informed assessment of the risks to credit. Meanwhile, we expect the markets to take a precautionary stance and governments to put into place short-term containment measures. Nevertheless, we believe this shows that, once again, more coordinated, and decisive efforts are needed to vaccinate the world's population to prevent the emergence of new, more dangerous variants.

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As discussed in our last Latin America macroeconomic update, we think pandemic-specific developments are influencing GDP growth less (see "Economic Outlook Latin America Q4 2021: Settling Into The New Post-Pandemic Normal Of Slow Growth," published on Sept. 27, 2021). While details are beginning to emerge about the new Omicron variant of COVID-19, the associated uncertainty and potential for more widespread mobility restrictions also increase downside risk to our growth projections. That said, in our baseline GDP scenario, slower growth in 2022 will result from tighter monetary policy (as discussed above), the removal of fiscal stimulus in most countries in the region, the negative impact of low levels of policy predictability in investment, and less supportive global trade dynamics. Beyond 2022 we expect real GDP growth in the region to remain near its traditionally slow trend growth of 2.5%, due to structurally low productivity.

More Persistent, Higher Inflation Will Keep Central Banks On A Tightening Bias

We expect sequential inflation to peak in fourth-quarter 2021, but it will remain above the central banks' targets throughout 2022, due to several factors. First, supply-chain disruptions have increased input costs across several industries, which will put upward pressure on the prices of final goods. Evidence suggests that so far the pass-through from producer to consumer prices has been relatively low. However, the magnitude of the recent increase in producer prices over the last few months suggests that pressure is building for producers to pass on some of the higher costs to consumers; the median producer price index (PPI) is running roughly 15 percentage points above the median consumer price index (CPI) in Latin America (see chart 1).

Chart 1

The second reason why we expect inflation to remain above target throughout 2022 is the impact of the recent surge in energy prices. The rapid increase in energy-related commodities--especially natural gas, coal, and oil, which are key in powering electricity for households and fuel for transportation--have accounted for over half of the year-over-year CPI reading in recent months in the region (see chart 2), and that will remain the case in the coming months.

Chart 2

Energy consumption (electricity plus fuel) in the typical Latin American economy accounts for 10% of the CPI basket, which is very similar compared with that of other emerging markets (EMs) outside the region. An outlier is Brazil, where the weight of energy consumption in the CPI has increased to 14.6% in October, from 12% at the end of last year, as CPI weights in Brazil are recalculated every month. In most other EMs, weights are calculated on a yearly, or longer, basis. This means that energy price increases will have an incrementally larger impact on Brazil's CPI than in other EMs. Conversely, this also means that the true impact of the recent increase in energy prices on the share of households' energy consumption is being underrepresented in the CPI readings of most EMs. Furthermore, second round effects of higher energy prices are also likely to show up in the coming months, through higher prices in other sectors, such as services and agriculture (higher prices of petrochemical fertilizers). This will happen even as actual global energy prices start to moderate, which is what we expect to take place in the coming months.

Chart 3

Third, depreciation of Latin American currencies has intensified in recent months, which also increases the costs of imported goods, many of which are included in the CPI basket. The median currency in Latin America has weakened 10% this year versus the U.S. dollar. A large part of that depreciation, in our view, has been driven by a repricing of U.S. monetary policy expectations, evident in the recent increase in yields at the short end of the U.S. Treasury curve. As a result, U.S. monetary policy expectations will be a key factor in the trajectory. And fourth, the broader ongoing reopening of economic activity will also increase prices, especially in sectors that were offering discounts.

Chart 4

Importantly, inflation expectations have risen and are above all major Latin American economies' central bank targets (see chart 4). The region's central banks have been among the first of EMs to start increasing interest rates, and we expect them to continue doing so into next year to anchor the current above-target inflation expectations. Depending on the country, markets are pricing over the next year between 200 basis points (bps) in rate hikes (in the case of Mexico) and 500 bps (in the case of Brazil; see chart 5). Real interest rates are now above neutral across the board in one-year ex-ante terms (see chart 9). The shift from ultra-loose in 2021 to tight monetary policy conditions in 2022 will be a main cause of slower GDP growth.

Supply-Chain Disruptions Will Continue To Hit Mexico And Brazil The Most

In addition to the effect of supply-chain disruptions on inflation across the region, those bottlenecks also have a direct impact on manufacturing production in several countries, especially in Mexico and Brazil. Both countries have large auto production hubs, a sector that has been hit hard by the shortage in semiconductors. In both countries, the number of cars produced in 2021 is trending to be roughly 15% below a typical pre-pandemic year. We expect supply-chain disruptions to persist throughout 2022 in most sectors (see "Supply Chain Strains And Rising Costs Will Pressure Profitability In 2022," published Nov. 18, 2021). Even when semiconductor shortages start easing, it will take some time to acquire and incorporate those inputs into auto production. In Mexico, Chrysler, General Motors, and Nissan make up for over half of total auto production in the country. This means that in Mexico's case, how quickly auto production picks up will largely depend on how effective those three carmakers are able to acquire semiconductors and deploy them into production.

Chart 6

The Combination Of High Inflation And High Unemployment Increases Risks Of Fiscal Slippage

Even though most major Latin American economies returned to their pre-pandemic GDP levels in mid-2021 or will do so by early 2022, the recovery in employment has been much slower. As we approach the end of this year, the level of employment is still on average about 5% below its pre-COVID-19 trend (see chart 7). In Chile it is about 10% below that level, and this doesn't account for underemployment. In some countries, underemployment is still very high. For example, in Mexico, while employment levels are only about 3% below their pre-COVID-19 trend, underemployment is about 12%, which is five percentage points above its pre-pandemic level. A weak labor market, combined with high inflation, could increase demands for more government support. The heavy electoral cycle over the next year means that political pressure to appease those demands will be particularly high. The possibility of weaker fiscal dynamics could add more upward pressure on interest rates to compensate for the additional fiscal risk premia. Furthermore, lower levels of policy predictability will also likely keep investment subdued.

Chart 7

Risk Of Deeper GDP Slowdown In 2022 Is Highest In Chile And Brazil

Chile and Brazil stand out as two economies that are highly vulnerable to a weaker-than-expected slowdown in growth next year, for different reasons. In Chile the above 11% GDP growth expected in 2021 was driven largely by three rounds of pension withdrawal allowances (totaling well over 15% of GDP), which fueled a boom in domestic demand. Domestic demand in Chile is already 20% above its pre-pandemic level, a clear outlier in the region (see chart 8). While there are ongoing legislative discussions surrounding a fourth round of pension withdrawals, those would not match the amount injected into the economy throughout 2021. This means that there is a real risk of domestic demand contracting in 2022 and GDP slowing to more than our 2% projection.

Chart 8

In Brazil's case, double-digit inflation and the rapid deterioration of fiscal dynamics have prompted the central bank to begin an aggressive monetary policy tightening cycle. The central bank has hiked its policy rate by 575 bps so far this year to 7.75%, and it will likely end up above 10% for most of 2022 as the tightening cycle continues. In real terms, it will be at the highest level since 2015, a year in which the economy contracted. We currently expect GDP growth in Brazil to slow to 0.8% in 2022 from 4.8% this year, but the risks are skewed firmly to the downside.

Chart 9

Our GDP Forecasts

Argentina:   Our macroeconomic narrative for Argentina has not changed materially since our last update. Growth in the third quarter (GDP data for that period is not out yet) is trending to be a touch higher than our expectations, as the economy continued to reopen several sectors. This pushed our 2021 GDP growth up to 7.5% from 7.2%. However, we kept our 2022 forecast unchanged at 2.1%. The result of the midterm elections on Nov. 14, in which the ruling coalition lost legislative seats, does not alter our growth outlook significantly. Inflation is still likely to stay close to 50% year over year through the rest of 2021 and in 2022, driven by wage adjustment and high cost of imported goods. The exchange rate will remain under pressure, given the combination of lower foreign-exchange reserves and a heavy foreign-currency debt burden. The government faces large fiscal imbalances and has limited access to international capital markets following the restructuring of $65 billion worth of debt last year. This means that the government will continue to finance its large fiscal deficit through local debt issuance, which will add pressure to the currency and to inflation.

Brazil:   We have lowered our projections for Brazil due to the impact of supply-chain disruptions on manufacturing, abrupt monetary tightening in the face of persistently high inflation, and a more challenging fiscal scenario. We now forecast GDP growth of 4.8% in 2021 and 0.8% in 2022 (compared with our previous 5.1% and 1.8% projections). We expect inflation to stay close to its current 10% year-over-year level into early 2022, which will prompt the central bank to continue tightening monetary policy. We expect the policy rate to be above 11% by end-2022, from its current 7.75% level. Plans to continue government stimulus measures next year have increased the fiscal risk premia, which partly explains the increase in rates, to compensate for the extra risk. Uncertainty over next year's general election--in which former President Luiz Inácio Lula da Silva, known as Lula, is likely to run--could also result in delays to investment. We see the risks to our 2022 growth outlook skewed to the downside.

Chile:   Data has been much stronger than we initially expected, but in our view, this will mean a sharper slowdown in 2022. The strong third-quarter GDP growth of 4.9%, compared to upward revisions in previous quarters, pushed up our 2021 GDP growth projection to 11.4% from 9%. However, we lowered our 2022 projection to 2.0% from 2.5%. The third round of pension withdrawals, combined with an ongoing reopening of the services sectors following lockdowns in the second quarter, boosted consumption in services--it grew 12% in the third quarter from the second quarter. However, this also means consumption will slow sharply next year as more pension-withdrawal-related spending is seeming less likely. Uncertainty over the rewriting of Chile's constitution and the implications of the presidential election's outcome, which is heading to a runoff on Dec. 19, will also likely temper investment plans.

Colombia:   We revised up our 2021 and 2022 forecast for Colombia, due to stronger-than-expected data, as well as the recent increase in oil prices. Colombia is one of the only countries in the region that benefits from higher oil prices on a net basis (considering oil-related imports). The economy grew 5.7% in the third quarter from the second quarter, driven by an 11.3% increase in exports. We now forecast GDP growth of 9.2% in 2021 and 3.5% in 2022, from 8.0% and 3.2% previously projected. The removal of stimulus measures will likely result in lower consumption growth next year, which will be a main driver of slower GDP growth. Uncertainty surrounding the March 2022 legislative election and May 2022 presidential election is likely to keep investment subdued.

Mexico:   The supply-side bottlenecks, especially those in the semiconductors segment, have taken a larger toll on Mexico's auto production than we envisioned. In a typical pre-COVID-19 year, Mexico produced about four million vehicles; this year auto production is trending below 3.5 million. As a result, we have lowered our GDP projections to 5.8% in 2021 and 2.8% in 2022, from 6.2% and 2.9% previously. The investment outlook outside of the manufacturing sector remains downbeat, partly due to government policies that have undermined investment incentives in key sectors, especially energy. However, the country will continue to benefit from a strong U.S. recovery, which is also filtering through record-high remittances. This, in our view, will keep GDP growth above-trend in 2022. Our forecast implies average quarter-over-quarter growth of 0.75% through the year, above our trend growth estimate of 0.55%.

Peru:   Stronger-than-expected growth of 2.8% in the third quarter from the second quarter pushed up our 2021 GDP growth projection to 13.5%, compared with our previous 12% projection. Growth in the third quarter was driven by an improvement in domestic demand, as the economy reopened several sectors that had COVID-19 related restrictions in the second quarter. However, we kept our 2022 projection unchanged at 3.0%. Higher inflation, which at 5.8% year over year is at its highest level since 2009, will prompt the central bank to continue tightening monetary policy in the coming months. The removal of fiscal stimulus measures will also soften domestic demand next year. There is a lot of uncertainty over policy direction, after the highly polarized June election, in which previously the largely unknown anti-establishment candidate Pedro Castillo became the new president. In our view, this will keep investors more cautious toward the country until there is higher visibility on the new administration's policies.

Appendix Tables

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