Economic growth in Latin America toward the end of 2021 was generally better than expected, benefiting from a continued recovery in demand and, in some cases, stimulus measures. By the end of last year, GDP in every major Latin American economy was back to its pre-pandemic level, except for Mexico, where supply-chain disruptions and weak investments led economic activity to stall in the second half of 2021. The impact of the Russia-Ukraine conflict on Latin America's GDP is relatively mild compared with most of the world because of low trade and financial linkages with that region. Nevertheless, the impact on GDP will still be net negative for all the major economies in the region, mainly owing to the impact of higher commodity prices on inflation and consequently on household spending, which will more than offset the gains commodity producers will enjoy from higher international prices.

We lowered our average 2022 GDP growth forecast for the six largest Latin America economies by 0.3 percentage points to 1.7%. Thereafter, we continue to expect most economies in the region to converge toward their traditionally low 2%-3% growth rates (see table 1). However, we did raise our 2022 GDP growth forecasts for Argentina, Chile, and Colombia, mainly because of stronger-than-expected growth in the fourth quarter of 2021, which resulted in a higher carryover to GDP in 2022, more than offsetting the negative impact of the conflict on GDP.

Table 1

Table 2

Breaking Down The Impact Of The Conflict On Latin America's GDP

The main transmission mechanisms from the Russia-Ukraine conflict to Latin America are tighter global financial conditions, weaker demand from key trading partners, higher commodity prices, and longer supply-chain disruptions. We conclude that, on balance, the aggregate exposure is higher for Chile (financial conditions, commodity prices) and Mexico (weaker demand from key trading partners, commodity prices, supply-chain disruptions).

Global financial conditions

Most vulnerable: broadly the same across the board, but slightly higher in Chile.   Typically, in periods of general risk-off sentiment, Mexican assets tend to see higher volatility, given it is among the most liquid emerging market and has previously been treated by investors as a barometer for general risk aversion. However, Chilean assets have been the most volatile relative to their own history, with implied volatility on the Chilean peso over the last month reaching levels comparable to the deepest point of the COVID-19 downturn in second-quarter 2020, while Mexico's case volatility is about half of what it was during the pandemic (see table 3). The reasons for high volatility in Chilean assets are likely to remain as the conflict continues, in our view. These reasons include a sharp deterioration in external account dynamics (current account deficit came in at 6.4% in 2021, the widest in recent history) and uncertainty regarding the drafting of a new constitution.

Table 3

Global demand

Most vulnerable: exposure is generally low across the region, but highest in Mexico.   The immediate fallout of the conflict is likely to affect European demand the most, given its reliance on Russian energy and other traded goods. Trade with Europe tends to be relatively low in Latin America, accounting for 3% of GDP or less in the major economies in the region. However, if the conflict starts to affect demand in other economies outside of Europe, like the U.S., potentially in response from higher gasoline prices, Mexico is the most exposed. Total exports as a share of GDP in Mexico are close to 40%, the highest by far across Latin America (see chart 1), with 30% of GDP going to the U.S. alone. This means that even a small negative impact on U.S. demand could have a material consequence for Mexico's GDP.

Chart 1

Higher commodity prices

Most vulnerable: Chile, Peru, and Mexico from a trade perspective, but broadly uniform across the board from an inflation perspective.   With the exception of Mexico, most of the largest Latin American economies are net commodity exporters (see chart 2), which means that depending on which commodities they export, some economies in the region will have improved terms of trade after the recent increase in the prices of raw materials. This is especially the case for net energy exporters and net food exporters, the two commodity groups with the largest price increases since the Russia-Ukraine conflict began.

Among the major Latin American economies, Colombia, Brazil, and Argentina stand out as having improved terms of trade, given the mix of commodities they sell and buy from abroad. All these economies are either net importers of food or energy. In the case of Argentina, the country is a small net importer of energy, but the net exports of food more than compensate for the energy import bill. Conversely, Chile, Peru, and Mexico are likely to see a deterioration in terms of trade, given they all are net importers of energy, and copper prices (the main commodity export of Chile and Peru) have only risen a fraction of the rise in the price of energy-related commodities.

Chart 2

However, better terms of trade do not necessarily imply overall immediate better GDP growth prospects for two reasons. The demand for several of those commodities may also fall, especially in the current environment of high global uncertainty, which ultimately means lower volumes exported. Additionally, higher commodity prices also mean higher inflation on key goods of the consumer basket (energy and food), lowering disposable income to purchase other goods and services. On average in the region, energy prices are running above 15% year over year and food 10% (see chart 3), and the recent increase in international prices of those goods is likely to show up in inflation further over the coming months. This means benefits accrued by commodity producers are likely to be more than offset by reduced overall consumption in the region.

Chart 3

As higher commodity prices will likely keep inflation elevated for longer than anticipated, central banks in the region are also likely to react with higher interest rates, further constraining domestic demand. Since the conflict began, most interest rate curves have priced in more hikes this year, and central banks that have held monetary policy meetings since then have delivered a more hawkish stance than their previous meeting. If we look at the one-year real ex ante interest rates, in most cases they are the highest they have been in at least a decade (see chart 4). The one-year real ex ante interest rates are a good gauge of domestic financial conditions because they take into account expectations of interest rates and inflation a year out, rather than the most volatile current rates.

Chart 4

Supply-chain disruptions

Most vulnerable: Mexico and Brazil are likely to be hit the most on the production side.   However, all economies in the region are susceptible to the impact that supply-chain disruptions have on inflation, through higher prices on final manufactured goods. Several key inputs of goods that are manufactured in Latin America are produced in Russia and Ukraine, and prices for those goods have risen considerably as their supply comes under threat because of the conflict. In particular, palladium and nickel, two key inputs in the value chain of auto production, are at play. Mexico has the largest auto sector in the region, followed by Brazil, and both are key employment generators. In both countries, auto production is running roughly 20% below pre-pandemic levels, and the conflict is likely to further drag on the sector's recovery.

Chart 5

Conflict Increases The Risk Of Social Unrest And Lowers Policy Predictability

For Latin America, arguably one of the largest fallouts from the conflict is that it amplifies preexisting social- and political-related risks, with a potentially large negative impact on growth if those materialize. Several years of structurally low growth, which have constrained opportunities for upward income mobility (GDP per capita is virtually unchanged over the last decade in most of the region), have resulted in increased social unrest. The pandemic worsened this trend, as middle- and lower-income households were among the worst hit by the economic downturn. As a result, less conventional and less known leaders have won elections, which has lowered policy visibility across most of the region, making long-term investment decisions more challenging. The higher energy and food prices since the Russia-Ukraine conflict, during weak labor market dynamics and a heavy electoral agenda, further increases the risk of social unrest. Consequently, the risk of fiscal slippage has also risen, as the government could attempt to prevent and appease periods of social unrest through higher social spending.

Chart 6

The recovery in the labor market is far from complete, with employment on average still 5% below the pre-pandemic trend in the typical Latin American economy (see chart 6). Additionally, underemployment is still very high, which means that many employees would prefer to work more hours. In this environment, demands for continued fiscal support through programs like unemployment insurance, or cash transfers, could stay high as households weather the cost of higher energy and food prices.

In addition, even though GDP has returned to its pre-pandemic level in most economies in the region, the recovery has been very uneven across sectors, and many of these could increase demands for government support as they face higher input costs. In several of Mexico's services sectors, Colombian construction, and Chilean fishing industry, output is still at least 15% below their pre-pandemic output levels (see table below). In several countries, governments have already reacted through tax policy on fuels (Brazil, Mexico, Colombia). However, the longer energy costs stay high, the larger the fiscal burden will be for these economies, at a time when fiscal consolidation efforts were on the way.

Two Other Risks: The Fed And China

Since our previous quarterly update, we have made material changes regarding our expectations on monetary policy by the U.S. Federal Reserve. We now see the Fed normalizing monetary policy sooner and faster than originally expected, owing to more persistent inflation than previously forecast. We now expect 175 basis points (bps) in total interest rate hikes this year (including the 25 bps rate hike done in March), followed by 100 bps more of hikes in 2023, with risks concentrated on the upside. The Fed's tapering of asset purchases has ended, and we expect an announcement on the strategy for reducing the size of the balance sheet as early as May.

We believe Latin America is generally well-positioned to withstand the ramifications of the current Fed's tightening process, given that central banks in the region have already been increasing interest rates since last year. The spread between one-year interest rates in Latin America and those in the U.S. are already high, in some cases the highest in recent history (see chart 7). In other words, additional upward pressure on Latin American interest rates stemming from Fed policy is likely to be marginal. However, if the Fed surprises with an even faster monetary policy normalization than what is expected, we believe countries with large external imbalances, such as Chile, or a recent sharp increase in public debt (Brazil), are the economies that would face the highest pressure on interest rates (see "How Prepared Are Emerging Markets For The Upcoming Fed Policy Normalization?," published on Jan. 27, 2022).

Chart 7

A faster-than-expected slowdown in domestic demand in China is also a significant risk for growth this year in Latin America. Latin America's exposure to Chinese demand increased throughout the pandemic, as the share of exports sent to China is now larger as a share of GDP than just a few years ago (see chart). We assume China's economy will grow 4.9% this year, which is below the government's 5.5% target. However, the zero-COVID-19 policy threatens to reduce domestic demand beyond our expectations, especially in the event of more significant outbreaks of the virus that lead to more lockdowns. Policy reaction of the Chinese government to below-target GDP growth will be key. If stimulus measures are directed toward increasing investment in the property market, this could benefit Latin American economies that export key inputs for infrastructure, like copper.

Chart 8

Our GDP Forecasts

Argentina:   Our macroeconomic narrative for Argentina has not changed materially since our last update. Growth in 2021 was 10.3%, significantly higher than the 7.5% we envisioned because of strong exports and domestic demand in the last quarter of the year. This pushes up the statistical carryover to 2022 GDP growth--the main reason we now project the economy to expand 2.8% this year, compared with 2.1% previously.

Argentina's producers of grains will benefit from the increase in prices since the Russia-Ukraine conflict began. However, government policies, like the recent increase in export taxes on soymeal, will limit those gains. The government is in the process of renegotiating its $45 billion deal with the IMF as repayments come due. However, implementation of the agreement will be challenging since it will likely involve removing subsidies on energy prices, which are rising due to the Russia-Ukraine conflict.

We expect inflation to remain high throughout the year, which will conversely keep interest rates high. The exchange rate will remain under pressure, given the combination of lower foreign-exchange reserves and a heavy foreign-currency debt burden. The government continues to face 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, adding pressure to the currency and inflation.

Brazil:   We have lowered our projections for Brazil because of the impact of supply-chain disruptions on manufacturing, abrupt monetary tightening in face of persistently high inflation, and a more challenging fiscal scenario. We now forecast GDP growth of 0.4% in 2022 (compared with 0.8% previously). We expect inflation to stay above 10% year over year throughout the first half of the year, which will prompt the central bank to continue tightening monetary policy. We see the policy rate above 13% by the end of 2022, from its current 11.75%. This, combined with less fiscal support as some of the pandemic-related measures continue to be unwound, will result in weaker domestic demand this year. Uncertainty regarding the general election in October--in which former President Luiz Inácio Lula da Silva 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 continued to be stronger than we initially expected in the fourth quarter of last year, driven by stimulus measures that boosted domestic demand, which pushed GDP growth to 11.7% in 2021. While, in our view, Chile is one of the Latin American economies that will be the worst hit by the Russia-Ukraine conflict through a higher energy bill, we revised our 2022 GDP growth forecast up marginally to 2.1% (from 2.0%). This is because the stronger-than-expected growth in the fourth quarter resulted in a large carryover effect of roughly 4 percentage points for GDP in 2022, that it more than offset the estimated negative impact on GDP growth this year.

We expect consumption to moderate significantly this year, following 20% growth in households spending last year, largely fueled by several rounds of allowances of pension withdrawals. Uncertainty over the rewriting of Chile's constitution, currently suffering from delayed, will also likely temper investment until there is more policy visibility.

Colombia:   We revised up our 2022 GDP forecast for Colombia due to stronger-than-expected data and the recent increase in oil prices. We now forecast 4.6% growth this year, compared with our previous 3.5% projection. Colombia is one of the only countries in the region that benefits from higher oil prices on a net basis. Net energy exports account for about 5% of GDP. Although, conversely, higher energy prices will also impact inflation and lower household spending on other goods and services. Additionally, uncertainty surrounding the May 2022 presidential election is likely to keep investment subdued. We expect growth to return to around its 3% potential in 2023 and beyond, but with risks firmly to the downside resulting from policy uncertainty.

Mexico:   We lowered our 2022 GDP growth forecast for Mexico to 2.0%, from 2.8%. The Russia-Ukraine conflict is likely to extend supply-side bottlenecks, which will continue to take a toll on Mexico's auto production. Additionally, Mexico is a net energy importer, given the large amount of imports of gasoline and natural gas, which means the recent increase in energy prices will constrain growth. The government has reacted to higher energy prices by lowering taxes on gasoline, and potentially subsidizing them if prices continue to increase. As a result, the longer that oil prices stay high, the more material the fiscal cost will be for the Mexican government.

We also lowered our expectations for U.S. GDP growth this year to 3.2% from 3.9%, which filters into lower demand for Mexican manufactured goods. Beyond 2022, we continue to expect Mexico to grow close to its traditional structurally low growth rate of 2% because of low and inefficient levels of investment.

Peru:   We lowered our growth profile for Peru, following persistent political deadlock, which is likely to constrain investment. Peru's government continues to be in a standstill between the executive and the legislative powers for several years. President Castillo has faced impeachment proceedings and has to navigate a fragmented congress, which will keep policy predictability low. We now forecast 2.5% GDP growth in 2022, compared with 3% previously projected. High copper prices, and potentially higher demand for that metal as an input for new technologies, like electrical vehicles, could support growth. But beyond that, more investment is needed to return to the above 4% growth Peru was used to in the past. Beyond 2022, we expect growth to stay near 3%.

Appendix Tables

Table 4

Table 5

Table 6

Table 7

Table 8

Table 9