Economic growth in Latin America was stronger than expected in the first half of 2022, expanding on average 1% quarter-over-quarter, both in the first and second quarter, roughly twice that of trend GDP growth (~0.5% quarter-over-quarter). The reason for stronger-than-expected GDP growth in the region is mainly robust domestic demand growth, which has been resilient to current external headwinds including supply-side shocks to inflation, rising U.S. interest rates, and growing uncertainty towards the trajectory of the global economy. In several countries, exports have also been strong, especially in food and energy-related commodities.

Chart 1

As a result, we increased our 2022 GDP growth forecast for the region to 2.8%, from 2.0% previously. However, we expect the region to enter a period of below-trend growth by the end of this year and into 2023, as global demand weakens more intensely, and lower confidence levels take a toll on domestic demand across Latin America. We now forecast GDP growth of 0.9% in 2023 (about half of annual trend growth of roughly 2%), from 1.8% previously. We then expect GDP growth to head back towards trend in 2024 as the global economy improve, projecting a 2.2% expansion.

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Peak Inflation, Peak Domestic Interest Rates, But Also Peak Resilience In Domestic Demand

We believe headline month-over-month inflation in Latin America likely already peaked (in late first quarter/early second quarter), when the price shock from the Russia-Ukraine conflict on food and energy goods was most intense. However, we expect inflation to remain elevated for some time, owing to second round effects, as higher energy and food prices are passed through to core prices, especially those in the services sectors. Year-over-year, we believe inflation already peaked in Brazil (second quarter 2022); will peak in the current quarter (third quarter 2022) in Chile, Mexico, and Peru; in Colombia it will reach its highest point in Q4-2022; and in Argentina it will peak in the first quarter of 2023.

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The major central banks in the region, which have been increasing interest rates for well over a year now, are approaching the end of their hiking cycles, most noticeably in Brazil where we do not expect additional rate hikes. However, considering the persistence in inflation, which will remain above target for some time, central banks will tread cautiously in normalizing monetary policy. We don't expect central banks in the region to start lowering interest rates at least until the second half of 2023. Central bank action in the region will continue to be highly influenced by the Federal Reserve's own interest rate decisions. Higher than-expected interest rates path by the Fed would likely postpone monetary policy normalization in Latin America.

Chart 3

However, despite lower inflation, and less upward pressure on domestic interest rates, we expect domestic demand to moderate, following its strong performance in the first half of 2022. In our view, the resilience in domestic demand to weakening external conditions is explained by two factors that are losing momentum. First, domestic demand in the region was still recovering from the pandemic downturn, given large levels of slack, especially in the services sectors that were operating significantly below capacity. However, those gaps in capacity are much narrower now, and in some cases have been completely closed. Domestic demand in the region, as of the second quarter, is now back above its pre-pandemic level in every major economy in Latin America (see chart 4).

Chart 4

Second, the impact of stimulus measures on consumption and investment, many with policies introduced shortly after the onset of the pandemic that were extended, is starting to fade. In some countries, new measures have been introduced, like the case in second quarter-2022 in Brazil when reduced taxes on gasoline and a fresh round of cash transfers to households were implemented. However, unless more measures are announced, we expect household spending to weaken compared with what we have observed so far this year. In addition the recent deterioration in business confidence, in light of growing uncertainty over the trajectory of the global economy, is likely to take a toll on employment in the region, further dimming the prospects for domestic demand.

Weaker Exports In 2023; Upside For Energy-Related Goods

Dimming prospects for growth in the U.S., Europe, and China, means that global trade is likely to soften, with negative implications for exports out of Latin America. We expect weaker exports in the region in 2023, compared with 2022. This is particularly the case for consumer-facing exports, like manufacturing goods, which are more sensitive to the weaker global demand.

Chart 5

Commodity exports will likely also weaken, but price dynamics could remain favorable for several goods because of uncertainty over food and energy exports out of Russia and Ukraine. We still assume volumes for most of energy-related exports out of Latin America will soften. One notable exception is Colombian thermal coal, which has been surging, arguably partly resulting from concerns over energy shortages in Europe. Thermal coal is an alternative source of energy to natural gas, and Colombian coal exports to Europe have doubled since the onset of the Russia-Ukraine crisis. In volume terms, they increased 70% in the second quarter of 2022 alone. Coal accounts for about 7% of total Colombia's goods exports, and we assume those will remain robust in 2023.

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The Evolution Of The U.S. Economy Is A Key Risk

We currently expect a shallow recession in the U.S. in 2023, forecasting growth of just 0.2% for the year. A weaker U.S. economy has clear negative implications for the region--especially for Mexico, which relies heavily on the U.S. to purchase its manufactured products. However, there is a significant amount of uncertainty regarding the trajectory of the U.S. economy, given the mix of well above-target inflation, and the U.S. Federal Reserve's commitment to rein in inflation through aggressive monetary policy tightening. In a separate report, we recently explored the implications of a weaker than expected U.S. economy driven by a rapid tightening in monetary policy, a so-called "hard landing" (see "What A Hard Landing For The U.S. Would Mean For Emerging Markets", Aug. 3, 2022).

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While such a scenario would have negative implications for the entire region through further tightening financial conditions, among the major economies in Latin America, Mexico would be affected the most. Mexico's goods exports to the U.S. account for nearly 28% of its GDP, higher than the 20% share just before the global financial crisis of 2008-2009. A 5% drop in real goods exports to the U.S., for example, half the size of the drop during 2009, would now alone subtract 1.4 percentage points to Mexico's GDP growth. One important caveat to point out regarding Mexico is the behavior of remittances from the U.S., which could offset some of the negative impact from trade. In past periods of U.S. economic weakness, remittances to Mexico fell in 2009, for example, by nearly $4 billion. During the pandemic-downturn however, remittances increased, by just over $4 billion in 2020 (about 1% of GDP higher than the previous year).

Policy Uncertainty In The Region Could Continue To Restrain Investment

Weaker growth in the context of incomplete labor market recoveries from the pandemic and high inflation means that social and political pressure for more fiscal support is likely to remain high. The potential for a weaker fiscal picture in the region usually keeps upward pressure on interest rates as investors demand a higher-risk premia to hold domestic assets, in the face of a higher fiscal risk, with overall negative implications for investment. In addition to that dynamic, two political events, which could further increase investor uncertainty and hamper economic growth, are worth noting. The the process to put in place a new constitution in Chile has taken another step back, after a new version was rejected in a referendum on Sept. 4. This generates a degree of uncertainty over how and when the new constitution process will end, and what it will mean for key policies towards important sectors, like mining, as well as for overall fiscal policy in the country. For now, we assume that regardless of the outcome of the constitutional process, policies towards the mining sector will remain generally business friendly. The Brazilian general election on Oct. 2 could also have implications for the economy. However, regardless of whether Luiz Inácio Lula da Silva becomes Brazil's next president, President Jair Bolsonaro wins re-election, general policy continuity, defined broadly, will remain in place in the country under the next administration.

Our GDP Forecasts

Argentina:   We kept our 2022 GDP growth forecast of 3.3% unchanged but lowered our 2023 projection to 1.0%, from 1.8% previously projected. The government is facing a challenging environment with inflation running around 80% year-over-year and heading higher, the exchange rate has strong depreciatory pressures, at a time when net foreign reserves are close to zero. The government reached a staff level agreement to renegotiate its $45 billion deal with the multilateral organization. However, implementation of the agreement will be challenging, requiring ambitious fiscal, monetary, and reserves targets. We expect inflationary pressures to remain high during the remainder of this year and in 2023, which will conversely keep interest rates high. 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 to inflation.

Brazil:   We have increased our projections for 2022 GDP growth forecast for Brazil to 2.5%, from 1.2% because of stronger-than-expected growth in the second quarter of 1.2% compared with 1.1% growth in the first quarter. The Brazilian economy has benefited from terms of trade gains, as food and energy prices increased in the first half of the year. Furthermore, a fresh round of cash transfers to households, and a cut on gasoline taxes, drove stronger than expected consumption so far this year. However, we expect the economy to weaken as the impact of stimulus measures fades, high real interest rates take a toll on domestic demand, and weaker external conditions soften exports. As a result, we lowered our 2023 GDP growth projection to 0.6%, from 1.4% previously. Inflation, in our view, already peaked in year-over-year terms, but will remain above the central bank target throughout 2023. However, we believe the central bank is done with interest rate hikes and is likely to start normalizing policy in the second half of 2023, as inflation expectations continue to fall amid weaker growth. Uncertainty regarding the general election in October--in which former President Luiz Inácio Lula da Silva is likely to win--could also result in delays to investment. We think the risks to growth outlook are skewed to the downside.

Chile:   We increased our 2022 growth forecast to 2.4%, from 2.1% previously. The economy fared better than we expected in the second quarter, with flat GDP growth a minor contraction. We expect domestic demand in Chile to contract in 2023, following very strong growth in 2021 and early 2022, fueled by pension withdrawal allowances no longer in place. Chile is the largest importer of energy among the major Latin American economies, which will also constrain consumptions if energy prices remain high. A weaker outlook for China is likely to put downward pressure on demand for copper, a key export for Chile. As a result, we revised down our 2023 GDP growth forecast to 0.3%, from 1.3%previously. Uncertainty over the rewriting of Chile's constitutio, will also likely temper investment until there is more policy visibility.

Colombia:   We increased our 2022 growth to 6.5%, from 4.6% previously. GDP in the second quarter was significantly stronger than we expected, growing 1.5% from the first quarter, driven by a 7.6% expansion in exports. Colombia's thermal coal exports to Europe surged, doubling since the onset of the Russia-Ukraine crisis, as they are being used as an alternative source of energy amiduncertainty over natural gas coming out of Russia. While we expect coal exports to remain strong in 2023, we believe domestic demand will weaken in Colombia, as the impact of stimulus measures continue to fade, and confidence is hit by rising uncertainty over global growth. We now project growth of 1.9% in 2023, compared with 2.7%previously.

Mexico:   We increased our 2022 GDP growth forecast for Mexico to 2.1%, from 1.7% previously, owing to stronger-than-expected domestic demand in the second quarter, which expanded 1.7% compared with the first quarter, and is now back to pre-pandemic levels. However, we lowered our 2023 GDP growth projection to 0.8%, from 1.9%, because of a weakening in the outlook for the U.S. economy, which we see entering a shallow recession in 2023. Risks to our growth outlook to Mexico are mostly to the downside and tied with the evolution of the U.S. economy. Beyond 2023, 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 2022 growth forecast to 2.2% from 2.5%, and revised down our 2023 projection to 2.5%, from 2.8% previously, because of weaker external conditions. President Castillo continues to survive several impeachment proceedings against him, and must navigate a fragmented congress, which will keep policy predictability low. A weaker outlook for the Chinese economy is likely to take a toll on copper markets, with industrial metal being a key Peruvian export. Investment is likely to weaken owing to both higher uncertainty over global growth, and uncertainty over domestic policies. Beyond 2023, we expect growth to stay near 3%.

Appendix

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