S&P Global Ratings' macroeconomic assumptions for Latin America remain broadly unchanged since our previous update in September. Stronger-than-expected growth in the third quarter pushed up our 2022 GDP growth estimate for Latin America to 3.4%, from 2.8% previously, but we still expect the major economies in the region to enter a period of below-trend growth in 2023. We forecast growth to slow to 0.7% in 2023, compared to 0.9% in our previous projection. The combination of the effects of tight global financial conditions, weak demand in key trading partners (especially the U.S. and China), and a deterioration in domestic demand as the still ongoing recovery from the pandemic-related downturn loses momentum will mainly drive the slower GDP growth next year. We then expect growth in the region to return to its traditionally low rate of just above 2% in 2024.

Table 1

Table 2

Manufacturing Will Likely Drag Down Growth

Manufacturing has performed strongly in most of the major economies in Latin America for much of this year, helped by an improvement in earlier disruptions to supply chains and continued robust demand from key trading partners, in particular the U.S. However, a recent dip in both confidence indicators and hard data, especially starting in the third quarter (see chart 1 below) point to weakening manufacturing output in the coming quarters. As growth weakens in the main global economies, we expect this trend to intensify further, leading manufacturing output to weigh on GDP growth in most of Latin America next year.

Chart 1

One way to analyze how much manufacturing output could hamper GDP growth in Latin America is by estimating the relationship of those sectors with GDP growth in the U.S., which we project to be negative 0.1% in 2023. Although China has a larger influence on activity than the U.S. for several economies in the region, even in those economies, the U.S. still plays an important role in their manufacturing sectors due to supply chain links and overall influence on global demand.

We construct two scenarios for 2023: one in which GDP growth in the U.S. is 0% (very close to our baseline for the U.S.) and one in which GDP declines by 1%. We estimate that in a scenario of zero GDP growth, U.S. manufacturing output declines 1.8%, and in the scenario of a 1% decline in GDP, output declines 3.5%. We then estimate the elasticities between the manufacturing sectors in the U.S. with those in Latin American countries. Finally, we use those cross-country coefficients to apply the U.S. manufacturing output declines we estimate for both the 0% and negative 1% GDP growth scenarios (-1.8%, and -3.5%, respectively). Considering 0% U.S. GDP growth (a 1.8% decline in U.S. manufacturing output), the median estimated drag on GDP growth in Latin America next year would be 0.2 percentage points, implying a median net drag to GDP (contribution to GDP growth in 2023 minus in 2022) of 0.8 percentage points (see table 3). In the more severe scenario of a 1% decline in U.S. GDP (a 3.5% decline in U.S. manufacturing output), the median estimated drag to GDP growth in Latin America next year would be 0.5 percentage points, implying a median net drag to GDP (contribution to GDP growth in 2023 minus in 2022) of 1.1 percentage points (see table 3).

Table 3

Table 4

Resilience In The Services Sectors Will Lose Momentum

Services-related sectors in Latin America have also performed well this year, helped the ongoing recovery in employment after the pandemic-related downturn, as well as a rapid improvement in tourism in most countries in the region. The services sectors, which were among the worst hit during the pandemic, as a share of GDP are now above their pre-pandemic levels, in some cases substantially like in Chile and Colombia (see table 5 below), indicating their strong recovery.

Table 5

However, we think the recent deterioration in confidence indicators and expectations for slower global growth will dampen employment rates, leading to lower activity in the services sector. Employment levels in most economies in the region have already returned to their pre-pandemic trend (see chart 2 below). Further improvements in employment would require additional investment, which becomes more challenging amid the current uncertainty over global growth and the tight financial conditions.

Chart 2

More Moderate Inflation Will Encourage Central Banks To Start Lowering Rates Next Year

In month-on-month terms, inflation in the region peaked either in late first quarter or early second quarter, depending on the country. We expect this disinflation to continue gradually next year, assuming commodity prices don't jump higher. The pass-through of headline inflation to core prices has been relatively orderly, and we expect this will encourage central banks in Latin America to start lowering interest rates next year. We forecast that Chile's central bank will cut its benchmark interest rate as early as first quarter 2023, Brazil will follow suit soon after, and most of the other major central banks in the region will reduce interest rates in the second half of 2023. The trajectory of monetary policy by the U.S. Federal Reserve (Fed) will be a key determinant in the timing of interest rate reductions in Latin America. If market expectations for the Fed's interest rate path shift (currently implying that tightening will peak in the first half of next year and interest rate cuts would start between late 2023 and early 2024), this will likely influence interest rate expectations in Latin America in the same direction.

Chart 3

Fiscal Response To A Period Of Below-Trend Growth Could Generate Investor Uncertainty

The government response to our expected period of slower economic growth is likely to generate some investor uncertainty about the risk of fiscal slippage. This risk is likely to be higher in countries where new executive branches have been elected that campaigned on higher social spending, such as Brazil and Colombia. However, in both cases the legislative branch is divided, which means proposals will have to be negotiated with opposing political parties, likely resulting in a degree of dilution. However, if more expansionary-than-expected fiscal packages are approved, risk premiums for holding domestic assets would likely increase, putting upward pressure on interest rates and depreciatory pressure on currencies.

Our GDP Forecasts

Argentina:  We lowered our 2023 GDP growth forecast to 0.5% from the previous 1.0%, implying a significant slowdown from the 4.6% growth we expect in 2022. Inflation will end 2022 at about 100% year-over-year and stay close to that level throughout most of 2023, due to wage adjustments and the effect of a weaker exchange rate on import costs. The exchange rate will continue to face strong depreciatory pressures next year, with net foreign reserves close to zero. The government will face a tough implementation of the Extended Fund Facility (EEF) targets with the IMF, after reaching an agreement to renegotiate its $45 billion deal with the multilateral organization earlier this year. The EEF targets imply politically challenging fiscal, monetary, and reserve targets amid the high inflation and slowing economic growth. Signs that EEF targets aren't met would likely intensify pressure on the exchange rate, increase inflation, and lower investment. This factor puts the risks to our 2023 GDP growth forecast for Argentina firmly to the downside.

Brazil:  We've kept our 2023 GDP growth projection broadly unchanged at 0.5% (from the previous 0.6%). The Brazilian economy will slow next year from the expected 2.9% GDP growth this year, as the initial boost from improved terms of trade gains as commodity prices increased this year fades. In addition, the impact of tight monetary policy will likely intensify as growth prospects dim, dampening domestic demand. Furthermore, the change in government, as recently elected President Luiz Inácio Lula da Silva takes office in January, could also slow investment implementation due to administrative delays. Some uncertainty about the Lula administration's policies, especially on the fiscal front, could also pare back investment until there is more visibility. However, in our view, a U-turn in economic policy direction under President Lula is unlikely because Brazil's polarized congress will likely limit his political capital on more radical policy proposals (see "Credit FAQ: What Will Lula's New Presidency Imply For Our Sovereign Credit Rating On Brazil?", published on Oct. 31, 2022).

Chile:  We lowered our 2023 GDP projection to a contraction of 0.4%, compared to 0.3% growth previously, and we expect 2.5% growth this year. Domestic demand in third quarter 2022 contracted by about 3% from second quarter 2022, its largest decline since the worst of the pandemic downturn in second quarter 2020. We expect demand to contract in 2023, as the fading effect of the removal of stimulus measures continues, especially those that boosted consumption such as pension withdrawal allowances. Uncertainty about the rewriting of Chile's constitution will also likely temper investment until there is more policy visibility.

Colombia:  We lowered our 2023 growth forecast to 1.1% from 1.9% previously. This implies a sharp slowdown from the 7.7% growth we expect in 2022. There are clear signs that the very strong domestic demand growth of the last two years is starting to weaken, as the impact of stimulus measures from the pandemic fade. Private consumption declined 2.2% quarter-over-quarter in third quarter 2022, its first quarterly decline since second quarter 2020 when the pandemic-related downturn took its largest toll on demand. We expect demand to remain weak in 2023 as the more sluggish global growth weakens confidence. Inflation in Colombia is among the highest in the region (12.2% year-over-year in October), due in large part to rising food import costs. We expect inflation to remain elevated throughout most of 2023. This will keep domestic interest rates relatively high (above 10% for most of 2023), given that inflation expectations remain well above the central bank's 3% target--at about 7.5% for year-end 2023. We expect investor uncertainty about policies under the recently elected President Gustavo Petro, especially in terms of the energy sector and on the fiscal side.

Mexico:  We kept our 2023 GDP growth forecast for Mexico unchanged at 0.8%. The economy will slow from 2.6% growth we expect in 2022, primarily due to lower U.S. demand for Mexico's manufactured exports. We project the U.S. GDP to decline 0.1% in 2023, as the Fed's monetary policy tightening pushes down demand. This will mean that Mexico's manufacturing output in 2023 will likely contract. Services, which have done relatively well in recent quarters, will also soften as employment weakens. Continued strong remittances from the U.S., if they continue in 2023 even as the U.S. economy weakens, would help boost consumption in Mexico. Beyond 2023, we continue to expect Mexico to grow close to its traditional structurally low growth rate of 2% due to low and inefficient investment levels.

Peru:  We kept our 2023 growth projection unchanged at 2.5%, from the 2.2% growth we expect this year. President Castillo continues to face significant opposition in the legislature, following several failed impeachment proceedings against him. This has resulted in political stalemate, which will limit investment in the coming quarters and keep growth well below trend, which we estimate to be between 3.0% and 3.5%. Consumption also started to decline in the third quarter, hindered by record-high inflation (8.3% year-over-year in October), which has pushed the central bank to raise the reference interest rate to 7.25% - its highest level in over 20 years. Weaker global growth prospects are likely to keep demand for copper, Peru's largest export, subdued in 2023.

Appendix

Table 6

Table 7

Table 8

Table 9

Table 10

Table 11