Taking stock of the global financial crisis and adjusting plans in Latin America.
BY JOHN PRICE
The crisis struck when most businesses were in the middle of their planning season. Many of those firms continue to delay the finalizing of their 2009 investment plans and operating budgets. As inconvenient as the timing of this crisis has proven to be, the shift in the business climate in Latin America, and elsewhere, is significant enough that it bears studying before plans are cancelled or approved. Some business models that were working profitably in the first half of 2008 will prove unviable in 2009. Likewise, new opportunities have emerged that oblige business planners to re-direct investment plans quickly or watch a market gap be filled by the competition.
INVESTMENT GRADE SURVIVES
As financial markets deleveraged in New York and London, traders called in their traders called in their chits placed in emerging markets and capital fled out of Latin America and capital fled out of Latin America, Asia, Russia and the Mideast, pulling their currencies down. Latin American currencies were dragged down further by falling commodity prices. However, post-mortem analysis indicates that currencies in Latin America were over-inflated and the 30 percent downturn will likely settle at a 20-25 percent decline, proving to be a healthy correction that brings some much needed competitiveness back to the region’s export industries.
That analysis, however, is appropriately limited to the region’s key investment markets, namely Mexico, Brazil, Colombia, Chile and Peru, which capture most of the region’s inbound FDI. The difference between correction and devaluation is that, historically, Latin America experienced devaluations under conditions of high foreign debt and poor financial management that led to spiraling inflation and further devaluation. This time around, the big five markets mentioned above all share well-trained ministries of finance, record levels of foreign reserves, conservative levels of foreign debt, and a rapidly maturing political class that understands the need for fiscal prudence. The investment grade standing of the sovereign debt of these five countries is being put to the test and, thus far, is winning.
CORPORATES: ACHILLES HEEL
Where this financial crisis has revealed real weakness in Latin America is in the irrational exuberance of its rapidly growing and highly indebted corporate sector. While the big five investment market finance ministries were busy paying down debt since 2003, the corporate sector piled on record debt levels at unprecedentedly low rates, available in large measure due to the prudent behavior of their home market’s central banks. In Brazil, private sector debt grew at an astonishing 34 percent per year on average during the boom years.
Latin American corporate indulgence in debt will prove costly in 2009 when loans come due and need to be renegotiated at elevated rates. Many of those highly leveraged firms include the region’s largest exporters, who faced ever shrinking margins from 2007 through the second quarter of 2008 as their currencies appreciated rapidly against the dollar and even against a strong euro. As currency losses crept upwards, several dozen large exporters took on hedging contracts, betting against the dollar. When the region’s currencies declined, these exporters began realizing massive derivative (hedging) losses, which continue to be counted as their contracts mature. An estimated $50-60 billion of accumulated derivative losses will hit the balance sheets of Latin America’s largest companies between September, 2008 and June, 2009.
The combination of hedging losses, increased debt, and lower commodity prices will prove overwhelming for some of Latin America’s burgeoning corporates. Fortunate for these firms, their central banks are in a better position to help them than ever before. Brazil’s Henrique Mereilles is leading the way in feeding excess foreign reserves into the domestic market in order to deliver much needed liquidity and enable banks to extend credit to these troubled firms. Some of Latin America’s largest firms will not survive the fallout of the derivative and debt crisis, though many more will thanks to well-funded central banks. The ensuing struggle will reshape the competitive corporate landscape in Latin America.
The less fiscally prudent economies in the region will not bode so well in a global financial crisis. While their currencies have barely shifted as the investment grade currencies slide, any resulting sense of confidence is false. Beneath the facade of a managed currency in Venezuela or Argentina, or the dollarization of Ecuador, lies a fiscal crisis waiting to happen.
Venezuela’s creeping nationalism, gas subsidies, domestic spending largesse, oil diplomacy, and incalculable corruption have added huge costs to the government’s bill. Chavez, in his eight years in office, presided over the greatest government fiscal expansion that Latin America has ever witnessed. At the time of writing this article, Brent crude stood at $54 per barrel, 63 percent off of its peak price less than six months ago. With most pricing analysts
anticipating further drops before any recovery is registered, Venezuela’s leadership will have to begin curbing spending and is likely to be forced to devaluate the Bolivar, which now stands out as grossly overvalued in a region that where currencies have dropped on average by 25 percent since August, 2008. The Venezuelan market, which has been so profitable to foreign suppliers in recent years, will likely suffer a large and sudden contraction sometime over the next 3-12 months as spending slows, the currency devalues, and greater restrictions are placed on the issuance of dollars to Venezuelans, thereby inhibiting import flow.
Predictions of political calamity for President Chavez, however, may be premature. Venezuela still boasts massive reserves that provide a cushion against the hardship ahead and will stave off any political ruin for at least a few years, by which time oil prices may recover.
Less hopeful, however, is the fiscal situation in Ecuador, a country that carries proportionately more foreign debt than Venezuela and has far fewer reserves from which to draw. As a dollarized economy, devaluation is not an option. Its non-oil exports just became very uncompetitive vis-à-vis other producers whose currencies have slid by 20-40 percent. Already, President Correa is sending signals indicating a possible delay or even cancellation of foreign debt payments. Any move in that direction will dramatically raise the cost of capital to Ecuadorian firms, thereby halting investment. In 2009, Ecuador may inch along if cooler heads prevail in the finance ministry, but most analysts are betting otherwise.
Perhaps the single greatest risk market at present is Argentina. What sets Argentina apart from other markets in Latin America is that its tenuous condition is mostly of its own doing, as opposed to contagion imported by an American-made financial crisis. With a much depleted capital market and a purposely undervalued currency, Argentina suffered minimal capital flight as a direct result of the financial crisis. However, the government’s dogged mission to stimulate growth, at the expense of high inflation (and its own credibility when it lied about inflation levels) has created a home-grown fiscal crisis. The latest and most desperate revenue grab by government is legislation designed to nationalize the pension system, putting at risk the savings of an entire nation. In the month of October alone, bank deposits were drawn down by 8 percent in nominal terms. Unless confidence returns, Argentines will continue to withdraw their savings from Argentine banks and deposit them in Uruguayan banks and other offshore options. Such a trend would force the Argentine government to impose another corralito-style freeze on bank accounts.
If the increased country risk evolving in Venezuela, Ecuador and Argentina has a silver lining, it is that the world will finally realize that there are (at least) two Latin Americas; a modern, and competently governed Latin America exemplified by the five investment grade economies, and the outdated, populist-governed nations whose irresponsibility will now pay an enormous price. While the United States and much of Europe embrace a move to the left, Latin Americans are reminded today that populism and fiscally enlarged government is no panacea, and that greater government transparency is the way forward.
EXPORTING TO LATAM
From 2006 to 2008, foreign suppliers began to gain market share in many product categories in Latin America as local currencies appreciated and both household and business consumers sought greater variety and quality from imported brands. With a 30 percent downward currency shift, some of those export business models will no longer remain viable and foreign suppliers may lose market share to domestic competitors. Examples include the automotive parts market in Mexico and the industrial machinery market in Brazil. SME (Small and Medium Enterprise) exporters who became reliant upon Latin American markets may find themselves priced out of the market unless they offer a product that is not easily substituted by local suppliers. More aggressive pricing and longer credit terms can help exporter market share, but both tactics carry costs and risks.
Before capitulating on product pricing across the board, exporters should assess the market and competitive pricing to determine which products should be pulled from the market, which should be more inexpensively priced, and what unique products can withstand the price increase (in local currency terms). Companies poised for a market entry may need to re-size the viable market, considering that their imported product will be more expensive and consumers will have less access to credit going forward.
SERVICE INDUSTRY MODEL
An increasing share of Latin America’s foreign direct investment in recent years has been spearheaded by service firms. Over $100 billion has been invested by the banking industry alone over the last fifteen years. Retailing, construction, logistics, and IT services are all industries that modernized and consolidated thanks to the massive investments made by global and regional corporate giants. Now, some of those investments will suffer going forward. Service industries collect revenue in local currencies but rely on a great deal of dollarized inputs and debt financing for their cost structure. Consider global retailers operating in Latin America who built international sourcing contracts with suppliers. They will now need to find local suppliers to keep pricing grounded. A trucking company in Chile that collects in pesos maintains a truck fleet that uses imported parts priced in euros, yen or dollars. The construction industry is equally vulnerable to currency shift but even more threatened by a downturn in demand as tax poor governments cancel infrastructure projects and the Latin American real-estate bubble begins to deflate.
Service firms will need to reassess the market viability of their business model by measuring market demand and pricing, and then retooling their asset structure to meet that demand by selling off under-utilized assets quickly in what tends to be a high fixed cost structure industry.
Larger companies who have the ability to shift production around the globe will look again to sourcing in Latin America. Likewise, Latin American companies who were considering shutting down local manufacturing and moving production to Asia may reconsider. Mexico’s currency movement provides it with a 30 percent price cut vis-à-vis Chinese competitors which, when combined with its proximity, provides a compelling opportunity to manufacturers.
Adjusted currency levels are not the only source of savings for companies looking to build or base their business in the region. Real estate prices, which appreciated aggressively in recent years, are expected to slide as liquidity suffers and central banks raise interest rates as a policy response to capital flight.
Going forward, many product categories face a new deflationary reality. If companies cannot cut their pricing, they risk losing share as price, once again, becomes king. Companies will scour their cost structure looking for ways to save. If this global recession is as long-lived as many analysts predict, then the short term cost of relocation will prove a worthwhile sacrifice when longer term variable cost savings can be realized by the move.
Companies should consider a location study to determine the most cost effective location and business model structure in the medium term (3-5 years), while product pricing remains the dominant customer driver.
The sudden currency shift will leave many importers in weakened positions. Six years of boom led to complacency by foreign suppliers, who allowed their Latin American importers to take on longer credit terms of up to 180 days or more after shipment. Given that most companies import on financing, it means that they were highly leveraged. For example, a company that imports $10 million per year of product can do so with as little as $500,000 in working capital by borrowing additional capital from a bank to qualify for 6-month credit terms from suppliers. When the local currency drops 35%, the importer finds himself paying more to the supplier (in dollars) for goods he already sold at a lower price in local currency, even with a 10-20 percent markup. A 35 percent currency downturn can wipe out an importer’s working capital and spook his bank into recalling his line of credit, rendering that importer insolvent.
Manufacturers face some difficult decisions with their distributor relationships. It is not in the distributor’s best interest to truthfully reveal any financial vulnerability because his suppliers are also his primary bankers. Therefore, it is vital to conduct financial due diligence of one’s importers in a discrete fashion. Armed with more information, they can then decide whether to shorten or lengthen the credit line to their distributors or even end the relationship. If the relationship is ended acrimoniously, one must assume that the distributor will migrate to a competitor product, thereby jeopardizing the manufacturer’s market position. Such a situation calls for delicate negotiations, but ahead of these comes the quest for information in the form of financial and reputational due diligence on one’s distribution partners.
Larger exporters who sold directly to retailers and corporate clients face a similar risk – financially unhealthy customers. The sudden demise of Commercial Mexicana, caught off-guard by an imbalanced hedging position, taught foreign suppliers how costly an insolvent customer can be to their business. Most large, importing customers in Latin America today can demand credit terms from their international suppliers of up to 180 days. Many of these same firms have taken on record debt levels and will face financial hardship and shrinking cash on hand as they enter 2009. That leaves even less to repay foreign suppliers, lengthening the accounts receivables timeframe of challenged foreign suppliers.
Foreign suppliers that sell directly to large clients in Latin America should conduct financial due diligence on said customers to determine which may be at risk of late payments or even non-payment. If insolvency is imminent, it is vital to be at the front of the creditor line to collect even a fraction of the monies owed. Such preventative actions require a thorough investigation of the customer, followed possibly by legal action and a search for assets that can be seized in a worst-case scenario.
For all of us, the market has turned and many of the assumptions that business grew accustomed to making in Latin America have dramatically changed. This is a time to alter course, to measure risk, and to mitigate against it. It is equally a period in the business cycle when opportunities abound, triggered by weakened and retreating competitors who leave markets and assets up for grabs to those with healthy balance sheets and a dose of courage. Smart and decisive decision making, a product of thorough business intelligence and managerial experience, becomes the crucial factor for companies looking to turn crisis into opportunity.
John Price is a Managing Director for Kroll Latin America based in Miami. This article is republished with permission from Tendencias, the magazine of Kroll InfoAmericas.