The Pacific Alliance: Showing the Way Forward

Transcription

1 The Pacific Alliance: Showing the Way Forward February 9, 1 The Pacific Alliance, composed of Chile, Colombia, Mexico and Peru, is a vibrant axis of growth that demonstrates the benefits of economic integration The Alliance s overriding integration principle is free trade, both within the block and with the rest of the world Integration is being driven by converging pro-market policies and strong free-trade commitment Alliance countries have become a magnet for global and regional investors By supporting exports, floating exchange regimes will ease the adjustment to a more challenging external backdrop Well-prepared for rougher global conditions, the Alliance's contribution to regional growth is set to increase Ramón Aracena CHIEF ECONOMIST Latin America Department raracena@iif.com Todd Martinez ASSOCIATE ECONOMIST Latin America Department tmartinez@iif.com GOOD VIBRATIONS The Pacific Alliance initiative, composed of Chile, Colombia, Mexico and Peru, has taken a pivotal role for Latin America s integration and growth (Charts 1 and ). Integration is being driven by pragmatism and policy convergence. Alliance nations have all established well-balanced policy frameworks, are making efforts to implement productivity-enhancing structural reforms, and have a high degree of external trade openness, including free trade agreements (FTAs) with the U.S. This exposure to market forces bolsters competitiveness and efficient integration. Well-entrenched commitment to free trade and policy discipline allowed Alliance countries to weather the 8 global crisis largely unscathed and will facilitate the adjustment to tighter global financial conditions and softer commodity prices. Commitment to pro-market policies through thick and thin has firmly anchored business confidence in the medium-term viability of the Pacific Alliance, underpinning investment and trend economic growth. Integration is being driven by pragmatism and policy convergence Chart 1 Gross Domestic Product (13) $ trillion (at PPP) % 35% Share of Region % Chart Latin America: Contributions to Regional GDP Growth percentage points Arg, Ecu, Ven 3. Brazil Pacific Alliance Pacific Alliance Brazil Arg, Ecu, Ven Source: IMF World Economic Outlook (WEO) e 1f 15f Source: IIF; e=estimate; f= forecast. iif.com Copyright 1. The Institute of International Finance, Inc. All rights reserved.

2 page WHAT MAKES THE PACIFIC ALLIANCE DIFFERENT? The Pacific Alliance is a bottom-up regional integration initiative based on policy, language and cultural affinities. Laid out in its founding Lima-Peru Declaration in 11 and Framework Agreement signed in Paranal, Chile in 1, the Alliance s ultimate objective is the free movement of goods, services, capital, and persons (business, education, tourism). It can therefore be categorized as a free-trade area enhanced by financial integration and free non-labor movement of citizens across borders. The Alliance s overriding principle is free trade, both within the block and with the rest of the world, so as to reap economies of scale, ensure efficient resource allocation and boost competitiveness. Openness to the rest of the world is the Alliance s key difference with MERCOSUR (Argentina, Brazil, Paraguay, Uruguay and Venezuela), whose paramount objective is to create a broader market for its members but shield it from outside competition through common trade barriers. The Pacific Alliance s main integration drivers are: The Alliance s ultimate objective is the free movement of goods, services, capital, and persons Converging pro-market policy frameworks: Alliance countries have in place credible and effective inflation-targeting regimes complemented by prudent fiscal policies. All countries have or are in the process of adopting cyclically-adjusted fiscal targets. Reliance on floating exchange regimes, particularly in Chile and Mexico, provides an effective shock absorber to mitigate the impact of terms-of-trade swings and shifts in external financing conditions related to the U.S. Federal Reserve s exit from quantitative easing (QE). Strong free-trade commitment: External trade openness is substantial in the Alliance economies, which helps to develop vibrant, competitive private sectors (regional corporations) and lowers output growth volatility by diversifying export markets and reducing domestic demand dependency. Alliance members all have FTAs with the U.S. and with each other. Ratios of exports to GDP are the highest in the region, and a large portion of external trade is channeled through FTAs (Charts 3 and ). Chart 3 Trade Openness exports + imports / GDP (8-1 avg.) Chart Free Trade Partners number percent of world exports Free Trade Partners (lhs) FTA Partners' Share in World Exports (rhs) MERCOSUR Pacific Alliance Brazil Arg+Ven Source: IIF. Chi Per Mex Col Uru Brz Arg Ven* Source: IIF and OAS; *Upon full accession into Mercosur. iif.com Copyright 1. The Institute of International Finance, Inc. All rights reserved.

3 page 3 Policy consistency: The strong commitment of Alliance members to pro-market policies regardless of prevailing global conditions has become a major intangible asset. By bolstering policy credibility and underpinning confidence among foreign and domestic investors, policy consistency should ease the transition to a more challenging backdrop of rising external borrowing costs, lower growth in China, and softer commodity prices. INTEGRATION INROADS The Pacific Alliance initiative is strengthening the productive bases of its member countries in several ways: 1) boosting FDI inflows as investors seek to gain access to an expanded regional market and/or to the U.S. via bilateral FTAs; ) boosting intra-block trade and its contribution to growth; and 3) setting up the foundations for increased financial integration. Pro-market policy discipline and external trade openness have made the Pacific Alliance nations major targets for global and regional investors. The Alliance s ratio of inward direct equity investment to GDP was 3.% in 13, compared to 1.9% in Brazil and.9% in Argentina and Venezuela (Chart 5). Albeit from a low base, intra-alliance direct investment (FDI) has gained prominence as corporates have sought to secure larger market bases via mergers and acquisitions (Table 1). Intra-Alliance FDI flows have represented a rising share of total FDI inflows into the block, growing to around $5 billion in 8-1 from $ billion in 3-7 (Chart, next page). We expect this trend to continue as integration deepens. Pro-market policy discipline and external trade openness have made the Pacific Alliance nations major targets for global and regional investors Intra-regional FDI has been led by Chile, a major capital exporter (Chart 7, next page). Its strong banks and retail corporations invested about $1 billion from 8 to 1 in the Alliance block, far more than in MERCOSUR (5% versus 35% of the total, respectively). Increased intra-alliance investment has also played a stabilizing role, as well-capitalized Chart 5 Direct Equity Investment Inflows percent of GDP 3 1 Brazil Pacific Alliance Argentina, Venezuela e Source: IIF; e=estimate. Table 1 Major Intra-Pacific Alliance M&A Deals (5-13) Aug 5 Sep 1 Dec 11 Jun 1 Dec 1 Dec 1 Mar 13 Aug 13 Target Acquirer Type Value Smartcom (Chile), TIM Peru América Móvil (Mexico) Telecom 1. Farmacias Ahumada (Chile) Grupo Casa Saba (Mexico) Consumer. ING Pension assets (Mex, Col, Chi, Per) Grupo Sura (Colombia) Financial 3. Banco Santander Colombia* Corpbanca (Chile) Financial 1. Carrefour Colombia* Cencosud (Chile) Retail. Lafrancol (Colombia) CFR (Chile) Pharm..5 Emgesa, Condesa (Colombia) Enersis (Chile) Energy.9 Tresmontes Lucchetti (Chile) Grupo Nutresa (Colombia) Consumer.8 Source: Thomson Reuters; *Seller in 3rd country iif.com Copyright 1. The Institute of International Finance, Inc. All rights reserved.

4 page Chart Intra-Pacific Alliance FDI $ billion percent of total Chart 7 Intra-Pacific Alliance FDI $ billion Intra-Pacific Alliance FDI (lhs) Share of Total FDI Inflows (rhs) Source: IIF based on national sources by Investing Country Peru Mexico Colombia Chile Source: IIF based on national sources. 8 by Recipient Country local banks have stepped up to offset retrenchment by U.S. and European banks. For example, Chile s Corpbanca s became one of Colombia s largest banks after buying Santander s subsidiary in 1 and Helm Bank in 13. The Alliance's attractiveness has lifted the investment-to-gdp ratio, in sharp contrast with trends in Brazil, Argentina and Venezuela (Chart 8). We expect this investment gap to widen over the medium term, reflecting the Alliance s more predictable and credible polices, implementation of structural reforms (particularly by Mexico), and prospects of deepening intra-regional financing. Intra-Pacific Alliance trade remains low, but it is growing as a share of total exports (Chart 9). Thus far, integration is mostly taking place via the setting up of operations in Alliance member markets by regional corporations seeking to reap economies of scale. This is supporting noninflationary trend growth by boosting the competiveness and exports of the host country. The Alliance's attractiveness has lifted the investment-to- GDP ratio, in sharp contrast with trends in Brazil, Argentina and Venezuela Chart 8 Latin America: Fixed Investment percent of GDP, -quarter rolling Chart 9 Intra-Regional Trade percent of total exports Argentina, Venezuela Pacific Alliance 1 Brazil Source: IIF based on national sources. PA Mercosur LatAm Asia NAFTA Source: IMF, DOT Statistics. iif.com Copyright 1. The Institute of International Finance, Inc. All rights reserved.

5 page 5 Chart 1 Stock Market Size and Depth $ billion (13) 1, 1, 8 Capitalization 1, 1, Bovespa MILA Source: Word Federation of Exchanges. Trading Volume 87 Bovespa Peru Colombia Chile Mexico 37 MILA Chart 11 MILA Cumulative Equity Investment Flows $ million (May 11- Dec 13) Total ($3 mn): Colombia Outflows Inflows Chile 35. Source: MILA Peru NASCENT FINANCIAL INTEGRATION Though still nascent, financial integration within the Alliance is set to deepen in the medium term. A key institutional step in this direction is the Integrated Latin American Market (MILA), launched in May 11. MILA electronically integrates the stock exchanges of Chile, Colombia and Peru, allowing registered traders in each country to buy and sell equity shares in the others, while maintaining each country s regulatory autonomy. Mexico s stock exchange is set to join in 1. The combined capitalization of the four markets matches Brazil s stock market, Bovespa, but trading activity is likely to remain lower, at least in the short term (Chart 1). MILA s objective is to provide both issuers and investors greater liquidity...and diversification MILA s objective is to provide both issuers and investors greater liquidity (exposing each market to a larger pool of investors) and diversification (Chile s bourse is heavy in retail, Colombia s in energy and financials, Peru s in mining). Participation in Initial Public Offerings (IPOs) was authorized as of 1 and supervisors have announced plans to expand MILA to other equity-based instruments (e.g. ETFs), fixed-income and derivatives. After two-and-a-half years, cross-border MILA trading remains low and lopsided. Peru has been the primary capital exporter, with net outflows of $18 million, while Chile has attracted net inflows of $15 million and Colombia $3 million (Chart 11). Several obstacles are holding the MILA back: Unharmonized tax/regulatory regimes. Chile and Colombia do not tax capital gains, but Peru levies a tax of 5%. The three countries tax dividends at different rates (15%, 5% and.1%, respectively) and assess different fees and commissions on trades. Pension regulations. While some investment takes place indirectly via ETFs traded in developed markets and securities issued in tax havens, intra-block pension investment is constrained by regulation (e.g. Chile s funds are barred from investing directly in countries with lower credit ratings) (Chart 1). Though foreign investment limits have been lifted somewhat, but further regulatory convergence is required. Chart 1 Foreign Pension Assets percent of GDP Chi Per Col Mex Mature Markets Other EM Other LatAm Intra-PA Source: IIF estimates based on pension superintendencies. iif.com Copyright 1. The Institute of International Finance, Inc. All rights reserved.

6 page Chart 13 Public Sector Balances percent of GDP e 1f Chile* Colombia Mexico Peru Source: IIF; *Central government alone. Table Monetary Policy Stance as of Feb. 5, 1 Inflation Policy Rate Target 1 Exp. Actual Neutral* Brazil.5± Pacific Alliance Chile 3.± Colombia 3.± Mexico 3.± Peru.± Source: National Sources; *IIF estimates. Lack of hedging mechanisms. Because MILA trading has not yet been extended to derivatives, investors lack straightforward means of hedging foreign-exchange and other risks on cross-border investments. Impending regulatory changes will boost growth of intra-block portfolio investment, which remains low. Alliance countries plan to make each other eligible for pension investments (which Mexico did in 13) and move ahead on a key multilateral proposal to exempt each other s securities from regulatory caps on the foreign holdings of pension funds. WELL-PREPARED FOR GLOBAL REALIGNMENT We expect the Pacific Alliance to continue to outperform the rest of the region in the years ahead, reflecting well-balanced policy frameworks and significant export exposure to the strengthening U.S. economy. By bolstering market differentiation, these attributes should stem unwarranted contagion from potential difficulties elsewhere in the region. Alliance countries have relatively robust fiscal positions and policy interest rates around neutral, providing scope for countercyclical policy support if deemed necessary (Chart 13 and Table ). Stronger U.S. growth should help to mitigate slowing growth in Asia and softer commodity prices. Alliance exports to the U.S. market accounted for % of the total in 1 (78% in Mexico), compared to 11% of Brazil and 19% in Argentina and Venezuela. We expect the Pacific Alliance to continue to outperform the rest of the region in the years ahead, reflecting wellbalanced policy frameworks Floating exchange regimes provide scope to adjust flexibly to more challenging external conditions. While short-lived volatility cannot be ruled out, we expect an orderly depreciation of Alliance currencies against the dollar. Well-anchored inflation expectations, a consequence of credible inflation targeting regimes, will most likely limit the pass-through of depreciation to inflation, mitigating terms-of-trade losses and iif.com Copyright 1. The Institute of International Finance, Inc. All rights reserved.

7 page 7 Table 3 Outlook at Glance GDP-weighted figures 1 13e 1f 15f Pacific Alliance Real GDP Growth (percent y/y) Inflation (percent oya) Current Account Balance (% of GDP) International Reserve Coverage* (percent) Brazil Real GDP Growth (percent y/y) Inflation (percent oya) Current Account Balance (% of GDP) International Reserve Coverage* (percent) Argentina, Ecuador Real GDP Growth (percent y/y) and Venezuela Inflation (percent oya) Current Account Balance (% of GDP) International Reserve Coverage* (percent) Source: IIF; * = Intl. Reserves (ex. gold) / (Current Account Deficit + ST Ext. Debt + Ext. Debt Amortizations). supporting exports and real GDP growth (Table 3). The region s currencies have weakened somewhat since May 13, but the nominal exchange rate index for the Pacific block remains stronger than its long-term average (Charts 1 and 15). BRIGHT PROSPECTS AHEAD We believe that the Pacific Alliance is on track to become a full-fledged free-trade area as imports tariffs on 9% of merchandise goods are removed as of 1 (Chart 1, next page), the remaining 8% is phased out in the coming years and members gradually move forward on the elimination of non-tariff trade barriers and harmonization of customs procedures, including rules of origin and sanitary standards. Mexico s inclusion in MILA Chart 1 Nominal Exchange Rates index (3-13 average=1), (-) indicates LCU depreciation Brazil Pacific Alliance* Source: IIF; *Simple average. Chart 15 Nominal Exchange Rates index (May 1, 13=1), (-) indicates LCU depreciation Pacific Alliance* 8 Fed 'Taper' Brazil India, Indonesia, Talk Begins S. Africa, Turkey* 75 May 13 Aug 13 Nov 13 Feb 1 Source: Thomson Reuters; *Simple averages. iif.com Copyright 1. The Institute of International Finance, Inc. All rights reserved.

8 page 8 Chart 1 Pacific Alliance Timeline Chi-Per FTA Lima Declaration (establishes PA) Mex-Per FTA Launch of PA Business Council Costa Rica, Panama become PA candidates Tariff elimination (9% of items) Chi-Col FTA Source: IIF. Launch of MILA (Chi, Mex, Per) PA Framework Agreement signed (Paranal, Chile) Launch of PA Cooperation Fund Mexico to enter MILA (exp. mid-1) will boost intra-block financial flows. The Alliance s attractiveness as an effective and reliable partner for sustainable economic growth is likely to result in broader membership, with Costa Rica and Panama as the main candidates. With solid foundations, the Alliance is set to gain prominence within the region as a source of growth and political stability. Because of its higher average growth, we expect its contribution to Latin America s growth to increase over the medium term. In 13 it accounted for around half of the region s.3% growth. The Alliance s performance will provide a strong demonstration effect on the benefits of disciplined pro-market policies, helping to diminish the allure of populism. the Alliance is set to gain prominence within the region as a source of growth and political stability iif.com Copyright 1. The Institute of International Finance, Inc. All rights reserved.