Latin American Outlook

Latin America will recover in 2010, but its expansion will likely be below its potential. Given aggressive foreign and domestic policy responses in Latin American countries, the region is stabilizing in the second half of 2009 after having contracted severely in the first half of the year. Although global and regional economic and financial conditions will likely improve in 2010, I expect the pace of external and local demand revival to be measured. Commodity prices will stay on hold in the middle ground between record highs and recent lows, mainly because of below-potential recovery in the U.S. and advanced economies, as well as in China. Though global liquidity will remain elevated in the upcoming quarters, favoring Latin American asset classes, market anxiety about the timing of exit strategies around the world represents a significant risk. Miscalculations in exit strategies and disappointing economic results pose the main risks to Latin American market dynamics in 2010.

Regional Grow Outlook

Benefiting from massive global fiscal and monetary policy stimulus programs, Latin America is stabilizing, while domestic countercyclical efforts have soothed local confidence and eased downside pressures on labor markets. Furthermore, strong fundamentals contained the free fall in internal demand, while global inventory restocking, which had tapered off, picked up again in the third quarter of 2009.

However, recovery of external and domestic demand will likely be limited, keeping Latin America’s recovery below potential in 2010. Against this backdrop, my analysts and I have revised up Latin America’s regional GDP forecast to a year over year contraction of 2.6% from 3% in 2009, and we now project growth of 3.3% year over year in 2010, up from our prior projection of 3.0%. The main driver of our shifting forecast is an improved economic outlook in Brazil. But it should also be noted that Latin America’s growth outlook in 2010 remains well below the 2003 to 2008 trend of around 4.5% year over year on average.

Price Pressures

Inflationary pressures will likely be contained in 2010, and the disinflationary trend should continue through the rest of 2009 owing to slow closing of the output gap, stable if not strong currencies, temperate commodity prices and measured domestic demand. Central banks will most likely achieve their inflation targets but will start moving away from an accommodating monetary stance toward a neutral one in 2010 in order to temper medium-term inflation expectations once the recovery has gained momentum. The central banks that acted first and most aggressively in the cycle of monetary accommodation, such as Chile, will lead the way, while the ones that lagged in responding, such as Mexico, will have to wait longer for a more sustained recovery.

External Accounts and Budgets

The current account deficits of Latin American countries will likely widen in 2010 after having shrunk in 2009, but strong capital flows should cover the gap. While imports have fallen at a faster pace than exports so far this year, I anticipate a reverse of these dynamics in 2010, mainly because I expect domestic demand to rebound at a stronger rate than external demand, putting widening pressures on current accounts.

Meanwhile, significantly improved global financial conditions and risk appetite, elevated global liquidity and Latin America’s relatively palatable rebound will mean that capital flows to the region will likely improve, thus keeping balance-of-payments risks contained. Risks associated with worse-than-anticipated global and regional growth, higher global benchmark yields and a failure to implement reforms could potentially cap capital inflows.

Balancing fiscal accounts will remain a major challenge for Latin American countries in 2010, much as it was in 2009. Since I anticipate a gradual global and regional upturn, fiscal revenues will recover slowly, but the political cycle, rising social pressures and structural fiscal rigidities will place constraints on the opportunity to enact meaningful spending cuts.

My analysts and I maintain the view that Latin American currencies will be supported by a weak U.S. dollar and solid commodity prices, as well as higher potential growth and wider interest rate differentials. However, verbal interventions or administrative measures by the central banks to contain financial flows, together with risks associated with disappointing economic numbers (globally and locally), and policy actions to restore the stock of international reserves, could emerge as a counterbalance. Moreover, as advanced economies approach their exit strategies, upward pressures on Latin American currencies should subside.

Regional Politics

The political cycle in several Latin American countries starts at the end of 2009. In Chile, most polls suggest that the right-wing opposition candidate, Sebastián Pineda, leads the race in the country’s December 2009 presidential election. Pineda is followed by the candidate for the ruling Concertación party, former president Eduardo Frei, and independent candidate Marco Enríquez-Ominami is not far behind. Regardless of who wins, market-friendly policies and sound macroeconomic management will likely continue, and the institutional framework will be reinforced.

In Colombia, presidential elections will be held in May 2010. Although it is not clear yet whether the current president, Alvaro Uribe, will run for a third term, the country’s next president will likely maintain Colombia’s current domestic-security policy and market-oriented policies. In Brazil, although presidential elections are still a year away, polls indicate interesting dynamics: the latest Datafolha poll from September 2009 shows that São Paulo State Governor José Serra, from the Social Democratic Party (PSDB), leads the race with 37% support, followed by President Lula’s chief of staff Dilma Rousseff, from the Workers Party (PT), with 16%.

Overall, I believe that regardless of who takes power, Brazil’s current achievements in economic policy are most likely to be maintained. Market watchers should keep a close eye on fiscal dynamics and the likelihood of the incoming government taking action to consolidate the fiscal accounts.

Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes. (Read all of his columns here.) Bertrand Delgado, senior analyst at Roubini Global Economics, assisted in the writing of this column.