Feeling the heat in Latin America

The recent 2008 financial crisis casts a big shadow over the other lessons learned from financial meltdowns, which could be just as important for investors. Like the debt crisis in the 1980s in Latin America.

I’m fortunate to work with relationship building within asset management. Therefore, I have learned that we discuss the investment performance during the recent financial crisis at one-on-one client meetings all the time. How did the portfolio management team react? What was learned in the investment process? What happened to the tracking error in the portfolio? Did you have large outflows? What happened to the organization?

These are stable questions for the equity portfolio managers. And similar for the credit managers: How did you handle liquidity? What happened to your default rates? What did you learn for future reference? How many investors did you lose? When did you change back to risk on mode in 2009 or 2010? Stuff like that.

It was the mother of all financial crisis, and it is still remembered from own experience by any senior decision-maker aged from 35 years and older. It makes sense to bring it up ever so often.

Yet it seems to me, it now cast a big shadow over the lessons learned from other financial meltdowns. Strangely, a singular focus on the experience from financial crisis could lower investors risk aversion. The reasons for this meltdown-which was followed by a sovereign debt crisis in Southern Europe-are well understood, and there are significant risk metrics to observe now, but also other events to forget.

To name one other big financial crisis, Latin America went through a lost decade in the 1980s, when growth disappeared and the governments in most countries were in default. They could no longer handle their heavy burden of US-denominated sovereign debt generously provided by US Banks in the in the 1960s and 1970s. Growth-rates had been high, but troubles lay ahead.

Loans had financed industrialization and infrastructure investment. It became more difficult after the oil-price soared in 1973, but oil-rich countries were then happy to lend to sovereigns in Latin America through private US Banks. So the loan binge went too far-which is easy to conclude sitting in a comfortable 2020 Danish chair-but these countries where unable to cope with the second oil crisis in 1979, falling prices of their commodity export and the US interest rate chock when US Fed Governor Paul Volcker started a serious fight with inflation in 1979. Add to it their falling exchange rates, and the debt burden in local currency became impossible to handle. The list of calamities is much longer than this; several articles on Wikipedia wrap it up nicely.

As always, in hindsight, it looked obvious this would go wrong, not least because of weak institutions and, well, never mind the macroeconomics, the societies in Latin America just didn’t work very well in the region.

I make no claim to be an expert on these matters, but to escape the University of Copenhagen with a Master Degree in 1994, I tried to connect a huge body of 1980s academic sovereign debt theory with the new subject of transitioning the central planned in Eastern Europe in the 1990s (when sovereign debt relief was also the agenda).

On both occasions, the IMF and the World Bank had to struggle for years with these serious challenges, and part of the effort was producing the relevant economic knowledge with academic research. Not only by top economists, also huge volumes written by staff members, which developed new insights.

It was conventional wisdom in the 1980s that a sovereign state would go at extreme length not to default, because it would cut it off from future lending in the international capital markets and leave them in bad standing for many decades. The punishment would be awful. Yet leading American economist started to challenge this assumption with game theory and other modern tools, arguing this could be for a period of only 8-10 years, leaving it a rational choice to walk away from sovereign debt. But would debt relief for some countries twist the incentives towards nonpayment for all of them and weaken the case for financial austerity and economic reforms? And so on. Academics had a field day. Meanwhile, poverty rates skyrocket in the region, and the populations went through immense hardships.

Another subject gaining new attention was the interconnections between macroeconomics and the society. Would the prescriptions from technocratic economic doctors work better in some societies than others? How could they explain to the population that poverty was inevitable, but foreign creditors had to receive payments?

Based on all this, I would be somewhat concerned as an investor about Latin America sovereign debt, which makes up a large part of the emerging market debt universe. Things are not looking too good at the moment. Weak links from politics to finance are hard to detect armed with modern portfolio theory. According to The Economist, Brazil is improving somewhat, but from a very low base. Argentina is a basket case, Venezuela a complete tragedy, Peru, Columbia and Ecuador shoulders a huge burden of refugees from Venezuela. The usual bright spot, Chile, is home to social riots bordering a civil war. These countries also suffer from twin deficits; they are in red with both their public finances and trade balances, which is difficult to deal with for policy makers when growth rates are modest. 

Going back to lessons learned from different financial crises, the events in Latin America from the 1980s could be just as relevant as the big financial crisis when testing emerging markets debt. I’m sure there are many other scenarios in the markets, where knowledge about a forgotten financial crisis would also be a useful point of reference for investors.