'A Strong Dependence': The Potential Downside to China's Investments in Latin America

'A Strong Dependence': The Potential Downside to China's Investments in Latin America

Despite the global financial crisis, the economies of Latin America have remained strong in recent years. Moreover, analysts predict that their growth rates will continue to be solid. The International Monetary Fund (IMF) estimates that the region’s Gross Domestic Product (GDP) will increase by 4.5% in 2011 and by 4% in 2012, after having expanded by 6.1% in 2010.

The region has benefitted especially from the high demand for raw materials from developing economies -- the best example of which may be China. In recent years, strong demand for commodities in China has transformed that country into an important engine of economic growth for Latin America. This situation has been a godsend for some countries in Latin America, which have suffered because of the unfavorable international economic environment, a decline in the price of basic products and restricted access to loans and liquidity.

For example, China has become the principal trading partner of Brazil and Chile, and it is now the second-largest trading partner of Peru and Argentina, according to the Inter-American Bank of Development. The figures are truly spectacular: Chinese imports of Latin American products rose by 1,153% between 2000 and 2010, while its exports to the region rose by 1,800% during the same period.

According to the Economic Commission for Latin America and the Caribbean (ECLAC), during the past 10 years China has gone from capturing 1% of the region’s exports to capturing 7% of them. ECLAC estimates that if demand for Latin American products from the United States, the European Union and the rest of the world continues to grow at the current pace, while demand from China grows at only half the current rate, China will surpass the European Union in 2014 to become the second largest market for the Latin America’s exports.

Last September, a World Bank report titled, "Long-Term Growth in Latin American and the Caribbean: Made in China?" noted that the robust growth of the region over the past decade is a direct reflection of its connection with China. Nevertheless, the report questions if this relationship with China, which is highly dependent on the abundant natural resources of South America, can be capitalized on in a way that enables the region to eventually achieve the same living standards as developed countries.

Benefits and Damages

“Right now, Latin America is benefitting from the strong growth rate of China, which buys a great amount of the raw materials that it needs from the region,” notes Jaume GinéDavi, professor of law at the ESADE business school, and a specialist on business in Asia. “Over the short term, this is a good thing, but over the long term, not so much so, because this situation is creating a strong dependence on China in South American countries.”

At the moment, "you can say that these are complementary economies, because one of them [Latin America] produces the primary products that the other [China] needs. But their trade relationship is asymmetrical,” Davi warns. “China buys raw materials and land in order to supply itself, but over the long term it floods the markets of Latin America with its cheap manufactured products, with which the region’s industry cannot compete, so Latin America winds up being damaged a great deal.” Davi believes that this could lead to problems over the long term if China slows down and reduces its demand for raw materials. In such a case, “The Latin countries would suffer.”

According to Mauro Guillén, director of the Lauder Institute at Wharton, “When it comes to China, there are two Latin Americas.” He notes that “Mexico and Central America are damaged in their trading relationship [with China]because they export products that compete against the Chinese.” On the other hand, “South America benefits from its exports of natural resources [to China].” Moreover, Guillén predicts that “China is going to be [South America's] main trading partner quite soon.” In any case, he adds that it is “an unequal relationship, like all relationships that Latin America has had historically.”

According to the World Bank, there is no concrete evidence that the trade relationship between China and Latin America has spread any technology into the region, or had a spillover effect on knowledge. Nor is there evidence that the influx of foreign direct investment from China brings along knowledge with it. “The crux of the matter is that the existing commercial ties with China by themselves (which are not accompanied by, nor bring along with them any training of human capital, investments in innovation, adoption, adaptation of technologies or cumulative learning) probably are not generating any sustained growth in productivity," the World Bank warns in its report. "Even more so, the expansion in [Latin American] revenues through growing exports reflects only the high prices of raw materials.”

Direct Investment Tumbles

Hong Lei, spokesman for China’s foreign ministry, recently defended his country's positioning in Latin America, while rejecting the criticisms of the World Bank. “Non-financial direct investment by China in 2010 was US$11 billion, in areas that range from energy and mining to manufacturing, infrastructure and agriculture, among others,” he said during a press conference in China. According to Chinese officials, China's investments have strengthened the economies of Latin America and its social development.

However, according to the World Bank, direct Chinese investment in the region between 2003 and 2009 amounted to only US$4 billion a year. ECLAC considers that quantity “modest” compared with the investment made into the region by the U.S. and the Netherlands in 2010, which amounted, respectively, to US$19 billion and US$14.7 billion.

Rafael Pampillón, professor of economics at the IE Business School, in Madrid, believes that "[foreign] direct investment is always a good thing, wherever it comes from,” because whatever region it goes to, the investment “generates production.” It also helps to increase trade, and “trade relations are always beneficial because they improve the economic situation” of the parties involved. “Exporting primary products means getting money -- that is to say, getting financing so you can import what [your country doesn't] produce," he says.

Excessive Dependence on Exports

On October 5, the IMF published a report titled, “The Americas: Changing Winds and New Policy Challenges.” The report clarified one of the biggest challenges facing the region in coming years, which stems from its dependence on selling raw materials in general, and to China in particular. The report emphasized the region’s strong dependence on exports, stressing that in some nations, exports amount to 10% of GDP. The IMF went on to warn that although this region has been only minimally affected by the global recession so far, China’s reduced expectations for growth in the future, along with the continuation of the crisis in the world’s richest economies, could mean that Latin America's growth could come to an end more quickly than was previously anticipated.

Pampillón believes that the economies of Latin America must take advantage of these favorable winds from China, but that they need to be careful not to experience what has been called “the curse of raw materials” or the “Dutch disease.” That is to say, they need to prevent the strong influx of foreign currency into their countries from leading to a very strong upward revaluation of their local currencies, which would endanger the competitiveness of the rest of the goods and services that they sell abroad.

Given this situation, Davi suggests that the countries of South America must diversify their exports, both with respect to their product offerings and the countries that they sell them to, in order to mitigate the possible impact of any future slowdown of the Chinese economy, and any subsequent decline in demand for raw materials. “Right now, I believe that the countries [of Latin America] are not following this path, and are comfortable with the current situation," he notes. "They are boasting about their high growth rates compared with the United States and Europe. Public officials are especially distracted by short-term economic factors, because the easier road to growth now is to sell unprocessed raw materials.”

Davi believes that Latin American countries have to maintain their industrial sectors as much as possible, so that they are prepared for any possible arrival of foreign companies who want to gain a presence in the region. “If, over the long term, China's production levels slow down and the country's growth rate drops, the Chinese will pay more attention to their domestic market [than to foreign markets]," he predicts. "In such a case, foreign companies will earn less from their Chinese plants, Chinese labor costs will increase, and companies that have been focusing on China in order to produce more cheaply [there than at home] may turn to such countries as those in Latin America.”

Along the same lines, Pampillón notes that it is critical for the countries of Latin America to try to grow in areas outside of raw materials. “Over the long term, they must organize their economies in order to be able to strengthen themselves in vital areas such as training human capital, innovation, and improving technology and its adoption -- all with the goal of being able to create an industrial network capable of producing a lot of products in the most efficient ways possible. When all is said and done, the richest countries are the most industrialized ones.”

Pampillón adds that South American governments need to face up to an important challenge in the coming years. “They need to figure out how to create and facilitate [growth] for the economy, and they must give added value to their [countries'] products by improving the quality of their human capital, their infrastructure and their capacity for innovation. And they must do all of that without intervening too much [in the economy], which would be counterproductive.”

Is that the road that politicians are following now? “I don’t know if they are really going in that direction," he says, "but it is very clear that they are well aware that this is the direction that they must move in. But it is too comfortable for them to live with [their dependence on] primary products, and it is not easy to tear yourself away from that.”