Many of the economies in South America are on a roll, with strong economic growth and improving credit ratings. Problem is, some of them may be hitting the capacity wall.
At the heart of the story is a company operating at capacity and selling everything it produces. The economy is growing, because of rising domestic and foreign demand, and the company finds it difficult to satisfy its customers. It runs the risk of losing them, if it does not expand capacity.
Such a decision is difficult enough to take at any time, but the company must also count on the government to expand the economy's infrastructure capacity — ports, roads, rail, energy systems and so on. When there is enough uncertainty in the air, companies and governments alike may under-invest, and the country's growth process can be severely constrained.
Consider Argentina, for instance. Since the post-crisis recovery began, there have been 14 consecutive quarters of growth, and industrial production is up by more than 50%. But the economy is showing signs of strain — inflation has doubled in the past year, to over 12%, and energy shortages are a persistent concern. The government's response has been to try to negotiate price agreements, rather than to use interest rates to slow the economy.
Brazil has some similar capacity problems. Growth slowed briefly in the second half of 2005, but all signs point to a solid 2006, with growth likely to exceed 3%. Capacity utilisation is well over 80% overall, and above 90% in some sectors, which is unsustainable. Clogged roads, rail systems and ports are forcing exporters to use less efficient routes and carry high inventories. The central bank has been resisting inflationary pressures in textbook fashion — raising interest rates to moderate growth — and inflation has begun to ease as a result.
Contrast those cases with Chile, where growth has been strong (5-6%) but inflation has risen only slightly, and that due mainly to energy costs. A key difference is that Chile offers an environment in which companies can confidently invest for the future, so capacity keeps pace with demand.
The good news is that Brazil's macroeconomic situation has improved dramatically, as underscored by increasing interest of foreign investors, who have driven interest rate spreads down and the currency up. Companies are using the strong currency to boost imports of new machinery, up by over 30% in the past year. At the same time, the government has put in place a public-private-partnership law to encourage the development of critical infrastructure projects. Foreign investors are less impressed with Argentina, but even there investment is finally starting to happen — private investment spending rose by more than 20% during 2005, and construction spending is up by more than 20% as the government works to improve roads and infrastructure.
The bottom line? Most economies take for granted that at some point an economic expansion will shift gears and investment in new capacity will take the lead. Economic and financial uncertainty can lead to under-investment — but reducing uncertainty can pay dividends long into the future.
March 16, 2006