The Pacific Alliance: a new Latin American superpower

Times are tough for the former richest man in Brazil. Flamboyant Eike Batista made a name for himself by creating a string of billion-dollar commodity and infrastructure companies. But in the last year he saw a stunning $25bn wiped off his net worth. So where did it all gone wrong?

At his peak, Batista was a stock market darling, feted by investors for his ability to build exciting companies from mundane projects. And in the last few years he launched some of the biggest IPOs in Brazilian history. Batista’s meteoric rise made him a symbol of the Brazilian boom as investors came to love the companies he founded. Spotting one of his creations is easy. They’re normally huge, based around massive infrastructure or commodity projects, and all bear Batista’s signature X in the name – energy firm MPX, oil firm OGX, shipping firm SBX – you get the picture. In total he created five publicly-listed companies in the past six years. Men like Batista made Brazil a Latin American superpower.

Unfortunately another shared trait of Batista’s firms is that – despite their vast potential – none of them make a profit. With targets being missed, investors are starting to lose faith, and Batista has been hit hard. Questions are being asked about his companies’ ability to keep borrowing money and Batista has been forced into a fire-sale of some assets. That, combined with the sliding market value of his companies, has knocked billions off his personal worth.

Now, I don’t feel too sorry for Batista. After all, he’s still worth $9bn, and is dating a beautiful model-stroke-lawyer-cum-businesswoman who is half his age… so I guess his life isn’t too bad. But his tale is a useful one for New World readers, because his fortunes mirror those of Brazil.

Last year the Brazilian economy grew at a Britain-like 0.9%. Meanwhile, investors have started to doubt the Brazil story, and the main Bovespa index has dropped 13% in the last year. Brazil’s problem is that bureaucracy, poor infrastructure and high costs are suffocating economic growth and preventing it making the most of its considerable assets. Over the long-term I’m still bullish on the country – and Batista – but Brazil needs serious reform to get the economy moving again.

Invest in the ‘next Brazil’

Fortunately for investors there is a ‘new Brazil’… one which has already made some of those difficult reforms. It’s called the Pacific Alliance. Regular readers will know that I’m a big fan of the Alliance – a new trade bloc made up of Latin America’s fastest-growing major economies: Mexico, Colombia, Chile and Peru. The strengths of each member economy are well known to most institutional investors (if you need a refresher, I’ve written about them before) but, judging by some of the reader feedback I get, many private investors remain unconvinced.

Indeed, despite the recent poor performance, most British retail investment in Latin America still goes to Brazil. In many ways that’s to be expected. As the only world top-ten economy in Latin America, Brazil may seem a natural investment choice for UK investors putting money in the region for the first time. They’re taking that step because in Britain, informed investors have figured out that the game is rigged against them. They know that the only way to protect their savings is to get it into another currency, so investing in booming markets in Latin American and Asia makes a lot of sense. (The trick is finding good local knowledge. That’s where my colleague Lars Henriksson comes in – he’s spent his life scouring the globe for exciting profit opportunities. To read how he does it, click here).

Those UK investors usually invest through Latin America-focused investment funds… and they normally have a strong Brazil bias. Also readers often tell me that countries such as Colombia and Peru often seem too small and risky.

But last week I attended a debate at the London School of Economics that made me think about the Pacific Alliance as a single entity. It’s a thought exercise that makes you realise you don’t always have to go straight for Brazil.

Looked at as a single economy, the Pacific Alliance is Latin America’s biggest, accounting for 40% of Latin American GDP and around half of all trade. With 210 million people it’s bigger than Brazil and richer too, both in absolute and per capita terms. Its capital markets are on par with Brazil’s and it is already attracting more foreign direct investment. Last year it brought in $70bn, up from just $18bn in 2004. It’s also an export powerhouse, accounting for about half the regional total. Moreover, those exports are balanced – a healthy mix of manufactured goods and commodities – and growing at 8% per year.

Most importantly – and this is where it differs from Brazil – it’s one of the most open economies in the world as all of the members have extensive free trade agreements with Asia, Europe and North America. The Pacific Alliance also has a much better business environment, with the World Bank putting the four members at the top of its regional ‘ease of doing business’ indicators.

Is it just a marketing trick?

As beguiling as all the above sounds… not everyone at the LSE debate was convinced. One by one, the distinguished panel started to list their doubts about the Alliance. One of the most pertinent came from Dr Gianluca Gardini, a lecturer in international relations and Latin American politics at Bath University. He noted that “most of the best things about the Pacific Alliance” predate the signing of the treaty. “All four member economies were growing strongly before the Alliance was formed… They also had already signed the free trade agreements. So what value does the Alliance really add?”

Gardini also pointed out that the Pacific Alliance has barely any institutions and no judicial authority. That matters, because despite talk of ‘embracing Asia’, no-one actually has the authority to sign a treaty in the name of the Alliance. “Ultimately any negotiations with a third-party, such as China, would have to be carried out on a bi-lateral level by each member country.” A similar point was made by Michael Reid, Americas editor at The Economist. “The Alliance is a great brand but is it just a marketing trick?”, he asked. He also questioned the practicality of an economic union where one member, Mexico, is thousands of miles away from another, Chile.

Funnily enough I don’t disagree with them – for the large part their analysis seems spot on. But from an investor point of view many of these factors are actually strengths. Take the lack of EU-style institutions for example. OK, that might inhibit the bloc when it comes to making fancy declarations in foreign embassies, but for investors this lack of political involvement can only be a good thing. Let’s face it, one of the causes of the current eurozone crisis is that too often decisions were made for political rather than business reasons; tax revenues were redistributed as subsidies and grants, as over eager EU officials decided which countries and sectors needed investment.

I also agree with Gardini that the strong economic growth of the members has nothing to do with the Alliance per se. All four were growing strongly before the treaty was signed in 2012. They’d also already taken strong steps to reform their economies and open up to international trade. But for investors that’s fine. It makes it an alliance of likeminded economies that have several shared traits. That’s unlike the European situation, where opposites such as Greece and Germany were always going to struggle to coexist.

So we have a situation where four strong, likeminded economies have decided to build on their success and work together. They’re taking steps to create freedom of movement of goods, people and capital between their borders without the grand ‘ideals’ that inspired the European project.

What’s the next step for the Pacific Alliance?

There are early signs that the Alliance is starting to add to member growth. Visa requirements have been abolished so that member citizens can now travel freely between countries. Meanwhile, policymakers are working to extend the scope of existing trade agreements. Chile’s foreign minister recently announced plans to abolish tariffs on 90% of goods traded between members, while the remaining 10% would receive some exemptions. If this goes ahead – it’s likely to be confirmed when the presidents meet for a summit in May – it would be a significant step towards establishing a common market.

Integrating capital markets is another important step for the Pacific Alliance. Important progress has already been made on this front, with Peru, Colombia and Chile linking their exchanges through the Mercado Integrado Latinoamericano – Mila. The idea was to deepen local equity markets while bringing together exchanges with different strengths. Chile is strong in retail and services, Colombia in financials and energy, and Peru in mining. The initiative has been slow to get off the ground, and trading volumes are still pretty low. However, if Mexico’s exchange gets on board – and it has said it will – that would create a monster with a total market capitalisation of around $1trn.

Taken together, all of these steps are helping to accelerate a trend that’s become more and more noticeable in recent years – increasing trade and investment between Mexico, Colombia, Peru and Chile. Thanks to the Pacific Alliance, local firms are starting to get better access to finance and are able to sell their wares to a larger, tariff-free market. That will allow them to build up scale and create a new generation of Latin American multinationals.

One firm that looks well placed to benefit from this increasing integration is Chilean retailer Cencosud (NYSE:CNCO.T). The firm is the region’s third-biggest retailer with department stores, supermarkets and DIY chains across Chile, Peru, Colombia, Argentina and Brazil. Since I first tipped it back in December it’s up almost 15%, but I think there is potential for the share price to go higher. It’s a bit of a risky buy, as the firm has funded its expansion by loading up with debt. However, I think it’s made its move at just the right time as consumer spending power is growing in nearly all of its main markets.

I’ll be looking at more ways to play growth in the Pacific Alliance in coming issues.

This article is taken from The New World, MoneyWeek’s FREE regular email of investment ideas and news from Asia and Latin America. Sign up to The New World here.