Pulp buyers get a real deal from South America

by Brendan Lowney

Argentina is only a tiny player in the world pulp industry. So why are the actions of its spendthrift politicians giving pulp producers in North America, Europe and Asia heartburn? The short answer is that Argentina's longstanding tendency to live beyond its means has brought yet another financial crisis to South America. The current crisis has dented confidence and led to currency devaluations across the region. As a result, Brazilian and Chilean pulp makers, who were already the world's low-cost producers before their currencies started their latest downswing, have become even more competitive.

Large currency devaluations are nothing new to South America. After all, the Chilean peso has lost 40% of its value against the dollar since 1995 and the Brazilian real has shed 65% of its value over the same period. Moreover, the last six years represent a period of tranquility compared to the bad old days in the 1980s and early 1990s when the Chilean peso would routinely lose 20-30% of its value per year and the Brazilian currency would typically lose 20-30% per month.

In those days, the region's currencies tended to depreciate due to the rampant inflation that was the result of wildly irresponsible monetary polices throughout the region. However, over the last five years, producer price inflation has averaged just 5.3% in Chile and 10.5% in Brazil, way below the norms of the previous two decades. Over the last several years, South America's currencies have been driven down by recurring financial crises that have plagued the region.

Argentina and Brazil's dependence on foreign capital lies at the heart of these periodic crises. Savings rates in both countries are insufficient to fund even the comparatively low level of investment spending in these economies. Moreover, neither country has a large export sector (as a percentage of GDP) with which to finance this capital inflow. As a result, their economies have become subject to the vagaries of the international capital markets. The latest crisis centers on fears that Argentina will have to either default on its bond obligations or devalue its currency.

Over the border

The crisis in Argentina has spilled over into Brazil and Chile because of the extensive trade links between the countries and due to herd behavior among investors. The total spillover effect has driven the Brazilian real down by 22% and the Chilean peso down by 15% since the beginning of 2001.

All other things being equal, a currency devaluation in an exporter's country will tend to benefit the exporter by making its products cheaper for foreigners to buy and, in turn, making its foreign competitors' goods relatively more expensive. However, a firm is no better off if domestic inflation drives up its costs by more than the devaluation boosts its revenues. Because of this, most economic models use inflation-adjusted exchange rates to determine the impact of devaluation with respect to competitiveness. (Economists construct these real exchange rates by dividing the nominal exchange rate by a measure of inflation; at RISI we use the total producer price index).

In 1999 and the first half of 2000, the Brazilian real and Chilean peso held their own or even gained versus the currencies of the other major pulp producers after adjusting for inflation. Their strength began to abate in the second half of 2000 and the slide gained momentum in 2001. From June 2000 to June 2001, the inflation-adjusted Brazilian currency - the "real" real - depreciated by 15% against the real US dollar. Back in June 2000, Brazilian hardwood market pulp producers already had average variable costs (delivered to Northern Europe) that were nearly 30% below those of the southern US producers. Meanwhile, the inflation-adjusted real lost 6% against the real euro and 4% against the real Indonesian rupiah. Before this devaluation, the average variable costs of Brazilian market pulp producers were 13% below those of the Finnish producers and 1% below those of the Indonesian producers (delivered to southern China).

Chilean producers are getting a similar boost in the softwood pulp market. The real Chilean peso declined by nearly 6% against the real Swedish krona, 9% against the real Canadian dollar, and 10% against the real US dollar in the 12 months through June 2001. Before this devaluation, the average variable costs of Chile's market pulp producers (delivered to northern Europe) were 18% below those of Sweden's producers, 30% below those of the southern US producers, and 40% below those of British Columbia's coastal producers.

In Brazil and Chile, the consensus among most economic forecasters is that inflation will not accelerate to a level that would offset the large devaluation in the exchange rate.

Given their combination of abundant and low-priced fiber along with low labor costs, Brazil and Chile were already the giving rest of the world's market pulp producers plenty to worry about. After the latest devaluations of the real and the peso, North American, European, and Asian producers may shelve the antacid tablets and grab the nearest bottle of Scotch.