By Ruchir Sharma
Newsweek International
Febuary. 14 2005

Following dismal economic growth in the '90s, it seemed that Latin America's leaders had convinced themselves that good economics was bad politics. Hugo Chavez in Venezuela, Nestor Kirchner in Argentina and Lucio Gutierrez in Ecuador were repudiating international debts, infringing on private-property rights and interfering with the pricing mechanism for key utilities. In late 2002, the international financial community was convinced that with the election of Luiz Inacio Lula da Silva, Brazil, too, was going to join the renegade camp. The continent was a lost cause.

Well, the powerful global economic expansion of the past 18 months has made for many comeback tales, but Latin America's has to be the most impressive. In 2004, the region is estimated to have grown at 5.8 percent, the highest annual gain in its recorded history. Blockbuster growth was accompanied by an average inflation rate of 7 percent, a surplus in the current account (which includes both trade in goods and financial flows) of 1.8 percent of gross domestic product and nearly balanced government budgets.

Has Latin America then stumbled upon a new growth model that advocates debt defaults, Robin Hood economics, and political demagoguery? Over the past year, Venezuela's economy grew by 17 percent—taking Chavez's popularity to new highs—and Argentina's by 8.4 percent, all in the face of policies judged to be plain bad by international financial institutions.

The radical left may want to spin the success to validate Argentina's and Venezuela's way. But the real story is Brazil's rediscovery of the only proven model for a political economy: capitalist democracy. The region's largest economy has matched the illusory growth of smaller neighbors by following economic orthodoxy—and attracting foreign investors—within a proper democratic framework. High growth in Argentina and Venezuela over the past year largely represents an overdue bounce following severe recessions. Inflation-adjusted GDP in both countries remains well below late-'90s peaks, while Brazil's GDP is now at a new high.

To bounce is easy, but to stay airborne is hard. And Brazil has by far the best shot at doing so, because accelerating investment will raise productivity—the key to sustained growth. Meanwhile Argentina and Venezuela are relying on cyclical commodity exports and government consumption to fuel growth. With oil exports making up 35 percent of GDP, Venezuela enjoys a current-account surplus that reached nearly 13 percent of GDP in 2004. The problem is that despite capital controls, $10 billion of capital—or 10 percent of GDP—fled the country last year. The economy's growth trajectory will then be dictated by the volatile price of oil, as overall investor confidence remains low.

In Argentina, Kirchner has followed a less extreme path. Compared with Chavez, he has shown at least some respect for private-property rights. Still, Argentina remains isolated from world markets as a result of its debt default in 2001, and its tough posturing with creditors is likely to raise the risk premium on Argentine debt for some time. The defining characteristic of the political economy in Venezuela and Argentina is the violation of contractual agreements. And historically, weak rule of law is the major reason for economic underachievement.

While Lula, too, has at times played to the galleries, speaking out as a strident nationalist and opponent of U.S. foreign policy, his actions have been consistently pro-market and devoid of short-term populism. Lula has shown respect for the country's institutions, such as the central bank, and let the financially savvy Finance minister, Antonio Palocci, run economic policy often over vociferous objections from the more reactionary forces in his party.

Most important, Lula was tested by the usual bout of public impatience in the first half of last year, when economic growth remained moribund and his popularity ratings plunged as he focused on monetary and fiscal discipline to restore the health of the country's balance sheet. Rather than take the easy escape route to stave off internal stress—as Chavez and Kirchner have—Lula never flinched in the belief that eventually, good economics makes for good politics. The reason for optimism over Latin America has to be that the region's largest economy is headed the right way. If they're smart, others will follow.

Sharma is co-head of global emerging markets at Morgan Stanley Investment Management.

© 2005 Newsweek, Inc.