After experiencing another decade of turbulence, Latin America has registered good macroeconomic performance over the past three years. Although there are large differences among countries, the region as a whole is estimated to have expanded at an average annual rate of 5 percent during 2004–05, the fastest two-year growth rate in two and a half decades. It has done so while generally maintaining low inflation and recording current account and primary fiscal surpluses. Moreover, 2006 is expected to be another strong year. A recent IMF Working Paper considers whether the region’s recent performance marks a distinct break from the past.
Over the past century, countries in the Latin American region have tended to experience macroeconomic instability, with boom-bust cycles, bouts of hyperinflation, devaluations, failed currency reforms, banking sector collapses, and debt defaults. Periods of strong growth have tended to be relatively short-lived, often ending in deep recessions, financial instability, and crisis. Output volatility has been higher and average growth lower than in many other regions (see chart, this page), contributing to persistent economic inequality and high poverty.
Roots of instability
What explains this history of recurrent macroeconomic instability? To be sure, external shocks have played a role, especially given the region’s dependence on commodity exports and foreign capital. Terms of trade volatility and global capital market conditions have indeed weighed on the region’s macroeconomic performance. At the same time, however, recent IMF research finds that more than 70 percent of the volatility of real GDP per capita growth in Latin America is due to country-specific shocks, including those stemming from volatile macroeconomic policies.
Monetary and exchange rate policies have tended in the past to amplify rather than dampen the cycle in the region. An important underlying factor has been the pressure to finance large budget deficits, which has often forced monetary policymakers to provide excessively easy access to central bank credit. The resulting inflationary bias, coupled with the tendency of the region’s central banks to act pro-cyclically (loosening during upswings and tightening in the face of negative shocks) and the predominance of pegged exchange rate regimes, left the region highly prone to macroeconomic and financial instability.
However, the primary driver of macroeconomic instability in the region has been fiscal policy and frequent changes in the fiscal stance. Indeed, Latin America’s fiscal volatility during 1960-2000, as measured by discretionary changes in government spending, was considerably higher than in other regions of the world over the same period. Fiscal volatility has been triggered partly by the tendency of fiscal policymakers to act in a procyclical manner—overextending the public sector during boom times and sharply curtailing spending during downturns—and has amplified cyclical instability in the wider economy. That tendency, coupled with heavily dollarized economies, fixed exchange rates, and weak central banks, has created cycles characterized by a ratcheting up of public debt, monetary accommodation, accelerating inflation, and eventual crisis.
On average per capita, growth in Latin America, has been lower…
Citation: 35, 15; 10.5089/9781451968507.023.A010
1Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay, and Venezuela.
Data: Angus Maddison (2001), The World Economy: A Millennial Perspective (Paris: Organization for Economic Cooperation and Development).
Encouragingly, though, there has been steady progress in advancing market-based reforms and entrenching sound macroeconomic policy frameworks, which seem to have begun bearing fruit. In recent years, a number of countries have made concerted efforts toward fiscal consolidation and have exhibited a willingness to tackle inflationary pressures at an early stage. This more favorable policy implementation appears to reflect a strengthened political commitment to macroeconomic stability, especially low inflation.
Accordingly, these countries have implemented a range of institutional and operational reforms to improve central bank autonomy, adopt inflation targeting, and allow for much greater exchange rate flexibility than they did in the wake of the exchange rate stabilization plans they initially followed in the 1990s. Countries have also instituted improvements to make financial systems more resilient and, while more work remains to be done, the decline in non-performing loan ratios and strengthened capital adequacy ratios illustrate the strides made in this area.
Given that much of the region’s past volatility can be attributed to fiscal weakness, it is especially encouraging to see the improvements in government budgets (see chart, this page). A number of countries in the region have undertaken important institutional reforms to help discipline fiscal policy. One welcome sign of success is the significant decline in debt-to-GDP ratios since 2002. Based on a sample of nine countries in the region (namely, Argentina, Brazil, Chile, Costa Rica, Ecuador, Mexico, Peru, Uruguay, and Venezuela, which account for 90 percent of the region’s GDP at market exchange rates), the weighted average ratio of public debt to GDP is estimated to have fallen by about 26 percentage points between end-2002 and end-2005, with declines in all nine countries.
On average, these nine Latin American countries maintained primary fiscal surpluses of 3⅓ percent of GDP during 2003–05, more than twice the average surplus they achieved during the preceding decade and much higher than those of other emerging markets, where primary deficits have been the norm in recent years. Although this improvement partly reflects the boost to revenues that oil and other commodity exporters in the region have experienced, primary balances also improved in other countries, including those with high levels of debt. Combined with solid economic growth, these primary surpluses accounted for most of the decline in the region’s debt-to-GDP ratio.
The recent decline in debt has been accompanied by a welcome improvement in debt management. Notably, foreign currency–denominated debt has been reduced, as some countries (Brazil, Chile, Colombia, Mexico, and Peru) have increased their reliance on debt issuance in domestic currencies, including in international markets (Brazil, Colombia, and Uruguay). The decline in the share of foreign currency debt has also benefited from an appreciation of the real exchange rate and from the debt exchange in Argentina, which increased the share of debt in the local currency.
The region has made important strides in addressing the roots of macroeconomic stability and, in a still relatively favorable environment, has scope to make further progress. As for future priorities, the top ones are continued policy and institutional reforms to reduce public debt and strengthen fiscal frameworks. Other related priorities are to solidify the commitment to low inflation; improve the business environment, including by lowering the cost of financial intermediation; and implement labor market and other structural reforms to improve flexibility.
Such an agenda clearly requires a strong social and political consensus. In this regard, the entrenchment of democracy in the region, as exemplified by the continued successful and peaceful conclusion of democratic elections generally, augurs well for consolidating popular support for the market-based reforms and institutions that are needed to support macroeconomic stability and sustain higher growth.
Director, IMF Western Hemisphere Department
This article is based on IMF Working Paper No. 06/166, “Macroeconomic Volatility: The Policy Lessons from Latin America,” by Anoop Singh. Copies are available for $15.00 each from IMF Publication Services. For ordering information, see page 240. The full text is also available on the IMF’s website (www.imf.org).