Journal Issue

Aninat views Latin America at turning point, not “tipping” point

International Monetary Fund. External Relations Dept.
Published Date:
March 2003
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Latin America’s economic performance has long lent itself to hyperbole, and the troubles of the past few years have been no exception to this practice. The U.K. newspaper The Guardian spoke of the failure of “neoliberalism, the global marketplace, and the adoption of IMF policies” in an article last November entitled “A Continent on the Edge of a Volcano.” Some others have likewise expressed the view that because of the region’s economic weakness of the past couple of years, Latin America is at a tipping point—a point of sudden and major policy changes in the region.

The truth may be somewhat more banal. Latin America is not at a tipping point, but at a cyclical turning point—moving from a slowdown induced in part by the global economic cycle to a position of recovery. So it is wrong to view recent economic performance as reflecting either the failure of policies of the 1990s or the dangers of globalization. Were it not for many of the policies put in place during the 1990s, this region might have encountered even greater turbulence during the global slowdown. And far from turning their backs on globalization as a result of recent events, countries should design national strategies “to take advantage of the potential [of globalization] and meet the requirements associated with greater integration into the world economy,” as a United Nations regional agency noted in a recent report.

Global linkages

The region’s economic weakness over the past two years owes much to the global cycle, particularly the slowdown in U.S. activity during 2001. In 2000, the performance of the region was, on average, only a bit below global growth. Of the 33 countries in the Latin America and Caribbean region, only two were in recession, Argentina and Uruguay. The others had modest to reasonable growth, with Brazil, Chile, and Mexico being at the top of the league in that year.

Toward the end of 2000, we came to the end of what was a very long expansion in the global economy and the United States. There was a global slowdown during much of 2001, the effects of which were of course felt in this region, which is already quite integrated with the United States through several links.

This is best exemplified by Mexico. Former Mexican President Porfirio Díaz—to whom the remark about Mexico being “so close to the United States and so far from God” is generally attributed—could scarcely have imagined that his more recent successors would launch a deliberate policy of moving the country even closer to the United States, particularly through the signing of the North American Free Trade Agreement (NAFTA). Remarkably, the correlation between 12-month changes in U.S. and Mexican industrial production has risen from under 0.15 in the pre-NAFTA era to 0.9 in recent years—a near-perfect correlation. Mexico was thus among the first to feel the effects of the U.S. slowdown; economic activity there contracted slightly in 2001. But Mexico also rebounded quickly—mirroring the pickup in the United States during 2002. In 2003, Mexico is expected to grow about 3 percent, according to the latest private sector forecasts.

Economic activity in many other countries in the region displays a similar qualitative pattern: growth slowed in tandem with the global slowdown, and there are signs of recovery again in 2003 as global conditions improve.

But the region of course needs to do more than just wait for the global recovery to lift all boats. I propose a three-part agenda of self-help for countries in the region: first, making the macroeconomic and financial framework more “crisis proof”; second, accelerating the structural reforms needed to boost growth (and—in some cases—also to help with crisis prevention); and, third, taking better advantage of globalization.

Crisis proofing

Making Latin American countries less crisis prone will require, at the very least, exchange rate flexibility (combined with inflation targeting as a monetary anchor), conservative limits on public debt, and a move away from excessive dollarization of the debt.

While exchange-rate-based stabilization regimes in the early 1990s were successful in lowering inflation, over time the regimes bred rigidities that constrained responses to internal and external shocks. They also encouraged capital inflows and balance-sheet mismatches through indirect dollarization. While economic activity initially increased as a result of capital inflows, competitiveness was undermined over time by real exchange rate appreciation. The encouragement of capital flows also undermined fiscal discipline. Similarly, the momentum of trade liberalization was undermined because of the lack of exchange rate flexibility needed to adjust to the effects. So Latin America, learning from experience, should shy away from inflexible exchange rate regimes, which, almost everywhere, have proved disastrous.

Another common vulnerability leading up to recent crises has been rising levels of public indebtedness and the currency composition of the debt. While not yet remarkably high by some international standards, debt-GDP ratios in Latin American countries have often concealed important weaknesses. For instance, in some countries, debt ratios drifted systematically up during the 1990s, even during good times, indicating a lack of budget discipline. Moreover, a lack of credibility led to reliance on dollar-linked or dollar-interest-linked debts. And overvalued real exchange rates meant that, from a medium-term perspective, debt-GDP ratios were understated and also wrongly assessed.

Rising debt is a result of deeper weaknesses in fiscal systems. Such weaknesses include narrow revenue bases and weak collection mechanisms; rigidities in current spending (exemplified by the majority of spending that is subject to earmarking and floors); and inflexible arrangements with subnational levels of government. Fiscal structures and institutions must be improved to make policy implementation more flexible, support increased social spending, and boost long-term growth. In fact, improving institutions is now at the core of the agenda for change in Latin America.

It is wrong to view recent economic performance as reflecting either the failure of policies of the 1990s or the dangers of globalization.

—Eduardo Aninat

Overcoming reform fatigue

Structural reform efforts in many key areas, such as trade liberalization and tax policy reforms, faltered in the second half of the 1990s and now need to be revitalized.

Trade integration in Latin American countries has lagged behind capital market opening. This has resulted in greater vulnerabilities, particularly in the form of very high ratios of foreign debt to exports—in particular of public debt to exports—overshadowing the generally lower ratios of foreign debt to GDP. Growth potential has been affected. The evidence suggests that countries with high trade shares grow consistently faster than those with more inward-looking trade structures. Latin American trade shares are generally half those of East Asian countries, and their long-term growth rates have also been consistently lower.

The still relatively small trade sectors of Latin American economies and concentration of exports in a few commodities amplified problems of rising external debt, fragile financing structures, and exchange rate rigidities. With exports representing a small share of GDP, large real exchange rate movements were needed to improve external positions to meet higher debt-servicing payments or other shocks, adding to concerns about maintaining external solvency. In contrast, Asian countries were able to rebound faster after their 1997-98 crises because of their open economies, which allowed for greater export responses to devaluations.

Structural reforms in trade, fiscal, and other areas will not yield their full benefits, however, unless they are accompanied by governance reforms. Widespread corruption has hampered growth and undermined support for reforms, with several Latin American countries ranked among the most corrupt in the world. Visibly reducing corruption would clearly be desirable to sustain support for the reform process, as it would add to a more fair and equitable society. The quality of foreign investment has also been shown to depend on transparency and absence of corruption. Reforms, for example in privatization, should be structured to minimize scope for illegal appropriation of the benefits. Establishing an independent and responsible judiciary is central to increasing the credibility of the rule of law and improving the environment for the operation of market forces.

A global consensus?

In an integrated world economy, countries not only need to pursue their own domestic agendas but also have to be aware of how best to capture the gains of globalization. The gains from trade are by now widely appreciated. That more trade has meant faster economic growth and higher standards of living is most clearly seen in East Asia: real incomes in Korea, for instance, have doubled every 12 years since 1960. Along with the expansion of trade, capital market integration has also advanced in recent decades. Private capital flows to emerging market and developing countries now exceed public overseas development aid many times over. Openness to capital flows, when combined with sound domestic policies, gives countries access to a much larger pool of capital with which to finance development. But the emerging consensus view—including that of the IMF—is that developing countries need to have a set of preconditions in place to benefit from financial globalization and to avoid an increased probability of a currency or banking crisis. That is why capital account liberalization is being approached with much greater caution: as the IMF’s Economic Counsellor, Kenneth Rogoff, puts it, developing countries are targeting how they “can drink from the waters of international capital markets without being drowned by them.”

Certainly, foreign direct investment (FDI) should be encouraged because it is more stable than other types of external finance and speeds up capital accumulation and absorption of foreign technologies. Like trade, FDI has been shown to promote economic growth. Foreign holdings of equities, while sometimes unstable, provide benefits in terms of risk sharing. And their instability may have had more to do with having in place rigidly fixed exchange rates than with some intrinsic property of cross-border holding of equities. The issue of restrictions, therefore, arises more in the case of debt instruments—both short-term flows (that is, hot money) and certain types of long-term flows (for example, debt payable in foreign currency or indexed to short-term domestic interest rates). Debt lacks the desirable risk-sharing properties of FDI and equity, and can make countries susceptible to reversals of sentiment, causing reversals of fortunes, and, in some cases, even to insolvency problems.

We can learn from the experience of the 1990s and of the past few years to make the region more crisis proof and to have more vigorous growth.

—Eduardo Aninat

Staying connected

International trade and cautious access to foreign capital are two important ways for developing countries to tap into the benefits of a globalized world. But, increasingly, developing countries will have to find ways to take advantage of technological advances abroad.

During the early years of the twentieth century, Latin America missed out on opportunities for rapid growth in industries such as forestry and mining that were exploited by similarly endowed countries such as Australia, Canada, the countries of Scandinavia, and—to some extent—the United States. Why? A recent World Bank study suggests two answers. First, the monopoly power created by inward-looking industrialization policies was a barrier to innovation and technological adoption. Industries preferred the guaranteed monopoly rents granted to them by government fiat to competing for profits by gaining a technological edge over competitors.

Second, human capital and networks of institutions that facilitate the adoption and creation of new technologies were deficient relative to other nations. An indication of this is the much lower percentage of engineers in Latin America than in other regions around the turn of the twentieth century. U.S. and Australian successes in mining were helped considerably by intellectual networks linking world-class mining universities and by private as well as government research efforts. Likewise, Scandinavia’s excellence in forestry owed much to knowledge networks—clusters of universities and private and public think tanks that furthered productivity growth. It is perhaps not an accident that Finland’s earliest pulp mill was located in a place called Nokia, today the site and symbol of the country’s leadership in telecommunications. Of course, exceptions can be found in a few of the Latin American experiences.

Today’s Latin America is different. Most countries in the region have moved to a clear outward orientation. And many have made new investments in improving human capital and the quality of educational institutions. Moreover, access to information technology (IT) permits countries to close the knowledge gap with advanced nations faster than was previously possible. With IT, education can potentially be delivered at much lower expense to a much wider group of people. People on the margins of domestic and international markets can be brought into the mainstream through the provision of better information and the reduction of transaction costs.

IT expenditure rose, albeit from a low base, throughout the 1990s for most developing countries and for many of them at a rate significantly greater than in advanced economies. Moreover, the rate of diffusion of IT to developing countries has been rapid compared with earlier all-purpose technologies. In short, developing countries—in Latin America and elsewhere—are making the kind of investments in IT that will enable them to stay connected.

Summing up

There is no denying that this region has had a tougher time over the past few years than many other regions. It has, of course, suffered the consequences of the global slowdown. But special factors have also been at work in some countries—for example, Argentina’s disorderly exit from an exchange rate peg, along with fiscal disarray; market perceptions of policy uncertainties during an election year in Brazil in 2002; acute political strife in Venezuela; and so on. But our forecast is that a turning point will come in 2003: growth will clearly resume in the region.

Some have used the region’s troubles of these past few years to argue that we should turn the clock back on the economic policies of the 1990s and on the advance of globalization during the past few decades. I have very little sympathy for such views! The 1990s were a decade of much achievement in Latin America, as many of us know and as many citizens in the region actually experienced.

Of course, no era is perfect—there are always things that could have been done better. And the 1990s, while good, were very far from the level of achievement that was required. So we can learn from the experience of the 1990s and of the past few years to make the region more crisis proof and to have more vigorous growth.

Nor should the region turn its back on globalization. Despite the vocal protests in some quarters, there is actually a consensus building about how developing countries can take advantage of globalization. Developing countries—including in Latin America—should embrace globalization wholeheartedly while adapting to it in a variety of more sophisticated ways.

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