Dora Iakova, Luis Cubeddu, Gustavo Adler, and Sebastian Sosa
Published Date:
December 2014
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Dora Iakova

Latin America had a remarkable economic performance in the first decade of the 2000s. Real output grew at a rapid pace, inflation was low and relatively stable, public debt declined significantly, and international reserves increased. The economic prosperity was broadly shared: income inequality declined in many countries and there was a sharp reduction in poverty rates. Although prudent policies and skillful economic management contributed to these achievements, exceptionally favorable external conditions played a key role, acting as a catalyst for growth. Strong demand for the region’s commodity exports led to a wave of investment and an unprecedented income windfall, while easy global financial conditions pushed financing costs to record lows. The global recession of 2009 made only a temporary dent in the region’s growth ascent. In the two years following the crisis, many countries posted record-high growth rates.

More recently, however, Latin America has faced rising economic challenges. The external tailwinds that helped propel growth in the past are fading. Commodity prices have eased based on concerns about China’s ability to sustain high rates of investment-led growth. In the months following the May 2013 announcement by the Federal Reserve that monetary policy in the United States would gradually normalize, global financial conditions tightened and volatility in financial markets increased. At the same time, domestic bottlenecks have constrained the pace of growth in many Latin American countries. As a result, economic activity has decelerated across the region, and real output growth is expected to be only 1¼ percent in 2014, compared with 6 percent in 2010.

The chapters in this book address questions that are currently at the heart of the economic policy debate on Latin America. Can the region maintain high rates of economic growth in the medium term? How vulnerable is Latin America to a reversal of commodity prices? Have countries saved a sufficient share of the income windfall from the commodity price boom? Are fiscal fundamentals strong enough to withstand a deterioration of external conditions? Will there be significant spillovers from the normalization of U.S. monetary policy? Is the region well prepared to deal with new global financial shocks and increased capital flow volatility? The insights from these studies have provided the basis of an ongoing and forward-looking policy dialog with authorities across Latin America in the context of regional surveillance by the International Monetary Fund’s Western Hemisphere Department.

Part I of this volume analyzes Latin America’s medium-term growth prospects. The opening chapter by Dora Iakova, Sebastián Sosa, and Alejandro Werner provides an overview of the main economic challenges faced by the region and discusses policies to address them. The key recommendation is that in order to achieve sustainable growth, policymakers need to give priority to microeconomic reforms to help improve educational outcomes, close infrastructure gaps, and increase productivity growth.

In Chapter 2, Sebastián Sosa, Evridiki Tsounta, and Hye Sun Kim analyze the drivers of growth in Latin America during the period 1970–2012 from a supply-side perspective. The strong growth in the first decade of the 21st century was made possible by a significant increase in factor utilization, especially labor. However, in the coming years the pace of economic activity will depend increasingly on rising total factor productivity, as labor participation is already at relatively high levels and investment is likely to be affected by the expected tightening of financial conditions and the stabilization of commodity prices.

Turning to the effect of external conditions on growth, in Chapter 3 Bertrand Gruss presents an innovative empirical analysis of the effects of the end of the commodity price boom on Latin America’s economic prospects. His results suggest that medium-term growth for the region would be significantly lower than during the boom years, even if commodity prices were to remain flat at their current high levels.

Part II distills policy lessons from past episodes of terms-of-trade shocks and explores whether the region has built strong enough buffers during the boom years to guard against a deterioration in external conditions. In Chapter 4, Gustavo Adler and Sebastián Sosa assess the vulnerability of Latin America to a reversal in commodity prices. They document that the region remains heavily dependent on commodity exports, and find that a country’s vulnerability to swings in commodity prices is largely determined by the strength of its fundamentals and its macroeconomic policy framework. Limited exchange rate flexibility, large underlying current account deficits, and a weak fiscal position tend to amplify the effects of adverse terms-of-trade shocks on domestic output. Financial dollarization also appears to act as a shock amplifier. With improved fundamentals in many of these dimensions, the region today appears better placed to cope with commodity price volatility than it was in the past.

In Chapter 5, Gustavo Adler and Nicolas E. Magud present a new data set on terms-of-trade booms across the world over the last 40 years and develop a measure of the associated income windfall. They find that Latin America’s terms-of-trade shocks in the 2000s were of a similar magnitude to those observed during the 1970s. However, the associated income windfalls have been substantially larger in the 2000s because the region has become more open to trade. In some countries, such as Venezuela, Bolivia, and Chile, the additional income from the commodity price boom in the 2000s is estimated to have exceeded 150 percent of GDP. The chapter finds that aggregate savings during the recent boom in Latin America increased more than in past boom episodes, but that the share of the windfall saved (the marginal saving rate) was lower than in the past. The authors conclude that the marked improvement of economic fundamentals in the region largely reflects the sheer size of the positive income shock, rather than greater efforts to save that income.

Strong fiscal policy frameworks are critical for managing macroeconomic volatility triggered by external shocks. In Chapter 6, Gustavo Adler and Sebastián Sosa tackle the question of whether the region has built sufficient fiscal buffers to mitigate the effects of a less-favorable external environment in the coming years. They examine empirically the link between global factors (such as commodity prices, world growth, and global financial market conditions) and key domestic variables (GDP growth, trade balance, real exchange rate, and sovereign spreads) that drive public and external debt dynamics. The results suggest that several countries in the region (such as Bolivia, Chile, Paraguay, Peru) have sufficiently strong fiscal and external positions to withstand moderate to severe external shocks, but many countries would benefit from building stronger buffers.

In Chapter 7, Alexander Klemm shows that fiscal policy procyclicality remains an issue in the region, though several countries have strengthened their policy frameworks and reduced policy procyclicality over the last decade.

Part III focuses on Latin America’s ability to cope with renewed capital flow volatility, and offers policy advice informed by the experiences of emerging market economies during historical episodes of financial turbulence. In Chapter 8, Gustavo Adler and Camilo E. Tovar study the role of financial integration and macroeconomic fundamentals in mitigating or amplifying the output effects of global financial shocks on Latin America and other emerging market economies. They establish that better fundamentals, such as exchange rate flexibility and a robust external position, strengthen an economy’s resilience to shocks. Moreover, greater financial integration amplifies global financial shocks in countries with fixed exchange rate regimes, but mitigates them in countries with flexible exchange regimes.

When nonresident investors withdrew capital from Latin America during the global financial crisis of 2009, in some cases residents played a stabilizing role by repatriating capital. It is an open question whether local investors will continue to play such a stabilizing role in future periods of capital flow volatility. In Chapter 9, Gustavo Adler, Marie L. Djigbenou, and Sebastián Sosa find that residents tend to repatriate capital to their home countries in the face of global uncertainty shocks (possibly reflecting asymmetric information or a home bias), but less so in response to increases in U.S. interest rates.

In Chapter 10, Alexander Klemm, Andre Meier, and Sebastián Sosa discuss potential spillovers to Latin America in the process of normalization of U.S. monetary policy. They conclude that the effects would likely be limited in a gradual normalization scenario, driven by improving growth prospects in the United States. Nonetheless, important risks remain. Renewed volatility in U.S. bond yields could trigger large moves in emerging market bond prices, especially if it were to coincide with other negative shocks to investor sentiment, such as adverse political or economic developments in emerging markets. Based on evidence from the mid-2013 taper tantrum, countries with domestic or external weaknesses would be especially vulnerable.

Housing market busts have been a trigger or a major channel of propagation of financial crises in the advanced economies. In the final chapter, Luis Cubeddu, Camilo E. Tovar, and Evridiki Tsounta explore whether the housing market is a potential source of vulnerability in Latin America. Their results indicate that housing prices do not appear to be significantly overvalued, though the rapid growth of mortgage credit in recent years (some of it extended by public banks) is a potential source of concern, as interest rates are set to increase, while growth is moderating.

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