Chapter

Chapter 1. Latin America: Rising to New Challenges

Author(s):
Dora Iakova, Luis Cubeddu, Gustavo Adler, and Sebastian Sosa
Published Date:
December 2014
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Author(s)
Dora Iakova, Sebastián Sosa and Alejandro Werner 

Over the past 15 years, the countries of Latin America have made tremendous progress in strengthening their economies and improving living standards. A growing and vibrant middle class has emerged. The weight of the region in global economic output increased from about 6 percent in the 1990s to 8 percent in 2012. The region has also achieved impressive gains in terms of macroeconomic and financial stability. Real output growth has been strong and steady, inflation has been low and well contained in most countries, and international reserves have increased significantly. Public debt has fallen, and most countries no longer suffer from “the original sin”—the inability to borrow abroad in their domestic currency—with government debt now issued mostly in local currency. The adoption of flexible exchange rate regimes has strengthened the resilience of countries to external shocks. Financial deepening has proceeded at a steady pace in the context of overall sound and resilient financial systems. These achievements helped the region weather the global financial crisis relatively unscathed. Although output fell temporarily, most countries staged a rapid recovery supported by countercyclical policy.

This success has owed much to good policies. The implementation of important structural reforms and the liberalization of trade in the 1990s, together with the establishment of stronger institutions and credible policy frameworks, provided the foundations for the economic resurgence. But good luck in the form of very favorable external conditions has also played a key role. Commodity prices rose sharply between 2003 and 2011, providing an unprecedented income windfall for Latin America’s commodity exporters. At the same time, global financial conditions eased progressively (apart from a temporary tightening during the 2009 global financial crisis), lowering the cost of debt for governments and corporations. These twin tailwinds helped propel economic growth and strengthen public finances.

More recently, however, Latin America has been facing rising challenges, both domestic and external. Externally, the favorable tailwinds that propelled growth in the recent past are turning into headwinds. Commodity prices have eased from their 2011 peaks and are expected to stay broadly flat or soften further in the medium term. Global financial conditions have started to tighten since mid-2013 when long-term interest rates in the United States increased from historically low levels.

Domestically, the pace of growth in Latin America has been increasingly constrained by supply-side bottlenecks, including low investment rates, inadequate infrastructure, slowing labor force growth, and skill mismatches. Several years of strong bank credit growth and bond issuance have resulted in some increase in private sector leverage, increasing vulnerability to a growth slowdown or tightening of financial conditions.

At the same time, with improved living standards and a growing middle class, demands for better public services are on the rise. Students are asking for better publicly funded education, firms expect infrastructure upgrades and a more business-friendly environment, and social pressures are mounting to alleviate poverty and provide greater opportunities for social mobility. Despite a marginal decline in income inequality in recent years, Latin American societies remain among the most unequal in the world.

Demographic developments will add another hurdle to economic prospects going forward. Latin America is currently reaping a demographic dividend, with very low dependency ratios and relatively low spending on pensions and health. However, this trend is projected to turn around by 2020, with dependency ratios rising quickly thereafter. This will constrain growth in living standards unless productivity increases substantially.

This chapter discusses how Latin America can build on its achievements to address these new challenges. With renewed commitment to growth-oriented reforms, the region can achieve lasting prosperity and stability.

Exceptional Gains

The period from 2003–12 was a time of exceptional gains in living standards for Latin America. Real GDP growth reached an annual average of 4.8 percent—close to two times higher than the growth rate in the 1980s and 1990s (Figure 1.1). The growth momentum was accompanied by an impressive strengthening of macroeconomic fundamentals and policy frameworks. Public sector balance sheets improved substantially, and external debt levels declined. Inflation remained low and relatively stable in most countries, in sharp contrast to the high inflation rates characteristic of the region in previous decades (Figure 1.2).

Figure 1.1Latin America: Real GDP Growth

(Percent)

Source: IMF, April 2014 World Economic Outlook.

Note: Measured as a simple average of Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay, and Venezuela.

Figure 1.2Latin America: Annual Inflation

(Percent)

Source: IMF, April 2014 World Economic Outlook.

Note: Measured as a simple average of Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay, and Venezuela.

Most countries took advantage of the favorable economic conditions to improve their fiscal positions in the years prior to the global financial crisis. Chapter 6 in this volume documents that many countries ran substantial primary fiscal surpluses, leading to a marked reduction in public debt levels (amounting to 30 percentage points of GDP on average during 2003–08). At the same time, the currency composition and maturity structure of the debt improved significantly (Figure 1.3). The average share of foreign-currency debt in total public debt declined from 65 percent in the early 2000s to 45 percent in 2012. Moreover, average debt maturity increased, with the share of short-term debt in total public debt falling from over 10 percent of GDP in the early 2000s to about 6 percent by 2012.

Figure 1.3Latin America: Key Fiscal Indicators

(Percent of GDP, unless otherwise noted)

Sources: IMF, International Financial Statistics; and IMF country desks.

Note: Measured as a simple average of Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay, and Venezuela.

1 Short-term debt at residual maturity in percent of total debt. Excludes Bolivia and Paraguay.

External positions also strengthened across Latin America. In contrast with previous periods of rapid growth in the region, the high-growth episode prior to the global financial crisis was accompanied by a significant improvement in current account balances. The more financially integrated countries in the region went from an average current account deficit of 2½ percent of GDP during 1997–2002 to a surplus of ½ percent of GDP in 2004–07 (Figure 1.4).1 Gross external debt levels declined by more than 30 percentage points of GDP on average during this period (though some of the decline was due to a trend appreciation of local currencies). In addition, the composition of capital inflows improved in the 2000s, with foreign direct investment accounting for a much larger share of inflows than in the previous decade. Countries also used a greater share of these inflows to build up international reserves and private sector foreign assets. Along with a much greater role for flexible exchange rates to act as a shock absorber, this buildup of external buffers led to a notable reduction in the region’s vulnerability to negative external shocks.

Figure 1.4Latin America: External Current Account Balance

(Percent of GDP)

Sources: IMF, April 2014 World Economic Outlook; and IMF staff calculations.

Note: Measured as a simple average of Brazil, Chile, Colombia, Mexico, Peru and Uruguay.

Bank soundness indicators also generally improved during the period, despite relatively strong credit growth over a number of years. After a history of repeated banking crises in past decades, banks in the region have behaved relatively conservatively in the 2000s, maintaining high deposit-to-loan ratios and strong capital and liquidity ratios. Improving supervision and regulation have also helped maintain the soundness of the financial system.

Gains in economic prosperity have been broadly shared. Employment rates for both males and females increased in most countries and there was a sharp reduction in poverty. Absolute poverty rates fell more than 10 percentage points between 2002 and 2010, lifting more than 55 million people out of poverty.2 Contrary to the trends in other emerging and advanced economies, income distribution improved over the past decade. The region’s robust output and employment growth, and its success in bringing down inflation, played a decisive role in reducing poverty and inequality. Other contributing factors include increased government transfers to the poor (especially through targeted programs such as Brazil’s Bolsa Familia, Chile’s Ingreso Etico Familiar, and Mexico’s Oportunidades), and a narrowing wage gap between skilled and low-skilled workers (Lopez-Calva and Lustig, 2010; Tsounta and Osueke, 2014).

This extraordinary success has been underpinned by an increased social consensus on the importance of macroeconomic stability. Macroeconomic policies remained prudent in most of the region, despite successive transfers of power between elected governments of different political orientations. Many countries strengthened policy institutions and established credible monetary and fiscal policy frameworks. Some countries introduced formal fiscal rules and established stabilization funds, entrenching fiscal discipline in the law and reducing the tendency to run procyclical fiscal policy, which had been very common in the past (see Chapter 7). The adoption of credible inflation-targeting regimes, accompanied by greater exchange rate flexibility, played a key role in anchoring inflation expectations and reducing vulnerability to external shocks.

The significant improvement in policies and fundamentals was rewarded by the market, with credit ratings improving across all countries during the decade. In 2012, six of the eight largest Latin American countries had investment-grade ratings, compared with only two in 2003. Bond spreads declined sharply and market access improved across the board.

Better macroeconomic management and stronger fundamentals also helped Latin America weather the global financial crisis of 2008–09 relatively unscathed.3 Improved government finances, reduced external debt, higher international reserves, more flexible exchange rates, and strengthened financial regulation and oversight all played a role in limiting the impact of the crisis on the region. In contrast to past crisis episodes (such as in 1982, 1998, and 2001), the region was well positioned to mitigate the external shock by implementing countercyclical stimulus. Practically for the first time in living memory, governments and central banks in many countries expanded public spending and reduced interest rates in the face of the global recession. Meanwhile, currency depreciations helped Latin American countries cope with the drop in external demand, without causing a spike in inflation or creating financial system turmoil.

While prudent policies explain part of Latin America’s success over the past decade, exceptionally favorable external conditions played an important role as well. Commodity prices almost tripled in U.S. dollar terms between 2003 and 2012, creating an unprecedented rise in the terms of trade for the region’s commodity exporters. As documented in Chapter 5, the income windfall associated with that commodity boom was much larger than in previous episodes. The average annual increase in income for the commodity exporters was 15 percent per year, with a cumulative average windfall over the episode of 100 percent of GDP. The largest gains accrued to Bolivia, Chile, and, especially Venezuela (for which the estimated cumulative income windfall was 300 percent of GDP). The terms-of-trade boom provided significant stimulus to domestic demand and output growth. Indeed, growth over the past decade was far stronger among South America’s net commodity exporters than it was in the rest of Latin America (Mexico and Central America) (Figure 1.5).

Figure 1.5Latin America: Commodity Exporters versus Noncommodity Exporters

Sources: IMF, April 2014 World Economic Outlook; and IMF staff calculations.

Note: Measured as a simple average of annual data. Commodity exporters include Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela. Noncommodity exporters include Costa Rica, El Salvador, Honduras, Mexico, and Nicaragua.

At the same time, the region enjoyed extremely favorable external financing conditions, with ample access to cheap credit, interrupted only temporarily by the 2008–09 crisis. Record low international interest rates, abundant liquidity in global financial markets, and strong risk appetite among global investors caused external spreads and interest rates to decline significantly across the region (Figure 1.6). This benefited not only sovereigns, but also private firms, which stepped up issuance of corporate bonds. Easier external financing conditions also spilled over into domestic-currency markets, fueling strong credit growth and providing further stimulus to economic activity. These two tailwinds helped propel growth and establish a virtuous cycle of strong growth, falling interest rates, and improving debt dynamics.

Figure 1.6Latin America Bond Yields and U.S. 10-Year Treasury Bond Yield

(Percent)

Sources: Board of Governors of the Federal Reserve System; and Bloomberg, L.P.

Note: Latest observation is from August 30, 2014. EMBI = Emerging Market Bond Index.

The countries were well-positioned to take advantage of these tailwinds given their cyclical position. In the early 2000s, most countries started from a position of substantial economic slack, with high unemployment rates and low labor participation rates. The favorable external environment stimulated growth without putting pressure on domestic resources.

Darker Clouds on the Horizon

All of these positive developments notwithstanding, a note of caution is in order when interpreting developments during Latin America’s “golden decade.” Much of the improvement in economic fundamentals took place during the period 2003–08. Since the global financial crisis, some of these favorable trends have been reversed, with current account and fiscal balances deteriorating in a number of countries. It appears that in the initial years of the commodity price boom, governments acted on the belief that the gains were likely to be temporary and saved part of the windfall. This prudent approach paid off during the sharp global downturn in 2009. However, as commodity prices recovered and kept rising after the crisis, governments increasingly perceived the positive commodity price shock as permanent and adjusted their spending behavior. The adoption of more accommodative policies resulted in overheating pressures and a widening of external imbalances in a number of countries during 2010–13, increasing vulnerabilities to external shocks.

More recently, the external environment has turned less favorable for Latin America’s commodity exporters. Commodity prices have softened since their peak in 2011, and are projected to moderate further in the medium term as demand from large emerging market economies (EMEs) is expected to decelerate (Figure 1.7) (IMF, 2014a). Even though prices remain high by historical standards, countries can no longer count on the tailwinds from steadily improving terms of trade. Chapter 3 finds that even if commodity prices simply stop growing and stabilize at their current levels, average output growth of Latin America’s commodity exporters would be about one percentage point lower than in 2010–12.

Figure 1.7Commodity Prices

(2005 = 100; index)

Sources: Haver Analytics; and IMF, April 2014 World Economic Outlook.

Note: Shaded area refers to projections.

At the same time, the strong tailwind from ultra-low external financing costs is also coming to an end. Long-term U.S. interest rates have started to rise, with knock-on effects for EMEs’ financing costs. After May 2013, when the Federal Reserve first raised the possibility of tapering its bond purchases, bond yields in Latin America and other EMEs increased, equity prices fell sharply, and currencies weakened (Figure 1.8). There has been renewed appetite for emerging market assets since then, and financial conditions remained fairly benign as of mid-2014. However, volatility is likely to increase again when the Federal Reserve starts to raise interest rates.4

Figure 1.8Latin America: Financial Indicators

Sources: Bloomberg, L.P.; Haver Analytics; and IMF, International Financial Statistics.

Note: Latest observation is from September 8, 2014. BOP = balance of payments; EMBI = Emerging Market Bond Index; EPFR refers to EPFR Global.

1 Simple average of Chile, Colombia, Peru, and Uruguay except for equity prices, where Uruguay is excluded.

2 Aggregate flows to Latin America. EPFR data refer to inflows into exchange-traded funds and mutual funds.

Against this backdrop, economic activity across the region has been cooling off. Growth in Latin America declined from about 6 percent in 2010 to below 3 percent in 2013, and is projected to drop further to 1.3 percent in 2014, the lowest rate in 12 years (excluding 2009). However, it would be incorrect to attribute all of the recent slowdown to external conditions. Domestic supply constraints are playing an important role in a number of countries. During the golden decade, employment growth was a major driver of economic growth, but unemployment rates already reached historical lows in many countries by 2012. There is also limited room to further increase labor force participation rates, which are already relatively high by international standards (though there is scope to raise female labor participation rates in some cases). Looking further ahead, demographic factors will become an increasing constraint on employment growth. The dependency ratio is expected to start to rise in a number of countries around 2020.

Compounding these challenges, the region suffers a serious and chronic shortage of human capital, with only a small share of the labor force occupied in high-skill professions. Poor schooling outcomes appear to be the main culprit. Indeed, the proficiency of the average Latin American student lags well behind that of peers in the rest of the world. Latin American countries have scored persistently among the weakest 20 percent in the rankings of the Program for International Student Assessment, despite levels of education spending that do not appear to be unusually low compared to other economies at similar income levels (Figure 1.9).

Figure 1.9Latin America: Structural Performance Indicators, Percentile Ranks

Sources: Organization for Economic Development, Program for International Student Assessment (PISA) (2012); World Bank (WB), Ease of Doing Business database (2013); World Economic Forum (WEF), Global Competitiveness Report (2013–14); and IMF staff calculations.

Note: The scale reflects the percentile distribution of all countries for each respective survey; higher scores reflect higher performance.

In addition, Latin America continues to have relatively low investment rates, especially compared to EMEs in Asia. As a result, many countries have inadequate physical infrastructure, including in transport, energy, and telecommunications. For example, physical infrastructure bottlenecks have been a significant constraint on activity in Brazil, while energy shortages have curbed production in Argentina and Venezuela.

These persistent challenges point to a broader gap in microeconomic reform efforts in the region. There is a clear need to improve educational outcomes, increase government efficiency, address perceptions of corruption, strengthen security, and enhance the business environment. These deficiencies did not hold back growth during the commodity bonanza, but are clearly constraining it now. With output close to potential, maintaining growth requires greater investment and productivity gains, so emphasis on enabling reforms is critical.

Meanwhile, the macroeconomic fundamentals in much of the region have weakened somewhat compared to the period before the global financial crisis. First, current accounts have widened in many countries, increasing their vulnerability to a reversal of capital flows or to adverse terms-of-trade movements. Second, a prolonged period of high credit growth and strong external corporate bond issuance may have created pockets of financial vulnerability in the private sector. Third, the fiscal stimulus put in place during the crisis was not fully withdrawn in the following years. As a result, public debt stopped declining, and even increased in a few countries.

Looking at the fiscal accounts more closely, primary public expenditure has increased steadily as a share of GDP since 2009, while the growth in fiscal revenues has started to moderate. The slowdown of revenues is likely to persist in the medium term as a consequence of weaker commodity-related revenues and lower economic growth. At the same time, pressures to raise public spending remain high, reflecting increased demands for better public services and crucial infrastructure needs. The protests in Chile, Brazil, and elsewhere in recent years are a reflection of the increased social activism of the growing middle class. In the longer term, rising interest costs and aging-related spending would further add to spending pressures. Maintaining fiscal discipline will thus be a serious challenge, requiring difficult choices.

What Should Policymakers Do?

Addressing these challenges will require a clear focus on structural reforms to boost potential growth, while preserving the gains in macroeconomic stability. It will be important to preserve credible policy frameworks, carefully calibrate macroeconomic policies, and maintain strong external and fiscal buffers to cope with adverse shocks.

Calibrating macroeconomic policies appropriately to the new reality is a priority. Even though near-term growth is projected to remain below recent cyclical highs, output is generally close to potential. Still-tight labor markets, infrastructure bottlenecks, and sizable current account deficits all suggest limited spare capacity in most of the larger countries. The analysis in Chapter 2 suggests that potential growth in the medium term will also be significantly lower than growth during the boom years. In this context, countering the current slowdown with fiscal stimulus is not warranted. A neutral fiscal stance is appropriate in countries with strong public finances and low external current account deficits, while other countries should aim for gradual consolidation to put debt firmly on a downward path. Countercyclical fiscal stimulus would be recommended only in the event of a sharp slowdown in activity amid evidence of considerable economic slack, and only for countries with sufficient fiscal space.

Monetary policy and flexible exchange rates should provide the first line of defense to cope with external shocks and cyclical downturns. As demonstrated recently, countries with low inflation and well-anchored inflation expectations retain flexibility to ease monetary policy in response to a growth slowdown even in an environment of rising global interest rates. Large international reserve positions are an additional source of strength. All of the more financially integrated countries in Latin America have sufficient reserves to provide foreign exchange liquidity if faced with disorderly market conditions. Temporary interventions to smooth excessive exchange rate volatility could also be justified in some cases, although they should not be used to defend fundamentally misaligned exchange rates or as a substitute for macroeconomic policy adjustments. Indeed, exchange rate flexibility remains a critical instrument to facilitate the rebalancing of demand in response to shocks.

Similarly, strong and proactive financial sector regulation and supervision are crucial to safeguard financial stability in the region. Banks in the more financially integrated countries generally have sound capital and liquidity ratios, good asset quality, strict limits to open foreign exchange positions, and limited reliance on external financing. However, some of these buffers may be eroded in a scenario of weaker growth and tighter financial conditions. Targeted macroprudential measures could play a greater role in reducing financial vulnerabilities. Policymakers should strive to improve the quality of information and data collected to better understand changing patterns of interconnectedness among financial and nonfinancial institutions, and to identify potential risks early. The buildup of corporate debt in recent years bears close monitoring, especially where the debt is denominated in foreign currencies. More generally, maintaining credible policy frameworks, strong balance sheets, and adequate buffers are the best insurance against market pressures.

Early planning and prudent policies are critical to cope with long-term fiscal challenges. Countries would benefit from making long-term fiscal projections an integral part of the annual budget to help anchor medium-term fiscal goals (this is especially relevant for countries that rely heavily on fiscal revenues from exhaustible resources). Fiscal income windfalls from commodity booms should be used to increase public savings and for high-return investment projects. Many countries maintain highly inefficient and expensive energy subsidies, which should be eliminated and replaced with more targeted transfers to the most vulnerable (IMF, 2014b, Box 2.3).

The most critical task is to create conditions for sustainable and steady growth in the medium term. Continued convergence to a higher income level would not only increase living standards for the average person, but would also provide the foundation for further progress on the social agenda. Output growth in the past decade was driven mainly by factor accumulation, aided by favorable financing conditions and strong demographics. To sustain high growth rates in the medium term, policymakers need to boost productivity and competitiveness through structural reforms. Scarce budgetary resources should be focused on upgrading domestic infrastructure and enhancing the quality of education. Consideration should be given to mobilizing resources where tax burdens are low. In much of the region, there is also a need to further improve the business climate and reduce barriers to entry, including reforming anti-trust frameworks. Increasing domestic savings, which are relatively low in Latin America by international standards, would also support investment and long-term growth.

Specific Challenges Facing the Less Financially Integrated Countries

Some of the large countries in the region have resisted the general trend toward stability-oriented macroeconomic policies and are now facing increasingly urgent challenges. Argentina, and particularly Venezuela, have maintained highly expansionary fiscal and monetary policies for nearly a decade, helped by strong terms-of-trade windfalls. While these policies helped improve social indicators in the past, they have clearly become unsustainable, giving rise to significant fiscal and external imbalances.

These imbalances are especially acute in Venezuela, which suffered a sharp economic slowdown and a steep rise in inflation in 2013, together with widespread shortages of basic consumer goods as a result of price controls. Tight controls on trade and the foreign exchange market have failed to ease pressure on the external accounts, and reserves have declined to very low levels, prompting the authorities to introduce a third foreign exchange market segment (where the local currency is quoted well below the official parity, though still stronger than in the informal parallel market). In this environment, Venezuela is projected to suffer a recession in 2014, with significant risks of disorderly economic dynamics.

Argentina is also projected to see negative growth in 2014, as distortionary economic policies are taking a toll on activity. The authorities responded to growing economic imbalances by allowing a depreciation of the official exchange rate in early 2014, raising domestic interest rates, and reducing the level of certain utility subsidies. They have also made fresh efforts to normalize their relationship with international creditors, including the Paris Club, although the ongoing legal conflict with holdout bondholders remains a large source of uncertainty.

Overall, the recent policy measures in the two economies are steps in the right direction, but significant imbalances and distortions remain, as fiscal policy is not on a sustainable path, real interest rates are still negative, and a sizable gap persists between exchange rates in the official and the informal market. Thus, more fundamental policy adjustments are required to restore macroeconomic stability and lock in the social gains achieved over the past decade, especially in the context of less-favorable prospects for commodity prices. In particular, fiscal policy needs to be tightened on a sustained basis to address unfavorable public debt dynamics and reduce pressures on the current account. One important area for reform is energy subsidies, which are very high, especially in Venezuela. These fiscal efforts would need to be underpinned by sufficiently restrictive monetary policy to rein in inflationary pressures, regain central bank credibility, and allow a gradual move toward a market-determined foreign exchange regime. The phasing-out of distortionary restrictions on trade, foreign exchange, and prices will have to be coordinated and managed carefully to avoid disorderly adjustment dynamics. Meanwhile, structural reforms are critically needed to raise potential growth, notably by improving the difficult business environment.

Conclusions

After a decade of impressive economic growth propelled by favorable external tailwinds, structural reforms, and good policies, Latin America is facing a more challenging period ahead. A continued rapid rise in living standards will be more difficult to achieve in an environment of flat or declining commodity prices and tighter financial conditions.

Even so, Latin America can rise to the challenge. The current environment provides an opportunity to reach consensus on targeted structural reforms that would help the region move to a new growth paradigm based on improved human capital, higher productivity growth, and more diversified and competitive economies. Policymakers in several countries are already implementing reforms in education, energy, and other sectors. More is needed, and more is possible, in Latin America’s quest to continue to improve living standards.

References

As indicated in Figure 1.4, the more financially integrated Latin American countries are defined here as Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

World Bank, Poverty and Equity Databank and PovcalNet. http://povertydata.worldbank.org/poverty/region/LAC.

See De Gregorio (2014) for a more detailed discussion.

As discussed in Chapter 10, a gradual increase in U.S. rates, driven by positive developments in the economy, should have a relatively moderate effect on Latin America, with some differences across countries. Close U.S. trading partners such as Mexico and Central America would benefit more from positive trade spillovers than would South America’s commodity exporters. Of greater concern is the risk of a pure U.S. interest rate shock, for example prompted by a rise in inflation in the United States, or a renewed bout of volatility affecting the prices of emerging market assets.

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