II. Latin American and Caribbean Outlook

International Monetary Fund. Western Hemisphere Dept.

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Author: International Monetary Fund. Western Hemisphere Dept.

Language:: English

Keywords:: REO; bank; IMF staff calculation; lending; price; commodity exporter; currency depreciation; derivatives exposure; balance of payments; financing condition; Global

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Abstract

The region is now feeling a “double squeeze” from external shocks to the capital and current accounts of the balance of payments. In tandem with worsening external conditions, the growth outlook has deteriorated considerably, and the expansionary cycle has ended abruptly. However, improved policy frameworks and balance sheets provide some cushion for many countries in the region. Key challenges ahead include managing an orderly adjustment to these external shocks, while minimizing real sector-financial sector feedback loops, and the associated output and employment losses. Room for countercyclical policies to support the outlook for countries of the Latin American and Caribbean (LAC) region depends in part on the extent of their past preparation in terms of building policy frameworks and buffers.

A “Double Squeeze” on the Balance of Payments

Downside risks highlighted in the previous REO have fully materialized. Global financial stress has turned out to be much stronger and more protracted than previously anticipated. Global trade and industrial production collapsed in late 2008, with the global economy projected to contract by around 1½ percent in 2009, the weakest performance in 60 years. Moreover, the process of deleveraging in advanced economies has continued, now with significant spillover to emerging markets. At the same time, commodity prices have fallen sharply from record highs in mid-2008.

Global shocks are working their way through the LAC region through several channels: (i) a tightening of external financing conditions, (ii) lower demand for regional exports, (iii) a severe drop in the terms of trade, and (iv) weaker remittances and tourism prospects. These shocks combined amount to a double squeeze in the capital and current accounts of the balance of payments.

As presented in the previous REO, we consider three main subgroups of countries to analyze the LAC outlook: (i) net commodity importers, (ii) inflation-targeting commodity exporters, and (iii) other commodity exporters. These groups of countries differ not only in their exposure to commodity shocks but also in their policy frameworks and other characteristics (Box 2.1).

Box 2.1.

LAC Country Groupings

In analyzing the outlook, we group the countries in the region to capture their different exposure to terms-of-trade shocks. The first distinction is made between net commodity importers and net commodity exporters. Among the net commodity exporters, we also distinguish between those that have implemented inflation-targeting regimes and those that have not.

Net commodity-importing countries, primarily in Central America and the Caribbean. These countries had suffered from the run-up in fuel and food commodity prices in recent years—and more recently benefited from declines in those prices. Their external financial linkages are generally limited.
Net commodity exporters with inflation-targeting regimes (Brazil, Chile, Colombia, Mexico, and Peru, which account for two-thirds of the region’s GDP). These countries more generally follow rules based macroeconomic policies, but will be referred to as inflation-targeting countries for simplicity. These five countries had experienced sizable—though not extreme—terms of trade gains until mid-2008, but since then have been exposed to the commodity price fall. They also tend to have more developed capital markets and are more linked to global financial markets, with access to those markets on relatively favorable terms. For example, just prior to the global financial turmoil that erupted in September 2008, sovereign spreads in these countries were only about 225 basis points, on average.
Other net commodity exporters without inflation-targeting regimes, primarily the energy exporting countries. These countries had experienced very large terms of trade gains over the past five years, and correspondingly have experienced the most significant drop in the terms of trade since mid-2008, driven especially by falling fuel prices. Even so, their terms of trade are expected to remain much better than earlier in this decade. In general, these countries are less integrated with global financial markets.

Tight external financial conditions

The global financial crisis has undoubtedly spilled over to emerging markets. As illustrated in the global financial “heat map,” the first indications of financial stress in advanced markets appeared in mortgage-backed securities in early 2007, but quickly spread to other financial institutions.¹ By late 2008, global financial shocks visibly affected emerging markets. A heat map for the major economies in the LAC region points to financial stress in all asset classes starting in the third quarter of 2008, and particularly acute stress for currencies, corporate spreads, and sovereign credit default swap (CDS) spreads.

LAC sovereign spreads shot up in October 2008 and have remained elevated since then. Volatility has also increased significantly. The movement of spreads has been quite similar to that of other regions; our statistical analysis suggests that global financial developments explain most of this rise (Annex 2.1). At the same time, the strong precrisis differentiation of spreads across countries has been preserved—in fact the dispersion of spreads has widened substantially.

Still, since the global financial crisis began in 2007, Latin sovereigns have broadly managed to satisfy their borrowing needs, though the reliance on foreign bond markets has at times been replaced by domestic bonds, a return to foreign bank borrowing, and lending from multilateral institutions. There was some resumption of external issuances by a few of the higher-rated sovereigns in the region in early 2009: Brazil, Colombia, Mexico, Panama, and Peru were able to tap global capital markets at manageable rates, helped by the low yield on long-term U.S. bonds.

The impact of the crisis on private firms’ financing has been more severe. LAC firms’ external bond spreads have roughly doubled since October, also driven mainly by external developments. With the onset of the U.S. housing finance crisis, issuances by firms in the form of syndicated loans and bonds placed abroad started to decline (Annex 2.2). And by the end of 2008, foreign bond markets were effectively closed to Latin American firms, an apparent “sudden stop.” In early 2009, some investment grade corporations regained access to international markets.

Lower external demand overall

While the LAC region is not as reliant on foreign trade as other regions, trade linkages are now an important channel of transmission of the global recession to the region; the recent drop in global trade has been severe and is affecting all LAC countries trading partners. The region as a whole continues to be most strongly exposed to trade shocks through linkages to the United States, notwithstanding an increase in trade within the region, and also with Europe and China over the past few years (Annex 2.3). However, amid a global downturn, even those countries with more diversified export destinations—such as Brazil—are feeling the pinch.

Reversal of the commodity boom

Commodity prices have declined sharply from their peaks in mid-2008. Oil, aluminum, and copper prices have experienced the largest drops. Food commodity prices have also gone down by an important margin. Overall, the commodity prices that are relevant for the LAC region’s net exports are expected to drop in 2009, by over 33 percent compared with 2008, and to recover by only about 3 percent in 2010.²

The fall in commodity prices constitutes a considerable terms of trade loss for the region as a whole. As discussed later, this has significant implications for fiscal and external positions. However, there is heterogeneous impact within the region, with nearly all countries in Central America and the Caribbean in fact benefiting from falling commodity prices.

Weak remittances and tourism prospects

In line with the deceleration in advanced economies, there has been a notable decline in remittances and tourism receipts, two important sources of foreign exchange income for many countries in the region.

Remittances to the LAC region grew at an average of more than 15 percent per year since 2000, but started to decelerate in mid-2006. As the global downturn deepened, the deceleration became even more drastic (Annex 2.4). Remittances to several countries are already contracting. In some cases (e.g., Colombia, Mexico), large currency depreciations in late 2008 have cushioned or offset the decline in the dollar value of remittances, although this gain is being eroded by the ongoing decline in dollar inflows.

The severe and protracted recession in the United States represents a serious risk to the outlook for remittances, given that about 80 percent of the total come from the United States. Other economies that are important sources of remittances—e.g., Spain, for remittances to Bolivia and Ecuador—are also slowing. Countries in Central America are particularly affected, as remittances account for a significant share of GDP.

Tourism has also been affected by the global crisis, weighing down on economic prospects for the Caribbean countries in particular. After an uptick in the first half of 2008, tourist visits to the Caribbean are estimated to have fallen by about 5 percent during the second half of the year. It is expected that tourism receipts will decline substantially more in 2009, also leading to a significant drop in tourism-related construction, and weakening employment and growth. This will exert pressure on fiscal positions in many Caribbean countries and reduce foreign exchange inflows (Annex 2.5).

Ongoing Adjustment

The effect of the global shocks on the region’s economic activity has been sudden and significant. Growth was resilient through the third quarter of 2008, but decelerated rapidly by end-2008 as the global financial crisis spread to the region. On a quarter-on-quarter basis, growth was negative in several countries by end-2008, with annualized rates of decline in the double digits in some cases (e.g., Brazil, Mexico). Both external and domestic demand showed substantial contractions. Available indicators for early 2009 suggest that the downturn is continuing. Industrial production growth, already in negative territory for many countries in 2008, has contracted further. There has also been a sharp drop in exports and imports.

Weakening growth prospects have been reflected in equity markets. In close synchronization with other regions, the bulk of losses in stock prices in the LAC region occurred abruptly, in September–October of 2008. Still, the region shows a cumulative outperformance over other regions, with equity prices somewhat above January 2006 levels.

This has been accompanied by a continued slowdown in credit growth to the private sector, reflecting both a reduction in the supply and the demand for credit given the uncertain macroeconomic environment. Anecdotal evidence in several countries (Dominican Republic, Brazil, Chile, Mexico) suggests that with more difficult access to foreign financing, domestic banks have been called on to provide additional funding to better-rated firms. Were this to become a generalized trend, the deleveraging process would more seriously affect smaller firms and, possibly, households. Moreover, Bank for International Settlements (BIS) data available up to end-2008 already shows a slowdown in total lending growth to the region by foreign banks—especially cross-border financing from parent banks located in advanced economies, as well as lending by their local affiliates in the region. This reflects, in part, liquidity strains in global interbank markets and financial stress in banks’ balance sheets in their home markets.

Importantly, in contrast to other regions, there have been no widespread episodes of distress in LAC financial systems so far. Aggregate financial soundness indicators suggest that Latin American banks are on average solvent and profitable, with systemwide capital and liquidity cushions that will help them weather some financial turmoil. Moreover, although funding costs shot up in a number of countries’ interbank markets in the fourth quarter of 2008, they have declined since then. Major strains did emerge in the case of two financial institutions in the Caribbean,³ in one case leading to contagion in neighboring countries.

Financial systems in the LAC region may face further stresses, as financial shocks continue to play out and borrowers experience the full effects of real shocks. Chapter 3 explores the sources of financial stress arising from the worsening international environment, highlighting the implied policy and regulatory challenges. Chapter 4 considers whether the international banks that are active in the LAC region could transmit the credit crunch in advanced countries to the region.

Amid slowing demand and the reversal of global shocks to commodity prices, inflation pressures are subsiding in most countries in the region. Annual LAC inflation peaked in October 2008 at 8.9 percent and had declined to around 7½ percent by March. Two of the officially dollarized countries (El Salvador and Panama) showed the fastest pace of disinflation, in line with trends in the United States. In the inflation-targeting countries, where inflation rates have been the lowest, inflation declined by about 1 percentage point through March, and in commodity-importing countries by 5 percent.

The abrupt worsening of the external environment has also affected government revenues. In general, tax revenues are stagnating or declining given the slowdown in economic activity. In some countries, the fall in commodity export prices has also sharply reduced fiscal revenues (with strong direct effects in countries with state ownership of exporting companies, but also where tax revenues are heavily dependent on commodities). For some governments, however, the fiscal revenue loss has been tempered by substantial depreciations of the real exchange rate.

These effects are squeezing government balances at a time of more difficult financing possibilities. The loss of external revenue is particularly troublesome; unlike a cut in domestic taxes, this loss plays no countercyclical role. Moreover, many LAC economies had grown accustomed in the commodity boom years to a strong fiscal impulse, with rapid growth rates of primary government expenditure. In the group of other commodity exporters, for example, primary expenditures jumped from about 26 percent of GDP in 2005 to 32 percent of GDP in 2008.

The adjustment in external current accounts has been very heterogeneous within the region:

In the inflation-targeting commodity exporters, previous trends had continued through mid-2008: external current accounts weakened further, on account of declining trade balances, but also due to rising profit and dividend repatriation by foreign firms. However, trends were broken in the second half of 2008: after years of strong growth, trade surpluses turned into deficits (in part from lower commodity prices, but also in line with the global decline in export demand). There was also a slowdown in profit and dividend repatriation. Overall, current account balances in these countries deteriorated moderately, but with a very different composition than previously. In early 2009, there were signs that trade balances were improving in several countries.
Reflecting the much larger terms-of-trade loss, current account surpluses have fallen sharply, or vanished, for the non-inflation-targeting commodity exporters.
Commodity importers, in contrast, have seen improvements in their external current account balances, especially from reduced energy import bills. So far, this gain has offset the drop in remittances and tourism receipts.

The region experienced net financial outflows in the last quarter of 2008, with some loss of international reserves. FDI inflows held steady, but there was a marked reversal of non-FDI inflows. In Brazil, Chile, and Mexico, such inflows had kept coming through the third quarter, but in the final quarter, foreigners began exiting such investments, in sizable amounts. This was not the whole story, however: residents of Brazil, Chile, and Mexico also stopped accumulating assets abroad, and brought funds back home, helping to cushion the large external financing shock.

The social impact of the global crisis is becoming visible. Following an extended period of decline, unemployment has started to rise in several countries, with record employment losses in late 2008 in some cases. The effect has been likely more prominent in informal labor markets. Unemployment benefit schemes have low coverage in many LAC countries, leaving many households unprotected when employment is being cut. (This also limits the automatic effects of rising unemployment on public expenditures.) Elevated food prices, until the third quarter of 2008, coupled with the slowdown in economic activity by the end of the year, have also held back the pace of poverty reduction. Regarding the “inflation tax” more broadly—which tends to fall hardest on the poor—there has been some decline in the past two quarters, but inflation rates remain quite elevated in a number of countries. Finally, because remittances are especially important to low-income households, the decline in remittances will likely have adverse consequences on poverty.

Policy Responses Thus Far

Governments throughout the region have reacted quickly to external developments, in many cases changing the direction of macroeconomic policies to support economic activity. In contrast to previous episodes, there has been no major effort to defend or support exchange rates by tightening interest rates (except in Jamaica). On the contrary, a number of central banks have started the easing cycle, in some cases quite aggressively.

Liquidity provision

Countries have adopted extraordinary measures to ensure the normal functioning of financial markets. These have included liquidity support to ensure orderly money markets (Argentina, Brazil, Chile, Costa Rica, Colombia, Guatemala, Mexico, Peru); widening the scope of institutions with access to the discount window (Brazil, Costa Rica, Mexico); easing reserve requirements (Argentina, Brazil, Colombia, Dominican Republic, Honduras, Paraguay, Peru); and supporting external refinancing needs of the corporate sector through the use of international reserves (Brazil) and access to the Fed swap line (Mexico). For the inflation-targeting countries, these actions have complemented the flexibility cushion provided by movements in the exchange rate.

Flexible exchange rates: key shock absorber in some countries

The global financial shock quickly induced significant depreciation in several currencies. Currencies in the inflation-targeting commodity exporters had appreciated considerably through mid-2008 with respect to the U.S. dollar. This trend quickly reversed in the last quarter of the year, with depreciations that were larger, and more abrupt, than elsewhere in the region (though broadly similar to depreciations seen in other regions). In addition, currencies were allowed to depreciate by some 20 percent in countries such as Argentina and Jamaica, albeit more gradually.

By letting their currencies adjust to changing conditions, these countries did not experience major losses in their international reserves—even as foreign investors sought to withdraw from emerging markets in general, in favor of securities issued by governments of advanced economies. For example, it appears that much of the reduction in foreign investors’ portfolios allocated to Brazilian and Mexican assets occurred through large valuation changes, rather than through capital outflows.

Nevertheless, most central banks changed their policies for accumulation of international reserves and foreign exchange market intervention to dampen depreciation pressures and avoid excess currency volatility. After several years of strong buildups, reserves abruptly changed direction. Even Mexico—which had avoided discretionary intervention for a decade—changed course in October 2008. A number of countries also implemented other forms of intervention (e.g., Brazil, with forward market and similar operations).

Where large nominal depreciations occurred, these do not seem to have triggered major financial instability. This speaks to the improvement in balance sheets that has taken place in recent years, particularly in the composition of public debt, giving some countries the ability to weather depreciation without major strains. In some countries, the private sector has also reduced its exposure to exchange rate risks. However, some adverse surprises emerged—notably in Brazil and Mexico, where some large firms took undue risks in the foreign exchange derivatives market and experienced large losses (Box 2.2).

Box 2.2.

Corporate Sector Exposure to Foreign-Currency Derivative Contracts in Brazil and Mexico

Recent losses on currency derivatives held by firms in Mexico, Brazil, and other emerging markets have been one of the unwelcome surprises of the global financial crisis. Over the past decade, listed firms in Latin America have in general reduced their vulnerability to exchange rate risk by substantially lowering on-balance-sheet currency mismatches (IMF, 2008). However, the financial turbulence in October 2008 revealed substantial off-balance-sheet currency exposures associated with speculative derivative positions in a number of large corporations in Brazil and Mexico. In Chile and Colombia, on the other hand, there were no reports of significant corporate losses tied to off-balance-sheet activities during this period.

Currency derivative exposures often involved currency options. In Brazil and Mexico, some firms entered into complex option structures, either as an outright bet against depreciation of the domestic currency or to profit from the positive differentials between local interest rates and generally lower U.S. dollar interest rates (similar issues arose in India, Poland, and Korea). Many of the resulting positions had nonlinear payoff structures whereby losses accumulated more rapidly after local currencies depreciated past a certain strike price. While these transactions were profitable when the domestic currency was appreciating, or as long as exchange rates did not fluctuate too much, large losses mounted when the currencies depreciated sharply following the global risk repricing of late 2008.¹

The size of companies’ losses is difficult to ascertain, but in Brazil and Mexico it was large enough to prompt a significant response from the central banks. Exposure to currency risk through derivatives led to financial stresses and threatened to trigger a potential amplification of currency depreciation, as firms increased their demand for dollars when asked by their counterparties for additional collateral to cover their mark-to-market losses. For instance, in Mexico, the large losses on currency positions, and resulting extraordinary demand for dollars, prompted the central bank to intervene in a discretionary manner in the foreign exchange market for the first time in a decade, and sell through auction about 10 percent of its international reserves in a three-day period. The special intervention measure was aimed at meeting an exceptional demand for dollars that had resulted from the derivatives losses and the closing out of derivative positions, rather than at trying to prevent a depreciation of the domestic currency. In Brazil, the central bank sold dollar futures contracts to help affected corporations hedge or unwind their positions, and to help reduce market volatility.

The sharp drop in firms’ stock prices following their disclosure of derivative losses provides robust evidence that the exposure to derivatives was “news” to the markets. Our results for Mexico, for example, suggest that for most of the firms that reported the biggest derivative losses, the market priced a positive stock market exchange rate exposure (i.e., nominal share values have tended to rise with a domestic currency depreciation) before the October crisis.²

Supervisors as well as the public need more detailed information on the exposures of nonfinancial corporations to derivative positions. The global crisis revealed gaps in financial data disclosure and the understanding of underlying risks. Financial activities by nonfinancial corporations expanded in areas such as offshore derivative contracts with limited disclosure requirements or enforcement, leaving regulators unable to assess risk concentrations. The surprises in the exposure of Brazilian and Mexican firms to currency derivatives, and the reaction of currency markets and the central banks, illustrate the potential macroeconomic consequences of insufficient information on the financial activities of the corporate sector.

The recent episodes in Brazil and Mexico also exposed problems with financial risk management at the firm level. Derivative losses were also caused by varying combinations of governance failures at the firm level (poor risk management) and lack of appropriate disclosure from suppliers of instruments (banks that did advise options buyers of the embedded risk). Authorities should be aware of the skewed incentives generated by low-volatility environments, and the potential for banks and their clients to overreach in tranquil times and take too many risks.

In the future, supervisors in countries with significant over-the-counter (OTC) derivatives markets could improve the transparency and disclosure of information of these operations. Financial institutions operating in these markets could report these transactions more frequently and include more detailed information on instruments and counterparties. There may also be clear advantages to encouraging exchange trading of derivatives to reduce counterparty risk and enhance transparency. In particular, there may be benefits to requiring nonfinancial publicly traded corporations to report their derivatives exposures undertaken in offshore markets, which in the past have not been monitored systematically by regulators. Such measures would help assess any buildup of systemic risks associated with derivative trading. It would also strengthen market discipline, helping final investors perform some of the due diligence currently outsourced to rating agencies.

Some country authorities are already moving in this direction. For instance, in Brazil the central clearinghouse for OTC transactions (CETIP) recently announced a project to expand and organize data being collected to allow better analysis and risk monitoring. In addition, the securities regulator (CVM) has requested that large firms submit notes in their financial statements showing derivatives positions, along with scenario analysis of the impact of adverse developments. These are expected to become formal reporting requirements. In Mexico, the monitoring of firms’ derivative positions has been substantially strengthened. Supervisors are monitoring onshore OTC derivative trading on a transaction-by-transaction basis and are seeking to broaden the coverage of offshore transactions. The authorities are also considering creating a central credit registry to record all OTC transactions subject to both market and credit risk.

Estimated Losses from Foreign Currency Derivative Positions 1/

Sources: Bloomberg L.P.; quarterly financial reports for Mexican firms; and Reuters.

^{^1/}Reported in the fourth quarter of 2008. Estimates for Brazilian firms based on press reports.

Estimated Losses from Foreign Currency Derivative Positions 1/

Firm		In millions of US dollars	In percent of total assets
Mexican firms
	Comerci	2,200	60
	Cemex	911	2
	Gruma	852	27
	Vitro	358	15
	Alfa	194	2
	GISSA	161	34
Brazilian firms
	Sadia	2400	41
	Aracruz Celulose	2100	42
	Grupo Votontarin	1000	55

Sources: Bloomberg L.P.; quarterly financial reports for Mexican firms; and Reuters.

^{^1/}Reported in the fourth quarter of 2008. Estimates for Brazilian firms based on press reports.

Estimated Losses from Foreign Currency Derivative Positions 1/

Firm		In millions of US dollars	In percent of total assets
Mexican firms
	Comerci	2,200	60
	Cemex	911	2
	Gruma	852	27
	Vitro	358	15
	Alfa	194	2
	GISSA	161	34
Brazilian firms
	Sadia	2400	41
	Aracruz Celulose	2100	42
	Grupo Votontarin	1000	55

Sources: Bloomberg L.P.; quarterly financial reports for Mexican firms; and Reuters.

^{^1/}Reported in the fourth quarter of 2008. Estimates for Brazilian firms based on press reports.

Note: This box was prepared by Herman Kamil and Chris Walker.¹ Some exporting firms hedged as part of their business operations, but had large losses on their derivative positions given the extraordinary spike in exchange rates.² To gauge a firm’s overall foreign currency exposure as priced by the market, we estimated the contemporaneous impact of exchange rate movements on a firm’s stockmarket valuation over the three-year period preceding the financial turmoil in October 2008. If all information is priced efficiently, stock prices’ sensitivity to exchange rate fluctuations should, in principle, summarize the multiple channels through which exchange rate fluctuations can affect firms’ value.

Real effective exchange rates (REERs, which are trade weighted) have diverged strongly across countries, even moving in opposite directions. Since August 2008, some countries have had strong REER depreciations, especially Brazil, Chile, Colombia, Jamaica, and Mexico, reflecting mainly nominal depreciations against the U.S. dollar mentioned earlier. At the same time, some countries experienced REER appreciations, as the currencies of their trading partners depreciated against the U.S. dollar, or as a result of ongoing higher rates of domestic inflation.

Monetary policy easing

As economic activity and inflation pressures began to recede, monetary authorities in many countries shifted into an easing cycle. Policy rates were cut in all the inflation-targeting countries, with Colombia beginning the loosening phase in December 2008 with a 50 basis point (bp) cut, and Chile delivering the largest cut so far (650 bps through April). Monetary conditions were also relaxed in other countries (Dominican Republic, Honduras, Paraguay, Venezuela), though in some cases inflation remains elevated. Monetary conditions have been tightened in only a few countries, owing to their particular macroeconomic circumstances. For instance, in Jamaica, interest rates and reserve requirements were raised to alleviate pressures on the exchange rate.

In the inflation-targeting countries, sharp exchange rate depreciations and a jump in exchange rate volatility initially raised concerns of potentially large upward effects on inflation and inflation expectations. However, such strong effects have not materialized—in sharp contrast to past experiences with large and abrupt depreciations. Enhanced credibility in maintaining the mandate of low inflation, along with reduced exposure to foreign currency debt, has contributed to this outcome. The fast and widespread contraction in demand was also a significant factor, likely reducing markups and countering upside inflation pressures from exchange rate pass-through.

Monetary Policy Decisions in Selected LAC Countries 1/

Sources: Central banks.

^{^1/}Since October 2008.

^{^2/}TFFC stands for temporary lending facility in foreign currency and TFLC stands for temporary or new lending facility in local currency.

^{^3/}Brazil and Mexico established a U.S. dollar swap facility with the U.S. Federal Reserve for up to US$30 billion.

Monetary Policy Decisions in Selected LAC Countries 1/

Country	Interest Rate	Reserve Req.	Discount Window	Foreign Exchange	Other
Commodity Importers
Costa Rica	+	…	TFLC	Widening of band	…
Dominican Republic	–	–	…	…	…
Guatemala	–	…	…	Change in intervention rules	…
Honduras	–	–	…	…	…
Jamaica	+	+	TFFC	…	…
Inflation Targeting Commodity Exporters
Brazil	–	–	TFFC, TFLC 2/	Intervention in the spot market	FED SWAP 3/
TFFC, Chile	–	…	TFFC, TFLC 2/	Suspension of USD purchases	…
Colombia	–	–	…	Suspension of USD purchases	Support to foreign credit lines
Mexico	–	…	TFFC, TFLC 2/	Change in intervention rules	FED SWAP 3/
Peru	–	–	TFLC 2/	Intervention in the spot market	…
Other Commodity Exporters
Argentina	–	–	Broader access to discount window	Intervention in the spot and forward markets	…
Bolivia	…	…	…	Change in intervention rules	…

Sources: Central banks.

^{^1/}Since October 2008.

^{^2/}TFFC stands for temporary lending facility in foreign currency and TFLC stands for temporary or new lending facility in local currency.

^{^3/}Brazil and Mexico established a U.S. dollar swap facility with the U.S. Federal Reserve for up to US$30 billion.

Monetary Policy Decisions in Selected LAC Countries 1/

Country	Interest Rate	Reserve Req.	Discount Window	Foreign Exchange	Other
Commodity Importers
Costa Rica	+	…	TFLC	Widening of band	…
Dominican Republic	–	–	…	…	…
Guatemala	–	…	…	Change in intervention rules	…
Honduras	–	–	…	…	…
Jamaica	+	+	TFFC	…	…
Inflation Targeting Commodity Exporters
Brazil	–	–	TFFC, TFLC 2/	Intervention in the spot market	FED SWAP 3/
TFFC, Chile	–	…	TFFC, TFLC 2/	Suspension of USD purchases	…
Colombia	–	–	…	Suspension of USD purchases	Support to foreign credit lines
Mexico	–	…	TFFC, TFLC 2/	Change in intervention rules	FED SWAP 3/
Peru	–	–	TFLC 2/	Intervention in the spot market	…
Other Commodity Exporters
Argentina	–	–	Broader access to discount window	Intervention in the spot and forward markets	…
Bolivia	…	…	…	Change in intervention rules	…

Sources: Central banks.

^{^1/}Since October 2008.

^{^2/}TFFC stands for temporary lending facility in foreign currency and TFLC stands for temporary or new lending facility in local currency.

^{^3/}Brazil and Mexico established a U.S. dollar swap facility with the U.S. Federal Reserve for up to US$30 billion.

Composition of Fiscal Stimulus Packages

Sources: National authorities, and IMF staff calculations.Note: T: temporary measures (with explicit sunset provisions or time-bound spending).S: self-reversing measures (costs are recouped by compensatory measures in future years).P: permanent measures (with recurrent fiscal costs).

^{^1/}Does not include the cost of support through public banks.

Composition of Fiscal Stimulus Packages

Action	Argentina	Brazil	Chile	Mexico	Peru
Expenditure
Infrastructure investment	T	T	T	S	T
Support to SME and/ or farmers	T	T	T	S	T
Safety nets	T		T		T
Housing/construction sector	T	T	T	S
Increase in public wage bill
Other			T
Revenue
Corporate Income tax		T	T		T
Personal Income tax	P		T
Indirect tax		T	T	T	T
Other
Estimated budget cost for 2009
(Percent of GDP) 1/	1.5	0.6	2.9	1.5	2.0

^{^1/}Does not include the cost of support through public banks.

Composition of Fiscal Stimulus Packages

Action	Argentina	Brazil	Chile	Mexico	Peru
Expenditure
Infrastructure investment	T	T	T	S	T
Support to SME and/ or farmers	T	T	T	S	T
Safety nets	T		T		T
Housing/construction sector	T	T	T	S
Increase in public wage bill
Other			T
Revenue
Corporate Income tax		T	T		T
Personal Income tax	P		T
Indirect tax		T	T	T	T
Other
Estimated budget cost for 2009
(Percent of GDP) 1/	1.5	0.6	2.9	1.5	2.0

^{^1/}Does not include the cost of support through public banks.

Fiscal policies are also playing a role

In the inflation-targeting countries, the authorities have announced transitory and targeted fiscal stimulus packages, with budget costs in 2009 ranging from 0.6 percent of GDP in Brazil to 2.9 percent of GDP in Chile. Several countries are also implementing stimulus plans through guarantees and loans to public development banks, which are not classified as government expenditure. In the case of Brazil, these measures amount to 3.5 percent of GDP over 2009–10.

With falling revenues, fiscal balances weakened in most countries in the last two quarters of 2008. Cuts in primary expenditure have been the exception, occurring only in a few countries where financing realities clearly left governments with few options. More typically, governments have begun to actively raise expenditure, with a view to having some countercyclical impact (including in Bolivia, Costa Rica, Paraguay).

A number of countries also have widened the coverage of social programs to ameliorate the effects of rising unemployment. Measures have included widening the coverage of or introducing unemployment insurance (Antigua and Barbuda, Brazil), a subsidy for youth employment (Chile), health benefits for the unemployed (Mexico), and increases in income transfers or targeted cash programs (Antigua and Barbuda, Argentina, The Bahamas, Brazil, Chile, Costa Rica, Dominica, El Salvador, Guatemala, Honduras, St. Lucia).

Relative to some countries in other regions, the overall “cost” of announced policies in response to the economic downturn has been modest. This reflects in part the absence of massive bank bailouts, and the still limited quasifiscal cost from credit guarantees by development banks. It also reflects governments’ assessment of the limits on the availability of financing to pursue fiscal stimulus on a grander scale.

Economic Outlook and Risks

A significant markdown in growth. . .

For 2009, LAC output is expected to contract by 1½ percent, following growth of about 4½ percent in 2008. The slowdown is projected across the board, being more pronounced for the region’s commodity exporters and for economies with the strongest manufacturing ties to global industrial production chains. This is a sharp markdown from the previous forecast in the October 2008 REO, despite new monetary and fiscal stimulus in the pipeline. However, this suggests relatively good performance for the region compared with the past. While in previous global recessions the decline in LAC growth was generally more abrupt than in the rest of the world, this time around LAC growth is expected to decline at the same pace as global growth. This speaks to the improvements in policy frameworks and the buildup of resilience in recent years. Indeed, IMF staff analysis suggests that, absent these improvements, the decline in growth would have been even more significant (Box 2.3).

Box 2.3.

Why Do Bad Things Still Happen to Resilient Economies?

In this decade, many LAC countries made important progress in improving their resilience to external shocks. Such progress—in terms of improved policy frameworks and balance sheets, and greater credibility—has been widely recognized, including in previous REOs, and also by financial markets.

The current global crisis represents the first big test of whether this perceived buildup in resilience can bring real benefits. However, assessing this question is not a simple matter of observing whether countries have maintained growth, since the size of the current shocks has been unusually large, and moreover has varied substantially across countries.

In fact, both the nature and the size of the shocks affecting different economies in the region have varied, with some of the countries that have improved their policy frameworks being hit particularly hard in the current crisis.

First, a key factor has been the degree of a country’s capital market development and integration with global financial markets. In particular, the global deleveraging process has hit countries with larger and more liquid markets, such as Brazil and Mexico, more quickly than others. Second, manufacturing has taken a toll worldwide, and economies with larger shares of manufacturing in their production structures tended to show deeper contractions in overall GDP in the last quarter of 2008.¹ In addition countries with stronger ties to the United States have been naturally more exposed. Mexican GDP in particular tends to move closely with industrial production in the United States, which recently has contracted at double-digit rates.² Finally, commodity exporters have suffered more than commodity importers.

The large size of recent external shocks underscores the value of the gains in countries’ preparedness and resilience, to mitigate the output losses and prevent a bad situation from becoming much worse. A clear sign—and an important benefit—of those gains has been the steady relative improvement in this decade of several countries’ external financing conditions. During the 2001 dot-com crisis, sovereign spreads for Brazil, Colombia, Peru, and (to a lesser extent) Mexico tended to follow those of U.S. high-yield corporate bonds, which are highly volatile and indeed now exceed 1,500 basis points. However, by the time of the current crisis, these countries had uncoupled from that risky asset class, and their bond spreads moved down, becoming much closer to those of the more stable U.S. investment grade bonds, and recently even below that level.

Thus, while all EM countries—and private companies, around the world—suffered tighter financing conditions after the Lehman Brothers’ event, the shock to Brazil, Colombia, Mexico, and Peru was much less than it would have been if they had not achieved fundamental improvements in the credibility of their policy frameworks. (A number of other LAC countries also achieved important degrees of uncoupling in recent years; in the case of Chile, sovereign spreads already had uncoupled from “high yield” spreads by the time of the 2001 crisis.) In turn, such gains in credibility have made feasible the implementation of countercyclical policies in the current episode.

More broadly, if these countries had not reduced vulnerabilities and strengthened policy frameworks over the years, it is very likely that the impact of global shocks on their output growth would have been more severe than has been the case. To illustrate this point, we estimated the BVAR model for the five countries mentioned above (the LAC5) on different time periods: 1994–2002 and 1994–2008. During the first subperiod, these countries were still in the process of implementing key macroeconomic reforms, whereas the longer sample period is able to capture more of the buildup of resilience in this decade. The exercise highlights two essential points. First, recent external shocks indeed have been larger in the most recent period than in the past. Second, the sensitivity of these countries’ output to external shocks has diminished in recent years. For example, while a shock to world demand of 1 percent would have led to a reduction of almost 2 percent in LAC5 growth during the “pre-resilience” period, the same shock would be expected to reduce growth by significantly less today. The same kind of result is found also for shocks to external financial conditions and for shocks to commodity prices.

In sum, a number of countries in the region that have built resilience have been hit hard during the current global financial crisis as a result of their external shocks being especially severe. However, absent the significant improvements in policy frameworks, balance sheets, and credibility, these economies likely would have faced larger output losses.

Size of External Shocks 1/

(Quarterly percent change, except where noted)

Source: Merrill Lynch and IMF staff calculations.

^{^1/}Standard deviation of residuals in BVAR model

Response of LAC-5 Output to a One Percent Negative Shock to External Variables 1/

(Year-on-year growth rate four quarters after the shock)

Sources: Merrill Lynch and IMF staff calculations.

^{^1/}Except for commodity prices, where a 10 percent shock is assumed. Countries include Brazil, Chile, Colombia, Mexico, and Peru.

Note: This box was prepared by Herman Kamil and Steve Phillips.¹ In a worldwide sample of about 40 countries, the share of advanced manufacturing in GDP can explain almost half of the variation in GDP growth performance in 2008Q4 (see Asian and Pacific Regional Economic Outlook, May 2009).² See Sosa (2008) for a detailed analysis of Mexico’s comovements with the U.S. real sector. Chiquiar and Ramos-Francia (2005) have documented an increase in the degree of synchronization of Mexican and U.S. cycles.

We project LAC growth will rebound to about 1½ percent by 2010, in line with global growth but at a faster pace than in advanced economies. This is supported by the absence of systemic banking problems in the region, which would allow LAC economies to resume growth more quickly than in regions where severe problems persist in the financial sector. In addition, the greater scope for countercyclical policies, including to sustain public spending on infrastructure and social safety nets, would support growth going forward. Overall, output losses from the current crisis would amount to several percentage points of the region’s GDP over 2009–10.⁴

Still, the current crisis is likely reducing medium-term growth prospects in the LAC region as well as in other regions. Historically, recessions that are highly synchronized across countries, as the current one is, have been longer and deeper than those confined to a single region. Potential growth may also be affected, given the lasting damage on labor markets and the productive capital stock, particularly as supply chains need to be rebuilt. This underscores the importance of advancing the structural reform agenda of the region.

. . .still with downside risks. . .

The global crisis represents an unprecedented combination of negative shocks for the LAC region since the 1930s. To assess the impact of external shocks, the regional BVAR model for the LA6 countries was updated.⁵ The model captures real and financial linkages with the global economy, and allows a quantification of shocks to international financial conditions, external demand, and commodity prices. In the past, these external factors have been able to explain about 50–60 percent of the medium-term variance in growth of the LA6 economies.

As rules of thumb, the model suggests that a shock to trade partner growth of 1 percent reduces regional growth by about 1½ percent, including lagged effects after four quarters; a 10 percent drop in commodity prices reduces regional growth by about 0.7 percentage point; and tighter external financial conditions, proxied by a 100 bp increase in the U.S. high-yield spread, are estimated to reduce growth by about 0.8 percentage point.

Overall, downside risks continue to be important in the global and LAC growth outlooks. Upside risks to global growth are possible, but concern remains that policies may be insufficient to break the negative feedback loop between real activity and financial conditions. In this context, the WEO considers a downside scenario for the world economy, with growth being –1.7 percent lower than in the baseline. Conditioning the region’s forecast on this lower global growth, LA6 growth in 2009 would decline to –3 percent, compared with –1.5 percent in the baseline. This alternative scenario incorporates the impact of lower global growth on commodity prices and on international and domestic financial conditions.

. . .and inflation declining further

The widening output gap and falling commodity prices will help ease inflation pressures throughout the region, and in most countries inflation will decline. For the region as a whole, inflation in the baseline scenario is projected to fall by about 2 percentage points, to about 6 percent in 2009. In a majority of countries, inflation is expected to reach the authorities’ objectives by the end of 2009. However, in some cases, inflation is still expected to remain well in the double digits and even to accelerate further.

Fiscal positions and external balances likely to weaken

Sharply decelerating economic activity, trade volumes, and much-reduced commodity prices are taking a toll on LAC fiscal revenues. Coupled with a pickup in discretionary spending in some countries, this will weaken the primary fiscal surplus of the region, from around 3 percent of GDP in 2008 to about 0 percent in 2009 (with much of this decline coming from the revenue side, especially in commodity-exporting countries).

But there will be major differences within the region. For some countries, real expenditure is expected to grow in excess of potential output, providing stimulus to demand. This group includes Chile, for example, where real primary government expenditure is projected to grow by over 15 percent in 2009, supported by drawdown of wealth funds that were accumulated during the commodity boom years. At the other end of the spectrum, real expenditures are projected to be cut in Ecuador and Venezuela by about 10 percent.

The external current account balance for the region is also expected to weaken. The decline will be particularly pronounced in the other exporting countries, where current account surpluses are projected to shrink significantly, and in some cases shift into deficits. In the current global environment, the financing of such deficits is not assured and in the short-term may require the use of international reserves on a large scale.

External balances in the inflation-targeting commodity exporters are estimated to remain broadly unchanged from 2008—with an important expenditure-switching role played by the currency depreciations already seen. Finally, current account balances are projected to improve in most of the net commodity importers, particularly due to lower oil import bills, even with declining remittances and tourism receipts.

Net financing flows for the region are expected to decline markedly in 2009, but still remain around levels seen at the beginning of the decade. Tighter credit conditions and scarce bank capital in mature markets are expected to reduce trade finance to the corporate sector. Foreign direct investment is also projected to decline, given less favorable conditions in commodity sectors going forward. In contrast, financing from official sources, including multilaterals, is expected to pick up.

The region is better prepared but vulnerabilities remain

The region has built up resilience to external shocks over recent years (Figure 2.1). External vulnerabilities have declined, and large foreign reserves were accumulated throughout much of 2008. Public debt has fallen, along with improvements in its composition, and fiscal policy has become more credible in many countries. Monetary policy frameworks have also been strengthened, with flexible exchange rates acting as a key shock absorber in several cases. Balance sheet exposures to currency depreciation have been reduced. The financial sector remains well capitalized and profitable, and important progress has been made to improve supervision and regulation. Notwithstanding these substantial buffers, the external shocks buffeting the region are deeper, more widespread, and longer lasting than ever seen before.

Amid tight external financing conditions, rising current account deficits and declining foreign asset positions need to be carefully monitored. At end-2008, international reserves surpassed 10 percent of GDP in many countries, and also matched or exceeded short-term external debt coming due in 2009. These ratios are well above those at the time of the previous episodes of external shocks, including the Asian crisis and the bursting of the dot-com bubble. But in a number of countries, reserves are below total external financing requirements (i.e., current account deficits plus short-term debt). In addition, such economy-wide calculations of reserve coverage can mask differences between the public and private sectors, with most foreign exchange liquidity being held by the public sector, whereas external financing and rollover needs may be concentrated in the private sector. In fact, firms in several countries face larger rollover needs in 2009 than in 2008.

Funding concerns also arise in a number of countries with still significant public sector borrowing requirements. Overall, the public sector is now more protected against an external shock than in the past. For example, the inflation-targeting countries have strongly reduced the exposure of public debt to foreign exchange risks, and some public sectors stand to benefit from currency depreciation. However, this development has sometimes taken place at the cost of a shortening of debt maturities, increasing rollover risks. For example, public sector borrowing needs are particularly high in Brazil, Jamaica, the Dominican Republic, and the members of Eastern Caribbean Currency Union.

Moreover, fiscal risks arise given the dependence of several countries on commodity revenues. IMF staff analysis suggests that the sensitivity of fiscal revenues to commodity price swings has intensified in several countries during the recent boom. This would expose commodity exporters to substantial revenue losses if commodity prices were to fall further, adding pressures to borrowing requirements or forcing a rapid contraction of public expenditure or drawdown of financial assets (Box 2.4).

Box 2.4.

Saving for a Rainy Day? Sensitivity of LAC Fiscal Positions to Commodity Prices

The steep reversal in commodity prices in recent months has raised concerns about the impact on LAC fiscal positions. For almost five years, rising commodity prices boosted tax revenues, foreign direct investment, and overall economic activity in many countries in Latin America. While some governments in the region saved a large portion of buoyant revenues and accumulated financial assets, others used revenue windfalls to fuel growing government spending. However, the recent plunge in commodity prices and global trade has hammered net commodity-producing countries. As a result, government finances have come under pressure in many countries in the region.

This box provides estimates of the sensitivity of fiscal indicators to commodity price fluctuations for a group of net commodity-exporting countries. The analysis is based on quarterly fiscal indicators during 1995–2008. The data also include country-specific commodity export price indices, which combine international prices of 44 commodities and commodity export shares by country. To estimate the effect of commodity prices on fiscal variables, year-on-year changes in fiscal revenues and primary expenditures were regressed against changes in commodity prices, controlling for changes in GDP.¹ As such, these regressions only measure the direct effect of commodity price changes, i.e., they do not capture their indirect impact through their (likely) effect on real GDP. To allow for adjustments in fiscal responses over time (because, for instance, to changes in the tax structure or the implementation of fiscal rules), rolling regressions were estimated, each spanning 20 quarters five years). The scatter plots below report such country-specific estimated coefficients for the periods ending in December 2005 and December 2008. Higher values indicate more sensitivity of fiscal revenues and/or expenditures to commodity price changes. The charts allow for comparisons between countries, and for country-specific comparisons over time.

The empirical evidence suggests the following:

Changes in commodity prices have an especially strong impact on fiscal revenues in Chile, Ecuador, Peru, and Venezuela, in line with the large weight of extractive sectors in these economies. Commodity-related fiscal revenues are especially large in Venezuela and Ecuador—where oil companies are fully state owned and hydrocarbon resources constitute a large share of exports and GDP. In Chile, a significant proportion of the copper produced is still mined by a state-owned company. The sensitivity of fiscal revenues in Argentina, Colombia, and Mexico is in a middle range, with Argentina at the top and Mexico at the bottom. In the case of Argentina, the larger revenue sensitivity in the most recent period may reflect policy changes that increased the tax intake on the export sector, as well as larger production volumes of soybeans. In the case of Mexico, although oil-related fiscal revenues are relatively high, most are linked to domestic sales at administered prices, so these revenues are less sensitive to changes in international prices. The lower sensitivity could also be due to policies to hedge against volatility in oil prices. Fiscal revenues in Brazil show the lowest sensitivity, reflecting a more diversified export base and relatively more stable country-specific commodity prices.

The sensitivity of changes in primary fiscal expenditures to changes in commodity prices also differs significantly across countries. Cross-country differences were mostly underpinned by the implementation (or lack thereof) of fiscal rules (both formally and informally), though different levels of budgetary rigidities, as well as diverse public financial management systems, have also likely had a bearing.
Interestingly, there seems to be a correspondence between the size of sensitivities for expenditures and for revenues. Moreover, this correspondence has become stronger in the more recent period (i.e., points in the scatter plot got closer to the 45 degree line), in particular in Argentina, Ecuador, and Venezuela. In the two latter countries, expenditure sensitivity even surpassed revenue sensitivity in 2008. Chile is a notable exception, with fairly high revenue sensitivity but quite low expenditure sensitivity—reflecting the effect of the fiscal rule that has resulted in a large proportion of the commodity price windfall being saved. Expenditure sensitivity is also lower than revenue sensitivity in Colombia and Peru. The low expenditure sensitivity in Brazil is consistent with lower revenue sensitivity, but may also suggest that the effect of commodity prices feeds into revenues and expenditures indirectly, i.e., through their effect on GDP.

Past procyclical behavior may constrain future policy options. Given the temporary nature of the increases in revenues caused by the spike in commodity prices in the recent period, countries where commodity-linked revenues are sizable and that pursued more procyclical fiscal policies during the boom, would be in a relatively more precarious position to implement countercyclical fiscal policies now that commodity prices have declined. Primary balances could rapidly turn into deficits if spending growth continues unabated and the cyclical tax buoyancy disappears. The inability to implement countercyclical policies would be compounded by lack of access to international markets and tighter conditions in domestic markets.

The large fluctuations in commodity prices underscore the need for sound management of commodity-related windfalls. To mitigate the impact of terms-of-trade-linked fluctuations on fiscal balances, budgets should be formulated within a medium- to long-term framework that uses long-term commodity price estimates. This would help avoid spending pressures during boom periods, since political economy considerations can make it difficult to rein in expenditures once prices retreat. Stabilization funds integrated with the budget process (like those in place in Chile and Mexico) can be useful to manage the windfalls, which should be invested according to conservative principles and in currencies that provide a natural hedge against commodity price fluctuations. The results also illustrate the benefits of well-designed and effective fiscal rules that can make public finances less vulnerable to global price swings, as in Chile. International experience suggests that expenditure rules can be helpful but need to be supported by broad political consensus, consistent revenue policies, and, in some cases, expenditure reforms.

Note: This box was prepared by Gabriel Di Bella, Herman Kamil, and Leandro Medina.¹ All variables are expressed in real, domestic currency terms. Both explanatory variables are lagged one period. The estimated coefficients capture net effects; for example, the Mexican government imports hydrocarbons as well as exporting them.

Regarding the financial system, the LAC region has weathered the external shocks reasonably well so far, but challenges lie ahead (Chapter 3). Exposure to subprime-related, structured financial vehicles, or other toxic assets has been limited. Yet the quickly deteriorating macroeconomic environment represents a significant stress test for banking systems, increasing credit risks.

Moreover, global banks are important players in LAC financial systems. As their losses accumulate, foreign banks may reassess their cross-border positions and retrench from emerging markets, which could create additional liquidity strains in the LAC region. It should be noted, however, that foreign banks operating in LAC countries have relied primarily on domestic deposits to fund domestic credit. This is in contrast to the situation in emerging Europe, for example, where bank funding has increasingly relied on foreign inflows. In addition, prudential regulations in many countries have limited banks’ direct exposure to currency depreciation and indirect exposure to borrowers’ currency mismatches.⁶

Policy Challenges: Orderly Adjustment with Limited Output Losses

It is expected that the process of deleveraging will continue for some time, and in a selective way, with advanced economy financial institutions tending to reduce their claims on emerging market countries more than proportionately. This process may not be smooth, and another wave of financial pressures could hit emerging markets.

The challenges for LAC policymakers will be to manage an orderly adjustment, by limiting feedback loops between the real and financial sectors, and minimizing associated output and employment losses. The rebuilding of balance sheets has proved key for resilience, and the slowdown will be less pronounced if confidence in policy frameworks is maintained.

Compared with advanced economies, countries in the region face tighter constraints in applying countercyclical macroeconomic policies. These are not “reserve currency” countries and lack the same perception of long-run credibility. The region’s better-prepared economies have more policy room than others, but even they are constrained to a degree.

In this context, there is a crucial role to be played by international financial institutions. In particular, the IMF can help coordinate the macroeconomic response to the global crisis to avoid adverse spillovers from national actions. IMF financing can aid in cushioning the social and economic costs of the global shocks, especially if assistance is requested early on. It can also ease pressures on the external sector, providing more scope for monetary easing.

The IMF has an array of instruments that can be tailored to countries’ needs and circumstances. For instance, several countries in Central America (Costa Rica, El Salvador, Guatemala) have large precautionary arrangements with the IMF to reduce uncertainty and bolster confidence. In the Caribbean, several countries have requested IMF financing or augmented existing arrangements (see Annex 2.5). Finally, the IMF has invited strong-performing countries that may face difficulties in financial markets to use the newly created Flexible Credit Line to underscore international confidence. Mexico and Colombia have responded to this invitation and the IMF Board has approved or will consider shortly arrangements under this facility.

Financial stability policies

LAC financial systems have weathered the global crisis relatively well so far, given their limited direct exposure to structured finance and toxic assets. This resilience also reflects strengthened policy and supervisory frameworks. However, financial spillovers from the global crisis and the worsening macroeconomic outlook entail a significant stress test for LAC financial systems. A major challenge going forward will be to limit the feedback between the real and financial sectors.

The immediate focus should be on close supervision of high-frequency developments and early-warning systems to detect and correct problems in financial institutions that could become systemic. It will be important to make progress on contingency planning, financial safety nets, and bank resolution frameworks. This may involve strengthening crisis management strategies and identifying necessary improvements to the legal and regulatory arrangements. Granting supervisors legal power to act on behalf of the financial stability of the country is arguably at the top of the agenda in some Latin American countries. Supervisory authorities may also need access to a broader information set, including off-balance-sheet operations of banks, household indebtedness, firms’ derivatives exposures, real estate prices, and other collateral values.

Monetary and exchange rate policy

Monetary policy, and central bank policies more broadly, has been geared to maintaining orderly conditions in financial markets and supporting economic activity, including through foreign exchange credit lines to offset cutbacks in external credit. Aided by the buildup of stronger credentials to fight inflation, the authorities in the inflation-targeting countries appropriately relaxed monetary conditions once it became clear that the slowdown in economic activity and the drop in food and fuel prices would eventually exert important downward pressure on inflation and inflation expectations. In these countries, flexible exchange rates also have been crucial elements in cushioning the effects from external shocks.

Going forward, room for further easing will depend in large part on the extent of policy credibility that has been accumulated over the years. Further monetary easing in some countries could be warranted, provided exchange rate flexibility is maintained and inflation expectations remain anchored. Central banks’ efforts to unclog financial markets can continue to take a wide range of forms, tailored to the financial structure and other circumstances of each country. In general, it is best that such unconventional operations be conducted in a neutral manner, that is, rather than favoring certain economic sectors or companies.

In contrast, room for monetary easing is much lower in countries where inflation remains high, or where exchange rates are pegged or balance sheets are ill prepared for currency depreciation. In these countries, care should be taken to avoid excessively expansionary monetary policies that might undermine confidence.

Fiscal policy

The global crisis has major implications for public finances. Fiscal revenues are declining across the board in the LAC region, owing to the slowdown in activity and the drop in commodity and asset prices. At the same time, many countries are planning expansionary expenditure policies, further weakening fiscal balances in the coming years.

A countercyclical fiscal policy response is desirable to mitigate the risk of a prolonged economic slowdown. However, the scope for fiscal stimulus varies, and key trade-offs need to be carefully considered. Financing conditions for emerging markets will remain tight, and could deteriorate even further, limiting the scope for fiscal expansion. In addition, if fiscal stimulus is perceived to threaten sustainability, it can trigger an adverse market reaction that could undermine stability and complicate the growth outlook. Close coordination between monetary and fiscal policy is also important (Box 2.5).

Box 2.5.

Countercyclical Fiscal Policy under Alternative Monetary Policy Frameworks

The IMF has recommended that countries use fiscal policy to try to smooth the effects of the global recession, to the extent that each country has room to do so successfully. Because fiscal easing has the potential to mitigate output and employment losses, many countries have been exploring the feasibility and effectiveness of this option. Active countercyclical fiscal policy efforts are under way in many of the advanced economies and in Latin America as well.

Much analysis has been done on the feasibility of countercyclical fiscal policy and the possibility that fiscal easing would be ineffective or even counterproductive in some circumstances. Feasibility in each country will depend on the preexisting fiscal balance position, public debt level and rollover needs, and financing possibilities, which vary widely across Latin American countries. It also depends on perceptions of governments’ credibility in terms of a sustainable fiscal policy. Indeed, fiscal easing could be counterproductive during a recession in highly indebted countries or countries that lack policy credibility. Relaxing the fiscal stance during an economic downturn requires tightening it during a boom; a commitment to do so may suffice to maintain confidence in a recession in countries with a good track record of policy implementation. In other countries, investors may view a relaxation in the fiscal stance skeptically, concerned that the government may be unable to tighten the fiscal stance in the future and become more likely to eventually default. This may lead to higher interest rates that may depress private sector demand. Thus, a countercyclical fiscal policy effort could end up being ineffective or procyclical. This issue was explored in the April 2008 REO.¹

Another issue is how countercyclical fiscal policies interact with a country’s monetary policy regime. To analyze this, we use a version of the Global Integrated Monetary and Fiscal model (GIMF), developed by the IMF (Kumhof and Laxton, 2007). The structure of this model is such that countercyclical fiscal policy is feasible: it can (partly) offset the effect on output of a collapse in external demand and an increase in the cost of external financing. The model is calibrated to represent the interactions between a large economy (say, the United States, or all advanced economies in aggregate) and a smaller economy in Latin America. Our exercise studies the effects on the small economy of a scenario associated with financial stress in the large economy that limits funds available for investment and increases the risk premium. This shock leads to a sharp output gap, falling inflation, and lower interest rates in the large economy, which in turn results in a sharp reduction in growth prospects in the small economy. The macroeconomic impact on the small economy, however, will partly depend on the fiscal and monetary policies in place.

To shed light on the role of monetary policy in helping countercyclical fiscal efforts, we analyze the effect of the global stress scenario and countercyclical fiscal policies under three monetary policy frameworks: (i) inflation targeting with a freely floating exchange rate, (ii) inflation targeting with some “concern” about the exchange rate, and (iii) a crawling peg. The exercise first compares the effects of a constant overall deficit rule with that of the countercyclical tax and spending policy rule, as in Kumhof and Laxton (2007).² Subsequently, the countercyclical policy rule also requires a significant fiscal tightening effort. The main result is that the recession can be worse in countries with lower exchange rate flexibility given the complex interaction between monetary and fiscal policy rules (see figure). Three observations provide some insight. First, compared with pure inflation-targeting countries that react to developments in inflation and the output gap, interest rates in countries with limited exchange rate flexibility tend to be higher because these countries also need to confront pressures for currency depreciation. Second, the output loss is lower in inflation-targeting countries concerned about the exchange rate than in countries with crawling pegs because currency depreciation helps protect their export sectors from collapsing external demand. Finally, following the same fiscal policy rule can lead to different fiscal balance outcomes under different monetary policy frameworks given the different equilibrium paths for output, interest, and exchange rates. In the exercise, inflation-targeting countries can provide a higher initial fiscal stimulus as measured by a larger primary fiscal deficit, at the cost of having to deliver higher primary surpluses in the future. This greater up-front fiscal stimulus, combined with lower interest rates and weaker exchange rates, also contributes to better growth performance. The analysis highlights the value, particularly in times of stress, of close coordination between monetary and fiscal policy, to factor in the interactions between such policies in designing the macropolicy response to a macroeconomic shock.

Note: This box was prepared by Jorge Iván Canales-Kriljenko.¹ See Box 1.6 in the April 2008 REO. In addition, Clements, Flores, and Leigh (2009) and Leigh (2008, 2009) have calibrated the GIMF for the commodity-exporting cases of Colombia and Peru and used it to compare a neutral fiscal stance with a procyclical fiscal policy under a balanced budget rule in an inflation-targeting country. They also explore the fiscal policy reaction under a variety of shocks, including lack of available financing and boom and bust dynamics.² The constant overall deficit rule considered here also fixes government consumption and public investment as a percent of GDP, while taxes adjust to deliver the constant overall deficit given changes in the interest rate bill. The countercyclical fiscal policy rule increases public spending during a recession, while taxes adjust to ensure debt sustainability in the medium term.

Countries in the LAC region face different constraints in this regard. Fiscal room is evidently larger in countries that have strengthened their fiscal frameworks in recent years, built credibility during the commodity boom, and reduced fiscal vulnerabilities. Markets indeed have differentiated across countries, with sovereign spreads rising less for countries that built buffers during the upswing of the economic cycle. However, even for these countries, financing conditions have tightened, and carry heightened uncertainty going forward. Thus, some countries may need to moderate their stimulus efforts this year, saving more room for sustaining stimulus in 2010.

To ensure fiscal solvency and avoid an adverse and counterproductive market reaction, three considerations would be particularly important: (i) fiscal stimulus needs to be credibly temporary and well targeted; (ii) medium-term fiscal frameworks must underscore the government’s commitment to fiscal correction once economic conditions improve; and (iii) structural reforms need to be implemented to enhance growth, and thus, medium-term revenue prospects.

Some countries in the region face severe constraints on financing fiscal stimulus in a sustainable manner. Some countries, particularly in the Caribbean, are already grappling with high public debt levels. In many of the non-inflation-targeting commodity exporters, revenue losses due to the fall in commodity prices are expected to be sizable, with fiscal balances projected to deteriorate by a significant margin over 2009–10. These countries are also facing much more difficult financing conditions. In the immediate term, a drawdown of international reserves may fill the financing gap, and this approach is being taken by some countries on a large scale. But the sustainability of such a strategy is doubtful, particularly if the economic slowdown and terms-of-trade loss prove to be protracted. Other ad hoc financing strategies may exacerbate credibility problems and threaten further fiscal sustainability. In some of these countries, circumstances may require that expenditures be curtailed and even cut significantly, notwithstanding the undesirable effect on domestic demand.

Social policies

The global crisis and its impact on the region are already taking a toll on the most vulnerable. Weak remittances and tourism prospects are disproportionately affecting the low-income countries in the region. In addition, the widespread decline in economic activity is being reflected in rising unemployment and job shedding and a switch from formal to informal employment. Slower growth and rising inequality, coupled with high food prices throughout much of last year, may set back some of the hard-won reductions in poverty in the region.

It is encouraging that many countries have already taken steps to strengthen unemployment insurance schemes. These steps aid in limiting feedback from the real to the financial sector. However, in many countries, unemployment insurance schemes have limited coverage and do not reach the poorer households, as these generally participate in informal labor markets. In this context, it is as important as ever to protect priority and targeted poverty spending during the downturn. And the expected sluggish recovery only underscores the urgency of strengthening social safety nets in the region.

Trade policies

So far, creeping trade protectionism has not been the norm within countries in the LAC region. However, some countries have opted or threatened to raise import tariffs to deal with the sharp reversal in external flows. While higher import tariffs are the most evident form of protectionism, other nontariff policies could produce the same negative effects on economic efficiency (for instance, the introduction of subsidies to domestic industries with clear potential effects in competing foreign firms, or provisions to introduce a “home bias” element in domestic lending policies). The latter is of particular concern in countries where a large share of domestic financing comes from foreign banks, which in turn have received large influxes of fiscal public resources from their governments. Going forward, it is important to resist pressures to implement shortsighted protectionist policies that would be counterproductive, as they may end up making all countries worse off.

The medium-term agenda

The experience of the global financial crisis so far points to some key policy lessons going forward. One broad lesson for the LAC region is the importance of strengthening policy preparedness during “good times,” to build up resilience (not immunity) to future adverse shocks. Relatedly, when shocks do materialize, preparations implemented over past years will largely determine how much room a country has for immediate policy responses to mitigate those shocks. The recent experience should provide ample motivation for building up sound policies for many years to come.

The less favorable medium-term macroeconomic environment heightens the importance of accelerating structural reforms to boost investment and growth and to reduce poverty. With regard to the private sector, key priorities include increasing intermediation and access to bank and capital market funding for smaller firms, strengthening the financial infrastructure, and improving the business environment. The need to increase the level of public investment and improve the quality of public services are also long-standing challenges in the LAC region, both with respect to physical as well as social infrastructure. Reducing budgetary rigidities and phasing out subsidies not targeted to the poor will be essential, to provide fiscal room for public and social investment in the region.

The emerging global debate on financial reform will also influence the region’s medium-term agenda. The global debate is focusing on the longer-term reforms needed to close the gaps in financial supervision that helped sow the seeds of the current crisis. These reforms would also help strengthen financial systems in the region, especially as the depth and sophistication of the region’s financial markets develop over time. Two issues that are particularly relevant for the LAC region at the current juncture include the need to further strengthen consolidated and cross-border supervision, as well as reduce procyclicality in prudential regulation (see Chapter 3).

Annex. Channels of Transmission

2.1. Global shocks and sovereign bond yields

This section was prepared by Jorge Iván Canales-Kriljenko.

The global financial crisis has significantly increased both the level and dispersion of sovereign yields in Latin America. Following the Lehman Brothers collapse, median sovereign yields of Latin American bonds included in JPMorgan’s EMBIG index jumped from 5.6 percent to 10 percent in the last quarter of 2008, with most of the shift occurring in a few weeks. Spreads have remained high since then.⁷

The increase in yields was not uniform across countries, as the dispersion of yields widened sharply. In the last quarter of 2008, sovereign yields ranged between 6.6 and 36.4 percent, whereas before the Lehman Brothers collapse they ranged from 5.6 to 11.4 percent. Taking out the highest 20 percent of the distribution to eliminate a few extremely high-yield outliers, the range of yields roughly doubled, to 6.6–18.1 percent in late 2008, from 5.6–10.7 percent in September 2008. In general, as the dispersion of yields dramatically widened, the precrisis ranking of countries’ bond yields has been maintained, with just a few exceptions. But while there has been little new relative differentiation among countries, it is clear from higher secondary market prices that many more countries are now essentially frozen out of new issuance.

Most of the increase in sovereign yields can be attributed to the evolution of global international financial variables. Sovereign yields clearly move together and global international financial variables are strongly associated with them. For the empirical analysis, we separate foreign yields into sovereign spreads (as a proxy for sovereign risk) and the U.S. 10-year bond yield. We find that three financial variables have been linearly associated with sovereign spreads in Latin America, explaining most of the fluctuations in yields over the past five years, in bad as well as good times. Positively associated are the Chicago Board Options Exchange Volatility (VIX) Index⁸ and the U.S. term premium (as measured by the difference between the 10-year U.S. treasury bond yield and the U.S. federal funds rate). The VIX is a proxy for global investor sentiment and the U.S. business cycle. Negatively associated is the S&P500 stock exchange index.

The increasing dispersion in yields likely reflects investors’ perceptions of differences in country risk during a period in which investors rapidly changed their pricing of risk in general. While sovereign spreads move together, spreads of those countries perceived to be riskier rise faster than average when global developments are increasing spreads, and vice versa. The repricing of risk can happen rapidly, but country risk perceptions are likely to change slowly over time and reflect structural factors, political institutions, and policy frameworks. We find that higher sovereign spreads are indeed correlated with higher risk ratings and moreover that they are more sensitive to global market developments.

We find that the association between sovereign spreads and global financial variables is robust. It can be found through a variety of econometric methods on over different time periods.⁹ The global factors explain movements not only in the aggregate fluctuations (technically measured by the principal component of spreads in the EMBIG index), but also in each of the individual sovereign spreads included in its computation. The relationship has also been robust to the inclusion of other plausible factors (oil prices and aggregated commodity price indices, U.S. industrial production, U.S. corporate bond spreads, the overnight interest rate swap spread to the LIBOR rate), which were dropped from the final specification because either they were not statistically significant or their estimated parameter changed signs as the sample was reduced. We do find that country-specific commodity export prices, however, are statistically significant and negatively affect sovereign spreads in most individual country regressions, at least for the whole sample.

Empirical support also can be found for the idea that sovereign spreads can be grouped into different risk classes.¹⁰ In the spirit of the capital asset pricing model, individual country yields net of the U.S. federal funds rate were regressed on a constant and the corresponding excess yield associated with aggregate market fluctuations due to global financial variables.¹¹ Higher betas are associated with higher excess returns.

Sensitivity of Individual Sovereign Spreads to Market Trends 1/

Sources: JPMorgan and IMF staff calculations.

^{^1/}As measured by its beta $({y i e l d}_{t}^{i} - f e d f u n d s) = {c + b e t a}^{i} {f i t t e d y i e l d}_{t} - f e d f u n d s$ where the fitted yield is estimated from the first principal component of Latin American sovereign spreads in the EMBIG.

Sensitivity of Individual Sovereign Spreads to Market Trends 1/

	2005	2006	2007	2008
Argentina	8.2	9.2	9.0	7.0
Dominican Republic	1.5	1.7	1.7	1.7
Ecuador	1.5	1.4	1.2	1.7
Venezuela	1.8	1.7	1.5	1.6
Uruguay	1.7	1.5	1.5	1.3
Brazil	1.5	1.4	1.4	1.2
Colombia	1.0	1.0	1.1	1.0
Peru	1.0	1.0	1.0	0.9
Panama	0.8	0.9	0.9	0.8
El Salvador	0.7	0.7	0.8	0.8
Mexico	0.7	0.7	0.7	0.7
Chile	0.7	0.6	0.6	0.6
Principal Component	1.0	1.0	1.0	1.0

Sources: JPMorgan and IMF staff calculations.

Sensitivity of Individual Sovereign Spreads to Market Trends 1/

	2005	2006	2007	2008
Argentina	8.2	9.2	9.0	7.0
Dominican Republic	1.5	1.7	1.7	1.7
Ecuador	1.5	1.4	1.2	1.7
Venezuela	1.8	1.7	1.5	1.6
Uruguay	1.7	1.5	1.5	1.3
Brazil	1.5	1.4	1.4	1.2
Colombia	1.0	1.0	1.1	1.0
Peru	1.0	1.0	1.0	0.9
Panama	0.8	0.9	0.9	0.8
El Salvador	0.7	0.7	0.8	0.8
Mexico	0.7	0.7	0.7	0.7
Chile	0.7	0.6	0.6	0.6
Principal Component	1.0	1.0	1.0	1.0

Sources: JPMorgan and IMF staff calculations.

Overall, these findings suggest that Latin American sovereign bonds have suffered contagion from the international financial crisis and that no decoupling is apparent. While there may have been relatively little reassessment of individual countries’ risk in recent quarters, there has been a very large repricing of risk in the global capital market, and such repricing hits hardest the countries with the greatest perceived risk. The findings suggest that the impact of global developments on sovereign bond pricing discriminates among countries, with the countries least affected being those that have good credit ratings.

2.2. Financing conditions for corporates

This section was prepared by Herman Kamil and Bennett Sutton.

The global credit crunch has taken a toll on emerging-market economies, reducing access to financing by LAC corporates by end-2008. Bond and loan issuance by Latin corporates, including quasi-sovereigns, peaked in the third quarter of 2007, as the commodity boom and positive economic prospects boosted investor demand. But this has slowed notably since the deterioration of global financial markets. Deleveraging by corporates started with a sharp decline in syndicated loans and bonds placed abroad, and private issuers all but disappeared from external bond markets by the end of 2008. With rising turmoil in dollar funding markets starting in the second half of 2007, corporates relied increasingly on domestic bond markets, which provided 60 percent of Latin corporate debt financing needs by 2008Q1. However, domestic bond markets eventually succumbed to the repricing of risk that drove down appetite for new corporate bonds of any variety, and domestic issuance fell sharply in 2008Q4.

Aside from capital market financing, other forms of funding have also suffered from the global financial stress. Anecdotal evidence indicates that the availability of short-term trade financing has contracted significantly since the onset of the crisis, reflecting lower credit lines from bank counterparts and credit capacity constraints on both buyers and suppliers.¹² In addition, local affiliates of foreign firms could also face funding gaps as intra-group credit from parent firms dries up, reflecting their own higher cost of funding.

Borrowing costs are also rising. Spreads on syndicated loans to Latin American corporates (over U.S. treasury bills) rose by over 100 basis points in the last quarter of 2008, both for investment-grade and high-yield firms. The gap spiked to a record high in mid-December as the global credit crisis prompted more than $1 trillion of losses and writedowns at financial firms.

LAC corporates may face higher financing pressures in 2009 and 2010. The retrenchment of cross-border bank flows, coupled with falling revenues from the downturn, raise concerns about the private sector’s ability to pay or refinance external debt.¹³ Our estimates suggest that financial and nonfinancial companies in LA6 need to repay or roll over approximately US$148 billion in external debt with nonresidents (including bonds, loans, short-term trade finance and intercompany loans) in 2009. In percent of GDP, Argentina, Chile, and Peru face the largest borrowing needs. The currencies of several Latin American economies have dropped more than 20 percent against the dollar in the past year, increasing the cost of servicing foreign currency obligations. At the same time, many of these companies that do have foreign currency obligations are also exporters (and/or may have liquid assets denominated in foreign currency).

As external funding has become more difficult, Latin American corporations have turned to domestic markets. Some corporates have been successful in switching to banks as a source of financing, although this is likely to crowd out bank financing to smaller firms and/or households. In Chile, for example, some companies have resorted to domestic capital markets. Chilean corporates have also replaced short-term external debt for long-term domestic debt, reducing both rollover and currency risks. In Mexico, the association of pension funds has committed to using the expansion of the funds’ portfolios to buy domestically issued securities.

Still, some corporates may need to renegotiate with their creditors or seek government aid through development banks to remain current on their external obligations.¹⁴ In an effort to alleviate refinancing risks of external debt, central banks in several countries in the region have offered foreign currency credit to banks, provided the funds are onlent to local companies with maturing foreign debt. The lending has been financed out of currency reserves. Brazil’s central bank, for example, unveiled plans in February 2009 to provide more than $20 billion to help 4,000 or more companies meet external debt payments this year. Companies in Mexico have received some support from development banks, including through credit guarantees.¹⁵ Mexico has recently drawn from its swap facility with the U.S. Federal Reserve (US$30 billion) to help finance the corporate sector.

2.3. Geographical concentration of LAC exports and exposure to shocks in the United States and Europe

This section was prepared by Roberto Garcia-Saltos and Carolina Saizar.

The sudden drop in the LAC region’s exports is a clear consequence of the global recession. Although this is not different from other regions, insufficient geographical diversification in LAC’s exports could be a drag on economic recovery. A shock to a common trading partner such as the current one could fuel a cascading effect in reducing trade and negatively affect growth.¹⁶

LAC’s high exposure to the United States and Europe is of particular concern, given the expected severe slowdown in these economies. The United States and Europe remain the main trading partners of most countries in LAC and there is limited room in the short term for intraregional trade or trade with other regions to substitute falling demand from those countries.

Relative to other regions, exports from LAC countries are more geographically exposed to the United States or Europe. Intraregional trade and trade with Asia has increased in recent years, but so has the synchronicity of business cycles between LAC and the United States and Europe.¹⁷ Indeed, impulse responses derived from the regional global projection model (GPM) show a high degree of synchronization in the response of the LA5 output gap to a negative shock in the United States or in Europe.¹⁸ While the intensity of the response varies, the negative effect of the shock lasts for about 8 quarters. Also, countries with relatively low direct export exposure to the United States or Europe may still be affected, if they export heavily to partners with strong ties with these advanced countries (i.e., indirect exposure). Countries where this indirect exposure is important include Bolivia, Paraguay, Suriname, and Uruguay in South America; and Barbados, Dominica, and Grenada in the Caribbean.

2.4. Declining workers’ remittances

This section was prepared by Ewa Gradzka and Carolina Saizar.

Since the onset of the global crisis, remittances to the LAC region have decelerated sharply. Growth in remittances had started to decelerate in mid-2006, but as the financial crisis spread and advanced economies slowed, this pace accelerated in many countries. In several LAC countries, remittances already posted negative growth by end-2008 (e.g., Argentina, Mexico, Ecuador).

This trend is likely to continue, given the bleak economic outlook in the United States and Spain. The United States is the most important source of remittances for LAC, followed by Spain. The ongoing recession in these countries is having a severe impact on the employment outlook of Hispanic immigrants, taking a toll on remittances flows. The unemployment rate for Hispanics or Latinos in the United States has jumped from 6.3 percent in February 2008 to 10.9 percent in February 2009. Remittances to some countries have been especially sensitive to conditions in the United States construction sector. But more recently all U.S. sectors have been affected, weakening the outlook for remittances even if the construction sector bottoms out. In addition, as the United States continues tightening immigration laws, employers have been induced to lay off immigrant workers. In Spain, the second-largest source of remittances to LAC, unemployment is already one of the highest in the European Union (at 14 percent), and the government is providing monetary incentives for immigrants to volunteer to return to their home countries.

The IMF staff projects that remittances will fall further in 2009. For Mexico, remittances are assumed to drop by 10 percent in dollar terms and only gradually recover as growth in the United States picks up. In Central America, they are expected to decrease by about 5 percent on average and in Haiti by about 7 percent. For the LAC region as a whole, the World Bank projects that remittances in 2009 will fall by around 4.4 percent under a baseline scenario, and by as much as 7.7 percent under a more pessimistic scenario that assumes recent migrants return to their home countries (Ratha and Mohapatra, 2009). Even modest contractions will represent a significant loss relative to the fast growth trend of remittances to which many LAC countries have been accustomed in recent years.

While remittances are falling in terms of foreign currency inflows, the recent depreciation of the real exchange rate in some countries has provided a cushion to recipients of remittances. Previously, rising inflation since mid-2007 and throughout much of 2008, combined with exchange rate appreciation in many LAC countries, had contributed to reducing the real value of the remittances in domestic currency. However, as global shocks deepened, inflation has slowed. In addition, nominal exchange rates depreciated sharply in some LAC countries, including Mexico, more than offsetting the decline of remittances measured in foreign currency. Still, the continued decline in dollar flows is eroding the gains from depreciation. In dollarized economies such as El Salvador, declining dollar remittances are not being cushioned by exchange rate depreciation.

Remittances: Nominal vs. Real Terms

(Average of the monthly annual growth rates)

Sources: Haver Analytics; and IMF staff calculations.

Remittances: Nominal vs. Real Terms

(Average of the monthly annual growth rates)

	U.S. dollars		Local currency		Real terms
	Jan-Sep 2008	Oct-Dec 2008	Jan-Sep 2008	Oct-Dec 2008	Jan-Sep 2008	Oct-Dec 2008
Mexico	-3.9	-3.1	-7.7	16.6	-11.8	9.8
El Salvador	5.4	-5.5	5.4	-5.5	-2.1	-10.9

Sources: Haver Analytics; and IMF staff calculations.

Remittances: Nominal vs. Real Terms

(Average of the monthly annual growth rates)

	U.S. dollars		Local currency		Real terms
	Jan-Sep 2008	Oct-Dec 2008	Jan-Sep 2008	Oct-Dec 2008	Jan-Sep 2008	Oct-Dec 2008
Mexico	-3.9	-3.1	-7.7	16.6	-11.8	9.8
El Salvador	5.4	-5.5	5.4	-5.5	-2.1	-10.9

Sources: Haver Analytics; and IMF staff calculations.

Declining remittances inflows can have significant effects on the external balance of payments, growth, and social conditions of recipient countries. Workers’ remittances have become a significant source of external inflows for many LAC countries. As a region, LAC receives the largest volume of remittances globally, reaching US$61 billion in 2007, followed by east Asia and the Pacific with US$58 billion. For some countries, remittances account for a significant share of GDP. Haiti tops the list, with remittances at 19.7 percent of GDP in 2008, followed by Honduras (19.1 percent of GDP), El Salvador (17.2 percent of GDP), Nicaragua (13 percent of GDP), and Guatemala (12 percent of GDP). While Mexico receives the largest amount in dollar terms, this represents less than 3 percent of its GDP, which may limit the impact on the overall national economy. In dollarized economies such as El Salvador, weakness in remittances could reduce the country’s capacity to purchase goods and services from abroad. It is thought that a large proportion of remittances is spent mainly on consumption, so the drop in remittances will lead to a corresponding drop in domestic demand. Moreover, remittances have been a vital source of personal income, thus playing an important role in reducing poverty (Acosta and others, 2007; Adams and Page, 2005). The study by Acosta and others which considers 11 countries in LAC, estimates that for each 1 percent increase in the share of remittances to GDP, the fraction of population living in moderate poverty is reduced by an average of about 0.4 percent.

2.5 Caribbean tourism: a severe demand downturn and policy responses

This section was prepared by Bernhard Fritz-Krockow and Yan Sun.

Caribbean¹⁹ economies are among the most tourism-dependent in the world. For most countries, tourism is the main source of economic growth, employment, and foreign exchange earnings. Of the top 20 tourism-dependent countries, ranked by average travel receipts in percent of GDP during 1980–2007, 10 are from the Caribbean region. Tourism receipts in Antigua and Barbuda, the most tourism-dependent country, have averaged almost 50 percent of GDP over the past three decades. The employment impact of the tourism sector is considerable. In addition, Caribbean countries benefit from tourism-related construction in terms of employment and economic growth, with the associated foreign direct investment supporting balance of payments inflows. In Barbados and The Bahamas, tourism-related construction accounted for an estimated 4–5 percent of GDP during 2003–07.

The still-unfolding economic downturn in advanced countries is dampening tourism activity, with significant economic consequences for Caribbean countries. Historically, tourism arrivals have been closely correlated with economic activity in tourism-source countries.²⁰ Caribbean tourism arrivals fell by a cumulative 8.6 percent during the 2001 recession and by 2.9 percent during the 1981 recession. After an uptick in the first half of 2008, stay-over tourists to the Caribbean are estimated to have fallen by about 5 percent during the second half of the year. Tourism receipts are expected to continue falling in 2009—on average by 15 percent, even though the decline in stay-over arrivals may be more modest, as hotel operators are currently offering heavily discounted prices. Reflecting the weak tourism performance, real GDP is projected to decline by an average of ½ percent this year.

The slowdown in visitor arrivals and tourism-related development projects is reducing foreign exchange inflows. To some extent, the negative impact on the external current accounts of the Caribbean countries will be dampened by a decline in imports amid sluggish domestic activity and sharply lower oil import prices. Nevertheless, with a projected fall-off in capital flows, including to tourism-related construction projects, pressure will increase on international reserve levels and/or currencies, as many countries in the region have pegged exchange rates. Increasing layoffs and reduced profit margins in the tourism sector will also pressure fiscal positions in many Caribbean countries.

Some Caribbean countries have introduced policy measures to soften the shock to the tourism industry. A number of governments (e.g., Antigua and Barbuda, Jamaica, St. Kitts and Nevis, and St. Vincent and the Grenadines) are providing shortterm tax relief to hotels and other tourism operators, along with reduced charges for electricity, water, and other inputs to tourism services, in some cases on condition that proactive measures are taken to preserve employment, increase operating efficiency, and reduce operating costs. Many governments are also supporting aggressive marketing efforts, including major advertising campaigns (e.g., The Bahamas, Barbados, Jamaica, St. Lucia, St. Vincent and the Grenadines). In Jamaica, in particular, the advertising campaign and discounted vacation packages appear thus far to have been successful, as stay-over arrivals are up about 3 percent for the first two months of 2009 compared with a year ago.

Macroeconomic policy options may be limited. The scope for countercyclical fiscal policies in response to the global economic downturn is constrained by the already-high debt levels in many Caribbean countries. Even in cases where an expansionary policy would not jeopardize fiscal sustainability, the deterioration in tourism earnings, and associated fiscal revenue, may require a tightening of macroeconomic policies in order to sustain the fixed exchange rate pegs that characterize many Caribbean countries—especially if capital inflows remain low. Although the regional financial systems weathered the global shocks well initially, given recent local shocks (CL Financial in Trinidad and Tobago, and Stanford Group in Antigua and Barbuda), it will be important to closely monitor developments in the financial system. A prolonged global downturn could lead to further unemployment, financial strain, and bankruptcies in the tourism sector, which could have adverse spillovers onto the banking system and hinder a recovery during the cyclical upturn.

In response to the downturn in tourism receipts, several Caribbean countries have sought IMF financial assistance. St. Vincent and the Grenadines (followed shortly thereafter by Dominica and St. Lucia) is the first country in the Western Hemisphere to request a drawing under the IMF’s Exogenous Shock Facility, responding to the transitory fall in its tourism receipts. Similarly, Grenada has requested an augmentation of its Poverty Reduction and Growth Facility to help absorb the shock to its balance of payments position arising from the downturn in tourist receipts. Belize has received assistance through the IMF’s emergency assistance for natural disasters (ENDA) to mitigate the adverse effects of recent floods on international reserves. St. Kitts and Nevis is also requesting assistance through ENDA to help cope with the adverse balance of payments impact of a hurricane.

Western Hemisphere Main Economic Indicators

Sources: IMF, World Economic Outlook; and IMF staff estimates.

^{^1/}End-of-period rates, i.e., December on December. These will generally differ from period average inflation rates quoted in the IMF, World Economic Outlook, although both are based on identical underlying projections.

^{^2/}Weighted average. For output and inflation, weighted by PPP GDP; for external current account, dollar-weighted GDP.

^{^3/}Eastern Caribbean Currency Union. For inflation, dollar-weighted GDP. For output and current account, ECCU aggregate.

^{^4/}Fiscal year data.

Western Hemisphere Main Economic Indicators

	Output Growth (Annual rate in percent)							Inflation (End-of-period, in percent) 1/							External Current Account (In percent of GDP)
	1995-2004 Avg.	2005	2006	2007	2008 Est.	2009 Proj.	2010 Proj.	1995-2004 Avg.	2005	2006	2007	2008 Est.	2009 Proj.	2010 Proj.	1995-2004 Avg.	2005	2006	2007	2008 Est.	2009 Proj.	2010 Proj.
North America 2/	3.1	3.0	3.0	2.2	1.1	-2.8	0.1	3.4	3.3	3.2	2.9	4.2	0.2	0.8	-3.0	-4.9	-5.0	-4.5	-4.0	-2.6	-2.6
United States	3.1	2.9	2.8	2.0	1.1	-2.8	0.0	2.5	3.7	2.2	4.1	0.8	-0.1	0.1	-3.3	-5.9	-6.0	-5.3	-4.7	-2.8	-2.8
Canada	3.3	2.9	3.1	2.7	0.5	-2.5	1.2	2.1	2.3	1.4	2.5	1.9	-0.2	0.9	0.8	1.9	1.4	0.9	0.6	-0.9	-0.7
Mexico	2.7	3.2	5.1	3.3	1.3	-3.7	1.0	15.4	3.3	4.0	3.7	6.5	3.5	3.1	-1.8	-0.5	-0.5	-0.8	-1.4	-2.5	-2.2
South America 2/	2.4	5.3	5.7	6.6	5.3	-0.8	1.8	10.5	6.8	5.4	7.0	8.8	7.8	7.8	-1.5	2.7	2.8	1.3	0.1	-1.7	-1.0
Argentina	1.3	9.2	8.5	8.7	7.0	-1.5	0.7	4.9	12.3	9.8	8.5	7.2	7.2	7.2	-0.5	1.7	2.3	1.6	1.4	1.0	1.8
Bolivia	3.3	4.4	4.8	4.6	5.9	2.2	2.9	5.0	4.9	4.9	11.7	11.8	6.0	5.5	-3.8	6.5	11.3	13.2	11.5	-2.1	-1.1
Brazil	2.5	3.2	4.0	5.7	5.1	-1.3	2.2	8.6	5.7	3.1	4.5	5.9	4.2	4.0	-2.4	1.6	1.3	0.1	-1.8	-1.8	-1.8
Chile	4.8	5.6	4.6	4.7	3.2	0.1	3.0	4.2	3.7	2.6	7.8	6.9	2.2	3.0	-1.8	1.2	4.9	4.4	-2.0	-4.8	-5.0
Colombia	2.4	5.7	6.9	7.5	2.5	0.0	1.3	12.0	4.9	4.5	5.7	7.7	4.6	3.6	-2.1	-1.3	-1.8	-2.8	-2.8	-3.9	-3.3
Ecuador	2.8	6.0	3.9	2.5	5.3	-2.0	1.0	31.4	3.1	2.9	3.3	8.8	2.0	2.5	-1.8	0.8	3.9	2.3	2.4	-3.5	-2.3
Paraguay	1.5	2.9	4.3	6.8	5.8	0.5	1.5	8.9	9.8	12.5	5.9	7.5	5.5	5.0	-1.7	0.3	0.5	0.7	-1.4	-1.0	-0.9
Peru	3.5	6.8	7.7	8.9	9.8	3.5	4.5	4.9	1.2	1.1	3.9	6.7	2.5	2.0	-3.7	1.4	3.0	1.4	-3.3	-3.3	-3.2
Uruguay	0.4	7.5	4.6	7.6	8.9	1.3	2.0	14.0	4.9	6.4	8.5	9.2	6.4	6.5	-1.1	0.0	-2.3	-0.8	-3.6	-1.7	-2.4
Venezuela	1.3	10.3	10.3	8.4	4.8	-2.2	-0.5	35.1	14.4	17.0	22.5	30.9	42.0	45.0	6.5	17.7	14.7	8.8	12.3	-0.4	4.1
Central America 2/	3.7	4.7	6.3	6.9	4.3	1.1	1.8	7.6	8.0	6.0	8.6	9.6	5.7	5.0	-5.2	-4.8	-4.7	-7.0	-9.2	-6.1	-7.1
Costa Rica	4.3	5.9	8.8	7.8	2.9	0.5	1.5	12.4	14.1	9.4	10.8	13.9	8.0	7.0	-3.8	-4.9	-4.5	-6.3	-8.9	-5.3	-5.3
El Salvador	3.0	3.1	4.2	4.7	2.5	0.0	0.5	4.0	4.3	4.9	4.9	5.5	2.5	2.3	-2.4	-3.3	-3.6	-5.5	-7.2	-2.3	-3.9
Guatemala	3.4	3.3	5.4	6.3	4.0	1.0	1.8	7.4	8.6	5.8	8.7	9.4	5.5	4.7	-5.2	-4.5	-5.0	-5.2	-4.8	-4.0	-4.9
Honduras	3.7	6.1	6.6	6.3	4.0	1.5	1.9	13.4	7.7	5.3	8.9	10.8	9.4	8.1	-4.6	-3.0	-3.7	-10.3	-14.0	-8.0	-9.2
Nicaragua	4.3	4.3	3.9	3.2	3.0	0.5	1.0	8.5	9.6	9.5	16.9	13.8	7.0	7.4	-20.6	-14.6	-13.6	-18.3	-23.2	-15.5	-14.5
Panama	4.4	7.2	8.5	11.5	9.2	3.0	4.0	0.9	3.4	2.2	6.4	6.8	3.2	2.5	-5.3	-4.9	-3.1	-7.3	-12.4	-10.1	-11.6
The Caribbean 2/	3.9	5.8	8.2	5.8	3.0	-0.2	1.5	9.7	8.3	5.9	9.0	8.9	5.3	5.2	-3.1	0.3	2.1	-1.5	-2.8	-5.1	-4.1
The Bahamas	3.0	3.3	4.6	2.8	-1.3	-4.5	-0.5	1.7	1.2	2.3	2.9	4.5	1.0	0.2	-10.4	-10.0	-20.4	-18.2	-13.4	-9.5	-10.4
Barbados	2.2	3.9	3.2	3.4	0.6	-3.5	0.5	2.5	7.3	5.6	4.8	8.9	-3.6	7.6	-4.0	-12.8	-8.4	-5.2	-8.4	-7.2	-6.9
Belize	5.5	3.0	4.7	1.2	3.0	1.0	2.0	1.8	4.2	2.9	4.1	4.4	2.5	2.5	-11.5	-13.6	-2.1	-4.0	-11.4	-6.7	-6.2
Dominican Republic	4.9	9.3	10.7	8.5	4.8	0.5	2.0	13.0	7.4	5.0	8.9	4.5	6.0	5.0	-0.8	-1.4	-3.6	-5.0	-9.7	-6.8	-6.9
ECCU 3/	2.5	5.6	6.3	5.2	1.8	-2.4	-0.1	1.5	4.2	2.8	5.7	5.0	2.4	2.3	-16.2	-22.4	-29.7	-34.8	-33.9	-24.2	-24.1
Guyana	2.4	-1.9	5.1	5.4	3.2	2.6	3.4	5.4	8.3	4.2	14.0	6.4	5.0	5.0	-12.0	-14.8	-20.9	-18.0	-20.8	-18.1	-15.6
Haiti 4/	1.8	1.8	2.3	3.4	1.3	1.0	2.0	8.6	14.8	12.4	7.9	20.8	3.0	5.0	-1.0	2.6	-1.4	-0.3	-3.1	-3.3	-2.8
Jamaica	0.7	1.0	2.7	1.4	-1.2	-2.6	-0.3	11.5	12.6	5.7	16.8	16.8	8.9	8.9	-5.7	-9.4	-10.2	-14.9	-15.3	-12.5	-10.9
Suriname	3.2	4.5	4.8	5.5	6.5	2.8	2.5	15.4	15.8	4.7	8.4	9.3	9.5	8.0	-7.2	-4.3	1.8	2.9	0.2	-7.8	-1.9
Trinidad & Tobago	7.6	5.4	13.3	5.5	3.4	0.5	2.0	3.8	7.2	9.1	7.6	14.5	5.0	5.0	2.0	22.4	37.5	24.8	26.8	7.4	10.2
Memorandum item:
Latin America and the Caribbean 2/	2.6	4.7	5.7	5.7	4.2	-1.5	1.6	11.4	5.9	5.0	6.2	8.1	6.2	6.1	-1.9	1.3	1.5	0.4	-0.7	-2.2	-1.6

Sources: IMF, World Economic Outlook; and IMF staff estimates.

^{^2/}Weighted average. For output and inflation, weighted by PPP GDP; for external current account, dollar-weighted GDP.

^{^3/}Eastern Caribbean Currency Union. For inflation, dollar-weighted GDP. For output and current account, ECCU aggregate.

^{^4/}Fiscal year data.

Western Hemisphere Main Economic Indicators

	Output Growth (Annual rate in percent)							Inflation (End-of-period, in percent) 1/							External Current Account (In percent of GDP)
	1995-2004 Avg.	2005	2006	2007	2008 Est.	2009 Proj.	2010 Proj.	1995-2004 Avg.	2005	2006	2007	2008 Est.	2009 Proj.	2010 Proj.	1995-2004 Avg.	2005	2006	2007	2008 Est.	2009 Proj.	2010 Proj.
North America 2/	3.1	3.0	3.0	2.2	1.1	-2.8	0.1	3.4	3.3	3.2	2.9	4.2	0.2	0.8	-3.0	-4.9	-5.0	-4.5	-4.0	-2.6	-2.6
United States	3.1	2.9	2.8	2.0	1.1	-2.8	0.0	2.5	3.7	2.2	4.1	0.8	-0.1	0.1	-3.3	-5.9	-6.0	-5.3	-4.7	-2.8	-2.8
Canada	3.3	2.9	3.1	2.7	0.5	-2.5	1.2	2.1	2.3	1.4	2.5	1.9	-0.2	0.9	0.8	1.9	1.4	0.9	0.6	-0.9	-0.7
Mexico	2.7	3.2	5.1	3.3	1.3	-3.7	1.0	15.4	3.3	4.0	3.7	6.5	3.5	3.1	-1.8	-0.5	-0.5	-0.8	-1.4	-2.5	-2.2
South America 2/	2.4	5.3	5.7	6.6	5.3	-0.8	1.8	10.5	6.8	5.4	7.0	8.8	7.8	7.8	-1.5	2.7	2.8	1.3	0.1	-1.7	-1.0
Argentina	1.3	9.2	8.5	8.7	7.0	-1.5	0.7	4.9	12.3	9.8	8.5	7.2	7.2	7.2	-0.5	1.7	2.3	1.6	1.4	1.0	1.8
Bolivia	3.3	4.4	4.8	4.6	5.9	2.2	2.9	5.0	4.9	4.9	11.7	11.8	6.0	5.5	-3.8	6.5	11.3	13.2	11.5	-2.1	-1.1
Brazil	2.5	3.2	4.0	5.7	5.1	-1.3	2.2	8.6	5.7	3.1	4.5	5.9	4.2	4.0	-2.4	1.6	1.3	0.1	-1.8	-1.8	-1.8
Chile	4.8	5.6	4.6	4.7	3.2	0.1	3.0	4.2	3.7	2.6	7.8	6.9	2.2	3.0	-1.8	1.2	4.9	4.4	-2.0	-4.8	-5.0
Colombia	2.4	5.7	6.9	7.5	2.5	0.0	1.3	12.0	4.9	4.5	5.7	7.7	4.6	3.6	-2.1	-1.3	-1.8	-2.8	-2.8	-3.9	-3.3
Ecuador	2.8	6.0	3.9	2.5	5.3	-2.0	1.0	31.4	3.1	2.9	3.3	8.8	2.0	2.5	-1.8	0.8	3.9	2.3	2.4	-3.5	-2.3
Paraguay	1.5	2.9	4.3	6.8	5.8	0.5	1.5	8.9	9.8	12.5	5.9	7.5	5.5	5.0	-1.7	0.3	0.5	0.7	-1.4	-1.0	-0.9
Peru	3.5	6.8	7.7	8.9	9.8	3.5	4.5	4.9	1.2	1.1	3.9	6.7	2.5	2.0	-3.7	1.4	3.0	1.4	-3.3	-3.3	-3.2
Uruguay	0.4	7.5	4.6	7.6	8.9	1.3	2.0	14.0	4.9	6.4	8.5	9.2	6.4	6.5	-1.1	0.0	-2.3	-0.8	-3.6	-1.7	-2.4
Venezuela	1.3	10.3	10.3	8.4	4.8	-2.2	-0.5	35.1	14.4	17.0	22.5	30.9	42.0	45.0	6.5	17.7	14.7	8.8	12.3	-0.4	4.1
Central America 2/

	1994–02	1994–08
World demand	0.39	0.45
U.S. high-yield spread (basis points)	73.81	108.20
Commodity prices	3.86	5.46

	1994–02	1994–08
World demand	0.39	0.45
U.S. high-yield spread (basis points)	73.81	108.20
Commodity prices	3.86	5.46

	1994–02	1994–08
Shock to:
World demand	-1.87	-1.52
U.S. high-yield spread (basis points)	-1.19	-0.84
Commodity prices	-0.85	-0.68

	1994–02	1994–08
Shock to:
World demand	-1.87	-1.52
U.S. high-yield spread (basis points)	-1.19	-0.84
Commodity prices	-0.85	-0.68

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Abstract

A “Double Squeeze” on the Balance of Payments

Tight external financial conditions

Lower external demand overall

Reversal of the commodity boom

Weak remittances and tourism prospects

Ongoing Adjustment

Policy Responses Thus Far

Liquidity provision

Flexible exchange rates: key shock absorber in some countries

Monetary policy easing

Fiscal policies are also playing a role

Economic Outlook and Risks

A significant markdown in growth. . .

. . .still with downside risks. . .

. . .and inflation declining further

Fiscal positions and external balances likely to weaken

The region is better prepared but vulnerabilities remain

Policy Challenges: Orderly Adjustment with Limited Output Losses

Financial stability policies

Monetary and exchange rate policy

Fiscal policy

Social policies

Trade policies

The medium-term agenda

Annex. Channels of Transmission

2.1. Global shocks and sovereign bond yields

2.2. Financing conditions for corporates

2.3. Geographical concentration of LAC exports and exposure to shocks in the United States and Europe

2.4. Declining workers’ remittances

2.5 Caribbean tourism: a severe demand downturn and policy responses