Abstract

The aim of this study has been to take stock of the achievements and disappointments in Latin America since the start of market-based reforms in the early 1990s, a period that also witnessed growing democratization in the region. This concluding section draws lessons from this period and, based on this experience, discusses policy priorities and the future roles of the major players involved—the policymakers in Latin America; the international institutions, and especially the IMF; and industrial country governments—in order to make a decisive break from the region’s long history of recurrent crisis and to entrench growing prosperity.

The aim of this study has been to take stock of the achievements and disappointments in Latin America since the start of market-based reforms in the early 1990s, a period that also witnessed growing democratization in the region. This concluding section draws lessons from this period and, based on this experience, discusses policy priorities and the future roles of the major players involved—the policymakers in Latin America; the international institutions, and especially the IMF; and industrial country governments—in order to make a decisive break from the region’s long history of recurrent crisis and to entrench growing prosperity.

Looking Back

When Latin America’s experience since the early 1990s is viewed against the backdrop of the 1980s—an unsettled period for the region—it is clear that much has been achieved. This study has pointed to the following principal achievements.

Policy Performance

The 1990s saw the establishment of low inflation, a major achievement for much of Latin America, given its past record of high and volatile inflation. An important reason has been the emergence of widespread public awareness of the need to bring inflation down, leading to popular resistance to policies that would risk reigniting inflationary pressures. Thus, for example, the deep economic and financial crises of Argentina and Uruguay resulted in only a temporary acceleration of inflation, followed quickly by a return to single-digit rates. Similarly, strenuous efforts have kept inflation low in Bolivia despite fiscal and financial imbalances in a situation of political difficulty. Nevertheless, in many countries across the region, the sustainability of low inflation still needs to become fully entrenched, which will require sustained progress to bring down public debt and to address concerns raised by financial dollarization.

Policy Flexibility

The adoption of much more market-determined exchange rates by many Latin American countries in recent years has greatly improved the flexibility of the macroeconomic policy frameworks. In parallel, the region is also successfully developing a new basis for monetary policy by moving away from exchange rate anchors and toward placing growing reliance on inflation-targeting regimes, which has contributed to successful inflation outcomes. The shift to inflation targeting has underscored the importance of central bank autonomy and encouraged greater transparency in communicating the rationale for monetary policy decisions to the wider community.

Role Models

The region has yielded important role models. The experiences of Chile and Mexico in delivering sustained and less volatile growth, improving policy flexibility, and striving for social consensus have become important examples for the region. Both countries have established sound macroeconomic frameworks and open trade regimes that have allowed them to successfully avoid the financial difficulties affecting other countries in the region during recent years. Moreover, they offer valuable lessons on the benefits of containing public debt, implementing an inflation-targeting framework, and building a strong regulatory and supervisory framework for the banking system. Other countries in the region have also demonstrated successes in important areas that can be followed by others—for example, Brazil’s success in building a strong set of institutions for fiscal management.

Crisis Resolution

Although financial crises have recurred in the region, the speed with which the affected countries have been able to recover has generally exceeded expectations. For example, Brazil has endured two periods of high stress since 1998, but, each time, the government’s commitment to low inflation and fiscal prudence has fostered a rapid stabilization of the situation and return of the country’s access to international markets. Elsewhere in the region, Argentina and Uruguay have now returned to growth faster than had been anticipated, although recessions were very deep after their crises in 2002. Thus, countries in the region have generally been better positioned to benefit from the global recovery over the past year.

Speed of Response

The international community has also demonstrated its ability to act swiftly and comprehensively in addressing crisis situations. IMF-led support packages were assembled in record time in many cases, incorporating increasing safeguards against moral hazard. An important feature of recent IMF-led official assistance in many Latin American countries has been the ability to support economic policy continuity, thereby smoothing political transitions. Thus, in different ways tailored to individual circumstances, recent IMF-supported programs in Argentina, Brazil, Bolivia, Guatemala, and Paraguay have helped maintain macroeconomic stability through periods of political change. There have also been improvements in the role of the private sector in crisis resolution. Uruguay was able to complete a debt exchange in record time last year, and collective-action clauses have become standard in new emerging market bond issues.

Disappointments

Nevertheless, the past decade has also witnessed many disappointments. Most importantly, in contrast to objectives set at the start of the 1990s, a number of Latin American countries have not been able to boost growth in an enduring way and to reduce the recurrence of financial crises. Moreover, efforts to address the region’s high poverty and income inequality have had very disappointing results, leading to concerns about the political sustainability of reforms.

Key Disappointments

The revival of growth and initial improvements in poverty in the early 1990s were not generally sustained. Since the latter part of the decade, per capita income has increased very little, thereby extending for another decade the stagnation of the 1980s. Repeated episodes of financial instability again proved to have lasting adverse effects in terms of lost output and rising poverty and income inequality. Overall, no clear trend emerged toward reducing the region’s high poverty rates and income inequalities. As a result, the gap in living standards with North America has grown over the past decade, and Latin America has continued to fall behind fast-growing economies in Asia.

Prolonged Use of IMF Resources

The period since the early 1990s was marked by continued and prolonged use of IMF resources. Argentina and Bolivia—together with Honduras, Nicaragua, Panama, and El Salvador in Central America—had almost continuous financial arrangements with the IMF in this period. They were not alone, however, since virtually all countries in the region—with the exception of Chile—made substantial use of IMF resources.

Political Economy Factors

The disappointments of the 1990s have had important political economy implications for a number of countries in the region. There has been a risk that popular support for reform programs would be seriously undermined by repeated adjustment programs. Moreover, there has been a growing sense, in many countries, that the benefits of global integration have been unevenly distributed, accruing primarily to those in upper-income brackets although the costs have been borne by the less wealthy majority. In a few countries, there has even been a growing militancy among disenfranchised groups. Thus, the experience of the last decade has emphasized to policymakers and the international community that much more needs to be done to secure and maintain a domestic consensus on continuing economic reforms. In many countries, new or enhanced dialogues with civil society are now under way—auguring well for maintaining the consistency of the reform process in the future.

Explanatory Factors

Although external factors certainly played a role in explaining the recent disappointments in Latin American economic performance, this study suggests that shortfalls in domestic policies bore the principal responsibility. Three types of problems have been identified: policy imbalances, the lack of policy resilience (“crisis proofing”), and the need for more sustained reforms.

Policy Imbalances

The study points to a number of inconsistencies and imbalances in the stabilization and reform programs adopted by Latin American countries in the 1990s:

  • Macroeconomic imbalances. With public debt rising, rather than falling, during the 1990s, a key vulnerability was allowed to persist, constraining overall macroeconomic policy. Fiscal policy remained procyclical; and monetary policy was constrained, first by the fixed exchange rate regimes and then by the events surrounding the disorderly exits from these regimes, including financial-system pressures and strains.

  • Financial systems. The liberalization of financial systems that occurred in the early 1990s was not accompanied by consistently strong regulatory and supervisory frameworks and effective strategies to curtail fiscal dominance. As a result, financial systems remained exposed to systemic risk from public debt and dollarization, which, in turn, created balance-sheet mismatches owing to exchange rate fluctuations. Even well-regarded financial systems, such as that of Argentina, harbored vulnerabilities, especially exposure to public debt and government interference, that were not adequately addressed.

  • Structural reforms. Notwithstanding the ambitious plans of the early 1990s, progress on structural reforms was inconsistent and unbalanced. As indicated earlier in this paper, Latin America’s financial liberalization and capital-market opening in the early 1990s proved to be faster than the adoption of key supporting reforms. Thus, trade opening moved ahead more slowly, and labor and key product markets remained inflexible, with the result that adjustment of trade balances in response to external shocks proved much more difficult than it had been, for example, in Asian economies in the aftermath of the Asian crisis of 1997–98.

Need for “Crisis Proofing”

Latin America’s failure to provide greater insurance against shocks can be attributed to its persisting macroeconomic vulnerabilities, especially in fiscal policy and public debt. In a number of countries, crisis proofing probably weakened, rather than strengthened, as public debt climbed to an average of 60 percent of GDP, despite the Brady debt-restructuring initiative and large-scale privatization programs in many countries that helped to reduce their debts in the early 1990s. Moreover, the debt was often foreign currency-denominated or indexed and issued at short maturities. This debt structure contributed to vulnerabilities, especially when a loss in market confidence entailed higher interest rates or exchange rate depreciation.

The lack of progress with crisis proofing reflected underlying weaknesses in spending and revenue systems and institutions. In addition, there were the heavy costs of dealing with vulnerabilities in banking systems and the recognition of “fiscal skeletons” whose existence was initially hidden in off-budget accounts. Overall, for many countries in the region, “debt intolerance” rose again.178

Sustainability of Reforms

Sustainability of reforms was another problem. Even where reforms were implemented, too often the supporting institutional structures remained weak. Sustainability problems were evidenced in the persistence of informal dollarization because of the continued lack of credibility of macroeconomic policy frameworks. Sustainability issues were most important in the public finances, where problems in tax administration contributed to low collections despite high rates (especially for income taxes and indirect taxes). Low revenues, combined with high revenue volatility and expenditure earmarking, increasingly limited resources for infrastructure and growth while imparting a procyclical bias to fiscal policy and raising the public debt. Structural reform policies, however, also were subject to sustainability problems. In a number of reform areas—including, for example, privatization—the results fell short of expectations because of a lack of complementary policies to strengthen regulations or to ensure an adequately competitive business environment.

Priorities for Future Agenda

In looking at the future agenda for Latin America, the focus needs to be much broader than short-run policies alone. It needs to embrace institutional change that will enhance the sustainability of policy frameworks. Thus, when policymakers are reviewing the priorities in each of the major areas of macroeconomic and structural policies, they need to emphasize institutional change.

Macroeconomic Policies

Monetary and Exchange Rate Policies

Many countries have exited fixed exchange rate systems and have adopted inflation-targeting regimes that offer promising frameworks for implementing monetary and exchange rate policies in the region. Inflation targeting has the key strength of focusing the policy debate on what monetary policy can do on a sustainable basis—that is, controlling inflation—rather than on what it cannot do—raising output growth or boosting external competitiveness. It also provides a suitable framework for implementing flexible exchange rate regimes, which provide greater resilience in the face of shocks. Two important challenges remain, however. First, in those countries that have already adopted inflation targeting, how can the institutional framework for inflation targeting be reinforced to improve implementation and, therefore, entrench credibility? And, second, how can suitably robust frameworks for monetary and exchange rate policies be developed for those countries that choose to pursue alternative policy approaches?

To ensure the credibility of inflation targeting, it is important to establish a clear framework for central bank autonomy. A number of countries have already made good progress toward this goal. This progress can be reinforced by developing stronger central bank laws that clearly assign monetary policy responsibility to senior bank officials; provide appropriate objectives, incentives for performance, and budgeting independence; and further reduce fiscal dominance and financial sector vulnerabilities. Regarding implementation, an important task is to increase transparency about the decision-making process and generally progress further in putting in place all the enabling conditions for full-fledged inflation targeting. This includes the publication of regular reports that discuss the outlook for inflation and the consistency of policy settings with meeting the inflation target. Such an approach would help to convey to markets how the authorities intend to meet their objectives, especially in the face of shocks such as sudden, sharp exchange rate movements.

In contrast to countries with inflation targeting and flexible exchange rate regimes, a number of countries in the region, especially in Central America, continue with less flexible exchange rate systems in which monetary policy is geared toward exchange rate objectives. For many of these countries, priority must be given to developing an institutional and policy framework that will gradually allow for greater flexibility in an orderly way. Some countries, however, may choose to remain with an inflexible exchange rate system or to progress toward full dollarization. Choice of the latter regime typically reflects a country’s circumstances, including trading patterns, degree of dollarization, and past record of inflation control. Countries making such choices must then ensure that fiscal policy is sufficiently robust to support such a regime while making sure that structural policies provide sufficient flexibility in the economy to absorb shocks.

Fiscal Policy and Public Debt

Debt burdens in many Latin American countries are above prudent levels and must be brought down. Reinhart, Rogoff, and Savastano (2003) suggest that the safe range needs to be particularly low for countries with a history of default and high inflation. At the same time, historical experience has taught us that such a transition does not become credible simply through the running of large primary budget surpluses. The pursuit of surpluses needs to be demonstrably sustainable and rigorously implemented, ensuring that—in particular—it is not based on unrealistic spending cuts and distortionary taxes inimical to efficiency and growth. More generally, the pursuit of debt sustainability must be based on a broader agenda to raise growth and implement structural reforms, especially institutional reforms, that can set in motion a virtuous circle of improving confidence, lower interest rates, and higher growth. Short-run policy adjustments that are not accompanied by efforts to achieve broader institutional change are unlikely to bring about such a virtuous circle or be sustained and, therefore, are not likely to succeed in bringing the public debt ratio down in an enduring way.

Institutional weaknesses in fiscal systems identified in this study include reliance on distortionary taxes, low effective tax rates, revenue volatility, and expenditure earmarking and other budgetary rigidities. Raising the effective tax rate depends on addressing tax avoidance and strengthening weak tax administration. Revenue volatility can be dampened by reducing the reliance on the taxation of commodity exports and broadening the tax base. Expenditure earmarking and special wage regimes for protected public sector employees raise difficult issues requiring, in many cases, constitutional changes to implement reforms.

Broader reforms to the overall fiscal framework may also be helpful in instilling fiscal discipline. Legislation to impose conservative and sustainable debt limits may be useful, particularly in countries where strong political forces are driving spending decisions, or where their natural resource revenues are subject to wide short-term swings, but experience has shown that such rules can all too easily be circumvented. Chile’s success with fiscal consolidation in the 1990s illustrates the effectiveness of a range of institutional reforms to support prudent fiscal policy decisions. Important factors that contributed to debt reduction in Chile included giving more power to the finance ministry than to other ministries or the legislature; prohibiting the central bank from extending credit to the government; and preventing lower levels of government from borrowing, thus eliminating the subnational free-rider problem. Brazil’s recent success in strengthening its fiscal position and consistently meeting fiscal objectives has also benefited from a series of fundamental improvements in the budgeting process and the structure of center-state relations in the context of a fiscal responsibility law.

Improving the composition of debt is as important as reducing the level of debt. Specifically, countries should take every opportunity to replace short-term, floating-rate, and foreign currency-linked debt with longer-term domestic debt. Otherwise, countries are left vulnerable to high rates of rollovers and changes in credibility and global financial conditions. To this end, domestic debt must be made more attractive to investors, which requires working to entrench a sound framework for sustaining macroeconomic stability. Inflation indexing domestic debt would reduce the risk of fluctuations in real value, both to lenders and borrowers. This approach has succeeded in promoting longer-term domestic financial intermediation in Chile and Colombia. In addition, experience—especially in Mexico—underlines the importance of maintaining an active investor-relations program, especially to provide transparency and transmittal of information on economic and debt developments.

Structural Reforms for Raising Growth and Reducing Poverty

Latin America has suffered from a chronically weak growth performance, with the structural reforms of the 1990s providing only a temporary reprieve from disappointing outcomes. To improve growth and poverty reduction, macroeconomic policy strengthening needs to be supported by a broad-based structural reform agenda and, in particular, institutional reform. What should be the priorities?

Financial Systems

Achieving sound and resilient financial systems is a key element in reducing Latin America’s vulnerability to crisis and sustaining long-term economic growth. In particular, financial systems across the region require strengthening to enable them to deliver the steadily rising financial intermediation that is needed to support sustained growth. Argentina’s experience shows, however, that even a well-regarded financial system is not safe as long as public debt remains a key vulnerability. Although considerable progress was made during the 1990s in strengthening banking systems, there is a continuing need to improve banking regulation and supervision. It will be important to encourage provisioning requirements based on more forward-looking risk assessments and to ensure that these requirements are reviewed and enforced, minimizing the need for regulatory forbearance as much as possible. Moreover, further efforts are needed to implement crisis-management and bank-resolution frameworks, to improve legal protection for bank supervisors, and to monitor risks arising from cross-border financial integration. In some countries, the legacy of financial crisis persists in the form of nonperforming loans that remain to be efficiently liquidated and public banks that need to be restructured.

Enhancing the transparency of financial activities would help to promote prudent decision making and risk taking. Accounting and auditing standards need to be strengthened to improve the availability and reliability of information to the public while encouraging the emergence of formal credit rating of borrowers, which would help to reduce the cost of lending for banks. Moral hazard implied by deposit-insurance systems would be contained by introducing explicit limits on payouts and restricting benefits to small depositors.

Lack of suitable financing remains an important constraint on growth in Latin America. Sustained credit creation would be encouraged by reducing the costs of dealing with defaults on problem loans. A key step toward achieving this objective is to strengthen lenders’ ability to recover value from distressed loans. In many countries, antiquated bankruptcy laws favor borrowers over creditors, making it difficult to appropriately resolve claims in cases of default. Increasing the operational efficiency of banks, especially of public banks; enhancing competition; and allowing lenders to make more informed decisions would help deepen financial intermediation. It is also important to develop alternative vehicles of financing—for example, through the deepening of capital markets and expansion of microfinancing initiatives.

Trade Opening

Despite considerable efforts to liberalize trade during the 1990s, Latin America remains much less open than other dynamic regions of the world. Reforms to further liberalize trade are critical to stimulating growth and reducing vulnerabilities. The greatest benefits would flow from successful multilateral trade negotiations, which could bring countries improved market access for their key exports, such as agricultural products and textiles. Even if progress on the multilateral front were slow, there would remain considerable scope and benefit for Latin American countries to encourage trade opening, including within the region, by doing the following:

  • curtailing still-widespread protectionist practices in Latin America—in particular, the use of non-tariff barriers, high tariffs on processed goods, and restrictions on trade in services;

  • addressing the shortcomings of existing regional trade agreements to make them more comprehensive in scope in terms of the products and types of policies (investment, regulatory, etc.) covered; and

  • advancing bilateral trade agreements with industrial country trading partners—as well as agreements within the region—that would help to reduce problems of trade diversion and bring a number of advantages, including increased investment flows and technology transfers.

For these initiatives to bear fruit, however, it will be important for Latin American countries to maintain a stable macroeconomic environment with appropriate exchange rates and to further develop trade-related institutions and infrastructure. In particular, improvements are needed in port and customs administrations, which currently impose costly delays and inefficiencies in many countries. Other institutional weaknesses that have hindered trade flows—including legal uncertainties and corruption—and need to be remedied to permit sustained growth are discussed more broadly in the next subsections.

Labor Markets

Labor market reforms—which were notably absent from the reform agendas of most Latin American countries in the 1990s—assume even greater significance in the context of increased trade liberalization. International experience suggests that this is a key step toward increasing flexibility, private investment, and growth in the economy. Recent research has stressed that reaping the full benefits of trade integration depends upon the flexibility within economies for labor to move across employment sectors—from less productive to more productive ones.179 Institutional arrangements in the form of high severance costs and restrictions on hiring temporary workers act as significant barriers to entry and exit and, therefore, to such flexibility. Elevated nonwage labor costs are also an impediment to employment. Although initial political obstacles must be overcome, labor market reforms that make it more attractive to hire workers will, over time, yield broad-based benefits, including more rapid growth of employment in the formal sector, that would, in turn, likely increase popular support for the reform process. The state has an important role, in this context, in providing for efficient mechanisms to deal with transitional problems associated with intersectoral mobility, and to invest in workers’ training and skill upgrading, especially in the context of increased external trade openness.

Role of State in Governance and Institutional Reforms

In a number of Latin American countries, weak institutions of governance have undermined market activity; support for broad-based reforms; and, ultimately, growth. Institutional reforms are needed to confront these weaknesses, create a firmer foundation for economic activity, and thereby sustain growth.180 The task is arguably more difficult now, since institutions in the region have been successively weakened by a history—in many countries—of recurrent crisis.181

Corruption has tended to hamper economic growth and foreign investment, which relies on investors’ perceptions of contract viability, ease of profit repatriation, and the probability of payment without delay. The poor have been hardest hit by corruption, given their greater reliance on public services and inability to pay the high costs of bribery or fraud. Visibly reducing corruption would provide a positive impetus to growth and help to sustain support for the reform process. For example, fostering greater accountability of the public sector—for example, by assuring public access to government information—would help to deter corruption.

Reforms are also needed in the judicial system, which is often regarded as weak and highly politicized rather than impartial in predictably enforcing laws. The absence of a strong judicial system tends to undermine investor confidence and property rights, hindering the introduction of new reforms, increasing lending risk, and ultimately restraining economic activity. Establishing an independent and responsible judiciary is central to increasing the credibility of the rule of law and improving the environment for the operation of market forces. Strengthening the judicial process will require improving the accountability of judges—including through publishing information on judicial performance. Judicial efficiency could be improved by simplifying legal procedures and establishing specialized court systems—such as bankruptcy and commercial courts—or alternative dispute-resolution mechanisms.

Many of these concerns directly affect the business environment, which is crucial for attracting and increasing private investment. As previously discussed, Latin America generally does less well than other, more rapidly growing regions in providing the key ingredients of a friendly investment climate. A number of surveys have shown the increased dead-weight costs associated with heavy regulation of the entry and exit of businesses, labor force management, and contract enforcement. These costly distortions in the regulatory and incentive structures in many Latin American countries divert domestic capital and investment overseas, and often hit hardest small and medium-sized enterprises and those in rural areas, which typically face greater difficulty than urban enterprises in accessing public services. Improving the investment climate can directly help attract new private investment that is crucial for productivity and growth; and provided the improvements are equitably implemented within countries, they can also help to integrate the small enterprises and the rural economy—thereby reducing income inequalities and poverty. The state has a crucial role in improving regulatory governance and better securing property rights to help establish a more enabling investment climate.

IMF Role: Supporting Growth Agendas

Faced with the economic and financial crises in Latin America, as well as in other emerging market countries, over the past decade, the IMF has understandably emphasized crisis resolution and prevention. Much progress has been made, especially in drawing lessons from these crises in emerging markets, expanding the tools of crisis prevention, and deepening IMF surveillance of key risks and vulnerabilities.

Taken together, the various initiatives have already brought about a sea change in the role of the IMF:

  • The need to reduce vulnerabilities to crises has led the IMF to emphasize developing a framework of internationally agreed standards and codes for monetary, fiscal, and financial transparency (reflected in countries’ preparation of reports on standards and codes, or ROSCs); encourage deeper cooperation on financial sector issues, including through the Financial Stability Forum; emphasize greater transparency of IMF staff work, including through the publication of country reports and policy papers; and deliberately focus on the social costs of crises and their alleviation.

  • The IMF has also been at the center of the continuing debate on crisis resolution that has led to the widespread acceptance of collective-action clauses (CACs) in new bond issues with no evidence of any additional interest premium resulting from their use. The increased issuance under local law of international sovereign bonds including CACs in New York, where they had not been the market standard, has been a major positive development since 2003.

  • The IMF’s stronger focus on potential vulnerabilities, with more rigorous and candid assessments of debt sustainability, exchange rate arrangements, and balance-sheet exposures have raised the bar for surveillance and Article IV consultations.

Although they are still being consolidated, these initiatives have helped to catalyze stronger and more transparent policymaking in Latin America, which has already had a considerable impact on markets. There is evidence that contagion risks have lessened; the dispersion of spreads on emerging market debt has increased; and cross-country correlation of financial market developments has been reduced—all evidence of greater market discrimination between countries.

The agenda for the region’s future includes, in particular, sharpening the IMF’s surveillance role, particularly in countries that have had a succession of IMF-supported programs, and increasing the focus on entrenching growth. Several aspects of these issues warrant further discussion:

  • The experience in Latin America of prolonged dependence on IMF arrangements and financial assistance, in a situation of recurrent financial crisis, has exposed the need for the surveillance process to include “a fresh pair of eyes.” This applies to both sides of the dialogue. Prolonged use of IMF resources has probably also been inimical to a process of widening contact in the community and building awareness for longer-term institutional change, given the typically small group of officials charged with the responsibility of putting together IMF-supported programs in times of crisis. In particular, the IMF’s surveillance role, carried out through the Article IV consultation process, should be strongly maintained even while the country has a current IMF-supported program.

  • A parallel challenge for the IMF lies in sharpening its focus on promoting growth. A growth-focused agenda will have many dimensions—including infrastructure investment, the corporate sector, the labor market, and other issues that lie outside the IMF’s core expertise—and thus heighten the need for effective coordination with the other relevant international financial institutions (IFIs)—the World Bank and the Inter-American Development Bank. To be sure, in recent years, a number of important initiatives have already helped to improve such coordination—such as the poverty reduction strategy paper (PRSP) process for low-income countries and the broadening use of Financial Sector Assessment Programs (FSAPs). There is room, however, for expanding collaboration in the higher-income countries in the region, where PRSPs are not prepared, and especially in helping identify and raise funds for efficient public investments and coordinating technical assistance.

  • Institutional reforms have been a recurring theme of this paper. Recent IMF research indicates that institutional factors—including those related to governance and corruption issues—are more important than capital-labor ratios in explaining cross-country differences in per capita incomes. Institutional strengthening is seen as crucial to build and foster increased levels of “crisis proofing,” improve the business climate, attract private investments, and support growth. Achieving the priority objectives for Latin America that were discussed in the previous subsections will depend heavily on achieving institutional change. Such an approach will also place increased demands on closer coordination among the IFIs.

Experience in Latin America over the last decade and a half suggests two important lessons for the IMF and the other IFIs to keep in mind as they increase their emphasis on institutional change and reform:

  • first, broad country ownership of the institutional policy agenda will be even more essential, since political interests would be directly involved; and

  • second, external incentives or anchors can play a crucial role in catalyzing the process of domestic institution building in Latin America.

Establishing country ownership of institutional change will, most likely, prove to be an even more daunting challenge than doing so for ownership of prudent short-run macroeconomic management—particularly since it involves even greater political sensitivities and trade-offs. In addition, institutional reforms do not always lend themselves to “best-practice” formulations because of the diversity of individual circumstances and conditions.182 The payoffs from doing this would be considerable, however, most notably because tensions over short-run policies could be reduced. The shift to inflation targeting is a good example of an institutional change that has generally reduced controversy over short-run monetary policy. Accordingly, conditionality in IMF lending programs will need to evolve further and emphasize institutional change rather than short-term policy adjustment. In many countries, such a shift would be regarded as politically intrusive. The ground therefore needs to be carefully prepared by an outreach strategy that is well coordinated among the IFIs. Such an outreach strategy could include the following elements:

  • Contacts with national congresses. The IFIs could present coordinated seminars for members of congress in selected countries to encourage greater understanding of the policies that the IFIs are advocating and improve the IFIs’ understanding of the concerns of lawmakers and the constraints that they face.

  • Contacts with civil society. In the course of their country work, staff members of the IFIs need to find opportunities to explain policy options to civil society. These contacts are essential to ensure that the IFIs fully understand the issues facing a country and communicate effectively the logic behind IFI policies to as wide an audience as possible, thereby helping encourage ownership. It is especially important to explain the need for civil service reforms; and, toward this end, the IFIs will need to undertake presentations to groups—such as teachers, health service workers, and the military—that typically have special wage and/or pension regimes.

Finally, an improved set of external incentives or anchors can play an important role in supporting the process of domestic institution building in Latin America. International trade offers clear possibilities for such anchors and incentives:

  • Greater trade openness in Latin America would—in addition to its other benefits—help to strengthen institutions. The opening up of markets can play an important role in weakening vested interests and reducing economic rents associated with long-standing economic and institutional arrangements. Trade can thus spur improvements in domestic institutions that otherwise would not have been possible.

  • International agreements can be an important external anchor and catalyst for institutional change by breaking through domestic impediments to reforms. For example, participation in NAFTA has helped to build stronger institutions in Mexico than might otherwise have been possible. The emerging trade agreements with the United States that are under consideration—such as the U.S.-Central American Free Trade Agreement—are likely to provide a boost to institutional development in a number of countries. From a broader perspective, membership requirements of the World Trade Organization will also contribute to reforms.

Access to IMF arrangements that rewards good policies and, thereby, strengthens the incentives for good practice is also likely to continue to be very beneficial as an external anchor. Although prolonged use of IMF resources may have perversely reduced program ownership in many countries, well-designed instruments that reward good behavior could catalyze the opposite effect.

References

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  • International Monetary Fund (IMF), 2004, World Economic Outlook: A Survey by the Staff of the International Monetary Fund, April, World Economic and Financial Surveys (Washington).

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  • Reinhart, Carmen, Kenneth Rogoff, and Miguel Savastano, 2003, “Debt Intolerance,” Brookings Papers on Economic Activity, 1, Brookings Institution, pp. 174.

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1

The reform policies included fiscal discipline, reordering public expenditure toward basic health and education, tax reform, market-determined interest rates, a competitive exchange rate, trade liberalization, openness to foreign direct investment, privatization, deregulation, and improved property rights. See Williamson (1990).

2

There is a growing literature published, both within and outside the IMF, that analyzes the economic impact of IMF programs. Prominent examples of this literature with particular relevance to the Latin American experience include Hutchison and Noy (2004); IMF, Independent Evaluation Office (2002, 2003, 2004); IMF (2003); and Mussa (2002).

3

Given that monetary anchors had failed to control inflation, exchange rates were viewed as a more effective anchor that would introduce credibility to policy that the central bank lacked under a discretionary framework. These issues are discussed in more detail in Section IV.

4

There is emerging evidence that the pass-through of exchange rate depreciations to inflation has been falling in Latin America. See, for example, Carstens and Werner (1999), Mihaljek and Klau (2001), and Belaisch (2003).

5

For a discussion of the factors that contributed to the fall in growth during the 1980s, see Loayza, Fajnzylber, and Calderón (2003).

6

A recent report by Brazil’s Ministry of Finance estimated that per capita income in Brazil is currently just as far from the North American level as it was in 1960. See Brazil, Ministry of Finance (2003).

9

An even higher proportion is engaged outside the formal sector in Brazil, where the share of informal employment has steadily increased over the past decade, with negative effects on productivity and real wages. See Brazil, Ministry of Finance (2003).

10

Kochhar, Lane, and Savastano (2003) survey the crisis experiences in Ecuador (1999), Mexico (1995), Brazil (1999), Indonesia (1998), Thailand (1998), Malaysia (1998), the Republic of Korea (1998), Russia (1998), and the Philippines (1998). Almost all were characterized by a sharp drop in output in the first year, led by a collapse in domestic demand.

11

Poverty statistics vary considerably, depending upon the underlying methodology used. See Székely, Lustig, Cumpa, and Mejia-Guerra (2000) for a discussion. In this section, poverty data are based on those compiled in ECLAC (2002). For a discussion of poverty trends, see ECLAC (2002). Morley (2001) and ECLAC (1997) provide various explanations for the persistence of poverty in the region.

12

World Bank data, which define poverty as those people living on less than $1 per day, show similar poverty trends. Based on this alternative definition, the poverty rate in Latin America edged down from 11.3 percent of the population in 1990 to 9.5 percent in 2001, the most recent year for which data are available. In absolute terms, over the same period, the number of people living in poverty rose by about 500,000 people to 49.8 million. For a discussion of World Bank methodology and data, see World Bank (2003c and 2001).

13

Poverty rates increased sharply in both Argentina and Uruguay in 2001–2002 following financial crises. ECLAC (2003) estimates that poverty in Argentina doubled to 45 percent in 2002 from its 1999 level. Similarly, in Uruguay, poverty is estimated to have increased to 15 percent from about 9 percent in 1999. In Colombia, the impact of higher social expenditures was offset by displacements caused by the ongoing internal conflict.

14

Deininger and Squire (1996); see also Morley (2001). Empirical evidence suggests that the dominant factor in explaining differences in inequality is the level of education. See Menezes-Filho (2001).

15

See World Bank (2003b), Deininger and Squire (1996), and Morley (2001). The Gini coefficient (which ranges from 0 to 1) measures inequality; the higher the coefficient, the higher the level of inequality.

16

Székely (2001) estimates income inequality trends based on regression estimates for each country, where the dependent variable is the Gini coefficient and the independent variable is a time trend.

18

For a detailed discussion, see World Bank (2003b).

19

Evidence on the effect of inequality on growth is mixed. The studies surveyed in Benabou (1996) and Perotti (1996) suggested that higher inequality tended to reduce future growth, but Forbes (2003) finds that this result is reversed when different measures of inequality are used on panel data.

20

The analysis early in the decade of Calvo, Leiderman, and Reinhart (1992) presaged many of the subsequent difficulties with external shocks and capital flows to the region.

22

Stallings and Peres (2000) provide evidence that economic growth in the region is more closely linked with capital inflows than with trade flows. Fernandez-Arias and Panizza (2001) find that an increase in private net capital flows of 1 percentage point of GDP boosts growth by almost ½ of 1 percentage point.

23

Immediate contagion from Mexico was experienced by Argentina, whose fixed exchange rate regime was tested, and successfully defended, in April 1995.

24

Nevertheless, there was also a notable slowdown in Chile’s total factor productivity growth over this period. Although there is not yet a consensus on the sources of this slowdown, it appears to have been at least partly due to a fading of the effects of structural reforms, for instance in education (Beyer and Vergara, 2002).

25

Not all programs were framed in a crisis context, however. It should be noted that a number of arrangements with the IMF were precautionary in nature, in the sense that these countries did not expect to use IMF resources. The Poverty Reduction and Growth Facility (PRGF) programs were in support of poverty reduction and growth agendas, and were not necessarily responses to financial crises.

26

The underlying problem was the lack of fiscal restraint when economic conditions were favorable, which, in turn, led to debt accumulation. When economic conditions deteriorated and market access disappeared, the only options were fiscal restraint or a return to the reliance on inflationary financing of fiscal deficits seen during the 1980s.

27

Some studies have analyzed the interaction between structural reforms and macroeconomic stabilization. For example, Ocampo (2004) observes that the most aggressive structural reformers also introduced strong stabilization policies that reinforced the initial results—for example, Chile and Peru in the early 1990s, with Argentina also having been viewed as a strong reformer in this period. Over time, however, rigid stabilization frameworks tended to undermine the effects of reforms. Lora and Panizza (2002) finds that the extent of reforms has tended to differ more across policy areas than across countries.

28

The Lora and Barrera (1997) estimates suggested that structural reforms had boosted growth by 1.9 percentage points, or a total of 2.2 percentage points if macroeconomic stabilization plans were also included. Other early studies also concluding that the reforms had a positive and significant impact on growth include Fernandez-Arias and Montiel (1997); Easterly, Loayza, and Montiel (1997); and IADB (1997).

29

Lora and Panizza (2002), as well as Stallings and Peres (2000) and Escaith and Morley (2000), conclude that the reforms had a smaller and less robust effect on growth than had previously been thought.

30

The importance of labor market reforms in Chile’s early reform efforts is discussed in Foxley (2003). Foxley points out the benefits of establishing a permanent tripartite dialogue between the government, the private sector, and labor organizations.

31

For recent evidence on the importance of strong governance and institutions in fostering sustained growth, see IMF (2003); Rodrik, Subramanian, and Trebbi (2002); Kaufmann and Kraay (2002); Hall and Jones (1999); and Rodrik (1999). Institutions are found to be important because of their role in determining transaction costs and facilitating market activity; supporting structural reforms; and promoting incentives for productive activities, such as the accumulation of skills or the development of new goods, rather than redistributive activity, such as rent seeking, corruption, or theft.

33

The extent of privatization has varied considerably among countries, with Bolivia, Brazil, and Argentina having undertaken the most aggressive programs. For the region, more than half the privatizations (measured by value) have taken place in the infrastructure sector, with another 10 percent in the banking sector.

34

Of course, debt problems in the region have a long history, dating back to the Peruvian default in 1826; see Kaminsky, Rein-hart, and Végh (2003).

35

See Montiel and Reinhart (2001) for a general discussion of different views on the role of “push” versus “pull” factors in causing volatility in capital flows. On Argentina’s widely analyzed experience in the late 1990s, Mussa (2002) and Perry and Servén (2003) emphasize domestic policy errors, while Calvo, Izquierdo, and Talvi (2002) place more weight on external influences.

36

Contrary to the widespread view at the time that exchange rate-based stabilization plans would discipline fiscal policies, Tornell and Velasco (1995, 1998) and, more recently, Sun (2003) provide theoretical models of why fixed exchange rates would not have this effect. Empirically, Hamann (2001) finds no evidence that fiscal discipline has been enhanced by exchange rate-based stabilization plans.

37

As discussed in IMF (2003), external public debt was not notably high relative to GDP in Latin America, as ratios for countries in this region were similar to those in emerging Asian economies in the 1980s and 1990s. There was an important difference, however, in the ratio of external public debt to exports, which was much higher in Latin America than in Asia. The implications of this imbalance are discussed in more detail in Section VII.

38

The average public debt ratio in Latin America rose by 13 percentage points during 1993–2002. Replicating the decomposition used in IMF (2003) indicates that cumulated primary balances over this period caused the ratio to fall by 10 percentage points while real growth contributed to a decline of another 9 percentage points. In contrast, “other factors”—including interest costs and off-balance-sheet and contingent liabilities, and, in many cases, the fiscal costs of bank restructuring—contributed to a 32 percentage point increase in the ratio.

39

See Mussa (2002) for a discussion of the Argentina case. Reinhart, Rogoff, and Savastano (2003) show that countries with characteristics common in Latin America become vulnerable to crises at debt levels that are moderate by international standards.

40

See IMF (2003) and Perry (2002) for an overview of this procyclical bias. See also López Murphy (1994) for Argentina; Gavin and others (1996) and Gavin and Perotti (1997) for Latin America; Talvi and Végh (2000); and Hausmann (2002a). Calderón and Schmidt-Hebbel (2003) present evidence that procyclicality was specific to countries with low credibility and larger associated risk premiums.

42

The difficulty for emerging markets borrowing abroad in domestic currency—“original sin”—has been extensively analyzed. See Hausmann (2002a) and Eichengreen, Hausmann, and Panizza (2002) for recent discussions. Ortíz (2002) notes, however, that Chile and, more recently, Mexico are examples of countries that have overcome original sin through the promotion of domestic financial markets.

43

The view that equilibrium real exchange rates would be more appreciated as a result of structural reforms contributed to this belated recognition. For Argentina, however, Calderón and Schmidt-Hebbel (2003) calculate that even large productivity increases would have an effect of less than 1 percent on the real exchange rate over three years.

44

Of course, part of the eventual depreciation in Argentina likely reflected an overshooting of the real exchange rate. Using a model-based estimate of the equilibrium real exchange rate, Perry and Servén (2003) calculate an overvaluation of the Argentine peso of 53 percent in 2001, implying an adjusted debt-to-GDP ratio of 95 percent, in contrast to the measured 62 percent.

45

Carstens, Hardy, and Pazarbaşioğlu (2004) observe that these failures in supervision were generally not due to a lack of technical skill or ignorance of the true situation, but rather to political interference in oversight of the financial system. They stress the need to insulate supervision from political influences and to ensure that these institutions have the appropriate resources and legal authority to operate effectively.

46

See Hemming and Ter-Minassian (2003). In some countries, such as Brazil, the eventual cost may decrease as guarantees are liquidated.

47

Some authors characterized the increase in bank exposure to the government as involuntary, as described, for example, in de la Torre, Levy Yeyati, and Schmukler (2003): “in April 2001, the government used moral suasion to place some $2 billion of bonds with banks in Argentina, allowing banks to use those bonds to meet up to 18 percent of the liquidity requirement.”

48

Indeed, this was common to the prudential frameworks of all countries that subscribed to the Basel I capital-adequacy guidelines.

49

The role of structural fiscal weaknesses in contributing to failed stabilization efforts in the region is discussed in Ter-Minassian and Schwartz (1997).

51

In addition to lack of institutional capacity at the local government level, this may have reflected weak incentives for local governments to raise revenues given the availability of federal transfers in several countries.

53

In Mexico, for instance, tax expenditures are estimated to amount to about 5 percent of GDP, compared with total tax revenues of 12 percent of GDP.

55

Earmarked spending is defined to include constitutionally mandated floors on certain spending items and subnational government transfers.

56

Since 1999, for example, the Brazilian constitution has required that spending on health care rise by at least 5 percent per year.

57

Another contributor to high and rigid wage costs was generous pension plans provided to the public sector, including public enterprises, teachers, and the military.

61

See Lloyd-Sherlock (2000) and Chu, Davoodi, and Gupta (2000). A study by the World Bank (1994) reveals that social insurance programs in Latin America rarely cover more than half of the labor force, versus an estimated 94 percent in OECD member countries.

63

In Colombia, by contrast, although public expenditure has been decentralized, the central government has retained considerable control (for example, in setting wages and earmarking inter-governmental transfers for specific functions). Mexico is another example of limited decentralization, with the central government maintaining control over the majority of expenditures.

66

PIDIREGAS stands for Proyectos de Infraestructura Productiva de Largo Plazo.

67

Mackenzie (1995) surveys the problems of public pension systems in Latin America.

68

Chile was the first Latin American country to radically reform its pension system by introducing a private, defined-contribution scheme in 1981. See, for example, Diamond (1994) and Edwards (1996). In the 1990s, Chile’s reform formed the basis for reforms in other Latin American countries. For example, in Bolivia and Mexico, the public system was replaced with a privatized one, whereas Argentina, Uruguay, Colombia, and Peru added a new private tier and modified the public system. In contrast, Brazil offered supplementary pensions. For a detailed comparison, see Kay and Kritzer (2001) and Mitchell and Barreto (1997).

69

For example, in Chile, Colombia, and Peru, active labor force participants at the time of reform were given “recognition bonds” that would mature at retirement. In contrast, Argentina and Bolivia simply pay compensatory pensions. See Schmidt-Hebbel (1999).

70

Reviews of the literature include Alesina and Perotti (1996) and Annett (2002).

73

As discussed in Kopits (2001), however, fiscal rules are not a panacea. Governments with strong fiscal records, for instance, may find explicit rules to be overly restrictive; conversely, in cases where the underlying political commitment to prudence is lacking, rules may not effectively constrain actual policy implementation.

76

Net revenues were defined as total current revenues, less constitutionally mandated transfers from the federal government and social security contributions from current civil servants.

77

See Pazos (1972) for a review of the longer history of monetary instability in the region.

78

Based on Cagan’s (1956) definition of hyperinflation “as beginning in the month in which the rise in prices exceeds 50 percent and ending in the month before the monthly rise in prices drops below that amount.”

81

The classic reference to long-run fiscal dominance is Sargent and Wallace (1981).

82

The regression in the pre-stabilization period yields a slope coefficient of 23.5 with a t-statistic of 3.01, while the post-stabilization coefficient is 0.014 with a t-statistic of 0.004. Excluding the extreme case of Bolivia in the pre-stabilization period, which had a particularly large fiscal deficit of about 20 percent of GDP, the slope coefficient is 35.2 with a t-statistic of 2.40.

83

For countries with hard exchange rate targets, the classifications and timing in Table 4.1 generally correspond to the official implementation of explicit regime changes. The classification of countries with informal inflation objectives is based on Corbo (2000). Countries were defined as having “soft” exchange rate objectives when the volatility of nominal exchange rate movements was significantly greater than under hard exchange rate targeting (Table 4.2).

Looking more narrowly at exchange rate regimes, as opposed to the overall monetary policy framework, the literature on de facto classifications includes Ghosh and others (1997), Calvo and Reinhart (2000), Reinhart and Rogoff (2002), Levy Yeyati and Sturzenegger (2002a), and Bubula and Ötker-Robe (2002). For the purposes of this study, one drawback to these classifications is that they look only at exchange rate regimes as opposed to the overall monetary framework. Frenkel (2003) also notes that the conclusions of these studies are often contradictory and depend on the criteria chosen.

84

Bolivia is excluded from this classification because stabilization was initially achieved in 1985–86 without an explicit exchange rate anchor. The crawling-peg system was introduced in late 1986 after inflation had fallen sharply.

85

The choice of exchange rate regime in stabilization plans is discussed in Edwards (1998) and Gould (1996). Interestingly, these studies generally argue that a history of high inflation is associated with the choice of money-based stabilization as opposed to exchange rate-based stabilization, which seems to be at odds with the experience in Latin America in the late 1980s and early 1990s.

86

In terms of fiscal measures, Brazil is an exception, since its primary surplus in 1994 reached 5.1 percent of GDP. Both Jácome (2001) and Gutiérrez (2003) find evidence that greater central bank independence is associated with better inflation performance in Latin America.

87

Of course, subsequent developments underscore the fact that institutional arrangements of this nature do not offer complete protection against the failure of monetary regimes.

88

For Peru, the beginning of the stabilization effort could also be dated from mid-1990, with the election of Alberto Fujimori’s government; specific inflation objectives were not introduced until the beginning of 1993.

89

See Mishkin and Savastano (2000) for a discussion of this issue. Corbo (2000) analyzes econometrically the response of these countries’ policies to various factors, supporting the view that they behaved as inflation targeters.

90

At the same time, it may be surprising that the plans enjoyed sufficient credibility to bring down inflation quickly, given the extensive and unsuccessful track record of exchange rate-based stabilization plans in the region. See Edwards (2000) for a discussion of the experience in the 1970s and Pazos (1972) for a longer historical perspective. The difference may have been that these plans were introduced in the context of more comprehensive efforts to correct deficiencies in fiscal and monetary policies.

91

As discussed below, Mexico had a similar experience of slow disinflation after adopting an informal inflation objective following the 1994–95 crisis; Brazil, in contrast, made the transition to formal inflation targeting in 1999 without a sustained period of double-digit inflation.

92

See, for example, Almeida and Goodhart (1998) and Bernanke and others (1999). Brazil’s experience in 1999 is somewhat unique, in that the initial level of inflation was very low (1.7 percent through 1998). The challenge for the inflation-targeting framework, then, was to contain inflation in the face of a large exchange rate depreciation as opposed to engineering a disinflation process.

93

If the starting point of monetary stabilization for Peru is instead dated at August 1990, when the “Fujishock” program was introduced, the real effective exchange rate would have depreciated about 20 percent during the period shown in Figure 4.4.

94

The consumer price index (CPI)-based real effective exchange rates of Mexico and Uruguay were, respectively, about 20 percent and 25 percent below the average of the 10 years preceding stabilization, while Argentina’s exchange rate was about 30 percent above the comparable level.

95

Although it would also be desirable to look at the evolution of real interest rates, it is difficult, in practice, to construct reliable estimates of inflation expectations given the high degree of financial volatility during the transition to stabilization.

96

References to the typical cycle associated with exchange rate-based stabilization include Végh (1992), Calvo and Végh (1999), and Kiguel and Liviatan (1992).

97

It is notable that business investment was typically not a driving force, perhaps reflecting underlying weaknesses in reform plans that failed to instill longer-term confidence.

98

This assessment, of course, is easier to make in hindsight. As discussed in Section II, there was a view at the time that higher potential owing to the reforms would allow countries to service debt more easily over the longer term. There was also an expectation that trade liberalization would lead to more rapid export growth than actually occurred, as is discussed in Section VII.

99

Designing a viable exit strategy would have presented its own challenges. The relevant issues are discussed in Eichengreen and Masson (1998), who observe that exit from a fixed exchange rate is easier when financial conditions are stable. Yet this is also the environment in which the motivation for abandoning the exchange rate anchor is least compelling.

100

Martinez and Werner (2002) provide firm-level evidence for Mexico that the foreign exchange exposure of corporations increased during the period of exchange rate-based stabilization.

101

Agosín and Ffrench-Davis (2001) discuss Chile’s experience. Controls were instituted in 1991 with a reserve requirement of 20 percent. The rate was raised to 30 percent a year later, reduced to 10 percent during the Asian crisis, and eventually eliminated in 1998. Ocampo and Tovar (2003) analyze the Colombian case. Controls in the form of compulsory deposits were in place from 1993 to 2000, with deposit rates that varied over time from 10 percent to almost 100 percent and also depended on the maturity of the inflow.

102

Le Fort and Budnevich (1996) and Le Fort and Lehmann (2003) argue that more scope was provided for policy independence, while De Gregorio, Edwards, and Valdes (2000) find little evidence of such an effect. Espinosa, Smith, and Yip (2000) provide a theoretical framework for how capital controls can reduce economic volatility and raise growth.

103

On the role of short-term external debt in predicting financial crises, see Radelet and Sachs (1998); Berg and Patillo (1999); and Berg, Borensztein, and Pattillo (1999).

104

On the general issue of why fiscal prudence may not be promoted by exchange rate-based stabilization, see Tornell and Velasco (1995, 1998).

105

In particular, a decline in domestic prices was needed to offset the decline in the domestic prices of imported goods associated with a reduction in trade barriers.

106

See Cuevas and Werner (2003) for evidence on liability dollarization in the Mexican corporate sector.

107

In this context, Hamann and Prati (2002) find that exchange rate anchors enhance the probability of a successful disinflation strategy. Their evaluation period, however, extends only three years after the beginning of the disinflation. Thus, the stabilizations in Argentina (1991), Mexico (1989), Uruguay (1992), and Ecuador (1994) are judged to have been successful, even though they eventually ended in crisis.

108

See Berg and others (2003) for a review of monetary regimes following financial crises, including Mexico (1994), Brazil (1999), and Ecuador (1999). The Mexican experience is described in more detail in Carstens and Werner (1999).

109

See Belaisch (2003) for a discussion of why inflation pass-through may have been low in Brazil during this episode.

110

About twenty countries worldwide have adopted inflation-targeting regimes, demonstrating a trend that is likely to continue. Argentina is also preparing to implement inflation targeting.

111

Ho and McCauley (2003) analyze how exchange rate movements have been incorporated in inflation-targeting frameworks in emerging market economies. Other recent analyses of inflation targeting and exchange rate policy in emerging markets include Schaecter, Stone, and Zelmer (2000); Williamson (2000); Rojas-Suarez (2003); and Goldstein (2002).

112

Ortíz (2002) discusses the recent experiences with counter-cyclical monetary policy in Mexico and Chile.

114

See Mishkin (2000); Mishkin and Schmidt-Hebbel (2001); and Fraga, Goldfajn, and Minella (2003) for comprehensive assessments of the conditions and unresolved issues regarding the implementation of inflation targeting, especially of the implications for emerging market countries. Corbo and Schmidt-Hebbel (2001) and Corbo (2002) present additional material on the Latin American experience.

115

See the recent discussion in Fischer (2003).

117

See Catão (1997) for a detailed discussion of the Argentine experience.

119

Section VI addresses issues associated with dollarization in Latin America.

120

Carrasquilla, Galindo, and Vásquez (2000) find that the severe credit contraction observed in Colombia after 1998 was mainly due to banks’ inability, rather than their unwillingness, to lend.

121

Attractive domestic factors were reinforced by the slowdown in industrial countries in the early 1990s and the decline in their interest rates.

122

Forty percent of all inflows during 1993–96 were in the form of short-term foreign currency lending to banks and equity portfolio flows.

123

Herrera and Perry (2003) discuss the interaction between excessive credit creation and bubble formation in Latin America.

124

For comprehensive discussions of the costs of banking crises, see Caprio and Klingebiel (2003) and Hoelscher and Quintyn (2003).

125

The total cost of the Argentina crisis of 2001–2002 has yet to be determined, but it is unlikely to exceed 20 percent of GDP.

126

Pimintel Puga (1999) estimates that in the year before the Asian crisis, loans made by Korea’s largest banks amounted to more than 800 percent of net equity; those in Indonesia averaged more than 900 percent; and in Thailand, they averaged 1,400 percent. In comparison, the average credit-to-equity ratio for the top five banks in the year before their banking crisis was 480 percent in Brazil and 550 percent in Argentina.

127

For more details on the unfolding of the crisis and the policy response, see Collyns and Kincaid (2003) and IMF (2003).

128

So far, FSAPs have been completed or planned for in 16 Latin American countries.

129

The benefits and costs of financial dollarization are discussed fully in Baliño, Bennett, and Borensztein (1999).

130

In Guatemala, reported onshore deposits in U.S. dollars understate the extent of dollarization. The offshore banking system, which was unregulated before 2003, is fully dollarized and is estimated to be equivalent to one-third of the onshore financial system. Costa Rica also has a sizable offshore sector that is fully dollarized, subject to limited supervision, and not captured in the reported data.

131

Ecuador introduced full dollarization in 2000 to bring the economy out of a severe crisis, while El Salvador made this shift in 2001 in an effort to lock in stability that had already been achieved and to promote growth. Panama has been officially dollarized since 1904.

132

Indeed, by 1999–2000, there was a growing body of research that pointed to the benefits of full, official dollarization for many Latin America countries (Calvo, 2001 and Alesina, Barro, and Tenreyro, 2002). There is also some evidence that dollarization has been somewhat successful at retaining financial depth during periods of high inflation (see De Nicolo, Honohan, and Ize, 2003).

133

See Ize and Levy Yeyati (1998) and De Nicolo, Honohan, and Ize (2003) for econometric support for this observation.

134

In Bolivia, for example, fewer than 4,500 holders of deposits higher than US$100,000 account for almost half of total deposits.

135

Loans to nonresidents financed by nonresident deposits incurred no reserve requirements. Loans to residents financed by nonresident deposits, however, had a higher reserve requirement.

136

The limits are usually wider, however, than in the five countries that have little or no dollarization. In Uruguay, the limits were very wide and left the banks exposed to significant exchange risk.

137

See Honohan and Shi (2001). According to this study, a 10 percentage point increase in dollarization is associated with an 8 percent increase in the pass-through coefficient.

138

Considerable cross-country empirical evidence has shown trade openness is associated with higher productivity and income per capita, and that trade liberalization contributes to growth. Empirical evidence on the positive connection between trade and growth is discussed in Berg and Krueger (2002).

139

For further details, see, for example, Burki and Perry (1997).

140

Based on evidence from Lora (2001).

141

Estimates are from Laird and Messerlin (2003).

142

Many Latin American countries also used export-promotion schemes (for example, import-duty drawbacks, export-processing zones, and marketing and insurance support) to foster and develop export markets. As discussed in Macario (2002), however, with the exceptions of Chile and Mexico, export promotion was relatively ineffective in boosting export growth.

143

Estimate based on 11 Latin American countries for which data are available. For further details, see IADB (1996).

144

Evidence in Burki and Perry (1997) shows that the weighted incidence of nontariff measures in Latin America fell from more than 30 percent in the 1980s to around 5 percent in the early 1990s, which was just above the level in the Asian newly industrializing countries. Nontariff restrictions are measured as the weighted percentage of tariff-code lines covered by various types of nontariff barriers (such as licenses, quotas, and prohibitions) as a percentage of all tariff code lines, using as weights the countries’ respective shares in world trade.

145

For a detailed examination of regional trade agreements in Latin America, see IADB and Iglesias (2002).

146

See for example, Devlin and Estevadeordal (2002). The objectives of the “new regionalism” go well beyond reducing trade protection. Other equally important objectives of these arrangements include supporting structural economic reforms; providing new opportunities for exports and diversification, which can serve as stepping stones to improved global competitiveness; attracting foreign direct investment; and fostering regional cooperation. For a detailed discussion, see IADB and Iglesias (2002).

147

Figures for emerging Asia exclude Hong Kong SAR and Singapore, where exports considerably exceed 100 percent of GDP.

148

Relatively open economies are typically defined as those that have a total trade-to-GDP ratio of greater than 50 percent. The concentration of exports in product categories is measured by a Herfindahl index of concentration of export shares. An index above 0.28 is consistent with a concentration of 50 percent or more of exports in one of 10 product categories.

149

Warcziarg and Welch (2003). See also Krueger (2004).

150

Evidence on undertrading in Latin America is based on conventional gravity model estimates, and is discussed in Morsink, Helbling, and Sgherri (2002). Such quantitative evidence may overstate undertrading owing to illegal and unreported trade activity.

151

One prominent example of tariff escalation is the tariff schedule for Mercosur, which affects the trade of some of the largest countries in the region. Region-wide studies suggest that there is significant tariff escalation in important product chains, including processed food, textiles and clothing, tobacco, wood products, and automobiles. See, for example, Laird, Cernat, and Turrini (2002).

152

IADB and Iglesias (2002) estimates are based on data compiled by the United Nations Conference on Trade and Development (UNCTAD) and the IADB under the project TRAINS for the Americas. Estimates include both quantitative restrictions and technical standards, with the latter being particularly difficult to measure.

153

For an overview on the debate about preferential trade arrangements, see Krueger (1999).

154

In addition, similar regional integration took place among Central American and Caribbean countries with, for example, the formation of the Central American Common Market and the Caribbean Community.

155

For example, Chang and Winters (2002) analyze the impact of Mercosur on the pricing of nonmembers’ exports to Brazil and conclude that the observed decline in export prices can be attributed to the effects of trade diversion.

156

See, for example, Yeats (1997).

157

Despite the positive results attributed in part to NAFTA, scope remains for further negotiations and liberalization under the agreement, particularly for rules of origin and manufacturing trade, agriculture, and the use of antidumping and countervailing-duty measures. For a detailed discussion, see World Bank (2003a).

158

NAFTA has been the exception and has illustrated the benefits of improved market access on export growth.

160

The model used for these estimates was the Global Trade Analysis Project (GTAP). For further details, see MacDonagh-Dumler, Yang, and Bannister (2002). Field crops include rice, wheat, grains, and oilseeds.

161

See, for example, ECLAC (2003).

163

One aspect of this special treatment is the wide gap between tariff levels committed to (“bound”) in the WTO and those actually applied, which further increases the uncertainty about future market access conditions.

164

Evidence in World Bank (2003b) suggests that transport cost barriers to trade generally outweigh tariff barriers and that improvements in service-sector infrastructure would provide large gains from trade.

167

See, for example, Rodrik (1999).

168

Empirical evidence on the economic benefits of capital account liberalization is mixed. Based on a survey of the literature, Edison and others (2002) conclude that the evidence does not strongly point to a general result regarding the consequences of capital account liberalization, although there is some mixed evidence that liberalization boosts long-term economic growth. These effects seem to be most pronounced in East Asian countries.

169

For a detailed discussion of capital account liberalization in Mexico and other countries, see Ishii and Habermeier (2002).

170

For a detailed discussion of the behavior of capital flows to Latin America over the last two decades, see Fernandez-Arias and Panizza (2001) and Griffith-Jones (1998).

171

For a discussion of how movements in the supply of external financing have triggered lending booms in emerging market countries, and in Latin America in particular, see Calvo, Reinhart, and Leiderman (1996) and Arora and Cerisola (2001).

172

FDI can have a positive impact on growth, especially in countries where education levels are high, thereby allowing FDI spillover effects to be exploited. The pickup in FDI flows was not unique to Latin America, since other emerging market countries were also recipients. See, for example, IMF (2001).

173

For a detailed discussion of capital account liberalization, see Ffrench-Davis (2000); Edwards (2001); Hanson (1995); and Arteta, Eichengreen, and Wyplosz (2001).

174

See Ishii and Habermeier (2002) and Nsouli, Rached, and Funke (2002) for a discussion of coordinating and sequencing capital account liberalization.

175

As noted in Morsink, Helbling, and Sgherri (2002), developing countries that are less integrated are about 20 percent more likely to experience a debt default and 30 percent more likely to have a currency crisis than the average developing country. Sgherri (2002) shows that the inverse relationship between trade integration and crises remains robust under alternative econometric specifications.

176

This subsection draws on Catão (2002).

178

Reinhart, Rogoff, and Savastano (2003) make the point that once a country slips into being a serial defaulter, it generates a high level of debt intolerance that is difficult to shed. A corollary of this point is the difficulty countries face in graduating from prolonged use of IMF resources.

179

For example, Chapter II in IMF (2004) discusses the implications of China’s integration for the international economy.

180

In the context of Chile’s experience, Foxley (2004) explains the importance of institutional reforms for sustaining poverty reduction.

181

Rodrik (2003) emphasizes the importance of institutional reforms for sustaining growth, as opposed to igniting economic growth. Many of the specific components of institutional reforms that he discusses—sound monetary policy, debt sustainability, and the rule of law—are also crucial for attracting private investment, especially the domestic private investments that are necessary for the acceleration phase. In any case, his distinction between accelerating and sustaining growth is less relevant in the context of Latin America, where there have been frequent false starts and recurring macroeconomic volatility.

182

Rodrik (2003) stresses this point.