Abstract

Growth in the Latin American and Caribbean region (LAC) remains robust. For the region as a whole, growth in 2006 reached 5½ percent. Last year’s outturn brings average growth in the last three years to 5¼ percent, the best performance since the late 1970s. With the recovery now at a more mature stage, the expansion has become increasingly reliant on domestic demand as the main engine of growth. Import growth has rebounded and net exports have exerted a downward pull on growth as several economies emerged from crises earlier in the decade.

Main Developments and Prospects

Growth in the Latin American and Caribbean region (LAC) remains robust. For the region as a whole, growth in 2006 reached 5½ percent. Last year’s outturn brings average growth in the last three years to 5¼ percent, the best performance since the late 1970s. With the recovery now at a more mature stage, the expansion has become increasingly reliant on domestic demand as the main engine of growth. Import growth has rebounded and net exports have exerted a downward pull on growth as several economies emerged from crises earlier in the decade.

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Real GDP Growth

(Annual % change)

Source: IMF staff estimates.
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Contributions to Growth

(%, per year)

Source: IMF staff estimates.

Although there are significant differences across countries, the near-term outlook for Latin America and the Caribbean remains broadly favorable. Growth overall is expected to ease slightly to a little below 5 percent in 2007 and 4¼ percent in 2008, reflecting a deceleration from historically high rates in a number of countries, the slowdown in the U.S. economy, and some declines in commodity prices.

The impact of the slowdown in the U.S. economy on the region was more than offset by other external factors and the strength of domestic demand in 2006. Several countries—including Argentina, Colombia, Costa Rica, the Dominican Republic, Panama, Peru, Trinidad and Tobago, Uruguay, and Venezuela—grew at around 7 percent or more. Growth was also the highest in several years in Peru, Colombia, and Mexico, among others. In Brazil, recently revised national accounts data (Box 2) indicate that growth picked up during the year with the easing of monetary policy, reaching 4¾ percent in the last quarter of 2006 over the same quarter of 2005. Growth for 2006 as a whole was 3.7 percent, significantly higher than in 2005. In Chile, growth is recovering toward potential following a slowdown in 2006 (4 percent) due to one-off factors, including strikes and a landslide in the mining sector.

Central America grew by 5¾ percent in 2006, its fastest expansion since 1998. Here too, domestic demand has played an important role, with consumption supported by strong remittances. Several factors, including the good performance of nontraditional exports, stronger foreign direct investment in a number of countries, and a new free trade agreement with the United States (CAFTADR) also supported the positive growth outturn. Sound macroeconomic policies have so far generally helped underpin the expansion, although public spending growth has recently picked up (see below). Notably, sound policies have been maintained during a period marked by several congressional and presidential elections—a testimony to the region’s strengthening economic and political stability.

Brazil: Revision of National Accounts

In late March, the Brazilian Statistical Institute (IGBE) released revised national accounts data for 1995– 2006. The revised data incorporate significant refinements in methodology, with the use of sectoral surveys and corporate income tax collection data to measure economic activity more accurately. The reference year for calculating the relative weights of each productive sector was also updated, from 1990 to 2000.

The revised 2006 GDP is 11 percent higher in nominal terms than previously estimated, with the main revisions affecting the last four years. On an annual basis, real GDP growth was revised from 2½ percent on average in 2002–06 to 3¼ percent. On the supply side, the most important change was an increase in the share of services (commerce and transportation particularly), reflecting the use of better data and statistical techniques. On the demand side, the main change stems from an upward revision in consumption. Overall investment was left broadly unchanged as an increase in investment in machinery and equipment was offset by downward revisions in construction.

The resulting higher GDP has altered key ratios in the Brazilian economy. The investment-to-GDP ratio was lowered to 16.2 percent during 2002–06—from 19.2 percent estimated earlier—while staff estimates for total factor productivity gains were revised up. The ratios of the primary fiscal surpluses and of the public debt to GDP were also revised downward. The primary surplus was reduced from an average of 4½ percent of GDP during 2002–06 to about 4 percent. End-2006 gross public debt is now estimated at about 65 percent of GDP, down from 70 percent in the previous data, and net public debt at 46 percent of GDP, compared with 51 percent in the previous data.

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Brazil: Real GDP Growth, 1996–2006

(%)

Source: National authorities.

While the GDP revision seems large, it is not an outlier compared to comprehensive methodological changes in other countries. For instance, about a year ago, the introduction of new census information raised Chinese nominal GDP by close to 17 percent, also because of better measurement of service sector activity.

Note: This box was prepared by Marcello Estevão.

In the Caribbean, growth has been supported by the strong performance of construction and tourism. In Trinidad and Tobago—the fastest-growing economy in the region—activity expanded at double-digit rates in 2006, benefiting from high energy prices, increased capacity in the gas processing industry, and a construction boom led by public expenditure.

Growth was also vigorous in the Dominican Republic at almost 11 percent, driven by strong consumption and investment (especially tourism-related construction) sustained by favorable external conditions and a rebound in confidence after the 2003–04 banking crisis. In addition, the upcoming Cricket World Cup (CWC) has boosted private and public construction across its host countries, helped by generous tax concessions, external grants, and public borrowing (Box 3). While the positive effects on the tourism sector could extend into the medium term, there is concern that the net effect of the CWC could well be negative in light of its heavy fiscal costs and already-high public debt burdens in the region.

The Caribbean: Growth and Fiscal Effects of the 2007 Cricket World Cup

The ninth Cricket World Cup (CWC), held in the Caribbean from March 5 to April 28, 2007, is the largest sporting event ever held in the region. Matches are taking place in nine countries, with semifinals in Jamaica and St. Lucia, and the final in Barbados. Organizers expect to sell close to 800,000 tickets, over 2 billion people worldwide to watch the matches by television, and about 100,000 additional (non-Caribbean) visitors to travel to the region.

Preparations for the CWC have led to accelerated economic activity in the region, particularly since 2005, but have been costly in terms of direct government expenditure and provision of new tax concessions. Five new stadiums were built and others were upgraded. Some of the stadiums were financed by grants—construction costs are estimated at US$250 million—and additional public expenditures were incurred on infrastructure (roads, airports, hotels, and marinas). Partly as a result of this expenditure, primary balances have deteriorated in most countries, and average public debt remained over 100 percent of GDP at end-2006 in host countries. There was strong expansion in private sector construction to increase tourism capacity, which is expected to continue into the medium term. Private investors have received generous tax concessions in most countries for such investment, which will erode the tax base going forward.

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Real GDP Growth, 1995–2007

Source: IMF staff calculations.1/Eastern Caribbean Currency Union. Includes six countries: Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines.
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Primary Balances, 1995–2007

(% of GDP)

Source: IMF staff calculations.1/ Eastern Caribbean Currency Union. Includes six countries: Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines.

The long-term net impact of the CWC is unclear, especially in light of the associated fiscal costs. Studies of other states hosting large one-off sporting and cultural events (such as the 2003 CWC in South Africa and the 2002 FIFA World Cup in Korea/Japan) generally find a small net positive effect. The economic benefits of the 2007 CWC are likely to be diluted as the matches are spread across multiple countries, and are taking place in the midst of the peak winter tourist season when occupancy rates are already very high. In general, Caribbean public investment has shown a relatively weak link with growth, suggesting the need to increase the efficiency of these outlays.1 Over the longer term, prospects for growth will hinge critically on the region’s ability to continue to market itself successfully as a tourist destination, to realize incremental revenues from the additional hotel rooms that have been constructed, and to address macroeconomic vulnerabilities, including high levels of public debt.

Note: This box was prepared by Vladimir Klyuev.1 See (Roache 2007); and (Sahay, Robinson, and Cashin 2006).

In light of the exceptionally benign external environment that the LAC region has enjoyed in recent years, the risks to the regional outlook are moderately weighted to the downside. They include (i) a sharper-than-expected slowdown in the United States; (ii) tighter global financial market conditions, including higher-than-expected emerging market risk premia; and (iii) a larger-than-expected decline in nonfuel commodity prices. Upside risks stem from faster world growth, for example, as a result of stronger-than-expected growth in Western Europe, or a faster return of growth to potential in the United States. Based on an econometric analysis (see Section III and Appendix), it is estimated that a 1 percent reduction in world growth would, over time, affect Latin America about one-for-one. Typical commodity price and financing shocks (around 5 percent and 115 basis points, respectively, within a quarter) would affect Latin American growth by about 0.3–0.5 percentage point. Combining this analysis with the WEO’s assessment of global risks suggests that there is about a one-in-four chance that LAC growth might be below 4 percent in 2007, and a similar chance that it might be around 5¼ percent or higher. The risk of 2007 regional growth falling to less than 3 percent is estimated at about 5 percent.

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Growth Prospects for Latin America and the Caribbean

(Weighted averages; % of GDP)

Sources: WEO, and IMF staff calculations.

Inflation declined in most countries last year. End-year inflation fell 1 percentage point to 5 percent. The decline was not universal, however. In some countries, inflation accelerated or remained high as economic activity continued to expand beyond potential. In some others, volatile items such as food pushed up inflation, as in Mexico—where end-year inflation was at the top of the authorities’ 2–4 percent band though it remained low by regional standards—and Paraguay.

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Inflation

(%, annual end-of-period)

Source: IMF staff estimates.

Inflation is expected to remain contained for the region as a whole in 2007 at an average of around 5½ percent. The small projected increase reflects modestly higher price increases in Brazil, where inflation is expected to rise toward the midpoint of the central bank’s target range. Inflation is likely to remain comparatively high in Argentina—where administrative measures contributed to a reduction of recorded inflation to just below 10 percent last year, while creating other distortions—as well as in Trinidad and Tobago and Venezuela.

Social indicators have continued to improve. The ongoing economic expansion, coupled with improved and expanded social assistance programs, contributed to a further reduction in unemployment and poverty rates across the region last year.

According to the United Nations Economic Commission for Latin America and the Caribbean (ECLAC), the average Latin American poverty rate declined from 44 percent in 2002 to about 40 percent in 2005, and is estimated to have fallen further to 38 percent in 2006. A reduction in extreme poverty rates, from 19 percent in 2002 to 15 percent in 2006, accounts for most of this decline. The largest reductions in poverty rates (through 2005) occurred in Venezuela and Argentina, where national data show poverty fell further to 27 percent in the second half of 2006, the lowest rate since 1998. Colombia, Ecuador, and Mexico experienced substantial declines as well. National source data also show sizable reductions in poverty in Brazil and Uruguay, as well as in Peru, where the authorities are targeting a further decline in the context of their Fund-supported program (Box 4). Several countries are also expanding targeted conditional cash transfer programs (see the November 2006 Regional Economic Outlook).

Falling poverty also reflects a moderate reduction in income inequality. The latest data show a reduction in income inequality (as measured by the Gini coefficient) since the late 1990s in 13 of 18 countries for which data are available. The largest improvements have been registered in Brazil, El Salvador, Paraguay, and Peru. However, inequality in Latin America remains very high compared with other regions (see Section IV).

Further progress has also been made on debt relief for low-income countries in the region. The Inter-American Development Bank approved full debt relief of US$4.4 billion—of which US$1 billion is for future interest payments—for Bolivia, Guyana, Haiti, Honduras, and Nicaragua in March 2007. Together with other debt relief provided under the Multilateral Debt Relief Initiative by the IMF and International Development Association, this is expected to sharply reduce debt burdens and assist countries in their efforts toward the Millennium Development Goals, including the goal of halving extreme poverty by 2015.

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Latin America: Poverty Rates, 1980–2006 1/

Source: ECLAC (2006).1/Population-weighted average for 19 countries.2/Estimates.
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Income Inequality

(Gini coefficient; larger figures indicate greater income inequality)1/

Sources: ECLAC; and De Ferranti et al. (2004).1/Population-weighted averages. For Latin American countries, 1990 =available observation closest to 1990; 1999 = available observation closest to 1999; 2005 = most recent available observation.

Peru’s New Economic Reform Program

In the second half of 2006, the Peruvian authorities developed an economic program centered on consolidating macroeconomic stability and advancing reforms to enhance the effectiveness of social assistance programs and promote higher sustainable growth. The Fund is supporting this program through a 25-month precautionary Stand-By Arrangement for about US$250 million, which was approved in January 2007.

The new government’s economic program aims to build on past achievements and address pending challenges. As a result of sound policies implemented over the past fifteen years, Peru’s real GDP growth has averaged 5 percent a year since 2000, one of the strongest in Latin America, while annual average inflation was one of the lowest at 2 percent, and net international reserves reached US$17.3 billion (close to 400 percent of short-term debt at end-2006). Less progress has been made in alleviating poverty, which still affects about half of the population. In these circumstances, President García and his economic team have developed an economic program centered on strengthening fiscal policy, enhancing social assistance programs, improving the business environment, strengthening the resilience and depth of the financial system, reducing high labor market informality, and further opening the economy. The authorities expect that this program will create conditions conducive to achieving investment-grade status over the medium term. Key elements are as follows:

  • Consolidating macroeconomic stability. Fiscal targets for 2007–08 are expected to remain below the 1 percent deficit ceiling in the Fiscal Responsibility and Transparency Law. The strength of the revenue effort will allow for increased spending to address social and infrastructure needs while keeping the debt-to-GDP ratio on a steady downward path. The government also intends to broaden the revenue base and improve the quality of public spending. Greater exchange rate flexibility is expected to enhance the credibility of the inflation-targeting regime and promote more widespread use of financial hedges, which would increase the overall resilience of the economy.

  • Tackling high poverty. The government is committed to enhancing the focus and effectiveness of social assistance programs (including for nutrition), as their current large number has complicated monitoring and there is some concern that not all of the resources channeled through these programs reach the intended recipients.

  • Strengthening the financial system. Reducing financial dollarization is another critical objective of the program, which will help strengthen the resilience of the financial system to exchange rate shocks. These efforts will be complemented by measures to allow for a better internalization of risks and deepen capital markets.

  • Institutional and structural reforms to boost long-term growth prospects. The government will continue its efforts to enhance the effectiveness of the state by consolidating agencies, simplifying regulatory requirements, and increasing the accountability of public institutions. Additional steps will also be taken to improve the business climate and competitiveness by extending commercial courts beyond Lima, enhancing labor market flexibility, and further opening the economy.

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Nutrition Program Beneficiaries by Poverty Level

Source: National authorities.
Note: This box was prepared by Eva Jenkner.

Financial Sector

Private sector credit has continued to grow briskly. In 2006, it expanded at an average rate of 32 percent in nominal terms in the seven largest Latin American countries, with individual country rates ranging from 15 percent in Peru to 68 percent in Venezuela.2 Private sector credit growth was also significant outside the largest countries, averaging 22 percent for the region as a whole (unweighted average of 20 countries). This expansion in private sector credit accentuates a trend that started in 2004. Credit to the public sector, by contrast, contracted in 2006 in many countries.

The expansion in private credit was driven mostly by credit to households. Household credit growth averaged 30 percent in five of the largest seven countries, and was also particularly strong in some countries in the Caribbean and Central America. As a result, household credit now constitutes between 30 and 40 percent of private sector credit across the region (except in Panama, where it exceeds 60 percent). While also growing at high rates, mortgage lending fell as a share of total household credit in most countries.3 Finally, the share of foreign currency credit decreased in most countries, but remains high in some, including Bolivia and Nicaragua.

Although high rates of credit growth have, in the past, signaled increased vulnerabilities, conditions in most countries do not yet appear to reflect a “lending boom” (see the November 2006 Regional Economic Outlook). At an aggregate level, the pick-up of credit comes after an extended period in which the stock of real credit declined, and credit levels are still generally low. In many countries, private credit-to-GDP ratios are still well below those prevailing in other regions; for instance, at end-2006 they were

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Credit Growth, 2002–06

Sources: National authorities; and IMF staff estimates.1/ Unweighted averages for Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. For 2006, rates are based on latest available data.
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Household and Corporate Credit

(Annual % change)1/

Sources: National authorities; and IMF staff estimates.1/For 2006, rates are based on latest available data.
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Household Credit Share in Private Sector Credit

Source: National authorities.

still below 20 percent of GDP in Argentina, the Dominican Republic, Paraguay, and Venezuela. Moreover, financial indicators, while backward-looking, remain strong thus far, and have improved further relative to 2005. Nevertheless, the recent rapid increases in banking credit require careful vigilance by financial sector supervisors, especially in cases when banks have limited experience with household loans and credit is unsecured by collateral. In addition, mergers and acquisitions in Central America, driven by the improved economic outlook, call for strengthened consolidated supervision, including of institutions licensed offshore (Box 5).

Financial market sentiment toward the region remained generally positive in 2006, reflecting both the benign conditions in global markets and the region’s improved fundamentals. Record or near-record lows were registered for external debt spreads, volatility, and the number of sovereign credit downgrades relative to upgrades. After shrugging off the effects of financial market turbulence in May–June 2006, the region’s emerging markets continued to benefit from large inflows from institutional investors, including hedge funds and pension funds, into local markets. This resulted in compressed spreads on external government debt but also lower interest rates in domestic debt markets, with yields on Latin American domestic issues falling faster than yields outside the region. Financial market gains were not limited to bond markets. The strength of global equity markets, combined with favorable domestic prospects, pushed equity markets in the region to record highs in all major countries. Despite these large gains, price-earnings ratios do not appear significantly out of line with other regions. However, the global sell-off that affected equity markets in late February and early March in most advanced and emerging market economies hit Latin America as well, with the major markets experiencing large swings. The financial turbulence primarily affected equity markets, with relatively subdued effects on exchange rates, interest rates, and spreads.

Financial Soundness Indicators for Latin America (%) 1/

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Source: IMF (2007b).

Unweighted averages. Fixed sample of countries over time for each indicator. The number of countries varies by indicator.

Latest data available.

Non-performing loans (NPLs) as a share of total loans.

Regulatory capital/risk weighted assets.

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Bond Market Developments

Sources: Bloomberg, L.P.; and Morgan Stanley.1/ Unweighted averages of country-specific emerging market spreads.2/ Unweighted averages of country-specific local bond indices.
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Equity Market Developments

(December, 2005 = 100; in local currency)

Sources: Bloomberg, L.P.; JPMorgan; and Morgan Stanley.

Offshore-Licensed Financial Entities in Central America and the Dominican Republic

A significant share of domestic banking in Central America is conducted through entities licensed in offshore centers such as The Bahamas, Barbados, Cayman Islands, Montserrat, and Panama. These entities serve local clients and operate from the same offices of banks licensed in Central America. Their share of assets varies from zero in El Salvador (where they are prohibited) and Honduras to as much as one-fourth of the banking system in other countries. The offshore license allows entities to take advantage of lower costs such as reduced income and transaction taxes, less restrictive prudential regulations (i.e., lower capital adequacy, liquidity requirements, and lending to insiders), the absence of central bank reserve requirements and deposit insurance fees, and higher confidentiality. Thus, owners can increase profits and clients can earn higher yields on investments and obtain lower cost loans. From the perspective of home countries, allowing the local operation of offshore-licensed entities has reduced the outflow of funds from Central America.

The supervision of offshore-licensed entities adds to the challenges confronted by financial sector regulators, especially for entities that do not belong to a formal financial group but are owned in parallel by local banks through common shareholders. These parallel arrangements could exacerbate contagion risks that spread among banks under shared control, and facilitate capital overvaluation, insider or related-party lending, and the potential for fraud and money laundering. The recent intervention of Bancafé in Guatemala highlights how the risks from the exposure to related parties and poor investments through offshore affiliates can affect the health of local banks.

Central American supervisors deal with offshore-licensed entities using a variety of approaches. These differences reflect previous experiences, disparities in the overall quality of supervision, and specific features in legal and accounting frameworks. Some require specific local authorization for the offshore entities to operate subject to the provision of financial reporting by the offshore-licensed entity, and in a few cases prior approval for transfers between the local bank and the offshore-licensed entity. However, in general, legal and capacity constraints, bank secrecy regulations, and weak supervisory practices limit effective consolidated accounting and supervision—which are the key safeguards to deter abuse of offshore-licensed entities and enable proper application of prudential limits.

Looking forward, the strategy to deal with offshore-licensed entities should be based on strengthened consolidated supervision of financial groups operating in the region. This would require improved regulatory and supervisory practices. An enhanced regulatory framework should aim at (i) improving the legal basis for consolidated supervision; (ii) harmonizing prudential rules and adopting consolidated accounting on the basis of international standards; (iii) licensing authority to review the financial and managerial qualifications of owners and managers; and (iv) improving sanctioning powers to enforce laws and regulations. Supervisory practices should be strengthened by (i) training supervisory staff; and (ii) increasing collaboration among supervisors, including with the offshore jurisdictions, by clarifying their roles and responsibilities.

The Fund is collaborating in these efforts. Through financial sector assessments in all Central American countries, the Fund and the World Bank have helped identify the strengths and challenges of supervisory authorities in the region, while providing recommendations that are now being implemented. Furthermore, through an ongoing regional technical assistance project, the Fund is discussing with the authorities an action plan to strengthen cross-border consolidated supervision in the region.

Note: This box was prepared by Ana Lucía Coronel and Michael Moore.
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Stock Market Volatility and Price-Earnings Ratios

Sources: Bloomberg, L.P.; and Morgan Stanley.1/ Unweighted averages. Annualized 30-day standard deviations of daily percentage changes.2/ Argentina, Brazil, Chile, Colombia, Mexico and Peru.3/ 19 emerging market countries.

Policy announcements in Ecuador and Venezuela had large effects on financial markets in these countries but did not spill over to others. In Ecuador, timely debt service of global bonds in February partly assuaged concerns that had earlier pushed spreads up sharply. In Venezuela, the announced nationalization of utility companies in early January 2007 was followed by sharp declines in the equity market.

Efforts to lengthen debt maturities and improve the liquidity of benchmark issues have continued in several countries. Peru and Uruguay swapped existing external debt—including Brady bonds in the case of Peru—for longer-term debt carrying maturities of up to 30 years. Uruguay used the proceeds from some of these placements to finance an early repayment of all of its outstanding IMF loans (US$1.1 billion). Brazil, Colombia, and Mexico made further progress in issuing long-term debt in domestic currency. In particular, Brazil issued its longest external bond in reais (20 years) and Mexico placed additional debt under its 30-year domestic bond—the longest-dated domestic local currency bond in Latin America—in exchange for less liquid instruments. As a result of continued improvement in debt management, an increasing share of Latin America’s public debt is now traded in local markets—in 2006, Mexico’s and Brazil’s local debt instruments were the most frequently traded local debt instruments among all emerging markets.

Several governments undertook steps to regularize relations with creditors. In Belize, a restructuring of the government’s external commercial debt was successfully completed with high creditor participation. The government in Antigua and Barbuda has announced its intention to regularize arrears and bring public debt (estimated at 103 percent of GDP at end-2006) to a manageable level, and is developing a strategy to approach creditors. In Argentina, the government reached an agreement to restructure some of its outstanding bilateral arrears to Spain, a further step toward the normalization of relations with creditors after the 2001–02 crisis. In addition, two Argentine provinces tapped the international capital markets for the first time since the crisis.

External Developments

Last year’s external current account surplus was 1¾ percent of GDP for the region as a whole, marginally stronger than in 2005, and the highest for the region in several decades. This strong performance was the result of favorable changes in the terms of trade (up 7¾ percent over the previous year) and moderate—albeit decelerating—export volume growth (4½ percent). These developments offset the negative impact of strong import growth (about 12 percent) on the trade balance. Outturns nevertheless varied widely across regions. While most countries in South America, including Argentina, Bolivia, Brazil, Chile, Ecuador, Peru, and

External Balance of Payments Developments, 2002–07

(In % of GDP, unless otherwise indicated) 1/

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Source: IMF staff estimates.

Refers to LAC region as a whole.

Projections.

Venezuela, experienced large trade surpluses, deficits were recorded in many countries in the Caribbean, in Central America and—to a lesser extent—in Mexico. In some of these countries, the high level of remittances (above 10 percent of GDP on average in Central America, and a high of 26 percent of GDP in Honduras) helped offset large trade deficits, as in previous years.

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Trade Volume and Terms of Trade

(Annual % change)

Source: WEO.

Foreign direct investment (FDI) remained the largest source of net foreign capital inflows, albeit at lower levels than in earlier years. FDI inflows in 2006 equaled about 2¾ percent of GDP, about ¼ percentage point lower than in 2005 and well below the record high in 1999–2000 (around 4 percent of GDP), when privatizations of public companies boosted FDI.4 The region overall has lost ground as a destination for FDI, capturing only one-fifth of these flows to developing countries, compared to its 46 percent share at the start of the decade. Almost two-thirds of the 2006 FDI flows to the region were directed to Brazil, Chile, and Mexico—although some countries, including Colombia and Uruguay, have seen a surge in their shares in recent years.

Non-FDI private capital flows have remained relatively subdued on a net basis for the region as a whole. A few countries attracted the lion’s share of financial inflows in 2006 and early 2007. In Brazil, short-term capital inflows seeking to benefit from interest rate differentials—including “carry trades,” for which data are not readily available—have assumed increasing importance. Large net positions have also been acquired in the currency and interest rate futures markets. As in the previous two years, there were net repayments by sovereign borrowers. Lower levels of issuance by sovereign borrowers allowed for a “crowding-in” of corporate issuers in primary markets (see the April 2007 Global Financial Stability Report).

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Gross External Debt Issuance, 1980 – 2006

(Billions of U.S. dollars)

Source: Dealogic database.

Looking forward, continued rapid import growth and less favorable terms of trade are projected to erode trade surpluses by 1¾ percentage points of GDP this year, reducing the region’s external current account surplus to only ½ percent of GDP. The deterioration in trade balances is expected in most countries across the region, with the most pronounced changes in commodity-rich countries. More subdued oil prices, however, are expected to help some oil-importing countries. As in the recent past, import volumes are projected to grow faster than real GDP (at an average rate of almost 10 percent). At the same time, growth in export volume, which has been losing momentum since 2004, is projected to remain below real GDP growth. And whereas improved terms of trade boosted the region’s trade balance by a remarkable 5½ percentage points of GDP during 2004–06, declining terms of trade are projected to subtract ½ percentage point of GDP in 2007.5

The region’s external sector remains dependent on commodity prices, given the continued high share of primary products in the export basket. Additional reductions in commodity prices would further erode trade and current account surpluses. For example, a decline in the terms of trade to the 2004 average would worsen the region’s overall trade balance by over 2 percentage points of GDP, pushing the trade balance into deficit. This risk would be compounded if import volume growth were to continue at last year’s brisk pace.

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Contribution to Changes in Trade Balance to GDP Ratios

Sources: WEO, and IMF staff calculations.1/ The import and export effects are the contributions from growth differentials between import and export volumes relative to real GDP growth (a positive import effect indicates an improvement in the trade balance due to import volume growth below the real GDP growth). The TOT and RER effects are the contribution from changes in terms of trade and bilateral real exchange rates with the United States.

Monetary and Exchange Rate Policies

Central banks have continued to pursue a mix of inflation and exchange rate objectives:

  • In the large countries that have adopted inflation targeting frameworks—Brazil, Chile, Colombia, Peru, and Mexico—monetary policy has evolved in response to cyclical developments, and inflation expectations appear well anchored. Brazil, Colombia, and Peru have also undertaken foreign exchange market intervention to bolster reserves, which has tended to smooth or brake nominal exchange rate appreciation.

  • Elsewhere, monetary conditions have often been influenced by developments in the balance of payments and, sometimes, by fiscal policy. In Argentina, although growth of the targeted monetary aggregate has moderated (through the continued sterilization of foreign exchange purchases), short-term interest rates remain negative in real terms and fiscal policy is adding to demand pressures. In Paraguay, reserve accumulation has led to rapid growth in currency despite sustained sterilization. In contrast, in Bolivia, a large fiscal surplus in 2006 helped absorb the impact of foreign currency inflows associated with the current account surplus.

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Export Structure Changes: Latin America and Emerging Asia, 1960s and 2000s 1/

Source: UNCOMTRADE database.1/Unweighted average of country-specific shares (SITC Revision 1-based classifications) of each export category in total exports. Total exports refers to exports from a country to the rest of the world.2/Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.3/China, India, Indonesia, Korea, Malaysia, Singapore, and Thailand.

Following significant appreciations in Brazil, Chile, Colombia, and Uruguay during 2005 and early 2006, currencies have stayed broadly constant vis-à-vis the U.S. dollar over the last twelve months, despite some fluctuations within the year. However, with the dollar weakening against the euro, nominal effective (trade-weighted) exchange rates have depreciated in most countries. Reserve accumulation played a role in limiting currency appreciation in many cases, pushing gross external reserves to record highs. In the largest countries, combined reserves stood at US$274 billion at end-2006, having further increased in relation to short-term external debt (to 3½ times) but not in terms of months of imports, owing to even more rapid import growth.

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Short-Term Real Interest Rates

Source: IMF staff estimates.1/ Difference between nominal interest rates and realized inflation. Policy interest rates are used except for Argentina and Venezuela, for which short-term bank rates are used.

Real effective exchange rates do not generally point to significant changes in competitiveness, and real exchange rates are broadly in line with their long-run averages. Following large depreciations early in the decade, the end-2006 real exchange rate in more than half of the countries in the region was more depreciated than its 1980–2006 average (based on a sample of 20 countries). Empirical models also suggest that, in most countries, real exchange rates are broadly in line with fundamentals.

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Exchange Rates and Reserves 1/

Sources: IMF, International Financial Statistics; and Information Notice System.1/ Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.2/ Seven-country monthly unweighted average. Increase indicates appreciation.

Looking forward, benefits from reserve accumulation—aimed in part at resisting appreciation—need to be carefully weighed against potential costs. If exchange rate targets are seen as dominant, the credibility and transparency of monetary policy could suffer and make the sterilization of foreign exchange intervention more difficult and costly. This could eventually jeopardize the objective of maintaining low inflation. Moreover, creating opportunities for one-way “bets” in financial markets could lead to the build-up of positions that would be destabilizing if unwound in a disorderly fashion.

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Cross Country Distribution of Real Exchange Rates

(Index 1980-to-present average = 100) 1/

Source: IMF, International Notice System, and IMF staff calculations.1/ For each country, the real exchange rate is normalized by its 1980-to-present average. The cross-country distribution is based on 20 LAC countries and is calculated on a month-by-month basis.

Fiscal Policy

Soaring commodity-based revenues have helped boost primary fiscal balances to historic highs. Public sector revenues in Latin America rose by an average of 1½ percentage points of GDP in 2006, with commodity-based revenues accounting for more than half of this increase.6 Since 2002, commodity-based revenues have surged by an average of 4¾ percentage points of GDP in the seven countries where they generate a substantial share of public receipts.7 Noncommodity revenues have also risen over the past three years in both Central and South America. As a consequence of the strengthened revenue effort in 2006, primary surpluses rose for the fourth consecutive year to 3¼ percent of GDP. Overall fiscal balances have also improved, with budgets in balance, on average, in the region.8

C2UF25

Total Revenues and Primary Spending

(% of GDP) 1/

Source: IMF staff estimates.1/Unweighted averages for 17 countries.

Public spending has also grown rapidly, after being contained in the early phase of the recovery. Real primary (i.e., noninterest) spending increases were above 10 percent in several countries in 2006, most notably in Venezuela, where these outlays rose by about 40 percent. Excluding Venezuela, real primary outlays rose by an average of 7¼ percent. Primary current outlays accounted for the lion’s share of the spending increases in the region (rising by an average of ¾ percentage point of GDP), while capital outlays remained virtually flat in relation to output. These developments are consistent with longer-term trends in the region, which suggest that little progress has been made in reversing the decline in the share of public investment in government expenditures and containing the upward drift in current outlays (Clements, Faircloth, and Verhoeven, 2007).

Annual Growth of Real Primary Expenditures, 2003-06

(%) 1/

article image
Source: IMF staff estimates.

Unweighted averages.

C2UF26

Public Sector Expenditures

(% of GDP) 1/

Source: IMF staff estimates.1/Unweighted averages for 17 countries.

Nevertheless, stronger fiscal balances, combined with solid economic growth, have resulted in declining debt-to-GDP ratios. Public debt is estimated to have declined to about 52 percent of GDP (weighted average basis) in 2006. Although still higher than in the mid-1990s, debt ratios have dropped by 24 percentage points since 2002. Vulnerabilities have also been reduced by changes in the composition of public debt, with foreign-currency-denominated debt showing an especially sharp decline over the past four years. However, in general, the increased reliance on domestically issued debt has not—at least not yet—been accompanied by an improvement in debt maturity; short-term debt-to-GDP ratios remain roughly unchanged despite some success in issuing domestic debt at longer maturities. Debt with residual maturity of less than one year remains at around 10 percent of GDP in the LAC region (unweighted average), somewhat higher than in emerging Asia and emerging Europe.

C2UF27

Public Debt Domestic – and Foreign–Currency–Denominated

(% of GDP)

Source: IMF staff estimates.1/ For Argentina, the debt figure for 2006 includes the effect of debt restructuring.2/ Weighted averages for 17 countries.

With commodity-based revenues declining and overall expenditure growth projected to remain high, primary balances are projected to weaken in 2007. The cooling of commodity prices, combined with real spending increases in the range of 8½ percent, is projected to lead to a deterioration in primary balances of about 1¼ percentage points of GDP for the region, continuing the procyclical pattern of the recent past (see the November 2006 Regional Economic Outlook). For those countries where activity is above potential, the envisaged expansionary fiscal policy could exacerbate inflationary pressures and place a burden on monetary policy.

Risks to the fiscal outlook come primarily from current spending and commodity prices. If primary current spending—which on average is projected to remain roughly unchanged relative to GDP in 2007—were instead to continue to rise at the same pace as in 2005 and 2006, primary balances would decline by an additional ½ percentage point of GDP (though this might be offset by continued underexecution of public investment budgets). As with the external accounts, fiscal positions would be affected if commodity prices fell more rapidly than expected. For the seven countries in the region that generate a substantial share of revenues from commodities, for example, a return of these revenues to their 2004 levels would reduce public receipts by an average of about 2½ percent of GDP.

C2UF28

Fiscal Policy Stance, 2004–06, 2006–07

(Change in % of GDP between indicated years) 1/

Source: IMF staff estimates.1/Unweighted averages for 17 countries.
2

The figure for Venezuela refers to credit growth through June 2006, the latest available data.

3

The share of mortgage credit in total household credit averaged 37 percent at end-2006, ranging from 13 percent (Brazil) to 62 percent (Chile).

4

The included table reports net foreign direct investment, that is, direct investment inflows to the region net of outward investment originating from the region. Net FDI fell in 2006 as a result of acquisitions of assets outside the region, including a large acquisition by a Brazilian mining company.

5

The terms of trade are forecast to worsen by 2 percent in 2007, after an average annual increase of over 6 percent in the last three years.

6

Unless otherwise noted, regional figures in this section refer to an unweighted average for 17 Latin American countries.

7

Bolivia, Chile, Colombia, Ecuador, Mexico, Peru, and Venezuela.

8

See the November 2006 Regional Economic Outlook for a more extensive discussion of developments in the fiscal stance.

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