Abstract

The economic recovery in the region has been stronger than previously anticipated for 2010, but also more divergent across countries. Growth in economies more advanced in the recovery—mainly in South America—is expected to moderate somewhat as the inventory cycle matures and policy stimulus is unwound. Although a more dampened outlook for advanced economies may create headwinds, strong commodity prices and a prolonged period of easy external financing conditions will continue to support domestic demand and growth—while also posing challenges in ensuring a moderation in domestic demand to avoid overheating. For countries with stronger linkages to the United States and other advanced economies, challenges are shaped by continued sluggish growth and often limited policy space.

The economic recovery in the region has been stronger than previously anticipated for 2010, but also more divergent across countries. Growth in economies more advanced in the recovery—mainly in South America—is expected to moderate somewhat as the inventory cycle matures and policy stimulus is unwound. Although a more dampened outlook for advanced economies may create headwinds, strong commodity prices and a prolonged period of easy external financing conditions will continue to support domestic demand and growth—while also posing challenges in ensuring a moderation in domestic demand to avoid overheating. For countries with stronger linkages to the United States and other advanced economies, challenges are shaped by continued sluggish growth and often limited policy space.

Growth to Normalize from Recent Highs

After posting impressive gains in the first half of 2010, economic growth in the Latin America and Caribbean (LAC) region is projected to moderate somewhat during the remainder of this year, but remain above trend. For the region as a whole, growth in the first six months of 2010 reached 7¼ percent (saar), driven by a strong rebound in private consumption and investment, reflecting still stimulative policies, a buildup in inventory, favorable terms of trade, and easy external financial conditions (Figure 2.1). High frequency data suggest some signs of normalization in recent months, particularly in the two largest economies (Brazil and Mexico). In Central America, the recovery is progressing more gradually after a sluggish start, while in the Caribbean, growth remains muted, following a severe contraction last year.

Figure 2.1.
Figure 2.1.

Strong domestic demand continues to support the recovery, with increased contribution from investment.

1 Numbers in chart correspond to the values of the current projection (blue bars).Source: Haver Analytics; and IMF staff calculations.

For 2010 as a whole, aggregate GDP is now projected to grow more than 5½ percent in 2010 (from a fall of 1¾ percent in 2009). This represents an upward revision of about 1½ percentage points from our earlier projection (May 2010 Regional Economic Outlook: Western Hemisphere). Within the region, the largest upward revisions are concentrated in the largest economies, underpinned by surprisingly robust domestic demand growth. The outlook for the key external conditions (commodity prices, world trade, and external financing costs), however, remains broadly unchanged since our last edition. Bouts of market volatility related to sovereign debt problems in southern Europe in the past months had only small and short-lived effects on the region (Box 2.1 and Figure 2.2), while the more recent deterioration of market conditions in some countries of the European periphery has not spilled over to Spain, the country with strongest ties to Latin America.

Figure 2.2.
Figure 2.2.

Markets have normalized following distress in Europe, and highly favorable financing conditions have returned.

Sources: Morgan Stanley; and EPFR Global.1 Five-week moving average.

Looking ahead, growth in the LAC region is projected to slow to about 4 percent in 2011, converging to more sustainable growth rates as output gaps close in most countries in the region. Importantly, the growth projection for 2011 assumes a necessary tightening in fiscal policy, although it remains unclear whether this will end up materializing.

Despite the drag from softer activity in advanced economies, continued growth in emerging Asia, which has become more domestically driven, should help support prices of the region’s key commodity exports (see Box 2.2). In addition, the prospects of an even longer period of easy monetary conditions in the United States will make conditions conducive to strong capital inflows to the more financially integrated economies of the region.

Barring an extreme downside scenario for global growth, the main risks for the largest countries in the region relate to the possibility of continued fast growth of domestic demand fueled by favorable external conditions (leading to a surge in capital inflows) and the continuation of stimulative policies. This could be problematic especially where output has already reached its potential level and demand pressures threaten to increase inflation or widen current account deficits.

Tail risks from a full-blown crisis in Europe have diminished, although difficulties in refinancing large sovereign obligations could renew market volatility. Countries with stronger linkages to the United States and other advanced economies are more vulnerable to the possibility of weaker-than-projected growth in advanced economies, which will be undergoing fiscal retrenchment and may encounter new financial sector challenges.

Wide Divergence in the Regional Outlook

Growth prospects within the region continue to be quite diverse reflecting the varying strength of macroeconomic policy frameworks, as well as the importance of different external linkages, including commodity prices, financial integration and trade openness and diversification.

Latin America’s Resilience to the European Financial Turmoil of 2010

Latin America has shown significant resilience to the turbulence in European financial markets. Distress of Greek sovereign debt instruments, both in January and more seriously in April/May, spilled over quickly to other European periphery countries (Ireland, Portugal, Spain, and even Italy)—reflecting market concerns about cross-border exposures and fiscal and competitiveness woes—as well as beyond the European region. The direct impact on Latin America, however, was limited. Sovereign spreads across the region were little affected by the shocks to southern Europe assets in January, and the effect was even smaller during the April/May episode. This stronger decoupling may reflect limited direct links between Latin America and southern Europe as well as the agreement on international financial assistance for Greece. It is noteworthy, however, that the region’s sensitivity to global risk aversion (proxied by the VIX) increased between the two episodes. This may suggest that distress in Europe could still affect the region through its impact on global financial markets.

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Sensitivity of Sovereign CDS Spreads to Key Variables1

Sources: Bloomberg; and IMF staff calculations.1 Based on multivariate country-by-country regressions of weekly percent changes LA5 CDS spreads on the Spanish CDS spread and the VIX during October 2009 to February 2010, and March 2010 to July 2010. Spain’s spreads are used to factor in that country’s closer ties to the LAC region than other European countries.

Potential spillovers through the financial sector have not materialized, and contagion through other channels is likely to be small. A significant presence of Spanish banks in LAC had the potential to become an important transmission channel for shocks. However, funding pressures faced by parent Spanish banks did not spill over to the region. As noted in the last Regional Economic Outlook: Western Hemisphere, this was partly due to the stable funding base of Latin American subsidiaries, which rely primarily on local deposits as opposed to wholesale or cross-border borrowing, and their healthy balance sheets. The information contained in the European bank stress tests released in July further dispelled concerns about parent banks. The full impact through trade also has yet to be seen, but likely will be modest for most countries as the trade exposure to southern Europe, and Europe in general, is relatively small. FDI and remittances from Europe are also relatively low in the larger economies of the LAC region. Weaker growth prospects for Europe are, however, likely to affect some of the smaller countries that depend heavily on European tourism.

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Bond Spreads of Latin American Sovereigns and Selected Spanish Bank CDS Spreads

(Basis points)

Sources: Bloomberg; and IMF staff calculations.1 Average for Brazil, Chile, Colombia, Mexico, and Peru.
Note: This box was prepared by Gustavo Adler.

The Outlook for Commodity Prices and the Role of China

Demand from China plays a key role in the outlook for the prices of some of Latin America’s most prominent commodity exports—this is especially true for copper and soybeans, though less so for oil.

Commodity exports are important for many countries in the region, especially in South America. For some countries commodity exports represent the bulk of their export proceeds. While the region exports a wide range of commodities, and commodity-based processed products, the most prominent are copper, soybeans, and oil.1

Latest IMF forecasts, based on futures market data, suggest that prices of these three key commodities will remain broadly unchanged at relatively high levels. A key element underlying this outlook is the positive growth momentum in emerging economies, particularly in China.

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Outlook for Key Commodity Export Prices1

(Index, 2005 = 100)

Source: IMF staff calculations.1 Soybeans: Chicago soybean futures contract; Copper: LME spot price; and Oil: crude oil simple average of three spot prices; Dated Brent, West Texas Intermediate, and the Dubai Fateh.

Beyond China’s faster GDP growth, differences in the intensity of use of commodities play a critical role. China’s demand for metals—especially copper—has been increasing at a faster rate than its GDP. As a result, in 2009, China represented about 40 percent of the world’s total demand for copper—up from only 7 percent in 1995. A important increase has been observed also in the case of soybeans, with China accounting now for more than 20 percent of the world’s total demand. In contrast, China’s oil demand has risen more moderately, and in the last five years by less than China’s GDP. China’s share of world demand for oil is only about 10 percent.

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China: GDP and Commodity Demand

(Indices, 1995 = 100)

Source: IMF staff calculations.
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China’s Share of Global Demand

(Percent, simple averages)

Source: IMF staff calculations.
Note: This box was prepared by Leandro Medina. For a more detailed discussion, see World Economic Outlook (April 2010 and October 2010).1 Iron ore is meaningful particularly for Brazil and Peru; however, it is not included in this analysis.

Country differences correlate with the broad geographic divisions of the LAC region. In this edition of the Regional Economic Outlook, we organize the discussion of developments and outlook in the region using three geographical groupings—South America, Mexico and Central America, and the Caribbean—while also emphasizing certain differences within each group (Figure 2.3).1

  • The South America subregion as a whole is relatively less dependent on trade relationships with the United States (or other advanced economies). Commodities represent a very high share of their total exports, with a strong positive relationship between individual countries’ terms of trade and a broad commodity price index. Moreover, a number of these countries have important trade linkages with each other, particularly with Brazil—a regional giant. That said, important differences exist among these countries, notably in their ability to access global financial markets at favorable terms, reflecting the varying strength of their macroeconomic policies. Policies at a microeconomic level differ as well, with implications for the supply side of the macroeconomy.

  • Mexico and Central America are characterized by their strong real linkages to the U.S. economy (trade and remittances) and relatively high degree of openness. Moreover, unlike many of the countries of South America, Mexico and Central America do not reap large terms-of-trade gains when commodity prices rise (this reflects Central American countries’ reliance on imported oil, and Mexico’s net fuel exports being relatively small as a share of GDP). Another similarity is that most of these economies face important fiscal policy challenges, albeit for different reasons. That said, in some key dimensions, Mexico’s economy and policy frameworks are more similar to those of the more financially integrated countries in South America.

  • Countries in the Caribbean region are generally highly dependent on tourism from the United States and other advanced economies. Much like Central America, in most of the Caribbean, changes in commodity prices are inversely related to their terms of trade.

Figure 2.3.
Figure 2.3.

Subregions differ in key dimensions.

Sources: IMF, Direction of Trade Statistics; IFS; Moody’s; S&P; Fitch; and IMF staff calculations.
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LAC: Macroeconomic Outlook1

1 Simple average within groups.Source: IMF staff calculations.

The differences in countries’ exposure to the global recovery currently under way help explain part of the intraregional differences in growth (see Figures 2.4). South America’s earlier and stronger recovery is to some extent due to favorable commodity prices, and weaker trade links with slow-growing advanced economies. The recovery in Mexico and Central America is dependent on U.S. import demand and remittances from migrant workers, and therefore somewhat slower. The Caribbean continues to lag reflecting tourism’s link to employment growth in advanced economies, which remains sluggish.

Figure 2.4.
Figure 2.4.

Recent data suggest heightened growth heterogeneity by subregions.

Growth Tracker by Subregion

Sources: Haver; U.S. Department of Commerce; national authorities; and IMF staff calculations.Note: The growth tracker for countries with high frequency data employs a dynamic factor forecasting model that summarizes the available series and fits GDP growth. For the other countries, seven key indicators are combined into a monthly growth indicator based on their ability to explain quarterly GDP growth. The most recent estimates include forecasts, coloring based on three-month growth rates of the centered (one-quarter forward and backward looking) average indicator.

Diverse Policy Challenges

In the faster-growing economies of South America, the key challenge at this juncture consists of ensuring a timely withdrawal of the policy stimulus. This would help avoid overheating pressures in the context of easy financial conditions and output gaps that are narrowing fast. Given favorable conditions for foreign borrowing and capital inflows, careful attention will need to be given to the policy mix. Consideration could be given to the adoption of complementary policies (for example, micro- and macroprudential) to avoid pockets of exuberance such as excessive credit growth or asset price bubbles, although these should not substitute conventional macroeconomic policies.

For some countries, this juncture presents an opportunity to bring down net public debt and rebuild policy space against future shocks. Indeed, current global market conditions provide a good opportunity to reduce debt vulnerabilities through active debt management (for example, extending maturities and reducing financing).

The priority for the countries in South America with less fluid access to international financial markets, but which nonetheless benefit from favorable commodity prices and intraregional linkages, should be to quickly withdraw their policy stimulus to avoid overheating. In other countries where the outlook is weaker mainly due to supply bottlenecks (Ecuador and especially Venezuela), boosting private investment, while adopting sound macroeconomic policies remains a key challenge. In particular, fiscal frameworks in these countries require strengthening to break from past patterns of procyclicality, while efforts to improve access to financial markets should continue.

In Mexico and in Central America, where the recovery is linked to growth and employment prospects in the United States, potential GDP is also likely to have fallen in tandem with declines in potential output in the United States. This risk underscores the need to adopt policies geared at boosting long-term growth. Moreover, notwithstanding a still significant output gap, Mexico will need to continue efforts aimed at consolidating public finances given the prospects of declining oil revenues. In Central America, where the impact of the crisis was less severe than in Mexico, the key challenges lie in rebuilding the policy space used since 2008 and in strengthening the business climate to raise private investment.

In the Caribbean, pressing ahead with fiscal consolidation, strengthening competitiveness, and safeguarding financial stability remain the overarching priorities. See Chapter 5 for a discussion of the Caribbean’s medium-term challenges.

South America—Ensuring a Soft Landing

Although the resurgence of domestic demand following the crisis was certainly a good development, a moderation of demand growth is necessary to avoid fanning inflationary pressures or widening current account deficits. The expansionary policies adopted earlier to confront the global recession now risk becoming procyclical and need timely normalization. While most countries will continue to benefit from favorable terms of trade, the more financially integrated economies will face additional challenges from easy external financing conditions. In some countries of South America, fast-growing intraregional demand will boost growth, while in other cases supply-side constraints will continue to hold back growth and maintain inflation pressures.

Expansionary macroeconomic policies and favorable terms of trade resulted in a rapid increase in domestic demand and GDP growth during the first half of 2010 in most of South America. More financially integrated economies (those with lower spreads and higher credit ratings) continue to benefit from capital inflows, which have picked up in recent months following a short-lived reprise earlier in the year. Some of the less financially integrated economies of South America are also benefiting from the strong expansion in Brazil, while supply constraints continue hindering growth in a few countries.

Withdrawing Policy Stimulus Amid Ample Global Liquidity

The more financially integrated economies of South America (Brazil, Chile, Colombia, Peru, and Uruguay) grew strongly in the first half of the year, with only minor signs of moderation. 2 Brazil, Peru, and Uruguay, where real GDP growth is projected to exceed 7 percent in 2010, are already operating at or near full capacity, with unemployment rates at historic lows in some cases. In Chile, activity has rebounded strongly in the last four months (following a short-lived decline earlier in the year on account of the strong earthquake), whereas in Colombia the recovery is gaining momentum despite headwinds from lower trade activity with neighboring Venezuela.

So far, inflation in all countries remains near targets (or within target ranges), although core inflation and inflation expectations have been rising in some cases. The recent increase in world food prices has had only minor effects thus far. Policy rates have been appropriately raised in most countries in recent months within a gradual move to a more neutral position.

With ample global liquidity, capital continues to flow into the more financially integrated countries in the region. Portfolio flows continue to dominate, while private external borrowing appears to be reviving (mainly in Brazil). Overall, gross flows are reaching levels similar to those of the precrisis years, although accompanied by renewed accumulation of foreign assets (outflows) mainly by the private sector (Figure 2.5).

Figure 2.5.
Figure 2.5.

Capital inflows are contributing to a pick-up in credit and some exchange rate appreciation.

Sources: Haver Analytics; EMED; IMF, International Financial Statistics; and IMF staff calculations

The rebound of domestic demand has pushed up imports. As a result, and despite favorable terms of trade and some recovery of export volumes, external current account balances have weakened somewhat. However, the increase in net capital flows has more than offset the deterioration in the external current account, and international reserves have continued to rise, albeit at a slower pace than in late 2009 (see Box 2.3). Reflecting these trends, exchange rates have continued to strengthen to above precrisis levels (in both nominal and real effective terms), with Brazil, Colombia, and Uruguay experiencing the largest appreciation since end-2009.

Reserve Accumulation: Building Insurance or Leaning Against Appreciation Winds?

Emerging Market Economies (EMEs) have returned to rapid reserve accumulation and Latin America is following the trend. Starting in 2005 up until the collapse of Lehman, EMEs accumulated an average of 20 percentage points (pps) of their GDP in reserves (15 pps if China is excluded). The trend resumed at a rapid pace following the normalization of market conditions in early-2009, with only a temporary slowdown in the first-half of 2010 as a result of the European crisis. Reserves in EMEs are now 5 pps of GDP higher than pre-Lehman levels. Latin America broadly conforms with this trend, though accumulation has been at a much slower pace than in other regions (reaching 8 pps of GDP since 2005).

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EMEs and LA: Reserve Accumulation1

(Percent of GDP, cummulative since 2005)

Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Weighted average for each group, using 2006–08 average GDP as weights. Shading highlights the period from the collapse of Lehman Brothers to the trough in global markets.
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Reserves Accumulation in Financially Integrated, Latin American Countries1

(Percent of GDP, cummulative since 2005)

Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Shading highlights the period from the collapse of Lehman Brothers to the trough in global markets.

There are, however, important differences within Latin America. Among the more financially integrated economies, Brazil, Peru, and Uruguay have increased reserves at rates similar to those of other EMEs (except China). Chile, Colombia, and Mexico on the other hand increased reserves at a slower pace; though the initial (pre-2005) level of reserve coverage does not account for the differences.1

Although they exceed standard thresholds, reserve buffers in the region are smaller than in other regions. As of mid-2010, the median EME stock of reserves was equivalent to about 20 percent of GDP, 170 percent of external short-term debt and 40 percent of broad money (M2), significantly above standard thresholds (100 percent of short-term debt and 20 percent of M2). In terms of those metrics, reserve holdings in emerging Latin America also exceed standard thresholds, but the median is somewhat below those of other EMEs. These median figures, however, mask important intraregional differences. Among the more financially integrated economies, Uruguay and Peru show high coverage ratios relative to the region as well as other EMEs, possibly reflecting a perceived need for additional insurance due to a high degree of financial dollarization (and large nonresident deposits in the case of Uruguay). Chile, Colombia, and Mexico on the other hand show relatively low ratios, standing out among the lowest ratios across all EMEs in some metrics. Brazil’s reserve coverage ratios are broadly in line or above the median for EMEs.

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Reserves-to-GDP1

(Percent of 2006–08 GDP, average)

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Reserves-to-Short Term Debt13

(Percent of short-term external debt)

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Reserves-to-M21

(Percent of M2)

Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Reserves as of June 2010 or latest available, including gold holdings (national valuation). The red lines present the distribution (in percentiles) of ratios across all emerging market countries.2 Gray bar shows the distribution of ratios within Latin America. It presents the range of values from the 10th to 90th percentiles; the black box marks the median of the region.3 Based on interpolation of annual values of external short term debt (residual maturity basis).

The reserves buildup of recent years seems to be a byproduct of policies aimed at “leaning against the appreciation wind,” rather than at strengthening precautionary buffers. Its timing has coincided with periods of easy external financing conditions and high commodity prices, which have meant for many EMEs, including in Latin America, significant exchange rate appreciation pressures. Furthermore, reserve accumulation has been faster in countries with already higher reserve coverage ratios. The absence of EMEs issuing long-term debt to boost reserve buffers more rapidly also suggests limited insurance motive.

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EME and LA: Reserve Accumulation and External Conditions

Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Weighted average of 3-month change in stock of reserves in percent of 2000–08 average GDP.
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Distribution of International Reserves in Emerging Market Economies

(Share of GDP)

Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Average of countries found in the first quartile in the first month of the precrisis, crisis, and postcrisis periods.2 Average of countries in Latin America and the Caribbean.

Compared with other regions, however, Latin America has exhibited more tolerance of exchange rate volatility and appreciation in recent years. In Latin America, an increase in reserves equivalent to 7 pp of GDP between January 2005 and August 2008 coincided with a 20 percent real appreciation, while in other EMEs, much larger reserve accumulation (19 pp of GDP) was accompanied by a smaller appreciation (14 percent). The contrast of observed appreciation is starker in (effective) nominal terms. Within Latin America, Brazil, Chile, Colombia, and Mexico have tended to react with a combination of sizable nominal appreciation and intervention while Peru and, to a lesser extent Uruguay, have relied heavily on intervention (and prudential or administrative measures).

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EMEs and LAC: Real Exchange Rate and Reserves

Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Index 2005=100. Weighted average.2 Gross international reserves as a share of 2006–08 average GDP. Weighted average.
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LAC, Financially Integrated Economies: Real Exchange Rate and Reserves1

Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Each path identifies 4 points time: 1) September 2005, pre-Lehman REER maximum, post-Lehman REER minimum and June 2010.
Note: This box was prepared by Gustavo Adler.1In the case of Chile, accumulation of foreign assets outside the central bank—reflecting fiscal savings of the commodity export windfall—would add about 10 percentage points of GDP to the precrisis figures.

The easy external financing conditions also have affected bank credit, with signs of acceleration in all countries in the group, but more pronounced in Brazil and Peru. In Brazil, the resumption of credit by private banks has offset some deceleration in lending by public banks, albeit from high rates of growth (see Chapter 3).

Although asset bubbles are notoriously difficult to detect, available indicators do not show clear evidence of their presence yet. Price earnings ratios remain within historical averages for most countries, and stock market valuations are only somewhat stronger than historical trends for Chile and Colombia. The information needed to assess real estate market conditions, however, is still scant.

Against this backdrop, the unwinding of policy stimulus that started in most countries will have to be firmed up in the coming months. Withdrawing policy support in a timely manner will help avoid boom-bust cycles of the past and create space for countercyclical policies in the future (Figure 2.6).

Figure 2.6.
Figure 2.6.

Policies in many countries remain accommodative, despite closing output gaps.

Sources: Haver Analytics; and IMF staff calculations.

When withdrawing the stimulus, careful consideration will need to be given to the policy mix, particularly amid pressures generated by cheap foreign money. Generally, fiscal stimulus should be withdrawn ahead of the (full) withdrawal of monetary stimulus, and the exchange rate should be allowed to move to avoid creating one-sided bets that would induce further inflows. In some cases, bolder action may be required to normalize policy rates, particularly if inflation expectations are becoming entrenched or inflation remains hovering near the upper end of a target range.

On the fiscal side, returning to a neutral stance will require a sharp slowdown in the rate of growth of real primary spending that, through mid-2010, has been much higher than trend output growth in most countries. In the case of Brazil, spending restraint will have to be accompanied by a decline in quasi-fiscal operations of public banks (which in turn would help address distortions in the credit channel that constrain the effectiveness of monetary policy).3

In countries with somewhat larger output gaps and stronger fiscal positions (Chile and to a lesser extent Colombia), consolidation can proceed more gradually. In Chile, significant earthquake reconstruction spending needs will tend to shift the task of restraining demand to monetary policy over the near term, with exchange rate flexibility providing the space for avoiding excessive pressure on domestic resources. In Colombia, a modest fiscal stimulus in 2010 is being accompanied by increased capital spending by a mostly state-owned petroleum company to boost petroleum production over the medium term.

If the domestic demand momentum does not react sufficiently fast to tighter macroeconomic policies or there are signs of exuberance, including on the exchange rate, macroprudential policies may prove helpful to avoid undesirable credit dynamics and influencing risks perceptions. This could include increasing reserve requirements on deposits (as done in Brazil and Peru), raising provisioning charges on higher loan-to-value ratios, and limiting the net foreign exchange position of banks. In addition, prudential measures could help to normalize monetary conditions in countries with a high degree of dollarization and weak monetary transmission mechanisms (see Chapter 4 and Box 2.4 for a fuller discussion of these issues). Administrative measures to discourage inflows could also be considered, but they should be broad-based and accompanied by an appropriate infrastructure to ensure some degree of effectiveness.4 These tools may complement, and not substitute for a further tightening of macroeconomic policies.

From a longer-term perspective, the relatively favorable external conditions provide an opportunity to further strengthen policy frameworks and balance sheets, and increase the effectiveness of complementary policy instruments.

On the fiscal front, efforts should focus on acquiring fiscal space that may be used in the future. For this, increased resolve to moderate the growth in primary government spending (particularly current spending), which over the past decade has grown well above trend growth, will be necessary. Most countries would benefit from moving policy toward targeting cyclically adjusted balances rather than nominal fiscal balance targets that allow procyclical expenditure responses to revenue developments.5 In Chile, the government intends to reduce the structural deficit, to 1 percent of GDP in 2014, mainly by restraining the growth rate of expenditure below that of GDP.

Strengthening balance sheets further by reducing dollarization and improving debt structures would enhance the usefulness of the exchange rate as a shock absorber, without creating destabilizing effects. For this reason, countries should redouble efforts to extend the maturity of public debt as well as to increase the share denominated in local currency, while continuing to let the exchange rate adjust freely (see Box 2.5).

What Is Driving Financial Dedollarization in Latin America?

Dollarization has been a distinguishing feature of banking systems of many Latin American countries. Although it was largely a consequence of past episodes of severe economic crises and high inflation, financial dollarization has remained stubbornly high even after a prolonged period of economic stability and low inflation.

Since the early 2000s, some Latin American countries (Bolivia, Paraguay, Peru, and to a lesser extent Uruguay) have recorded a gradual yet sustained decline in financial dollarization. On average, the share of foreign currency deposits in total deposits in these four countries fell by about 30 percentage points since 2002, with somewhat smaller declines (25 percentage points) in the case of bank credit. Declines in dollarization are similar across all types of deposits and loans. In Central America, where real linkages to the United States are strong, dollarization ratios have remained broadly unchanged over the past decade (although for most countries with a national currency dollarization, ratios remain lower than in South America). Mexico, which also had high dollarization ratios in the 1980s and 1990s, lowered them significantly in the 2000s.

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Dollarization of Credit1

(Percent of total credit outstanding)

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Dollarization of Deposits1

(Percent of total deposits)

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Dollarization of Deposits1

(Percent of total deposits)

Sources: IMF, International Financial Statistics; and IMF staff calculations.1Foreign currency credit and deposits valued at constant exchange rates.

Drivers of dedollarization. A great deal of work exists on the causes of financial dollarization, yet the empirical literature on dedollarization is scant, amid the relatively few episodes of successful market-based dedollarization. Kokenyne and others (2010) and Erasmus and others (2009) find that successful dedollarization has required a strong track record of macroeconomic stability with other policies to enhance the attractiveness of the local currency, including some degree of exchange rate volatility. Garcia-Escribano (2010) finds that in Peru, dedollarization has been driven not only by macroeconomic stability, but also by the introduction of prudential measures to better reflect currency risk and by the development of the capital market in local currency (which facilitated bank funding and pricing of long-term loans in domestic currency).

  • Currency appreciation and exchange rate volatility. In Bolivia, Paraguay, Peru, and Uruguay the recent decline in dollarization ratios has taken place in a context of macroeconomic stability and increased tolerance of currency appreciation. In addition, allowing some degree of exchange rate volatility (within an appreciation trend) seems to have been important for the dedollarization of credit (for example, in Peru).

  • Prudential measures. Active management of reserve requirements (in particular, increases in the differential between reserve requirement ratios on foreign and local currency deposits) appears to have been important in lowering dollarization ratios, by increasing the costs for banks of shifting liquidity balances among currencies. Increasing required provisions on foreign currency loans (Bolivia and Peru), introducing differentiated capital risk weights on foreign currency loans (Uruguay), and tightening of capital requirements against open foreign exchange positions (all four countries) may have also played a role in discouraging lending in foreign currency to unhedged borrowers.

  • Development of local capital market. Bolivia, Peru, and Uruguay have recently issued public bonds in domestic currency with maturities exceeding 10 years for the first time in decades. These issuances were part of an attempt to develop domestic capital markets, improve the structure of debt, and extend the domestic yield curve (up to 30 years in Bolivia and Peru). The creation of a benchmark for long-term domestic currency debt has facilitated pricing of private instruments in local currency at longer maturities and contributed to lower dollarization.

Challenges. Experience shows that market-based dollarization is a long-term process. While the steady decline in financial dollarization in recent years observed in Bolivia, Paraguay, Peru, and Uruguay has been remarkable, dollarization levels remain high, and efforts to lower them should continue. Policies that combine some degree of exchange rate volatility (in the context of macroeconomic stability) with low and predictable inflation will be critical, including by allowing agents to internalize exchange rate risks. Additional prudential measures may help to curb the risks of lending in foreign currency, while the development of capital markets in domestic currency should facilitate long-term lending in local currency.

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Exchange Rate Appreciation and Dollarization1

Sources: IMF, International Financial Statistics; and IMF staff calculations.1 Monthly data for Jan-2003 through Jun-2010. Data for Uruguay starts in 2004.2 Local currency per U.S. dollar exchange rate such that increases denote depreciation.
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Credit Dollarization and Debt Issuance1

(Percent of domestic credit)

Sources: Dealogic; IMF, International Financial Statistics; and IMF staff calculations.1 Lines represent credit in foreign currency in percent of total domestic credit. Dots represent moment of issuance of debt in domestic currency with maturity of more than 10 years.
Note: This box was prepared by Mercedes García-Escribano and Sebastián Sosa.

Domestic Demand Growth under Easy and Tight External Financial Conditions: The Role of Exchange Rate Flexibility

Exchange rate flexibility helps insulate countries from external financial developments in good and bad times. Episodes of easy global money have contributed to faster domestic demand growth in many emerging and small developed markets. But exchange rate regimes have made a difference. The pickup of domestic demand generally has been smaller in countries with more flexible exchange rate regimes during periods of easy global money. Conversely, the fall in domestic demand growth has been milder in more flexible regimes during periods of tight external liquidity.

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Contractions Under Tight Money1

Sources: IMF, International Financial Statistics and IMF staff calculations.1 In a sample of 42 advanced and emerging market countries. Periods of “easy money” include 1991–96 and 2004–07; periods of tight money include 1997–98 and 2009.

Domestic demand growth tends to be less volatile in more flexible exchange rate regimes. Analysis based on multivariate pooled regressions for 42 emerging and advanced economies shows that domestic demand rises when (i) global risk aversion (VIX) falls; (ii) terms of trade improve; and (iii) world growth increases. The effects of external variables, however, are often milder in more flexible exchange rate regimes. Pooled regressions for other domestic demand components suggest that external variables affect investment more heavily than consumption. They also suggest that consumption and investment are less affected in more flexible exchange rate regimes. External financial conditions and world growth also affect GDP, while the terms of trade seem to affect mostly the current account. Countries that rely less on flexible exchange rates need to rely more on other demand management policies (for example, fiscal or prudential) to offset the effect of external conditions.

Pool Regressions: Effect of External Variables on Domestic Demand, GDP, and Current Account Balances 1

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Sources: Chicago Board of Options Exchange; Haver Analytics; and IMF staff calculations.

The sample includes Argentina, Australia, Bolivia, Brazil, Bulgaria, Canada, Chile, Colombia, Costa Rica, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Guatemala, Honduras, India, Indonesia, Israel, Korea, Latvia, Lithuania, Malaysia, Mexico, New Zealand, Nicaragua, Norway, Pakistan, Panama, Paraguay, Peru, Philippines, Poland, Russia, South Africa, Thailand, Tunisia, Turkey, Ukraine, Uruguay, and Venezuela. Data are monthly observations for the period 1990–2009.

The flexible dummy takes a value of 1 for the more flexible exchange regimes under the IMF classification, defined as crawling pegs and above.

Note: This box was prepared by Jorge Iván Canales-Kriljenko.

Favorable Terms of Trade Continue to Offset Limited Market Access

Unlike the more financially integrated countries of South America, where demand is boosted by easy external financing conditions, growth in the rest of the subregion is being underpinned primarily by favorable terms of trade. However, differences within this group are large, reflecting varying degrees of supply constraints, reliance on commodity-related revenues, trade linkages with Brazil, and policy responses.

In Argentina and Paraguay, for example, strong growth is being supported by close intraregional trade ties with Brazil (see Box 2.6), a rebound in agriculture following the drought of 2009, and highly stimulative policies. In countries such as Ecuador and Venezuela, however, the recovery is much weaker, largely reflecting supply constraints and weak policy fundamentals. Despite large trade surpluses, uncertain business environments have resulted in sizeable capital flight and depressed private investment. This is seen most clearly in Venezuela, where output is contracting again this year, amid tighter exchange rate restrictions.6

In most countries of this group, fiscal and monetary policy stimulus are pushing demand up and contributing to a rise in inflation. Monetary aggregates are growing by an annual average of more than 20 percent thus far this year, while primary spending is accelerating to levels above trend output growth in many countries (Argentina, Ecuador, Paraguay, and Venezuela). The group is still projected to record an overall external current account surplus although favorable terms of trade mask a significant underlying deterioration (Figures 2.7 and 2.8).

Figure 2.7.
Figure 2.7.

In the less financially integrated countries of South America, favorable commodity prices remain key, although capital outflows continue.

Sources: EMED; Haver Analytics; IMF, International Financial Statistics; and IMF staff calculations.
Figure 2.8.
Figure 2.8.

In this group, policies remain largely procyclical.

Sources: Haver Analytics, IMF, International Financial Statistics, and IMF staff calculations.

Real Spillovers from Brazil to Neighboring Countries

Although Brazil’s imports from other Mercosur countries (Argentina, Paraguay, and Uruguay) represent only 10–12 percent of its total imports, Brazil is a key export destination for Mercosur countries, representing 25 percent of their total exports. In addition to being an important source of tourism and investment flows to Mercosur countries, Brazil imports from Mercosur mainly capital and intermediate goods, which have important backward linkages to the real economy. Following a decline of nearly 25 percent in the first half of 2009, (seasonally adjusted) imports from Mercosur grew by more than 10 percent year-over-year in the second half of 2009, and were up close to 20 percent in the first half of 2010. Imports of Argentine automobiles and auto parts were up close to 65 percent (y/y) in the first half of 2010, representing about 45 percent of total Argentine exports to Brazil (compared with 20 percent precrisis). Cereal imports from Paraguay and Uruguay increased by similar magnitudes.

ch02bx06ubx01ufig01

Brazil: Imports from Mercosur by Sector

(Percent of total imports from Mercosur)

ch02bx06ubx01ufig02

Change in Share of Exports to Brazil1

(Percent)

Sources: National authorities; Brazilian General Trade Statistics; and IMF staff calculations.1 Change in export share to Brazil by product is calculated as the difference in export shares for the period March 2009 through February 2010 against the period January 2001 through February 2008.

In addition to the direct effect of trade, GDP growth in Mercosur countries is strongly influenced by domestic demand in Brazil. Econometric estimates suggest that a 10 percent increase in Brazil’s GDP growth would increase Argentina’s growth by about 3 percent, whereas a 10 percent increase in capital goods imports by Brazil is estimated to pull up growth in Argentina by nearly 1 percentage point on an annualized basis, after controlling for other factors (that is, exports to China, U.S. growth, commodity prices, global interest rates). Similar effects are also found for Paraguay and Uruguay. These results are consistent with the large upward revisions in consensus forecasts for GDP growth in Brazil and its Mercosur partners since late 2009.

ch02ufig15

Brazilian Imports and Argentine Industrial Production

Sources: Haver Analytics; and IMF staff calculations.

Impact of Exports to Brazil on Real GDP Growth

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Sources: General Trade Statistics; and IMF staff estimates.

Real GDP regressed against volume of specified exports to Brazil, controlling for GDP growth in Brazil, the Unites States, Argentina, and lagged country GDP, commodity prices, Libor, U.S. interest rate spreads, Brazil export prices, Chinese imports from the region, and lags of these (not shown). Quarterly, 1995/98-2010, least squares, AR(1).

Note: This box was prepared by Rafael Romeu.

These countries would benefit from more prudent macroeconomic policies and from the establishment of institutions that help them put an end to procyclical fiscal policies and insulate their economies from swings in commodity prices. In that regard, the example of Bolivia is instructive as it has shown that careful management of energy receipts is consistent with well-targeted social spending, and has large payoffs to stability.

Strengthening the business climate remains critical. Interventionist policies are constraining the growth potential of these economies, and exposing them to increased fiscal and financial fragilities. In the case of Argentina, for example, improving access to international markets will require further efforts to regularize relations with creditors.7 Blanket foreign exchange restrictions (such as those implemented in Venezuela) should be avoided, as they prove largely ineffective at stemming outflows and often prove to be counterproductive.

Mexico and Central America—Recovery Gathers Strength Despite Headwinds from the United States

In Mexico and Central America the recovery is strengthening, and policies should aim at consolidating the fiscal position. Mexico needs to compensate for declining oil revenues, while Central American countries need to recover the fiscal policy space used during the crisis and to deepen reforms that improve the business climate. In this group, strong linkages to the United States magnify downside risks from weaker growth in advanced economies.

Mexico: Fiscal Consolidation Amid Weak Trading Partner Outlook

Mexico is staging a stronger-than-anticipated recovery in 2010 led by a pickup in domestic demand in the second quarter. Strong automobile exports to the United States, on account of a turnaround in the inventory cycle of U.S. automakers, and favorable oil prices have further supported domestic demand and helped contain the current account deficit. Reserves have increased on the back of the policy of retaining oil export earnings coupled with rules-based intervention. The latter has been facilitated also by portfolio-dominated capital inflows. Domestic credit is slowly starting to recover, after remaining stagnant since early 2008.

Growth for 2010 is projected to exceed 5 percent, even with a slowdown during the second half of the year in line with the projected cooling of the U.S. economy and unwinding of temporary factors that led to a surge in U.S. imports during the first semester. The output gap remains large and is projected to close gradually, in the face of limits to demand-led policies (Figure 2.9).

Figure 2.9.
Figure 2.9.

Ties with the United States dominate the outlook for Mexico and Central America.

Sources: Haver Analytics; and IMF staff calculations.

Fiscal policy is constrained by the clear need to consolidate public finances given medium term risks for budget revenues from uncertainties over future oil production. In this context, monetary policy can take up the slack and remain supportive for a longer period.

Risks to the outlook remain tilted to the downside. Deterioration in U.S. consumer confidence resulting from weaker housing and employment could affect Mexico’s recovery; in the other direction, easy external financing conditions could help to stimulate private demand. Moreover, with more than 80 percent of domestic banking system assets owned by systemic global banks, higher capital charges arising from the global financial sector regulatory reform could have knock-on effects on credit in Mexico. Potential spillovers, however, are limited given global banks’ use of subsidiaries (with own capital and healthy balance sheets) and their reliance on local deposits as their main source for their funding.

Central America: Rebuilding Policy Buffers

The countries in Central America are recovering gradually, led by a rebound in domestic demand (following its sharp contraction in 2009), which has partly spilled over into imports. Pickups in exports and more recently remittances have been further positive developments. Foreign direct investment (FDI) has been fairly resilient throughout the downturn and continues to finance the bulk of the region’s current account deficit.

The recovery has been faster in Panama and Costa Rica, where stronger policy frameworks were able to accommodate a larger policy stimulus.8 The recent slowdown in activity in the United States has thus far not affected the region’s recovery, although this may reflect transmission lags.

For 2010, output in the Central American region as a whole is projected to expand by about 3 percent, somewhat below potential. Output gaps are relatively small (the downturn in 2009 was not too severe, and potential output growth slowed), so room and desirability for active demand policies is very limited. Growth will remain dependent on the path of U.S. imports, which given the permanent output loss in the United States, would imply lower income levels for the region than those projected prior to the crisis.

The fiscal stimulus is being gradually withdrawn in most countries, though growth in real primary spending in 2010 in some countries remains well above trend growth. Monetary policy remains constrained in many cases by fixed exchange rate regimes and high levels of dollarization, as well as a low degree of financial intermediation.9

Looking forward, Central American countries should focus on restoring the fiscal policy space used during the crisis to give them more scope to conduct countercyclical policies in the future. Public debt in the Central American region is projected to average slightly more than 40 percent of GDP by end-2010 (4½ percentage points higher than in 2008), and debt ratios continue to be highly sensitive to growth and interest rate shocks.

Over the near term, fiscal consolidation should focus on slowing the growth in current spending, particularly on wages (Honduras, Nicaragua), and generalized energy subsidies (El Salvador). Efforts should also be made over the medium term in mobilizing revenues (Guatemala) and making public pension systems more viable (Honduras and Nicaragua), including to make space for much needed social and infrastructure spending (Figure 2.10).10 If downside risks to growth were to materialize, those countries with low public debt levels could make the pace of consolidation more gradual.

Figure 2.10.
Figure 2.10.

Fiscal buffers require rebuilding in some countries and spending composition has ample room to improve.

Sources: Fiscal Monitor, 2010; and IMF staff calculations.

Countries with scope to conduct monetary policy (Costa Rica and Guatemala) should continue strengthening their monetary frameworks, including by allowing greater exchange rate flexibility (Figure 2.11). In dollarized economies (El Salvador) or those with pegs (Honduras and Nicaragua), priority needs to be placed on keeping central bank credit in check and continuing to develop interbank markets, while embarking on reforms that reduce nominal price and wage rigidities.

Figure 2.11.
Figure 2.11.

In Central America, limited exchange rate flexibility and high levels of dollarization constrain monetary policy.

Sources: Bloomberg; Central American Monetary Council Secretariat; IMF, International Financial Statistics; and IMF staff calculations.

Emphasis will also need to be placed in improving the business climate in Central America (which ranks low by international standards) and increasing the diversification of exports.11

The Caribbean—Turning the Corner Amid Vast Challenges

The Caribbean region is gradually recovering from last year’s severe recession. Tourism appears to have turned the corner, yet headwinds from weak labor markets in advanced economies constrain tourism growth prospects. The key challenge lies in consolidating public finances while strengthening competitiveness. Prospects are somewhat more favorable in countries with lower debt burdens and lower dependence on tourism.

Securing Growth

After declining by more than 3 percent in 2009, real GDP for the Caribbean as a whole is projected to post only marginal gains in 2010 (growing by an average of about 1 percent, after relatively low debt ratios and is benefiting from ongoing reconstruction efforts in Haiti.

In Haiti, the reconstruction that followed the devastating earthquake in January 2010 is supporting a fragile recovery. Large external assistance in the years ahead is expected to boost growth, while the impact on inflation is expected to be contained given very large output gaps and the high import component of aid (see Box 5.1 for a more detailed discussion). The prospects would be much different, however, if the pledged assistance failed to materialize on time.

The tourism sector in the Caribbean is expanding very slowly, in line with the tepid recovery in employment conditions in advanced economies. During the first half of 2010, tourist arrivals in the Caribbean increased by an average of 3½ percent compared with the same period last year. This was led by increased arrivals from the United States and Canada, against continued declines from Europe.12

The recovery of tourism, however, has been uneven. Smaller islands in the region have experienced a sharper and more prolonged decline in tourist arrivals than some of the larger islands. A closer look at the data suggests that destinations that significantly reduced hotel prices following the crisis experienced milder declines in arrivals. Though many factors are likely at play, downward price rigidities could help explain these intraregional differences. For example, hotels in the Dominican Republic and Jamaica lowered prices more than other countries and did not experience a decline in the number of tourist arrivals. In contrast, hotels in the Bahamas and Barbados were more reluctant to reduce prices and their tourist arrivals fell (Figure 2.12).

Figure 2.12.
Figure 2.12.

Tourist arrivals are starting to recover, with help from hotel price cuts.

Sources: Caribbean Tourism Organization; WTO; Hotels.com; and IMF staff calculations.

Boosting competitiveness and growth over the medium term remains a key policy challenge. For the whole region, improving productivity will require sustained structural reforms, including enhancing the role of the tourism sector. Labor markets will need to be more flexible (especially important given fixed exchange rate systems) to allow the region to better react to external shocks and to increased competition for tourists from inside and outside the region (including Cuba, Box 5.2).

Risks to the region are on the downside. In addition to the risks of policy slippages, the region is highly exposed to advanced country labor conditions, which could falter. With no space to adopt countercyclical policies, the region would have to adjust to a more negative scenario by focusing any expenditure on protecting the poorest households.

Reducing High Debt Burdens

In most countries in the region, efforts are under way to consolidate public finances and reduce heavy public debt burdens, but weak growth and low revenues make progress difficult. Despite a contraction in real primary spending, public debt is projected to increase by an average of 15 percentage points of GDP between 2008 and 2010, for the region as a whole.

To finance their large fiscal imbalances, governments in the region have turned to local pension funds and banks, as well as International Financial Institutions to finance the large fiscal imbalances. Concessional financing from Venezuela’s PetroCaribe has also played an important role, though doubts persist over the sustainability of this assistance, given. economic conditions in Venezuela.

As noted in previous editions of the Regional Economic Outlook: Western Hemisphere and analyzed further in Chapter 5, placing and maintaining public debt on a firmly declining path is critical to breaking from the current low-growth, high-debt trap (Figure 2.13). Achieving the required large improvement in the primary balance will require strong resolve in containing primary spending, particularly public sector wages. This would also help improve competitiveness, given their spillovers on private compensation. In addition, measures aimed at broadening the tax base (including through the elimination of generous tax incentives) will be necessary to boost revenues over the medium term.

Figure 2.13.
Figure 2.13.

High debt hindered growth and room to implement countercyclical policies.

Sources: Country authorities; and IMF staff calculations.

Strengthening the Financial Sector

Credit in the Caribbean region has been slow to recover (much like Central America), due to weak credit demand, though in some cases damaged bank balance sheets have been a factor.13 In addition, in some countries large government financing needs may be crowding out credit to the private sector (The Bahamas, Barbados, and Jamaica). Moreover, some increase in non-performing loans resulting from the downturn, coupled with weak oversight and low provisioning ratios could pose additional risks to the system (Figure 2.14). Supervisory authorities need to keep close oversight and stand ready to intervene if needed.

Figure 2.14.
Figure 2.14.

Credit recovery is uneven, and vulnerabilities are building from knock-on effects of the downturn.

Sources: Bankscope; and IMF staff calculations.

Financial systems remain vulnerable to contagion shocks by cross-border financial conglomerates. Contingent liabilities associated with the collapse of the Trinidad and Tobago-based CL Financial Group14 remain a key fiscal risk, particularly for the ECCU, where insurance claims amount to 17 percent of regional GDP. Legislative proposals to strengthen and harmonize supervision and regulation across regional partners must be adopted immediately to improve oversight and mitigate fiscal risks. Consideration should be given to the establishment of a single regulatory umbrella that brings all nonbank financial institutions under one domain as well as to greater cross-border regional supervisory cooperation.

Note: This chapter was prepared by Gustavo Adler, Luis Cubeddu, and Rafael Romeu.

1

This entails a few changes since the last edition, which emphasized the combination of commodity exposures and financial integration. In this occasion, the strength of trading partners’ growth presents a distinct and highly relevant cross-sectional variation.

2

In Brazil, the slowdown in the second quarter of 2010 largely reflects temporary factors (including an early Easter and slower industrial and construction activity in June during the soccer World Cup).

3

Quasi-fiscal stimulus through the National Development Bank BNDES reached 2.3 percentage points of GDP in 2009, yet a 0.5 percentage point withdrawal is projected in 2010.

4

Brazil reintroduced a tax on capital short-term inflows in late 2009. More recently, Peru introduced a 4 percent fee on nonbank holdings of central bank paper and imposed daily and weekly limits to pension funds’ foreign exchange operations. It also increased reserve requirements on domestic-currency deposits of foreign financial institutions.

5

In Colombia, a draft Fiscal Responsibility Law (focused on the primary structural balance of the central government) was recently submitted to Congress.

6

In Venezuela, real GDP fell by 3½ percent during the first half of 2010 relative to the same period in 2009, owing in part to severe energy shortfalls. New foreign exchange regulations were adopted in June, establishing stricter limits for participating in the official market.

7

Argentina launched a debt restructuring process with holdout creditors in May/June 2010; 70 percent of holders of defaulted bonds participated in the exchange (increasing the total participation of holders of defaulted bonds in the 2005 exchange to 91 percent).

8

Panama has also benefited from works related to the canal expansion, while Costa Rica has stronger trade links with Asia.

9

Despite opening output gaps and a sharp drop in inflation following the crisis, policy rates were reduced only very modestly in 2009, likely reflecting concerns over currency depreciation.

10

Nicaragua enacted a revenue-raising tax reform in 2010, and Panama adopted two far-reaching tax reforms during 2009–10.

11

Earlier this year, an association agreement was signed with the European Union.

12

IMF staff estimates suggest that a 1 percent point increase in advanced-economy unemployment leads to roughly a 5 percent decline in arrivals. See Romeu and Wolfe (2010).

13

Private credit has rebounded in the Dominican Republic, likely reflecting low leverage ratios and improved growth prospects.

14

Trinidad and Tobago spent in 2009 about 4 percent of GDP in bailing out the group’s insurance subsidiaries: the Colonial Life Insurance Company (CLICO) and the British American Insurance Company (BAICO). The bailout is limited to CLICO operations in Trinidad, and the issue has yet to be resolved in other islands.

Heating Up in the South, Cooler in the North
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    Strong domestic demand continues to support the recovery, with increased contribution from investment.

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    Markets have normalized following distress in Europe, and highly favorable financing conditions have returned.

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    Sensitivity of Sovereign CDS Spreads to Key Variables1

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    Bond Spreads of Latin American Sovereigns and Selected Spanish Bank CDS Spreads

    (Basis points)

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    Outlook for Key Commodity Export Prices1

    (Index, 2005 = 100)

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    China: GDP and Commodity Demand

    (Indices, 1995 = 100)

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    China’s Share of Global Demand

    (Percent, simple averages)

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    Subregions differ in key dimensions.

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    LAC: Macroeconomic Outlook1

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    Recent data suggest heightened growth heterogeneity by subregions.

    Growth Tracker by Subregion

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    Capital inflows are contributing to a pick-up in credit and some exchange rate appreciation.

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    EMEs and LA: Reserve Accumulation1

    (Percent of GDP, cummulative since 2005)

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    Reserves Accumulation in Financially Integrated, Latin American Countries1

    (Percent of GDP, cummulative since 2005)

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    Reserves-to-GDP1

    (Percent of 2006–08 GDP, average)

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    Reserves-to-Short Term Debt13

    (Percent of short-term external debt)

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    Reserves-to-M21

    (Percent of M2)

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    EME and LA: Reserve Accumulation and External Conditions

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    Distribution of International Reserves in Emerging Market Economies

    (Share of GDP)

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    EMEs and LAC: Real Exchange Rate and Reserves

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    LAC, Financially Integrated Economies: Real Exchange Rate and Reserves1

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    Policies in many countries remain accommodative, despite closing output gaps.

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    Dollarization of Credit1

    (Percent of total credit outstanding)

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    Dollarization of Deposits1

    (Percent of total deposits)

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    Dollarization of Deposits1

    (Percent of total deposits)

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    Exchange Rate Appreciation and Dollarization1

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    Credit Dollarization and Debt Issuance1

    (Percent of domestic credit)

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    Expansions Under Easy Money 1

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    Contractions Under Tight Money1

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    In the less financially integrated countries of South America, favorable commodity prices remain key, although capital outflows continue.

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    In this group, policies remain largely procyclical.

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    Brazil: Imports from Mercosur by Sector

    (Percent of total imports from Mercosur)

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    Change in Share of Exports to Brazil1

    (Percent)

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    Brazilian Imports and Argentine Industrial Production

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    Ties with the United States dominate the outlook for Mexico and Central America.

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    Fiscal buffers require rebuilding in some countries and spending composition has ample room to improve.

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    In Central America, limited exchange rate flexibility and high levels of dollarization constrain monetary policy.

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    Tourist arrivals are starting to recover, with help from hotel price cuts.

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    High debt hindered growth and room to implement countercyclical policies.

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    Credit recovery is uneven, and vulnerabilities are building from knock-on effects of the downturn.

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