Abstract

Output growth in Latin America firmed up toward the end of 2012, after moderating earlier in the year, particularly in some of the region’s largest economies. In most economies, domestic demand remained robust and external current account deficits widened further. Growth is set to pick up further in 2013, supported by stronger external demand. In the context of closed output gaps and relatively easy financing conditions, key policy priorities are strengthening public finances and protecting financial sector stability. In the Caribbean, growth continues to be held back by high debt levels and weak competitiveness.

Output growth in Latin America firmed up toward the end of 2012, after moderating earlier in the year, particularly in some of the region’s largest economies. In most economies, domestic demand remained robust and external current account deficits widened further. Growth is set to pick up further in 2013, supported by stronger external demand. In the context of closed output gaps and relatively easy financing conditions, key policy priorities are strengthening public finances and protecting financial sector stability. In the Caribbean, growth continues to be held back by high debt levels and weak competitiveness.

Overview

Real GDP growth in Latin America and the Caribbean (LAC) moderated to about 3 percent in 2012, down from 4½ percent the previous year. The deceleration was particularly pronounced in some of the region’s largest economies (Figure 2.1). In Brazil, private investment declined sharply in the early part of 2012, partly reflecting weak business confidence and policy uncertainty, but has started to grow again more recently. In Argentina, widespread exchange and import controls weighed on confidence and activity. Growth remained strong in the rest of Latin America, in most cases with robust domestic demand helping to offset to some extent the slowdown in exports. Meanwhile, in much of the Caribbean, growth remained constrained by high debt levels and slow tourism activity.

Figure 2.1.
Figure 2.1.

Growth remains solid in much of Latin America, driven by strong domestic demand, and output gaps are closed.

Financial markets in the region have recovered from their mid-2012 lows as policy actions in advanced economies helped boost investors’ confidence. Strong portfolio inflows to the region led to further reduction in spreads and put upward pressure on local currencies (Figure 2.2). Sovereigns and corporations, including those with limited access to international markets in the past, have been able to place bonds at record low rates. Meanwhile, equity price-earnings ratios have again risen above historical averages in some countries.

Figure 2.2.
Figure 2.2.

Strong capital flows to the region have boosted asset prices.

Sources: Bloomberg, L.P.; Haver Analytics; IMF, International Financial Statistics; and IMF staff calculations.1 New investments less redemptions in mutual and exchange traded funds (ETFs) that track returns in LA6 bond and equity markets.2 Simple average of Chile, Colombia, Peru, and Uruguay except for equity prices where there is no data for Uruguay.

Looking ahead, global financial conditions are expected to remain favorable in the near term, and commodity prices are projected to remain relatively high (see Chapter 1). Under IMF staff baseline, growth in Latin America is projected to strengthen to 3½ percent in 2013, with activity in Brazil firming up. Growth in the Caribbean also should gather some strength, in line with the projected gradual pickup in external demand.

External risks to the near-term outlook have receded. Policy actions in the euro area and the United States have removed immediate threats to global growth and financial stability. Nonetheless, in Europe, the risk that adjustment fatigue stalls progress on the implementation of policy commitments remains. So far, deleveraging by European banks has had limited effects on the region’s credit markets (see Box 2.1), but as long as the repair of bank balance sheets in Europe is incomplete, further deleveraging remains a risk. In the United States, the short-term risks have become more balanced, although failure to replace the automatic fiscal spending cuts (“the sequester”) with more backloaded measures before the start of the next fiscal year (in October) would affect growth in late 2013 and beyond. Lower U.S. growth would have a negative impact on the region, particularly in Mexico and Central America, where links through trade and remittances are the strongest.

Medium-term risks remain tilted to the downside. The key risk is a reversal of the favorable tailwinds of easy financing conditions and strong commodity prices that have prevailed since 2010. The region would be particularly affected if a sharp slowdown in China or other key economies triggers a drop in commodity prices. Model simulations of a risk scenario of a synchronized 10 percent decline in investment in the four largest emerging markets (the BRICs) suggest that growth in Latin America would decline by about 1 percentage point relative to the baseline (Figure 2.3). Growth could be up to 2 percentage points lower if the investment shock is accompanied by capital outflows.1 Another risk is that lack of progress in addressing the medium-term fiscal challenges in key advanced economies leads to a sharp increase in sovereign and corporate risk premiums, with negative impact on global growth.

Figure 2.3.
Figure 2.3.

Growth is projected to reach 3½ percent in 2013 as activity in Brazil rebounds. Medium-term risks remain tilted to the downside.

Domestically, the risk of a deterioration of external and financial sector balance sheets has increased in some countries. Current account balances have weakened in recent years, and asset prices are on the rise. Credit growth has moderated, but remains high in a number of countries. Although financial stability issues do not pose an immediate concern, policies need to focus on mitigating potential balance sheet vulnerabilities.

Policy Challenges

Countries in Latin America should take advantage of the current favorable economic conditions to build a strong foundation for sustained growth in the future. Policy priorities include building stronger fiscal buffers, improving policy frameworks, and pressing ahead with structural reforms to increase productivity and potential growth. As global investors allocate a larger share of their portfolio to emerging markets, countries in the region need to continue strengthening prudential regulation to prevent a buildup of financial vulnerabilities.

IMF staff analysis suggests that potential growth rates in many countries are lower than those experienced during the recent cyclical upturn (see Chapter 3). Thus, it would be important for policymakers to calibrate macroeconomic policies based on a realistic assessment of the supply potential of the economy.

Financially Integrated Economies2

Developments

With the recovery from the 2008–09 global economic crisis completed, output growth in most financially integrated economies moderated toward potential in 2012, although heterogeneity among countries increased.

  • Growth decelerated sharply in Brazil, despite significant monetary and fiscal policy stimulus. High unit labor costs, infrastructure bottlenecks, and domestic policy uncertainty are likely to have weighed on business confidence and private investment. Recent indicators point to strengthening activity, and investment growth turned positive in the last quarter of 2012.

  • The slowdown in growth in the other economies was more gradual, and reflected mainly earlier policy tightening and softer external demand. Nonetheless, domestic demand remained robust. Consumption continued to be supported by rising labor income and easy credit conditions. In Chile and Peru, private investment also made a strong contribution to growth, partly reflecting large foreign direct investments in the mining sector. Following dynamic growth in early 2012, economic activity in Mexico moderated in the latter part of the year, in line with the slowdown in U.S. industrial production. Growth in Colombia also slowed in the second half of 2012, prompting some easing of macroeconomic policies.

Labor markets remained tight in all countries. Employment creation continued to exceed labor force growth, bringing unemployment rates to near record lows in most economies. Real wage growth was also strong, exceeding labor productivity growth in some cases (Brazil).

Inflation pressures remained contained, with some exceptions. Both core and headline inflation rates fell since mid-2012 in Chile, Colombia, and Peru, driven by moderation of food and energy prices and pass-through effects from currency appreciation. In these countries, headline inflation is close to the target (or below), and inflation expectations remain well anchored. In Mexico, inflation expectations have been relatively stable at a level somewhat above the mid-point of the inflation target. In contrast, inflation remains elevated in Brazil and Uruguay (Figure 2.4). In Brazil, inflation has risen since mid-2012, reflecting strong wage growth, tight capacity constraints in some sectors, and past currency depreciation. In Uruguay, higher food prices (driven by local weather-related shocks) and widespread wage indexation have played a role in keeping inflation well above the target.

Figure 2.4.
Figure 2.4.

Domestic demand remained strong. Inflation rates are close to the target in most countries despite tight labor markets.

The external current account deficits of these countries widened further despite strong terms of trade. Current account deficits rose to an average of 2.8 percent of GDP in 2012 (from 2 percent of GDP in 2011) as domestic demand growth continued to exceed output growth. In most countries, the deterioration was driven largely by buoyant private demand, partly offset by a modest increase in public savings (Figure 2.5).

Figure 2.5.
Figure 2.5.

Strong domestic demand led to further widening of current account deficits.

Capital inflows remained robust, although outflows have also increased, leaving net financial flows broadly at the same level as in 2011 (Figure 2.6). Foreign direct investment (in the commodity, finance, and retail sectors) continued to account for a large share of inflows, though portfolio inflows also picked up in the second half of the year (particularly in Mexico), putting upward pressure on local currencies and prompting a step up in the pace of reserve accumulation in some cases. One exception was Brazil, where lower interest rates, weaker growth, and the earlier tightening of capital flow measures led to deceleration of inflows in 2012.3

Figure 2.6.
Figure 2.6.

Strong capital inflows put pressure on local currencies in most countries and prompted a step up in reserve accumulation.

Bank credit growth remained strong, at more than 10 percent in real terms, although the pace of growth has moderated in recent months (Figure 2.7). Corporate bond issuance also picked up, with an increasing number of firms issuing for the first time. Firms in the region are increasingly able to issue bonds at much lower interest rates and at longer maturities than previously. Analysis of corporate balance sheets in the region suggests that they remain generally healthy, although debt-to-asset ratios have increased in some sectors such as construction, manufacturing, and retail trade (see Gonzalez-Miranda, 2012).

Figure 2.7.
Figure 2.7.

Credit growth remains strong, and financial sector indicators appear healthy.

House prices in major metropolitan areas in the region have increased rapidly in recent years, especially in Brazil and Peru. Household leverage is rising in many countries, although it remains relatively low compared with other emerging economies.

Outlook and Policy Priorities

Growth in the financially integrated economies is projected to be close to potential in 2013. In Brazil, output growth is expected to recover to 3 percent in 2013 (from 0.9 percent in 2012), reflecting the lagged impact of domestic policy easing and measures targeted at boosting private investment.

If the fiscal stance is relaxed or financing conditions ease further, domestic demand in these countries may grow faster than projected. With tight capacity constraints, this would lead to further widening of current account deficits and upward pressure on domestic prices.

In view of these risks, policy efforts should focus on preventing a buildup of macroeconomic and financial vulnerabilities. A key policy priority is to step up the pace of fiscal consolidation. Public debt declined rapidly in the years prior to the 2008 financial crisis, but regaining fiscal space since then has proved challenging, despite the boost to fiscal revenues from high commodity prices and strong growth. The ratio of public expenditure to GDP has remained high in most countries, and growth in public spending accelerated further in 2012. The 2013 fiscal budget implies a mild easing of the fiscal stance in Chile, Colombia, and Peru.

More prudent fiscal policy would help ease pressure on domestic capacity constraints and mitigate the widening of current account deficits. Stronger public balance sheets would also help shield these economies from adverse external shocks in the future (see Chapter 4), and strengthen their ability to deal with long-term challenges related to population aging.

Monetary policy should remain flexible and respond to changing economic circumstances. Countries with relatively high inflation (Brazil and Uruguay), or with strong pressures on capacity constraints, may need to tighten policies to help maintain macroeconomic stability (Figure 2.8). Countries with well-anchored inflation expectations can lower rates below neutral to support activity in the event of a slowdown.

Figure 2.8.
Figure 2.8.

Fiscal stance eased in some countries in 2012. Monetary policy remains highly accommodative in Brazil and Uruguay.

Exchange rate flexibility should continue to be used to discourage speculative capital flows (see Box 2.2). Stepping up the pace of reserve accumulation could be considered in countries where real exchange rates are close to the upper limit of the range consistent with fundamentals. In addition, further tightening of prudential policies could help limit the buildup of financial sector vulnerabilities (see below). Capital flow restrictions aimed at changing the volume or composition of inflows are also an option, although the effectiveness of these measures is limited and frequent readjustments are necessary to avoid circumvention.

Strengthening financial sector regulation and supervision remains critical to protect the stability of the banking system and prevent financial excesses. Banks in these countries have high capital and liquidity ratios, low nonperforming loans, and high return on assets. However, strong bank financial indicators are not unusual at this stage of the cycle and could mask rising vulnerabilities. Increasing leverage in cyclically sensitive sectors such as construction and retail should be monitored carefully. Prudential measures (such as forward-looking provisioning requirements, stricter loan-to-value ratios, higher capital requirements, and limits on sectoral exposure) would help mitigate risks. In fact, a number of countries (Peru, Colombia, and Uruguay) have appropriately tightened prudential policies in recent months (see Table 2.4). Additional prudential measures may be required in some countries to keep credit growth and associated vulnerabilities in check.

Table 2.1.

Western Hemisphere: Main Economic Indicators1

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Source: IMF staff calculations.

Regional aggregates are PPP-GDP weighted averages, unless otherwise noted.

End-of-period (December) rates. These will generally differ from period average inflation rates reported in the IMF’s World Economic Outlook, although both are based on identical underlying projections.

Data for Argentina are officially reported data. The IMF has, however, issued a declaration of censure and called on Argentina to adopt remedial measures to address the quality of the official GDP and CPI-GBA data. Alternative data sources have shown significantly lower real growth than the official data since 2008, and higher inflation rates than the official data since 2007. In this context, the IMF is also using alternative estimates of GDP growth for the surveillance of macroeconomic developments in Argentina. Note that the data from alternative statistical agencies may also have methodological shortcomings.

Fiscal year data.

Simple average for Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

Simple average for Argentina, Bolivia, Ecuador, Paraguay, and Venezuela.

Simple average of Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua.

Simple average of The Bahamas, Barbados, Jamaica, and ECCU member states.

Simple average of Belize, Guyana, Suriname, and Trinidad and Tobago.

Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines, as well as Anguilla and Montserrat, which are not IMF members.

Table 2.2.

Western Hemisphere: Main Fiscal Indicators1

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Source: IMF staff calculations.

Definitions of public sector accounts vary by country, depending on country-specific institutional differences, including on what constitutes the appropriate coverage from a fiscal policy perspective, as defined by the IMF staff. All indicators reported on fiscal year basis. Regional aggregates are PPP-GDP-weighted averages, unless otherwise noted.

Primary balance defined as total revenue less primary expenditures.

Federal government and provinces; includes interest payments on an accrued basis. Primary expenditure and balance include the federal government and provinces. Gross debt is for the federal government only.

Nonfinancial public sector reported for primary balances (excluding statistical discrepancies); combined public sector including Ecopetrol and excluding Banco de la República’s outstanding external debt reported for gross public debt.

Includes central government and social security agency. Gross debt is for the central government only.

Primary expenditures for Suriname exclude net lending.

Consolidated public sector; data for El Salvador include operations of pension trust funds.

Central government only. Gross debt for Belize includes both public and publicly guaranteed debt.

Central government for primary balance accounts; public sector for gross debt.

Fiscal data cover the nonfinancial public sector excluding the Panama Canal Authority.

Overall and primary balances include off-budget and public-private partnership activities for Barbados and the nonfinancial public sector. General government for gross debt.

Eastern Caribbean Currency Union members are Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines. Central government for primary balance accounts; public sector for gross debt.

Simple average for Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

Simple average for Argentina, Bolivia, Ecuador, Paraguay, and Venezuela.

Simple average of Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua.

Simple average of The Bahamas, Barbados, Jamaica, and ECCU member states.

Simple average of Belize, Guyana, Suriname, and Trinidad and Tobago.

Table 2.3.

Western Hemisphere: Selected Economic and Social Indicators, 2003–121

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Sources: Bloomberg, L.P.; World Bank, World Development Indicators; and IMF staff calculations.

Estimates may vary from those reported by national authorities on account of differences in methodology and source. Regional aggregates are PPP-GDP weighted averages, except for regional GDP in $US and population where totals are computed.

At market exchange rates, except for Venezuela for which official exchange rates are used.

End-of-period, 12-month percent change.

Exports plus imports of goods and services in percent of GDP.

Data from Socio-Economic Database for Latin America and the Caribbean (SEDLAC). Poverty is share of population earning less than US$2.50 per day. Data for the United States are from the U.S. Census Bureau and for Canada, Statistics Canada.

Median of ratings published by Moody’s, Standard & Poor’s, and Fitch.

Figures on real GDP growth and CPI inflation for Argentina are based on official data. The IMF has, however, issued a declaration of censure and called on Argentina to adopt remedial measures to address the quality of the official GDP and CPI-GBA data. Alternative data sources have shown significantly lower real growth than the official data since 2008, and higher inflation rates than the official data since 2007. In this context, the IMF is also using alternative estimates of GDP growth for the surveillance of macroeconomic developments in Argentina. Note that the data from alternative statistical agencies may also have methodological shortcomings.

Table 2.4.

Macroprudential (MaP) and Capital Flow Management (CFM) Measures in Latin America, 2008–13

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Source: IMF staff estimates.Note: A “” denotes policy tightening, while a “” policy easing. based on national sources.

Chile’s 2011 system of forward-looking provisioning is not classified as dynamic provisioning as it does not involve accumulating generic provisions in a reserve fund as is the case in the other countries cited, but rather bases a specific provision on forward-looking estimates of loan default.

In many countries liquidity requirements exists, but they do not necessarily involve stress testing conditions.

In recent months, Brazil has eased macroprudential policies by (i) lowering the capital requirements on auto loans and personal credit with maturities less than 36 months and payroll deduction loans with maturities less than 60 months—while raising the capital requirements on longer-term loans (Nov-2011); and (ii) authorizing large banks to acquire credit portfolios and securities of small banks through the use of resources locked in reserve requirements on time deposits (Dec-2011). To encourage the acquisition of these, the remuneration on time deposits was decreased.

In Brazil, in addition to increasing (reducing) the IOF tax rate, the base of the tax was increased (reduced) to include (exclude) flows of longer maturities.