Abstract

Economic activity in Latin America and the Caribbean (LAC) is expected to remain relatively subdued in 2014. While the faster recovery of the advanced economies should strengthen external demand, this effect is likely to be offset by the negative impact of lower commodity prices and tighter financial conditions on domestic demand. Policy priorities include strengthening public finances, addressing potential financial fragilities, and implementing structural reforms to ease supply-side constraints and raise potential growth.

Economic activity in Latin America and the Caribbean (LAC) is expected to remain relatively subdued in 2014. While the faster recovery of the advanced economies should strengthen external demand, this effect is likely to be offset by the negative impact of lower commodity prices and tighter financial conditions on domestic demand. Policy priorities include strengthening public finances, addressing potential financial fragilities, and implementing structural reforms to ease supply-side constraints and raise potential growth.

Real GDP growth in LAC moderated further in 2013 to 2¾ percent, down from 3 percent in 2012 and 4½ percent in 2011 (Figure 2.1 and Table 2.1). Activity was held back by weaker domestic demand, lower commodity prices, tightening financial conditions, and supply constraints in some cases. The particularly sharp slowdown in Mexico reflected lower public spending and construction activity, as well as weak demand from the United States. Inflation remained contained in most of the region, reflecting lower food prices and subdued activity. Regional financial markets were affected by repeated bouts of volatility over the past 12 months, as investors reassessed the relative risks and prospects of emerging market economies in the context of the U.S. Federal Reserve’s initial steps toward reducing the pace of its asset purchases (“tapering”).

Figure 2.1
Figure 2.1

Growth in Latin America moderated further in 2013. Asset prices have declined since the May 2013 “taper shock,” amid weaker investor sentiment.

Table 2.1.

Western Hemisphere: Main Economic Indicators1

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Source: IMF staff calculations and projections.Note: ECCU = Eastern Caribbean Currency Union; LAC = Latin America and the Caribbean.

Regional aggregates are purchasing power parity GDP-weighted averages unless otherwise noted. Current account aggregates are U.S. dollar nominal GDP-weighted averages. Consumer price index forecasts exclude Argentina.

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.

See Annex 2.1 for details on Argentina’s data.

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, the 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.

Growth is projected to remain in low gear in 2014, at about 2½ percent (Figure 2.2), despite some strengthening of external demand. The slowdown in investment growth is expected to continue, reflecting the completion of large projects in mining and other areas, rising funding costs, and weaker business confidence.

Figure 2.2
Figure 2.2

Growth is projected to remain subdued in 2014, reflecting weak investment. External current account deficits are expected to stop widening.

The headline growth number masks divergent dynamics for the region’s largest economies. Mexico’s economy is expected to rebound on the back of a stronger U.S. recovery and normalization of domestic factors. In Brazil, activity will remain subdued, as weak business confidence continues to weigh on private investment. Argentina and Venezuela, in turn, are faced with significant fiscal and external imbalances, which have prompted a variety of controls on trade, prices, and exchange rates that hamper activity. In the rest of Latin America, growth is expected to remain close to potential, with stronger external demand from the advanced economies offset by tighter global financing conditions and softer commodity prices. In the Caribbean, high debt levels and long-standing competitiveness problems will continue to constrain activity, though a recovery of tourism flows may provide a positive impulse.

Overall, the balance of risks to the outlook is still tilted to the downside. Although the effects from a gradual and orderly normalization of U.S. monetary policy should be contained for most of the LAC region, increased capital flow volatility remains a risk (see Chapter 3). Based on recent experience, countries with large current account deficits, high inflation, and limited domestic policy space are likely to be most affected by fresh bouts of financial market volatility. Another important risk is a sharper decline in commodity prices, for instance, driven by downward surprises to China’s growth outlook. Commodity prices have already softened over the past 12 months (especially metals prices, which declined by 15 percent through mid-March) and are projected to moderate further over the medium term as supply is increasing while demand growth from large emerging markets is expected to slow.1 A larger-than-envisaged decline in commodity prices would have negative effects on growth in South America’s commodity exporters (see Chapter 4).

Turning to domestic risks, weak fiscal positions represent an important vulnerability in a number of economies (see Table 2.2 and Chapter 5).

Table 2.2.

Western Hemisphere: Main Fiscal Indicators1

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Source: IMF staff calculations and projections.Note: ECCU = Eastern Caribbean Currency Union; LAC = Latin America and the Caribbean.

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 purchasing power parity GDP-weighted averages, unless otherwise noted.

Primary balance defined as total revenue less primary expenditures.

Data for the United States have been revised significantly following the Bureau of Economic Analysis’s recent comprehensive revision of the National Income and Product Accounts along the lines of the 2008 System of National Accounts (SNA). As a result of these methodological changes, the deficit includes several expenditure items not counted as expenditure in other countries which have not yet adopted the 2008 SNA. Moreover, for cross-country comparability, gross and net debt levels reported by national statistical agencies for countries that have adopted the 2008 SNA (Canada and the United States) are adjusted to exclude unfunded pension liabilities of government employees’ defined benefit pension plans. See Box 1.1 in the April 2014 Fiscal Monitor for more details.

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, excluding the operations of nationalized mixed-ownership companies in the hydrocarbon and electricity sectors.

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.

Primary expenditures for Suriname exclude net lending. Debt data refers to central government and government-guaranteed public debt.

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.

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

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

Overall and primary balances include off-budget and public-private partnership activities for Barbados and the nonfinancial public sector. Central government for gross debt (excludes NIS Holdings).

Debt includes PetroCaribe debt (net of its financing to the central government) and projected IMF disbursements and other international financial institutions.

ECCU 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, the 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.

Bank and household balance sheets are generally on sound footing, but several years of strong credit growth may have created pockets of vulnerability. Meanwhile, the increase in firms’ external debt issuance should be monitored closely, with particular attention to buildup of excessive leverage and potential currency mismatches. The combination of slower growth and tighter financial conditions could drive up nonperforming loans and lower bank profitability. These challenges are heightened by the fact that medium-term potential growth in many economies is estimated to be well below the high average growth rates of the past decade. As discussed in the May 2013 Regional Economic Outlook: Western Hemisphere, policies need to adjust to this new reality. In particular, macroeconomic policies should not be used to boost demand in economies with output levels close to potential, while structural reforms are needed to raise productivity in the medium term.

Financially Integrated Economies

Developments and Outlook

Output gaps remain relatively small in most of the financially integrated economies in the region. Near-term prospects vary, reflecting differences in potential growth across countries and some idiosyncratic factors:

  • Brazil’s growth is expected to fall below 2 percent in 2014. Weighing on activity are domestic supply constraints, especially in infrastructure, along with continued weak private investment growth, which seems to reflect loss of competitiveness and low confidence, as well as higher borrowing costs.

  • Growth in Mexico is set to rebound to 3 percent in 2014. Some of the headwinds to growth have already started to ease, with fiscal policy shifting to a more accommodative stance and U.S. demand picking up, although the recovery in construction activity remains tepid. Looking further ahead, Mexico’s ongoing structural reforms, especially in the energy and telecommunications sectors, are expected to raise potential growth over the medium term.

  • Among the other financially integrated economies, Colombia and Peru are expected to maintain fairly rapid growth. Activity in Chile is projected to moderate further, as private investment growth has slowed, especially in mining. In all three countries, private consumption growth remains robust, supported by low unemployment rates. In Uruguay, growth is also expected to moderate, as a major foreign direct investment–financed investment project reaches completion and external demand from regional trading partners weakens.

Labor markets remain relatively tight in most economies, with unemployment rates still near record-low levels (Figure 2.3 and Table 2.3). That said, a tentative easing of labor market pressures is apparent in several countries—employment growth and real wage growth are starting to moderate.

Figure 2.3
Figure 2.3

Unemployment remains at historically low levels, but real wage growth has started to moderate in some of the financially integrated economies.

Table 2.3.

Western Hemisphere: Selected Economic and Social Indicators, 2004–131

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Sources: Bloomberg, L.P.; national authorities; IMF, International Financial Statistics database; World Bank; and IMF staff calculations.

Estimates may vary from those reported by national authorities on account of differences in methodology and source. Regional aggregates are purchasing power parity GDP-weighted averages, except for regional GDP in U.S. dollars and population where totals are computed.

At market exchange rates, except for Argentina and Venezuela for which data used comes from national authorities and private analysts.

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, based on the latest country-specific household surveys. In most cases, the surveys are from 2011 or 2012, though the data for Guatemala (2009) and Venezuela (2006) are less recent. Poverty rate Is defined as the share of the population earning less than US$2.50 per day. Gini Index is calculated by the World Bank using pooled data for each country. Data for the United States are from the U.S. Census Bureau; those for Canada are from Statistics Canada.

Median of long-term foreign currency ratings published by Moody’s, Standard & Poor’s, and Fitch.

See Annex 2.1 for details on Argentina’s data.

Inflation generally remained contained in 2013, reflecting lower food prices and the moderation of domestic demand (Figure 2.4). Weaker currencies have created an inflationary impulse recently, but pass-through effects are likely to remain modest, consistent with empirical estimates for economies with credible inflation-targeting regimes. However, the outlook varies across countries. In Chile and Colombia, inflation has recently edged up, but is projected to remain close to the official target. In Mexico, inflation spiked in early 2014, owing to one-off tax changes, but is expected to fall back into the target range in the second half of the year. A similar pattern is projected for Peru, where food supply shocks have caused some upside pressure in recent months. In Brazil, inflation is expected to stay in the upper part of the target range despite significant monetary tightening, reflecting limited spare capacity, inflation inertia, and some pass-through from exchange rate depreciation. Inflation continues to be higher in Uruguay, amid robust demand and widespread wage indexation.

Figure 2.4
Figure 2.4

Inflationary pressures are limited to a few countries. External current account deficits rose further last year but were typically financed by foreign direct investment.

External current account deficits widened further in 2013, reaching 3.8 percent of GDP on average. Relatively weak growth of export volumes was a key factor, alongside some deterioration of the terms of trade, especially in Chile and Peru. Softer commodity prices will continue to weigh on export proceeds in the future, but this effect should be partly offset by expenditure switching from weaker real exchange rates. On balance, current account deficits are expected to stabilize or narrow somewhat over the next two years. A sharper-than-expected deterioration in the terms of trade, however, remains a key downside risk.

Net capital inflows remained relatively strong in 2013, despite jitters in global financial markets (Figure 2.5). Foreign direct investment inflows continue to exceed the current account deficit in most countries. Portfolio investment and other types of capital inflows also held up, despite some divestment by foreign mutual fund investors. More generally, the pattern of flows during the most recent capital inflow episode compares favorably with a previous inflow episode in 1991–94. In particular, the financially integrated economies have received a more resilient mix of inflows, with a greater share of foreign direct investment, and have used a larger share of those inflows to build up international reserves and private asset holdings overseas, while the widening of the current account deficit has been more contained.2 Nonetheless, the risk of a sudden stop of capital flows remains a concern.

Figure 2.5
Figure 2.5

Even as asset prices declined, net capital inflows remained relatively strong in 2013. Domestic credit growth also stayed buoyant.

Turning to domestic financial developments, bank lending growth moderated somewhat in Brazil, Chile, and Mexico, but remains buoyant—with real annual growth in excess of 10 percent in several countries. In Brazil, aggregate credit growth of 8 percent in real terms masks an important divergence between a slower pace of lending by private banks, in response to weak demand and tightening credit standards, and a still-strong expansion of lending by public banks. After several years of strong credit expansion, the challenge for most of the financially integrated economies is to engineer a smooth transition to more sustainable rates of credit growth.

Cyclically sensitive sectors with high leverage, such as commercial real estate development in Chile, could be especially vulnerable. An area of potential concern in Brazil is consumer credit, which has increased rapidly in recent years, albeit from a low base.

Corporate debt issuance in the region has also been very strong in recent years, though the bonds have relatively long maturities and there are no near-term maturity cliffs (Figure 2.6). In some cases, including Brazil, balance sheet leverage has increased, although debt metrics do not yet suggest broad-based financial excess (see Box 2.1).

Figure 2.6
Figure 2.6

Corporate bond issuance moderated in Brazil but continued at a strong pace elsewhere.

Policy Priorities

The outlook for the financially integrated economies presents two main policy challenges. First, investor sentiment toward emerging markets remains fragile. New episodes of market turbulence could further drive up funding costs, with negative knock-on effects for growth. Second, with the secular commodity price boom petering out and activity increasingly constrained by supply-side bottlenecks, economic growth is likely to settle below the high rates of the past decade, even in the absence of major external shocks. Addressing these challenges will require a careful recalibration of macroeconomic policies, a clear focus on reducing vulnerabilities, and stepped-up structural reforms to remove obstacles to growth.

Exchange rate flexibility played a key role in helping these countries adjust to the market turbulence in mid-2013, and will continue to provide an important buffer (Figure 2.7).3 In general, the depreciation of the past 12 months has brought these countries’ exchange rates closer in line with long-term fundamentals. Importantly, the economic benefits of better-aligned currencies have not been outweighed by adverse side effects: pass-through to inflation has generally been moderate, and there is little evidence for negative balance sheet effects, although potential vulnerabilities bear continued close monitoring.

Figure 2.7
Figure 2.7

Flexible exchange rates and high reserve levels provide important external buffers. Fiscal spending continued to rise, even as revenues slowed.

Large international reserve positions are an additional source of strength. All the financially integrated economies have sufficient resources to provide foreign exchange liquidity if faced with disorderly market conditions owing to illiquidity. Temporary interventions to smooth excessive exchange rate volatility could also be justified in some cases, although they should not be used to defend fundamentally misaligned exchange rates or as a substitute for necessary macroeconomic policy adjustments. The key to sustaining investor confidence, more broadly, lies in maintaining strong balance sheets, credible policy frameworks, and a prudent macroeconomic stance.

As seen over the past year, countries with low inflation and well-anchored inflation expectations retain the flexibility to ease monetary policy in response to a slowdown in growth, even when global interest rates are rising. In countries with relatively high and persistent inflation, both monetary and fiscal policies should focus on reducing inflation pressures and strengthening the credibility of the policy framework. Brazil and Uruguay tightened their monetary policy stance significantly over the past 12 months to rein in inflation and support the domestic currency, although fiscal policy has been broadly neutral.

With activity levels still close to potential in most countries, fiscal policy stimulus is not warranted. A neutral fiscal stance is appropriate for countries with strong public finances and low external current account deficits; others should aim for gradual tightening to put debt firmly on a downward path. Countercyclical fiscal stimulus would be appropriate only in case of a sharp slowdown in activity amid evidence of considerable slack in the economy, and only in countries with adequate fiscal space. In addition, increasing the transparency of fiscal accounts—including by improving the reporting and monitoring of public-private infrastructure projects—and minimizing reliance on one-off measures to meet budget targets would help strengthen investor confidence and keep risk premiums low.

Looking at longer-term trends, primary public expenditure as a share of GDP has increased steadily since the financial crisis, including in 2013, even though revenue growth has started to slow. The moderation of revenues is likely to persist over the period ahead, reflecting softer commodity prices, rising commodity extraction costs, and lower potential growth. At the same time, pressures on expenditure are growing, including from higher interest bills, critical infrastructure needs, and demands for better public services. Aging-related spending is also expected to increase in the medium term. All these factors underscore the importance of prudent fiscal policy as well as the need to improve the efficiency of public spending.

Strong financial sector regulation and supervision remain crucial to safeguard financial stability. Banks in the financially integrated economies generally have solid capital and liquidity ratios, good asset quality, strict ceilings on open currency positions, and limited reliance on external financing. However, some of these buffers may be eroded in a scenario of slower growth and tighter financial conditions, especially in economies that have seen high credit creation in recent years. Targeted macroprudential measures could be used to reduce vulnerabilities.

The key challenge over the medium term is to boost productivity and competitiveness. Total factor productivity in the region has improved over the last decade, but still lags compared with other fast-growing emerging markets (see Chapter 3 in the May 2013 Regional Economic Outlook: Western Hemisphere, and Sosa, Tsounta, and Kim, 2013). Output growth during that period was driven mainly by factor accumulation, aided by favorable financing conditions and strong demographics. To sustain high growth rates in the medium term, however, policymakers need to focus on upgrading the domestic infrastructure, improving educational outcomes, and strengthening competition (Figure 2.8). Mobilizing domestic saving (which is low in LAC by international standards) could also enhance investment and long-term growth.

Figure 2.8
Figure 2.8

Latin America compares unfavorably on education outcomes. Infrastructure standards and the business environment vary more across countries.

Other Commodity Exporters

Developments and Outlook

Developments in the other five large commodity exporters in Latin America reflected mostly differences in domestic policies (Figure 2.9).

Figure 2.9
Figure 2.9

Output growth was strong in 2013 among the other commodity exporters of the region, except in Venezuela, where activity weakened sharply.

Venezuela suffered a sharp economic slowdown, a steep rise in inflation, and an intensification of shortages of foodstuff and other consumer goods in 2013. These developments were a consequence of the highly expansionary policies in recent years, which—while helping to improve social indicators—led to the buildup of large macroeconomic imbalances. The imposition of extensive controls on prices has worsened economic distortions. In Argentina, strong agricultural output boosted real GDP growth in early 2013; however, activity slowed sharply in the second half of the year, and confidence has deteriorated. With no access to external funding, the Argentine authorities have increased reliance on central bank credit to finance the fiscal deficit. In both countries, tight controls on the foreign exchange market and trade have failed to ease pressures on the external accounts, with reserves declining to fairly low levels.

In January, the Argentine authorities allowed a depreciation of the official exchange rate, backed by an increase in domestic policy rates. However, real rates are still negative, and a sizable gap remains vis-à-vis the exchange rate in the informal market. In Venezuela, the bolivar/U.S. dollar exchange rate in the parallel market has recently been 8 to 13 times higher than the official exchange rate. Responding to this imbalance, the authorities introduced an additional official segment to the foreign exchange market in late March. The more depreciated exchange rate in this segment has resulted in a depreciation of the average official rate in Venezuela’s multiple exchange rate regime.

Assuming that economic policies do not change course, output in both countries is expected to stagnate during 2014, though projections are subject to significant uncertainty and downside risks.

In the other three countries in the group, growth has been strong. Bolivia’s economy expanded nearly 7 percent last year, supported by record-high hydrocarbon exports, strong private consumption, and accommodative macroeconomic policies. These factors should continue to support above-potential growth in 2014. Growth in Paraguay rebounded sharply as the agricultural sector recovered from a severe drought. The main risk to the outlook for both countries is a potential weakening of external demand from large regional trading partners (see Box 2.2, Chapter 4 in the May 2012 Regional Economic Outlook: Western Hemisphere, and Adler and Sosa, 2014). In Ecuador, growth is expected to remain more moderate at about 4 percent, in part owing to lower oil exports.

Inflation remained low in Ecuador and Paraguay (at 2¾ percent and 3¾ percent by end-2013, respectively), whereas it increased in Bolivia (to 7½ percent), due to food supply shocks. The external current account balances deteriorated in Bolivia and Ecuador in 2013, reflecting softer terms of trade, but improved in Paraguay, due to higher agriculture and meat export volumes.

Policy Priorities

Policy priorities among the other commodity-exporting economies differ depending on specific domestic conditions. In Argentina, recent measures to allow for a weaker exchange rate, higher domestic interest rates, and a reduction in certain utility subsidies are steps in the right direction. However, further policy adjustments are necessary to restore macroeconomic stability, especially in the context of less favorable prospects for global commodity prices. In Venezuela, the persistence of significant imbalances, including high inflation and pervasive scarcity of basic goods, underscores the need for fundamental policy adjustments to avert the risk of disorderly dynamics. For Ecuador, the key challenge relates to building buffers against the risk of a future drop in oil prices, which would put some strain on the external and fiscal accounts.

More generally, public expenditure as a share of GDP in most countries in the group has increased sharply over the last decade, on the back of rising commodity revenues. Energy subsidies account for a significant share of spending in all countries except for Paraguay (see Box 2.3). Spending should be scaled back significantly, including through a reduction and better targeting of subsidies, to correct macroeconomic imbalances and increase buffers. Meanwhile, sustaining inclusive growth is a common challenge in Bolivia, Ecuador, and Paraguay. Further efforts to enhance productivity, promote deeper and more efficient financial markets, and improve education and health standards remain critical.

Central America, Panama, and the Dominican Republic

Developments and Outlook

Economic activity in Central America slowed in 2013 as exports weakened, reflecting a slowdown in U.S. demand and the onset of the coffee roya disease (Figure 2.10). Growth in Panama also eased owing to a reduction in canal traffic and re-export activity (related in part to controls on foreign exchange payments by Venezuela). Moderate growth and lower food and commodity prices helped keep inflation low. The rise in financial market volatility since last May has affected Central America, Panama, and the Dominican Republic (CAPDR) as well. Exchange rates have depreciated, foreign exchange reserves have declined in some countries, and sovereign spreads have increased.

Figure 2.10
Figure 2.10

Growth moderated in the CAPDR region in 2013. The region was also affected by the increase in financial market volatility since last May.

Growth is projected at about 3¼ percent in 2014, similar to last year’s outturn. The projected pickup in U.S. demand is expected to have positive spillovers through higher exports and remittances. However, these will be offset by rising external financing costs and idiosyncratic factors, such as the need for fiscal consolidation and the impact of the coffee roya disease, which is expected to reduce growth over 2013–14 by a cumulative ¾ percentage point on average.

Risks to the outlook remain tilted to the downside. CAPDR is exposed to renewed bouts of negative investor sentiment toward emerging markets, given high financing needs and, in some cases, increased reliance on external funding. Reduced financing from Venezuela under the PetroCaribe program could also weigh on growth in some countries—especially the Dominican Republic and Nicaragua. On the upside, with more than 40 percent of exports going to the United States, higher-than-expected U.S. growth would be a net positive for the region (see Chapter 3). The expected stabilization of oil prices would also benefit most countries.

Weak fiscal positions remain a key vulnerability for most CAPDR countries. Public debt has increased significantly since 2008 in Costa Rica, the Dominican Republic, El Salvador, and Honduras, reflecting a permanent increase in expenditure.

Many countries have taken advantage of the favorable global financing conditions in recent years and issued international bonds to meet financing needs. The increased reliance on external financing could lead to a rise in refinancing costs and rollover risk in the medium term, as global financial conditions tighten.

External current account deficits are also large (7 percent of GDP on average), and external debt is high and rising in a number of countries, including the Dominican Republic, El Salvador, and Honduras (Figures 2.11 and 2.12). A moderation of foreign direct investment and portfolio inflows could pose risks, with international reserves providing only a limited cushion.

Figure 2.11
Figure 2.11

External positions remain weak in most of the CAPDR region.

Figure 2.12
Figure 2.12

Public and external debt has increased in most countries in the CAPDR region. Financial sector vulnerabilities remain significant in some cases.

Although banks across CAPDR are well capitalized and have liquidity ratios that meet or exceed Basel III standards, a high degree of dollarization remains a potential vulnerability. In addition, some banks have increased their reliance on external financing in recent years. A depreciation of the local currency could weaken the balance sheets of businesses and households, exposing banks to credit and refinancing risks. Another concern in some countries is the large exposure of banks to the public sector.

Policy Priorities

A consolidation of public finances is necessary to reduce fiscal and external imbalances, and to ensure debt sustainability. Consolidation efforts would have to include both expenditure restraint, such as curbs on public sector wage growth and improved targeting of subsidies, and higher tax revenues. Putting social security systems on a sound financial footing is also critical in many countries.

In addition, countries would benefit from strengthening the fiscal policy framework more broadly, including specifying medium-term fiscal objectives, introducing fiscal rules, and minimizing fiscal risks related to public-private partnerships.

The five CAPDR economies that are not officially dollarized would benefit from greater exchange rate flexibility to enhance their capacity to adjust to external shocks. Financial vulnerabilities related to dollarization should be addressed through enhanced prudential regulation to create stronger incentives for agents to internalize currency risks. Some countries are taking steps in this direction by imposing more stringent criteria for assessing credit risks of unhedged borrowers and raising provisioning requirements. Moreover, regulators will need to ensure that banks rigorously stress test their customers’ as well as their own foreign exchange exposures.

A key medium-term challenge is to raise productivity and potential growth, which remain constrained by a weak business environment, security issues, and poor infrastructure. Priorities include improving the investment climate and upgrading the quality of the labor force through better education and health care. Meanwhile, improving governments’ revenue-generating capacity would allow directing more resources to productive public investment.

The Caribbean

Developments and Outlook

Growth remains tepid in most of the Caribbean (Figure 2.13). In the tourism-dependent economies, real GDP growth picked up modestly in 2013 (to ¾ percent, up from close to zero in 2012). Construction activity seems to have bottomed out, but tourist arrivals and spending have continued to underperform in most countries. Ongoing financial sector stress is further weighing on growth in some cases. Growth has been stronger among the region’s commodity exporters—in particular Guyana and Suriname—and in Haiti, whose economy expanded 4 percent on the back of ongoing reconstruction spending and increased agricultural output and textile exports. Inflation is generally low across the region, as domestic demand remains weak and food and fuel prices soften.4

Figure 2.13
Figure 2.13

In most of the Caribbean, growth remains low, constrained by high public debt and significant external and financial vulnerabilities.

External positions remain very weak in the tourism-dependent economies. Their current account deficits averaged 17 percent of GDP in 2013, similar to the previous two years, reflecting a high oil import bill and persistently poor competitiveness. These large deficits continue to be financed mainly through net foreign direct investment and official flows, including from the IMF. Financing from Venezuela’s PetroCaribe is also important in some countries (Guyana, Haiti, Jamaica, and most of the Eastern Caribbean Currency Union [ECCU], where it represents as much as 4–7 percent of GDP per year). A sudden interruption of any of these flows would cause severe financing difficulties (see Box 2.2).5

Fiscal balances deteriorated in most of the region in 2013. Public debt levels remain especially high in the tourism-dependent economies (averaging more than 90 percent of GDP), where strong and sustained efforts will be required to bring debt to a sustainable path. In some countries, governments already face considerable financing challenges (Antigua and Barbuda, Barbados, Belize, Grenada, St. Lucia), underscoring the urgency of consolidation efforts.6 Public debt levels are significantly lower among the Caribbean commodity exporters (50 percent of GDP on average), but fiscal adjustment is still warranted in some countries to ensure debt sustainability.

Financial sector issues are prominent in the ECCU, where indigenous banks remain under stress. Reflecting the sluggish economy and high and rising nonperforming loans, along with a regulatory interest rate floor on savings deposits, banks’ profitability has been generally low and credit to the private sector has remained subdued.

On the positive side, provisioning for nonperforming loans has improved and deposits have recovered in some countries.

Looking ahead, growth in the tourism-dependent economies is expected to rise somewhat this year but remain constrained by debt overhang, weak competitiveness, and necessary fiscal consolidation. The fallout from further delays in the resolution of troubled financial institutions constitutes an important risk to the ECCU’s outlook. In the commodity-exporting economies, growth is expected to remain broadly stable in 2014.

Policy Priorities

Reducing high public debt levels is a key challenge in much of the Caribbean. The urgency and desirable speed of fiscal consolidation is directly related to the extent of the debt burden. Although fiscal consolidation can prove challenging in a context of slow growth, the cost of the status quo is likely to be more disruptive economically and socially at some point. Improving medium-term fiscal policy frameworks, lowering current spending to make room for capital expenditure, and reducing the level of tax waivers and concessions would help enhance the consolidation process. The recent introduction of an enhanced fiscal rule in the context of Jamaica’s Extended Fund Facility–supported program is an example of such reforms.

Reducing financial vulnerabilities is critical in the ECCU. An updated asset quality review of banks and legislative reforms to strengthen the bank resolution framework should be priorities. Additionally, strengthening the legal and regulatory framework to facilitate financial sector resolution and crisis management, and enhancing supervision of the entire system are also required to address financial sector weaknesses.

Boosting potential growth remains the main challenge for most of the Caribbean countries. Decisive reforms to foster competitiveness, enhance productivity, and raise private sector investment are necessary. In particular, reforms should focus on addressing key structural weaknesses (such as high energy and labor costs), reducing the cost of cross-border trading, and diversifying tourism markets.

Taking the Pulse: Leverage and Debt Servicing Capacity among Firms in Latin America

Several consecutive years of strong corporate debt issuance have given rise to concerns that companies across the financially integrated economies of Latin America may be reaching problematic degrees of financial leverage. To assess the issue, we consider a database of about 1,000 listed nonfinancial firms in Brazil, Chile, Colombia, Mexico, and Peru, tracking key indicators over the past decade.

Focusing initially on the median firm, a trend increase in indebtedness—measured as the ratio of total liabilities (i.e., all funding sources other than equity) to total assets—is readily visible since 2006, although the indicator has eased from its 2009 peak. At about 53 percent, the median LA5 firm turns out to be as leveraged in 2013 as it was 10 years ago (Figure 2.1.1). As regards the composition of debt, the ratio of bond debt to total assets has increased since 2009, while the ratio of bank term debt to total assets has remained broadly stable.

Figure 2.1.1
Figure 2.1.1

LA5: Median Ratio of Total Liabilities to Total Assets for Panels of Companies, 2003–13

(Percent)

Sources: Standard & Poor’s Capital IQ; and IMF staff calculations.Note: The dataset includes listed companies from Brazil, Chile, Colombia, Mexico, and Peru. The shaded area refers to a set of balanced panels, each starting in a given quarter and comprising all companies for which an uninterrupted time series through 2013:Q3 is available. Sample sizes range from 266 companies for the longest panel to 914 companies for the shortest.

A closer look at country-specific data shows that median leverage is highest among Brazilian firms, followed by their Mexican peers. Firms from Chile and especially Mexico rely relatively more on bond debt than on bank term loans, whereas the opposite holds for Brazil. From a sectoral perspective, industrial companies stand out as having geared up the most, with liabilities now representing more than 60 percent of total assets on average.

The rise in leverage in recent years does not yet appear to have compromised the debt-servicing capacity of the median company in the sample. Earnings before interest and taxes are three to four times higher than interest payments in most countries (Figure 2.1.2). However, these ratios are prone to marked declines in the event of a pronounced economic downturn or rise in interest rates. Moreover, statistics for the median firm conceal vulnerabilities in the weaker tail of companies. Data for 2013 reveal that some 30 percent of the companies in the sample had an interest coverage ratio below one (Figure 2.1.2). This group includes disproportionately many Brazilian companies. Looking across sectors, low interest coverage ratios are concentrated in the consumer sector, followed by materials, industrials, and energy.

Figure 2.1.2
Figure 2.1.2

LA5: Median Ratio of Earnings before Interest and Taxes to Interest Expenditure, 2003–131

Sources: Standard & Poor’s Capital IQ; and IMF staff calculations.1 The statistics shown are based on median values for unbalanced panels of companies covering the period 2003:Q1 through 2013:Q3. Companies for Colombia and Peru are considered in the same group to ensure a sufficient sample size.

Close monitoring of corporate sector financial data is important to ensure that remaining buffers do not get eroded too far, notably in countries whose firms already appear more highly geared. Authorities also need to be particularly vigilant to any indication—impossible to verify from the data used for this box—that the increased issuance of hard currency bonds by Latin American firms in recent years is creating problematic open positions in foreign currency.

Note: This box was prepared by Fabiano Rodrigues Bastos, Andre Meier, and Anayo Osueke.