From Global Collapse. Economic Adjustment and Growth Prospects in Latin America and the Caribbean THE WORLD BANK

Transcription

1 From Global Collapse to Recovery Economic Adjustment and Growth Prospects in Latin America and the Caribbean THE WORLD BANK

2 FROM GLOBAL COLLAPSE TO RECOVERY: ECONOMIC ADJUSTMENT AND GROWTH PROSPECTS IN LAC April 21, 2010 Foreword This semiannual report a product of the Office of the Chief Economist for the Latin America and the Caribbean Region of the World Bank analyzes where the Latin America and the Caribbean (LAC) region stands following the global crisis, its growth prospects and main challenges. The first part of the report focuses on macroeconomic and financial aspects, emphasizing the outlook going forward. The second part examines some aspects of the adjustment in labor markets during this crisis in comparison to previous ones. The preparation of this report was led by Augusto de la Torre, Regional Chief Economist, in close collaboration with Cesar Calderon, Tatiana Didier, Julian Messina, and Sergio Schmukler. Paula Pedro, Maria Virginia Poggio, and Carlos Felipe Prada provided outstanding research assistance. We would like to thank Tito Cordella, Francisco H. G. Ferreira, Samuel Freije-Rodríguez, Gladys López-Azevedo, William Maloney and Lars Christian Moller for their invaluable comments. We also extend our gratitude to M. Ayhan Kose (IMF) for providing us with the results of his research on the decomposition of business cycles into their global, regional, and idiosyncratic components.

3 PART I LAC RECOVERING IN A MULTI-POLAR GLOBAL ECONOMY Executive Summary The global crisis is now in the rear view mirror and world growth is being restored. In sharp contrast with past episodes of global turmoil, this time the recovery is led by the periphery specifically by the larger and more dynamic emerging markets (Brazil, China, India, South Korea, Malaysia, Philippines, and Thailand). For this group of emerging markets (EMs), the contraction in economic activity was much smaller than that of rich countries, the recovery started earlier, and the rebound has been much steeper. LAC is second among emerging regions, after Asia, in the strength of the recovery. LAC comes out of the crisis with a bruised income statement, no doubt, but its economic downturn in 2009 was less dramatic than that other of regions and it led to a milder than expected increase in unemployment when compared to past downturns. Moreover, LAC s balance sheet was not impaired by the crisis. Due to greatly improved macro and financial policy frameworks in LAC, factors that used to magnify external shocks (i.e., weak currencies, weak fiscal processes, and weak banking systems) this time helped cushion the shock. Several LAC countries were able to conduct countercyclical policy, particularly in the monetary front, for the first time in decades. The effectiveness of countercyclical policies in LAC was complemented and enhanced by multilateral institutions sizeable, flexible, and timely provision of liquidity and budget-support financing. The current pattern of global recovery has favored LAC so far. Countercyclical policies have supported domestic demand in the larger LAC countries and external demand from fast-growing EMs, especially China, has boosted exports and terms of trade for LAC s net commodity exporters which are mainly located in South America and account for over 90 percent of the region s population and GDP. Prospects for LAC in the short-term thus look good regional economic activity is forecast to expand by a solid 4 percent in Beyond the cyclical rebound, however, a higher trend growth will not be as easy to sustain for LAC because future economic dynamics for the rest of the world are clouded by uncertainty and complexity. It is unclear if rich countries will be able to overcome the growth-impairing effects of high government indebtedness without a significant increase in inflation further down the line. And while growth in LAC (especially in South America) can continue on the strength of its ties to emerging Asia, there are doubts about the sustainability of China s investment-reliant/export-based growth model. A smooth shift towards more of a consumption-based growth model in China would be easier to achieve with the help of international macroeconomic policy coordination, which seems unlikely to materialize at this stage. While central banks in rich countries will have to keep interest rates low to support their sagging economies, EMs will have hike them earlier to control inflation expectations as signs of economic overheating surface. The resulting widening of the interest rate differential will further boost capital flows to LAC, intensifying policy tensions vis-à-vis the risks of an overshooting in the appreciation of LAC

4 currencies (with potentially permanent adverse effects on export competitiveness) and excessive credit expansion (which may threaten financial fragility down the line). The policy debate in LAC going forward will thus tend to focus on macro-prudential policies to dampen credit creation as well as on policies to curb undue currency appreciation (international reserve accumulation, controls on capital inflows, fiscal tightening). The region s major longer-run challenge going forward will be to craft a bold productivity agenda. While the process of convergence towards rich-country standards of living has eluded LAC for more than a century, hopes that this trend may be changing emerged before the crisis, when several LAC countries other than Chile recorded visible productivity growth. With LAC coming out of this crisis relatively well positioned, such hopes are rekindling, especially considering that the improved macro-financial resiliency of the region gives greater assurance that future gains from growth will not be wiped out by financial crises. In addition, LAC has been making significant strides in the equity agenda and this could help mobilize consensus in favor of a long overdue growth-oriented reform agenda. But the jury is out on whether the region will be able to seize the opportunity to boost long-run growth, especially considering the large gaps that LAC would need to close in such key areas as saving, human capital accumulation, physical infrastructure, and the ability to adopt and adapt new technologies. LAC s natural resource wealth can broaden the scope for seizing the growth opportunity, but only if the associated windfall earnings are managed judiciously within a long-term horizon, so as to avoid falling victim to the so-called natural resource curse. A clear sign that the downside risks of commodity abundance are being avoided would materialize if commodity exporting countries mange to save (via cyclically adjusted primary fiscal surpluses) a substantial fraction of the commodity-related revenue windfalls. After the fall, LAC stands tall As discussed in our previous semi-annual report of September 2009, Update on the Global Crisis: The Worst is Over, LAC Poised to Recover, the crisis reached its darkest phase in the fourth quarter of 2008 and the early months of 2009, when the global credit crunch originated in the US shut down all economic engines of world growth. During that time, the systemic and global propagation of the downturn dominated country-specific strengths and rates of economic growth took a nose dive across countries in a highly synchronized manner. A full meltdown of financial intermediation in the rich countries was averted and confidence began to stabilize, on the strength of a broad menu of unprecedented risk-absorption and stimulus policies, led by the U.S. Federal Reserve Bank. In the process, however, the balance sheets of public sectors in rich countries were weakened by a major increase in indebtedness, raising the risk of fiscal crises down the line (see below). While the downturn in growth was globally synchronized, economic performance and policy reactions varied across countries, with some coping better than others. Like most countries in the world, LAC came out of the crisis with a bruised income statement but, unlike rich countries and some of the emerging economies in Eastern and Southern Europe, LAC s balance sheet was not impaired. This 3

5 remarkable fact stands in sharp contrast with LAC s own past experience, where domestic currency, banking and/or debt crises tended to wreak havoc at home following a major external shock. In other words, while LAC experienced a marked slowdown in growth it did not suffer systemic damage, and this has raised the relative attractiveness of many LAC countries as destinations for investment and placed them in a good position to resume growth. In particular, LAC s recession in 2009 (a GDP contraction of 2.3 percent) was deeper than that of the East Asian Tigers (0.1 percent) but milder than that of high-income countries (3.4 percent) and Eastern Europe (5.7 percent) (Figure 1.A). Excluding Mexico, moreover, whose output contraction of about 6.5 percent was a regional outlier, LAC s GDP hardly contracted in In addition, LAC s growth collapse (the difference in GDP growth rates between 2009 and 2007) of 6.3 percentage points (pp), although large in absolute terms, was just under that of the industrial countries and East Asian Tigers (6.9 pp and 7.4 pp, respectively) and much smaller than that of Eastern Europe (12.9 pp) (Figure 1.B). Figure 1. Real Growth and Growth Collapses for 2009 Across Regions A. Growth Across Regions, 2009 B. Growth Collapse 10% 8% 6% 4% 2% 0% -2% -4% -6% Real GDP Growth in 2009 Around the World Annual Real GDP Growth Rate 0% -2% -4% -6% -8% -10% -12% GDP Growth Collapses Around the World Differences Between Growth in 2007 and % ECA OECD LAC East Asian Tigers SSA MENA South Asia China Note: Growth collapse is defined as the difference between the GDP growth rate in 2009 vis-à-vis growth in ECA refers to Eastern Europe and Central Asia countries. East Asian Tigers are Hong Kong,China; Indonesia; Korea,Republic of; Malaysia; Singapore; Taiwan,China; and Thailand. OECD refers to OECD-member countries. LAC refers to countries in Latin America and the Caribbean. SSA refers to Sub-Saharan Africa countries. MENA makes reference to Middle East and North African countries. Data comes from Consensus Forecast as of December 2009 for countries that have not published 2009 growth figures yet. Source: Bloomberg, IMF International Financial Statistics (IFS) and Consensus Forecasts. -14% ECA East Asian Tigers OECD LAC China SSA MENA South Asia To be sure, the recession in LAC, while milder than expected, led to a partial reversal of the robust poverty reduction gains that the region achieved in the five years prior to the crisis. While 60 million Latin Americans are estimated to have left the poverty ranks during , some 9-10 million people joined the poor in 2009, and that number would have been greater had it not been for the fact that again breaking with history LAC governments were able to maintain, and in many cases 4

6 actually step up, social assistance programs, including the very effective conditional cash transfers schemes that have become a LAC trademark in social policy. From a cross-country perspective, as analyzed in greater detail in Appendix I.A, growth collapses around the world tended to be larger in economies characterized by greater trade openness, higher trade dependence on rich country markets, higher share of manufacturing exports, and weaker banking systems. Moreover, improvements in LAC s macro-financial policy frameworks paid off. They enabled LAC to better cushion the external shock and undertake countercyclical policies, especially on the monetary front but also, to a lesser extent, on the fiscal side. While banking system weaknesses did not play a role in most LAC countries (with the possible exception of some Caribbean countries), the rest of the mentioned factors help explain why, for instance, the growth collapse was more pronounced in Argentina, Mexico, Costa Rica, Panama and Peru compared to, say, Brazil and Chile, and why the growth collapse was comparatively very small in, say, Bolivia. Countercyclical capacity is a new and certainly notable feature in LAC s macroeconomic policymaking, a region where in the past external shocks were instead amplified by weak macroeconomic fundamentals. This capacity, furthermore, is a fruit of steady institution building over the past 25 years involving a virtuous combination of: more robust monetary policy frameworks (including greater exchange rate flexibility and credible and professional central banks), more viable fiscal processes (although these tend to remain pro-cyclical in most of LAC, with the salient exception of Chile), sounder and better regulated banking systems, a significant reduction of currency mismatches in debtor balance sheets, and a safer integration into international financial markets. The latter reflects a process that begun in this millennium, whereby LAC became a net creditor to the rest of the world on the debt side (that is, the side where systemic vulnerabilities can easily arise) while the rest of the world has become an increasing net claimant on LAC on the equity side (that is, the side where systemic vulnerabilities are much less likely to emerge) (Figure 2). Importantly, the flexible, sizeable, and timely provision of liquidity and budget support financing by multilateral financial institutions (including the IMF, World Bank, IDB, and CAF) complemented and boosted the ability of LAC s more robust macro-financial and social policy frameworks to cushion the effects of the external shock. 1 Indeed, the prompt response by multilaterals constituted a more prominent feature in the management of this crisis compared to previous ones. In this connection, a recent IDB study (Izquierdo and Talvi, 2010) that quantitatively assesses the impact of multilateral finance during the crisis finds that: (i) developing countries with access to multilateral resources outperformed those without it; and (ii) it was the combination of multilateral financial support and improved macro-financial fundamentals which enabled LAC to better withstand the crisis. The shock 1 The World Bank s commitments to disburse to the LAC region rose from an average of nearly US$ 5 billion per year during FY2003-FY2008 to around US$ 14 billion in FY2009. The average size of IBRD loan to countries in the region increased from US$ 116 million in FY2003-FY2008 to US$ 271 million in FY2009, as a large share of World Bank lending in 2009 took the form of fast-disbursing budget-support finance. 5

7 Net Debtor Net Creditor absorption capacity resulting from this combination also helps explain why labor markets in LAC behaved differently this time around, with unemployment rising less than in past crises (controlling for the size of the economic downturn) and the share of informal employment (surprisingly) not increasing. Part II of this report provides a detailed comparative analysis of the dynamics of labor markets in this and previous downturns. 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% -40% Figure 2. LAC: A Safer Integration A Safer Integration in LAC Net Debt Position vis-avis Rest of the World Net Equity Position visa-vis Rest of the World Source: The net debt position (vis-à-vis ROW) is the sum of debt assets and reserves minus debt liabilities. In turn, the net equity position (vis-à-vis ROW) is the sum of net FDI assets and net portfolio equity assets. The sample ranges from 1990 to Source: Lane and Milesi-Ferretti (2007). The global recovery: contrasting paths for the center and the periphery A year has passed since the first signs of a recovery, or the so-called green shoots, started to sprout systematically across countries. For the world as a whole, the cyclical recovery has so far taken a sharper V-shape than was expected a year ago, not least because economic activity is rebounding from a very low base. There has been a strong and steady comeback in asset prices, a sharp compression of spreads over U.S. Treasury securities, and a robust pick-up in commodity prices. Moreover, world trade volume, after falling more than 20 percent between April 2008 and May 2009, has rebounded significantly, already reaching mid-2007 levels and thus attenuating fears of a trade-less recovery. Global liquidity remains abundant and a vigorous search for yield seems underway, spurred by low interest rates, and capital flows are returning to pre-crisis paths while increasingly being directed towards emerging markets (Figure 3). While global economic growth is being restored overall, there is great heterogeneity in the strength of the post-crisis recovery across regions and within regions. Growth engines are being reignited at different paces and intensities across nations. In particular and in sharp contrast with past episodes of 6

8 f 2010f Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 Wheat, Copper and Soybean, 01-Jan-05=100 Oil WTI, Current US$ Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 global economic and financial turmoil, the recovery this time around has been led not by the center but by the periphery specifically by the larger and more dynamic emerging markets (namely, Brazil, China, India, South Korea, Malaysia, Philippines, and Thailand, which jointly account for nearly 55 percent of emerging markets GDP). For this group of emerging markets (dynamic EMs), not only was the fall from peak to through in average industrial production smaller than that of the advanced economies (mainly the U.S., Europe and Japan) but the through was reached three months earlier and the rebound since then has been much steeper UK S&P Figure 3. Signs of Recovery: A. Stock Prices B. World Trade Volumes Stock Prices Around the World Indexes: Jan-06=100 EAP Japan LAC ECA World Trade Volumes Seasonally Adjusted, Index 2000=100 Exports Imports 1,200 1, C. Capital Flows D. Commodity Prices Net Private Capital Flows to Emerging Economies US$ Billion Debt Investment Private Flows Portfolio Equity Investment FDI Commodity Prices Wheat, Copper and Soybean: Index Jan-01-05=100 Oil WTI in Current US$ Oil (rhs) Copper Wheat Soybean Note: EAP represents East Asia and the Pacific region. Note that the 2009 and 2010 figures on capital flows are forecasts from the Institute of International Finance. Source: Bloomberg, CPB (Netherlands Bureau for Economic Policy Analysis), and Institute of International Finance. 7

9 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Thus, industrial production for the dynamic EMs fell by 13.4 percent from the peak, touched bottom in February 2009, and has been increasing sharply since then, reaching pre-crisis levels by the time of this writing (Figure 4). When emerging regions are compared, emerging Asia and LAC have dominated the recovery, posting posted cumulative gains of 18.7 and 9.1 percent in industrial production since their troughs, respectively. By contrast, average industrial production for the rich countries fell by 16.9 percent from its peak, reached bottom in May 2009, and has been rising sluggishly since then (a cumulative increase of only 3.5 percent in the May 2009-December 2009 period), thus remaining substantially below pre-crisis levels by the time of this writing. Moreover, capacity utilization in the rich countries is still below the minimum of previous downturns and unemployment rates remain at stubbornly high levels (slightly below 10 percent in the U.S., more than 8 percent in Germany, almost 20 percent in Spain, and still rising in France and Ireland). By contrast, available data suggest that capacity utilization and employment are at around pre-crisis levels for the dynamic EMs as well as for many countries in LAC. 105 Figure 4. World Industrial Production World Industrial Production Index Apr-08 = Developed Countries Emerging Economies Note: The group of developed countries refers to OECD countries excluding Turkey, Mexico, Republic of Korea, and Central European countries. Source: CPB (Netherlands Bureau for Economic Policy Analysis). Consistent with the heterogeneity of the recovery described above, GDP growth forecasts range widely across regions. The most recent forecasts (i.e., Consensus forecasts as well as IMF and World Bank projections) put growth in the rich countries at 2.1 percent for 2010 and 2.25 percent for The U.S. is envisaged to grow slightly above that average flattening at 3.1 percent per annum during and Western Europe somewhat below at 1.2 percent in 2010 and 1.7 percent in By contrast, a much stronger rebound is forecast for the dynamic EMs. China is expected to post the highest growth rates, at 9.9 percent in 2010 and 9.1 percent in East Asia s GDP is forecast to grow by 5.5 percent in 2010 (5.1 percent in 2011) and LAC s economic activity is expected not to lag much behind, growing at a solid 4 percent per year during , with Brazil, Peru, Chile and 8

10 Panama leading the pack (see below). The GDP growth forecast for countries in the Middle East and North Africa is 4.4 percent per year in whereas growth in Eastern Europe is the lowest among emerging market regions (3.5 percent) (Figure 5). Figure 5. Regional Growth Forecasts for 2010 and Real GDP Growth Forecasts for Annual Real GDP Growth Rate Western Europe Japan Eastern Europe Note: Western Europe comprises Euro Zone countries, Denmark, Sweden, UK, Norway, and Switzerland. Source: Consensus Forecasts (December 2009 and March 2010), and Bloomberg. The considerable variation in the recovery across countries is not surprising given that the idiosyncratic strengths of individual economies play a greater role as the effect of the global systemic shock fades. A more systematic analysis of cross-country data suggests that this is indeed the case (Appendix I.B provides a more detailed analysis, including a comparison of the collapse-rebound patterns around the current and previous crises). In effect, countries that were able to conduct counter-cyclical policies are experiencing a faster recovery and so are countries that are experiencing a rebound in their net exports after the crisis. A purely arithmetic bounce-back effect also seems at play, as countries that recorded greater growth collapses also tend to register faster recoveries. The recovery in LAC: things are looking good overall US LAC MENA East Asian Tigers As noted, despite being one of the most financially globalized regions in the world, LAC is coming out of this crisis without systemic damage and is experiencing a relatively strong recovery in economic activity on average. This recovery was preceded by a strong V-shaped rebound in stock prices and a sharp compression of (sovereign and corporate) spreads. After reaching a trough in October 2008, stock prices in LAC recovered vigorously. The Brazilian stock price index was back to its pre-crisis peak levels already by end-march Analogous behavior is observed in stock markets in Chile, Colombia, Mexico, and Peru. China 9

11 Venezuela Ant. & Barb. Bahamas St. Kts. & Nv. Barbados Jamaica St. Vc. & Grs. Dominica St. Lucia Nicaragua Belize Guatemala Haiti Tri. & Tob. Honduras Ecuador Guyana Colombia Costa Rica Dom. Rep. Paraguay Suriname Bolivia Argentina Uruguay LAC Mexico Panama Chile Peru Brazil Venezuela St. Vc. & Grs. Haiti Jamaica Belize Nicaragua Argentina Ecuador Guatemala St. Lucia Honduras Dominica Guyana Mexico Colombia Uruguay LAC Costa Rica Paraguay Bolivia Dom. Rep. Brazil Peru Chile Panama While LAC s is forecast to grow by 4 percent in 2010 on a weighted average basis, there is significant heterogeneity in projected growth rates within the region. South America is envisaged to have a stronger recovery (4.7 percent over ) than Central America (4 percent) and the Caribbean (3.2 percent). Countries in LAC that are experiencing stronger rebounds tend to be characterized by: (i) vigorous expansion in domestic demand; (ii) extensive use of countercyclical policies; (iii) economic complementarity to Asia (especially China); and (iv) commodity abundance. The leader is Brazil, where industrial production has increased by almost 20 percent from the trough and its 2010 GDP growth forecast is at 5.5 percent. Peru, Chile, Panama and Mexico are also expected to record relatively faster GDP growth within the region between 4 and 5 percent in Growth rates in the 3-4 percent range for 2010 are expected for Argentina, Bolivia, Colombia, Costa Rica, Dominican Republic, Paraguay, and Uruguay. Lagging behind but rebounding nevertheless are most countries in Central America and the Caribbean. Lastly, Jamaica and Venezuela are expected to grow very little or even contract in 2010 (Figure 6). 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% Figure 6. Growth Forecasts for 2010 and 2011 among LAC Countries A Growth Forecasts B Growth Forecasts Real GDP Growth Forecasts for 2010 LAC countries 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% Real GDP Growth Forecasts for 2011 LAC countries Source: Latin American Consensus Forecasts as of March 2010, IMF s World Economic Outlook, IMF s Regional Economic Outlook. A few countries in LAC may begin to face the risk of economic overheating, with inflationary pressures expected to increase over the next months. Brazil is the most visible case in point economic activity is beginning to expand at a pace above the pre-crisis trend growth and inflation forecasts are already above the center of the targeted inflation. Moreover, the fiscal and quasi-fiscal stimulus measures taken in Brazil, which are estimated to have totaled around 4 percent of GDP, will likely not be undone in the near future due mostly to the electoral cycle. Hence, markets expect the initiation of a monetary policy tightening in the near future. For many countries in the region, however, output is expected to remain below potential (Mexico and Colombia) and/or inflationary pressures are not yet mounting to significant levels (Peru and Chile). After engineering a massive cut in policy rates (Figure 7), Latin 10

12 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 Output Gap Output Gap central banks are thus expected to start a gradual normalization of interest rates, but the timing and extent of interest rates increases will likely vary significantly across countries depending on the output gap and inflationary expectations (Figure 8). For the small, open economies in Central America and the Caribbean, where the scope for independent monetary policy is very narrow or non-existent, domestic price increases will tend to reflect developments in import prices (including foods and fuels) as well as supply conditions in the agricultural sector. Be it as it may, as interest rates increase in most of LAC while remaining low in rich countries, capital inflows are likely to surge, creating complex challenges for LAC central bankers, as discussed in more detail below PER CHL Figure 7. Output Gap and Inflation A B Output and Inflation Gaps BRA BOL PAN PRY COL SLV ECU GUA MEX URY DOM HND NIC CRI ARG Inflation Pressure in percentage points Note: Inflation pressures are calculated as the difference between the 2010 inflation rate forecast and an estimated target of 4% (assumed to be the target for most countries in the region). The output gap calculated as the difference between the (log of) actual and potential GDP, with the latter being calculated using the Hodrick-Prescott filter. Source: LCRCE Staff calculations based on Consensus Forecasts as of March Figure 8. Monetary Policy Rates in LAC countries 15.0% Monetary Policy Rates Inflation-Targeting Latin American Countries and the US 0 PER 2011 Output and Inflation Gaps CHL MEX COL PAN SLV GUA BRA BOL ECU URY PRY DOM HND CRI NIC ARG Inflation Pressure in percentage points 13.0% Brazil 11.0% 9.0% 7.0% 5.0% 3.0% 1.0% -1.0% Colombia Mexico Chile US Peru Source: Bloomberg. 11

13 Global growth prospects: obscured by clouds Whereas the prospects for growth in LAC countries in the near future are promising, the region is not isolated from the world economy and a significant fraction of the downside risks to growth lies in the external environment. To be sure, due to the mentioned substantial improvements in macro-financial policy frameworks LAC is much less vulnerable to shocks than it used to be. Hence, domestic macrofinancial crisis are arguably less likely than in the past to erase LAC s gains from growth going forward. But the sad fact remains that LAC has not managed to sustainably grow above the world average during the last hundred years! In general, LAC s growth has tended to track closely global growth. Full decoupling between LAC s growth and world growth is thus a chimera, implying that the growth prospects for LAC can only be assessed in the context of the growth prospects for the world. Growth in the rest of the world beyond the very short-run, however, is plagued by great complexity and uncertainty. Some of the regional differences and relevant factors affecting growth prospects outside LAC are briefly and selectively discussed in the rest of this section. Figure 9. Variation in Export Market Shares in LAC 20% 15% Variation in Export Market Shares for LAC Countries 2008 vs. 1990, in percentage points Euro Zone US China 10% 5% 0% -5% -10% -15% Source: IMF s Direction of Trade Statistics (DOTS). ARG BRA CHL COL ECU MEX PER PRY URY VEN One important point to keep in mind in this regard is that, as the region diversifies its linkages to the rest of the world, the sources and nature of external shocks will also diversify. In particular, shocks coming from other emerging countries may become increasingly more relevant for LAC in the future. The volatility of such shocks may be higher than those coming from international financial markets and rich country demand for LAC exports. In the past, LAC s trade was on average mostly linked to the U.S. and, to a lesser extent, Europe. The region now relies much more on external demand from other emerging markets, particularly China and the South East Asian countries (Figure 9). Kose, Otrok and Prasad (2008) find that business cycles among LAC-7 countries are increasingly accounted for by regional factors (that is, factors affecting individual regions rather than the whole world) and, 12

14 although there is no one-to-one mapping, it is likely that those regional factors are mainly driven by regional shocks. As a result, the share of output variation for LAC-7 countries accounted for by regional factors increased from 1.3 percent to 7.8 percent on average between and , reaching almost 16 percent in Peru and 10 percent in Brazil. Global (rather than regional ) factors (i.e. related to fluctuations affecting the entire world) are nonetheless still important for LAC, explaining more than 17 percent of output variations in Brazil and around 9 percent for non-lac7 countries (e.g., mainly Central American and the Caribbean countries) (Figure 10). 2 Figure 10. The Increased Importance of Regional Factors and Decreased Global Ones A. Global Factors B. Regional Factors Note: Global factors encompass all fluctuations that are common among industrial countries, emerging markets and other developing countries. Regional factors capture fluctuations that are common only within a particular group of countries (say, emerging markets). Source: Kose, Otrok, and Prasad (2008). Consider now the growth prospects for the rich countries. The recovery in the United States has so far been driven mostly by a restocking of inventories, massive stimulus policies, and a revival of net exports. There is uncertainty about the sources of future growth as the process of inventory restocking ends and the effects of the stimulus fizzle away towards the second half of this year in the absence of additional stimulus injections. So, prospects will largely depend on domestic private demand, which is still relatively weak and shows no clear signs of a solid recovery yet. Moreover, the management of the crisis implied that balance-sheet problems shifted from the private to the public sector, and this is likely to pose downside risks to a sustainable growth path in the medium term. The 2 Kose, Otrok and Prasad (2008) use dynamic factor models to decompose the fluctuations in output, consumption and investment for a sample of 106 countries over the period into global factors, regional factors, country factors, and idiosyncratic factors. The global factor includes all fluctuations that are common to industrial countries, emerging markets and other developing countries, and across all variables. Regional factors, on the other hand, are those that capture fluctuations that are common only to a particular group of countries, and across all variables. For instance, the regional factors for LAC-7 countries involve fluctuations affecting only theirs and other emerging markets output, consumption and investment. 13

15 extraordinarily high level of government indebtedness significantly limits the scope for fiscal expansionary policies and this shifts the countercyclical burden to monetary policy. While the U.S. Fed is already unwinding some credit support facilities that help stabilized the financial system, interest rates in the U.S. are likely to remain at near-zero for a while in order to continue providing an expansionary impulse to the economy. But this, in the absence of vigorous and well-designed regulatory reform, may foster a buildup of financial excesses similar to those that led to the crisis. Moreover, there are strong doubts that the U.S. will be able to grow at the very high rates, or undertake the extent of fiscal adjustment, required to restore public sector debt to robust viability. This, in turn, raises the inflation specter i.e., the specter that debt might have to be inflated away down the road. In Western Europe things look even worse and overall growth prospects are grim, although there is a wide variation in macro-financial circumstances among its countries. The forces of Western European growth recovery have been the same temporary ones at work in the U.S. inventory restocking and stimulus packages, along with net exports. Domestic demand is also at depressed levels and investment is not expected to pick up significantly in the near future. But the challenges for growth in Western Europe are more daunting. Unemployment is extremely high and unyielding, not least because of the well-known rigidities in European labor markets which are politically difficult to alter. Perhaps more importantly, the European Union (EJU) does not have the flexibility to tailor monetary policy to the different needs of different EU countries. In the absence of differentiated exchange rate adjustment mechanisms and given the severe restrictions on the ability to transfer fiscal resources among Euro members, recessionary forces are likely to be stronger and more persistent. This is particularly troublesome for EU countries with high debt levels and/or weak fiscal stances such as Greece, Ireland, Italy, Portugal, and Spain. The problems with Greece s debt have already led to increased fears of a double-dip recovery path in the EU, as the contractionary effects of fiscal austerity measures may spread. 3 Given the sluggish recovery and the challenges faced on the fiscal side, an exit from the monetary stimulus is unlikely to occur soon, and interest rates in the EU will also remain at very low levels for a while. Japan has experienced a slow export-based recovery so far. But it has still not seen a recovery in domestic (consumption and investment) demand and unemployment remains high. Moreover, the export-led rebound might slow down as inventory restocking ends. The country remains caught in a long-lasting liquidity trap, with deflationary pressures ensuring that interest rates will stay at near zero levels. The lack of room on the monetary policy front is putting an excess burden on fiscal policies. However, the country does not have much space on this front due to its large (gross) debt position of almost 200 percent of GDP. 3 A resolution to Greece s debt sustainability problems seems to be underway with both the IMF and Euro zone members involved in a rescue package, but this will have to be accompanied with painful fiscal austerity measures. 14

16 Turning now to emerging markets, China is playing an important role in the world s recovery. During the crisis, its main engine of growth, exports, collapsed. To sustain economic activity, the government launched a massive and unprecedented stimulus focused on infrastructure investments at the local government level, which were spurred by a gigantic increase in domestic credit. The resulting investment boom in China (investment is estimated to have risen to nearly 60 percent of GDP) led to a sharp rise in imports, particularly of industrial metals and minerals, which contributed to the rebound in commodity prices and helped with the recovery in other emerging markets, including of course the net commodity exporting countries of South America. However, household consumption in China seems to be growing at the same pace as real GDP (even if real wages seem to be rising a bit faster), suggesting that the high domestic saving rate has remained essentially unchanged. While China is expected to continue to grow strongly in the short-run, as its stimulus dwindles (a few measures have already been taken towards a normalization of conditions) uncertainties rise about the durability and sustainability of China s investment-based growth pull on the rest of the world. 4 The significant growth recovery in other Asian countries has been driven by their position in the global production chain, including in particular the integrated distribution of manufacturing production stages within Asia. Together with China and India, East Asian countries, have been the main drivers of global growth since January 2009 and will likely continue to be so in the near future. At the same time, however, with actual GDP growth rapidly approaching potential growth, inflationary pressures are surfacing, and this is inducing Asian EMs to normalize monetary conditions and even initiate the cycle of monetary policy tightening that would cool down growth. Malaysia already raised the policy interest rate and others are expected to follow soon. In sum, the prospects for global growth are clouded by great uncertainty and complexity regarding at least two main questions. The first question is whether rich countries will be able to overcome the growth-impairing effects of their damaged balance sheets (Figure 11). The difficulty involved in meeting this challenge is clear when one considers the large size of primary fiscal surpluses that the U.S., Europe and Japan would have to generate in order to bring down their debts to sustainable levels without inflation (Figure 12). The second question is whether Asian EMs will be able to sustain in the medium-term their current growth pattern. This is equally uncertain considering that their current growth model remains frankly reliant on exports. While the domestic market has played an important role in the recovery for some of the dynamic EMs (including Brazil), world consumption demand needs to be recomposed to put world export growth on a high and sustainable path over the medium-term. Ideally, more consumption demand will have to come from the surplus EMs, Germany and Japan (and 4 China is capable of designing the appropriate mix of policies to stimulate domestic demand, and consumption in particular, if external demand indeed remains weak. This would entail a shift towards a domestically-oriented growth model. Another way to stimulate domestic (private) consumption is the real appreciation of the Chinese Yuan. Real appreciation can be achieved through either domestic price inflation or a change in the current exchange rate policy. This is more likely to happen through a slow and gradual change in the nominal exchange rate in the event of high inflation. In the event of mounting inflationary pressures, Chinese authorities may allow the exchange rate to gradually adjust, thus giving a boost to domestic consumption. 15

17 Colombia Brazil Chile Mexico Peru Argentina Hungary Bulgaria Ukraine Turkey Philippines Indonesia Russia Romania South Africa Germany Italy France Portugal Spain UK US Japan Ireland Greece less from the U.S.) and this is difficult to envisage in the absence of stronger currencies in Asia, particularly China. But it is utterly unclear whether and how this might happen in the absence of effective international macroeconomic policy coordination involving not just the rich countries but also the dynamic EMs. That type of coordination unfortunately appears unfeasible in the near future. In the meantime, however, capital flows to EMs are likely to pick up further as the interest rate differentials rise that, is, as EMs increase interest rates to control inflation expectations in the midst of a possible economic overheating while rich countries keep interest rates low to stimulate their sagging economies. Figure 11. Gross nominal liabilities for developed countries and LAC Gross Nominal Liabilities % of GDP Source: EIU and Consensus Forecasts (various issues). 0 US Euro Japan UK OECD LAC-7 20 Figure 12. Required Fiscal Adjustments Required Fiscal Adjustment Between 2010 and 2020 To Reach Debt Levels of 60% in % of GDP Developed Countries Latin America Other Emerging Economies 0-5 Source: IMF Fiscal Affairs Deparment, Strategies for Fiscal Consolidation in the Post-Crisis World. Washington, DC: IMF, February. 16

18 Challenges ahead for LAC So far for LAC, the pattern of global recovery discussed above has brought benefits. Countercyclical policies have supported domestic demand in the larger LAC countries and external demand from fastgrowing EMs, especially China, has boosted exports and terms of trade for LAC s net commodity exporters which are mainly located in South America and account for over 90 percent of the region s population and GDP (Figure 13). Until now, moreover, the rebound in commodity prices and relatively fast pace of recovery in LAC has not awaken major inflationary pressures. This has hitherto allowed LAC central bankers to keep interest rates low and this has, in turn, helped dampen the pressures for LAC currencies to strengthen relative to other currencies. Things will not be as easy for LAC going forward, however, given the prospects and policy complications outside LAC as discussed in the previous section. This section briefly discusses some of the challenges ahead for LAC. Living with capital inflows and exchange rate appreciations As noted, interest rate differentials (already at non-trivial levels given the near zero rates in developed countries) will widen further, likely leading to greater capital flows to LAC. And this will happen in a context where foreign capital, especially from the equity side, is already flowing to LAC in considerable amounts, not least because of many LAC countries withstood the global crisis well and came out of it as relatively more attractive destinations for investment. The pressures for LAC currencies to appreciate will be further enhanced in the case of commodity exporters where a commodity export boom can easily materialize. Bolivia Ecuador Chile Paraguay Trin. and Tob. Colombia Peru Argentina Mexico Uruguay Brazil Panama Guatemala Costa Rica Nicaragua Dominica Dom. Rep. Honduras Figure 13. Terms of Trade Cumulative Change in Terms of Trade 2008q4-2009q4 2001q4-2008q2-40% -20% 0% 20% 40% 60% 80% 100% 120% 140% Note: The cumulative variation in the terms of trade index is calculated using quarterly data. The blue bars represent the cumulative percentage change during the recent commodity price boom up to the peak in 2008q2. The red bars capture the cumulative percentage change in terms of trade from its trough in 2008q4 to the most recently available quarter (2009q4). Source: WDI, DECPG, and Haver Analytics. 17

19 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan Figure 14. Exchange Market Pressures A. Brazil B. Chile Brazil 4 3 Chile Reserve Accumulation Appreciation Pressures Exchange Market Pressure Reserve Accumulation Appreciation Pressures Exchange Market Pressure C. Colombia D. Peru Colombia Peru Reserve Accumulation Appreciation Pressures Reserve Accumulation Appreciation Pressures -4 Exchange Market Pressure -3 Exchange Market Pressure Note: The Exchange Market Pressure Index is the weighted average of year-on-year percentage changes in: (a) the nominal exchange rate of the local currency vis-à-vis the US dollar (such that an increase represents an appreciation of the LAC currency), and (b) the level of international reserves. The weights are given by the inverse of the annual standard deviation of the changes in the nominal exchange rate and the standard deviation of the changes in reserves. An increase in the Exchange Market Pressure index signals appreciation pressures and/or accumulation of reserves. Source: LCRCE Staff calculations based on IMF s IFS. Consequently, countries in the LAC region will continue to face significant challenges in the monetary/exchange rate front. Having moved to more robust monetary policy frameworks that rely on greater exchange rate flexibility, and given a generally limited scope for fiscal policy adjustment, the feasible fiscal-monetary policy mix will likely shift the burden towards monetary policy. LAC policy makers will thus likely face increasingly difficult policy tensions vis-à-vis the risks of overshooting in currency appreciations (which could inflict adverse and permanent effects on export competitiveness) and capital inflows-induced excessive credit expansion (which could weaken the financial system down the line). There is of course no easy way out of these tensions. The option to step up exchange rate intervention aimed at dampening appreciation pressures will naturally be considered despite its 18

20 costs for it calls for a significant degree of sterilization, via the issuance of relatively expensive localcurrency debt securities, of the monetary impact of such intervention. The ongoing strengthening of LAC currencies and/or the accumulation of international reserves in several LAC countries (e.g., Brazil, Chile, Colombia, Mexico, and Peru) already reflects the interventions in the exchange rate market motivated by the need to find a reasonable balance in the face of the tensions (Figure 14). Not surprisingly, therefore, alternative options to lean against the wind in exchange rate markets might become an important item in the monetary policy debate in LAC going forward. To the extent that currency appreciation in LAC would be lower if China s currency were allowed to strengthen, LAC countries might also interpret their intervention in exchange rate markets as a way to offset a global distortion. The actual mix of policies will, however, depend on whether flows and associated appreciation pressures are perceived to be permanent or temporary. Controls on capital inflows, as pointed out in a recent IMF Staff Position Note (Ostry et al, 2010), is likely also to be part of the menu of options, although these controls might bring distortions to financial systems that would be hard to reverse in the future. Furthermore, such controls tend to be easy to circumvent and thus become less and less ineffective over time. Alternatively, LAC authorities might focus on averting the excessive credit expansion that could result from the surge in capital inflows. In this case, macro-prudential policy tools could be considered, including, for instance, unremunerated reserve requirements on financial intermediaries and/or counter-cyclical prudential (capital or provisioning) norms. Lastly, although harder to implement, fiscal tightening will also have to be considered, as it could allow interest rates to be lower, and the real exchange rate to appreciate less, than otherwise. In the end, with no simple solution in sight, countries in LAC are likely to have to learn to live with more appreciated real exchange rates, for which the only lasting solution is productivity growth. Assembling a productivity agenda while averting the downside risks of commodity wealth With the possible exception of Chile, LAC has failed to engineer sustained high growth. The process of convergence towards rich-country standards of living has in fact eluded LAC for more than a century, in sharp contrast with the East Asian tigers where convergence has been taking place at a rapid rate since the 1970s (Figure 15). Some hope that this trend may be changing emerged before the crisis, during the period, where several LAC countries other than Chile (chiefly Peru and Panama, but also Brazil and Colombia) recorded significantly higher growth rates than in rich countries on the strength not just of favorable external conditions (low interest rates, abundant liquidity, and high commodity prices) but also of productivity growth. With LAC coming out of this crisis relatively well positioned, those hopes appear to be rekindling. Moreover, as noted, the improved macro-financial resiliency of the region gives greater assurance that whatever gains from growth that LAC could achieve in the future will be less likely to be wiped out by financial crises, as tended to be the case in the past. In addition, LAC has been making significant strides in the equity agenda through noticeable improvement in poverty-reducing social policies and this could help mobilize consensus in favor of a long overdue reform agenda aimed at raising productivity growth. 19