External Factors, Macro Policies and Growth in LAC: Is Performance that Good?

External Factors, Macro Policies and Growth in LAC: Is Performance that Good? Alejandro Izquierdo IADB Emerging Powers in Global Governance Conference Paris, July 6, 2007 (based on work with Ernesto Talvi)

OUTLINE I. The External Environment: The Stars are Aligned II. Activity Performance: Great or Average? III. Macroeconomic Policies: Are They What They Seem? II. Final Remarks

7 Economic Boom in LAC: Strong World Output Growth (Real annual GDP growth) 6.9 6 5 5.1 5.4 5.3 4.9 5.1* 4.9** 4.5 4 4.1 3 Average 91-02: 3.3% 2 1 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: WEO *Estimation **Forecast

Economic Boom in LAC: High Commodity Prices (1991-1997 Average = 100) 400 350 300 250 200 Oil 252 % 356 350 310 270 230 190 Metals 306% 331 120 110 100 90 Food s Avg. 91-02 51% 118 160 150 140 130 120 110 100 150 100 50 Avg. 91-02 150 110 70 Avg. 91-02 80 70 90 80 70 60.6% 1991 1993 1995 1997 1999 2001 2003 2005 2007 1991 1993 1995 1997 1999 2001 2003 2005 2007 1991 1993 1995 1997 1999 2001 2003 2005 2007 1997.II 1998.I 1998.IV 1999.III 2000.II 2001.I 2001.IV 2002.III 2003.II 2004.I 2004.IV 2005.III 2006.II LAC-7 Terms of Trade (1997.II = 100) 39.9%* *excluding Venezuela

Economic Boom in LAC: Exceptional External Financial Conditions for EMs (EMBI+, bps) 2500 Tequila Crisis Russian Crisis EMBI+ Synthetic Bond Price* % Change 54.6% 2000 Yields 1500 EMBI Yield Average 91-02: 14.2% 1000 Spreads EMBI Spread Average 91-02: 806 500 6.3% 0 161 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 * Assuming an 11% coupon and 10-year maturity

OUTLINE I. The External Environment: The Stars are Aligned II. Activity Performance: Great or Average? III. Macroeconomic Policies: Are They What They Seem? II. Final Remarks

Business Cycle in Latin America: Here we go again? (LAC-7 GDP, real annual growth rate) 7% 70s Boom Lost Decade 90s Boom Russian Crisis Current Boom 6% 5.4 6.2 6.0 6.1 5% 4.5 4.6 4% 3% Average 74-06: 3.2% 2% 1% 1.5 0.7? 0% -1% -2% -3% 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: WEO

The Role of External Factors in LAC Business Cycle: Simulations* Growth Dynamics (GDP LAC-7, year on year growth rate) Growth Contribution (LAC-7, average 2003-2006).10 Beginning of Recovery 7.0%.08 6.0% Observed Growth.06.04.02 Historical Growth Rate: 3.5% 5.0% 4.0% 3.4% External Factors (57%) 3.0% 5.9%.00 -.02 2.0% 1.0% 2.5% Residual Growth (43%) -.04 02Q1 02Q3 03Q1 03Q3 04Q1 04Q3 05Q1 05Q3 06Q1 06Q3 0.0% *Predicted growth with external factors at 2002q4 levels *A. Izquierdo, R. Romero and E.Talvi (2006,2007), The Role of External Factors on Growth in Latin America.

Growth in Emerging Markets: A Comparative Perspective (GDP per capita, constant PPP, 1974 = 100) 390 370 350 330 310 290 270 250 230 210 190 170 150 130 110 90 70 Emerging Asia Chile Developed Countries Emerging Europe Latin America Africa 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 Source: Own calculations based on Angus Maddison

Growth in Emerging Regions: A Comparative Perspective (Real GDP, 2003-2006 annual growth) Emerging Asia World: 4.8% Ex USSR Middle East Emerging Europe Africa Latin America 2% 3% 4% 5% 6% 7% 8% 9% Source: WEO

Latin America: Investment & Productivity Investment (LAC-7, s.a. GFKF, Quarter 0 = 100) Total Factor Productivity (LAC, Year 0 = 100) 175 109 2002=0 165 155 % of GDP Current Prices Constant Prices 1998 2006 22% 20% 22% 23% 2002.IV=0 1991.I=0 108 107 1990=0 145 106 135 90s Expansion 105 104 Current Expansion 125 103 115 105 Current Expansion 102 101 90s Expansion 95 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 100 0 1 2 3 4 Source: IMF

OUTLINE I. The External Environment: The Stars are Aligned II. Activity Performance: Great or Average? III. Macroeconomic Policies: Are They What They Seem? II. Final Remarks

Latin America: Inflation 40% 35% 30% Inflation (LAC-7, CPI annual variation) Russian Crisis 90% 80% 70% Incidence of High Inflation (Latin America, % of countries with inflation over 10% for the last 5 consecutive years) 82% 25% 20% Average 91.I-98.II: 20.3% 60% 50% 15% 10% 5% 0% Mar-91 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Average 98.II-02.IV: 6.2% Average 03.I-06.IV: 5.0% Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 4.1% 40% 30% 20% 10% 0% 27% 16% 5% 1989 1997 2002 2006 *Median

Latin America: International Reserves (billions of US dollars and % of M2) Billions of US dollars 260 240 220 200 180 160 140 120 100 Russian Crisis Reserves / M2 Average 1991.I-1998.II: 1998.II: 45.6% Average 1998.II-2002.IV: 40.3% Reserves Average 2002.IV 2006.III: 48.3% 60% 55% 50% 45% 40% % of M2 Feb.07/Jun.98 Mexico 2.3 Venezuela 2.1 Colombia 1.9 Peru 1.7 LAC-7 1.7 Argentina 1.5 Uruguay 1.5 Brazil 1.4 Chile 1.0 80 60 35% 40 20 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 30% M2 = Currency outside banks + demand deposits + time, savings and foreign currency deposits of resident sectors Source: IFS and own calculations

Latin America External Balance: A Different Perspective* (LAC-7, current account, in millions of USD and % of GDP) 55,000 35,000 Russian Crisis 5% 3% % of GDP Millions of USD 15,000-5,000-25,000 Millions of USD 1% -1% % of GDP -45,000-65,000 Terms of Trade Adjusted at I.2002 prices -3% -5% -85,000-7% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 * Calvo and Talvi (2007): Current Account Surplus in Latin America: Recipe Against Capital Market Crises? ; www.rgemonitor.com (forthcoming)

Current Dilemmas of Monetary & Exchange Rate Policy Downward Pressure on the Real Exchange Rate Monetary and Exchange Rate Policy Options No FX Intervention Appreciation

Current Dilemmas of Monetary & Exchange Rate Policy Downward Pressure on the Real Exchange Rate Monetary and Exchange Rate Policy Options No FX Intervention FX Intervention Appreciation Inflation

Real Exchange Rate Policies: Leaning Against the Wind or Growth Oriented Policy? Leaning against the wind policies are short or medium-term in nature, and therefore could be manageable But growth oriented policies are in principle longer-term and may carry some difficult choices

Real Exchange Rate Policies: Costs Targeting the RER away from equilibrium may be a loosing battle with inflationary consequences (Calvo et al 1994). Alternatively, RER depreciation beyond equilibrium will require sterilization policies to fight inflation Cuasi-fiscal costs of sterilization Latin America is not China: Closed vs. open capital account Quasifiscal surplus vs. deficit

Real Exchange Rate Policies: Is it the tool? Studies do not control for Sudden Stop-type type crises: Large RER depreciation coincides with later recovery at high growth rates (Calvo( Calvo,, Izquierdo & Talvi,, 2006) If diversification is related to the provision of specific factors (Hausmann( et al, 2006), it is not clear that across the board policies in tradable sectors are desirable In particular, if accompanied by export taxes (the case of Argentina), most subsidies go to import substitution activities To the extent that the fisc depends on these taxes to obtain its primary surplus, then risks to debt sustainability increase

Federal Government: the Effect of New Taxes on the Primary Surplus 24% Revenues & Primary Expenditures (Central Government, % GDP) 5% Primary Surplus (Central Government, % GDP) 23% 4% 22% 21% 20% 19% 18% 17% Observed Revenues Primary Expenditures 3% 2% 1% 0% Observed Primary Surplus New Taxes* 16% -1% 15% 14% Revenues Excluding New Taxes* -2% Primary Surplus Excluding New Taxes* 13% -3% Oct-00 Abr-01 Oct-01 Abr-02 Oct-02 Abr-03 Oct-03 Abr-04 Oct-04 Abr-05 Oct-05 Abr-06 Oct-00 Abr-01 Oct-01 Abr-02 Oct-02 Abr-03 Oct-03 Abr-04 Oct-04 Abr-05 Oct-05 Abr-06 * Export Taxes and Financial Transactions Tax

Current Dilemmas of Monetary & Exchange Rate Policy Downward Pressure on the Real Exchange Rate Monetary and Exchange Rate Policy Options No FX Intervention FX Intervention Appreciation Dilemma Inflation The Fisc looses (lower export tariffs) The Central Bank looses (sterilization)

Latin America: Fiscal Balance (LAC-7, % of GDP) 1,5% 1.4% 1,0% 0,5% 0.3% 0,0% -0,5% Average 2003-2006: -0.2% -1,0% Average 1992-1998: -0.9% -1,5% -2,0% -2,5% -3,0% -2.7% Russian Crisis Average 1999-2002: -2.8% -2.8% -3,5% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Chile: Structural Fiscal Balance* Fiscal Revenues and Expenditures (Fiscal Revenues, Mar-91 = 100) Fiscal Balance (% of GDP) Russian Crisis Beginning of Current Boom 9,0% Russian Crisis Beginning of Current Boom 280 7,0% Fiscal Revenues 5,0% Observed Balance 230 3,0% 180 Adjusted Revenues 1,0% Structural Balance Fiscal Expenditures -1,0% 130-3,0% 80-5,0% Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Dic-91 Dic-92 Dic-93 Dic-94 Dic-95 Dic-96 Dic-97 Dic-98 Dic-99 Dic-00 Dic-01 Dic-02 Dic-03 Dic-04 Dic-05 Dic-06 *Talvi,, Ernesto (2007), If Latin America Were Chile: A Note on Structural Fiscal Balances.

Latin America: Structural Fiscal Balance* Fiscal Revenues and Expenditures (LAC, Fiscal Revenues, Mar-91 = 100) Fiscal Balance (LAC-7, % of GDP) 280 Russian Crisis Beginning of Current Boom 2.0% Russian Crisis Beginning of Current Boom 1.4% 260 Fiscal Revenues 1.0% Observed Balance 240 220 200 180 160 Fiscal Expenditures 0.0% -1.0% -2.0% Structural Balance* 140 120 100 Adjusted Revenues -3.0% -4.0% Structural Balance -4.2% 80 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006-5.0% Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 *Excluding Venezuela *Talvi,, Ernesto (2007), If Latin America Were Chile: A Note on Structural Fiscal Balances.

Latin America: Public Debt Dollarization (LAC-7, foreign currency debt, % of total debt) 65% 60% Average 97-02: 59.1% 55% 50% 45% 40% Average 03-06: 48.9% 40.1% 35% 30% 25% 20% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: Cowan, Levy, Panizza, Sturzenegger (2006) and own calculations based on official data.

Debt Mutation: An Illustration* (Public debt composition, % of total debt) Pre-October 2002 Election Debt Composition Current Debt Composition Pre-Asian Crises Debt Composition 90% 80% 70% 60% 50% 40% 83% Selic-linked + FX-linked + Repo Fixed rate 43% 55% 61% 30% 28% 20% 15% 10% 0% September 2002 March 2007 August 1997 * A. Izquierdo and E. Talvi (2007), External Financial Conditions and Debt Composition: the Mutation Factor (in progress)

Pre-Devaluation Debt Mutation* (Debt dollarization + Selic-linked in % of total debt, and exchange rate, R$ per US dollar) 100% 90% 80% Asian Crises Selic-linked Exchange rate-linked Real Devaluation 88% 2.20 2.00 70% 60% 50% 40% 30% 20% 10% Exchange Rate 1.80 1.60 1.40 1.20 1.00 0% 0.80 Aug-97 Sep-97 Oct-97 Nov-97 Dec-97 Jan-98 Feb-98 Mar-98 Apr-98 May-98 Jun-98 Jul-98 Aug-98 Sep-98 Oct-98 Nov-98 Dec-98 Jan-99 Debt Dollarization + Selic linked 28% Exchange Rate (R$ per US$) * A. Izquierdo and E. Talvi (2007), External Financial Conditions and Debt Composition: the Mutation Factor (in progress).

OUTLINE I. The External Environment: The Stars are Aligned II. Activity Performance: Great or Average? III. Macroeconomic Policies: Are They What They Seem? II. Final Remarks

FINAL REMARKS The current bonanza and macroeconomic fundamentals in Latin America are largely supported by an exceptionally favorable external environment. There have been policy improvements (more flexible exchange rate regimes, better monetary policy, dedollarization). However, the current bonanza may be masking fragilities: macroeconomic indicators that look good today may worsen quickly if the external environment deteriorates. And if it doesn t? What if higher terms of trade and benign financial conditions are here to stay? Are we using the good times to strengthen vulnerabilities? Are we making use of this bonanza for much needed long-term investments?