Celebration about recent growth in Latin America has quickly given way to near-universal alarm about economic prospects. Stock markets are collapsing. Latin currencies are under great pressure. More weakness almost certainly lies ahead. Real indicators of employment and economic activity have turned negative almost uniformly across the region.
Make no mistake about it. With the global financial system in disarray, Latin America stands clearly in harm’s way. The question is how severely the region will be damaged by a change in the external factors that pushed overall Latin economic growth to near 6% per annum over the last six years. Is this record – the best in 40 years, no less – now at risk?
The answer depends upon the depth and duration of the global shockwaves. It will also be a function of the skill of Latin American policymakers in defusing facile temptations to water down the economic reforms which have helped to deliver the recent economic growth. But defensive moves will not suffice. Latin American must consider adopting aggressive policy steps to protect domestic employment and income.
Two points need emphasis. First, Latin American economies (with exceptions) have enacted reforms in the last ten to fifteen years which should strengthen the ability of the individual countries in the region to withstand the global turmoil. Second, thanks to the breathing space provided by the recent prosperity, many countries in Latin America have at least some capacity to cushion the blows caused by collapsing commodity prices and a drying up of global credit flows. Let’s look at these two points in turn.
Economic Reform Legacy Could Buffer the Region
Latin America’s reform zeal has generally waned in recent years as the economy of the region has been lifted by global growth. Still, the economic policy environment in the region is much more robust, much less vulnerable than it has been on the eve of other global economic storms.
Two developments deserve particular mention. Latin America (on aggregate) has generated a fiscal surplus in the last six years of about 1% of GDP on the strength of rising government revenues and some (albeit not enough) spending moderation. Moreover, the region has generated a significant surplus in the balance of payments which has converted the region to a net lender to (rather than borrower from) the global community. Foreign exchange reserves are now in excess of $450 billion. The implications of these “twin surpluses” (fiscal and balance of payments) are clear: Latin America on the eve of this 2008 global crisis is not heavily indebted; its fiscal position is relatively well consolidated (although in need of shoring up); and it has a very substantial foreign exchange cushion to buffer the domestic economy from the credit crunch.
To be sure, the protections provided by the twin surpluses are far from ironclad. Collapsing commodity prices and withdrawals of foreign credit could quickly eat into Latin tax revenues and erode trade balances with lightening speed. Exchange rates throughout the region are under severe pressure. Brazil and Peru, among other countries, have been forced to intervene selling international reserves to ease the sudden currency shocks.
At the same time, it is well to remember that reforms have been enacted in Latin America which also provide breathing space. Monetary policy, for example, has played a leading role in guiding inflation rates down in this region once infamous for high rates of inflation. Trade liberalization has helped to improve competitive environments, though the region is still far too dependent on natural resources (more “curse” than “blessing”) for export earnings. While small and concentrated, the region’s banking sector is hardly exposed at all to the toxic assets associated with the U.S. subprime crisis and has not invested heavily in risky investments or complex derivatives. Finally, most governments in the region have taken steps to reduce the dollar component of public sector debt, to fund more of the public debt in local currency, and to issue debt at longer maturities than had been the case in the past.
One need not argue, and I do not, that the region has done all of its reform homework or that its reform gains are solid and irreversible. Reforms are of relatively recent vintage everywhere and backsliding has occurred in countries ranging from Venezuela to Argentina, often accompanied by anti-U.S. rhetoric. While Brazil has largely resisted such pressures and is a star performer in terms of growth, it has been resting on its oars in terms of implementing deeper fiscal reforms as well as in investing in energy, education, and health – the long-term determinants of economic growth.
What More Can Be Done?
Four policy initiatives need to be considered in Latin America for the region to reinforce the levees against the rising waters.
First, fiscal policy plans for 2009 need to be re-examined with the goal of adapting expenditures downward (or reducing their planned growth) in line with a likely deterioration in tax bases. Latin American budgets, as experience teaches us, can swiftly switch back into deficits as tax revenues wither in a crisis and expenditures programmed during times of prosperity prove politically impossible to reduce following the onset of a crisis. Public investment spending probably should be spared from cuts, but not so most other categories of government spending.
Second, monetary policy must be vigilant with respect to the established inflation targets which are already under pressure due to rising food prices and depreciating exchange rates. At a time when private sector investment is already under pressure due to faltering global confidence and weakening currencies, the last thing Latin America needs are further pressures on domestic interest rates due to inflation uncertainty. While seeking to protect private investment spending to the extent possible, regulatory and supervisory structures need to be strengthened to cool off the rapid growth of consumer credit which characterizes many markets in Latin America.
Third, while Latin America does have the luxury of large international reserve levels, these are perishable assets and they are also costly for the region to maintain as they require a counterpart issuance of domestic public debt. The countries of the region should examine the possibility of lining up contingent lines of credit with multilateral lenders, including the IMF and the World Bank, as a form of insurance policy if the global credit freeze is prolonged. This will not be a politically popular move in any country, but the quicker Latin America acts the calmer markets are likely to be when the crisis worsens.
Fourth, in addition to trimming public spending while protecting public sector investment, it will be important to ease the impact of slowing growth and employment on the most vulnerable populations in Latin America, especially the unemployed, the less well educated, and the so-called “working poor”. Latin American countries have made a great deal of progress over the last decade in devising conditional income transfer programs (e.g., Bolsa Familia in Brazil, Oportunidades in Mexico) to direct spending at these at-risk groups. Effects to maintain this flow of spending, and to improve its targeting, are critical in tough times to prevent these vulnerable groups from swelling the ranks of the extremely poor in Latin America.
No aspects of this four-point emergency agenda will be easy. Political resistance will be fierce to needed fiscal cuts in order to protect investment and the poor. Temptations will abound to swell public sector indebtedness, to preserve middle- and upper-class entitlements, to impose price controls, to ease interest rates artificially, and to prevent the exchange rate from depreciating. These temptations will exist, but if indulged by policymakers, they can erode the institutional basis so painfully put in place over the last fifteen years and which is the best hope for a recovery of economic growth when the global credit crunch finally relents.