Tailwinds or Headwinds? Adjusting the Economic Sails in Latin America

As the European crisis lingers and advanced economies stall, the next six to eighteen months will be challenging for Latin America. Increased global uncertainties may create headwinds for the region—greater stress in the global economy and markets—tailwinds, if the advanced countries’ problems are tackled and economies spring back to life, or volatile gusts—weak growth and continued uncertainty—like we are seeing now.

But it’s not easy to forecast the future of Latin America in these uncertain times, as we discuss in our just-published Regional Economic Outlook for Western Hemisphere. (Here I focus on Latin America, but our report covers the whole region, including North America, Central America, and the Caribbean.)

Today’s global uncertainties are virtually unprecedented. But then again, much of Latin America is stronger today than in past decades. In most countries, inflation is generally under control; government budgets are in reasonably good shape; financial systems are stronger; exposure to the vagaries of international finance is lower; and exchange rates are allowed to move more to absorb shocks.

We saw the results of these improved policies during the 2008–09 global crisis. While Latin America was hit by the global fallout, it bounced back strongly as the crisis receded, riding the dual tailwinds of buoyant commodity prices and easy external finance.

Until recently, it even seemed that these tailwinds were too strong—pushing some countries to overheating (growing inflation, widening current account deficits, and strong credit growth). And even with global growth weaker, Latin America should post solid growth this year and next, assuming that tailwinds persist.

But now the tailwinds are fading. Commodity prices are still high, but have come down, and could fall further if world demand falters. International financial markets remain volatile, and their mood is unusually fluid day to day. If global uncertainties are resolved, the tailwinds could come back strongly.

Headwinds?

As we’ve said elsewhere, the world economy is in a dangerous new phase. Confidence is fragile. If the problems in Europe aren’t resolved, a collapse in confidence could trigger intense volatility in global financial markets. And another recession in the advanced countries would slow growth in Asian emerging markets, which has been supporting commodity prices—which, in turn, have bolstered Latin America’s commodity exporters (see Chapter 3 of our Regional Economic Outlook).

The result: a heavy blow to the region. Capital flows could dry up, squeezing domestic credit markets. Growth could slow abruptly as foreign demand and commodity prices fall off. Many countries could find their currencies and financial conditions under pressure. And if a major emerging market elsewhere in the world comes under strain, investors will scrutinize Latin America’s fundamentals, looking for weaknesses that would give them reason to pull out.

Tailwinds?

Alternatively, an early resolution to global uncertainties could stoke up confidence and renew the wave of capital inflows to the region. Advanced economies would likely maintain easy monetary policies, further propelling capital flows. Commodity prices could soar as global demand revives, particularly in emerging Asia. The dual tailwinds could pick up to gale force—and suddenly, countries could be confronted with overheating risks again.

Navigating through shifting winds

Given all this uncertainty about how winds might shift, what should Latin America’s policymakers do? I would propose three things:

  • First and foremost, countries should stay the course of gradual fiscal consolidation until global prospects are clearer. The temptation to ramp up government spending now must be resisted. It would not only use up fiscal buffers that may be needed later to fight a real global downturn, but could also compromise fiscal policy credibility.

  • Second, monetary policy needs to be nimble. If countries need to fight a downturn when it appears, they should start with monetary policy, where easing is possible. Central banks that have a strong track record of controlling inflation, and where inflation expectations are well anchored, can afford to pause now, and even cut rates if risks materialize. But if uncertainties settle and tailwinds pick up, central banks may need to resume tightening.
  • Third, all countries should keep an eye open for stress in their financial institutions and corporations. While Latin America’s banks are much more robust than in past decades, they are not immune to global storms. Officials particularly need to keep watch for liquidity strains; as the 2008–09 crisis showed, they can spread virulently to emerging markets countries. Meanwhile, if external finance remains cheap, and domestic credit is frothy, tighter prudential policies could protect financial sectors (see Chapter 2 of our Regional Economic Outlook).

So overall, countries should stand ready to deal with the challenges of headwinds—and even the challenges of stronger tailwinds. Making predictions and crafting policies in these uncertain times is hard. But as the saying goes, the best way to forecast the future is to influence it. And with the right policies, Latin America can influence its future, whatever winds may come.

This post originally appeared at iMFdirect and is reproduced with permission.