Southern Resilience

Latin America’s resilience in the aftermath of the 2008 financial crisis has been remarkable, especially when compared to the region’s performance in the 1980’s and 1990’s. But, as the world economy faces renewed uncertainty, the region must find new strategies to reduce the potential impact of volatile financial markets and protracted stagnation in the world’s richest economies.

Although Latin America’s growth corresponds to global trends, there is a good chance that, in 2012, the region’s economies will outperform industrial countries once again. Contraction of world trade and reduced financial flows will likely slow growth somewhat, but the annual pace should remain close to the region’s 2000-2008 average of 4%.

One reason for this prediction is that abundant liquidity in international markets and continuing high demand from China and India may prevent commodity prices – especially for agricultural products – from falling as much as they did during the 2008-2009 crisis. Gains in terms of trade have been crucial for growth in Latin America, given the region’s low domestic saving rates, because they encourage investment but have relatively little negative impact on current-account balances.

Strong capital inflows, especially of foreign direct investment, and terms-of-trade recovery since 2009 have made the region less vulnerable to external shocks – that is, to recurrence of the abrupt capital-flow reversal that occurred in late 2008 and early 2009. More importantly, most Latin American countries now have in place counter-cyclical measures to mitigate any negative external impact.

For example, many countries that were tightening their monetary policy when the first signs of turbulence emerged have either put interest-rate hikes on hold, or, like Brazil, have already started to reduce rates. Most Latin American countries’ recent adjustments, moreover, have prevented their budget positions and current-account deficits from becoming sources of vulnerability.

This appears to be the case, for example, in Peru, where sound fiscal policies have kept deficits and inflation under control. It is also true in Colombia, where strong budget revenues could allow for a temporary spending boost to counter external risks. Noteworthy exceptions are Argentina and Venezuela, where macroeconomic tensions have reduced the scope for counter-cyclical action, and Mexico, whose fate is bound by extensive trade links to that of the United States.

Brazil, the region’s largest country, and one of its most prosperous, reflects several economic trends in Latin America. After the global financial crisis erupted in the last quarter of 2008, interest rates in Brazil fell sharply, credit expanded quickly, and fiscal policy shifted from neutral to strongly expansionary. The Brazilian treasury’s massive funding of the National Development Bank also acted as a buffer against declining investment.

This policy stimulus led to strong growth, in both consumption and investment, and economic activity recovered quickly. While the appreciation of the real’s exchange rate kept a lid on prices for tradable goods, non-tradable goods, especially services, remained a source of inflationary pressure. To fight accelerating price growth, the authorities adopted measures at the end of 2010 to cool overheating domestic demand, first through credit restrictions and higher reserve requirements for banks – so-called “macroprudential” measures – and later through the resumption of interest-rate hikes.

But the sudden deterioration of external financial conditions, and the prospect of protracted stagnation in Europe and the US, prompted Brazil to reverse its policy last August. The central bank has already cut its benchmark interest rate by 150 basis points, to 11%, and the downward trend is expected to take real rates to record lows in the post-crisis period.

But the price for this might well be that annual inflation remains significantly above the 4.5% target. Indeed, more recently, the credit restrictions that were implemented at the end of 2010 have been loosened in order to stimulate consumer demand.

Moreover, Brazilian fiscal policy is likely to switch from restrictive to neutral or slightly expansionary this year. The government has promised to make the move more gently than in 2009-2010, thereby allowing the flexibility to bring down interest rates over the long term.

In 2012, it plans to increase the minimum wage by 14% according to the current adjustment rule, with a strong impact on social-security benefits, and the public-investment outlays that were repressed last year are also likely to resume. These measures, plus a reduction in tax revenues, should reduce the primary surplus and contribute to reviving demand.

Latin America has achieved substantial progress in its macroeconomic policy framework, giving its authorities increased room for maneuver in softening the impact of external shocks. But demand management is only part of the job when it comes to fostering long-term economic growth. Having successfully steered their countries through the crisis, Latin America’s authorities should devote greater attention to resuming reform efforts aimed at improving competitiveness and ensuring the sustainability of high growth rates.

Paulo M. Levy, economic researcher at IPEA, the applied economic research institute of the Brazilian government.

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