New IMF Report Warns of Overheating Risks in Latin America

Press Release No. 11/157
May 3, 2011

Latin America continues to grow at a healthy pace led by strong expansion in domestic demand. But the region is experiencing an excessively stimulative environment that brings along the risk of overheating. High commodity prices and easy external financial conditions are the main “tailwinds” propelling growth, in some instances at a pace faster than some economies are prepared for, says the International Monetary Fund’s new report Regional Economic Outlook Western Hemisphere: Watching Out for Overheating, presented today in Mexico City.

The region’s Gross Domestic Product (GDP) is estimated to have expanded by around 6 percent in 2010, and while it is projected to moderate to about 4.75 percent this year, this will require that governments withdraw any policy stimulus on a timely basis.

“Currently, we have a unique combination of factors,” said Nicolás Eyzaguirre, director of the IMF’s Western Hemisphere Department, during a presentation of the report hosted by Banco de México. “There is no record of another period in which interest rates were so low for so long in the advanced economies; demand from Asia has kept commodities prices at a high level; and emerging economies have better macroeconomic fundamentals than in the past, making them objectively more attractive to foreign capital.” On top of that, he pointed out, many countries have not yet rolled back stimulative policies put in place during the financial crisis to support demand, at times when restrain is needed.

Signs of overheating

Against this background, early signs of overheating pressures and possible excesses are surfacing in several areas across the region:

• Inflation is rising stimulated by demand factors, and the problem is compounded by the recent rises in food and energy prices. Though many central banks have been raising policy rates, additional rate hikes will be needed to contain demand pressures and limit spillovers from higher food and fuel prices into core inflation and expectations.

• Current account deficits are widening, with import growth exceeding export growth, even in those economies benefitting from higher commodity export prices. An adjustment to fiscal policy could play an important role in preventing an excessive deterioration of external imbalances.

• Credit is accelerating. Although banking systems remain generally solid, leverage and borrowing in foreign currency has been expanding fast (particularly among corporations), and asset prices have reached high levels. Countries should continue to strengthen their financial systems using the so-called macro-prudential policies, though these should not be used as a substitute for macroeconomic adjustment.

Challenges differ across the region

The recovery is gaining strength in Central America, though growth has been somewhat weaker in countries highly reliant on remittances. The report recommends governments to rebuild policy buffers used during the global crisis now that output gaps are closing. Improving the business climate and institutions remains a key priority for this sub-region.

The Caribbean remains the most vulnerable part of the hemisphere. Most countries are expected to start their recovery from the two-year recession in 2011, although higher food and fuel prices pose a threat to the recovery. Because of still very high public debt levels, which are holding back growth, fiscal consolidation plans will have to proceed.

Protecting the poor

A major challenge for policymakers in the region is to protect the most vulnerable segments of societies from the effects of food and fuel increases and of rising inflation. For all countries, Mr. Eyzaguirre noted, but particularly for those where the recovery is weaker and fiscal space for action limited, “the challenge is to protect the poor, but avoid universal subsidies that are often very costly and regressive.”

Foreign exchange intervention

This Regional Economic Outlook takes a special look at foreign exchange intervention, examining intervention practices over the past seven years in Latin American and other countries with flexible exchange rates. The analysis concludes that foreign exchange interventions may help slowdown the pace of appreciation, but its effectiveness depends much on country-specific circumstances, including the degree of financial openness and the currency strength. Ultimately, the desirability of intervention policies should be evaluated within a comprehensive framework that considers the pros and cons of the policy toolkit, including other macroeconomic policies as well as prudential measures.



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