Economic Outlook for the Americas, An Address by Anne Krueger, First Deputy Managing Director, IMF
May 7, 2002Economic Outlook for the Americas
First Deputy Managing Director
International Monetary Fund
Council of the Americas
U. S. State Department, Washington DC, May 7, 2002
Mr Chairman. Ladies and Gentlemen.
Thank you for the opportunity to come here today and share with you our thoughts on the economic outlook for the Americas.
As a result of common global shocks and adverse local developments, the Americas—along with the rest of the world—experienced an unusually synchronized slowdown last year. The downturn has at least been relatively shallow in most countries. In part, this is thanks to the resilience of US consumer spending, the continued strength of Latin America's export volume growth, and the limited spillover from the crisis in Argentina. More fundamentally, in Latin America it reflects the important policy achievements that restored growth in the 1990s: adjustment programs that reduced dependence on foreign savings, lowered inflation and strengthened fiscal positions; combined with structural reforms that replaced inward-looking interventionist strategies with greater openness and reliance on market signals, and that enabled exchange rates to absorb part of any external shocks. These achievements provide a platform on which a strong and sustained recovery can now be built.
While the slowdown has been common to north and south, policy responses have necessarily differed. The US and Canada adopted increasingly expansionary fiscal and monetary policies to support a prompt recovery. But most Latin American and Caribbean countries have been constrained to more restrictive policies by weaker public finances.
Not surprisingly, the policy challenges looking forward differ too. As the recovery firms, the US and Canada will need to withdraw the stimulus they have injected into their economies. Latin America must continue to strengthen its fiscal position and financial supervision, creating room to use monetary policy cautiously to support the recovery. Building on past structural reform can also boost growth in the longer-term.
In Argentina, the policy challenge is clearly of a different order of magnitude. The economy shrank by almost 5 percent last year and will shrink even more sharply this year. It is essential that the authorities move quickly and decisively to put in place the foundations of a convincing economic program that can restore stability and growth.
Let me expand a little on this summary. I will begin by talking about recent economic developments, before asking why it is that the spillover from the Argentine crisis has been relatively modest. I will then turn to the near-term prospects and policy challenges. You will understand that I am constrained in what I can say about Argentina, but I will have a few brief comments to make before concluding.
2. Recent Economic Developments
Economic growth slowed to an unweighted average of just 1 percent across the Americas last year. This is the weakest performance for two decades.
The severity of the slowdown varied from country to country:
· Argentina and neighboring Uruguay fared worst, with output declining significantly for the third year running;
· Mexico, Peru, and some Caribbean and Central American countries saw their economies stagnate, with little or no change in GDP;
· The US, Canada, Bolivia, Brazil and Colombia recorded modest growth of between 1 and 2 percent;
· Chile, the Dominican Republic, Ecuador, Venezuela, and Trinidad & Tobago fared best, with growth of around 3 percent or more.
Notwithstanding these differences, the downturn was unusually synchronized. The US and Latin American economies were less divergent than in recent years, and the dispersion of growth rates within Latin America and the Caribbean was also very low.
In part, this reflected common shocks to the world economy, in particular the blow to confidence from September 11, which increased demand for liquid assets and undermined tourist industries. Synchronization also reflected the growth of trade and financial integration in the hemisphere, which increased the negative impact of weak US demand on the Canadian, Mexican, Central American and Caribbean economies. Financial linkages too encouraged business sentiment and investment to move in tandem in the US and Latin America. Finally, the synchronized downturn reflected separate but coincident local disturbances, including the bursting of the IT bubble in the US, the energy crisis in Brazil, natural disasters in Central America, an outbreak of foot-and-mouth disease in Uruguay, and—most dramatic—the crisis in Argentina.
With the exception of Argentina, the slowdown has been relatively shallow so far. In the US, 3 percent year-on-year growth in consumer spending helped offset a sharp decline in business investment and inventories. In Latin America, activity was underpinned by continued growth in export volumes in most countries, helped by in most cases by flexible exchange rate regimes.
But, although relatively modest, the slowdown was sufficient to weaken labor markets. In the US, private sector employment fell more than 1 percent and factory employment by more than 7 percent, taking unemployment to its highest rate in 6½ years. Factory employment also fell 6 percent in Mexico, with the maquila sector especially hit. Unemployment rates rose throughout Latin America, with Chile, Ecuador, the Dominican Republic and Trinidad & Tobago the only exceptions. And in each of these cases unemployment remained high by national historical standards.
Inflation was low though most of the region. Prudent monetary and fiscal policies, the slowdown in activity, and the weakening of labor markets all contributed.
Capital flows to Latin America and the Caribbean dipped sharply in the summer and fall of 2001, in response to the unfolding drama in Argentina. But by the end of the year they were recovering strongly despite the mounting expectation that Argentina would default. Only Uruguay suffered significant financial spillovers. Excluding Argentina, net private capital flows to the region were relatively stable for 2001 as a whole at $43bn, albeit well down on the $60bn recorded each year between 1996 and 1998. Foreign direct investment continued to account for the bulk of net inflows, although on the portfolio side it was notable that Argentina's difficulties did not prevent a record 12 sovereign bond issuers from accessing the market.
3. Why has Contagion from Argentina been so Limited?
Before turning to policy, it is worth discussing briefly why the economic and financial contagion from Argentina's problems has been so limited—certainly in comparison to way emerging market financial crises spread in the late 1990s.
Contagion in the bond market had been significant until last October with spreads throughout Latin America rising in step with the deterioration of Argentine credit risk. But since then, spreads on other Latin American bonds have declined markedly. By March they had reached their lowest levels since April 1998, although they have since edged up a little. As I mentioned a moment ago, bond issuance has also remained healthy.
Spillovers were also important in the currency markets until October, with exchange rate depreciation buffering the real sectors of neighboring economies. But they have since subsided. The Brazilian real and Chilean peso depreciated by 30 and 20 percent respectively between the second and third quarters of 2001, but recovered thereafter. Uruguay, which has particularly close financial links to Argentina suffered strong pressures on its currency as late as early this year, but these appear largely—but not entirely—to have abated after the authorities moved to a more flexible exchange rate regime.
Let me briefly mention five factors that might help explain why contagion has not been more important:
· First, sound macroeconomic management in most of the region has increased confidence. So too has the progress on structural reform in many countries, and the greater reliance on exchange rate flexibility.
· Second, trade and financial links between Argentina and most of its neighbors remain relatively limited. Only in Bolivia, Brazil, Chile, Paraguay and Uruguay does Argentina account for more than 10 percent of total trade. Argentina largely imports manufactures, but it is not a particularly important market for Latin American exporters - 1 percent of GDP for Bolivia, Brazil and Chile; 2 percent for Uruguay and 4 percent for Paraguay.
· Third, contagion was limited because the Argentine default was largely expected. Indeed, the crisis seemed to unfold almost in slow motion. As a result investors had ample opportunity to restructure their portfolios in advance. With the exception of Uruguay, most Latin American banks have maintained only a small exposure to Argentina. The Chilean corporate sector holds large investments in Argentina and has reported substantial valuation losses. But they have not been large enough to have a significant impact on the Chilean stock market or banking sector.
· Fourth, better and more timely economic information has fostered increased investor discrimination. This is an important example of how the global effort to reform the architecture of the international financial system is bearing fruit.
· Fifth, the search for increased portfolio diversification in an environment of ample global liquidity, low returns in the US and growing concerns about the quality of US corporate bonds after Enron has favored large and relatively liquid markets such as Mexico and Brazil. Argentina's share in the EMBI-Plus emerging market bond index has fallen from a peak of nearly 30 percent at the end of 1998, to 15 percent at the end of last October, to barely 2 percent now.
4. Policy Developments and the Near Term Outlook
As the global slowdown unfolded, the US and Canada eased monetary policy significantly. In the US the Federal Reserve reduced the Fed Funds rate no fewer than 11 times, taking it to a 40-year low of 1.75 percent. The real interest rate neared zero, supporting consumer and real estate lending (although long rates remained relatively firm). In Canada, the benchmark overnight interest rate was also reduced dramatically: by 375 basis points from January 2001 to January this year.
Fiscal policy turned expansionary as well. In the US, the budget is expected to have swung from a surplus of 2 percent of GDP in fiscal year 2000 to a deficit of just under 1 percent of GDP in fiscal year 2002. Most of this loosening reflects a shift in the structural budget balance, in turn reflecting last June's tax cuts and security-related spending. This is a much bigger turnaround than we saw in the 1990 recession, when monetary policy took almost all the shift. In Canada too, fiscal policy was supportive, thanks to scheduled tax cuts and the operation of the automatic stabilizers.
Looking forward, with business and consumer confidence picking up, it seems reasonable to expect GDP growth of around 2¼ percent this year in the US. Investment is likely to lead the way, with consumer spending possibly restrained by soft labor markets and the waning effects of tax cuts. Growth in Canada is likely to be even stronger, with indicators suggesting a strong recovery is already underway.
In both countries, it will therefore be important for the authorities to judge carefully how much economic stimulus is still required. If the recovery continues strongly, in coming months they will need to move back towards a more neutral stance. Canada has already raised rates 25 basis points. The Fed has also taken a step in this direction, shifting from a "negative bias" to a more balanced assessment of the forward-looking risks. Markets now expect short-rates to be raised quite sharply during the summer.
The story in Latin America and the Caribbean has been rather different.
Argentina aside, fiscal policy was overwhelmingly restrictive last year, in most cases reflecting ongoing consolidation efforts and structural fiscal reform. Bolivia and Venezuela loosened policy in an attempt to mitigate the slowdown, with Venezuela forced to change course early this year by severe pressures on its currency. A few countries, including Panama, allowed the automatic stabilizers to work. But, overall, the region's fiscal stance—measured by the cyclically-adjusted budget deficit—tightened by between half and 1 percent of GDP.
Tax increases were the main policy weapon, lifting the weighted-average ratio of revenue to GDP to a record 13.7 percent. The measures included higher VAT rates, wider use of the financial transactions tax, and reductions in tax exemptions. Attempts to reduce public spending were less successful, thanks to widespread earmarking, rigid wage and pension setting rules, and political resistance in general.
As for monetary policy, Bolivia, Chile, Colombia, the Dominican Republic and Mexico were all able to reduce interest rates—and prudently so. But all except Bolivia combined this with fiscal tightening. The smaller Caribbean economies also relaxed monetary policy to offset the impact of September 11 on their tourist revenues. But most large Latin American economies tightened monetary policy to strengthen credibility in the face of recurrent pressure on their currencies. Brazil and Chile have been able to relax their stance somewhat this year as this pressure has abated.
Looking forward, with the exception of Argentina, the IMF projects that output growth in Latin America and the Caribbean will gather momentum from the current quarter onwards, on the heels of the recovery in the US and global economy, and the associated strengthening of commodity prices. Regional growth (excluding Argentina) would then reach an annual rate of about 4 percent by the end of the year. This would give half a percent growth for the region as a whole this year, rising to 3½ percent in 2003. Inflation in most countries is projected to remain low.
However, there are a number of risks to this relatively benign outlook:
· First, external financial markets could be less welcoming to emerging market economies as the US recovery strengthens and interest rates rise.
· Second, although the US economy is performing more strongly than expected, downside risks remain. A weaker US upturn would delay the recovery in Latin America, and especially in Mexico.
· Third, domestic political timetables could unsettle investors, with five presidential elections due in the region before the end of the year.
· Fourth, contagion from Argentina could become more disruptive than it has been to date, for example through pressures on currency markets or reluctance on the part of corporate and portfolio investors. Some commentators also fear "political contagion" with countries turning away from market-friendly reforms and integration in the world economy. But many Latin American countries have been down that road before with very unhappy results.
Given these risks, the main policy challenge in the short term will be to support the recovery through monetary policy, but without endangering the valuable progress made in reducing inflation, raising credibility and implementing pro-growth structural policies. This implies that fiscal policy will have to remain tight to contain the growth of public debt. Targeted measures to alleviate the social impact of the downturn will have to be paid for with tax increases or spending cuts in less important policy areas.
At the same time, it is important to build on the structural reforms of recent years. This is the only way to deliver strong, sustained growth over the medium and long term. Many countries have already made significant progress, but there is always room to do more. Priorities across the region include: reforming labor markets to boost job creation; reducing the vulnerability of the financial system; strengthening tax systems; improving the regulation of private investment in utilities; liberalizing trade and capital accounts further; and raising the quality of governance.
Before I conclude, let me briefly say something about the unique policy challenges that confront Argentina, and how we are working with the authorities to address these challenges-so that Argentina can emerge as quickly as possible from the current crisis and lay the basis for returning to sustained growth.
You should be aware that, in helping develop such a program for Argentina, we have talked to a very wide range of people in Argentina and have also consulted with a number of experts from other countries. There can be no doubt of the commitment of the international community to help Argentina emerge from the current crisis, but this support needs to be for a program that is strong-and comprehensive-enough to regain the confidence of the Argentine people.
Progress was made in March and April in developing the major planks of a comprehensive economic program that could begin to rebuild confidence in this way. Our early contacts with the new economics team of Minister Lavagna encourage us that there will be continuity in our discussions, and that the new team will move quickly to consolidate and build upon the progress that was made in the previous months. Certainly, the 14-point plan put forward by the President and provincial governors recognizes the need for a comprehensive approach to dealing with Argentina's current situation. Now that plan needs to be developed into a consistent and sustainable program. To that end, the key steps that need to be taken include:
· First, restoring order to the banking system, the payments system, and the foreign exchange market. A sound macroeconomic policy framework is, of course, essential. It must be a central part of a comprehensive package to restore confidence in the banks.
· Second, amending the insolvency legislation and repealing the anti-subversion law, to provide a legal framework consistent with international standards. This is essential to get credit flowing again and to restore the confidence of domestic and foreign investors, without which it will be very difficult to revive investment and growth in Argentina. The Argentine authorities hope to have these important legal changes approved by Congress this week.
· Third, addressing the fiscal weaknesses that have been at the heart of Argentina's difficulties, and restoring a sound consolidated budget position over the medium term. Of course, we recognize that there are limits to the adjustment that can be achieved in the midst of a sharp contraction of the economy. And it is also important to strengthen the social safety net at this difficult time. Nevertheless, rebuilding confidence and laying the basis for medium-term growth will require an early start on key structural reforms that can pave the way to a sustainable fiscal position. It is in this context that we have emphasized the importance of including the provinces in the fiscal framework, and seeking an early end to the practice followed by some provinces of issuing paper that circulates as a substitute for money.
We look forward to working with Minister Lavagna and his team on the development of a strong program incorporating these elements. We have one technical team already in Buenos Aires and another ready to leave shortly. Assuming that adequate progress is made on the program, a full mission could then return to continue the negotiations. The situation clearly remains volatile and the risks are significant. So it is essential that the new economics team move quickly and decisively.
To conclude, notwithstanding the immense challenges facing Argentina, there is good reason to be optimistic. Recovery is under way in the north, with the south following not far behind. The policy challenge is to nurture and sustain that recovery. In the US and Canada, that means moving back to a more neutral monetary stance. In Latin America and the Caribbean, it means building credibility through continued fiscal and structural reform, thereby providing monetary policy with greater room for maneuver. Fiscal and structural reform are also key ingredients for strong and sustained growth in the longer term. Latin America has made impressive progress on these fronts over recent years, and further efforts would doubtless be rewarded.
This is certainly a challenging agenda. But it can be met and we at the IMF are ready to help in whatever way we can.