Macroeconomic Situation and External Debt in Latin America

Remarks by Anne O. Krueger
First Deputy Managing Director, IMF
Conference on Debt Swaps for Education co-sponsored by the Secretaría General Iberoamericana and the Spanish Ministry of Economy and Finance
Madrid, Spain
February 1, 2006

Good morning. I'm pleased to be here in Madrid and to have the chance to share some thoughts about the economic outlook for Latin America and the Caribbean in the context of possible debt swap initiatives.

I think we are all agreed that education—the main impetus for today's gathering—can play a vital role in improving the lives of millions of citizens and raising an economy's growth potential. Experience has repeatedly shown that a better educated workforce will be a more productive—and fulfilled—workforce. In today's high-tech global economy, there is a greater emphasis on the acquisition of knowledge than ever before. The provision of education is therefore more important than ever before: and that means provision of the highest standards at every level, starting, of course, with primary education.

So it makes sense to explore options for financing the provision of education and I congratulate the Spanish government for taking the initiative in examining the scope for increasing the resources for education in Latin America, especially in the neediest countries.

One obvious way of freeing up resources for education is, of course, for governments to reduce public debt burdens and thus debt servicing costs: this would not only create more budgetary room for maneuver but it would also make possible higher rates of growth. In some countries, this means focusing on raising tax revenues as a share of GDP; in others, it is likely to mean more on refocusing public spending to priority areas. In many countries, there is substantial scope for reducing ill-targeted subsidies and allocating the savings to, for example, education. But those things take time and there are limits to what can be done. Debt swaps can also help free up resources and so contribute to increasing an economy's growth potential by reducing debt servicing costs.

I want this morning to put these discussions in context by examining the economic prospects for Latin America and the Caribbean over the short and longer term. I propose to do that in two ways. First, it is helpful to view the region's economic situation and prospects against the backdrop of the region's past economic performance: how we got to where we are sheds light on the outlook over the medium term. And second, I want to assess the economic outlook for Latin America and the Caribbean in the context of the global economy. Taken together these analyses enable us to gain a better appreciation of the opportunities—and challenges—that Latin American policymakers currently face and the role that debt swaps for education might play.

The historical context

Compared with the performance of many other emerging market economies, and especially those in Asia, growth performance in Latin America and the Caribbean has, over many decades, been more volatile and less successful. There were successes, of course. Brazil was one of the most rapidly growing economies in the world between 1948 and 1964. It experienced another growth spurt from 1968 to 1974, based largely on shifting to a more outward orientation, after it was recognized that growth potential under import substitution was largely exhausted. The Brazilian economy grew by 9.8 percent a year on average between 1970 and 1974. Mexico also grew rapidly—averaging 6.5 percent between 1960 and 1979 and more than 5 percent annually between 1996 and 2000.

But in general, periods of rapid growth in the region have tended to be followed by sharp slowdowns. For much of the 1980s, for example, Brazil grew by less than 1 percent a year. Mexico's growth rate also dropped sharply after 1981 until the mid-1990s. Significantly, both countries had reintroduced trade restrictions at about the time their growth performance deteriorated: Latin American countries have tended to be more closed to trade than rapidly-growing regions such as Asia. And for decades, inflation rates in most countries in Latin America were even more volatile than growth performance.

Such uneven economic performance had its roots in policies that have since been discredited. High tariffs and import substitution policies—along with heavily regulated labor markets, credit rationing, and other measures—helped stunt the development of countries rich in potential.

By the late 1980s and early 1990s, most Latin American countries had embarked on reforms intended to reverse the decades of disappointing performance. The aims of these reforms were laudable: to raise growth rates and deliver macroeconomic stability through more market-oriented policies. In most cases, though, implementation left something to be desired. Inflation remained high, thus undermining efforts to achieve stability. And other reforms were often abandoned prematurely, or implemented half-heartedly. From the mid-1990s, there was a series of financial crises—in Mexico in 1994-95, Brazil in 1999 and again in 2002, and Argentina in 2001-2 among others—that further undermined efforts to achieve stability in those countries. Significantly, countries cut back—of necessity—their public spending on growth-related activities, such as education, because debt burdens and fiscal stances left no room for counter-cyclical policies.

In consequence, Latin America's growth performance in the 1990s was yet again disappointing.

Average per capita income in the region grew by around 2.5 percent a year between 1991 and 1997—a significant improvement when compared with the contraction of per capita GDP of 0.1 percent in the 1980s. But the improvement was not sustained: GDP per capita fell by an average of 0.25 percent a year between 1998 and 2002.

One country stands out as an exception, of course: Chile, where reforms were first introduced in the mid 1970s. It weathered the downturn of 2001-2002 more successfully than many of its neighbors, as a result of the strong fiscal and other reforms it had implemented. On the fiscal front successive governments avoided pro-cyclical fiscal policies by running surpluses during periods of strong growth and since 2000 the government has been committed to achieving structural balance over the medium term. This has enabled governments to reduce the public debt to a little over 30 percent of GDP. Monetary policy has delivered low inflation—which averaged less than 5 percent in the ten years to 2004.

Trade liberalization was an integral part of Chile's reforms. Tariffs in Chile have been progressively lowered over the years, to the current level of 6 percent uniform across all commodities. (The actual figure is lower, because of Free Trade Agreements that Chile has with several countries.) Chile is one of the most open economies in the region and has one of the most diversified export structures. [More recently, Mexico, too, has benefited from major tariff reductions and, of course, NAFTA.]

Since the late 1980s, Chile has experienced strong, crisis-free growth and at a much higher average rate of GDP growth than its neighbors.

Recent reforms

More recently, reforms have been at least partially introduced in many Latin American countries and there has, as a result, been a significant improvement in economic performance. Sustained efforts to reduce inflation have met with considerable success.

In the decade to 1996, the annual average rate of inflation for the region as a whole was more than 180 percent. Last year that average was down to 6.3 percent and we expect a further fall, to 5.4 percent this year. 21 countries of 33 emerging market economies in the Western Hemisphere region are expected to have inflation rates below 5 percent this year. Some of the countries with relatively high inflation rates have nevertheless been making substantial progress: the inflation rate in Uruguay this year is expected to be less than a third of the rate in 2003, and the same is true of Brazil, where the year on year inflation rate was below 6 percent at the end of last year. Only two countries in the region are likely to have double digit inflation rates in 2006.

Other reforms have contributed to a more stable macroeconomic environment. In many countries fiscal reforms have been introduced, and a start has been made on reducing budget deficits and public debt to GDP ratios. Exchange rate regimes have been made far more flexible, helping to make economies less vulnerable to shocks. Several countries have also embarked on structural reforms that should make economies more flexible, raise their growth potential and make them more resilient.

Brazil offers one of the best recent examples of the transformation that is under way. As you know, Brazil experienced a major crisis in early 1999 when the government abandoned its fixed exchange rate regime and introduce wide-ranging reforms. Yet by the middle of 2002, Brazil was widely seen as being on the brink of another crisis, brought about not by policy changes but by speculation about the anticipated economic policy changes that might follow the 2002 presidential election. There was concern that a new President might not follow the prudent macroeconomic policies that had helped the Brazilian economy recover from aftermath of the 1999 crisis. Electoral uncertainty led to concerns in particular about the sustainability of Brazil's large public debt.

A Fund-supported program was agreed during this pre-election period, committing all contending governments to maintenance of the existing fiscal and monetary framework, along with a longer term program of structural reforms. All three major Presidential candidates undertook to maintain the existing policy framework should they be elected. In the context of that commitment and the Fund program, the financial markets were rapidly reassured.

The result has been a remarkable transformation in Brazil's economic fortunes. The floating exchange rate regime, which had already been introduced, has undoubtedly helped smooth the adjustment process. And prudent fiscal policies—including a primary surplus of 4.6 percent of GDP in 2004, and an estimated surplus of 4.75 in 2005, and a projected 4.25 percent this year—have paved the way for more rapid growth and falling inflation. Growth has accelerated while inflation has fallen. Interest rates have been lowered and are now below the levels prevailing before the market turbulence of 2002.

Brazil's external financing requirements have fallen sharply, and the debt position has improved markedly. Debt as a percentage of exports is already well below mid-1990s levels: in 1995, debt was more than 300 percent of exports; it is estimated to have been around 125 percent by the end of 2005. And the risk premium on Brazil's bonds has fallen sharply—the spread is currently around 265 basis points over US Treasuries, compared with a spread of around 2400 points at the height of the trouble in 2002.

And, important in the context of today's gathering, the significant improvement in the macroeconomic picture has resulted in a marked rise in Brazilian living standards and significant reductions in poverty: between 2001 and 2004 the number of Brazilians living on less than a dollar a day fell by four and a half million.

Brazil is not an isolated example. Economic reforms have led to improved performance in countries across the region. Colombia, Mexico and Peru, as well as Brazil and Chile, have all introduced inflation targeting in recent years, for example. These same countries have also increased reduced their exposure to foreign-currency denominated debt and increased their reliance on debt issuance in domestic currencies.

A global expansion

Where reforms have been undertaken, the benefits have been enhanced by an expanding world economy. In 2004, global growth, at 5.1 percent was the strongest in thirty years. Growth last year, though more moderate, was around 4.5 percent and we expect similar strong growth this year. The remarkable expansion we have seen in the past couple of years has been worldwide with almost every region of the world experiencing buoyant growth—including Latin America.

The United States continues to be a major driving force for global growth. Real GDP grew by more than 4.2 percent 2004, an estimated 3.6 percent in 2005 and currently seems set to grow by only slightly less, around 3 and a quarter percent, this year. The buoyancy of the US economy has helped fuel growth in other regions. The pace of growth in emerging Asia, especially but not only in China and India, has also contributed to strong global performance in the past few years and this, too, looks set to continue, with growth in emerging market Asia forecast to exceed 7 percent this year. Many of the transition economies of Central and Eastern Europe have continued to grow rapidly, significantly more rapidly indeed than their Western European neighbors.

As we enter the New Year, there is also welcome news in those parts of the world where growth has been persistently sluggish. The Japanese economy appears better poised for a strong recovery than for many years, with deflation almost squeezed out of the system, and more buoyant consumer demand. And in the Euro area, there are signs that in some countries, at least, growth may be picking up, albeit slowly.

There are many reasons for the global expansion. A major one is the reduction in inflation rates worldwide. Over a long period high inflation inflicted great harm on many countries in Latin America and, indeed, in other parts of the world. But in recent years we have seen an extraordinary worldwide decline in inflation rates: not only in Latin America but also in Africa, Asia and the industrial countries. This has been a significant factor in the healthier rates of growth in those regions.

The low inflation environment has contributed significantly to the buoyancy of the global economy. The recent expansion has, after all, taken place against a backdrop which might have been expected to hamper global growth. Continuing geopolitical uncertainty, a sharp rise in oil prices, worries about the prospects for the Doha trade round and continuing concern about global imbalances: thus far, the collective impact of these concerns has been significantly less than many had predicted.

The buoyancy of the global economy, coupled with the economic reforms that have been introduced, has clearly benefited the Latin American region and has helped fuel export growth. Brazil grew by nearly 5 percent in 2004, and around 2.6 percent last year; it is expected to grow by about 3.5 percent this year. The Mexican economy expanded by 4.4 percent in 2004, 3 percent last year and we expect growth of about 3.5 percent this year. Chile's performance has been even more impressive: growth of 6.1 percent in 2004, 5.9 percent last year and, we expect, only a slightly lower rate of growth this year.

We are currently predicting growth at 3.5 percent or more in 20 countries in Latin America and the Caribbean—out of a total of 33—this year.

Global risks

So the current outlook, both at the global and at the regional level, is good. But there are nevertheless some important downside risks to which all policymakers, including those in Latin America, need to be ready to respond.

High oil prices are clearly at or close to the top of the list. So far, the rise in prices has been satisfactorily absorbed in most countries. This is partly a reflection of the fact that unlike the price rises of the 1970s the current increases have been demand rather than supply driven; and partly it reflects the fact that policymakers have taken to heart the lessons of the 1970s and have generally avoided making policy accommodative.

Of course, several Latin American and Caribbean countries—Argentina, Bolivia, Colombia, Ecuador, Trinidad and Tobago, and Venezuela—are energy exporters and are therefore beneficiaries of higher energy prices. The challenge for them is to ensure that the windfall gains are used in a way that improves their long-term growth prospects.

Global imbalances continue to pose a risk to continuing global growth. The current account deficit of the United States, now in excess of 6 percent of GDP, continues to increase and so fuel concerns about sustainability. But the payments imbalances are part of a wider problem of imbalances in the world economy, with rapidly rising reserves in Asia, and sluggish growth in Europe and Japan.

The main risk posed by these global imbalances is a disorderly resolution of the problem, for example, if holders of US assets become reluctant to increase their holdings or decide to liquidate them. We in the Fund continue to judge the risk of this happening to be relatively low in the short-term. But it is not zero, and the consequences could be severe: an abrupt adjustment of exchange rates and US interest rates, with obvious implications for emerging market debt, for example. Rapidly tightening financial markets for any reason would cause similar problems, and particularly for emerging market debtors.

Finally, there is the risk to global growth that a rise in protectionism would pose. The Hong Kong Ministerial meeting of the WTO is still much in all our minds, of course. But we tend to attach too little significance to the damage that would be inflicted, either by a failure to reach an agreement in the Doha round negotiations or, more likely, by a disappointingly unambitious round. This is not to say that a setback for the Doha round would plunge the world into recession. But there is a risk that protectionism—never far from the surface—would gain ground with the result that the growth of world trade would slow. History has consistently taught us that the expansion of world trade fuels the growth of the world economy. Slower world trade growth, resulting from increased levels of protectionism, would inevitably lead to slower global GDP growth.

The challenges for Latin America

The risks I've outlined should give Latin American policymakers particular cause for reflection. As I noted, reforms are now being implemented in many parts of the region. But relatively poor performance over many years that I described earlier means that in Latin America macroeconomic stability is still more fragile, public debt burdens higher, and structural weaknesses greater than in many other emerging market countries.

In most countries in Latin America and the Caribbean there is still a long way to go before governments can use counter-cyclical fiscal policy. That change would enable smaller reductions in GDP, and therefore smaller reductions in public expenditure, including on education, during periods of slow world growth and thus contribute significantly to a higher growth rate.

But getting to that position requires fiscal consolidation because debt ratios remain high: both when compared with, for example, the early 1990s and when compared with what we believe is sustainable for emerging market economies. In Latin America as a whole, public debt as a percentage of GDP is still higher than at the end of 2001 and around 10 percentage points higher than in 1997. A rule of thumb suggests that debt levels in excess of 40 percent of GDP are unlikely to be sustainable over the medium term, leaving countries uncomfortably exposed to interest rate rises. Debt levels that are higher are likely to retard growth, as well as diverting resources from growth-enhancing investments, including education, towards debt servicing costs. And they mean that in the event of a global downturn, governments will have little or no room for counter-cyclical fiscal policies: indeed, they may be obliged to run pro-cyclical fiscal policies.

So to achieve a position from which counter-cyclical fiscal policy can operate, there is a need to reduce debt to manageable levels over the medium term and thus enable built-in stabilizers to offset part of the impact of shocks. I mentioned Brazil's efforts to reduce its debt burden by maintaining a high primary surplus, and by restructuring its debt, both in terms of its maturity structure and its foreign currency exposure. Several other countries have similarly been seeking to reduce their debt burdens. Indeed, between 2003 and 2005, the average primary surplus in Latin America was 3.25 percent—double the average of the previous decade and marking a better performance than in most other emerging markets. But that only brought average debt to GDP ratios down from 65.5 percent of GDP in 2003 to 52.3 percent in 2005, still above the level of a decade earlier.

Although as I noted earlier Brazil has made great strides in reducing its debt to GDP ratio from more than 65 percent in 2002: it is a little over 50 percent. Similarly, Mexico has reduced its debt to GDP ratio by about 10 percentage points from the levels of the late 1990s: but the ratio is still around 45 percent. Colombia's debt to GDP ratio is on a declining path: but at around 50 percent of GDP it is still close to double the level of a decade ago. Bolivia and Uruguay both have debt ratios of around 70 percent of GDP.

In some Central American and Caribbean countries, debt to GDP remains at uncomfortably high levels. Jamaica, for example, has public debt close to 140 percent of GDP; and Panama's debt to GDP ratio is still above 70 percent as of 2004, the latest year for which we have figures.

It is because Latin American countries still have much to do to be able better to withstand the impact of shocks and global slowdowns that the downside risks to the current global outlook are so important for them. They have no time to lose: they need to press on with reforms now.

If the current expansion were to soften sooner rather than later, most countries in the region would therefore not be in a position to operate counter-cyclical fiscal policies. Relatively high debt to GDP ratios would also make them more vulnerable to shocks such as rising global interest rates which would increase the debt servicing burden and further squeeze government budgets and expenditure on education and other growth-promoting investments. Growth would be slower than if reforms had been undertaken. Slower growth in output would hamper poverty reduction efforts and many citizens would experience more slowly rising living standards than they have recently enjoyed, or no rise at all.

Experience has also shown that those countries with inwardly-oriented policies would be the most adversely affected: growth in outwardly-oriented economies is less severely affected by slower global growth. [And structural reforms that make economies more flexible and so raise long-term growth potential will also make them more resilient against shocks.]

So while the short-term global outlook remains favorable for the region, those governments that have embarked on reforms have the opportunity to make significant further progress on several fronts with a view both to raising growth potential over the medium and longer term; and to reducing further the exposure to short-term risks. Those governments where reforms have yet to be implemented on any significant scale can still take advantage of the favorable global environment to make a start.

Pressing ahead with fiscal consolidation is therefore vital. In many countries there is scope, through reform in the tax and public expenditure systems, both to increase revenues without increasing tax rates and to reduce expenditure without removing vital support for the poorest citizens in society.

On the tax side, for instance, the elimination of exemptions and distortions and an emphasis on the uniformity of treatment can deliver higher revenues, as can more efficient collection systems. Such reforms can also help reduce the incentive for citizens to opt out of the formal economy. On the expenditure side, many spending programs are indiscriminate and often only a small fraction goes to the poor. Better targeted spending programs, more efficiently administered, can bring significant budgetary savings while doing more to help the poor. There is also scope to increase the efficiency of expenditures.

The choice of policies on which to focus depends on individual circumstances, of course. Brazil, Colombia and Barbados, for example, are three countries where the tax to GDP ratio is already high and the thrust of consolidation efforts should probably be on the side of spending. However, even in these countries tax reform and efforts to improve tax administration are still important to reduce inefficiencies and provide room to lower rates or eliminate very inefficient taxes like financial intermediation taxes.

In contrast, Mexico, the Dominican Republic, Haiti, El Salvador and Costa Rica are all countries where the tax revenue to GDP ratio is low. Here there is scope for increasing the efficiency of tax collections to achieve further fiscal consolidation and to meet social and infrastructure needs. Guatemala and Peru are countries where the revenue ratio is low, but where the fiscal deficit is already low, thus making it possible to use most of the additional resources from high revenue collection to finance increased spending.

Structural reforms are also needed to raise medium and long term growth potential. These include reforms to make labor markets more flexible; to create a more business-friendly environment by cutting red tape and encouraging enterprise; and to strengthen property rights and contract enforcement. In Argentina and Bolivia those planning to start a new business have to go through 15 procedures: in Brazil and Paraguay they have to go through 17. According to the World Bank publication "Doing Business 2006, that makes these countries among the most difficult in the world in terms of start-up procedures. Australia and Canada, by contrast, require only 2 procedures. In Guatemala it takes 1, 459 days to enforce a contract—compared with only 48 days in the Netherlands.

Reforms in some areas can be carried out relatively quickly, but many can only be done over the medium term, of course. This, though, is an argument for early action rather than delay: structural reforms are always more easily achieved during periods of expansion.

Short-term fiscal consolidation, however, can bring rapid benefits in terms of lowering inflation and raising growth rates. We've seen this in Brazil. We have also seen it in countries outside the region as, for example, in Turkey, where in only a short time a high primary surplus has been maintained, inflation has been dramatically lowered and growth has been remarkable.

Pressing on with fiscal reforms will also help further reduce debt to GDP ratios and so improve the debt sustainability position. Continuing to lengthen the maturity of debt and reduce the foreign currency element will further reduce the risks from exposure to short-term interest rates movements and foreign currency fluctuations.

Reforms that reduce debt to GDP ratios, budgetary reforms that improve the efficiency of expenditure and reduce or eliminate badly-targeted subsidies: these will all enable governments to focus on policy measures like improving education that will contribute greatly to accelerated growth that can be sustained over a prolonged period. Debt swaps for education could contribute to this. Structural reforms that raise the long-term growth potential of the economy are vital if a lasting reduction in poverty is to be achieved. We all regard this as a high priority for Latin America.

The IMF's role

The IMF is supporting countries in Latin America and the Caribbean in pursing policies that will ensure they are well-placed to accelerate growth rates; to benefit from the current economic expansion; and to reduce their vulnerability to shocks. Our principal mandate is helping our members to achieve macroeconomic stability and, in turn, sustainable growth. I've already noted the very significant progress that many countries in the region have made in this regard. Sharp declines in inflation rates have certainly laid the foundations for stronger GDP growth in the context of the current global expansion. Fiscal consolidation has improved macroeconomic performance and has helped many countries make a significant start in reducing debt levels and improving the composition of remaining debt.

The Fund is supporting reforms in these areas, through our Article IV consultations, technical assistance and, where appropriate, financial support. Our unique cross-country perspective informs our surveillance work. In discussions with our member countries we use this cross-country experience to highlight those policies that have proven themselves to be effective, as well as those that experience has shown are unlikely to deliver the long-run macroeconomic stability and growth we all want to see.

As you know, calls on Fund financial support are currently lower in the region than for many years—itself a reflection of the progress made in so many countries. We want to keep it that way, which is why our work on crisis prevention is so important and why it has been strengthened in recent years

To be sure, there have been earlier periods of rapid global growth where calls upon Fund resources have been greatly reduced. But the reforms being undertaken give hope that, when global growth slows, Latin America will be less negatively affected than previously. But this is why it is so important for countries in the region to take the opportunities afforded by the current conjuncture to press ahead with reforms aimed at further reducing their debt vulnerabilities.


Let me briefly sum up.

The global outlook remains buoyant. The short-term outlook for Latin America is correspondingly bright, with the prospect of further strong growth in the coming year. This makes it a good time to continue reforms.

The progress made in the region in recent years is remarkable—and it thus all the more important, and urgent, to consolidate that progress. Bringing down debt relative to GDP and improving its structure can help reduce vulnerabilities and further strengthen economies. Debt swaps can play an important part in further reducing vulnerabilities: and debt swaps for education, by offering the prospect of a long-term improvement in the quality of the workforce, can also contribute directly to the structural change needed to raise growth potential.

It is much easier to pursue such reforms during the current upswing than at a time of slowing growth: governments—in Latin America and elsewhere—therefore have an opportunity to make substantial progress. But it is a time sensitive opportunity.

As governments in the region know only too well, credibility in economic policy is hard won. It takes years of effort to acquire. It can be lost much more quickly: hence the need to reduce the risk of that happening as far as possible.

Thank you.


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