Latin America: Building on Recent Trends and Sustaining Rising ProsperityAnoop Singh, Director, Western Hemisphere Department, IMF, Catholic University, La Paz, Bolivia
May 10, 2007
It is a privilege to be at the Catholic University, a premier institution of learning in Latin America, and one that has spread its roots across the country. This university has played a critical role in Bolivia's modern history, and I see many friends today who have played such a prominent role in enhancing human capital and public policy in Bolivia. I am going to talk to you today on Latin America's current favorable economic context and outlook and my optimism on how the region can do even better to build rising prosperity for all its citizens.
II. Current Context and Outlook
As we all know, 2006 was an excellent year for Latin America and the Caribbean. Output grew at an average rate of 5½ percent. About a third of the countries in the region experienced growth rates of 7 percent or higher, with several countries growing at their fastest pace in many years. Indeed, the 2004-2006 period is now on record as the most vigorous three years of activity in the region since the 1970s, with growth averaging about 5¼ percent a year. In contrast with previous expansionary periods, inflation has remained under control—trending steadily down on average—and critical unemployment, poverty, and social indicators have also shown improvement. In particular, inequality has finally come down, compared to the late 1990s, in 11 out of 14 Latin American countries for which data is available. In 2007, we expect growth to slow a bit, but to still remain high by historical averages for the region. This background is presented in our most recent Regional Economic Outlook, copies of which are available here today.
Bolivia has shared in most of the region's economic and social improvements. Bolivia's GDP growth has picked up from just 2.7 percent in 2003 to over 4½ percent in 2006, with indications that it should remain close to this rate in 2007. Although inflation has picked up slightly over the past few months, the financial sector has been stable, and the macroeconomic policy mix has managed the large export windfalls from hydrocarbons and mining. And poverty, while remaining high, has shown a declining trend in this period.
Against this generally favorable background, in Bolivia as much as in the rest of the region, attention has turned to the prospects for sustaining into the medium term the recent expansion. There have been mixed views on these prospects. Some observers have remarked that the present conditions are "too good to last," implying presumably that the present expansion will soon be interrupted. Other observers have said about the recent expansion in the region that "it is as good as it gets," implying that the region's potential over the medium term is limited to the growth rates already achieved. I will examine both these propositions today.
III. "Too Good to Last?"
Is the current expansion in the region destined for early interruption? Let's look briefly at the history. Indeed, a striking fact of Latin America's economic history is the frequency and regularity with which growth, once underway, has suffered setbacks. Rather than taking the form of a smooth, sustained "hill" (Pritchett, 2000), expansions have often been short-lived, ending with crises or prolonged periods of stagnation. Latin American business cycles have tended to be more volatile than those of advanced countries and developing countries outside the region (Aiolfi, Catão, and Timmerman, 2006). Large output drops have happened more frequently than in any other region except for Africa (Becker and Mauro, 2006). Long-run growth spells—that is, sustained periods of growth, with only transitory interruptions—have tended to be rarer than in other regions (Berg, Ostry and Zettelmeyer, 2007).
Why has this been the case? What lessons can be drawn from this history and compared with the current context in the region?
Two main reasons stand out to explain Latin America's vulnerability to early interruptions of its economic expansions. First, is the region's macroeconomic volatility. Second, external shocks to which the region has been perhaps more prone, and certainly less resilient, than others. My sense is that fiscal weakness has been common to both, and has interacted with the region's generally weaker institutions and higher inequalities to accentuate this vulnerability—through procyclical or overly expansionary policies and unsustainable spending demands. Hence, reducing vulnerabilities also requires addressing inequity and improving social conditions, in ways that are fiscally sustainable.
Macroeconomic volatility in Latin America has been manifested in bouts of financial instability (Singh, 2006; Singh and Cerisola, 2006). High and volatile inflation has been a recurrent phenomenon, along with other forms of financial turbulence, and the frequency of debt restructurings has been high. A legacy of such macroeconomic volatility has been the region's generally high level of financial dollarization, such as the one we see in Bolivia. Although many factors have been at play in explaining this volatility, our recent research focuses on fiscal policy as a key contributor to the region's record of stop-go growth. Indeed, Latin America's fiscal volatility over the period 1960-2000 has generally been higher than other regions, with excessive public spending being the root cause of recurrent lapses into fiscal imbalances.
Let's now look briefly at the role that external shocks have played in the region's history of macroeconomic volatility. For example, it is well known that the region has been relatively more dependent on the international commodity price cycle—both fuel and non-fuel. However, it also seems to be the case that the region has been less resilient in resisting these shocks; in Bolivia, recent research shows that terms of trade shocks have been very significant in explaining longer-run macroeconomic volatility. Again, fiscal weakness appears to be a root cause of this low resilience. Typically, improvements in Latin American fiscal positions have depended on the commodity cycle and have mainly been revenue driven. External shocks that involved downturns in the commodity cycle directly weakened fiscal positions because of the rigidities in budgets and the lack of flexibility in adjusting to revenue downturns.
Against this background, what are the prospects for sustaining Latin America's current expansion?
My sense is that the current situation in Latin America is greatly improved. With the region entering its fifth year of expansion, fiscal and external balances remain in surplus, and several traditional sources of macroeconomic volatility—particularly the debt structure, exchange rate, and the financial sector—have been reduced. We certainly see this in Bolivia's recent fiscal and external surpluses. Furthermore, helped by improvements in the fiscal position, as well as debt relief under the MDRI, Bolivia's public debt has declined markedly from 70 percent of GDP to less than 40 percent of GDP just in the last 2-3 years, and has been significantly de-dollarized. In the financial sector, although dollarization remains high, net foreign asset coverage of deposits has risen to over 100 percent. Therefore, from this perspective we can be more optimistic that the present expansion can be sustained longer than during previous cycles.
How does the region look in terms of its vulnerability to shocks? Here too, there are grounds for optimism. Over the past year, countries in the region have been able to protect macroeconomic stability from the cycle of elections. Indeed, inflation trended down further last year, demonstrating the wider political consensus that now exists in the region on preserving the inflation gains of the last decade. Similarly, stress tests show that Latin American growth appears to be more resilient to external shocks, for example moderate deteriorations in the external environment, such as a mid-cycle slowdown in the United States, a decline in commodity prices of the order of 20 percent, or a tightening of emerging market financing that is not coupled with slower world growth. However, the region may remain sensitive to a number of more adverse (albeit low-probability) external scenarios. These include sharply tighter financing conditions, particularly when combined with slower world growth, or a large and rapid drop in commodity prices, which in turn would have consequences for capital flows to the region (see Österholm and Zettelmeyer, 2007, for details) .
Although the combination of events that could bring about such a major decline in 2007 or 2008 is quite unlikely, governments in the region recognize that these risks need to be taken seriously, as well as the need to reduce vulnerabilities to such shocks. This means maintaining a strong fiscal position to further reduce public debt, making budgets and exchange rates more flexible, strengthening financial systems, and diversifying exports, which continue to be based heavily on commodities in many countries.
IV. "As good as it gets?"
Is the recent expansion as good as it gets? Or can the region do better? I believe that the answer to the last question needs to be a "yes". The region can do better, but it will require improving the economic fundamentals of saving, investment, and productivity.
The region certainly needs to do even better. This is because, despite the recent acceleration, the region's economic growth continues to lag much of the world. In 2006, for example, growth in other developing countries was about 8½ percent, about 3 percentage points higher than in the region; over the last three years, Latin America has trailed by a similar margin. Thus, while the region may be closing some of the gap with industrial countries, it still lags other, more dynamic areas of the world, including many countries that have not directly benefited from the commodities boom in the way that Latin America has benefited. And, while poverty and inequality appear to have been falling in recent years, both remain too high to be acceptable.
What are the main imperatives for the region, not only to sustain the recent expansion, but to reduce the growth-gap with other developing country regions? In our recent Regional Economic Outlook, we focus on the region's relatively weak record of investment and productivity as the main explanatory factors. As a share of GDP, investment in Latin America has remained significantly lower than the developing country average. Even more important has been the low growth in total factor productivity (TFP). Although TFP growth picked up in the early 1990s, and grew by about 0.8 percent per year since then, this was still a full percentage point below the weighed average for other developing countries, and even more distant from China's performance in this period. Among the largest Latin American countries, Chile is the only country that has significantly overperformed relative to the average for the other developing countries (excluding China) since 1990 (2½ percent). Moreover, the gap with other regions, if anything, seems to have increased in recent years.
Even during the current expansion, the performance of productivity and investment has not been especially noteworthy. Investment in the region still averages only 20 percent of GDP, which is no higher than its peak in earlier expansions. Productivity growth has also been only slightly better than in previous expansions, despite the sharp improvement in the terms of trade enjoyed by the region, and seems to reflect just cyclical factors
What would Latin America have to do to grow as fast as other developing regions? It is inescapable that achieving significant increases in per capita incomes will require higher investment and, more importantly, substantial improvements in TFP growth.
To illustrate the challenges facing LAC countries, we have looked at different scenarios in which per capita real incomes double over the next 20 years through different combinations of TFP growth and investment. These scenarios require considerably higher investment and TFP growth rates than seen in the region in the past. Even with a doubling of productivity growth over the rate achieved since 1990, the region's investment rate would need to rise significantly from current levels to an average of 24 ½ percent of GDP. In contrast, if investment and TFP growth stayed at the 2001-06 regional average during the next 20 years, average per capita income would increase by only around 50 percent.
These scenarios are only indicative of the many possible combinations that could raise per capita income over the long run. However, they underscore the importance of policies that foster both higher and more productive investment and a more efficient use of resources. In practice, there is a two-way, positive association between high rates of investment and productivity growth.
The question of what policy measures could raise productivity, growth, and employment in Latin America has attracted an intense policy debate in recent years (see Zettelmeyer, 2006, for a survey; and Calvo, 2006, IMF, 2005, Mercado et al, 2005, World Bank, 2005, and Kaufman, Mastruzzi, and Zavaleta, 2003, for recent papers focused on Bolivia). Although this is a subject that is best debated domestically by each country, depending upon its individual circumstances, the recent Latin American experience suggests that there are policy elements of critical importance, in particular combining macroeconomic stability and effective distributional policies with a stable business environment that is conducive to higher private investment, respects property rights, promotes greater competition, and leads to a deepening of the financial system.
V. Addressing Distributional Concerns in the Region
I have highlighted effective distributional policies as being among the critical elements to enhance the region's growth performance. Indeed, one of the key messages that I want to send today is that policies that address distributional concerns in the region are key both to fostering and—especially—sustaining higher growth. In our Regional Economic Outlook, we discuss how improving education and reducing labor market rigidities could raise employment and growth. These reforms would, in turn, have beneficial effects on equity (in the case of labor market reforms, by reducing the earning gap in the formal and informal sectors, for example). And greater equity and more equal opportunity would in turn reduce the pressures that are often the root cause of unsustainable macroeconomic policies and crises. How can this be done, given that income inequality is still high in the region, and many social needs are unmet?
Sacrificing macroeconomic stability is not part of the solution. Rather, history instructs that it has been part of the problem. I do believe there is a strong consensus in the region on this point. Indeed, the region's history of boom and bust—often exacerbated by procyclical government spending—has resulted in macroeconomic crises that impose harsh burdens on the poor. It is not a coincidence that poverty rates and income inequality have declined in recent years as macroeconomic stability has become better entrenched.
In spite of this encouraging progress, there is no doubt that more can be done to reduce inequality while maintaining strong fiscal positions. For example, there is significant scope to improve equity in the region within the existing envelope of public spending. About half of public spending in Latin America is for the social sectors, and at 13 percent of GDP, is not an insignificant sum. However, a large share of social outlays, such as those for public pensions, and fuel subsidies, to take just two examples, primarily benefit upper-income groups. At the same time, in some countries spending that is highly beneficial to the poor, such as targeted social assistance programs, is very low, and there is room to build on the targeted conditional cash transfer programs that have proved highly cost-effective in a number of countries. In a similar vein, tax exemptions that benefit upper income groups also deprive the state of resources that could be used for well-targeted social programs. And, reforms that introduce competition can help reduce the rents enjoyed by vested interests and contribute to greater equity (Clements, Faircloth, and Verhoeven, 2007).
Reforming social expenditures and tax systems, as in the industrial countries, poses political challenges, but will be essential for strengthening equity while maintaining macroeconomic stability. However, it is during a time of benign conditions that reforms should be considered and implemented, as the room for maneuver is higher, raising the likelihood of success.
VI. Concluding Remarks
These are historical times for Bolivia and I feel privileged for the opportunity to observe these developments closely. The country faces today both opportunities and challenges—the opportunity of taking advantage of vast natural resources; and the challenge of managing those resources efficiently to promote growth, employment, and social inclusion. Bolivia is well placed to address these challenges. The macroeconomic context is relatively strong, the external conditions favorable, and debt relief has helped significantly reduce the constraints from this source. Bolivian policy makers have incorporated many lessons from the country's history—in particular the importance of economic stability as a necessary condition for progress towards those broader objectives. While ownership of a home-grown strategy for the future is of paramount importance, lessons and experiences from other countries and regions that have made this transformation may also be extremely useful for Bolivia at this time. In particular, attracting new and highly productive investments from the public and private sectors should be one of the highest policy priorities for the coming years.
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