The U.S. Outlook and Implications for Latin America, Speech by Anoop Singh, Director, Western Hemisphere Department, IMF
May 29, 2008Speech by Anoop Singh
Director, Western Hemisphere Department
American Enterprise Institute,
May 29, 2008
1. It is a pleasure to talk to you today. My remarks will be mainly on the economic outlook for Latin America where growth has been holding up pretty well, despite the succession of shocks that have reverberated across the globe, especially in the United States. This is all the more welcome given the historical evidence that: (i) Latin America has had shorter-lived economic expansions and more volatile business cycles than others; (ii) external shocks have typically explained more than half of the region's growth variance; and (iii) domestic policies—mainly fiscal and monetary—have tended to amplify these shocks. Against this background, it is, therefore, all the more encouraging that Latin American economies are sustaining their current expansion. But let's first look more closely at the global context, particularly that of the United States, to see what it portends for the region.
I. The U.S. Outlook
2. At the heart of the global economic outlook is the downturn in the United States, where average 2008 growth is likely to fall to a low, but still positive level. I would like to summarize some of the underlying economic dynamics that are currently at work in the U.S. and offer our assessment as to why the recovery this time may be more gradual than the typical V-shape seen in the past. I'll go on to draw out the potential implications for Latin America.
3. The main difference now, relative to past downturns, lies in the nature of the shock—at its core, an exceptional nation-wide decline in house prices that has hit a heavily leveraged financial system, initially through the mortgage securities market. The resulting economic dynamic is likely to play out very differently from the typical rise and fall of investment and activity over the business cycle that we have seen before. In particular, not only may consumption be affected more markedly this time, but the process of adjustment could be much more protracted as housing and financial sector distress interact to produce negative feedback loops that exacerbate the initial shock.
4. How might this happen?
• First, falling house prices will, in the first instance, hit consumer spending by reducing wealth. But lower home prices have, and will continue to, accelerate foreclosures (as homeowners become reluctant to service loans worth more than the value of their properties) and delay home purchases (as buyers wait for better prices). Together, these forces will depress home values further, exacerbating the downward cycle, and prolonging eventual recovery.
• Second, the housing crisis is putting a significant strain on the core banking system, both directly through losses on housing related assets, and indirectly by forcing banks to take back onto their balance sheets the large volume of assets previously housed in lightly-capitalized conduits and specialized investment vehicles. Faced with less capital and more (and riskier) assets, at a time of heightened risk aversion, banks have reacted by raising new capital but also by rapidly tightening standards on new loans, despite the substantial monetary policy easing that has taken place. The contraction in credit that will likely follow will also press down demand—especially household spending—and, in time, risks feeding back into further loan losses as the economy slows. Again, this dynamic is a factor that will likely make for a gradual recovery.
5. We have been looking into the interaction of such dynamics between the real and financial sides of the US economy. One line of inquiry traces the impact of bank losses on tighter lending standards and its consequent effect on credit, final demand, and output, taking into account the second round effects on bank losses as loan performance deteriorates during the slowdown. We find that the combined impact on the financial sector could subtract 1-2 percent off of GDP, roughly the same order of magnitude found in parallel research on the impact of financial conditions on output. Moreover, the data suggest that this downdraft is not immediate but rather builds gradually over the course of a full year, indicating that we have probably yet to see its full effect play out.
6. The idea that macro-financial interactions from housing corrections could unleash pressures that will make for a gradual recovery is also consistent with both international experience and the U.S. experience with regional housing busts. This is understandable, since housing markets are not very flexible. Against this, we must weigh the fact that the U.S. economy is flexible and policymakers have reacted quickly to recent events. Our own forecast for the United States foresees a recovery that is somewhere between the standard U.S. V-shape and the housing-related U-shape typically seen in advanced economies with housing corrections. Needless to say, there is tremendous uncertainty around this forecast, and we are well aware of being in uncharted waters.
7. Clearly, recovery will be helped by a number of factors, most importantly, the strong and innovative actions taken by the monetary and fiscal authorities in the United States. In addition, U.S. corporations have entered this downturn with unusually strong balance sheets and U.S. labor markets remain exceptionally flexible. Equally importantly, banks have shown a surprising ability to face up to their losses and proactively raise capital from international investors. Reflecting these influences, many financial market indicators have pulled back from the peak stresses seen last March. All of this points to a relatively mild downturn compared to past recessions, with some upside potential.
8. Where are we today in the process of the adjustment of house prices, bank capital, and leverage? A key concern is that the housing price correction is not yet behind us; interbank markets, although improved from mid-March, remain stressed by historical standards; the deleveraging process continues; and the most recent Fed senior loan officer survey showed a further tightening in lending standards across most business and consumer sectors.
9. Perhaps most importantly, the negative feedback effects between the financial and real sectors risk now being supplemented by the recent sharp increases in global energy and commodity prices that could further depress consumer spending and aggregate demand, while simultaneously raising inflationary pressures that will, inevitably, constrain monetary policy options. In this situation, we could still see additional deterioration in credit quality beyond the subprime sector.
10. Indeed, inflation is increasingly becoming a concern. Headline CPI inflation has eased slightly in recent months but is still close to 4 percent on account of surging food and fuel prices. And, while core inflation has so far remained broadly under control, registering just over 2 percent most recently, evidence from bond markets suggests that inflation expectations are creeping upward. Recent FOMC minutes have taken an appropriately cautious tone, and markets now perceive the easing cycle to have ended.
11. Against the slowing of activity we expect in the U.S, we do see growth holding up well elsewhere in the world, especially in emerging Asia and in Europe. Growth in China and India, in particular, although expected to moderate from recent highs, should remain relatively robust. What then does all of this imply for Latin America?
II. The Impact on Latin America
12. A decade ago, we would have expected the headwinds blowing from the north to have serious repercussions on Latin America, given its longstanding vulnerability to external shocks, dependence on the United States, and policy frameworks that tended to amplify rather than dampen external shocks. However, in all these respects, the region has undergone important structural changes which have built resilience. The fact the region has witnessed relatively mild fallout from the shocks that have emanated from the U.S. is a clear testament to the progress that has been made.
13. On the financial markets side, direct linkages through housing-related assets or securitized vehicles in the region are minimal. There appears to have been no substantial exposure in the region's financial system to the complex, distressed credit products that have been at the center of the storm in global financial markets. This has been, in part, a result of good fortune and a less developed financial system but also due to the improved supervision and regulation framework in many countries of the region.
14. From a financial vulnerability perspective, the region is also protected by stronger fiscal and external positions than have been seen in a generation. Sovereign financing needs have declined substantially as fiscal positions and debt structures have improved. As a result, spreads on sovereign debt have risen by much less than could have been expected from historical experience and there are fewer concerns about fiscal sustainability. Risks are, however, probably higher for the corporate sector which has become more dependent on foreign financing of late, with corporate bond spreads higher than mid-2007, and access to markets somewhat curtailed.
15. As for direct trade linkages, our research indicates that much of the region has become far less dependent on U.S. demand than in the past, although Mexico and some Central American countries do still remain closely tied to the U.S. Correspondingly, Latin America's linkages with Asia have increased over the past decade. China, in particular, through its impact on commodity prices and as an important export destination in its own right, is a major factor for the region. While Latin America would certainly be significantly impacted by faltering growth in China—and Asia as a whole—and the concomitant effect on commodity prices, our forecasts shows the likelihood of such a slowdown is quite small. This is certainly good news for the region.
16. However, we are concerned that much of Latin America's recent export growth reflects a boom in commodity prices—more so than an expansion of export volumes. The flip side of this has been that the region's share of manufacturing in output has been crowded out and many economies have become highly dependent on hydrocarbons, minerals, and grains. A sudden or marked reversal of commodity prices—as we have seen during previous global slowdowns—would put substantial pressure on both fiscal and external deficits at a time that external financing would potentially be more difficult to obtain. This would amplify any regional downturn in economic growth.
17. In summary then, the financial shock to Latin America will probably continue to be relatively mild, and the downdraft from the United States is being offset, at least in part, by commodity prices and demand from China. Where then are the main challenges for policymakers?
18. My sense is that the most immediate challenge facing the region is from inflation. Of course, Latin America is not alone in this key respect. The external price shocks from energy and food have been a key channel driving prices quickly higher in emerging economies, especially where exchange rates have been less flexible. However, high domestic demand growth is also generally a major factor—in Latin America, not least because of the boost to real income from the improvement in the terms of trade in many countries and the impetus provided by capital inflows. Over the past year, inflation rates have reached double-digits in a number of countries, and, in others, inflation is now rising above the comfort level of the region's central banks. In this context, the burden on policy makers is to ensure that the initial impact of the supply shock on prices is contained and that macroeconomic policies successfully prevent higher inflation from becoming entrenched in expectations and wage demands.
19. In this, many central banks in the region are well advanced in containing inflationary pressures. In Brazil, for example, the central bank has acted early on forestall burgeoning price pressures, in large part stemming from the increased cost of food. Medium term inflation expectations have, as a consequence, remained anchored, a testament to the credibility of their monetary policy framework. Similarly, in Mexico, policy rates remain positive in real terms and monetary policy well directed at inflation converging back towards the central bank's target. Others, such as Chile, Uruguay, Peru and Colombia have all taken steps to rein in rising inflation and inflation expectations.
20. I would note, however, that this challenge of inflation raises not only monetary policy issues. As I have said, much of the current inflationary impulse emanates from higher prices of food and energy—i.e., commodities that absorb a large share of the spending of lower income households. Therefore, governments need to be proactive in recognizing the distributional impact of this particular type of inflation and should mitigate its effect through well-targeted social transfer programs. I do not believe such programs need to have a high fiscal cost to be effective—experience in Brazil and Mexico bears this out—but, if well designed, they can be an important tool to protect the poor from higher global food and fuel prices.
21. What else can be done for the region to preserve its recent record of macroeconomic stability and avoid amplifying the latest external shocks? A key concern is that credit growth in the region has been very rapid (averaging 25-35 percent in many countries), especially concentrated in consumer credit, and adding to already strong domestic demand. There are important mitigating factors to take into account. Credit is at a low level by international standards and there is some catch-up involved. Also, there have been important regulatory improvements in the region and banks have improved internal risk management systems and financed credit growth predominantly from domestic, rather than external, funding sources. Nevertheless, continued vigilance is required to avoid repeating the mistakes of past credit booms and to watch closely for falling credit standards and insufficient appreciation of, and provisioning for, risks.
22. Another concern is that public expenditure in many Latin American countries has grown rapidly during the recent economic expansion, further compounding demand pressures, and limiting the room for a countercyclical fiscal response if there were an economic slowdown. So far, expenditure growth has been accompanied by rising revenues, preventing a deterioration in the overall primary surplus, but unless the spending trends are checked primary fiscal surpluses in the region could begin to fall. Hence, my sense is that, in many countries, there needs to be greater conservatism in public spending growth. The priorities should be to protect the recent fiscal gains from a potential deterioration of global economic conditions, slow the growth in current expenditures, and have more efficient mechanisms for delivering infrastructure and social spending.
23. Let me now speak finally of a core medium term challenge for the region. It will be no surprise when I say that Latin America seriously lags behind in investment and productivity, which have not kept pace with other globalizing trends. To double per capita income over the next 20 years—not a very ambitious objective from the perspective of East Asia—Latin America will need to double its productivity performance and simultaneously increase aggregate investment by one third. The region is very far away from that goal. The average investment ratio in Latin America remains much lower than the developing country average, and about one third below that of East Asia. Perhaps more significantly, productivity growth since the early 1990s, although rising, has been one-third to one-half of other dynamic emerging market regions. Indeed, in many cases, the productivity gap between Latin America and other regions has widened in recent years.
24. More investment is particularly needed in industries that add value to the region's commodity exports, particularly those of food and mining. At the same time, investment will be vital to better exploit the region's significant comparative advantage in energy, a sector where investment and output in the major producers has been declining at a time of record world demand and prices. In this context, recent trends in Brazil and Columbia are encouraging and, in Mexico, President Calderon has sent an important energy reform bill to Congress.
25. In the drive for greater productivity, I am concerned that Latin America has a significant infrastructure gap relative to other regions, which has been a major constraint on competitiveness. Not just more spending on infrastructure is needed, including through innovative programs such as Private Public Partnerships, but also better spending is needed, with improved mechanisms for quality control and project prioritization. In addition to infrastructure, raising productivity will have to involve substantial progress in removing the region's relatively high regulatory, trade, and entry barriers to private investments.
26. Also, for productivity to improve, education is of fundamental importance. While educational levels in Latin America are comparable to other regions with similar per capita incomes, perceptions of educational quality lag. Education is key for long-term growth but also central, I believe, in mitigating the pervasive inequality that still affects the region. In an increasingly global economy, labor skills command a premium and there is a substantial risk that the discrepancy between unskilled and educated labor will widen considerably over time. As a result, improving educational opportunities and attainment will be essential to achieve greater productivity and meet basic social goals.
27. To sum up, I envisage some slowdown in regional growth this year and next, but the larger immediate policy challenge may now be from rising inflationary pressures which will need to be kept in check. However, our assessment is that the region's policy makers are focused on safeguarding the stability gains of recent years and that Latin America should be more resilient to the global shocks they are facing than they have been in past episodes of volatility.