Latin America in an Uneven Global Recovery: Managing Abundance
January 24, 2011III Forum économique International Amérique Latine et Caraïbes
by John Lipsky, First Deputy Managing Director, International Monetary Fund
Paris, January 24, 2011
As prepared for delivery
Good afternoon. It is an honor and a pleasure to be here today, and to have the opportunity to attend this interesting conference and to address this distinguished audience.
It is a particular pleasure to take part in such a high-level examination of Latin America’s economic and financial performance and prospects at such an auspicious moment. As we have heard already today—in abundant and encouraging detail—Latin America’s future is bright. With external conditions favorable and activity expanding at a solid pace, the region is enjoying an exceptional moment of abundance. In particular, the enabling confluence of high commodity prices and easy external financing conditions are helping to power a surge in both consumption and investment growth.
Of course, these favorable forces also are adding complexity to the challenges of economic policy management. After all, it is not unprecedented for good times to end painfully. Thus, the current abundance offers positive prospects, but no justification for complacency.
Taking as a starting point the current combination of abundance and challenge, I would like to discuss the principal trends in the global economy and how they are affecting Latin America, as well as touching upon the region’s role in the necessary and crucial process of global economic rebalancing.
Given the focus of my remarks today, I will not address the specific and special issues and challenges faced by many Caribbean countries. The Fund is closely engaged with members in this region, however. In fact, we are co-hosting―with our Caribbean partners―a two-day conference and open Town Hall meeting next week in Barbados that will analyze in detail that area’s policy challenges.
Latin America Context
As we all know, most Latin American countries weathered the Great Recession of 2008/2009 well, both in comparison to other regions and to the past. The region did not experience the large-scale banking or balance of payments crises that had besieged it in previous periods of global strain. Owing to earlier efforts that had strengthened policy frameworks, accumulated foreign reserve buffers and raised public savings, potential vulnerabilities had been reduced, and the region’s economies had become more resilient.
The strengthening of economic policy frameworks that had taken place in many countries included in many cases the adoption of inflation targeting and more flexible exchange rate regimes, together with the establishment and implementation of fiscal or debt sustainability rules. In these countries, the authorities were in a position to implement effective counter-cyclical policies in order to the resist the global crisis, despite facing exceptionally large external shocks. Domestic financial systems also had become much more resilient, in part owing to expanded and better quality capital and liquidity cushions, to a systematic upgrading of regulatory and supervisory frameworks, and to better risk management.
Of particular importance, the backdrop of macroeconomic stability over the past decade helped many South American countries to register notable progress in social and human welfare indicators. Successfully preventing major output losses during the global crisis helped to ensure that pre-crisis improvements in living standards and reductions in income inequality have been preserved. This stands in marked contrast to the past, when such gains often were reversed by recessions or crises.
One of the most important lessons to be drawn from the Great Recession isn’t a bit new, however. It is that the moment to strengthen the policy foundations that will make the difference in avoiding and/or weathering future strains is precisely during periods of relative abundance and solid growth. As I suspect that you all realize, the crucial time for sustaining and extending the current cycle of reform and progress is right now.
The Global Outlook and Challenges for Latin AmericaThe latest update to the Fund’s global forecast, which will be released tomorrow, indicates that 2011 global growth is expected to be slightly slower than the 4–3/4% rate registered last year. In one sense, this is rather impressive: the 10- and 20-year annual averages for global growth are about 3–1/2%. Nonetheless, the details are less satisfying regarding the performance of the advanced economies.
As is recognized universally, emerging economies have represented the driving force of the post-crisis global expansion: strong domestic demand -- buoyed by an accommodative policy stance and renewed inflows of foreign capital -- has powered a very robust recovery, even providing some boost to advanced economies. Instead of facing the challenge of recovering pre-crisis output levels – as is still the case in almost all advanced economies –emerging economies are closer to facing risks of overheating and resulting hard landings.
High commodity prices and rising food prices have added complexity to the outlook, as both inflation and inflation expectations are beginning to accelerate. In fact, headline inflation already is above target in many emerging economies. While some central banks appear willing to accept a temporary rise in inflation (via a widening in inflation target bands), in other countries policy shifts are needed now in order to help keep the expansion within a sustainable pace. In many cases, timely removal of policy stimulus and prudent “leaning against the wind” will be required in order to prevent a build-up in domestic imbalances.
In contrast, the expansion in most advanced economies is being sustained at only a moderate pace, with growth in many cases too weak to reduce unemployment significantly. Large output gaps and still-weakened household and bank balance sheets are holding back both credit growth and private demand.
Moreover, despite the relatively robust global growth pace, the expansion remains subject to non-trivial downside risks. These include: (1) concerns about links between financial stresses and fiscal sustainability—especially in the euro area—that have the potential to undermine growth; (2) the lack of progress in formulating credible medium-term fiscal consolidation plans in many advanced economies, that could weaken confidence and push up long-term interest rates and; and (3) high commodity and food prices, that could undermine macroeconomic stability and trigger social and political strains in developing countries. Not to be overlooked, indications that the global cooperation that characterized the response to the onset of the crisis was fraying seriously would aggravate these downside risks.
Against this positive but still challenging background, advanced economies do not have much policy room to maneuver to secure faster growth via shifts in domestic macroeconomic policies. While recent U.S. data and the latest policy initiatives there suggest that 2011 growth will be slightly better than expected previously, financial market participants are looking for indications that a political consensus is emerging regarding medium-term fiscal consolidation. Other countries either have no room for further fiscal expansion, or they are being pushed by financial market pressures to tighten budget policies immediately. In this context, accommodative monetary policies in advanced economies so far have been welcome and appropriate.
As for commodity prices, some are near historic highs. In part, this reflects short-term supply or production difficulties in certain agricultural products. The most salient factor, however, is the robust growth of key Asian economies, where the intensity of commodity use has been rising, and where demand increases have outstripped near-term supply gains. While this represents broadly good news for a number of Latin American economies, it also complicates everyones’ task of monetary policy and macroeconomic management.
What next? Steps for a Global Solution
This description of the key trends and risks in the global outlook leads more or less inexorably to the conclusion that developing and implementing coherent and timely policy initiatives to rebalance global growth and to reduce financial sector vulnerabilities will be critical elements in sustaining the global expansion. In other words, what is required at present is a cooperative, multilateral approach to economic policy setting that offers real prospects for mutually beneficial outcomes.
The power and potential effectiveness of global cooperation was demonstrated clearly during the acute phase of the 2008/2009 crisis. In contrast, recent headlines reflect many observers’ skepticism about whether the G-20 can deliver results in the absence of a sense of imminent and shared danger. My view is decidedly more positive than the headlines. The process of global policy cooperation remains alive and relevant, even though the characteristics of the uneven recovery are making the process more complex and challenging.
In fact, the onset of the crisis motivated the creation of a new G20 Leaders framework of international cooperation that has the potential to deliver an unprecedented and useful approach to the formulation of globally coherent economic and financial policies. In particular, the G20 Leaders’ “Framework for Strong, Balanced and Sustainable Growth”, represents a multilateral process through which G-20 countries―including Brazil, Mexico and Argentina ― have identified overall objectives for the global economy and the specific policies needed to reach them.
The G20 Leaders also committed to a “Mutual Assessment Process” (or MAP) for monitoring their progress towards meeting the shared objectives. For its part, IMF staff is providing technical and analytical support for this process, with inputs from other international organizations on issues such as labor and product markets, financial markets, and trade. The first round of results from this process included a set of policy commitments from each G-20 member that were made public at last November’s Seoul Leaders Summit. At present, the G20’s Framework Working Group is developing a concrete program for taking this process forward in line with the commitments specified in the Seoul Leaders Declaration.
So what actual policies are needed in the near term?
For advanced economies, the most urgent tasks are to accelerate repair and restructuring of financial systems, and commit to credible fiscal consolidation plans. Until growth begins to shrink current wide margins of excess capacity – and so long as inflation remains a non-issue in advanced economies -- central banks naturally will maintain an accommodative policy stance.
At the same time, emerging economies need to keep overheating pressures in check, while taking advantage of the benefits of low international interest rates and, for some, booming commodity export revenues. Of foremost importance, many countries will need to recalibrate macroeconomic policies so that demand and production do not surpass available resources. Otherwise, risks would rise quickly of a classic boom/bust cycle.
Those countries with large current account surpluses would gain from reorienting part of their domestic demand to imports. Those with external deficits, like many countries in Latin America, will need to exercise caution, so that domestic demand gains remain within sustainable margins. All need to remain attentive to potential financial sector vulnerabilities and to the risk of outsized asset price rises. Of course, such policies would help to sustain Latin America’s growth, but also contribute to a durable reduction of global imbalances.
Benefiting from Capital Inflows
Within this multilateral context, capital inflows to emerging markets have been at the center of public discussion in the past year. This is not surprising: After all, in the12 months through September 2010, emerging economies in both Latin America and Asia received more net inflows than in any previous year in the last decade.
Of course, this recent experience needs to be kept in perspective. First, it is important to underline that the rapid growth in inflows reflects a recovery from the sudden stop experienced in the wake of the crisis. Second, and perhaps more importantly, taking into account the prospect of sustained strong emerging economy growth -- and recognizing that institutional investment portfolios in advanced economies remain significantly underweight emerging economy assets on a long-term basis -- it is easy to conclude that robust capital inflows to emerging markets will form a structural characteristic of global financial markets for many years to come.
In fact, this prospect of sustained capital flows underscores confidence in the likelihood of strong emerging economy growth. The current exceptionally low yields in advanced economy bond markets and accommodative advanced economy monetary policies have added to these more fundamental drivers.
One key implication of these developments is that emerging economies will need to accommodate effectively not just the near-term recovery of capital inflows following the 2008/2009 hiatus, but also a trend increase in flows in the coming years. This prospect—like other recent developments—combines obvious benefits with challenges. Reaping the prospective benefits implies implementing a range of structural reforms, including steps to further develop and deepen financial markets, and to eliminate longstanding obstacles to productivity gains. Together, these moves will enhance potential growth and permit economies to absorb foreign capital more efficiently and effectively. Fortunately, current conditions present an excellent opportunity for countries to address these fundamental issues, which in other stages of the economic cycle may be much harder to fix.
In the short term, however, it is clear that inflows to emerging economies are contributing to already robust domestic demand. While in some cases this will be helpful in promoting a welcome rebalancing from external to domestic demand, in other cases large inflows could contribute to overheating and financial sector imbalances—reflecting, for instance, currency mismatches or excessive credit growth, and even asset price surges.
A third potential risk of capital inflows has attracted a good deal of attention in Latin America—that such flows can act as a potential drag on output, if they motivate a sharp exchange rate appreciation. While this last point dominates headlines, in fact it is not likely to represent a near-term Latin American problem, as a shortfall of aggregate demand is not a relevant concern. And if it did become as issue, it could be addressed relatively easily, by relaxing monetary policy.
Failure to maintain macroeconomic and financial balance could be troublesome in particular for emerging economies with external current account deficits, as a sudden stop of capital inflows for whatever reason could force abrupt reductions in domestic demand.
To counter the risks of macroeconomic and financial instability, the general advice to all emerging economies is to act on multiple fronts, keeping in mind that the impact on the broader economy of a permanent increase of capital flows should be allowed to play out over time, expanding potential long-term benefits.
It is of central importance that basic macroeconomic policy levers—fiscal, monetary, and exchange rate—be utilized to sustain balanced growth. The appropriate policy responses will vary across countries but likely will involve some of the following elements:
• Moves to absorb the impact of inflows with exchange rate flexibility ―where exchange rates are not already clearly overvalued― and possibly also with well designed intervention. It is important to recognize that part of the expected appreciation is an equilibrium phenomenon and a manifestation of success and maturity. Moreover, exchange rate flexibility should reduce incentives for excessive speculative inflows by eliminating the scope for “one way bets.”
• Adjust the fiscal/monetary macro policy mix by tightening fiscal policy to maintain a sustainable pace of demand growth and, if conditions permit, allow lower policy interest rates. The case is especially strong where previous fiscal stimulus has not yet been fully reversed. For those countries in need of underlying fiscal adjustment, the current favorable conditions present an unusual opportunity for action.
Beyond a macroeconomic response, other measures may also prove helpful:
• Strengthening prudential measures in the financial system, for example, with higher loan-to-value ratios if the real state sector expands too quickly or with funding composition restrictions if bank intermediation of capital inflows increase too fast.
• In some cases, capital controls could be considered as a part of the toolkit, but not as a substitute for needed macroeconomic and prudential measures.
• Of course, structural reforms – including financial sector development – will help to expand both growth potential and resilience to shocks. In fact, such reforms form a crucial aspect of the G20 Framework policy programs.
Is Latin America different?
A natural question is whether these policies will work in Latin America? After all, most Latin America countries differ from their emerging market peers in several important respects:
• Capital accounts are significantly more open, making them susceptible to inflow surges.
• Policy frameworks allow for a higher degree of exchange rate flexibility, in both directions. The counterpart of this is less recourse to foreign exchange intervention and reserve accumulation.
• Current account balances are in deficit—in contrast to several key Asian economies. Moreover, current accounts have been deteriorating of late -- despite the help from higher commodity revenues --as real domestic demand last year expanded much faster than output. In this respect, Latin American economies have much less space for further current account weakening.
Latin America will need to resist the buildup of financial excesses and demand booms―the bane of earlier boom/bust episodes and still one of the critical risks. In broad terms:
Take advantage of the region’s greater currency flexibility in order to avoid encouraging temporary capital inflows, and to adjust to higher commodity revenues. Countries such as Canada and Norway serve as good examples in this area. International experience suggests that demand booms are smaller where exchange rate flexibility is greater. In fact, even some temporary currency overshooting can be part of the solution to perceived temporary surges. It is important to remember that structural factors are driving capital inflows, and these imply some degree of equilibrium real appreciation. Excessive resistance to this adjustment is an unfortunately well-worn route to inflation overshooting and heightened economic volatility.
Don’t let fiscal policy feed an unsustainable demand boom. To begin with, it will be important to reverse previous fiscal stimulus as the output gap evaporates, moving the fiscal stance from expansionary at least back to a neutral gear. This is a well-recognized issue in Brazil, for example. In this context, gauging the need for fiscal adjustment will require taking into account the impact of quasi-fiscal activities, including the actions of public development banks. One possible approach would be to limit spending growth to match structural revenue gains, rather than including also temporary boom-related gains.
Strengthen and develop new macro-prudential policies. In this area, my Fund colleagues and I would advise working fast—don’t wait for a global consensus to develop regarding guidelines for optimal policy action. In fact, much can be accomplished by building on earlier, country-specific, experiences. Several Latin American countries—including Brazil, Colombia, and Peru—already have put in place useful regulations that should dampen the credit cycle, including cyclical or dynamic provisioning. If necessary, countries may want to strengthen regulation related to the nature and sources of funding of the domestic banking system.
Latin America in the Global Economy
I hope that my observations have been clear and to the point. Latin America demonstrated admirable resilience in the crisis, and now basks in the blessing of exciting opportunities. As the same time, this special phase of abundance needs to be managed with care. The authorities’ principal task will be to insure that the benefits of the current period of strong commodity revenues and plentiful foreign capital are harnessed for long-term gains, while fortifying resilience against external shocks.
As regards the global context, it can be argued that Latin America has been “doing its share” towards global rebalancing, with domestic demand growing faster even than its own output. Whatever Latin America does, however, will not be sufficient by itself to attain the goals of strong, sustainable and balanced global growth. As I stated earlier, at the minimum, a coherent, multilateral approach will be required to achieve these global goals. The G20 Framework/MAP process can provide a nucleus for such action. My Fund colleagues and I look forward to working with all its Latin American members to help to insure that the exceptional opportunities of the moment and realized and sustained. The time for action is at hand.
Thank you for your attention.