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The Long Road to Financial Stability
Claudio M. Loser and Martine Guerguil
Most countries in Latin America and the Caribbean weathered the economic crises of the late 1990s better than expected, thanks to the policy reforms of the past two decades. Further reform is urgently needed, however, to put the region on a faster growth path and reduce its vulnerability to external shocks.
The past few years have been difficult for Latin America and the Caribbean. The turmoil that swept through international capital markets in 1997 and 1998, combined with the region's deteriorating terms of trade and declining export earnings, produced an economic slowdown that boosted unemployment levels and depressed incomes. The downturn, the second in five years and the largest and broadest since the debt crisis of the 1980s, was a disappointment for a region that had been following a strenuous path of policy adjustment and reform for more than a decade. Per capita output in Latin America and the Caribbean was only 13 percent higher in 1999 than in 1989, and only 7 percent higher than in 1980. Nonetheless, in the face of an extremely adverse external environment, economies in the region displayed unexpected signs of strength, in large part because of the reforms they had undertaken earlier. Private investment proved resilient, and there are signs that output is already beginning to recover after a slowdown of relatively short duration.
Reforms of 1980s and 1990s
After the debt crisis, economic policy in Latin America and the Caribbean underwent a dramatic change. Plagued with severe distortions in the use of resources, most countries abandoned the old model of state-directed, import-substituting industrialization in favor of outward-looking, market-based policies.
In the late 1980s, the fight against inflation—and, more generally, the pursuit of financial stability—became the leading policy objective of many governments around the world, including those in Latin America and the Caribbean, which moved toward stricter fiscal management, reducing government expenditure, reforming bloated civil services, and overhauling tax systems. As a result, the region's average fiscal deficit shrank to about 2 percent of GDP in the mid-1990s, from 4-5 percent in the late 1980s. Countries achieved a more balanced tax burden, with lower trade taxes, greater tax efficiency, and higher ratios of tax revenues to GDP. The ratio of external public debt to GDP fell to less than 20 percent in 1997, from about 50 percent in the late 1980s. The improved fiscal stance made it possible for countries to achieve a more disciplined monetary management and to reduce central bank credit to government. The authorities increased their use of indirect instruments of monetary policy, with a view to enhancing the role of interest rates and improving the efficiency of monetary management. Many also strengthened economic institutions and increased the independence and accountability of their central banks, which were given the explicit mandate of pursuing price stability.
Most countries in the region undertook bold and wide-ranging structural reforms aimed at dismantling price controls and removing existing market distortions, with an emphasis on trade reform, financial liberalization, and the privatization of public enterprises.
In the early 1980s, when the region found itself engulfed in a string of acute financial crises, it suffered a prolonged shortage of foreign financing and a severe and protracted slump in output (see chart). Although the reforms that took place after these crises could not insulate the region from the global financial crisis that began in Asia in 1997, they limited the damage. Countries were able to control financial panic, preserve macroeconomic stability, and maintain some access to foreign financing.
The avoidance of financial collapse was a major achievement. Currency crises were quickly resolved (except in Ecuador) after short periods of turbulence. Although the share of nonperforming assets in banks' portfolios increased in most countries and some local banks came under stress, there were few systemic banking crises (except in Ecuador, Paraguay, and, to some extent, Jamaica) because the authorities were, in most cases, able to address banking problems promptly. Average regional inflation, which had dropped from nearly 1,000 percent at the end of 1990 to about 10 percent by the end of 1998, continued to decline, reaching 9� percent by the end of 1999, its lowest level in about 50 years. Only Ecuador, Suriname, and Venezuela still have inflation rates over 15 percent.
Several factors contributed to the resilience of the Latin American and Caribbean economies. Prominent among them are the speed and determination of the authorities' policy response to the financial turmoil of the 1990s. Strikingly, most policymakers resisted calls to close off their economies or return to administrative management. This response was possible because the reforms had strengthened economic institutions and increased the efficiency and flexibility of domestic markets. For instance, upgraded banking prudential rules enabled most domestic banks to weather currency devaluations and monetary tightening. Resolute stabilization and other reforms may have helped to change public expectations, limiting the inflationary impact of currency devaluations.
The decline in foreign financing flows to Latin America and the Caribbean in the late 1990s, although significant, was less dramatic than the decline experienced during the debt crisis of the 1980s, when capital rapidly began flowing out of the region; flows remained negative for most of the 1980s, and external obligations had to be renegotiated several times. In contrast, private capital inflows to the region, which had surged from $14 billion in 1990 to a record $86 billion in 1997 (4� percent of GDP), contracted to $47 billion in 1999 but did not turn negative. In large part, this resilience was due to the high share of foreign direct investment, a less volatile form of financing—about 50 percent of total net private capital inflows during 1990-97, compared with 20 percent before the debt crisis. Net flows of foreign direct investment to Latin America and the Caribbean rose from $7 billion in 1990 to a record $51 billion in 1997. They then declined by less than a fifth, to an estimated $43 billion in 1999.
Countries in the region also maintained access to other sources of foreign finance, although at a higher cost and in smaller quantities. The volume of international bond issues, for instance, was one-third lower in 1998-99 than in 1997, and spreads were twice as high, but bonds were still a significant source of finance (about $40 billion in both 1998 and 1999, equivalent to 60 percent of the external current account deficit).
Last, the reforms appear to have contributed to increases in labor and capital productivity, which, in turn, stimulated output growth. Average annual output growth was 3 percent in the 1990s, up from 2 percent in the 1980s. The rate of growth of domestic investment accelerated to 5 percent, from -1 percent, over the same period. Export volumes grew much faster in the 1990s than in the 1980s (9 percent a year, compared with 4 percent) and also grew faster than the overall volume of world trade. Empirical studies have concluded that the reforms raised the growth rate of total factor productivity by about 1� percentage points, boosting the region's potential output growth rate to more than 5 percent a year.
Although the reforms did not prevent an economic slowdown in the aftermath of the global financial crisis, there are indications that it will be shorter and shallower than initially expected. The most visible illustration of this is Brazil, whose prospects for 1999 have been revised upward several times and whose economy is expected to recover strongly in 2000—like the quick recovery of Mexico's economy after the Tequila crisis of 1994. Regional output is estimated to have remained virtually flat in 1999, and a robust recovery is expected in 2000. This is less dramatic than in 1982 and 1983, when the economies of Latin America and the Caribbean contracted by 0.8 percent and 2� percent, respectively. Out of a total of 32 countries, only 9 are expected to register a decline in output in 1999, compared with 17 in 1982 and 1983. By increasing the flexibility of the economies in the region, the reforms appear to have enhanced their capacity to adapt to shocks; the maintenance of sound financial policies and of open markets and continued strong foreign direct investment flows were also instrumental in limiting output volatility.
External vulnerability. Because of the sharp rise in the number and volume of cross-country financial transactions and the growing integration of financial markets, the size and volatility of international capital flows have increased. Crises have unfolded more quickly and less predictably and spread faster from one economy to another. The impact of these global developments on Latin America and the Caribbean was only partly mitigated by the higher share of foreign direct investment in total finance. The region's dependence on foreign financing has led at times to an unsustainable buildup of domestic demand, a widening of the external current account deficit, and large fluctuations in the real exchange rate. The strong correlation in the movements of foreign financing costs across countries illustrates the extent of financial contagion in the region.
The economies of Latin America and the Caribbean, richly endowed with natural resources, have also remained vulnerable to fluctuations in export prices because their exports tend to be concentrated in commodities or semi-commodities. In the 1990s, export receipts grew more slowly than both export and import volumes. As their terms of trade became less favorable, countries in Latin America and the Caribbean saw their export earnings drop in 1998, to recover only modestly in 1999, despite a slowdown in domestic demand and frequent currency depreciations. The region's growing integration into the world economy was not accompanied by the development of matching macroeconomic policy instruments. The scope for countercyclical policies was often limited by inconsistencies between fiscal and exchange rate policies and, as discussed below, by the fragility of the fiscal position, reflected in low levels of national savings. Thus, efforts to maintain macroeconomic stability relied mostly on a significant and often prolonged tightening of monetary conditions. Exchange rate bands proved vulnerable to speculative attacks and had to be abandoned, but the fixed exchange rate regimes of Argentina, El Salvador, Panama, and most Caribbean countries were successful and endured.
Fiscal fragility. The recent crises highlighted the importance of prudent fiscal policy for financial stability. This is not really a novel idea: as mentioned above, fiscal consolidation was a critical element of stabilization policies in the region in the 1990s. Increases in public savings, although partly offset by declines in private savings, have been shown to boost national savings. Further, sound fiscal management can improve overall economic efficiency, because it frees scarce financial resources that can be dedicated to productive, income-generating investment.
Recent developments suggest that the role of fiscal policy in today's world of increased financial integration and capital mobility may be more important than ever. This is because, in the globalized economy, market anxieties can spread quickly from one country to another, exposing underlying weaknesses and inconsistencies, and weak policies have more abrupt and pronounced consequences than in the past. This is particularly true of fiscal policy, because it is a very visible component of the authorities' policy stance and indicates the sacrifices they are willing and able to make to maintain financial stability.
Although the Latin American and Caribbean countries have taken steps to strengthen their public finances, by the end of the 1990s there was a resurgence of fiscal deficits that was due in part to the economic downturn and in part to problems that have not yet been addressed.
Weak institutions. The contribution of efficient public institutions and regulations to economic growth and welfare, although long recognized, acquired even greater prominence during the recent crises, particularly with regard to the availability of comprehensive and timely financial information, the accountability and transparency of government operations, and the stability of the regulatory and judicial systems. The region's progress in these areas has been relatively modest. Although countries throughout Latin America and the Caribbean embraced democracy during the 1990s, efforts to improve the quality of public institutions and services have often lagged behind other reforms. Legal and regulatory procedures, while improved, remain cumbersome. The protection of contractual and property rights is largely inadequate, and many business transactions are still informal. Institutions, including the courts, are weak and discredited in many countries and barely function in some. The quality of public services is often poor, corruption is widespread, and crime and violence have increased.
Corporate governance is also generally inadequate. Despite advances in banking regulation and supervision, banking sectors in many countries remain fragile, with low capital bases and high intermediation costs, and regulatory enforcement remains weak.
The policy agenda
Fiscal consolidation would help reduce Latin America and the Caribbean's external vulnerability, because it would allow for more proactive fiscal management and boost national savings. In many countries, there is still ample scope to strengthen public finances by revamping the tax system and reducing or eliminating inefficient public expenditure. To mitigate the impact of terms of trade fluctuations on fiscal revenues, governments may establish commodity stabilization funds such as those in place in Chile, Venezuela, and, most recently, Mexico. Finally, there is a need to impose hard budget constraints on subnational governments, public enterprises, and public financial institutions. More particularly, public debt management practices should be reviewed with a view to increasing the robustness of the public debt structure to external shocks.
Fiscal policy is, of course, not the sole instrument for reducing the region's external vulnerability; prudent monetary management, sound exchange rate policies that prevent severe currency misalignments, and adequate prudential regulation for the banking and financial systems also play a key role. Mechanisms to involve the private sector in the resolution of potential crises should also be explored. Nonetheless, both the new role of fiscal policy as a signal for the overall policy stance and the still significant scope for improvement in this area give a certain urgency to the strengthening of public finances in most of the region.
Governance is as crucial as it is complex and multifaceted, because it permeates nearly all aspects of economic performance. Governments in the region must strive to provide comprehensive, timely economic information and to meet international standards of transparency. With respect to financial regulation, they must avoid complacency and address remaining fragilities promptly (see "Banking Supervision" by Robert Rennhack in this issue). In the nonfinancial area, there is a need for simpler, more transparent regulatory systems that are equitably enforced. More results-oriented, transparent, and accountable governments are also needed at both the national and the subnational levels, and corporate governance must be strengthened.
Rocked by several successive waves of financial turbulence over the past few years, countries in Latin America and the Caribbean have shown great resilience. The task of reform is far from complete, however. To accelerate growth and improve social welfare, the region must maintain its reform momentum. Only then will it be able to combine its long-term ideal of sustained growth with democracy and social equity.