## _wp06166

## Source details

**Canonical URL:** [_wp06166](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06166.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06166.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06166.pdf.json)

---

### Introduction — regional performance and context
- The region as a whole expanded at an average rate of 5 percent during 2004–2005.
- This growth rate is described as the fastest two-year rate of growth in two and a half decades.
- Growth occurred while generally maintaining low inflation, and current account and primary fiscal surpluses.
- Paper structure (signposted):
  - Section II reviews the historical record of volatility in the region.
  - Section III traces the macroeconomic policies that have contributed to this record.
  - Section IV assesses the current conjuncture and examines whether the region can escape the legacy of the past.
  - Section V suggests a policy agenda that would reduce volatility and, thereby, help lift growth in the region.
  - Brief concluding remarks follow.

### II. MACROECONOMIC VOLATILITY IN LATIN AMERICA: A HISTORICAL PERSPECTIVE
- Recurrent macroeconomic instability:
  - Frequent hyperinflation, exchange rate devaluations, failed currency reforms, banking collapses, and debt default.
- High or hyperinflation:
  - Inflation spiraled upward during the 1970s and especially during the 1980s and early 1990s, reaching four-digit levels in several countries, including Argentina, Brazil, and Peru.
  - Latin America has no parallel in any other region in predisposition to periodic bouts of high inflation.
- Financial and exchange rate turbulence:
  - Marked propensity toward recurrent banking and currency crises; legacy of high financial dollarization.
- Debt restructuring/default frequency:
  - High frequency of implicit default through high inflation (notably in the 1980s and early 1990s) and frequent explicit defaults or restructuring operations.
- Growth and output volatility:
  - Less than half of growth spells in Latin America continued after seven years vs. over 85 percent for high-income countries and 100 percent for emerging Asia.
  - Currently only two countries (Chile and Trinidad and Tobago) are experiencing ongoing growth spells.
  - Average per capita growth in the region during the past three decades: 1 percent (compared with developing country average of 2¾ percent and about one third of emerging Asia).
  - GDP per capita growth rates in Latin America may be as much as ½ percentage point lower for every 1 standard deviation increase in cyclical volatility.
  - Investment rates in the region have been more than 10 percentage points of GDP below those in East Asia during the past two decades.
- Social impact:
  - Number of persons living in extreme poverty (less than $1 per day) rose from 49 million in 1990 to 50 million in 2001.
  - Recent growth has not been sufficiently “pro-poor” and has not benefited incomes at the lower tail of the distribution.

### III. ROLE OF MACROECONOMIC POLICIES
- External shocks vs. domestic policies:
  - Over 70 percent of volatility of real GDP per capita growth in Latin America is due to country-specific shocks, including volatility of macroeconomic policies.
  - World Bank estimates one third of output volatility owes to macroeconomic policies.
- Political factors:
  - Higher levels of political instability in parts of the region have weakened macroeconomic (especially fiscal) policy discipline.
  - Growing democratization is beginning to stabilize macroeconomic policies and political commitment to low inflation.
- Monetary policy characteristics:
  - Historically amplified the cycle via excessive central bank credit to finance fiscal pressures, causing high inflation.
  - Central banks often acted pro-cyclically—loosening during upswings or tightening after negative shocks.
  - Evidence of procyclical relationship between policy interest rates and output over 1960-2003; fiscal policy reinforced cyclicality of net capital inflows.
  - Legacy effects: currency and banking instability, dollarization, complexity in monetary management.
- Exchange rate regimes:
  - Fixed-type exchange rate regimes dominated much of recent history and magnified procyclical tendencies.
  - Fixed exchange rates tended to increase by a factor of two the effects of terms-of-trade shocks on output.
- Fiscal policy as primary driver of instability:
  - Frequent changes in fiscal stance, procyclical spending (overextending during booms, curtailing during downturns), amplified cyclical instability.
  - Common elements of fiscal volatility:
    - High volatility in government spending, especially investment.
    - Institutional factors: budget rigidities, high earmarking, constitutional spending floors.
    - Fiscal decentralization issues and inability to control local government borrowing.
    - Recurrent banking crises raised public debt (costs borne by the state).
    - Weak governance, high unemployment, poverty, and extreme income disparities undermined commitment to policy discipline.
- Debt dynamics:
  - Excessive borrowing in foreign currencies and short maturities; “debt intolerance” with interest rates above average growth rates.
  - Risk premia, contagion, and borrowing costs spike during adverse shocks, limiting counter-cyclical response options.

### IV. WHAT'S NEW THIS TIME AROUND?
- External environment contributions:
  - Region’s terms of trade improved by 14 percent since end-2002, especially in South America.
  - Low world interest rates and abundant global liquidity benefited investment-grade and recovering countries.
  - Closing output gaps and cyclical recoveries have supported growth.
- Policy and institutional progress:
  - Market-based reforms and sound macroeconomic frameworks have advanced; fiscal consolidation and early tackling of inflationary pressures.
  - Growth pattern more balanced; avoided prior over-appreciation and widening current account deficits.
  - Current cycle supported by diversified export growth, terms-of-trade gains, flexible and competitive currencies; current account surpluses raised reserves and reduced external capital dependence.
- Monetary policy reforms and outcomes:
  - Shift to greater exchange rate flexibility, central bank autonomy, and inflation targeting in many countries.
  - Brazil, Chile, Colombia, Mexico, and Peru adopted inflation-targeting frameworks in the late 1990s and early 2000s.
  - Inflation averaged just 7½ percent in the region since 2000 (vs. in excess of 500 percent in 1990 for the region).
  - New regimes effective in anchoring inflation expectations and allowing countercyclical monetary policy once credibility is established.
- Financial sector strengthening:
  - Improved bank supervision and regulation: loan-classification and provisioning standards, prompt corrective-action frameworks, greater independence for regulators.
  - Decline in nonperforming loan ratios and strengthened capital adequacy ratios indicate more resilient financial systems.
- Fiscal improvements and debt reduction:
  - Institutional fiscal reforms highlighted:
    - Chile: fiscal rule targeting structural surpluses equivalent to 1 percent of GDP in central government accounts.
    - Brazil: fiscal norms including fiscal responsibility law, debt restructuring agreements with sub-national governments, rules limiting public wage expenditures.
    - Colombia and Peru: Fiscal Responsibility and Transparency Laws.
  - By end-2005, average gross public debt-to-GDP ratio had fallen by about 26 percentage points compared with end-2002 across nine sampled LAC countries.
  - Strong growth contributed to an average reduction of about 9⅓ percent of GDP in the average debt ratio during recoveries.
  - Rebound in nominal exchange rates—average around 15 percent between 2002 and 2005—estimated to have reduced average debt ratio by 5 percent of GDP.
  - Primary fiscal surpluses of 3⅓ percent of GDP were maintained during 2003–2005 on average.
  - Fiscal consolidation composition:
    - High-debt countries adjusted mainly through spending cuts; average expenditure-to-GDP ratio fell after 2002.
    - Low-debt countries relied mostly on revenue increases.
    - Discretionary policy contributed large shares of cumulative improvement in primary balances in 2003–2005 for crisis-recovering countries.
  - Debt management and currency composition:
    - Reduction in foreign-currency denominated debt in several countries (Brazil, Chile, Colombia, Mexico, and Peru).
    - At end-2004, Latin America’s weighted average share of foreign currency debt stood at about 39 percent, down from 56 percent at end-2000.
    - Case of Brazil:
      - Share of debt linked to or denominated in foreign currency fell from 56 percent at end-2002 to 11 percent at end-June 2006.
      - Share of debt linked to short-term interest rates (SELIC) rose from 32 (December 2002) to a peak of 48 percent (July 2005), then to 44 percent (end-June).
      - Average debt maturity fell from 33 months (end-2002) to 27 months (November 2005), then rose to 29 months (June 2006).

### V. REMAINING AGENDA
- Core medium-term challenge:
  - Continued policy and institutional steps to reduce public debt and strengthen fiscal frameworks.
  - Public debt in Latin America remains at just over 50 percent of GDP; debt in many countries is well above this mark.
  - Aim to bring debt ratios down below the 40 percent of GDP benchmark that is often thought to be “safe” (with lower benchmarks depending on circumstances).
  - Need to develop domestic capital markets to reduce dependence on short-term and foreign-currency linked instruments.
- Strengthening fiscal frameworks:
  - Redirect spending from inefficient programs toward public infrastructure and well-targeted social programs.
  - Address persistent earmarks that distort spending and promote inappropriate fiscal responses.
  - Improve intergovernmental relations and tax administration.
  - Countries with oil-fueled windfalls (e.g., Ecuador, Mexico, Venezuela) should save a larger proportion of windfalls.
  - Fiscal rules and responsibility laws can help develop social consensus for fiscal discipline.
- Solidifying commitment to low inflation:
  - Inflation-targeting not yet widespread; face tests from expected rise in global interest rates, unwinding global current account imbalances, and closing output gaps.
  - Central banks need stronger policy transparency; Latin American central banks lag Europe, Asia, and Middle East and Central Asia in transparency.
  - High turnover among central bank governors: average tenure about two and a half years—below typical appointment terms (between 4 and 6 years); need to strengthen de facto operational autonomy.
- Deepening financial sector reform:
  - Improve access to credit; reduce real interest rates and deposit-lending spreads.
  - Strengthen banking regulation and supervision; reduce dollarization; improve accounting and auditing standards; revise bankruptcy laws to enhance recovery.
  - Deepen local bond and equity markets to diversify financing sources.
- Structural reforms to improve macroeconomic flexibility:
  - Strengthen market-based institutions to increase labor and product market flexibility.
  - Reforms to improve financial sector effectiveness and resilience, labor market mobility, international trade openness, and business-climate institutions (legal and regulatory systems).

### VI. CONCLUDING REMARKS
- Latin America has been relatively less successful than other regions in exploiting globalization and democratization due to long history of macroeconomic volatility linked to weak institutions and policy instability.
- Encouraging signs: steps to strengthen policy frameworks and create more stable macroeconomic environments after recent crises.
- Political and social coalitions are needed to advance reforms; the heavy near-term political calendar presents opportunities.
- Democracy consolidation augurs well for building popular support for market-based institutions needed for macroeconomic stability.
- IMF role:
  - IMF will collaborate with countries in the region; recent surveillance and policy analysis emphasize vulnerabilities, financial sector issues, debt sustainability, and institutional strengthening.
  - IMF provided debt relief to four countries under the Group of Eight’s Multilateral Debt Relief Initiative (MDRI).
  - New IMF instruments: Policy Support Initiative and an Exogenous Shocks Facility to assist Latin American countries in promoting macroeconomic stability and growth.

*Source: _wp06166 - Section VI.*

### References..............................................................................................................

### _wp06166 - References

### Figures (listed)
- 1. Inflation in Four Latin American Countries, 1880–2004
- 2. Inflation Across Regions, 1970–2004
- 3. Banking and Currency Crisis, 1880–1997
- 4. Dollarization in 2001
- 5. Defaults and Restructurings, 1820–2004
- 6. Duration of Growth Spells, 1950–2003
- 7. Episodes of Severe Contractions, by Decade, 1900–2001
- 8. Growth and Volatility of Per Capita Real GDP, 1900–2000
- 9. Per Capita Real GDP, 1900–2001
- 10. Composition of Growth Cycles
- 11. Annual Inflation Rate
- 12. Fiscal Policy During Cyclical Upswings
- 13. Contributions to Change in Public Debt, 2002–2005
- 14. Share of Foreign Currency Bonds
- 15. Public Debt in Latin America
- 16. Net Interest Margins of Banking Sector
- 17. Number of Procedures in Starting a Business
- 18. Contract Enforcement: Procedural Complexity Index

### Introduction — regional performance and context
- For Latin America, after another turbulent decade, the last two years have been good.
- The region as a whole expanded at an average rate of 5 percent during 2004–2005.
- This growth rate is described as the fastest two-year rate of growth in two and a half decades.
- Growth occurred while generally maintaining low inflation, and current account and primary fiscal surpluses.
- The paper's structure (as signposted):
  - Section II reviews the historical record of volatility in the region.
  - Section III traces the macroeconomic policies that have contributed to this record.
  - Section IV assesses the current conjuncture and examines whether we should be optimistic that the region can escape the legacy of the past.
  - Section V suggests a policy agenda that would reduce volatility and, thereby, help lift growth in the region.
  - Brief concluding remarks follow.

*Source: _wp06166 - References*

### Section VI.

### Section VI.

### II. MACROECONOMIC VOLATILITY IN LATIN AMERICA: A HISTORICAL PERSPECTIVE
- Recurrent macroeconomic instability: frequent hyperinflation, exchange rate devaluations, failed currency reforms, banking collapses, and debt default.
- High or hyperinflation:
  - Inflation spiraled upward during the 1970s and especially during the 1980s and early 1990s, reaching four-digit levels in several countries, including Argentina, Brazil, and Peru.
  - Latin America has no parallel in any other region in predisposition to periodic bouts of high inflation.
- Financial and exchange rate turbulence:
  - Marked propensity toward recurrent banking and currency crises; legacy of high financial dollarization.
- Debt restructuring/default frequency:
  - High frequency of implicit default through high inflation (notably in the 1980s and early 1990s) and frequent explicit defaults or restructuring operations.
- Growth and output volatility:
  - Growth spells duration: less than half of growth spells in Latin America continued after seven years vs. over 85 percent for high-income countries and 100 percent for emerging Asia.
  - Currently only two countries (Chile and Trinidad and Tobago) are experiencing ongoing growth spells.
  - Average per capita growth in the region during the past three decades: 1 percent (compared with developing country average of 2¾ percent and about one third of emerging Asia).
  - GDP per capita growth rates in Latin America may be as much as ½ percentage point lower for every 1 standard deviation increase in cyclical volatility.
  - Investment rates in the region have been more than 10 percentage points of GDP below those in East Asia during the past two decades.
- Social impact:
  - Number of persons living in extreme poverty (less than $1 per day) rose from 49 million in 1990 to 50 million in 2001.
  - Recent growth has not been sufficiently “pro-poor” and has not benefited incomes at the lower tail of the distribution.

### III. ROLE OF MACROECONOMIC POLICIES
- External shocks vs. domestic policies:
  - Over 70 percent of volatility of real GDP per capita growth in Latin America is due to country-specific shocks, including volatility of macroeconomic policies.
  - World Bank estimates one third of output volatility owes to macroeconomic policies.
- Political factors:
  - Higher levels of political instability in parts of the region have weakened macroeconomic (especially fiscal) policy discipline.
  - Growing democratization is beginning to stabilize macroeconomic policies and political commitment to low inflation.
- Monetary policy characteristics:
  - Historically amplified the cycle via excessive central bank credit to finance fiscal pressures, causing high inflation.
  - Central banks often acted pro-cyclically—loosening during upswings or tightening after negative shocks.
  - Evidence of procyclical relationship between policy interest rates and output over 1960-2003; fiscal policy reinforced cyclicality of net capital inflows.
  - Legacy effects: currency and banking instability, dollarization, complexity in monetary management.
- Exchange rate regimes:
  - Fixed-type exchange rate regimes dominated much of recent history and magnified procyclical tendencies.
  - Fixed exchange rates tended to increase by a factor of two the effects of terms-of-trade shocks on output.
- Fiscal policy as primary driver of instability:
  - Frequent changes in fiscal stance, procyclical spending (overextending during booms, curtailing during downturns), amplified cyclical instability.
  - Common elements of fiscal volatility:
    - High volatility in government spending, especially investment.
    - Institutional factors: budget rigidities, high earmarking, constitutional spending floors.
    - Fiscal decentralization issues and inability to control local government borrowing.
    - Recurrent banking crises raised public debt (costs borne by the state).
    - Weak governance, high unemployment, poverty, and extreme income disparities undermined commitment to policy discipline.
- Debt dynamics:
  - Excessive borrowing in foreign currencies and short maturities; “debt intolerance” with interest rates above average growth rates.
  - Risk premia, contagion, and borrowing costs spike during adverse shocks, limiting counter-cyclical response options.

### IV. WHAT'S NEW THIS TIME AROUND?
- External environment contributions:
  - Region’s terms of trade improved by 14 percent since end-2002, especially in South America.
  - Low world interest rates and abundant global liquidity benefited investment-grade and recovering countries.
  - Closing output gaps and cyclical recoveries have supported growth.
- Policy and institutional progress:
  - Market-based reforms and sound macroeconomic frameworks have advanced; fiscal consolidation and early tackling of inflationary pressures.
  - Growth pattern more balanced; avoided prior over-appreciation and widening current account deficits.
  - Current cycle supported by diversified export growth, terms-of-trade gains, flexible and competitive currencies; current account surpluses raised reserves and reduced external capital dependence.
- Monetary policy reforms and outcomes:
  - Shift to greater exchange rate flexibility, central bank autonomy, and inflation targeting in many countries.
  - Brazil, Chile, Colombia, Mexico, and Peru adopted inflation-targeting frameworks in the late 1990s and early 2000s.
  - Inflation averaged just 7½ percent in the region since 2000 (vs. in excess of 500 percent in 1990 for the region).
  - New regimes effective in anchoring inflation expectations and allowing countercyclical monetary policy once credibility is established.
- Financial sector strengthening:
  - Improved bank supervision and regulation: loan-classification and provisioning standards, prompt corrective-action frameworks, greater independence for regulators.
  - Decline in nonperforming loan ratios and strengthened capital adequacy ratios indicate more resilient financial systems.
- Fiscal improvements and debt reduction:
  - Institutional fiscal reforms:
    - Chile: fiscal rule targeting structural surpluses equivalent to 1 percent of GDP in central government accounts.
    - Brazil: fiscal norms including fiscal responsibility law, debt restructuring agreements with sub-national governments, rules limiting public wage expenditures.
    - Colombia and Peru: Fiscal Responsibility and Transparency Laws.
  - By end-2005, average gross public debt-to-GDP ratio had fallen by about 26 percentage points compared with end-2002 across nine sampled LAC countries.
  - Strong growth contributed to an average reduction of about 9⅓ percent of GDP in the average debt ratio during recoveries.
  - Rebound in nominal exchange rates—average around 15 percent between 2002 and 2005—estimated to have reduced average debt ratio by 5 percent of GDP.
  - Primary fiscal surpluses of 3⅓ percent of GDP were maintained during 2003–2005 on average.
  - Fiscal consolidation composition:
    - High-debt countries adjusted mainly through spending cuts; average expenditure-to-GDP ratio fell after 2002.
    - Low-debt countries relied mostly on revenue increases.
    - Discretionary policy contributed large shares of cumulative improvement in primary balances in 2003–2005 for crisis-recovering countries.
  - Debt management and currency composition:
    - Reduction in foreign-currency denominated debt in several countries (Brazil, Chile, Colombia, Mexico, and Peru).
    - At end-2004, Latin America’s weighted average share of foreign currency debt stood at about 39 percent, down from 56 percent at end-2000.
    - Case of Brazil: share of debt linked to or denominated in foreign currency fell from 56 percent at end-2002 to 11 percent at end-June 2006.
      - Share of debt linked to short-term interest rates (SELIC) rose from 32 (December 2002) to a peak of 48 percent (July 2005), then to 44 percent (end-June).
      - Average debt maturity fell from 33 months (end-2002) to 27 months (November 2005), then rose to 29 months (June 2006).

### V. REMAINING AGENDA
- Core medium-term challenge: continued policy and institutional steps to reduce public debt and strengthen fiscal frameworks.
  - Public debt in Latin America remains at just over 50 percent of GDP; debt in many countries is well above this mark.
  - Aim to bring debt ratios down below the 40 percent of GDP benchmark that is often thought to be “safe” (with lower benchmarks depending on circumstances).
  - Need to develop domestic capital markets to reduce dependence on short-term and foreign-currency linked instruments.
- Strengthening fiscal frameworks:
  - Redirect spending from inefficient programs toward public infrastructure and well-targeted social programs.
  - Address persistent earmarks that distort spending and promote inappropriate fiscal responses.
  - Improve intergovernmental relations and tax administration.
  - Countries with oil-fueled windfalls (e.g., Ecuador, Mexico, Venezuela) should save a larger proportion of windfalls.
  - Fiscal rules and responsibility laws can help develop social consensus for fiscal discipline.
- Solidifying commitment to low inflation:
  - Inflation-targeting not yet widespread; face tests from expected rise in global interest rates, unwinding global current account imbalances, and closing output gaps.
  - Central banks need stronger policy transparency; Latin American central banks lag Europe, Asia, and Middle East and Central Asia in transparency.
  - High turnover among central bank governors: average tenure about two and a half years—below typical appointment terms (between 4 and 6 years); need to strengthen de facto operational autonomy.
- Deepening financial sector reform:
  - Improve access to credit; reduce real interest rates and deposit-lending spreads.
  - Strengthen banking regulation and supervision; reduce dollarization; improve accounting and auditing standards; revise bankruptcy laws to enhance recovery.
  - Deepen local bond and equity markets to diversify financing sources.
- Structural reforms to improve macroeconomic flexibility:
  - Strengthen market-based institutions to increase labor and product market flexibility.
  - Reforms to improve financial sector effectiveness and resilience, labor market mobility, international trade openness, and business-climate institutions (legal and regulatory systems).

### VI. CONCLUDING REMARKS
- Latin America has been relatively less successful than other regions in exploiting globalization and democratization due to long history of macroeconomic volatility linked to weak institutions and policy instability.
- Encouraging signs: steps to strengthen policy frameworks and create more stable macroeconomic environments after recent crises.
- Political and social coalitions are needed to advance reforms; the heavy near-term political calendar presents opportunities.
- Democracy consolidation augurs well for building popular support for market-based institutions needed for macroeconomic stability.
- IMF role:
  - IMF will collaborate with countries in the region; recent surveillance and policy analysis emphasize vulnerabilities, financial sector issues, debt sustainability, and institutional strengthening.
  - IMF provided debt relief to four countries under the Group of Eight’s Multilateral Debt Relief Initiative (MDRI).
  - New IMF instruments: Policy Support Initiative and an Exogenous Shocks Facility to assist Latin American countries in promoting macroeconomic stability and growth.

*Source: _wp06166 - Section VI.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06166.pdf_