(Version in Español and Português)
Some basic realities seem to be getting lost in the debate over the Fed’s “exit” from unconventional monetary policy and its impact on Latin America.
First, the still-loose stance makes sense. U.S. inflation is too low, the output gap too large, and the labor market too weak. And even during tapering, the Fed’s stance will remain highly loose. The 10-year Treasury rate, adjusted for core inflation, is about 230 basis points below its 30-year average and the inflation-adjusted Fed funds rate is 320 basis points below. These rates are likely to remain below their 30-year average for at least the next two to three years.
Second, these loose monetary conditions have tangible benefits for Latin America. A stance that supports growth and financial stability in the world’s largest economy is good for the region, given its links to the United States. In turn, continued U.S. growth is positive for commodities demand, both directly from the U.S. and via other countries that benefit from U.S. growth.
And finally, international financing conditions remain very favorable for Latin America—the average yield on sovereign debt is still about 250 basis points below its 16-year average. These conditions have allowed governments and business to refinance their liabilities and finance infrastructure and other investment at historically low rates. Moreover, several countries have been able to issue for the first time in international markets.
That does not mean that countries in Latin America should rest easy. The volatility since May 2013 tells us that the process of normalization of U.S. monetary policy will be complicated and volatile. So it is smart to prepare for bumps.
How to prepare?
First, continue to take advantage of loose financial conditions by refinancing debt at low rates and increasing maturities, while avoiding a significant expansion of domestic spending fueled by cheap credit. Second, start adjusting for the exit. The exit might entail rising long-term dollar interest rates, weakening regional currencies, lower flows of capital to the region (and in some cases, maybe outflows), with pressure in local financial markets. This will increase debt service and tighten financing costs, thus affecting investment and growth. And this might not unfold smoothly—we might see big swings in markets. So to prepare, countries should make sure that banks, governments, businesses and households have solid balance sheets. These strengths were stress tested in May/June and they withstood the shock. However, during that period, some signs of illiquidity in local currency bond markets appeared and asset price volatility was high. Thus, countries should also strengthen liquidity conditions in local markets.
Another lesson from past bouts of volatility is that countries with weaker macroeconomic fundamentals tend to see more abrupt changes in capital flows and asset prices. Some concerns arise because since 2009 the region has seen a relaxation in fiscal policy, widening current account deficits and slowing growth. In addition, the slowdown underway might add to the differentiation markets will make as financial conditions get tighter, stressing the importance of structural reforms and sound fundamentals. Now is a good time to shore up fundamentals too, especially where fiscal buffers might be too thin. Finally, as the exit process will take time, it is important to use buffers wisely and keep one’s powder dry.
While there are certainly some concerns that the exit may be a bumpy ride, Latin America is better prepared than 10 or 20 years ago. Policies are better, banks are stronger, buffers are larger, the region is not excessively dependent on portfolio inflows, and the generalized adoption of flexible exchange rates makes a huge difference. More than two-thirds of the inflows have been accumulated as international reserves by central banks or as external assets by the private sector. During 2009-12, central banks in the region increased their reserve holdings by $304 billion and the private sector accumulated $266 billion in foreign assets (FDI and portfolio assets). The job now is making sure that this resilience is sufficient to handle a lot of volatility, and sufficient across a range of countries.
A lot of talk implies that the Fed’s edging toward the exit is a bad thing. The reality is that we should welcome the recent tapering announcement and, in the future, the beginning of the normalization of interest rates—it will come when the U.S. economic outlook is improving in earnest, which will be good news for Latin America. More importantly, it will be a step down the road toward putting the global financial crisis behind us once and for all.
