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IMF Survey: Latin America Faces Risk of Overheating

April 15, 2011

  • Region continues to expand, led by robust domestic demand
  • Policy challenge now is to prevent overheating
  • Need to help the poor cope with high food prices

As Latin American economies continue to expand, there are early signs of overheating pressures and possible excesses in several areas, said Nicolás Eyzaguirre, Director of the IMF’s Western Hemisphere Department.

Latin America Faces Risk of Overheating

Electric train project in Lima, Peru set to open in July 2011. Growth in Latin America remains strong (photo: Enrique Castro-Mendivil/Newscom)

IMF Spring Meetings

While growth in the region is expected to moderate this year, it remains robust and above trend, Eyzaguirre said at a press conference April 15, during the IMF Spring Meetings.

Domestic demand has been growing even faster, pushed not only by favorable external conditions but also by fiscal and monetary policies that have been quite stimulative and are only gradually normalizing.

Boom-bust risks

As a result, “early signs of overheating pressures and possible excesses are appearing in several areas,” Eyzaguirre told reporters.

Inflation is rising in much of the region. Some countries have begun to raise interest rates, from low levels, and it is clear that policy rates will need to be raised further to prevent overheating and an acceleration in inflation. In addition, Eyzaguirre said that vigilance will be needed to make sure that the recent rise in food and energy prices does not spill over into core inflation.

Fiscal policy is also part of the inflation picture. Noting that public expenditure grew rapidly last year, Eyzaguirre said that it will be important to “downshift” fiscal policy this year.

Robust private sector demand is leading to a widening in the current account deficit in many countries. Even in those benefitting from higher commodity export prices, import growth has been outpacing exports. So far, current account deficits have not become excessive, but their movement in that direction will need to slow. Eyzaguirre pointed out that fiscal policy discipline can also help in this area.

Credit growth is also accelerating in many countries, Eyzaguirre said. While banking systems seem to remain sound, vigilance is needed.

External borrowing by corporations is up and some asset prices are looking “a bit bubbly,” noted Eyzaguirre. “Countries have continued to adopt and strengthen macroprudential policies; this is appropriate but cannot substitute for having suitable monetary and fiscal policies in place,” he said.

Caution all around

Even those countries in the region that have been experiencing less rapid growth recently will need to proceed carefully. As their demand recovers, overheating risks will become ever-more relevant. The countries with less-established monetary policy frameworks will need to carefully watch that commodity price increases do not trigger large second-round effects on inflation.

According to Eyzaguirre, many countries, including in Central America, will need to turn fiscal policy now to the job of rebuilding buffers that were used during the recent crisis. And in the Caribbean, where public debt is very high, fiscal consolidation plans will need to proceed to ensure economic stability and set the stage for better growth in the future.

Rising commodity prices

But for all countries in Latin America and the Caribbean, rising world prices of commodities, especially food, pose an important social challenge, Eyzaguirre warned.

Policies to cushion the blow need to focus on protecting the most vulnerable members of society. “This means avoiding universal subsidy approaches that are often very costly and regressive, and can turn out to be permanent—requiring large adjustments to other parts of the budget,” he said.