Tailwinds or Headwinds? Adjusting the Economic Sails in Latin America

IMF Blog, October 5, 2011

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Author: Nicolás Eyzaguirre
Date: October 5, 2011
Focus: Latin America (analysis drawn from the Regional Economic Outlook for Western Hemisphere)
Outlook horizon referenced: the next six to eighteen months

Global uncertainty described as "virtually unprecedented."
Possible global scenarios affecting Latin America:
- Headwinds: greater stress in the global economy and markets resulting from unresolved problems in advanced economies.
- Tailwinds: renewed confidence and stronger global demand if advanced countries' problems are tackled.
- Volatile gusts: weak growth and continued uncertainty producing unstable outcomes similar to current conditions.

In 2008–09 global crisis, Latin America was hit but subsequently bounced back strongly.
The post-crisis recovery benefited from the dual tailwinds of buoyant commodity prices and easy external finance.
Prior to the fading of tailwinds, some countries experienced overheating symptoms: growing inflation, widening current account deficits, and strong credit growth.

Tailwinds are fading: commodity prices remain high but have come down and could fall further if world demand falters.
International financial markets remain volatile with unusually fluid day-to-day sentiment.
If global uncertainties are resolved, tailwinds could return strongly; if not, headwinds could intensify.

Collapse in confidence could trigger intense volatility in global financial markets.
Another recession in advanced countries would:
- Slow growth in Asian emerging markets.
- Reduce demand supporting commodity prices.
- Deliver a heavy blow to Latin America, particularly commodity exporters.
Potential consequences for the region:
- Capital flows could dry up, squeezing domestic credit markets.
- Growth could slow abruptly as foreign demand and commodity prices fall.
- Currencies and financial conditions could come under pressure.
- Investors, if spooked by troubles elsewhere, would scrutinize fundamentals and potentially pull out.

Early resolution to global uncertainties could:
- Stoke confidence and renew capital inflows to the region.
- Be accompanied by easy monetary policies in advanced economies, further propelling capital flows.
- Cause commodity prices to soar as global demand revives, particularly in emerging Asia.
Risk: renewed dual tailwinds could lead to overheating pressures again.

Fiscal policy:
- Stay the course of gradual fiscal consolidation until global prospects are clearer.
- Resist the temptation to ramp up government spending now to preserve fiscal buffers for a potential global downturn and to maintain fiscal credibility.
Monetary policy:
- Be nimble; use monetary easing first to counter a downturn when it appears.
- Central banks with strong inflation control records and well-anchored inflation expectations can pause now and even cut rates if risks materialize.
- If uncertainties settle and tailwinds return, central banks may need to resume tightening.
Financial sector vigilance and prudential policy:
- Monitor stress in financial institutions and corporations, particularly liquidity strains.
- Keep watch for liquidity strains that can spread virulently to emerging markets, as in 2008–09.
- If external finance remains cheap and domestic credit is frothy, implement tighter prudential policies to protect financial sectors.

Countries should stand ready to deal with both headwinds and stronger tailwinds.
With the right policies, Latin America can influence its future regardless of which external winds prevail.

Source: Tailwinds or Headwinds? Adjusting the Economic Sails in Latin America, Nicolás Eyzaguirre, October 5, 2011.