Uncertain Times, Difficult Choices

IMF Blog, September 28, 2015

Source details

Authors: Vitor Gaspar, Alejandro Werner
Date: September 28, 2015
Scope: Analysis of macroeconomic slowdown and fiscal challenges in Latin America, with focus on six larger, financially-integrated economies—Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.
Central question: How should fiscal policy balance smoothing the adjustment and strengthening credibility amid a sharp external shock and constrained policy space?

Primary driver: Sharp decline in commodity prices and China’s growth slowdown and rebalancing.
Consequences:
- Significant deterioration in Latin America’s terms of trade not expected to recover any time soon.
- Tighter financial conditions associated with U.S. monetary policy normalization.
- Sharp decline in Latin currencies, capital flows and equity prices, and an increase in interest rate spreads.
Historical buffer effects:
- In Chile, windfall gains to income owing to stronger terms of trade from the boom in commodity prices amounted to about 185 percentage points of GDP in cumulative terms over 2003-12.
- In Chile, discretionary stimulus during adverse macroeconomic shocks included a 4 percentage points of GDP fall in the cyclically-adjusted balance over the period 2007-09, providing a significant cushion to the economy.
Outlook: Medium-term growth prospects have been marked down, with the region experiencing the slowest growth rates in a decade.

Domestic factors exacerbating the shock:
- Political imbroglio and low confidence.
- Rising household and corporate leverage.
- Structural rigidities, including limited economic diversification and lagging trade performance.
- Relatively low levels of investment and weak productivity growth.
Fiscal developments:
- After a short rebound following the global financial crisis, budget balances began to deteriorate as government spending in the six larger economies increased by an average of 3 percentage points of GDP while commodity prices were still relatively high.
- The fall in commodity prices and slowdown in growth have led to a fall in fiscal revenues, accelerating fiscal deterioration.
- Current outlays—such as pensions, social protection, and health—have increased in all countries except Peru and, to a lesser extent, Colombia, complicating retrenchment.
- Fiscal risks from state owned enterprises and the financial sector add to vulnerability.

Given the magnitude and persistence of the shock, adjustment is unavoidable, though many of the six larger countries will see negative output gaps in the short run.
Suggested primary role of fiscal policy: anchor expectations and facilitate adjustment rather than act as large-scale cyclical stimulus.
Country-specific guidance:
- Brazil: urgent need to put debt ratios on a downward path.
- Uruguay: strengthen the fiscal position over the medium term to reinforce fiscal sustainability.
- Colombia and Mexico: fiscal tightening required to accommodate lower-than-expected revenues owing to weaker oil prices and slower potential growth.
- Chile and Peru: more room for gradual adjustment given public debt levels well below that of other emerging markets, but vulnerability to commodity price shocks argues for eventual adjustment to lower metal prices.
Determinants of consolidation size, timing, and pace: prospective debt dynamics, macroeconomic outlook, and market conditions.

Confidence and credibility determine fiscal latitude; maintaining or re-establishing fiscal anchors is imperative.
Fundamental objective: ensure a solid financial position for the general government.
Compliance with national fiscal rules and procedures is key; experience since 2009 shows medium-term fiscal objectives were frequently revised and rules bent in some cases.
Markets are discriminating between countries with a long-track record of credibility and those with accumulated policy and political risks.
Structural policy priorities:
- Diversify the revenue base for commodity producers (Chile, Colombia, Mexico, and Peru) and avoid overemphasis of government spending on the resource sector.
- Bolster public investment management and strengthen expenditure policies to ensure efficiency and effectiveness of government spending, thereby creating fiscal space and generating growth dividends.
- Build fiscal frameworks that create sufficient precautionary buffers to deal with uncertainty (noting further discussion in the forthcoming Fiscal Monitor, October 2015).

Six larger, financially-integrated economies: Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.
Chile windfall cumulative gains: about 185 percentage points of GDP over 2003-12.
Chile discretionary stimulus: 4 percentage points of GDP fall in the cyclically-adjusted balance over 2007-09.
Average increase in government spending after the crisis across the six economies: 3 percentage points of GDP.
Date of publication: September 28, 2015.

Source: Uncertain Times, Difficult Choices — Vitor Gaspar and Alejandro Werner, September 28, 2015.

Tempos incertos, escolhas difíceis; Vitor Gaspar e Alejandro Werner; 28 de setembro de 2015
- Tempos incertos, escolhas difíceis; Vitor Gaspar e Alejandro Werner; 28 de setembro de 2015 (Markdown version)
- Tempos incertos, escolhas difíceis; Vitor Gaspar e Alejandro Werner; 28 de setembro de 2015 (PDF)
Staff Discussion Note
- Staff Discussion Note (Markdown version)
- Staff Discussion Note (PDF)