Latin America Faces a Third Shock as Global Financial Conditions Tighten

IMF Blog, October 13, 2022

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Latin American countries face a third shock: the tightening of global financial conditions, following the pandemic and Russia’s invasion of Ukraine.
Current positive growth momentum reflects:
- Return of service sectors and employment to pre-pandemic levels.
- Favorable external conditions: high commodity prices, strong external demand and remittances, and rebounding tourism.
Financing conditions are becoming scarcer and costlier as major central banks raise interest rates to tame inflation.
- Capital inflows to emerging markets are slowing and external borrowing costs are increasing.
- Domestic interest rates in emerging markets are rising as central banks hike rates and investors reduce appetite for risker assets.
These factors are expected to decelerate activity by weighing on domestic credit, private consumption, and investment.
Higher interest rates are pushing commodity prices down as the global economy decelerates, reducing their cushioning effect on the region.
The transition to higher global interest rates may be bumpy, with possible spikes in volatility and investor risk aversion if a soft landing is uncertain.

The IMF upgraded its growth projection for Latin America and the Caribbean this year to 3.5 percent from 3 percent in July.
Growth next year is projected to slow to 1.7 percent.
Regional heterogeneity:
- Commodity exporters (South American countries, Mexico and some Caribbean economies) are likely to see growth rates halved next year due to lower commodity prices and rising interest rates.
- Economies of Central America, Panama and the Dominican Republic will slow as trade with the United States and incoming remittances weaken, though they benefit from lower commodity prices.
- Tourism-dependent Caribbean economies will continue recovering, but slower-than-anticipated amid weaker tourism prospects.

Despite slowing growth, high inflation will persist for some time.
Major central banks in the region hiked interest rates early, which will help bring down inflation, but the process will take time as monetary policy must tame domestic demand.
Price pressures have broadened beyond food and energy in Brazil, Chile, Colombia, Mexico and Peru.
- Inflation recently reached a two-decade high of 10 percent in these countries.
IMF inflation forecast for the five countries:
- Price increases will reach around 7.8 percent by year-end.
- Inflation will remain elevated at about 4.9 percent by the end of next year (still above central banks’ tolerance bands in most cases).

The region’s generally healthy banking systems mitigate the risk of financial distress; regulation and supervision have improved in many countries.
Pockets of vulnerability remain:
- Corporate debt has grown considerably over the last decade, especially outside the banking system.
- Monitoring these vulnerabilities is key to identify potential sources of stress and take early action.
High levels of international reserves and strong central bank credibility will help mitigate the impact of tighter financial conditions.
Rising borrowing costs will test public finances through higher interest payments, as public debt and financing needs remain elevated.

Monetary policy:
- Central banks in the region have acted fast and kept long-term inflation expectations anchored.
- Monetary policy should stay the course and not ease prematurely to avoid the high cost of restoring price stability later if inflation becomes entrenched.
Fiscal policy:
- Should focus on rebuilding policy space where needed by reining in public spending, improving tax system design, and strengthening fiscal frameworks for sustained discipline.
- Fiscal consolidation must be inclusive and protect the poor to be effective and durable.
- Where fiscal space exists, fiscal policy should be coordinated with monetary policy to support vulnerable groups while high inflation persists and growth weakens, but without fueling domestic demand.
- Careful calibration is required to offset spending measures aimed at protecting the poor.
Getting this balancing act right is presented as key to achieving inclusive and sustainable growth and building resilience against future shocks.

Authors: Santiago Acosta-Ormaechea, Gustavo Adler, Ilan Goldfajn, Anna Ivanova — October 13, 2022.