Dani Rodrik recently wrote in his daily blog that Andrés Velasco is the living example that sound macroeconomic policies have a high dividend. Chile’s decisive fiscal stimulus package—adopted last January—has made him President Bachelet’s most popular minister. Not too long ago, during the years of high copper prices, many Chileans questioned their government’s economic management for saving too much and postponing key investments. Of course, those critics are silent now. Events are showing that a commitment to rules that focus on long run objectives, rather that immediate gratification, pays-off.
But rather than talking about Chile, I would like to make a more general point regarding Latin America. Today’s conventional wisdom –and I say this in complete awareness that ministers generally adhere to, and oftentimes shape, mainstream views—is that stimulus packages are working and that Latin America will soon be out of the recession. In Brazil, for example, most analysts consider that the contraction is a thing of the past. I want to take issue with those views.
Let me start by stating what, in my view, is the conventional wisdom:
- The adoption of sound macroeconomic frameworks, mostly since the late 1990s, allowed Latin America to bring down inflation and public debt. Foreign reserves are high for historical standards, reflecting stronger current accounts and access to external capital. As a result, Latin America is coping with this crisis much better than a decade ago. In fact, there has been no crisis, just a mild recession.
- Key to the current episode has been the ability to conduct countercyclical monetary and fiscal policies. In the current phase of the cycle, policy rates set by the central banks have been cut to 0.75% in Chile (a reduction of 7.5 percentage points), 4% in Peru, 4.5% in Colombia, 4.75% in Mexico, and 9.25% in Brazil.
- Fiscal stimulus has also been the norm, although the size and composition of packages has also varied from country to country. The largest expansions have taken place in Chile (2.5% of GDP), Brazil, Peru, and Mexico.
- Macro-financial variables have shown remarkable stability. In 2009, inflation has been falling, exchange rates have appreciated, stock prices have increased, and spreads on sovereign debt are falling.
- Even though production and employment figures are still declining --and GDP growth projections are being revised downwards-- virtually all forecasts suggest that the recovery will start soon. The latest Global Development Finance Report from the World Bank (the less optimistic of the existing “official” reports) projects major rebounds in all economies. The difference between the 2010 and the 2009 GDP growth forecasts is 5 percentage points for the world economy. The corresponding figure is 5.4 percentage points for the OECD countries, and 4.2 percentage points for Latin America. The expected rebound is spectacular for Mexico (7.5 percentage points).
I think this view errs on the side of optimism. Latin America should hope for the best but prepare for the worst. By not properly considering the risks ahead, governments have the temptation of exhausting the policy tools and not reserving any ammunition for battles that are foreseeable. My critique of the conventional wisdom is based on the following four points:
- The numbers on real activity and aggregate demand conditions which are coming out from Latin America are not that encouraging
Although it is true that retail sales in Brazil increased 6.9% in April (relative to a year before), industrial production registered a 14.8% contraction in May. In Mexico, where GDP contracted by 8.2% in the first quarter, industrial production fell 13.2% in April, and consumer confidence continued to fall in May. The Chilean economic activity contracted 4.6% in April and industrial production fell by 11.1%. The figures for other countries show a similar picture: Latin American economies are experiencing a deep contraction, and the evidence does not suggest a significant recovery underway.
Of course, all this could change with a big rebound in the second semester. But, is that realistic? The contraction in investment has been in the double digits during the first months of this year for the majority of countries in the region, and will have an impact on future growth. More importantly, investor and consumer confidence measures are very low and still falling in the majority of Latin American countries. We know from past episodes that it takes time --and a good amount of positive economic news-- to reverse the direction of these perceptions, especially the consumer’s sentiment.
- Latin America is betting on the rebound of commodity prices
China’s real GDP growth slowed to 6.1% during the first quarter of this year. Although several measures of real activity and domestic demand have been improving lately (investment grew by 32.9% in five months to May), exports continue to deteriorate. Chinese exports contracted by 26.4% in May, suggesting that there is excess capacity. To the extent that exports do not recover, investment will loose momentum as well as commodity imports, which have increased for stockpiling purposes. These are very negative news because they suggest that the surge in commodity prices will not last. Why commodities moved ahead of the fundamentals is not clear, but Latin America should be prepared to deal with prices which are more in line with lower Chinese import demand in future months.
- Private capital flows are shrinking at an alarming pace
The World Bank projects that net private debt and equity flows to developing countries will decline from 8.6% of global GDP in 2007 to 2.0% in 2009. This is much worse than in the debt crisis of the 1980s or the Asian and Russian crises combined. Many in Latin America argue that the region is somehow immune to this trend, mainly because of the role that foreign direct investment plays in the region. This could be true, but at the same time, the evidence available suggests that FDI flows depend largely on growth in the OECD countries. With the major contractions expected in the U.S., Europe and Japan, FDI flows will fall in the medium term. The latest IMF data suggests that this is already happening. The investment projects under way are likely to be completed, but starting new investments is a different game. The recent drop in the cross-border M&A activity is a strong signal in this direction.
For the emerging and developing countries as a whole, private debt and equity flows will likely fall short of meeting external financing needs. The question is how much of the shortfall will affect Latin America. Some countries are better prepared than others. Countries with large current account deficits, strong dependence on tourism and remittances, and limited access to private debt and equity flows will suffer considerably. This of course, points in the direction of Central America and the Caribbean, where a sharp adjustment seems inevitable.
In the largest countries, with access to international markets, much will depend on the ability of private firms to roll over their debt. There are hundreds of corporations in these countries that borrowed in the international syndicated loan market and some that issued international bonds during the last few years. They hold the majority of the outstanding short term external debt as well as the medium to long term obligations coming due in 2009. Financing the public sector is not the problem; the real issue is how to refinance the large Latin American corporations.
The prospects in this regard are not all that encouraging. The supply of credit to the region could fall even further because there are mounting pressures on the capital position of the major banks. Liquidity problems in the global interbank market remain an obstacle for banks to fund additional assets, while tightening of credit standards has been generalized. Last but not least, government ownership (even if temporary and partial) of the large banks changes the priorities in the direction of domestic recovery in the developed world, rather than greater credit risk exposure in emerging countries.
- There is no ammunition left
The capacity of central banks to cut interest rates and of governments to provide more fiscal stimulus is very limited. Even in Chile, there is discussion that the fiscal deficit is already too high and that the government should bring it down again next year. The Mexican central bank has said that further cuts in interest rates are not likely, in line with the language other monetary authorities have used recently. In other words, fiscal and monetary policies do not have many degrees of freedom. If the world economy does not recover soon and private capital flows to Latin America remain low, there is not much that Latin American countries can do. Even worse, it is possible that some of the expansionary policies of the recent months will need to be reversed. This is already part of the debate in countries like Mexico, where the government may need a tax increase to cut the fiscal deficit in 2010.
In summary, Latin American governments and multilateral banks are betting excessively on a sharp economic recovery. For their projections to be right, a major recovery should be already underway. The latest figures, however, do not support that view. Even if the U.S. shows a moderate V- shaped recovery in the next two quarters, China’s imports, commodity prices, and private capital flows could still be the source of very unpleasant news for the region.