Curbing Success in Latin America

There are two Latin Americas and one is thriving. While Central America and the Caribbean are still struggling with the effects of the 2008 economic crisis and may grow below 2 percent this year, the stellar seven (Argentina, Brazil, Chile, Colombia, Mexico, Peru and Uruguay) passed with flying colors the test of the global slowdown. These seven countries are expected to grow at an average rate of 5 percent in the near future, fueled by apt domestic policies, favorable terms of trade and considerable amounts of foreign capital inflows.

However, success has come at a price. These seven countries are facing overvaluations in their currencies. Many worry that the region is catching a mild case of Dutch disease — a term coined by The Economist in 1973 to refer to the decline of the manufacturing sector in the Netherlands after the discovery of a large natural gas field in 1959. Dutch disease is an illness that kills jobs and competitiveness (sometimes permanently) in industrial sectors that are adversely affected by the appreciation of the currency.

Traditional Dutch disease has been linked primarily to the effects of high commodity export prices or volumes in one sector at the expense of other sectors. The symptoms are already apparent in commodity exporting countries like Argentina, Brazil, Chile and Colombia, where the volumes of non-primary net exports have been falling rapidly and industrial output and employment are starting to dwindle despite solid GDP growth figures.

But the Latin American seven (with the notable exception of Argentina) are also suffering from a new strain of the disease, the so-called “financial-Dutch disease”, which is driven by capital flows that exacerbate exchange rate appreciation pressures, making many of these countries too expensive for their own good. Initially dominated by foreign direct investment, capital flows are increasingly supplemented by portfolio flows.

In other words, if the traditional Dutch disease is linked to China, this new variety has its source in U.S. monetary policy.

Brazil deserves a special note in this regard. Its diversified manufacturing exports account for the country’s trade surplus. Thus, it is hard to argue that the country’s competitiveness is at stake due to a traditional case of Dutch disease triggered by booming metals and soybean prices. On the contrary, Brazil appears to epitomize financial Dutch disease, losing competitiveness at the hands of enthusiastic global speculators.

Understanding the nature of the disease is critical in order to prescribe a medicine that can cure the ailment. Traditional-Dutch disease from commodity booms calls for sector–specific interventions, such as a mix of taxes and subsidies designed to mitigate its impact on the relative competitiveness of the industry or sector stabilization funds to save the dollars from the external surplus abroad to limit its effect on the exchange rate.

But these measures are ineffective when it comes to a financial-Dutch disease, which requires a macroeconomic dam to keep away the dollar flood; for example, through sterilized exchange rate interventions or capital controls.

Sterilized interventions have become a permanent guest of the macroeconomic policy framework in the seven Latin jaguars (with the exception of Mexico). Capital controls that put sand-in-the-wheels of international finance are less pervasive. But Tobin taxes or unremunerated reserve requirements on selected foreign inflows, although admittedly more controversial, are also becoming part of the standard toolkit.

Micro-prudential measures, such as limits to banks´ foreign exchange positions and lifting of capital restrictions on outflows, are in the same category. An innovative addition to the policies under the macro-prudential umbrella is the use of standard commercial bank reserve requirements (as is the case in Turkey) or taxes on short-term lending (as is the case in Brazil) to widen the wedge between the deposit interest rate that determines the currency carry and the lending rate that governs the transmission of monetary policy.

These seven economies are increasingly attracted to these policy options, but two caveats are in order. First, as we argue in a recent Brookings report, both sterilized interventions and sand-in-the-wheel capital controls are effective, but only marginally and possibly decreasingly so over time.

Precisely because of this, neither the standard inflation-targeting framework nor its extended and expanded version (inflation targeting 2.0, which keep an eye on the potential deleterious influence of the global financial cycle) will be capable alone of delivering macroeconomic stability. In addition, these seven economies have been slow to unwind the fiscal stimulus implemented during the recent economic crisis, for reasons that have to do with elections in Argentina and Peru, natural disasters in Chile and Colombia, or more broadly the political cost of adjustment in an age of heightened expectations in Brazil.

At any rate, it is clear that these policies are not substitutes. A clever combination of exchange rate, monetary and fiscal policies is needed to prevent overvaluation and overheating, and to avoid a hard landing once the global financial cycle makes the inevitable turn.