Latin America: Time for Reform, Not for Complacency

Mauricio Cárdenas
Mauricio Cárdenas
Mauricio Cárdenas Visiting Senior Research Scholar, Center on Global Energy Policy - Colombia University, Former Minister of Finance and Public Credit - Republic of Colombia, Former Brookings Expert

October 19, 2009

Since the beginning of the financial crisis, Latin America has faced both challenges and opportunities. The region has dealt very well with the challenges, but still has to seize this crisis as an opportunity to make important reforms to solve longstanding problems.

It is evident that economic conditions in the region are already showing signs of improvement. Industrial production, housing construction, and consumer and business confidence levels are on the rise, relative to what happened in the first two quarters of 2009. With the exception of Mexico, the economic contraction is likely to be mild this year. In some countries, such as Colombia and Peru, positive economic growth in 2009 is still a likely possibility.

Why is Latin America overpeforming relative to the developed world? To a large extent this is the result of good policies, not good luck. What is remarkable about this crisis is the widening of the “policy space” in Latin America, meaning that governments have been under pressure to introduce measures that mitigate the effects of the crisis and, interestingly, they have had more policy options available than in the recent past.

There are two forces behind the greater policy space. First: countries have had more policy capabilities. With lower initial levels of public debt, high international reserves, and single-digit inflation rates, policymakers have been able to engineer an increase in government expenditures and a reduction in interest rates. The adoption of countercyclical fiscal and monetary policies was possible because the initial macroeconomic conditions were favorable. During the crisis of the late 1990s, in contrast, fiscal and monetary expansions would have resulted in a balance of payments crisis, large currency depreciations, and an even sharper economic contraction.

But today’s response is not just the result of improved initial conditions. There is an even more powerful force that is helping Latin America respond effectively and that is greater “policy tolerance.” This refers to the ability to adopt measures that were considered “unacceptable” a few years ago, which has increased the degrees of freedom in policymaking. To put it simply, a number of policy interventions we see today—in areas such as tax and financial policies—would have previously resulted in conflicts with the IMF and the multilateral development banks.

Understanding the origins of greater policy tolerance is a speculative exercise, but the fact that the crisis originated in the U.S. and other industrial economies is a key element. The role of the G-20 in steering the response—reflecting the increased political and economic weight of countries like Brazil and China—has also been influential. Also, to avoid being put on the defensive—for lack of previous oversight—the IMF adopted a proactive approach, which has been essential in order to enlarge the range of policies and interventions that are now considered acceptable.

The natural question to ask is: What are Latin American governments doing with the greater policy tolerance? I would argue that there are two policy areas in which the tolerance factor is critical: financial/credit and industrial policies. Let me illustrate this with a few examples.

In Brazil, the government is cutting sales taxes on durable goods, such as automobiles and appliances. It also used its development bank (called BNDS) to disburse nearly $50 billion in new loans to the private sector (from January – August 2009, which was 59 percent more than in 2008). The BNDS—which has given more loans this year than the World Bank—has been an effective arm for keeping credit levels high, both through direct lending and provision of guarantees. Meanwhile, the Colombian government adopted a subsidy on interest paid on mortgages. For individuals under the median national income, the government pays up to a third of the interest rate. In Chile, by providing a guarantee of up to 70 percent, the government is refinancing $1 billion in debt owed by the private sector. The measure was initially targeting bank loans from SMEs, but was later expanded to cover bigger firms and some financial institutions. Across the region, governments have pumped more money into infrastructure projects and conditional cash transfers programs, targeted to the poor.

The lesson is that policy space is being used in ways that we can now only begin to understand.

What does this mean for Latin America’s future? Although a world economic recovery may be underway, economic conditions in LAC can remain weak for the following reasons: First, the contraction in exports from Latin America does not show a clear sign of reversal, especially in non-commodities. Second, unemployment in the developed world will continue to increase for some time pushing remittances down. Third, fiscal expansions are generating high fiscal deficits that will be increasingly hard to finance. A good number of countries will either have to curb expenditures, raise taxes, or both. This will happen before the world economy fully recovers.

Unemployment rates in Latin America have already begun to increase—on average by two percentage points in every country—and will continue to increase in the coming months. This will reverse the declining trend in poverty rates and will weaken domestic demand, which until now has been the key force offsetting the collapse in exports and private investment.

The problem is that few countries are paying attention to the problems associated with the very sluggish generation of formal jobs. Unfortunately, greater policy tolerance also means more tolerance toward the status quo in terms of payroll taxes, and other aspects of the labor and social security legislation.

What Latin America needs is more reform and less complacency. True, Latin America is doing better than other regions. But it is equally true that, in the past, crises were great catalysts for reform. This is not the case now. The region should seize this moment to deal with old problems in a new way. Governments should take advantage of the greater policy space and begin solving the challenges of low productivity and high informality.