On the Record

The Impact of the Financial Crisis on Low-income Countries

Mauricio Cárdenas

Editor’s Note: At a Brookings Institution discussion that featured International Monetary Fund’s managing director Dominique Strauss-Kahn, Mauricio Cárdenas spoke on how the global financial crisis has impacted Latin America and addressed stimulus plans and challenges.

In my remarks I will make three major points.

First, contrary to what was believed a few months ago, Latin America is decelerating considerably. However, capital flows remain positive –although smaller than in the past two years—and credit to the private sector is still growing in the major economies, with the important exception of Mexico.

Second, monetary policy has been used to smooth out the business cycle in countries where inflation seems to be falling. The latest move in this direction is Colombia’s decision last Friday to cut the policy rate by 100 basis points, following a 2.5 percentage points reduction in Chile in mid-February. Easing monetary policy as a response to negative external shocks reflects a major change in macroeconomic conditions in the region.

On the fiscal side, the large revenue dependence on commodities has meant larger deficits, which act as automatic stabilizers. In some countries, discretionary expenditures have increased too. Fiscal stimulus packages on the order of 1% of GDP have been announced in almost all the large economies in the region. The smaller countries have been the exception, and they should naturally be the focus of attention.

Third, a larger than expected reduction in capital flows could seriously affect growth prospects, while at the same time will impose constraints on the ability of central banks and governments to sustain countercyclical policies. Although international reserves are relatively high, a considerable reversal in capital flows would require major multilateral financing in order to avoid a deep economic contraction. The readiness of the IFIs, including the regional development banks, like the IDB, should be the top priority from the point of view of the U.S. international economic policy. A concrete decision in this front on the part of the G20 is indispensable.

* * *

Operating mostly through a contraction in export volumes, falling export prices and a reduction on income from remittances, the effects of the crisis are apparent in all Latin American economies. In addition, private investment and consumption are growing a much slower pace than in 2007 and 2008, reflecting crisis a reduction in consumer and business confidence.

Economic activity is decelerating fast, al least judging from the monthly data on industrial production. In Brazil, manufacturing output fell 12.4% in December, for the third consecutive month. Brazilian companies are slashing output and staffing levels. For example, Embraer –the world’s fourth-largest aircraft maker– announced last week that will cut its workforce by 20% (or 4.200 people). Vale, the world’s biggest iron-ore producer, fired 1,300 workers in December. Industrial production in Mexico experienced the largest drop in almost seven years in December when output dropped 6.7% (50% in automobiles), reflecting the 19% reduction in exports to the U.S. The contraction in industrial production has reached double digit figures in other countries, like Chile and Colombia (-10% in both cases).

In light of the generalized downturn in aggregate demand, most analysts have revised downwards growth projections. Last October, the IMF’s regional economic outlook projected a 3% growth rate for the region, which was revised in January to 1.1%. Few people expect growth in the region to exceed 1 percent this year. An important source of uncertainty is related to growth in the U.S. (the elasticity of growth in LAC to growth in the US ranges from 1 to 0.5, depending on the country) as well as economic conditions in China. If China slows down, Latin America is more affected than other parts of the world.

As things look today, growth in 2009 is going to be negative in Mexico (given its greater interdependence with the U.S. economy and a contraction in consumer credit) and in Argentina, Ecuador, Bolivia and Venezuela who are paying the price associated with high country risk. A 2 percent contraction is realistic for most of these countries. A second group, including Brazil, Chile and Colombia, will see moderately positive growth (on the order of 1.5 percent). Peru and Panama will be outliers, with expansions around 4 percent.

* * *

In contrast to previous crises, a major reversal in capital flows is fortunately absent his time. Foreign Direct Equity Investment will remain strong (around $40 billion, down from $60 billion last year), while net portfolio and lending flows will be close to zero. At least, this is the prediction of the Institute of International Finance. But one wonders how safe is the assumption that the region will be able to refinance its bond and loan obligations, and that investors will not take their money out of the local capital markets.

Some comfort is provided by the performance of spreads. Country risk for the large market-friendly economies of the region is stable (EMBIs are between 350 and 450 basis points) which is a positive sign. Governments have been able to place new bond issues (in limited amounts) in international markets. These are the good news.

But things could change without prior notice. Spreads today are not a good predictor of spreads tomorrow. If capital starts to flow out of the region then central banks will be in no position to cut interest rates and governments will be unable to finance larger deficits. There are risks that LAC countries will be forced back to adjustment policies, and their pro-cyclical bias, which were characteristic of past crises episodes, notably the early 1980s and the late 1990s.

To prevent this from happening world leaders must make sure that the multilateral institutions are capable of responding to much more severe conditions. Raising their capital seems to be the most adequate option. This will not only allow them to increase their lending but also will be an opportunity to change some the governance structures of these institutions. However, this is easier said than done. Increasing the capital of multilaterals is a slow motion process, even when there are no intentions to reform these institutions.

A more expedite way is to change lending policies. For example, the IDB limits borrowing to disbursed capital, reserves and callable capital of the non-borrowing countries. If this practice is extended to include callable capital from the borrowing countries with investment grade, the IDB will enhance its capacity to deal with the current situation.

* * *

I will conclude by underscoring the importance of separating the short and long run challenges in international finance. Few doubt that the current crisis provides a unique catalyst to move forward on the need to improve the governance, representativeness, and legitimacy of multilateral institutions. There is an ongoing conversation on the need to change rules and practices regarding chairs, shares, veto powers, and selection of heads of the IMF and the World Bank. G20 leaders can seize the opportunity and reach agreements on these matters before the planned date of January 2011.

The same could be said of changes to international financial supervision and regulation. Given the interconnectedness in financial markets few can argue against the need for more coordination between the standard-setting bodies and those in charge of surveillance, both within and between countries.

But I worry that the issues related to global financial architecture are relegating two other more urgent matters. One is the issue of the readiness of the IMF and multilateral banks to deal with a sudden stop in capital flows to emerging countries. Preemptively capitalizing the regional development banks is the wise step. The other is the situation of low income countries which have suffered from a reduction in exports and access to finance. To avoid a major adjustment that would only aggravate matters in these countries, a new concessional lending facility has to be created, with less conditionality and more flexibility. This is the proposal that the IMF has rightly made.

I would add that doubling foreign aid should be embodied in any single fiscal stimulus package approved in the developed world. This is what the leaders of the G20 should agree to during their April 2nd meeting in London.