The World of Forking Paths
March 18, 2012
Projections for 2012 world growth have been declining, as prospects for Europe have deteriorated and the Chinese economy has started to slow. While the recent package announced for Greece is very good news and staved off a disorderly default, the experience in Latin America demonstrates that there is a long road ahead for Greece and also for other European periphery countries suffering from debt-competitiveness-banking sector problems. Generating higher growth through reforms and without employing the exchange rate to gain greater external competitiveness is likely to provoke political difficulties and much debate, noise and market volatility along the route to a solution. Recent figures for Brazil indicate that these global developments are already affecting Latin America and the Caribbean (LAC).
The recently released 2012 Latin American and Caribbean Macroeconomic Report of the Inter-American Development Bank (IDB) employs a baseline consistent with the World Economic Outlook (WEO) January 2012 projections. Under this reference projection LAC would grow some 3.6% in 2012, with Brazil and Mexico close to that regional average. However a shock in Europe of a similar size to the Lehman crisis in the United States, plus a relatively mild negative shock in China would push the United States back into recession and provoke a recession in LAC. A delayed and more severe shock would provoke a deeper and more persistent recession in the region.
These scenarios represent only a couple of potential realities, in fact given risks are significant, and it is not clear how they will play out, there are a myriad of potential scenarios. Moreover, any modeling technique can only provide a general vision as to how particular events might affect the region. The labyrinth of connections between LAC and the rest of the world imply that there are many potential transmission mechanisms and the region continues to have vulnerabilities. At the same time, however, the region has developed a better set of tools to manage any negative shocks. The Latin American and Caribbean Macroeconomic Report concludes with an assessment of these vulnerabilities and strengths and a set of recommendations.
Due to high prices and positive supply responses, the region has become increasingly commodity-dependent of late. While this development has increased producers’ export earnings, it also raises risks. As noted in Chapter 5 of the report, assumptions regarding the structural prices for commodities imply significant changes in structural deficit calculations. Metals prices in particular are vulnerable to a slowdown in China and to a fall in China’s rate of investment. Grain prices may also decline, although risks here appear more contained given more permanent changes in the Chinese economy.
The region is additionally vulnerable for having been the recipient of a large influx of capital. Emerging economies have suffered either a banking crisis or a recession in about 50% of cases of such capital inflow surges. Given the nature of the latest inflow surge, particularly the proportion of portfolio and banking flows, there may yet be latent risks. If a negative shock hits the region, then growth and credit growth will surely abate, and it is only when banks’ balance sheets cease to expand rapidly that the full extent of the capital inflow and credit boom’s after-effects will be known.
Although fiscal policy was used effectively during the recent global economic crisis, for perhaps the first time in the region’s recent history with such downturns, some fiscal stimulus measures remain in place. Structural fiscal deficits have therefore grown, and fiscal credibility may have been somewhat eroded. Although structural debt fell in recent decades, it has since stabilized at around 42% of Gross Domestic Product (GDP) for the last few years. The Region is consequently less prepared to respond to a negative shock with countercyclical fiscal policy than it was before the great recession.
The vast majority of countries in the region (across quite different monetary and exchange rate regimes), have maintained stable money growth and have been able to contain inflation despite strong exogenous shocks. The region as a whole continues to transition towards inflation targeting, and countries with inflation targeting regimes used interest rates and direct (or non-conventional) policies in a variety of ways during the crisis. In the event of a large negative shock, however, inflation targeters may have only limited space to employ interest rate policies.
The region maintains strong links to international banks and especially to European institutions. If the European crisis deepens this may be a source of vulnerability as a result of direct or indirect channels. Direct channels include pure crossborder lending and the presence of European banks in the Region. While most such banks are fully funded domestically, the process of deleveraging in Europe may still have significant impacts, potentially restricting capital and hence lending. Deleveraging has additionally promoted asset sales, and—if funds to buy assets are limited or sales imply the break-up of relationships—may lead to deleterious effects. Moreover, if the European crisis deepens, tensions may rise within the corporate governance of international banks and between home and host supervisors. In some cases however, indirect exposures may be even more important than those through direct links. The network of international banking is complex, and exposures may result not only from direct lending relationships but also through relations to banks that have lent to affected countries or institutions.
While large capital inflows have increased potential risks, financial supervision in the region has improved, and countries have employed a set of macro-prudential tools that have surely reduced the risk of a crisis. The use of those tools, moreover, has been a learning experience, and the lessons learned will be useful to the region going forward.
The same can be said for fiscal policy. While structural deficits have increased, implementing countercyclical fiscal stimulus has been a process of trial and error for the Region, and the remaining fiscal space for countercyclical actions varies across countries. The experience of the previous downturn, however, will assist the region in selecting the most effective policies given the more limited space.
Balance sheets in LAC overall have improved. Net liabilities fell, in particular those of commodity exporters, including the larger economies of the region, although more recently the stock of portfolio debt and equity liabilities have risen. International reserves have grown. Moreover, the composition of public sector debt has changed. In general there is a greater share of domestic debt issued in local currency; the public sector balance sheet has improved.
Finally, many countries in the region have displayed greater exchange rate flexibility, perhaps in part as monetary credibility has increased and dollarization declined. Moreover, countries in the Region have greater reserves and an array of direct or nonconventional monetary policies as part of their tool kit to respond to negative shocks.
Commodity dependency has risen in the region, and commodity-dependent countries should actively manage this dependency. Commodity prices are likely to fall as China and the world slow, although metals may fall by a much greater amount than grains. However, there remains significant uncertainty regarding future outcomes. Countries should be considering how best to insure against these risks in the short term, perhaps employing financial hedging instruments, and how to adjust to lower prices in the medium term.
A number of commodity importers, most located in Central America and the Caribbean, will benefit from any falls in commodity prices. While many will be affected less by the negative scenarios outlined in the report, if the epicenter of a future crisis is Europe and not the United States, they start from weaker positions. Moreover, several countries in this category have limited or no exchange rate flexibility and have limited fiscal space to respond with countercyclical policy. In the face of a negative shock, countries in this position may wish to consider fiscal stimulus as space allows while at the same time committing to future fiscal reform and adjustment, enhancing the credibility of such a plan through an agreement with the International Monetary Fund (IMF). Some may also wish to consider an ex ante agreement along these lines as insurance in case such a downturn occurs.
More generally, several countries in the region implemented effective fiscal policy during the great recession, although in some cases policies have not been fully reversed during the recovery. In the event of a new downturn, countries should consider carefully designing fiscal stimulus packages to ensure that the measures implemented can readily be reversed in the event of a temporary negative shock.
The region now includes nine countries with inflation targeting, including two countries transitioning to that regime. Inflation targeters have used both interest rates and more direct monetary policy tools. At times these policies have been used as substitutes, responding in different ways to different types of shocks, and at times they have been used as complements; direct tools may speed up transmission mechanisms of monetary policy or may make monetary policy more effective. Inflation targeting is in part based on effective communication with the private sector so that actors incorporate likely policy actions into their expectations, thus increasing the credibility of the nominal anchor adopted. However, this only works if objectives and instruments and the links between them are well understood. More work may be required to communicate the respective circumstances under which direct tools and interest rates will be employed and how their use relates to the objectives of the monetary authority.
Although a number of countries in the region have experienced large capital inflows and strong credit growth, at the same time prudential measures have been strengthened, decreasing the likelihood that latent risks in financial systems will develop into more serious problems. This experience underlines the importance of taking strong measures to lean against the wind in boom times. Now, as credit growth abates, authorities may wish to monitor the quality of banks’ and other financial institutions’ lending portfolios to be able to take prompt action if any problems do emerge.
The region is host to a set of international banks including European institutions that are currently undergoing a process of deleveraging. While such institutions are largely run as independent subsidiaries in the Region, it is advisable to develop rules that highlight appropriate corporate governance of domestic banks irrespective of their ownership structures. Authorities may wish to monitor liquidity to ensure there is no disruption to local markets if the situation deteriorates.
While current capital levels appear healthy, as deleveraging continues there may be lending restrictions and further asset sales. Such sales require identifying potential eligible purchasers, and many regulatory approvals, and it will be important to ensure that that these transactions produce only minimal disruption to lender-borrower relations. Authorities in the Region may wish to take preemptive action to identify potential purchasers. They may additionally wish to smooth processes for regulatory approvals and influence the nature of those transactions to minimize information destruction.
Apart from Spain, countries in Europe’s periphery provide little direct lending to the region. However, indirect exposures through the global banking network may be important. This calls for a high level of international cooperation to understand the nature of these risks and be in a position to take cooperative action to address them. European banks are also important in particular markets including trade finance. Latin American and Caribbean authorities may wish to consider specific actions in those areas where European banks’ activities are focused in order to ensure that those markets continue to operate smoothly in the event of a negative shock.