2. Outlook and Policy Challenges for Latin America and the Caribbean
Author: International Monetary Fund
Language:
English
Keywords:
REO; commodity; emerging market; bond yield; fiscal policy; real GDP; financial market; commodity price; foreign direct investment; Inflation; Current account deficits; Global
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Abstract

Economic activity in Latin America and the Caribbean (LAC) is expected to remain relatively subdued in 2014. While the faster recovery of the advanced economies should strengthen external demand, this effect is likely to be offset by the negative impact of lower commodity prices and tighter financial conditions on domestic demand. Policy priorities include strengthening public finances, addressing potential financial fragilities, and implementing structural reforms to ease supply-side constraints and raise potential growth.

Economic activity in Latin America and the Caribbean (LAC) is expected to remain relatively subdued in 2014. While the faster recovery of the advanced economies should strengthen external demand, this effect is likely to be offset by the negative impact of lower commodity prices and tighter financial conditions on domestic demand. Policy priorities include strengthening public finances, addressing potential financial fragilities, and implementing structural reforms to ease supply-side constraints and raise potential growth.

Real GDP growth in LAC moderated further in 2013 to 2¾ percent, down from 3 percent in 2012 and 4½ percent in 2011 (Figure 2.1 and Table 2.1). Activity was held back by weaker domestic demand, lower commodity prices, tightening financial conditions, and supply constraints in some cases. The particularly sharp slowdown in Mexico reflected lower public spending and construction activity, as well as weak demand from the United States. Inflation remained contained in most of the region, reflecting lower food prices and subdued activity. Regional financial markets were affected by repeated bouts of volatility over the past 12 months, as investors reassessed the relative risks and prospects of emerging market economies in the context of the U.S. Federal Reserve’s initial steps toward reducing the pace of its asset purchases (“tapering”).

Figure 2.1
Figure 2.1

Growth in Latin America moderated further in 2013. Asset prices have declined since the May 2013 “taper shock,” amid weaker investor sentiment.

Table 2.1.

Western Hemisphere: Main Economic Indicators1

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Source: IMF staff calculations and projections.Note: ECCU = Eastern Caribbean Currency Union; LAC = Latin America and the Caribbean.

Regional aggregates are purchasing power parity GDP-weighted averages unless otherwise noted. Current account aggregates are U.S. dollar nominal GDP-weighted averages. Consumer price index forecasts exclude Argentina.

End-of-period (December) rates. These will generally differ from period average inflation rates reported in the IMF’s World Economic Outlook, although both are based on identical underlying projections.

See Annex 2.1 for details on Argentina’s data.

Fiscal year data.

Simple average for Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

Simple average for Argentina, Bolivia, Ecuador, Paraguay, and Venezuela.

Simple average of Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua.

Simple average of the Bahamas, Barbados, Jamaica, and ECCU member states.

Simple average of Belize, Guyana, Suriname, and Trinidad and Tobago.

Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines, as well as Anguilla and Montserrat, which are not IMF members.

Growth is projected to remain in low gear in 2014, at about 2½ percent (Figure 2.2), despite some strengthening of external demand. The slowdown in investment growth is expected to continue, reflecting the completion of large projects in mining and other areas, rising funding costs, and weaker business confidence.

Figure 2.2
Figure 2.2

Growth is projected to remain subdued in 2014, reflecting weak investment. External current account deficits are expected to stop widening.

The headline growth number masks divergent dynamics for the region’s largest economies. Mexico’s economy is expected to rebound on the back of a stronger U.S. recovery and normalization of domestic factors. In Brazil, activity will remain subdued, as weak business confidence continues to weigh on private investment. Argentina and Venezuela, in turn, are faced with significant fiscal and external imbalances, which have prompted a variety of controls on trade, prices, and exchange rates that hamper activity. In the rest of Latin America, growth is expected to remain close to potential, with stronger external demand from the advanced economies offset by tighter global financing conditions and softer commodity prices. In the Caribbean, high debt levels and long-standing competitiveness problems will continue to constrain activity, though a recovery of tourism flows may provide a positive impulse.

Overall, the balance of risks to the outlook is still tilted to the downside. Although the effects from a gradual and orderly normalization of U.S. monetary policy should be contained for most of the LAC region, increased capital flow volatility remains a risk (see Chapter 3). Based on recent experience, countries with large current account deficits, high inflation, and limited domestic policy space are likely to be most affected by fresh bouts of financial market volatility. Another important risk is a sharper decline in commodity prices, for instance, driven by downward surprises to China’s growth outlook. Commodity prices have already softened over the past 12 months (especially metals prices, which declined by 15 percent through mid-March) and are projected to moderate further over the medium term as supply is increasing while demand growth from large emerging markets is expected to slow.1 A larger-than-envisaged decline in commodity prices would have negative effects on growth in South America’s commodity exporters (see Chapter 4).

Turning to domestic risks, weak fiscal positions represent an important vulnerability in a number of economies (see Table 2.2 and Chapter 5).

Table 2.2.

Western Hemisphere: Main Fiscal Indicators1

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Source: IMF staff calculations and projections.Note: ECCU = Eastern Caribbean Currency Union; LAC = Latin America and the Caribbean.

Definitions of public sector accounts vary by country, depending on country-specific institutional differences, including on what constitutes the appropriate coverage from a fiscal policy perspective, as defined by the IMF staff. All indicators reported on fiscal year basis. Regional aggregates are purchasing power parity GDP-weighted averages, unless otherwise noted.

Primary balance defined as total revenue less primary expenditures.

Data for the United States have been revised significantly following the Bureau of Economic Analysis’s recent comprehensive revision of the National Income and Product Accounts along the lines of the 2008 System of National Accounts (SNA). As a result of these methodological changes, the deficit includes several expenditure items not counted as expenditure in other countries which have not yet adopted the 2008 SNA. Moreover, for cross-country comparability, gross and net debt levels reported by national statistical agencies for countries that have adopted the 2008 SNA (Canada and the United States) are adjusted to exclude unfunded pension liabilities of government employees’ defined benefit pension plans. See Box 1.1 in the April 2014 Fiscal Monitor for more details.

Federal government and provinces; includes interest payments on an accrued basis. Primary expenditure and balance include the federal government and provinces. Gross debt is for the federal government only.

Nonfinancial public sector, excluding the operations of nationalized mixed-ownership companies in the hydrocarbon and electricity sectors.

Nonfinancial public sector reported for primary balances (excluding statistical discrepancies); combined public sector including Ecopetrol and excluding Banco de la República’s outstanding external debt reported for gross public debt.

Includes central government.

Primary expenditures for Suriname exclude net lending. Debt data refers to central government and government-guaranteed public debt.

Consolidated public sector; data for El Salvador include operations of pension trust funds.

Central government only. Gross debt for Belize includes both public and publicly guaranteed debt.

Fiscal data cover the nonfinancial public sector excluding the Panama Canal Authority.

Central government for primary balance accounts; public sector for gross debt.

Overall and primary balances include off-budget and public-private partnership activities for Barbados and the nonfinancial public sector. Central government for gross debt (excludes NIS Holdings).

Debt includes PetroCaribe debt (net of its financing to the central government) and projected IMF disbursements and other international financial institutions.

ECCU members are Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines. Central government for primary balance accounts; public sector for gross debt.

Simple average for Brazil, Chile, Colombia, Mexico, Peru, and Uruguay.

Simple average for Argentina, Bolivia, Ecuador, Paraguay, and Venezuela.

Simple average of Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, and Nicaragua.

Simple average of the Bahamas, Barbados, Jamaica, and ECCU member states.

Simple average of Belize, Guyana, Suriname, and Trinidad and Tobago.

Bank and household balance sheets are generally on sound footing, but several years of strong credit growth may have created pockets of vulnerability. Meanwhile, the increase in firms’ external debt issuance should be monitored closely, with particular attention to buildup of excessive leverage and potential currency mismatches. The combination of slower growth and tighter financial conditions could drive up nonperforming loans and lower bank profitability. These challenges are heightened by the fact that medium-term potential growth in many economies is estimated to be well below the high average growth rates of the past decade. As discussed in the May 2013 Regional Economic Outlook: Western Hemisphere, policies need to adjust to this new reality. In particular, macroeconomic policies should not be used to boost demand in economies with output levels close to potential, while structural reforms are needed to raise productivity in the medium term.

Financially Integrated Economies

Developments and Outlook

Output gaps remain relatively small in most of the financially integrated economies in the region. Near-term prospects vary, reflecting differences in potential growth across countries and some idiosyncratic factors:

  • Brazil’s growth is expected to fall below 2 percent in 2014. Weighing on activity are domestic supply constraints, especially in infrastructure, along with continued weak private investment growth, which seems to reflect loss of competitiveness and low confidence, as well as higher borrowing costs.

  • Growth in Mexico is set to rebound to 3 percent in 2014. Some of the headwinds to growth have already started to ease, with fiscal policy shifting to a more accommodative stance and U.S. demand picking up, although the recovery in construction activity remains tepid. Looking further ahead, Mexico’s ongoing structural reforms, especially in the energy and telecommunications sectors, are expected to raise potential growth over the medium term.

  • Among the other financially integrated economies, Colombia and Peru are expected to maintain fairly rapid growth. Activity in Chile is projected to moderate further, as private investment growth has slowed, especially in mining. In all three countries, private consumption growth remains robust, supported by low unemployment rates. In Uruguay, growth is also expected to moderate, as a major foreign direct investment–financed investment project reaches completion and external demand from regional trading partners weakens.

Labor markets remain relatively tight in most economies, with unemployment rates still near record-low levels (Figure 2.3 and Table 2.3). That said, a tentative easing of labor market pressures is apparent in several countries—employment growth and real wage growth are starting to moderate.

Figure 2.3
Figure 2.3

Unemployment remains at historically low levels, but real wage growth has started to moderate in some of the financially integrated economies.

Table 2.3.

Western Hemisphere: Selected Economic and Social Indicators, 2004–131

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Sources: Bloomberg, L.P.; national authorities; IMF, International Financial Statistics database; World Bank; and IMF staff calculations.

Estimates may vary from those reported by national authorities on account of differences in methodology and source. Regional aggregates are purchasing power parity GDP-weighted averages, except for regional GDP in U.S. dollars and population where totals are computed.

At market exchange rates, except for Argentina and Venezuela for which data used comes from national authorities and private analysts.

End-of-period, 12-month percent change.

Exports plus imports of goods and services in percent of GDP.

Data from Socio-Economic Database for Latin America and the Caribbean, based on the latest country-specific household surveys. In most cases, the surveys are from 2011 or 2012, though the data for Guatemala (2009) and Venezuela (2006) are less recent. Poverty rate Is defined as the share of the population earning less than US$2.50 per day. Gini Index is calculated by the World Bank using pooled data for each country. Data for the United States are from the U.S. Census Bureau; those for Canada are from Statistics Canada.

Median of long-term foreign currency ratings published by Moody’s, Standard & Poor’s, and Fitch.

See Annex 2.1 for details on Argentina’s data.

Inflation generally remained contained in 2013, reflecting lower food prices and the moderation of domestic demand (Figure 2.4). Weaker currencies have created an inflationary impulse recently, but pass-through effects are likely to remain modest, consistent with empirical estimates for economies with credible inflation-targeting regimes. However, the outlook varies across countries. In Chile and Colombia, inflation has recently edged up, but is projected to remain close to the official target. In Mexico, inflation spiked in early 2014, owing to one-off tax changes, but is expected to fall back into the target range in the second half of the year. A similar pattern is projected for Peru, where food supply shocks have caused some upside pressure in recent months. In Brazil, inflation is expected to stay in the upper part of the target range despite significant monetary tightening, reflecting limited spare capacity, inflation inertia, and some pass-through from exchange rate depreciation. Inflation continues to be higher in Uruguay, amid robust demand and widespread wage indexation.

Figure 2.4
Figure 2.4

Inflationary pressures are limited to a few countries. External current account deficits rose further last year but were typically financed by foreign direct investment.

External current account deficits widened further in 2013, reaching 3.8 percent of GDP on average. Relatively weak growth of export volumes was a key factor, alongside some deterioration of the terms of trade, especially in Chile and Peru. Softer commodity prices will continue to weigh on export proceeds in the future, but this effect should be partly offset by expenditure switching from weaker real exchange rates. On balance, current account deficits are expected to stabilize or narrow somewhat over the next two years. A sharper-than-expected deterioration in the terms of trade, however, remains a key downside risk.

Net capital inflows remained relatively strong in 2013, despite jitters in global financial markets (Figure 2.5). Foreign direct investment inflows continue to exceed the current account deficit in most countries. Portfolio investment and other types of capital inflows also held up, despite some divestment by foreign mutual fund investors. More generally, the pattern of flows during the most recent capital inflow episode compares favorably with a previous inflow episode in 1991–94. In particular, the financially integrated economies have received a more resilient mix of inflows, with a greater share of foreign direct investment, and have used a larger share of those inflows to build up international reserves and private asset holdings overseas, while the widening of the current account deficit has been more contained.2 Nonetheless, the risk of a sudden stop of capital flows remains a concern.

Figure 2.5
Figure 2.5

Even as asset prices declined, net capital inflows remained relatively strong in 2013. Domestic credit growth also stayed buoyant.

Turning to domestic financial developments, bank lending growth moderated somewhat in Brazil, Chile, and Mexico, but remains buoyant—with real annual growth in excess of 10 percent in several countries. In Brazil, aggregate credit growth of 8 percent in real terms masks an important divergence between a slower pace of lending by private banks, in response to weak demand and tightening credit standards, and a still-strong expansion of lending by public banks. After several years of strong credit expansion, the challenge for most of the financially integrated economies is to engineer a smooth transition to more sustainable rates of credit growth.

Cyclically sensitive sectors with high leverage, such as commercial real estate development in Chile, could be especially vulnerable. An area of potential concern in Brazil is consumer credit, which has increased rapidly in recent years, albeit from a low base.

Corporate debt issuance in the region has also been very strong in recent years, though the bonds have relatively long maturities and there are no near-term maturity cliffs (Figure 2.6). In some cases, including Brazil, balance sheet leverage has increased, although debt metrics do not yet suggest broad-based financial excess (see Box 2.1).

Figure 2.6
Figure 2.6

Corporate bond issuance moderated in Brazil but continued at a strong pace elsewhere.

Policy Priorities

The outlook for the financially integrated economies presents two main policy challenges. First, investor sentiment toward emerging markets remains fragile. New episodes of market turbulence could further drive up funding costs, with negative knock-on effects for growth. Second, with the secular commodity price boom petering out and activity increasingly constrained by supply-side bottlenecks, economic growth is likely to settle below the high rates of the past decade, even in the absence of major external shocks. Addressing these challenges will require a careful recalibration of macroeconomic policies, a clear focus on reducing vulnerabilities, and stepped-up structural reforms to remove obstacles to growth.

Exchange rate flexibility played a key role in helping these countries adjust to the market turbulence in mid-2013, and will continue to provide an important buffer (Figure 2.7).3 In general, the depreciation of the past 12 months has brought these countries’ exchange rates closer in line with long-term fundamentals. Importantly, the economic benefits of better-aligned currencies have not been outweighed by adverse side effects: pass-through to inflation has generally been moderate, and there is little evidence for negative balance sheet effects, although potential vulnerabilities bear continued close monitoring.

Figure 2.7