CHAPTER I

PROSPECTS FOR GROWTH AND SOCIAL DEVELOPMENT IN LATIN AMERICA

1. INTRODUCTION

1.1 Latin America has experienced a fundamental change in economic policy designed to accelerate economic growth and increase equity. As a consequence, a number of countries in the region have made progress in restoring macroeconomic balance, in advancing structural changes designed to enhance international competitiveness, and in the search for broader participation to include all strata of society in the distribution of the benefits of growth. This has encompassed efforts to achieve a strengthened but smaller, fiscally disciplined government which complements the private sector. It also includes a more open international trade and payments regime, a liberalized system of incentives which reduces discretion in the administration of controls, licenses and subsidies, thereby placing greater reliance on market forces and more equitable and effective social service delivery systems.

1.2 The cornerstone of this approach has been the creation of an environment which is supportive of savings, investment and growth through macroeconomic stability within a context of social concern and strengthened democratic institutions. Of special significance is that these policy changes have been initiated and sustained by governments of different political orientation. This has been made possible by sustained political support for change which exists among broad segments of the population in these countries. The consensus for reform, not always present in Latin America, was born of the economic crisis of the 1980s. It has emerged as the consequence of sustained dialogue among policy makers, political leaders and private sector agents.

1.3 In a number of countries, the process of policy reform and adjustment is fairly advanced. In others, such efforts are at an earlier stage. Only in a very few countries has it been difficult to initiate the necessary reforms. The challenge for each country is different, but all share the same imperative: to create and sustain a policy environment supportive of economic recovery. For this to occur, uncertainty associated with macroeconomic imbalance must be reduced, transparency of economic policy must be maintained, the investment climate must improve, incentives for capital flight must be eliminated, returns on private investment must be strengthened, and public investment in economic and social infrastructure which complements private investment must be increased.

1.4 An essential part of this growth strategy is a more productive use of all available resources, including human resources. Reducing poverty by increasing the productivity of the poor, an important objective in its own right, plays an especially critical role in the modernization process and in establishing the conditions for sustained economic growth. Without this, the broad segment of the population which has difficulty meeting its minimum food, health, shelter and education requirements remains at the margin of the productive process, thereby constraining advance to a decentralized, more open, adaptable and technologically dynamic modern market economy. The objective of such an approach is to reduce social inequality by incorporating fully the most disadvantaged strata of society into the modern economy. Ultimately, political stability and democracy as well as equitable growth are closely linked to the successful implementation of such policies.

2. RECENT DEVELOPMENTS

1.5 Large budget deficits which triggered and maintained an explosive inflationary process in several countries during the 1980s have been sharply reduced or eliminated in most countries. Balance-of- payments deficits brought about, in part, by adverse shifts in the region's terms of trade, by excessive public sector spending, by record high interest rates on these countries' variable rate external debt, and by overvalued real exchange rates which were financed by unsustainable increases in external borrowing have been brought under control. Excessive external debt burdens which reduced resources available for investment and thereby slowed resumption of economic growth have been made more manageable for some countries under the international debt strategy for dealing with commercial debt, the easing of terms on Paris Club reschedulings, strong export performance and increased capital inflows. Since 1989, as a consequence, total interest due as a percentage of exports of goods and services dropped significantly (see table). For the region the drop was from 18.3 to 13.5 percent, reflecting in part the sharp decline in the interest burden of Argentina, Brazil, Chile, Colombia, Costa Rica, Mexico, Uruguay and Venezuela.

1.6 Massive subsidies and the expansion of inefficient state enterprises which pushed scarce resources into unproductive uses have been cut sharply in a few countries through deficit-reduction measures, closure or privatization. High trade barriers used to shield local firms, some of which were inefficient, from international competition have been substantially reduced in almost every country in the region. To complement opening of their economies to international trade, most have taken vigorous action in the last three years to increase trade with their neighbors through subregional free trade agreements.

1.7 As a consequence of the progress made in implementing these reforms, there has been a significant improvement in economic performance in the region. After several years of stagnation, regional GDP rose by 3.7 percent in 1991, 2.9 percent in 1992, and 3.3 percent in 1993 (see Table I-1). A number of countries - Argentina, Chile, Guyana, and Panama - have been especially successful in re-establishing growth, with an average real GDP growth in excess of 7 percent for the period 1990-1993. Belize, Costa Rica, and Uruguay also showed strong economic performance in the last two years with average growth rates above 5.5 percent. This upturn in economic activity was accompanied by substantial progress in reducing inflation. Almost all countries in the region now have relatively low rates of inflation. The greatest progress was achieved in some of the countries with extremely high inflation. Argentina, Nicaragua and Peru, which were experiencing near hyperinflation in 1988-1990, sharply reduced the rate of price increase in the last several years. Bolivia, Chile, Colombia, Ecuador, Guatemala, Mexico, and Trinidad and Tobago also significantly reduced inflation.

1.8 The favorable expectations generated by the reform process stimulated private investment, encouraged a boom in the equity markets, and continue attracting substantial financial flows from abroad. The net increase in capital flows, coupled with the lowest U.S. interest rates in more than a decade, has been of such a magnitude that it has reversed the transfer of resources in the region's favor, thus facilitating the full conversion of domestic savings into new capital formation. As a result, the region's gross domestic investment grew at an average rate of 8.0 percent in the last three years, after several years of continuous decline, providing a major stimulus to economic activity. For many countries in the region there was a substantial recovery of gross domestic investment. Strong increases have been experienced by Argentina, Belize, Bolivia, Chile, Colombia, Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Mexico, Panama, Peru, and Uruguay.

1.9 Net capital inflows of US$175 billion in the last four years, much of them in the form of non-debt creating flows, have dramatically changed the external accounts of Latin America. More than half of the total capital inflow has been used to rebuild international reserves; the remainder has financed a substantial increase in imports. This is a positive development because it indicates that the process of transformation of the financial flows into fixed capital formation and into increased consumption is under way. In 1993 the accumulation of more than US$23 billion in international reserves which took place raised total reserves to over US$110 billion, the highest nominal level ever.

3. SOCIAL REFORMS

1.10 Experience indicates that while macroeconomic stability and structural adjustment are necessary to revive growth, they are not sufficient to deal effectively with the social problems which exist in the region and which would continue over the long term in the absence of social reform. Even in those countries which are now most advanced in the adjustment process and where the recovery of economic growth is well under way, such problems continue to exist and the implementation of programs designed to address them is receiving priority attention.

1.11 Poverty and its associated social dislocations are rooted in the historical experience of the region. During the 1980s, existing social problems became more serious. Economic stagnation contributed to a decline in the growth of employment opportunities, erosion of key institutions and deterioration of essential public services. Health, water supply and the environment deteriorated. Education was seriously underfunded and, as a consequence, progress in developing a well trained, more productive and flexible workforce was disrupted. Throughout the region, a high incidence of underemployment, depressed per capita incomes, and a level of social services which has failed to keep pace with the growing needs of an expanding population have resulted in an enormous backlog of social and institutional needs.

1.12 As countries have carried out reform programs, the best informed, most flexible economic actors with the knowledge and capital to respond to the new economic incentives have been the main agents of change. As a consequence, benefits have been least for the poorest, who lacked the training, flexibility and resources to adapt quickly to the changed incentives. They continue to be the most vulnerable since they are least equipped to respond to change, are living at a subsistence level and are unable to contribute to the growth process. High priority has been assigned by governments throughout the region to opening economic opportunities for the poor and to empowering them to become more productive participants in economic growth. Greater recognition is being given to the key role of women in the development process. A special focus of these countries' efforts is to increase health, education, and vocational skills for all, especially the poor. Equally important is a pace of economic growth which ensures adequate growth of opportunities for productive employment.

1.13 Currently many of the social programs in the region do not reach the most disadvantaged segments of the population. Economic reform is being directed to improving the distributive impact of these programs and to making them more efficient, thereby enhancing their contribution to incorporating the poor into the modernization process. Programs which are targeted to the poor have a special role to play in this regard. A substantial increase in the quality and targeting of social services can be obtained through institutional reforms aimed at increasing the cost effectiveness of social service delivery systems.

4. REQUIREMENTS FOR ACCELERATING DEVELOPMENT

1.14 One of the lessons learned by Latin American countries from historical experience is that acceleration of development requires simultaneous progress on a number of interrelated fronts. Reform of the public sector is an essential part of this process. A number of countries in the region have initiated such reforms in recognition of the importance of providing government with the instruments of a modern state so that they can carry out their functions efficiently in support of the development process.

1.15 The objective of such reform is to strengthen public administration, including the capacity to analyze, formulate and implement economic and social policy, to manage public expenditure, to improve the design of tax policy and tax administration, and to introduce an appropriate regulatory framework for complementing ongoing privatization programs. It also encompasses modernization of judicial systems, provision of basic support services to enhance the efficacy of the legislative process and strengthen the financial viability and efficiency of social security systems. These efforts, aimed at modernizing, focusing and strengthening the machinery of the State, are essential to accelerating economic and social development.

1.16 Of equal importance for accelerated development is improving the efficiency and growth of the private sector. To compete successfully in global markets, the private sector in these countries will have to speed up absorption of modern technology. This will require improving human capital, as well as technological and other economic infrastructure. Deepening and widening of domestic capital markets, or creating them where they do not exist, is also of high priority so that increased domestic and external savings can be mobilized for investment in modernization of the private sector. Such measures would stimulate the continuing reflow of capital from abroad and channel some of it to long-term finance for modernization of industry and agriculture and to commercial infrastructure.

1.17 Modernizing both the agricultural and industrial sectors is an essential part of the trade liberalization process. Growth of developing countries is closely linked to exports of manufactures and agricultural products. To increase international competitive- ness, countries will need to sustain the momentum of market reforms, obtain greater access to external markets through formation of strategic alliances with the private sector abroad, construct better international communication links and adopt new production and management techniques. Countries with a well trained labor force and group of entrepreneurs and which maintain open trade and investment flows are best able to absorb and disseminate such techniques domestically. Failure to emphasize human resource development at all levels and to establish international information links will make it more difficult to compete successfully in global export markets.

1.18 Of special importance is the so-called informal sector. This sector has grown rapidly as overall economic growth stagnated in the 1980s, and the challenge is now to integrate it more fully into the national economy. This will require both modernizing microenterprises and enhancing opportunities for growth of small and medium-sized industry. This is an important step not only for increasing the efficiency of the overall economy but also as an integral part of social reform since the income levels of many of those in the informal sector are low. Small and medium-sized firms are those best suited to channel entrepreneurial creativity, most effective at putting new technologies to use, and most active at creating new jobs. Part of the process of modernizing the private sector is to promote a more open approach that will facilitate integration of the informal sector and of microenterprises into the economy. Programs in support of microenterprises and the informal sector generally are vital to this process.

1.19 There can be no economic growth without a stable society. The sweeping economic reforms being implemented in Latin America will achieve the desired results only if they take place within a more integrated society in which factors of exclusion are being reduced so that all groups can be involved in and benefit from modernization of the productive sectors. A more integrated society can only enrich this process through the creativity and support of a large number of economic agents concerned with its success, leading ultimately to the greater social cohesion which is essential to sustained, accelerated economic growth in the future. The essential prerequisite for overcoming marginalization and poverty is for society as a whole to support a process of political participation which leads to democratic consensus-building and stable, responsive and transparent government. This will strengthen social cohesion, promote the participation of all in the productive process and help to achieve agreements which favor a more equitable distribution of the benefits of economic growth.

1.20 This goal cannot be attained without meeting challenges on a number of fronts. One of these, of special interest to the Bank, is financial sector reform. This is needed to increase mobilization of domestic financial savings for investment and to strengthen institutions which can allocate these resources efficiently to all enterprises, including small and medium-sized businesses, self- employed workers and microenterprises in the informal sector. Another important challenge is the creation of a network of institutions which can provide technical assistance and expert advice to these types of enterprises.

1.21 Rapid industrialization throughout the region has given rise to severe urban environmental problems. These problems, which for the most part affect low-income groups more seriously, have not been addressed over the past decade of declining public investment. Further progress in dealing with these problems will require substantial investment. In its absence, environmental problems will continue to constrain development. In rural areas, particularly those where small, low-income farmers prevail, high rates of deforestation and soil erosion pose an equally serious problem. The cost associated with arresting degradation of the natural environment and improving the urban environment is enormous, not only in terms of financing but also in terms of the need to create the appropriate institutional and technological capabilities at both government and private sector levels. This is an effort which will require substantial support from the international financial institutions.

1.22 The gravity of these environmental and natural resource problems has led to important initiatives by governments and by non- governmental agencies within the region. These efforts have ranged from policy, legal and institutional reforms to design of investment projects and are based on recognition of the increased financial resources required for sustaining such initiatives.

5. PROSPECTS FOR THE WORLD ECONOMY: INCREASED INTERDEPENDENCE

1.23 As countries in Latin America have moved dramatically to reduce trade barriers and to reestablish access to world capital markets, their interdependence with the world economy has grown. Developments in the industrial countries are increasingly important in their impact on trends in the economies of Latin America. The future course of world commodity prices remains important. Where a secular decline in the price of specific commodities appears unlikely to be reversed, countries must undertake changes of their productive structure aimed at creating new sources of income and export earnings. Given the Latin American countries' more recent success in diversifying and expanding nontraditional exports, including food, raw materials and manufactured goods, access to industrial country markets has assumed greater importance. Given the more integrated and competitive global business environment, growth prospects for these countries will, to a significant extent, be determined increasingly by their success in strengthening linkages with the world economy.

1.24 The outlook for the world economy for the remainder of the decade is mixed. The recovery in the United States is strong and the other industrial countries, as a group, are now experiencing a recovery from the cyclical downturn they recently went through. The consensus projection for industrial country growth in the second half of the 1990s assumes moderate success with management of economic policy in these countries, including reduced budget deficits, lower inflation, some easing of real interest rates and higher rates of growth that in the first half of the decade. Average growth for the entire decade is expected to be below that of the 1980s. However, the long awaited, successful conclusion of the seven years of negotiation in the Uruguay Round of GATT gives grounds for optimism as to the future of the world trade system and world economic growth.

1.25 There are risks associated with this consensus projection which should be taken into account. It is possible that industrial countries which thus far have avoided inflationary expectations may enter a period of rising budget deficits, increased inflation, prolonged conflict over wage bargaining and high real interest rates to dampen inflationary pressure. Other countries may have no greater success in dealing with budget deficits than in the past; this could put continued upward pressure on real interest rates and weaken the recovery. The reform process in Eastern Europe and the former Soviet Union could falter. Regional trade blocs could turn inward and trade diversion increase. While these are not elements of the prevailing consensus base case at present, all are plausible. Should they materialize, the external environment will be less supportive of economic recovery in the region.

6. INCREASING INTERNATIONAL COMPETITIVENESS

1.26 Latin American countries moved forcefully over the past year to reduce trade barriers, to integrate more closely with the world, and to establish regional and subregional integration agreements such as MERCOSUR, CARICOM and the Central American Common Market. Approval of the North American Free Trade Agreement is bound to enhance the growth prospects of the three member nations and opens the way for a future Western Hemisphere Free Trade Agreement. In the more open, competitive world economy of the 1990s, Latin American countries' need to press ahead with policies and programs designed to increase their international competitiveness now has assumed increased urgency. An efficient supply response of domestic producers of both import substitutes and exports will be a critical determinant of the sustainability of the opening up process.

1.27 To achieve the rates of economic growth which are required to absorb the vast pool of underemployed labor which accumulated in Latin America during the decade of the 1980s, the region's exports will have to grow more rapidly than world trade throughout the rest of the 1990s. Latin American countries will have to increase their share of world markets. To achieve this, international competi- tiveness must be enhanced by expanding and deepening market reforms; by absorbing, disseminating and mastering new, productivity-enhancing production, management and marketing technology; and by building stronger international trade, finance, investment and communications links.

1.28 Reduced transport and communication costs have increased globalization of production and marketing. This has resulted in greater specialization between countries in different products and within different stages of production. New technologies which permit more differentiated products, closer links between production and demand and "just-in-time" inventory management, made possible by computerization, require close coordination between designers, producers, suppliers and retailers. Greater competition in global and regional markets has increased pressure on firms in Latin America to adopt global corporate strategies consistent with the dynamic comparative advantage of the economic environment in which they are based. Local manpower skills, modern infrastructure to support production flexibility required to adhere to quality and delivery specifications, and an international network of domestic business have grown in importance.

1.29 Increasing the standard of living without losing international competitiveness requires raising productivity. A cost-effective way of achieving this is to adopt management and production techniques which have been developed by others. Foreign direct investment and creation of strategic alliances between local and foreign firms can facilitate this. Countries with a highly skilled, well educated labor force and which have open trade and investment regimes are the best positioned to absorb and disseminate internally innovative production and management techniques. Those which are not successful in accelerating human resource development and in establishing international links will be left behind in the increasingly competitive global market. Latin American countries cannot be confined to merely exporting raw materials and the products of low-cost labor. The region needs to take advantage of the creativity of its people, enhancing its human resources through training and development, scientific knowledge and new technology. This is why it is so important to achieve greater integration of the most vulnerable segments of society into the modern economy.

1.30 To accelerate their export-led growth, the countries of the region will have to diversify their exports into those areas where the growth of their value added is likely to be the fastest. These will reflect the region's comparative advantage as a supplier of resource-based products including agricultural, mineral and manufactured products such as processed raw materials, non- traditional processed foodstuffs and beverages. The growth of agricultural exports will be assisted by the opening up process, by deregulation and by elimination of the past "anti-agrarian" bias of sectoral development policies. These actions have reinforced the comparative advantage derived from the region's abundant natural resources.

1.31 Both the growth and composition of exports of manufactured products are likely to be strongly influenced by three mutually reinforcing developments. First, as industrial countries move into more technology-intensive products, there will be an increasing demand for other products that are produced more efficiently abroad, providing Latin American countries with growing export opportunities for products which are farther up the technology chain. Second, increased investment in human resources and accelerated absorption and development of new technologies will increase inter-industry trade. Third, trade liberalization and expansion of regional free trade areas will provide increased opportunities to obtain economies of scale and a more efficient export manufacturing base.

7. EXTERNAL CAPITAL REQUIREMENTS AND PROSPECTS

1.32 Taking into account expected economic trends in the world economy in the 1990s, the global savings-investment balance might remain tight throughout the decade. Traditional sources of external finance for developing countries will be scarce. Borrowing will be scrutinized more closely and additional effort will be made by both official and commercial lenders to secure the most effective distribution of their resources. Those countries in the region which are most successful in implementing policies to resume growth and restore their creditworthiness will have the greatest access to additional flows. This has already started to occur as several countries have carried out far-reaching reforms, negotiated reductions in debt, reestablished growth and regained a position of creditworthiness in world financial markets.

1.33 As a consequence, net capital inflows to the region increased in the period from 1991 to 1993. The inflow has included bond issues, private placements, commercial paper, certificates of deposit and increased foreign direct investment. Substantial repatriation of flight capital appears to be included in these flows. The inflow has been concentrated in a few countries - Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Little has gone to others. Moreover, the pattern of these flows suggests that the process is still fragile. The capital inflows which have taken place so far appear to be limited in their developmental impact, having gone in part to bidding up the price of existing financial assets rather than fully contributing to increased long-term investment which accelerates development.

1.34 The fact that capital inflows have also taken place in some countries in the region which are still experiencing major macroeconomic imbalances and severe financial problems suggests that investors may be anticipating improvements which have not yet taken place, based on the improved economic performance which has occurred in other countries in the region. If these macroeconomic imbalances are not corrected, a slowness in capital flows to the region could result, and the decade of the 1990s could witness once again a period of acute external capital shortage for a number of countries.

1.35 In spite of the capital inflows, the risk still exists that inadequate long-term external finance could again constrain development and undermine adjustment efforts. To date only relatively few countries and large firms in Latin America have been successful in accessing international capital markets on a sustainable basis. A portion of the capital flows have been relatively short-term in nature and not suitable for many of the long-term developmental expenditures which now must be made by the countries in the region if social and economic infrastructure are not to impede sustained recovery. With the continued upward pressure on world interest rates which is expected in the 1990s, private lending is likely to remain limited and become costly even for countries which maintain their creditworthiness. For smaller, lower income countries and for small and medium-sized firms, it is unlikely to be available.

8. OFFICIAL FINANCING

1.36 Even if the region is successful in attracting increased private capital, such flows tend to be directed more to the larger, middle- income countries and to the larger, more established firms. Moreover, private flows have characteristics which make complementary flows of official development assistance essential. Such flows are typically associated with expansion of investment in plant and equipment which requires complementary investment in economic and social infrastructure. In the absence of domestic fixed income capital markets, such infrastructure investments must be financed by official development assistance. This need is particularly acute in Latin America where the 1980s have left most countries with enormous infrastructure deficits. The infra- structure gap has already affected adversely economic growth in the region and this in turn has limited private capital inflows.

1.37 The financial requirements of infrastructure are large. These will not be met without a close partnership between private and official finance. This is especially true for power generation and even more so for water and basic sanitation. Large investments in electricity generation need to be in hydro power which requires terms the private financial markets cannot provide. The alternative would be to rely on thermal power, with its adverse environmental impact. Water, sanitation and basic social services such as health, training and education also require official involvement. While the private sector can contribute to more effective delivery of such services, and in some cases can provide funding, this will have to come primarily from official sources. While introduction of realistic user charges may increase the sustainability and efficiency of such services, their initial capitalization cannot be covered by private sources of finance since the returns from such investment in human capital are frequently difficult to capture and may only occur over a period far in excess of private investors' time horizon. Long-term official development finance has an essential role to play in the design and support of these services.

1.38 Concessional resources for smaller, lower-income countries or countries which are in the early stages of adjustment can be critical in helping to bridge the financing gap, which is needed to facilitate trade flows and to cover the reconstruction and expansion of infrastructure. Countries experiencing a large, unexpected external shock and a sudden deterioration in their external position are unlikely to attract private capital flows during the time such flows are most urgently required. For these countries, official assistance may be the only source for financing their external deficit. For countries which are just completing the adjustment process and have established a base for recovery of investment and output, official development assistance can have a strong catalyzing effect on private flows.

1.39 Official sources of external finance for all developing countries will be limited in the 1990s. This will be especially true for Latin America. Net resource flows on grants and bilateral loans to the region, concessional and non-concessional, have already begun to decline. Net flows on lending by multilateral institutions fell from US$4.1 billion in 1990 to US$3.4 billion in 1992. Among the international financial institutions, the Inter-American Development Bank is the only official lender which is expected to have positive net flows in the years ahead. In the absence of an Eighth Replenishment, net flows of the IDB would start declining in 1994 and would not be sufficient to offset the negative net flows of the International Monetary Fund and the World Bank.

9. CONCLUSION

1.40 As the next millennium approaches, the region must move from a period of crisis and reform toward achieving growth that is financially, environmentally, and socially sustainable. This would represent nothing less than a transformation for the region and it will be a major challenge for the Bank to assist countries in this effort

1.41 Countries of the region are choosing a path to sustainable growth that is based on liberal, open, market-oriented economies that can compete successfully in the global economy. Realizing the reforms necessary to create these economies while maintaining democratic societies is a formidable task. It will require creating dynamic private sectors to generate employment and income; and efficient public sectors to provide the social, economic, and regulatory infrastructure necessary for growth. Since social and political stability are indispensable conditions for creating sustainable growth, all parts of society must believe that they have a stake in the system and in the country's future. This will mean that equity considerations must be given greater weight than in the past and countries will have to make a determined effort to bring excluded groups into modern society.