Fiscal reform key to boost growth in Latin America and the Caribbean

Region faces commodity, demographic shocks. Baseline scenario is 1.5 percent growth in 2016-2018

NASSAU – Weak global growth, a fading demographic boom, lower commodity prices and deteriorating fiscal positions are underscoring the urgent need for major reformulations in fiscal policies of Latin America and the Caribbean, according to the Inter-American Development Bank’s annual macroeconomic report released here today.

Most countries need to trim fiscal spending. However, the report argues against cutting capital investments but rather undertake more fundamental reforms.

“Fiscal adjustments are never easy,” said IDB Vice President Santiago Levy. “Many countries are in the difficult position of having to act now or face more painful adjustments later on. The good news is that there is room to increase spending efficiency and rebalance fiscal policy to improve growth and protect the many social gains that have been achieved over the past decade.”

Titled Time to Act: Latin America and the Caribbean Facing Strong Challenges, the report notes that commodity prices have returned to their levels of the 1990s and are unlikely to bounce back anytime soon.

Low growth is new normal

The region will experience flat to slightly negative growth in 2016. However, IDB Chief Economist Jose Juan Ruiz notes that “the reality is heterogeneous. While the region as a whole faces negative growth this year, almost a quarter of the IDB’s 26 borrowing countries are registering growth of 3.5 percent or higher.”

Besides lower commodity prices, Latin America and the Caribbean region faces a demographic shock, too. An ageing population and other demographic trends mean that in 2011-2020 the increase in the employment share may only contribute 0.6% to growth rather than 2% in the 2000s – a potential loss of 1.4 percent.

The upshot is that in the post-commodity boom period of 2014-2020, average annual growth is expected to be 1.7 percent, far below the 4 percent registered during the exceptional commodity boom of 2003-2013.

“Most forecasts predict only moderate increases for commodity prices” said Andrew Powell, IDB’s Principal Economic Advisor and the lead author of the report, “but we should note that commodity prices are virtually impossible to predict. Countries need to find better ways to manage commodity price uncertainty”.

There are additional downside risks. According to IDB calculations, for every 1 percent in slower growth in China reduces growth in Latin America and the Caribbean by 0.6 percent. Every one percent reduction in the growth of the US economy trims additional 1.5 percent off growth in Latin America and the Caribbean. “Adding China and the US shocks together will delay the region’s recovery by one year,” said Ruiz.

Some countries saved and can now smooth the transition to lower-commodity prices. However, several countries increased fiscal spending in response to the 2009 recession and then failed to reverse the increases as the recession receded.

Central America and the Caribbean countries are benefitting from lower oil prices and the US economic recovery but several countries still require fiscal adjustment to keep debt from rising.

The report analyzes announced fiscal budgets of 15 countries. Revenue is expected to increase 1.1 percent while cuts amounted to 1.7 percent, of which one percentage point comes from reductions in capital expenditures, which will impact future growth.

There is an opportunity to rebalance spending in favor of public investment such as maintenance and infrastructure repair programs. Developing nations should invest at least 5 percent of GDP in infrastructure to boost growth. Over 2008-2013, the average for 16 countries in the region is 3.7 percent of GDP.

Better infrastructure will also help improve the region’s export performance, something that can be further helped by deepening regional integration to increase scale and allow firms to compete in global markets.

The report details fiscal reforms in four countries – Jamaica, Honduras, Mexico and Chile – that promote sustainability over the longer term.

The report also recommends trimming current spending by better targeting subsidies on gasoline, electricity and public transportation, which tend to leak to higher-income households. Targeting in conditional cash transfer programs can also be improved. Low international oil prices are an opportunity to levy more taxes on gasoline.

There is also considerable space to improve efficiency, particularly in education and health, which tend to account for a large proportion of expenditure. The IDB will issue a flagship report in June on the importance of savings to boost future growth.