IDB study highlights need for fiscal prudency, trade policies to increase the region’s access to Asian, U.S. and European markets
The new economic order that has emerged after the global financial crisis will likely generate an unprecedented favorable international environment for Latin America and the Caribbean in coming years. Policymakers in the region should seize the opportunity to adopt policies that reduce external vulnerabilities and ensure sustainable economic growth, according to a study by the Inter-American Development Bank (IDB).
Increasing commodity prices, the rise of Asia as a main buyer of Latin American raw materials, low world interest rates and rising capital inflows mean large commodity exporters in South America and commodity importers elsewhere in Latin America and the Caribbean would grow at different speeds, presenting distinct policy challenges.
“The rebalancing in the world economy is providing the seeds of what could be a sustained economic boom in Latin America and the Caribbean,’’ said IDB Principal Economist Alejandro Izquierdo, one of the coordinators of the study. “However, for this to happen, countries in the region need to address as soon as possible the new challenges posed by this emerging economic environment, particularly in terms of prudent macroeconomic management, new trade opportunities and higher productivity levels.”
The study, “One Region, Two Speeds? Challenges of the New Global Economic Order for Latin America and the Caribbean,” coordinated by Izquierdo and Ernesto Talvi, director of the Center of Economic and Social Studies (CERES, in its Spanish acronym) in Uruguay, was presented today to the Board of Governors of the IDB during the Bank’s Annual Meeting in Calgary, Canada.
The study provides a detailed analysis of current economic trends that have emerged since the global financial crisis and analyzes the potential role Latin America and the Caribbean can play under this new environment.
The new economic order
The composition of global economic growth has suffered a dramatic change after the financial crisis as North America and Europe increase domestic savings and reduce their current account deficits. Emerging economies now account for 75 percent of world demand growth, up from 50 percent in 2006, according to the study.
The IDB report forecasts the shift in demand will prevail for several years, leading to a much higher propensity to consume primary goods.
This shift has brought profound macroeconomic and trade implications for Latin America. It has led to a surge in commodities prices and financial flows into the region. The price of oil, metals, and foods are 23 percent, 8 percent, and 35 percent higher, respectively, than prevailing levels in 2006. The cost of financing for emerging economies is substantially lower than pre-crisis levels given that excess saving, generated mainly in Asia, is not being absorbed by industrial countries.
Capital inflows to the region have resumed at a rapid pace, reaching a historical record of $266 billion in 2010, and leading to pre-crisis sovereign yields. Unlike the past, financial flows are now predominant. Whereas by 2006 one-third of total capital inflows were non-financial flows, these now represent 55 percent of total inflows.
On the trade side, the rise of Asia has created a growing and insatiable demand for Latin America’s natural resources and placed growing and relentless competitive pressure on Latin America’s manufacturing producers, both at home and abroad.
The current environment will likely prompt commodity exporting countries in the region to grow at faster rates than countries that are mostly commodity importers and more reliant on exports of goods and services to North America and Europe and on remittances from immigrants, according to the study.
Macroeconomic Policy Recommendations
The current economic situation is causing several commodity exporting countries to battle overheating, currency appreciation and an inflow of short-term capital that can have de-stabilizing effects in the economy.
The study calls for these countries to make good use of the external bonanza with sound macroeconomic and financial management to keep in check any buildup of vulnerabilities that may put their economiesat risk.
The study recommends these countries cut back on spending and, in the case of countries suffering from large capital inflows, attain fiscal surpluses that could be used to buy back or retire debt. The report advises policymakers to use capital control measures with caution, given their mixed results in helping slow currency appreciation, and to strengthen liquidity and capital requirement rules to allow the banking system to better adapt to economic cycles.
“If capital inflows are large and economic growth is strong, this is the time to review regulations to allow banks in the region to build up capital and liquidity,’’ said Talvi, noting that Latin America survived the recent crisis reasonably well in part because it had prudent macroeconomic policies in place. “This will allow them to build a strong cushion during the good times and use it when the international environment becomes less favorable.”
Countries in the region that are mostly commodity importers will also need to cut back on spending but for a different reason: as they grow at a smaller pace, they need to ensure fiscal sustainability.
Regarding monetary policy, these commodity importing countries should move towards further transparency and exchange rate flexibility in order to accommodate shocks more easily than at the time of the global crisis. In some countries, this implies increasing efforts to de-dollarize the economy and the financial system to improve the ability to use the exchange rate as a buffer.
Trade Opportunities
The rise of Asia as the main engine of growth poses important trade opportunities and challenges for Latin America. For commodity exporting countries, the challenge is to diversify exports to Asia beyond a very limited number of basic commodities, such as oil, copper, soy and iron ore.
For commodity importers, the challenges range from establishing a foothold in the booming Asian market, by exploiting promising export niches in manufacturing and services, and restructuring their manufacturing sector to better face and accommodate Asia’s competition.
The study recommends the region pursue policies that will unify markets at home and increase access to Asian, U.S. and European markets by reducing tariffs and non-tariff barriers as well as transport costs. The reportcalls for policymakers to support across-the-board policies aimed at improving infrastructure, promoting competition in transport services and facilitating and harmonizing customs procedures.
For manufacturing in the region to improve its competitiveness abroad, the study also stresses the need for Latin America to increase productivity, particularly in the service sector, which employs 60 percent of the labor force, compared to about 20 percent in each of the primary and the manufacturing sector.
The study recommends that the region should support policies and investments to boost productivity in key non-tradable areas. These include retail and wholesale trade, finance, community and personal services, and transportation and construction. The report calls for the elimination of standout tax regimes that discriminate in favor of small and informal firms and social programs that subsidize informal employment at the expense of formal jobs, as well as the implementation of policies that increase credit available to companies.
“The demands posed by the new economic order on market efficiency and productivity in Latin America will be major,’’ said Izquierdo. “Certain industries will cease to be competitive while others types of industries will flourish. Latin American countries will need to have to have in place policies that facilitate reallocation of labor, capital and financial resources to emerging and more productive sectors.”