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Growth seen at 3 percent for Latin America and the Caribbean economies

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Reforms to boost productivity and gain policy space critical to lessen impact of U.S. monetary tightening or lower growth in China

COSTA DO SAUIPE, Brazil - Latin America and the Caribbean economies are set to grow at 3 percent in 2014 and 3.3 percent in 2015 thanks to improving economic conditions in the United States and Europe, a study issued here today by the Inter-American Development Bank says.

This is in line with the region’s baseline potential in the absence of growth-inducing reforms to boost productivity, according the 2014 Latin American and Caribbean Macroeconomic Report, titled “Global Recovery and Monetary Normalization: Escaping a Chronicle Foretold.”

Improved economic prospects in the U.S. and Europe will help boost growth, and there is an upside potential that the U.S. economy will grow at a stronger pace than anticipated, providing additional growth potential to the region, and particularly to Mexico, Central America and the Caribbean, whose economies are more closely tied to the United States.

The Latin American and the Caribbean region also faces two potential negative risks: financial shocks if interest rate hikes in the U.S. are faster than expected and a drag on real growth in the region if there is slower economic growth in China. South American economies are especially vulnerable to a Chinese slowdown.

Though the region’s economies are on a more sound footing than they were during the shocks of the mid-1990s, most countries are in a weaker position than they were in 2007, prior to the onset of the Great Recession.

In recent years, public debt and dollarization levels have risen, and countries have increased fiscal expenditures in programs that are more difficult to dial back in countercyclical ways, according to the study, which is issued on the side of the Annual Meeting of the IDB.

Fiscal policy is critical

Looking ahead, higher interest rates in the U.S. could mean declining capital inflows, which will hurt growth and, in some cases, lead to exchange rate depreciations and higher inflation.

Countries, especially those with fixed exchange rates, will need to rely less on monetary options and enhance fiscal countercyclical tools. “Fiscal balances have deteriorated and rebuilding fiscal buffers should be a priority especially given current uncertainties,” said Santiago Levy, IDB Vice President for Knowledge and Sectors.

There may also be risks stemming from the strong growth in domestic credit and the issuance of dollar external debt by non-financial firms, two phenomena that are linked. Domestic credit has doubled in the last four years, while firms have issued substantial amounts in dollars and the deposits of those firms in local financial systems account for almost 60 percent of total deposits. Financial supervisors need to monitor and assess such risks carefully.

Latin America and the Caribbean region may also be at an increased risk of a so-called Sudden Stop scenario in capital flows. This is a more dramatic event whose impact depends on a country’s fiscal deficit, on the current account deficit and the level of dollarization and reserves, among other variables. Most countries in the region have seen these indicators deteriorate in recent years.

“This report suggests that reserve levels, while higher in many countries, are below levels that are optimal given the risks of a Sudden Stop scenario,” said IDB economist Andrew Powell, who coordinated the study. “We need to take a closer look at reserve levels in this environment of heightened risks and higher fiscal deficits. And we need to monitor private sector currency mismatches and liquidity risks. We cannot be complacent.”

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