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Latin America and the Caribbean remain resilient to external shocks, IDB study says

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New report says region would only suffer a relatively mild recession if European debt crisis worsens and Chinese economy decelerates

MONTEVIDEO – Latin America and the Caribbean remain resilient to a possible slowdown in world economic growth that could stem from a deepening of the debt crisis in Europe and a deceleration in China, according to the Inter-American Development Bank’s 2012 Latin American and Caribbean Macroeconomic Report released today during the Bank’s annual meeting.

Image removed.The report outlines two major potential economic risks the region could face in the next year: a faster-than-expected deceleration of China’s economy and deepening economic problems in Europe. Using a global economic model, the study concludes that even if both of these two major events were to occur, Latin America and the Caribbean might suffer only a relatively mild recession.

The study presented to the IDB’s Board of Governors, “The World of Forking Paths,” offers a comprehensive analysis of potential risks affecting the region in the short and medium-term, providing an assessment of main macroeconomic vulnerabilities and strengths as well as policy recommendations.

“We are cautiously optimistic for Latin America and the Caribbean. The region has grown strongly in the last couple of years and it has shown it is resilient to shocks,’’ said Santiago Levy, Vice President for Sectors and Knowledge for the IDB. “Most importantly, the region has developed a set of policy tools that have proven to be effective during economic downturns.”

The report notes that a number of countries, especially commodity exporters, have accumulated international reserves that would help cushion them from international financial turbulence and have reduced external liabilities. Breaking with the past, most countries were able to implement effective fiscal stimulus packages to smooth the last downturn, and have gained valuable experience in counter cyclical fisal policymaking.

Most of the larger economies in the region have adopted flexible exchange rate regimes that make it easier for them to smooth fluctuations. And, several countries in recent years have implemented more sophisticated monetary policies and employed macro-prudential tools, such as the active use of Bank-liquidity requirements and measures to slow currency appreciation, which have all enhanced the region’s resilience against another possible international financial crisis.

Vulnerabilities and Stress Tests

“Even though current economic scenarios do not anticipate a major crisis in Europe or a strong slowdown in China, the world is quite uncertain right now—it really is one of forking paths,’’ Andrew Powell, Principal Advisor in the IDB’s Research Department and the coordinator of the report, said. “Our report shows that resilience has increased for the region but certain vulnerabilities remain and may limit the scope for countercyclical policies if the crisis were to worsen in Europe.”

According to the report, Latin America and the Caribbean’s dependency on commodities remains high and a surge in capital inflows has increased private sector, foreign-currency portfolio liabilities. Moreover, the presence of a large number of European banks could make the region’s banking sector vulnerable to a credit squeeze.

Under the stress scenarios outlined in the study, the report reaches the following conclusions:

  • Latin America and Caribbean external accounts remain resilient to external shocks and the region should continue to have access to external borrowing and to official sources if required. Since 2008, public sector external debt has fallen and international reserves have increased for commodity-exporting economies. Commodity importers’ foreign debt levels and international reserves have remained roughly stable. Composition of public debt for the region has improved, with more debt issued locally and with longer maturities. For commodity importers, private sector external liabilities, mostly in the form of foreign direct investment, have increased.
  • A series of micro and macro prudential regulations have reduced latent risks for problems in the financial sector stemming from strong capital inflows and credit boom over the last few years. Macro prudential measures implemented by countries in the region in recent years included high bank capital requirements and dynamic loan-loss provisions. The report recommends that policymakers monitor Bank portfolios carefully, develop rules on corporate governance for international banks, and provide strong supervision.
  • One area of some concern is that most of the countries in the region have less room to implement a fiscal stimulus package today than in the wake of the 2008 Lehman crisis. In several countries that implemented fiscal stimulus packages in 2008, part of that increased spending appears to have become permanent. Out of a sample of 23 countries, only four have ample room for a countercyclical fiscal policy in the event of another international financial crisis. In their stimulus packages, countries with limited fiscal space should design temporary measures that may be retired once the negative shock has dissipated. 
  • In contrast to the past, most countries in the region under a variety of exchange rate regimes have managed to contain monetary growth and inflation despite external shocks. In the event of another major financial crisis, countries that utilize inflation-targeting may not have as much flexibility to lower policy interest rates but have ample room to employ non-conventional tools such as lowering bank reserve requirements and introducing foreign currency auctions to increase domestic liquidity. Inflation targeting is about effective communications and countries with this regime may wish to explain more clearly under what circumstances these different tools will be employed and how they relate to the objectives of the monetary authority. Countries that choose to have a managed or fixed exchange rate regime may wish to find other ways to enhance their flexibility to external shocks by allowing greater wage and domestic price movements. 
  • A worsening of the crisis in Europe may lead major European banks in the region to accelerate asset sales and reduce lending. Banking regulators should monitor the behavior of all banks and develop rules to strengthen the corporate governance of local subsidiaries. Authorities may wish to monitor banking liquidity to ensure that there is no disruption in domestic financial markets, in the event of a negative external shock, and should work with European institutions to ensure they are in a position to sell assets in Latin America with minimal disruption if the need arises. 
  • Metal producers in the region are expected to be more affected by a Chinese slowdown than agricultural producers. Chinese demand for metals would be affected not only by a reduction in the level of China’s economic growth but also by an anticipated change in the composition of GDP, implying a lower rate of investment. Grain prices would be less affected because their demand is linked to longer-term changes in food consumption patterns that are unlikely to be reversed. The study says countries and firms should consider investing in hedging mechanisms. Risks that are not hedged through third parties may be managed internally through stabilization funds and other instruments.
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