The financial crisis has brought Keynesianism back to the center stage of the policy debate worldwide. Several Latin American and Caribbean nations are announcing their own fiscal stimulus packages to try to weather the latest global credit crunch.
A new study by the Inter-American Development Bank shows that recessions are far less severe in countries with room to adopt more flexible monetary and fiscal policies. However, this is not something for all nations, as success depends on economic initial conditions at the time of the crisis.
The study alerts that countries in which governments have saved little during the commodity boom years will have limited scope to increase spending to alleviate the upcoming recession stemming from the current crisis. Any attempt to boost spending dramatically could erode confidence in the country’s ability to repay its debts in the future.
The IDB study “Dealing with an International Credit Crunch: Policy Responses to Sudden Stops in Latin America” looks into successful policy responses during past global financial crises and draws some important lessons that can shed some light to the policy options countries in the region are facing today.
”Without good initial economic conditions, countries have limited scope to act,” Said Eduardo Cavallo, one of the IDB economists that participated in the study said. “Still, initial conditions are not destiny. Adequate policy decisions and support from multilateral organizations can help alleviate some of such constraints.’’
Policy Responses and Output Behavior
The study found that countries that were able to adopt fairly more flexible fiscal and monetary policies in the aftermath of a financial crisis had a loss in output of less than 5 percent, while nations with much less flexibility had output contractions above 10 percent.
The study analyzed policy responses by 19 developing countries during the Tequila, Asian and Russian crisis in the 1990s, periods of broadening sovereign interest rate spreads and capital flow reductions that affected a large set of emerging countries at the same time.
"Countries that adopted anti-cyclical policies definitely did better but that doesn’t mean that countries that didn’t adopt counter-cyclical policies would have performed better if they had done the opposite," said Cavallo. "In some cases their economic conditions were so weak to begin with that any attempt to be a more aggressive could have made the situation worse by eroding confidence on their creditworthiness."
Right Economic Conditions
Successful anti-cyclical policies during financial crises work when governments can boost spending in a sustainable way and conduct looser monetary policy that does not fuel inflation or lead to balance-sheet problems in both public and private sectors when both have debts denominated in dollars.
To boost aggregate demand sustainably, governments need to ensure their actions won’t affect the country’s credibility and solvency. Therefore, countries need to have credible central banks that can keep inflation expectations at bay by using genuine resources to fight the crisis.
Countries will need to have a reasonable level of reserves to cover payments of international obligations and provide financing for trade. Low levels of debt denominated in dollars will give central banks more flexibility to depreciate the country’s currency in order to make its products more competitive to global trade, the study said.
Latin America and the Caribbean have improved their economic conditions since the Russian crisis, giving them some leeway, particularly regarding monetary policy, to implement measures to fight the crisis, said Alejandro Izquierdo, another IDB economist who participated in the study. Countries have built up US$ 400 billion in international reserves, and they have substantially reduced the level of dollar-denominated debts, particularly within the banking system, he said
Lower levels of debt dollarization allowed Brazil, for example, to loosen monetary policy amid the credit crunch in ways that other countries were not able to do during the aftermath of Russian crisis, the study said.
Loose monetary policy typically leads to currency depreciation and an increase in exports that helps ease the economic slowdown. However, currency depreciation, which boosted exports as a way out of the crisis for several emerging markets in the past, may not fully work this time because of the ongoing global recession, particularly in rich nations, according to Izquierdo.
Adequate Policy Response
The adequate policy response will depend on the nature and extent of the crisis. Global systemic financial crises cause a dramatic reduction in capital flows to emerging market nations that can last for just a few months – as was the case of the 1994 Tequila crisis – or several years, such as in the Russian crisis, when capital flows took five years to return to their normal levels.
The longer capital flows take to return to their historical levels to the region, the bigger the chance that a liquidity crisis could be turned into a solvency problem for a country, the study alerts.
"There is a good chance that financial access will remain expensive for emerging markets, particularly in terms of their export prices, and may even remain closed for some countries for quite a while" said Izquierdo. "As a result, governments will have to balance very carefully their potentially expansionary fiscal policies with their current and future financing needs."
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*IDB estimates based on official capital inflows, trade balance and international reserves for Argentina. Brazil. Chile. Colombia. Mexico. Peru and Venezuela. These countries represent 93% of Latin America’s GDP.
The bigger the savings a country has accumulated, the more aggressive it can be on its fiscal policy, the study said. Countries that have the flexibility to implement such policies are the ones that resisted the temptation of taking comfort in favorable tailwinds and drafted policies that took into account cycles in the international economy, commodity prices and world financial markets.
Some nations in Lain America will be forced to cut spending in the face of the current crisis because of insufficient savings, said Izquierdo. For others, the most feasible policy will be to maintain the current level of government spending but only a few such as Chile are in a position to increase spending, he said.
Most of the region’s nations built up very little savings during the five-year commodity boom that ended last year, according to a 2008 IDB study called "All that Glitters May Not Be Gold: Assessing Latin America’s Recent Macroeconomic Performance."
A simple average of the region’s seven biggest economies – Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela – shows that they spent 77 percent of the extra revenue from the commodity bonanza since 2002. Chile, in comparison, which set aside a considerable part of the increased tax collection into a special fund, spent only 34 percent, according to the 2008 study.
The role of the Multilaterals
The biggest danger from the current crisis is that Latin America and the Caribbean can still suffer a lot from a systemic financial crisis even though they have improved their resilience, Izquierdo said.
Countries need to use the boom years to lay the groundwork to improve their economic conditions which will allow them to implement counter-cyclical policies during bad times, the study concluded.
Nations with insufficient savings will have to implement a combination of policies during the crisis: control spending and find other sources of financing, such as an increase in borrowing from multilateral agencies to smooth out the impact of the crisis, to the extent that they remain sustainable, Izquierdo said.
For multilaterals, the current crisis offers an opportunity for a different approach when compared with the policy options taken during the Russian crisis.
The prevailing view in 1998 was that emerging nations needed to reassure creditors about the solvency of their economies. As a result, emerging countries around the globe were asked to cut spending and raise interest rates, which deepened the recession.
The IDB study of successful policy responses during past crises suggests multilaterals must take into account initial conditions from each country before supporting a certain type of policy. Countries with good initial conditions do not need to go over strong adjustment policies to signal crediblitty. The multilateral system can help governments by boosting their foreign currency reserves and provide financing for government with a sustainable fiscal position, according to the study.
Examples of Successful Responses
Nevertheless, even unfavorable initial conditions are not destiny, Izquierdo said.
Peru, for example, was a highly dollarized economy before the 1998 financial crisis hit, making it quite vulnerable to external shocks leading to currency depreciation. However, authorities were able to build up a large cushion of foreign reserves to provide banks with dollar financing during the crisis and avoid large depreciation of the currency. This was vital for the survival of the economy, making Peru a successful case in terms of crisis management.
Brazil is another example. In 2002, the country faced a dramatic reduction in trade credit lines because of investor uncertainty over the outcome of the country’s presidential election that year. The central bank used its international reserves and auctioned dollars in a targeted manner in the spot currency markets to provide exporters with hard currency financing, alleviating the credit crunch for a sector that was vital for the economy. Helping the export sector helped bring dollars into the country, mitigating a shortage of currency stemming from a reduction in foreign capital inflows.
"There is no single formula on how to deal with this current crisis," said Cavallo. "Even though initial conditions many times are not ideal for countries in the region, they can increase their margin of maneuverability with adequate policies and the support from the multilateral system."