It is hard to believe, after a few days at the Mexican coast, but the sunny days are over for Latin America. The sunshine might come back, but the next few quarters will be challenging. Latin America has been carried by a wave of low interest rates and high commodity prices for a decade. Now the tide is heading back out to sea and, as the saying goes, everybody will see who has been swimming without their trunks on.
The World Economic Forum's meeting in Mexico in early May has focused the global business community's interest on Latin America. As always, the meeting has brought new insights. It is clear that there are long-term opportunities—Latin America has huge potential— but in the near future the risk of a "taper tantrum" from the Federal Reserve might create a currency storm.
Among the finance ministers in Northern Europe, we have a saying, coined when Iceland, Latvia, and Ireland were hit by the Lehman crash back in 2008: "Don't waste a good crisis."
This was the message Sweden, Finland, and Denmark had learned a decade earlier, and this was the message that Jurki Katainen, Lars Lökke Rasmussen, and I hammered home to our Baltic colleagues and in the Ecofin council.
All countries are put to the test once in a while. That is what separates the wheat from the chaff. Those who were prudent before the crisis and who are willing to focus on structural reforms might come out stronger. The fact that Ireland and Iceland will grow slightly less than 4 percent in 2015, and that the Baltic countries, in spite of geopolitical problems, will grow only a little slower illustrates the point. And the experience is not confined to northern Europe. After the Asian crisis of the mid-1990s, average growth was close to 5 percent for the next decade.
If Latin American countries stick to the sound macroeconomic policies that we have seen in the last few years and use the crisis to push through policy reforms, they might not only avoid the taper tantrum contagion but also improve their long term outlook.
The slowdown has already been substantial. 2014 growth was lower than expected in Latin America at 1.4 percent year-on-year—half the level the International Monetary Fund (IMF) forecast in April 2014. This year the IMF expects GDP growth of less than 1 percent. After a decade of almost 5 percent average growth, this is a climate change. Model estimates, presented in the IMF regional report for Latin America, suggest that a further dollar appreciation of 10 percent could slow growth by 0.5 to 1 percent.
There is a clear risk, if we are heading for a super taper tantrum, of a recession in Latin America in 2015. There are many reasons for slower growth. Commodity prices had been moving south even before oil prices started to decline. After almost four years around $100 per barrel, oil bounced down to $50 during the spring (oil is 61 percent of Colombia's commodity exports). Soybeans (51 percent of Argentina's commodity exports), copper (94 percent of Chile's, 51.6 percent of Peru's), and iron ore (30.4 percent of Brazil's), have all fallen by 20 to 50 percent.
The commodity supercycle driven by strong growth in China seems to be over, at least for the time being. IMF research indicates that Latin America is particularly sensitive to a Chinese slowdown. A 1 percent fall in Chinese growth reduces the average export price for commodities from Latin America by 3 to 8 percent. This could mean growth may fall from almost 5 percent for 2003–13 to well below 2 percent for 2014–18.
Whether growth will bounce right back up again or whether large capital flows out of emerging markets shift Latin America onto a dismal growth path for years to come is the big question.
It is clear that a lot has changed for the better in Latin America over the last few decades. Democratization has brought stronger governance and increased political stability. Democracy in Latin America is, as elsewhere, far from perfect, but elections are now the normal way to bring about a change in government. Leaders are worried about opinion polls, not political speculation within regimental wardrooms.
The number of victims of armed conflicts has fallen dramatically, even if security issues are still a major concern. In Colombia, haunted by violence for decades, the number of people affected by armed conflict was 75 percent lower in 2014 than its average during 2000–2005.
Corruption is still a central issue, but the willingness of electorates to accept leaders who are using public office for private purposes seems to have evaporated, at least according to the latest polls coming in from Chile and Brazil. The middle class is growing and the level of education level has risen. Better access to information with increased connectivity makes deception more difficult.
The increased institutional supply of democracy is matched by an increasing demographic demand for clean government. The demand for right- or left- wing "Caudillo-populism" has fallen substantially in this new environment.
Macroeconomic stability has improved dramatically. Average inflation has been in single digits for the past decade. Current account deficits have been manageable. Openness has increased: While average tariffs in the mid-1980s were between 40 and 50 percent, and in some cases like Brazil and Colombia double that, they are now around 4 to 5 percent. Informal barriers to trade remain substantial, but it's clear that openness has taken a quantum leap in the Western Hemisphere.
There has also been very strong improvement in economic policy institutions. The major central banks are acting more independently and implementing a flexible inflation regime with floating exchange rates that function as a buffer. Fiscal policy has been anchored towards long-term sustainable public finances. Fiscal rules and budget processes have been strengthened in many countries. The gross debt of the public sector is now below 50 percent of GDP on average in Latin America, almost half the level of the OECD average.
Banks in Latin America have been, to quote the IMF, "relatively conservative" during the boom years. Capital ratios are generally strong, and deposit-to-loan ratios have been kept under control. Stronger supervision and tighter regulation have been helpful here.
Having underlined that the political and economic fundamentals have improved, it's equally important to point out the substantial downside risks over the next few quarters, which aren't confined to short term jitters on the markets.
A key challenge for Latin America is total factor productivity. How much you can produce with a given quantity of labor and capital depends on the total factor productivity of the country. Total factor productivity accounts for all the growth that is not directly caused by mobilizing more capital or labor. Technology, legal institutions, and the enforceability of property rights, levels of education, the entrepreneurial climate, the level of trust between citizens, and many other factors determine the economy's ability to grow.
Total factor productivity has been weak in Latin America. For the last three decades growth has been close to zero. Even in the last decade, when GDP growth was close to 5 percent, total factor productivity was disappointing: 85 percent of the growth over the last decade was the result of the mobilization of more labor and capital—more people entering the labor market and increased investments and high commodity prices—rather than broad-based improvements in the efficiency of Latin American economies.
In essence, this is not the time for complacency in Latin America. Sunny days are gone, the season of adjustment has begun, and now is the time to prepare for bad weather. Policymakers at the World Economic Forum meeting in Mexico were crystal clear on this point. Luis Videgaray Caso, Mexico's minister of finance, voiced a clear strategy based on three pillars:
- Stick to sound macroeconomic fundamentals: This is not the time to abandon fiscal rules.
- Central banks need to stand ready to provide liquidity to the markets if large capital outflows are seen, while letting the currency play its role as shock absorber.
- Structural reforms should be reinforced.
I could sign up to all three of these points. This is exactly the right way to put your house in order to weather a storm.
You could argue that some countries—Chile, Colombia, Peru and Mexico—have the fiscal space to implement countercyclical measures. But Mauricio Cardenas, Colombia's minister of finance, gave a convincing counter-argument. If economic policy, Cardenas pointed out, was evaluated only by well-informed academic macroeconomists, then this might be possible. However, in the real world, where countries are graded by financial markets, this is not the time to test the limits of credibility for open economies with a Latin American track record.
I think economic policy always should be pragmatic. It is prudent to use fiscal policy to stabilize demand. Policy has to be flexible to avoid high social costs in terms of unemployment and social exclusion. At the same time we know that markets are far from rational. When the herd of investors is running to the door in illiquid markets, there can be some collateral damage. It is better to be cautious, keep the powder dry, and avoid being forced to implement austerity measures when demand is already weak. One can only support Videgaray, Cardenas, and their colleagues in their ambition.
I would like to point out one lesson I learned as a finance minister in the autumn of 2008. If you suspect that a crisis might be coming, it is better to communicate that upfront. If you whitewash the situation and get caught trying to oversell the strength of your economy, then you risk undermining your credibility—something that you will sorely need when the going gets tough.
The best political strategy, to my mind, is to take ownership of the crisis by clearly defining the problem and outlining the necessary steps to deal with it. This might sound counterintuitive, because the natural instinct might be to calm people down, but it is better to show leadership than lose the confidence of the public by underestimating the severity of the situation. Taking ownership also means defining the required policy measures. If the ministry of finance is convinced that structural reforms in product markets or the labor market are necessary, then it is better to respond to the crises directly with such policy measures rather than get pushed by public debate towards short-term demand stimulus and temporary measures.
A crisis increases the demand for economic policy solutions. A minister of finance should stand ready to increase the supply of solutions.
I think this lesson can be applied to the current situation in Latin America. The biggest risk in a situation where the markets are getting jittery is to find one's self dependent on portfolio investments rather than real investments in plants and production lines. If fiscal space is limited, then the most efficient way of attracting foreign direct investment is to open new sectors and to decrease barriers to entry. If energy sector reform is accelerated, that can attract new investments on a large scale, a point underlined by the energy industry discussions at the World Economic Forum meeting. Mexico has received deserved praise for its reforms of the energy sector. Now is the right time to reinforce and step up such ambitions.
If a weaker exchange rate leads to higher import prices, deregulation of the retail sector or opening the transportation sector to more competition could both attract foreign direct investment and reduce cost pressures. Increased foreign direct investment would also decrease the vulnerability of economies to current account deficits. If the cost of doing business is reduced, then the risk that currency depreciation will lead to a sustained import price increase is limited, which increases the room for maneuver for the central bank without undermining the credibility of inflation targets.
Latin America might be heading for a difficult period. Hopefully stronger institutions and better fundamentals will mean that the voices of Videgaray and Cardenas will prevail and that Latin America pushes through the period of uncertainty to take the lead among emerging economies. Don't waste a good crisis: Use it to lay the pillars of a stronger future for Latin America.
Anders Borg, former finance minister of Sweden (2006–14), is the chair of the World Economic Forum's Global Financial System Initiative and recently joined the Peterson Institute for International Economics as a nonresident senior fellow. This post originally appeared on the World Economic Forum blog Agenda.