Global growth reached a three decade high in 2004. Growth is projected to slow to more sustainable levels in 2005 as output gaps narrow and policy stimulus is gradually withdrawn.
Nevertheless economic activity should remain above trend at around 4½ percent, underpinned by still generally accommodative macroeconomic policies, and improving corporate balance sheets.
This outturn remains achievable despite recent economic indicators that suggest an “emerging soft patch” in major industrialized countries. In general, the soft patch is expected to be mild and temporary, particularly if oil prices ease further.
Indeed, for the U.S. economy, recent data – notably, the strong April employment and retail sales reports – have alleviated concerns that the economy could be faltering. Thus, we expect that U.S. growth at around 3½ percent in 2005-06 will remain a source of strength for the world economy, underpinned by continuing strong productivity growth.
There are, however, important risks to the global outlook, which could have significant regional implications. Foremost of these is the growing divergence of economic performance across regions, which has helped to widen global imbalances.
The recent IMFC meetings in Washington reaffirmed the importance of a collaborative international effort to address and reduce these imbalances in an orderly way, thereby avoiding outcomes that could involve a substantial loss of global output and employment, and financial turbulence. In this context, the small recent reduction in the U.S. trade deficit in March was encouraging.
Now let me turn my attention to Latin America, and I am humbled by the fact that I am talking to the experts and decision-makers in the region.
As you know, there was a marked pickup in activity in most of Latin America in 2004, with the region enjoying its strongest growth in twenty-five years. This development reflects a combination of external and domestic factors.
Externally, robust activity in trading partners, generally positive market sentiment toward emerging markets, and higher commodity prices have played key roles.
In this context, although high oil prices are adversely affecting some countries in the region – especially in Central America – they are benefiting oil exporters such as Colombia, Ecuador, Mexico, and Venezuela.
In addition, the rise in nonfuel commodity prices has favored exporters of metals and agricultural products such as Argentina, Brazil, Chile, and Peru.
Improved domestic policies are also contributing importantly to the turnaround. Indeed, given past episodes of sharp – but short-lived-growth spurts in the region, it is encouraging to note several features that distinguish the current economic cycle from previous ones.
* First, and most importantly, there is now much greater policy flexibility to buffer against external and domestic shocks. Exchange rates are much more flexible and the commitment to low inflation is strong, testimony to generally more autonomous central banks. Indeed, despite high commodity prices, inflation has been well contained, falling to about 6½ percent by end 2004 – the lowest level since 2001 – and is projected to decline further in 2005.
* Fiscal and external positions have greatly firmed, in contrast to previous growth episodes that were accompanied by large inflows of external financing that fueled both private and public spending. Rather, the recent recoveries have generally been export-led-witness, for example, the high and continuing growth rate of Brazilian exports among other countries – with domestic demand strengthening in response.
* What this means is that many governments are using the recovery and the associated higher revenues to reduce budget deficits and public debt ratios, and to improve debt management, including by reducing the reliance on foreign-currency and short-term instruments. In short, there have been important structural improvements in fiscal policy.
Global capital markets have also provided an important source of support for the recovery in Latin America. Sovereign spreads remain near historical lows, in part reflecting the improved policy settings in many economies across the region.
Since 2004, a number of countries – including significantly Brazil, Chile, Mexico, Peru, and Uruguay – have all experienced ratings upgrades.
In addition, many countries in Latin America have taken advantage of the supportive financing conditions to pre-fund roughly two-thirds of their net borrowing needs for 2005, thus substantially decreasing rollover risks.
Of course, the uptick in spreads in recent weeks following political developments in some countries is illustrative of how quickly uncertainty and instability can affect spreads.
Against this background, we continue to see strong growth in 2005 in the Latin American region of a little over 4 percent, although the picture is clearly differentiated between countries.
This said, there are downside risks, particularly if oil prices spike higher, interest rates in industrial countries rise more sharply than expected, or industrial country growth slows in a prolonged way.
I would also add that the removal this year of quotas for textiles and clothing will pose a particular challenge to some producers in the region.
Nevertheless, the region still confronts several short-term vulnerabilities and important medium-term challenges that need to be addressed to ensure that the present growth spurt is sustained and that the region does not lapse back into another period of growth volatility.
There are surely many factors at play in explaining the region’s growth volatility in the past. Let me share with you one perspective that is emerging from some recent research being undertaken in the Fund.(1)
This research focuses on high fiscal volatility as one key contributor to the region’s record of stop-go growth. Fiscal volatility is seen as hurting growth and raising its volatility mainly through reducing productivity.
High fiscal volatility – especially in discretionary fiscal policy-signals a lack of consistency and predictability in policy, and dampens investment in productivity-enhancing areas.
In this context, Latin America’s record of fiscal volatility over the period 1960-2000 is generally higher than other regions, and has been closely associated with its lower growth performance. Within the Latin American region, the correlation also seems to hold.
Of course, the sources of fiscal volatility are unique to individual countries. Institutional factors tend to be especially important in helping to introduce checks and balances that can reduce volatility.
It is, therefore, important that institutional reforms keep pace with the growth of per capita incomes, and that fiscal decentralization is undertaken with a view to maintaining fiscal discipline and consistency, thereby dampening rather than amplifying fiscal volatility.
Institutional weaknesses also arise from situations of high unemployment and poverty, as well as extreme income disparities between rich and poor.
Such weaknesses, if left unaddressed, typically tend to erode the political commitment to policy discipline and growth-enhancing reforms, and leave governments vulnerable to pressures to undertake popular but destabilizing discretionary fiscal policy.
With this as background, it is not surprising that I would give primary importance to the need for continued policy and institutional steps to reduce public debt among the core medium-term challenges for many countries in the region.
Using the opportunity of the strong recovery to make progress in reducing debt, curbing nonessential expenditures, and boosting revenues would make room for higher spending on physical and social infrastructure within a sustainable overall fiscal position.
In this context, a key challenge for many Latin American countries will be to improve budget flexibility by eliminating the widespread earmarking of revenues and expenditures. In the near term, there should be scope for more ambitious fiscal targets in many countries for this year.
However, constraining discretionary fiscal policy over the medium term will probably require a marked strengthening of fiscal rules and institutions. The region already yields important role models in this respect.
In Chile, the fiscal rule successfully targets structural surpluses equivalent to 1 percent of GDP in the accounts of the central government.
In Brazil, various fiscal norms and regulations, including the fiscal responsibility law and the debt restructuring agreements with sub-national governments, and rules limiting public wage expenditures, are a reflection of this country’s commitment to fiscal discipline.
In Peru, under the Fiscal Responsibility and Transparency Law, the deficit of the combined public sector has been significantly reduced in recent years and is projected to be reduced further, to 1 percent of GDP in 2005.
Finally, I would note that Colombia has also established fiscal responsibility laws for national governments and strengthened fiscal frameworks for sub-national governments
Moving to other areas, I would like to return to the issue of entrenching low inflation. It is my view that, in many countries, there is still scope to secure more firmly the remarkable progress that has been made in reducing inflation.
It is encouraging that central banks are continuing to strengthen their monetary policy frameworks – often in the context of inflation targeting regimes – and are being pro-active in weighing against any nascent inflation pressures, including those that may be triggered by higher oil prices.
In terms of the structural agenda, while I have briefly touched on several reforms on the fiscal front, I would like to highlight four additional structural reform priorities.
* First, enhancing trade openness. Latin America remains much less open to foreign trade than other dynamic regions of the world, thus reducing its potential to fully benefit from robust worldwide growth and demand. The potential for Latin America to become more open should be very clear. The export response in many countries in the region, over the past two years of recovery, is testimony to this potential. I have already pointed to Brazil’s performance, among that of other countries, in this regard over the recent period. In this area, I should also highlight Chile – a country in which the tariff rates are now at the low level of 2.5 percent on average.
* Second, labor market reforms. International experience suggests that labor market reforms help greatly in terms of raising flexibility, boosting private investment, strengthening growth, and thereby help countries benefit more fully from globalization. Institutional arrangements in the form of high severance costs and restrictions on hiring temporary workers act as significant barriers to entry and exit in many countries. Elevated nonwage labor costs are also an impediment to employment. Policies that make it more attractive to hire workers will, over time, support more rapid employment growth in the formal sector. Colombia is a good example in this regards. Of course, labor market reforms may involve transitional costs as resources shift across sectors, which will require investment in education and training and an adequate social safety net.
* Third, strengthening the business environment. We have seen a sharp drop in foreign direct investment into the region in the wake of the Argentine crisis, and FDI flows to Latin America are still well below 2001 levels. To improve this situation, reforms aimed at strengthening the credibility of the rule of law and the enforcement of contracts are needed. Moreover, reforms to reduce regulatory and other hurdles to starting a new business will also be essential to keep pace with countries in other regions competing for FDI. Some countries, such as Colombia, have already begun to strengthen their business environments, but generally speaking, much more work remains to be done throughout the region. It should not be necessary for the region to take much longer, for example, to approve new businesses than it does in other parts of the world.
* Fourth, financial sector reform. Financial intermediation often lags behind other regions and real interest rates and deposit-lending spreads remain too high in many countries. Going forward, financial sectors in the region need to be transformed from sources of vulnerability to institutions of economic strength capable of delivering the sustained financial resources essential to underpin economic growth. Further efforts to strengthen banking regulation and supervision, reduce dollarization in the banking system, improve accounting and auditing standards, and revise bankruptcy laws to enhance the ability of lenders to recover value from distressed loans will be needed. The deepening of local bond and equity markets, too, will diversify the sources of finances for enterprises.
While I realize this is an ambitious policy agenda, there is nonetheless scope for policymakers in the region to take these initiatives forward.
A large number of countries – close to twenty – will hold elections from now to the end of 2006, including some of the largest Latin American countries.
These elections provide a unique opportunity for policymakers to secure a strong mandate in support of prudent macroeconomic policy frameworks and to deepen the structural reform agenda.
This would help send a clear signal of the durability of the shift in macroeconomic policy orientation that is already underway in many countries throughout the Latin American region.
Let me conclude by reaffirming my optimism about Latin America’s economic future. While not without risks, the ongoing expansion offers an important opportunity to deepen the reforms initiated over the past few years. And, the payoff from further deepening reform would be substantial indeed.
(1) This research is being led by Ashoka Mody and Martin Schindler who have looked at the growth experiences of key emerging market countries in the context of comparing the growth performance of different regions.
The text above are the remarks by Anoop Singh, Director, Western Hemisphere Department for the IMF, at the XXI Meeting of the Latin American Network of Central Banks and Finance Ministries, IDB, Washington, DC, Friday, May 13, 2005
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