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The Latin American Shadow Regulatory Committee, known as CLAAF for its Spanish acronym, warns today in its biannual statement that despite positive policies and safeguards, the region is facing external and local risks that could affect its economic and financial outlook. Specifically, although the region’s exposure to financial risk is much more complex now than it was in the 1980s and 90s, the region is still vulnerable to hikes in interest rates, volatility in short-term capital markets, and uncertainty about its level of indebtedness to China. Brazil’s fiscal problems, growing since the Lehman’s crisis, are especially troublesome and could damage the region’s economy if not contained. CLAAF therefore recommends that the IMF stand ready to support adjustments in Brazil. Such IMF support could determine whether Latin America rebounds or returns to the crises of the 1980s.

More details from our report follow below.

Sources of contagion are more complex

Relative to the 1980s and 1990s, when large hikes in international interest rates played a central role in Latin America’s financial crises, the sources of external financial contagion are now more complex:

  • The US Fed’s increase in interest rates will most likely be small and gradual, but even modest increases may lead to significant rises in sovereign risk premium across Latin America.
  • Short-term capital flow volatility has increased, complicating risk management for banks. While no full-fledged banking crisis has taken place, numerous credit-rating downgrades have occurred.
  • Both traditional (international capital markets) and the recently new, nontraditional (bilateral agreements with China) sources of external funding to Latin America are in retrenchment.
  • The potential channels of contagion from China are multiple. Not only does the economic slowdown in China negatively affect Latin America’s terms of trade, but there is also large uncertainty about the size of the region’s indebtedness to China, which increased significantly during the boom years in a number of countries.

Flexible exchange rates are good but not foolproof

Flexible exchange rates in the region, absent in the 1980s and 1990s crises episodes, are now an important buffer against external shocks, but there are caveats:

  • Significant cumulative exchange-rate depreciations could rekindle the pass-through from exchange-rate changes to inflation, fueling inflationary expectations, and potentially jeopardizing the credibility of central banks.
  • Without well-anchored low-inflation expectations, domestic interest rates would increase, leading to a vicious circle of debt unsustainability — a well-known feature of Latin America in the 1980s. Brazil is a case in point.

Brazil’s fiscal health is crucial to the region

Brazil’s resolution of its current economic problems is central to facilitating Latin America’s growth recovery.

  • Brazil’s growing fiscal problems since the Lehman’s crisis forced its monetary authorities to rely on interest-rate increases as a means to anchor inflation and inflationary expectations. In the context of a large stock of domestic debt, increases in interest rates further worsen its fiscal stance. Debt unsustainability is a serious threat in Brazil.
  • A financial crisis in Brazil could pose severe contagion to other countries in the region through trade links as well as through financial channels, given Brazil’s significance in investors’ portfolios with large exposures to Latin America’s debt markets.
  • Containing a potential sharp deterioration in Brazil’s economy may be particularly important for Argentina, which will soon have a new government that will have to deal with large homemade economic difficulties.
  • CLAAF recommends that the IMF stand ready to support adjustments in Brazil. This support would not only help Brazil regain its fiscal anchor and the credibility of its monetary policy, but would also contain contagion to the rest of the region. Whether Latin America rebounds or returns to the crises of the 1980s may depend on such IMF support.

Liliana Rojas-Suarez chairs the Latin American Shadow Regulatory Committee. This and previous CLAAF statements are available in English, Spanish, and Portuguese.  You can also subscribe to the Latin American Initiative in order to receive more timely and groundbreaking research on the region.

Disclaimer

CGD blog posts reflect the views of the authors drawing on prior research and experience in their areas of expertise. CGD does not take institutional positions.