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This is a joint post with Maria Cecilia Ramirez

This week, CGD’s Latin America Initiative hosted the members of the Latin American Shadow Financial Regulatory Committee (CLAAF) for a fruitful three-day discussion on the main issues affecting the Latin American economic and financial outlook.

The main driver of our discussion was the ongoing change in the external economic environment facing Latin America. The US Federal Reserve’s May 22nd announcement on the possible “tapering” of its assets purchase program signaled that the era of lax monetary policy, which benefited most emerging economies, is bound to end sooner or later. As a matter of fact, capital flows to the main emerging market economies have since started to decelerate. In addition, lower demand growth coming from India and China are impacting negatively the region’s economic growth. In this sense, the lack of key reforms to boost Latin America’s productivity levels to sustain long-term growth is a deep concern.

It is clear that the bonanza years are over, and the new scenario is presenting new challenges and risks to Latin America and other emerging market economies. But, is Latin America ready? We think that the presence of a number of vulnerabilities built during the bonanza years could affect the region’s capacity to effectively deal with adversity. Thus it could be less prepared than conventional indicators would predict.

First, Latin American countries are showing current account deficits of about 4-6% of GDP, stemming from large private sector leveraging and worsening fiscal deficits. This contrasts sharply with the pre-global crisis situation, when the region displayed fiscal and current account surpluses. Second, if a scenario of lower economic growth in the region materializes, it could translate into higher unemployment and, therefore, higher fiscal deficits via lower tax collection and greater expenditure in social safety nets.

Third, high international liquidity and low interest rates may have fostered an overvaluation of assets prices, an unusual bank credit expansion, as well as higher foreign debt issuance by domestic firms. A crucial risk that seems to have gone unnoticed is a private sector currency mismatch: firms have to honor their debt in foreign currency, but their bank deposits are denominated in domestic currency. Hence a strong depreciation could create insolvency problems in the corporate sector, which would in turn affect banks’ balance sheets. This points out that we could be in presence of a serious risk mispricing in the banking system.

Last, policymakers’ response to economic turmoil has the potential to trigger further problems in the economy. For example, fiscal stimulus in a scenario of dwindling growth might not be appropriate, given the recent weakening of fiscal accounts, and the risk of losing access to external financing under a scenario of abrupt interruption of capital inflows (commonly known as a sudden stop)

Taking these risks into account, we have identified four key aspects that policymakers in the region, and other emerging economies, should be aware of when trying to deal with the challenges lying ahead:

  1. A clear priority is to go beyond the traditional indicators of economic and financial stability, and to place special emphasis on assessing the sources and magnitude of any potential hidden debts in the economy.
  2. Despite the huge international reserves accumulation observed over the past years, current reserves stocks in the region might not be enough to cope with a potential sudden stop. A proper buildup of international reserves is an essential tool to deal with capital flows interruptions.
  3. When taking policy decisions in the event of a sudden stop, policymakers must be aware that any monetary policy response entails an implicit decision between higher employment and higher income inequality. For example, recent research demonstrates that choosing a flexible exchange rate helps to bring down unemployment (via higher inflation and lower real wages), but could also induce higher income inequality (via a lower labor share on total income).
  4. Policymakers should try to minimize the impact of a sudden stop on medium-term growth. One way to do so is to tackle lower aggregate demand by prioritizing the stability of investment over that of consumption.

Click here to read our public statement and some relevant related academic material.