The impact of war on Latin America and the Caribbean
To address the economic shockwaves of Russia’s invasion of Ukraine, a post-pandemic fiscal consolidation is necessary, writes Mauricio Cardenas, Professor of Professional Practice in the School of International and Public Affairs at Columbia University.
The once-in-a-century Covid-19 pandemic is not the only example of a new wave of global challenges. The fallout from Russia’s invasion of Ukraine is a reminder that we live in a permanent state of emergency. The economic shockwaves of war and sanctions are highly relevant for Latin America and the Caribbean despite Russia and Ukraine’s relatively small share of global gross domestic product and their distance from the region. It arises because of their role in commodity markets that are important for LAC and through the war’s economic impact in Europe: a key export market for LAC goods and services.
Despite a positive terms of trade windfall for commodity exporters, LAC countries are likely to be negatively impacted by Russia’s invasion of Ukraine. Greater global economic uncertainty is causing a flight to safe assets, changing the direction of capital flows and putting pressure on exchange rates. Higher inflation is forcing central banks to raise policy rates, while governments are providing new subsidies to offset the effects of higher food and energy prices.
Inflation and trade
Inflation is region-wide. While its pressures predate the invasion of Ukraine, they have accelerated since, generating social and political tensions. Higher unemployment and poverty rates resulting from Covid-19 are yet to be resolved and can be exacerbated by the war in Ukraine. As the war contributes to food and energy inflationary pressures, the vulnerability of lower-income households has increased.
Increases in food and energy prices, together with increased consumer demand and wage indexation, explain why the average annual consumer price index increased by 7.2% in LAC in 2021 (excluding the very high inflation countries). This is likely to exacerbate social tensions. Incidents of social unrest in LAC have nearly doubled since the first quarter of 2020. The vulnerability of low-income households to price increases has forced governments to complement monetary policy tightening with measures to support consumption of key basic products. These measures have only been partially effective in reducing social tensions – and at great fiscal cost.
Trade disruptions in key commodity markets have had a cross-cutting impact on the external account balances of LAC countries. Current account deficits are expected to fall to around half of the pre-war estimates for the median LAC country in 2022, relative to 2021. However, the scenario differs significantly between countries that are commodity exporters, those that mainly rely on tourism and those few that have diversified export baskets. High commodity prices are likely to turn the current accounts of commodity exporters positive, while increasing the deficits of tourism-reliant commodity importers (their estimated deficit may be around 9% of GDP). The group of commodity exporters with a similar export basket as Russia and Ukraine can expect to benefit from commodity inflation and, in some cases, higher export volumes, as they fill the gap generated by global supply restrictions.
In terms of fiscal impact, while commodity-exporting countries are the apparent winners in the current crisis – from a trade perspective — adding the fiscal dimension makes that conclusion less clear cut. Although national oil companies in countries such as Brazil, Colombia and Mexico benefit from high oil prices, there are other dimensions to consider: to prevent social unrest, fuel subsidies have increased in tandem with higher international prices. The net fiscal effect depends on the profit of the NOC and the magnitude of the subsidy. Conceivably, if profits are low (because of very inefficient production and high costs) and subsidies are high (for example, in Colombia the subsidy on a gallon of gasoline is close to 50% of the international price), the net fiscal effect can be negative. Another issue is who bears the fiscal cost. In some countries (including Venezuela) it is the NOC, while in others, the cost is borne by the national government (such as in Colombia). Some countries (for example Brazil) opt for a shared arrangement between the NOC and the national government.
The positive effects of high commodity prices for energy and food exporters notwithstanding, assessing the fiscal effects of the crisis on these countries is not straightforward. Net commodity exporters are using the extra revenues to offset the effects of inflation on consumers. For countries that are not benefitting from commodity price increases, it is harder to articulate an effective response, given their constrained fiscal space and the lack of increased export-derived incomes to counter it.
‘Inflation is region-wide. While its pressures predate the invasion of Ukraine, they have accelerated since, generating social and political tensions.’
Even before the Ukraine war, governments were under fiscal pressure owing to the expense of social protection measures to mitigate Covid-19, compounded by a reduction in taxes collected as a proportion of GDP. Countries in LAC have now put in place new energy and food subsidies to mitigate inflation: some of the social protection measures introduced during the pandemic will even increase.
Energy subsidies are regressive and compromise fiscal sustainability. These subsidies tend to bring disproportionate benefits to high-income groups that have more energy-intensive consumption baskets. Ecuador illustrates this point: the highest income quintile receives 53% of the benefit from gasoline subsidies and 34% of the benefit from diesel subsidies, while the benefits for the lowest income quintile are 5% and 11%, respectively.
Whether countries are commodity exporters, tourism-reliant or diversified exporters, most will end 2022 with lower fiscal consolidations than expected before the war. The Inter-American Development Bank estimates that the combination of increased fiscal deficits, inflationary pressures and costly public financing could lead debt-to-GDP ratios to increase to 74% by 2024 for the average Latin American country, with rises to 68% for commodity exporting and 87% for tourism-intensive economies.
Given the previous projections and the increased cost of financing, the key question becomes how to structure effective fiscal consolidation policies that are also consistent with the socio-economic vulnerabilities of low-income households. Governments should not shut down their spending on social programmes that offset high food and energy prices, nor should they focus budget cuts on health and education, where the scarring effects of the pandemic are still present and visible. Instead, initiatives for employment support are less necessary in cases where unemployment figures have returned to pre-pandemic levels. Intelligent austerity should prioritise the support of vulnerable households impacted by the pandemic and high inflation.
Moreover, geopolitical tensions, inflation and the risk of recession in advanced economies have unsettled global financial markets. Consequently, there is an exacerbated risk for LAC countries that have significant external gross financial needs and lack robust reserve cushions. The combination of higher interest rates and lower growth projections impacts debt sustainability. The region would require a larger primary surplus relative to its needs before the invasion. But higher primary surpluses are much harder to achieve given the expenditure pressures associated with the subsidies introduced to cope with higher prices.
‘Geopolitical tensions, inflation and the risk of recession in advanced economies have unsettled global financial markets.’
The measures governments implement in the short run as a response to the initial shocks of the invasion could have long-lasting negative effects on fiscal stability and financial markets. This will undermine economic growth and the ability of governments to reduce high unemployment and poverty rates, yet to return to pre-pandemic levels. This poses a serious risk: governments may be tempted to adopt expansionary fiscal policies at a time when debt levels are already high, interest rates are increasing and there is a flight to quality in international capital flows.
An adequate response has to give enough weight to risks such as a global recession and capital flow retrenchment. This calls for prudence and caution. Countries should not increase fiscal imbalances. Cutting unnecessary expenditures and raising tax revenues is an unpleasant but indispensable recommendation.
This article is an abridged version of an August 2022 United Nations Development Programme LAC policy paper: ‘The Economic Impact of the War in Ukraine on Latin America and the Caribbean’, which can be found here.