Autumn 2022
Don’t take resilience for granted
Latin American economies should not risk their hard-won monetary and fiscal credibility, writes Alexandre Tombini, chief representative of the Bank for International Settlements in the Americas.
The Covid-19 pandemic is a tragedy that has caused a massive loss of life and great economic hardship, with Latin America being particularly hard hit. Even so, Latin American economies have so far proven more resilient than feared in early 2020.
Despite a massive contraction in output and employment, large capital outflows at the start of the pandemic soon reversed. No currency or funding crisis ensued. Once vaccination programmes expanded and mobility restrictions were lifted, economic activity recovered more quickly and strongly than initially anticipated, and continued to expand in 2021 and 2022 in most economies. Russia’s invasion of Ukraine only had a short-lived negative impact on capital flows and growth. And so far, no major stress has emerged in Latin American financial markets since the Federal Reserve and other major central banks began to normalise monetary policy.
The enormous and simultaneous expansion of monetary and fiscal policies by major economies in the early stages of the pandemic played a critical role in buttressing financial investors’ confidence and avoiding the worst. Equally important in the most recent phase of policy normalisation has been the Fed’s careful communication about its policy decisions. Yet domestic policy factors – both structural and cyclical – also helped.
One important structural factor is the strong macro-financial stability framework that countries have adopted and enhanced since the late 1990s. Determined to avoid the crises that had plagued their economies in the previous 20 years, authorities strengthened the regulation and capital buffers of their financial institutions, consolidated their fiscal accounts and granted central banks more autonomy. Authorities also buttressed the newfound fiscal discipline through strict limits on monetary financing of public debt and deficits and the introduction of fiscal responsibility laws.
Latin American economies have become less vulnerable to changes in exchange rates and currency mismatches than they were two decades ago.
In most Latin American countries, these steps were then complemented in the early 2000s by the abandonment of exchange rate pegs and the introduction of inflation targeting. All these allowed Latin American countries to deploy countercyclical macroeconomic policies to respond to the Covid-19 shock.
Another important structural change has been the deepening of local debt markets through pension reforms and other measures that aided the emergence of domestic institutional investors, and the removal of barriers to entry and exit of foreign investment. Along with a more stable macroeconomic environment, this helped reduce the share of sovereign debt denominated in foreign currency and increase participation of foreign investors in local currency debt markets. As a result, Latin American economies have become less vulnerable to changes in exchange rates and currency mismatches than they were two decades ago.
Inflation targeting in major Latin American economies has involved not only the use of the policy interest rate but also foreign exchange interventions and macroprudential measures. For instance, during a boom, FX intervention has allowed several central banks to accumulate significant international reserves as a precautionary measure. FX intervention has also helped to smooth exchange rate volatility, limiting its impact on inflation and financial conditions. Macroprudential measures have strengthened the resilience of financial institutions and possibly slowed the build-up of financial vulnerabilities. By decreasing financial vulnerabilities and building buffers, the use of multiple instruments in good times has reduced the fear of floating and increased the scope for the exchange rate to act as a shock absorber rather than a shock amplifier in bad times.
It is no coincidence that the Latin American economies did not suffer any major debt or currency disaster when the financial crisis struck in 2008-09, during the so-called ‘taper tantrum’ episode in 2013 and after the commodity price boom ended in 2014-15. Likewise, they did not experience a debt crisis or episodes of high financial stress during the pandemic. Indeed, during this latest shock the banking sector in the region was part of the solution, not the problem.
In addition to a strong policy framework, a few cyclical reasons help explain the region’s resilience. First, unlike in previous episodes, the pandemic was not preceded by a large credit and capital inflow boom. Since the end of the commodity supercycle in 2014-15, average growth in the region has generally fallen and capital flows have moderated.
During the recovery from the pandemic, central banks started to raise policy rates earlier than advanced economies, reacting promptly to changes in the inflation outlook.
Second, during the recovery from the pandemic, central banks started to raise policy rates earlier than advanced economies, reacting promptly to changes in the inflation outlook. This translated into larger interest differentials with the US and other major economies than in previous global policy tightening cycles, which helped compensate investors for the higher perceived asset class risk.
Third, fiscal positions and measures of sovereign risk worsened compared with before the pandemic, but (much) less than initially expected. The rapid recovery and the spike in inflation increased revenues and nominal income, thus helping to moderate the increase in debt ratios.
Finally, commodity prices rose significantly, contributing to supporting exports and fiscal sustainability. All of this helped decrease downward pressures on exchange rates in several countries.
Despite all this, macroeconomic resilience and the policy framework that underpins it cannot be taken for granted. Latin American economies are now facing several major challenges that risk undoing what has been achieved over the past quarter of a century.
The first challenge is for central banks to bring inflation back to target while minimising the costs to output and employment. Calibrating the policy response is, however, a complex task given the high degree of uncertainty that policy-makers currently face. A key uncertainty is how much inertia there is in current inflation developments. Although there are signs of moderation due to the recent drop in commodity prices and easing of supply bottlenecks, services inflation and core inflation are still rising in several countries.
Despite all this, macroeconomic resilience and the policy framework that underpins it cannot be taken for granted. Latin American economies are now facing several major challenges that risk undoing what has been achieved over the past quarter of a century.
Second, there is substantial uncertainty about how the economy would respond to monetary policy tightening. Not much is known about possible pandemic-induced structural changes affecting the relationship between inflation and economic activity. Moreover, while the stock of non-performing loans is now on the rise, it is uncertain to what extent it may increase with additional hikes in policy rates. To further complicate matters, the global economy may slow significantly, which may negatively impact domestic growth. Given the great uncertainty, policy mistakes may be unavoidable. However, it is better to err on the side of caution than to lose the anti-inflationary credibility that has been built over the past two decades. A de-anchoring of inflation expectations would be more costly for society in the longer term than any reduction in growth or economic activity in the short term.
A third challenge is to ensure that fiscal consolidation takes place. The ability to control inflation, especially at the current juncture, very much depends on sound fiscal policy and the expectation that fiscal policy will remain sound in the future. This means that fiscal consolidation cannot be avoided or postponed for long, even in the face of strong social demands. Postponing it will merely translate into higher costs of adjustment in the future. How consolidation should be enacted is a political rather than a technical decision, which involves finding the right compromises across society. That said, it would be a mistake not to restore fiscal sustainability or to pressure the central bank to keep interest rates lower than necessary in the attempt to buy space for fiscal policy. Even worse would be to reduce the central bank’s autonomy.
Finally, reducing fiscal deficits may not be enough to ensure a stable macroeconomic environment. Average economic growth has been anemic over the past decade. Poor trend growth prospects reduce fiscal sustainability, raise the cost of financing public debt and increase the risk of capital outflows. Structural and supply side measures to boost investment, productivity and output should complement any fiscal measures.
Latin American citizens are right to ask for solutions to the economic and social ills that have persisted for so long in their countries. Unfortunately, there is no easy recipe to address them. But one thing is certain: any solution should not put at risk the policy framework that has so far made their economies more resilient.