On April 11, the International Monetary Fund published a report titled, “World Economic Outlook: Tensions from the Two-speed Recovery.” In it, the IMF raised its forecast for 2011 economic growth in Latin America to 4.7% from a previous forecast of 4.3%. While this is excellent news for the region, it doesn’t seem that the good news will continue for long: The report also warned that a group of nations it called the “Financially Integrated Commodities Exporters” — Brazil, Chile, Colombia, Peru and Uruguay — reveal “signs of a potential overheating, in which capital flows have already caused tensions.”
German Sanhueza, professor of management at the University of Santiago de Chile (USACH), agrees with the IMF. Sanhueza notes that the overheating is directly due to increased public spending and growth in domestic consumption, which have also raised domestic prices and contributed to inflation. Adds Francisco Castañeda, also a professor of management at USACH, “This means there are serious risks for the region, such as the potential for an abrupt contraction in GDP over the short term, and a series of restrictions on fiscal policy that have until now been expansive in the majority of Latin American countries.”
Reasons for Overheating
Nevertheless, Igal Magendzo, a professor at the business school of the Adolfo Ibáñez University in Chile, says that the real reason for the economic overheating in Latin America is the rapid economic recovery that the region has experienced after taking a beating from the global financial crisis of 2008. In the wake of the economic disaster, he notes, “Latin America managed to move forward rapidly, thanks to the high price of the commodities that it exports to the rest of the world [including copper, iron, zinc, cellulose, coffee, wheat, salmon and soy among other foods], leading to the current export boom and a notable increase in the revenues of the region.” He adds that a key factor behind the increase in the price of primary products is the strong performance of China, which has strengthened its position as the principal buyer of the primary products that the region exports.
In addition, notes Magendzo, Asian countries and oil exporters continue to save a significant portion of their earnings. “In a global situation where the developed world is perceived as very risky and not very dynamic, Latin America seems like a very attractive place to put those savings,” he says.
Without doubt, the problems facing the United States – which has yet to move completely beyond the subprime crisis – and such European nations as Greece, Ireland and Portugal have led foreign investors to redirect capital toward Latin America, notes Guillermo Paraje, professor at the business school of the Adolfo Ibáñez University. “That is reflected in the strong results in the stock markets of Latin American countries, almost all of which have shown gains.”
All of these factors have led to significant economic growth in the region, notes Paraje. “Peru leads the way, growing by 8.9% in 2010, followed by Brazil, which expanded by 7.5%. Chile has not done at all poorly, growing by 6% last year. Without doubt, these growth rates are comparable to those in the Asian countries.”
However, despite these auspicious conditions, Magendzo warns that Latin America “cannot rest on its laurels.” It cannot continue to be confident about the high price of primary products in international markets — much less rest assured that there will be generous flows of foreign capital to sustain its growth, “since these situations are transitory.”
Sanhueza goes further. He warns that there is a possibility that at any given moment China will face much higher inflation rates and have to raise its interest rates significantly. “And when that happens, there is a strong possibility that prices will drop for the basic products that the region exports around the world.”
The Special Case of Peru
Experts note that Peru may be one of the Latin American countries most likely to suffer from overheating, considering the fast pace at which it continues to grow — 8.9% — and the worrisome increase in its inflation rate.
“Eight months ago, [inflation] was at an annual rate of about 0.5%, while it is now close to 2.5%,” notes Waldo Mendoza, professor of economics at the Pontifical Catholic University of Peru. Nevertheless, Mendoza adds that Peru has already taken certain measures. The Central Bank has already raised its interest rate to 4%, up from 3.75%. “The Minister of Economics and Finance has established a policy for contracting [the economy].” In his view, the Peruvian Central Bank’s policies, in addition to the policies of the Minister of Economics, will prevent inflation from continuing to increase at annual rates of 5% to 6%.
Moreover, the Peruvian people will be electing a successor to outgoing President Alan Garcia this year, notes Efrain Gonzáles, professor of economics at the Pontifical Catholic University of Peru. “In this situation, we should expect some changes in the current economic policy.” On June 5, Ollanta Humala, the leftist presidential candidate and former military officer, will face off against Keiko Fujimori, daughter of ex-president Alberto Fujimori, a right-wing populist, in the second round of the elections. According to a recent report in El Comercio, a local newspaper, Humala is favored by 42% of voters, compared with only 36% for Fujimori. Humala wants to nationalize the hydrocarbon sector and raise the country’s mining royalty– that is to say, increase the income tax on mining companies.
The Instruments at Hand
What can the countries of the region do to cool off their overheated economies? Mendoza says this is an enormous challenge, although he notes that “in the case of Peru, it is easier [to achieve] since, with the country’s annual growth [currently] near 10%, cooling off its economic system a bit would not be so harmful, and the Central Bank could easily raise interest rates a bit in order for the country to grow by 7% or 8% a year.”
By contrast, in other Latin American countries where growth rates are lower, it is harder to undertake contractive fiscal and monetary policies. “This may be the case in Venezuela, which is currently undergoing a recession. Ecuador is another country that is also not growing a lot.” Meanwhile, in Brazil, Chile and Colombia, notes Mendoza, where growth rates are above their usual levels, the classic tools of stabilization – such as raising interest rates and restricting public spending – can be the optimal instruments for preventing inflation from getting out of hand.
Nevertheless, those aren’t the only strategies that can help the region. There are other mechanisms that can help counteract the excessive economic dynamism. As Castañeda suggests, “When commodity prices shoot up, that creates a situation in which countries maintain those fiscal surpluses in the form of sovereign funds. [A] countercyclical tax policy, known as Structural Fiscal Surplus, permits them to moderate internal demand so that they don’t spend the fiscal surpluses, and they analyze spending from a medium-term perspective, associated with macroeconomic behavior.”
In that sense, Chile is doing something reasonable and sensible with its Copper Stabilization Fund, which accumulates profits generated from its copper exports, notes Paraje. He notes that “the main goal of the fund is to maintain the stability of the government’s revenues despite the impact of sudden changes in the prices of primary products…. Clearly, this measure is insufficient, since you only have to imagine what would happen in Chile if the current price of copper [US$4.26 per pound on the London Metals Exchange] were to fall to US$2 per pound [of copper]. In other words, while it is okay to export primary products, the problem comes when you base all of your prospects for growth exclusively on a particular item.”
You have to diversify the productive base of your country, Paraje argues — but there isn’t any simple recipe for achieving that goal. “However, if the countries of Southeast Asia have been quite successful in achieving the goal of exporting commodities as well as adding value to their chains of production, why can’t Latin America do the same thing?”
The problem is that until now, Latin America has not had the vision to promote industrial policies oriented toward developing clusters of industries, “the way they did it in Taiwan, in [South] Korea and later on in China,” notes Sanhueza.
Fiscal and Monetary Apprenticeship
Paraje believes that Latin America still has not learned any specific lessons from its periods of good times “such as the export boom we’re currently experiencing.” However, throughout the years, the region has undergone a certain sort of “apprenticeship in macroeconomic matters especially with regard to fiscal behavior and monetary discipline.” Mendoza cites what happened to Peru when the Asian crisis of 1998 broke out following the devaluation of the Thai currency, which had a domino effect that reached Malaysia, Indonesia, the Philippines, Taiwan, Hong Kong and South Korea. According to Mendoza, “In Peru, the exchange rate rose by 20% in only four months, causing the banking system to deteriorate, real salaries to drop, and leading to a recession. The country’s central bank limited itself to merely observing the crisis.”
On the other hand, however, when the global recession spread in 2008, the external shock for the overall system was much harder than that during the 1998 crisis, Paraje says — but the key difference for Peru was that in 2008, the country’s Central Bank reacted immediately “by placing 11 billion dollars into the market, thus, injecting resources into the banking sector so banks would have liquidity. No one realized that there was a crisis because the exchange rate remained fixed and stable, and companies found it easy to have access to loans.”
Beyond that, disciplinary fiscal policies, which involve moderating the momentum of internal demand, whether it is at the level of public-sector or private-sector spending, are moving in the correct direction, notes Castañeda.
Nevertheless, for Mendoza, “the political leadership of the region has shown itself to be myopic about the issue of the distribution of wealth, which in the case of Peru is very unequal, and there has been very little progress in that regard.”
According to Paraje, “Latin America is one of the worst regions in the world when it comes to income distribution.” The great inequality in social and economic conditions affects the population’s access to education, training and specialization. “There aren’t any strategies for developing sufficient human capital, and this is the shortfall that has dragged down Latin American governments for years. It should become the central focus of their economic policies.”