LAC Success Put to the Test (April 2011) by World Bank Publications

SUCCESS

Put to the Test

SUCCESS

Put to the Test

April 12, 2011

Foreword This semiannual report—a product of the Office of the Chief Economist for the Latin America and the Caribbean Region of the World Bank—examines the nature of the very good overall performance of the Latin America and the Caribbean (LAC) region in the aftermath of the 2008-09 global financial crisis and presents a comparative analysis of the post-crisis recovery patterns in the region vis-à-vis other regions. The first part of this report provides an overview of recent economic developments, an indepth look at the drivers of the post-crisis performance in the region, analyzes the external and domestic risks that could drag down growth performance in LAC, and discusses policy response options. The preparation of this part of the report was led by Augusto de la Torre, Regional Chief Economist, in close collaboration with César Calderón, Tatiana Didier, Julián Messina, and Sergio Schmukler. Paula Pedro provided outstanding research assistance. We would like to thank Paloma Anos Casero, Tito Cordella, Alain Ize, Sergio Jellinek and Marcela Sanchez-Bender for their invaluable comments. The second part of the report documents the adverse impact of the crisis on the Caribbean region as well as its slow recovery. It distinguishes the poorer performance of English speaking Caribbean nations vis-à-vis Non-English speaking ones, and highlights the dependence of the region on countries in the epicenter of the crisis, especially the United States, and the limited fiscal space that disabled a counter-cyclical policy response. This part was led by Auguste Tano Kouame, Lead Economist of the Caribbean, and Maria Ivanova Reyes, and written based on their paper “Slow Recovery in the Caribbean after the Global Financial Crisis: Can the Region Strike Back?” The authors are thankful to the World Bank LCSPE team for providing inputs—especially to Carolina Biagini, Andresa Lagerborg, Apostolos Apostolou, and Riccardo Trezzi—as well as to the LAC Chief Economist office for comments and suggestions.

April 12, 2011 |5

6 | LAC Success Put to the Test

Part One LAC Success Put to the Test

8 | LAC Success Put to the Test

Executive Summary It is well known that LAC’s economic recovery—which gathered considerable momentum in 2010 when real GDP expanded by 6 percent—has been impressive compared to the region’s past. It is perhaps less well known that LAC’s recovery has decisively outperformed the middle-income country (MIC) average so far. LAC’s recovery started earlier and has been much stronger compared to the MIC average. The region’s economic rebound has been riding on a brisk upturn in domestic demand, which has in turn been spurred by major terms of trade gains and a surge in capital flows. In a break with the past, the current upturn in the region has neither been creditless nor job-less. A strong pick up in private credit has accompanied the recovery—a testimony of the fact that, in sharp contrast with the rich countries of the center, LAC’s financial systems come out of this crisis with unimpaired balance sheets. Similarly, and with the exception of a few countries (including Mexico), the region’s recovery has created jobs at a relatively fast clip, as unemployment rates have been typically declining while labor force participation rates have been stable or rising. To be sure, cyclical growth performance has been quite uneven within LAC. At one extreme are several countries in South America—most notably Argentina, Brazil, Peru, Paraguay, and Uruguay, but also Colombia and Chile—which have registered a remarkably vigorous recovery. At the other extreme are Mexico and the Caribbean countries, which tended to experience the largest growth decline in 2009 and where growth rates in 2010 were insufficient to fully revert the growth losses. Somewhere in the middle are Central America and the Dominican Republic (DR), where a meek rebound in most countries overshadows the lively recovery in Panama and the DR. The countries with a more stellar performance tend to share three policy-related strengths: (i) a greatly improved macro-financial “immune system” and consequent ability to conduct countercyclical policy; (ii) increasing trade links to emerging Asia—nowadays the leading and most dynamic growth pole in the planet; and (iii) a safer integration into international financial markets—becoming net creditors vis-à-vis the rest of the world as regards debt and growing net debtors in the equity side (i.e., major recipients of foreign direct investment). As the recovery phase of the cycle matures in the region, the scope for policy tensions and tradeoffs is widening and home-grown dynamics are playing a larger role in the balance of risks, even if some global threats remain and loom large in the horizon. Tensions arise as the authorities try to reconcile the objectives of, on the one hand, keeping inflation expectations anchored in the face of economic overheating and rising international prices of foods and fuels and, on the other hand, avoiding an “excessive appreciation” of the local currency in the face of high and potentially volatile commodity prices and capital inflows. These complexities raise the premium on skillful policy. Contrary to popular perception, the quality of macro-financial policy is being more subtly and perhaps more severely tested in the midst of the current buoyant juncture, as policy is called to pre-empt the risk of euphoric over-expansion. Indeed, buoyant economic activity in many LAC countries is already hitting capacity constraints and generating inflation pressures. These are, in turn, being further fed by the pass-through to the local economy of sharply rising international prices of foods and fuels. As central banks raise

interest rates to cool down the economy and keep inflation expectations anchored, they are also adding to the interest rate differential that is attracting short-term capital inflows, thereby boosting pressures for local currencies to appreciate. The combination of high but potentially volatile capital inflows and commodity prices is raising concerns among Latin American policy makers of an “excessive” currency appreciation that can undercut export diversification and long-run growth and lead to financial sector vulnerabilities down the line. In all, the maneuvering room for macro-financial policy has become much constrained. As policy makers seek to align conflicting goals, they have in all cases stayed away from the policy extreme of allowing the currency to freely float. They have rather adopted some variant of a “hybrid” approach—characterized by combinations of: intervention in foreign exchange markets, sterilization, monetary policy tightening, some fiscal policy tightening, a willingness to allow inflation to transitorily stay close to or slightly above the upper band of the inflation target, and a relatively ad-hoc application of broadly-defined macro-prudential interventions, including controls on capital inflows. This hybrid approach, however, has in practice unduly shifted the burden to monetary policy, as fiscal policy has fallen behind the curve and become pro-cyclical rather than turning more austere in current good times. While striking a perfect balance in the macro-financial policy mix under the current circumstances may be unfeasible, the hybrid approach can be improved along three directions. First and foremost, by a greater fiscal effort—that is, higher primary fiscal surpluses (an even more aggressively so in countries experiencing a major commodity windfall)—that does not undermine social policy. If anything, social policy will have to become more active and better focused to protect the vulnerable poor from, and mitigate the adverse distributional consequences of, the sharp rises in the socially sensitive prices of foods and fuels. Second, by ensuring that macro-prudential policy is used as a complement (not a substitute) to monetary policy and by deploying macro—prudential instruments with the main objective of averting the gestation of financial sector vulnerability. Third, by learning to live with a more appreciated local currency to the extent that it reflects fundamental factors—i.e., improved growth prospects, rising terms of trade, and robust (non-frothy) capital inflows. This calls for structural and microeconomic reforms geared at raising economic efficiency and productivity. Having reduced its macro-financial vulnerability, having taken important steps forward in its equity agenda (significant poverty reduction and a decline in inequality), and having walked ahead of many other emerging economies towards the consolidation of democratic institutions, LAC is unprecedentedly well positioned to embrace a vigorous growth agenda. However, skilful macro-financial policy in the present juncture is necessary—although far from sufficient—to turn what has so far been a cyclical recovery into a higher rate of trend growth while making further progress in the equity agenda. That will require a deepening of social policy and reforms to relax LAC’s structural speed limits to long-run growth. The present juncture is auspicious to pass these tests, especially for those countries in the region that are experiencing a major commodity windfall. But that will be only possible if—and this is a big if—they manage to save a large fraction of the windfall and then invest those savings at a pace consistent with the country’s absorptive capacity and in projects and programs with high social rate of return. The latter unavoidably will entail a focus on closing the well-known gaps that LAC has in human capital (through improved coverage and quality of education and health), physical capital (infrastructure), and innovation.

10 | LAC Success Put to the Test

Introduction LAC had a strong growth period before the crisis. It performed admirably well during the downturn, as its traditional sources of shock amplification—weak currencies, weak banking systems, and weak fiscal processes—were turned into shock absorbers—flexible exchange rates, well capitalized and liquid banks, governments with more savings and less debt. Moreover, the region has had on average a stellar post-crisis economic recovery to date compared to both LAC’s own past recoveries and other middle-income countries (MIC). Why this apparent break with history? In our 2010 Annual Meetings report—Globalized, Resilient, Dynamic: The New Face of Latin America and the Caribbean—we argued that the resilience during the crisis and the ability to orchestrate a lively upturn in economic activity was due to external factors as well as domestic policy improvements. On the external front, we highlighted (i) the rapid and strong rebound in commodity prices and (ii) the earlier-thanexpected swing from global risk aversion to risk appetite. They jointly spurred the recovery in the region—and especially that of net commodity exporters and financially globalized countries. On the policy front, we highlighted three crucial factors that have built structural strengths in the region: (i) the mentioned improvement in the region’s macro-financial immune system; (ii) the diversification of destination markets for LAC’s exports (particularly the intensified trade links with China); and (iii) the safer integration into international financial markets, whereby LAC has become a net creditor vis-à-vis the rest of the world as regards debt contracts and a net debtor as regards equity (particularly FDI) contracts. As the recovery phase of the cycle matures, however, the scope for policy tradeoffs and tensions is widening. It is precisely the LAC countries that are more robustly recovering the ones that face more intensively the conflicting objectives. The tension is particularly acute between the objective of keeping inflation expectations anchored in the face of economic overheating and the upward pressures on local prices stemming from the rising international prices of foods and fuels, on the one hand, and the objective of avoiding an “excessive appreciation” of the local currency in the face of high and potentially volatile commodity prices and short-term capital inflows, on the other. The need to navigate safely through the tradeoffs as the recovery matures puts a premium on the quality of macroeconomic and financial policies. This part of the report takes a deeper look at the features of the economic upturn in LAC and the factors driving it, analyze the nature of domestic and external risks and opportunities, and discuss the options open to policy makers. It is structured as follows. In the first place, it examines the recovery in LAC as a whole, compared to other regions, and characterizes the heterogeneity in the strength of the recovery across different types of countries within LAC. Relative to the pre-crisis peak, the report documents the sharp contrast between a very strong | 11

recovery in South America and a rather weak one in Mexico and the Caribbean, with Central America somewhere in between.1 Secondly, the report zooms in on the factors driving the cyclical upturn. To this end, it uses an event study approach to evaluate the dynamics of macro-financial indicators in the current cycle and compare them with the dynamics of LAC’s average past cycles as well as with the patterns of the non-LAC MICs. This event study analysis supports the following propositions: LAC has in this cycle outperformed both its own past and the MIC average; domestic demand is playing a major role in the recovery phase of the cycle; credit is accompanying the recovery, instead of lagging it, as was the typical case in the past; the postcrisis appreciation of the currency has been much stronger than in the past; and that the rebound in services is generally outpacing that of manufacturing. Thirdly, the report examines the adjustments in LAC’s labor markets. It finds that the recovery has, by and large, led to significant job creation, with the exception of Mexico. It also shows that employment in services has remained generally stable throughout the depths of the crisis and has been rising strongly in some countries, particularly Brazil. Finally, it highlights that wages in the retail sectors have been outpacing those in manufacturing. In the fourth place, the report characterizes upside and downside risks stemming from both the external front and from home-grown dynamics. The two key issues in the external front— the pace of the recovery in advanced economies and the surge in commodity prices—are being complicated by spillovers from the recent natural and nuclear disaster in Japan and the implications from the political turmoil in the Middle East and North Africa. The two key home-grown dynamics that complicate the policy setting are the closing of the output gaps and associated inflation risks, on the one hand, and the appreciation of local currencies, on the other. Finally, in light of the issues raised by the previous sections, the report discusses the nature of the tradeoffs and tensions for macro-financial policies and the options open to policy makers. It highlights that there is no policy silver bullet and that the region has adopted a hybrid, pragmatic policy approach. However, it argues that the current policy mix under the hybrid approach has unduly shifted the burden to monetary policy and that fiscal policy is noticeably behind the curve. Whereas monetary authorities have already started the tightening cycle, finance ministers are yet to rebuild the buffers that helped them successfully manage the cycle. Hence, the hybrid approach can be improved upon by stepping up fiscal saving (higher primary surpluses) without endangering social policy, more systematically and judiciously complementing monetary policy with macro-prudential policies, and adapting to stronger currencies (to the extent that they reflect fundamental factors) through reforms aimed at enhancing productivity growth. The report concludes by emphasizing that skillful cycle management is necessary—although far from sufficient—to be able to turn what has to date been a cyclical recovery into a higher rate of trend growth. Moreover, countries experiencing a formidable windfall from the high 1

This is in spite of strong growth rates recorded in 2010 for Mexico (5.5 percent), which were unable to offset fully the contraction in 2009.

12 | LAC Success Put to the Test

commodity prices are in a unique position to seize the opportunity—by judiciously saving and investing out of the windfall, they could relax the structural speed limits that have so far kept economic activity from rising to a higher long-run growth path.

Post-crisis economic recovery in LAC and around the world The engines of global growth started reigniting in 2009 although at different paces and intensities. As our previous report documented, these differences can be attributed to the degree of resilience across countries, as captured by policy buffers built in the pre-crisis period, the efficacy of counter-cyclical policy responses, and the quality of integration into international markets. When the impact of the worldwide systemic shock faded, the relative strengths of individual countries or regions played an increasingly greater role in the rebound than common global factors. Emerging economies continue to lead the world recovery and their current level of economic activity has already reached or surpassed the pre-crisis peak levels. In 2010, MIC growth (6.8 percent) significantly exceeded that of high-income countries (HICs) (2.5 percent), but there was considerable variance in growth performance across MIC regions and countries. Among BRICs (which now jointly account for 24 percent for world GDP, in PPP adjusted terms), China, India, and Brazil registered the strongest recoveries, with GDP growth rates of 10.5, 8.6, and 7.5 percent, respectively. Among emerging regions, LAC’s growth of about 6 percent, while lower than that in the East Asian Tigers (7.6 percent), exceeded by about two percentage points the growth rate of Eastern Europe and Central Asia (ECA) (4.1 percent) (Figure 1.1). FIGURE 1.1. Real GDP Growth in 2010 and Forecasts for 2011 PANEL A. Across Regions PANEL B. Across LAC Countries Real GDP Growth and Forecasts around the World Annual Real GDP Growth Rate, Weighted Averages

Real GDP Growth Forecasts for 2011 LAC Countries 8%

12% 2010

2011

10%

6% 5%

4% 6%

3% 2%

0% High Income

South Africa

ECA

LAC

East Asian Tigers

India

China

St. Kt. & Nev. Venezuela Bahamas Grenada Dominica Belize Jamaica El Salvador Ant. & Barb. St. Lucia Trin. & Tob. Barbados Guatemala St. Vct. & Grens. Guyana Ecuador Nicaragua Honduras Costa Rica Brazil LAC Bolivia Mexico Colombia Uruguay Suriname Paraguay Dom. Rep. Argentina Chile Peru Panama Haiti

Sources: Consensus Forecasts (March 2011), The World Bank’s Global Economic Prospects - GEP (January 2011), and IMF's World Economic Outlook (October 2010).

| 13

Within the LAC region, the best GDP growth performance in 2010 was observed in Argentina, Brazil, Paraguay, Peru, and Uruguay, all of which registered growth rates that exceeded 7.5 percent. In contrast, economic activity in many countries in Central America and the Caribbean (including for instance El Salvador, Guatemala, Honduras, Nicaragua, and Trinidad & Tobago) expanded weakly and well below the regional average, at rates in the 1-3 percent range. Negative growth rates were registered for very few countries in the region, notably Jamaica (-0.1 percent), Venezuela (-1.4 percent), and Haiti (-8.5 percent), the latter reflecting the devastating effects of the January 2010 earthquake. The marked heterogeneity in recent growth performance within the LAC region is best understood by looking jointly at the 2009 downturn and the 2010 upturn (Figure 1.2). Mexico and the Caribbean countries experienced the largest contraction in real economic activity in 2009 compared to their pre-crisis peaks (6.8 and 2.9 percent, respectively) and are the farthest from recovering the pre-crisis level in 2010. Real GDP in Mexico and the Caribbean in 2010 is still 1.4 and 2.6 percent below their pre-crisis peaks. As Part II of this report points out, the sharp decline in output and the sluggish recovery in the Caribbean is driven by the English speaking countries in that region (e.g. Antigua & Barbuda, The Bahamas, Barbados, Grenada, and St. Kitts & Nevis).2 By contrast, real economic activity in Central America and the Dominican Republic as well as in South America essentially only flattened during the downturn phase of the global crisis. While real GDP in 2009 was 0.3 percent below its pre-crisis peak in South America, it was only 0.2 percent above in Central American (including the Dominican Republic). Although real GDP on average barely changed in 2009 with respect to its pre-crisis peak, there was marked heterogeneity across individual countries. Some countries experienced in 2009 a decline of more than 2 percent from their pre-crisis peak (e.g. Paraguay and Venezuela in South America, and El Salvador and Nicaragua in Central America) while others were more than 2 percent above (the Dominican Republic and Panama in Central America and Bolivia and Uruguay in South America). Finally, South American countries have displayed a much stronger recovery than countries in Central America, even if fast growing DR is included in the Central America grouping. On average, real economic activity for South America in 2010 was 5.9 percent above its pre-crisis peak but only 4.2 percent in Central America and the DR. The only country that has yet to recover its pre-crisis peak in South America is Venezuela. Growth forecasts for 2011â&#x20AC;&#x201D;which are subject to a fair degree of uncertaintyâ&#x20AC;&#x201D;point to a continuation of robust growth in China (9.4 percent) and India (8.2 percent) and a general slowdown of growth (by about 2-3 percentage points) in most other large emerging economies, including Brazil (Figure 1.1). GDP growth in LAC as a whole is forecast to be in the 4-5 percent range in 2011, which is similar to the growth forecast for the East Asian Tigers. Such a deceleration is consistent with a closing of the gap between actual and 2

It should be noted that although the Haitian economy grew in 2009, it contracted drastically (-6 percent from its peak) after the severe earthquake that ravaged the country.

14 | LAC Success Put to the Test

potential growth in several of the larger LAC countries, including Brazil, which is expected to grow roughly at the regional average.3 Argentina, Chile, Panama, and Peru are envisaged to FIGURE 1.2. Recession and Recovery in LAC PANEL A. Performance across LAC Countries Level of GDP in 2009 Compared to Level of GDP in the Peak Logs of the Ratios

Level of GDP in 2010 Compared to Level of GDP in the Peak Logs of the Ratios St. Kt. & Nev. Ant. & Barb. Barbados Grenada Haiti Bahamas Venezuela St. Vct. & Grens. Jamaica St. Lucia El Salvador Nicaragua Mexico Trin. & Tob. Dominica Honduras LAC Belize Costa Rica Ecuador Guatemala Chile Colombia Guyana Suriname Brazil Bolivia Paraguay Panama Peru Dom. Rep. Argentina Uruguay

Ant. & Barb. St. Kt. & Nev. Grenada Mexico Bahamas Barbados Nicaragua Paraguay St. Lucia Jamaica El Salvador Venezuela Trin. & Tob. St. Vct. & Grens. Honduras LAC Chile Costa Rica Dominica Brazil Belize Ecuador Guatemala Colombia Argentina Peru Panama Suriname Uruguay Haiti Guyana Bolivia Dom. Rep.

-10%

-5%

-15%

-10%

-5%

10%

15%

PANEL B. Performance across Sub-Regions Level of GDP in 2009 Compared to Level of GDP in the Peak Logs of the Ratios, Simple Averages

Level of GDP in 2010 Compared to Level of GDP in the Peak Logs of the Ratios, Simple Averages

Mexico

Caribbean (Ex. DR)

Mexico

LAC

Central America (+DR)

South America

-8% -7% -6% -5% -4% -3% -2% -1% 0% 1%

-4%

-2%

Notes: Panel A and B compare 2009 and 2010 real GDP levels with their pre-crisis peak, which is the maximum annual value of real GDP in the period 2007-208. Sub-regional averages presented in Panel B are weighted averages using the 2007 GDP in US dollars (at current prices) as weights. Real GDP in 2010 is constructed based on forecast growth rates for 2010. Sources: World Bank’s World Development Indicators – WDI (December 2010), IMF's World Economic Outlook – WEO (October 2010), The World Bank’s Global Economic Prospects – GEP (January 2011), and Consensus Forecasts (March 2011).

Recently published figures for 2010Q4 as well as information on leading indicators for 2011Q1 for some countries in the region have led to upgrades in the 2011 GDP growth projections. For instance, Argentina is expected to grow 7 percent in 2011 (vis-à-vis consensus forecasts of 5.8 percent), while Colombia’s growth forecast for 2011 has been revised upwards to 5.5 percent (from 4.6 percent).

| 15

register growth rates of 1-2 percentage points above the regional average (Figure 1.1). GDP growth in 2011 is expected to accelerate in some countries that had a very poor growth performance in 2010, including most notably Haiti, where GDP is expected to rebound by 7.6 percent. FIGURE 1.3. Real Output and Domestic Demand around Troughs in GDP PANEL A. Real GDP

T+4

T+5

T+6 T+6

T+3

T+2

T+5

Previous Cycles

T+1

T-1

T-2

T-3

T-6

T+6

Current Cycle

T+4

Previous Cycles

T+5

-0.16

T+4

-0.16

T+3

-0.12

T+2

-0.12

T+1

-0.08

T-1

-0.04

T-2

-0.04

T-3

0.00

T-4

0.00

T-5

0.04

T-6

0.04

T-4

Latin America and the Caribbean

T-5

Middle Income Countries

Current Cycle

PANEL B. Private Consumption Middle Income Countries

Previous Cycles

Current Cycle

Previous Cycles

T+3

T+2

T+1

T-1

T-2

T-3

T-4

T-5

T+6

T+5

T+4

T+3

T+2

-0.12

T+1

-0.12

-0.08

T-1

-0.08

T-2

-0.04

T-3

-0.04

T-4

0.00

T-5

0.00

T-6

0.04

T-6

Latin America and the Caribbean

0.04

Current Cycle

Notes: The figures depicted here represent the deviations from regional/group trend growth in real GDP and private consumption on 13-quarter windows centered on previous and current troughs on real GDP. This figure depicts the behavior of real GDP and private consumption in previous and current recession-recovery cycles. Sources: IMFâ&#x20AC;&#x2122;s International Financial Statistics â&#x20AC;&#x201C; IFS, National Statistical Institutes and Central Banks, Haver Analytics.

Zooming in on the cyclical upturn in LAC: domestic and external factors This section characterizes the drivers behind the cyclical upturn in real economic activity in LAC compared to the non-LAC MICs. To that end, it uses an event study approach that draws on quarterly data from 1970 to 2010 to contrast the evolution of real and financial indicators in the current cycle to an average of previous episodes of recessions and 16 | LAC Success Put to the Test

expansions.4 The variables analyzed include indicators of real economic activity and aggregate demand (real output, industrial production, private consumption, investment, and net exports), policy variables (real interest rates and public consumption), external buffers (current account and international reserves), financial indicators (private credit, stock prices, real exchange rates), and exogenous factors (terms of trade and capital flows). While our 2010 Annual Meetings Report (“Globalized, Resilient, Dynamic: The New Face of Latin America and the Caribbean”) examined the behavior of GDP, aggregate demand components, and policy variables around peaks by focusing on the peak-to-trough phase of the cycle, this report evaluates the dynamics of macro-financial indicators around troughs and focuses on the recovery phase, comparing the patterns of the current recovery with the average dynamics of past (post-1970) recoveries.5 The event study analysis clearly shows that this time around the LAC region has, on average, outperformed its historical recoveries.6 It confirms not only that the decline in real output during the current cycle had less amplitude and shorter duration when compared to previous recessions, but also, and perhaps more importantly, that the current recovery has been swifter and stronger than previous recoveries. In the current cycle, growth in LAC’s GDP outpaced 4

Our sample of countries comprises 24 HICs and 42 MICs, of which 15 countries belong to the LAC region, with quarterly data for the period 1970-2010 is classified as follows. (1) Industrial countries (HICs): Australia, Austria, Belgium, Canada, Switzerland, Denmark, Germany, Spain, Finland, France, United Kingdom, Ireland, Iceland, Italy, Japan, Luxembourg, Netherlands, Norway, New Zealand, Portugal, Sweden, and the United States. (2) Latin America and the Caribbean (LAC): Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Dominican Republic, Ecuador, El Salvador, Mexico, Panama, Paraguay, Peru, Uruguay, and R.B. Venezuela. (3) Middle income countries, excluding LAC (MICs): Botswana, Bulgaria, P.R. China, Croatia, Czech Republic, Estonia, Hong Kong- China, Hungary, India, Indonesia, Iran, Israel, Jordan, Rep. Korea, Latvia, Lithuania, Malaysia, Malta, Morocco, Philippines, Poland, Romania, Russian Federation, Singapore, Slovak Republic, Slovenia, South Africa , Sri Lanka, Taiwan-China, Thailand, Turkey, and Ukraine. 5

Peaks and troughs in real economic activity are identified using the Bry-Boschan quarterly BBQ algorithm (Harding and Pagan, 2002; Engel, Haugh and Pagan, 2005). This method defines business cycles as sequences of expansions and contractions in real output and it has extensively used in recent empirical assessment of real and financial cycles (Claessens et al. 2009, 2010a, 2010b). Once troughs are identified, panel data regressions are estimated with country fixed-effects on a 13-quarter window centered in the trough of real GDP, which signals the start of the recovery (period T). The dependent variable in our regression is either a real or a financial indicator (real GDP, private consumption, public consumption, real investment, industrial production, real exchange rate, real credit per capita, non-FDI gross inflows and terms of trade). All dependent variables are expressed as year-on-year growth rates (%), except for the ratios to GDP that are expressed as year-on-year variation (% of GDP). The regression analysis distinguishes the current recovery process from the average patterns observed during previous (post-1970) recoveries. The estimates of these regressions for the different indicators considered here are depicted in Figures 1.3, 1.4, 1.7, and 1.9. These coefficient estimates should be interpreted as deviations from the regional average over the full time period for the corresponding real and financial indicators. For all variables, these are deviations from average year-on-year growth per region over the full time period —and, for variables expressed as ratio to GDP, it is deviations from year-on-year variation in the ratio to GDP. For simplicity, this average growth (or variation) is interpreted as trend growth.

Comparability is limited inasmuch as average of past cycles reflects a mix of crises originated in the rich countries of the center as well as crises originated in emerging markets.

| 17

the historical (sample) average four quarters after the beginning of the recovery process (T+4). This better performance in the current cycle is appears to be mostly driven by the recovery in domestic demand, with the rebound in private consumption and investment outperforming the past and, most notably, a marked counter-cyclical behavior of public consumption during the downturn phase that constitutes a significant break with the past (Figures 1.3 and 1.4). The evidence in Figure 1.4, however, suggests that public consumption has tended to become pro-cyclical as the recovery matures. In effect, public consumption grew above (sample) historic averages before the start of the recovery but continued growing 2 percentage points above that average (at an annualized growth rate of 6 percent) well after the upturn in real economic activity was already underway. FIGURE 1.4. Real Output and Domestic Demand around Troughs in GDP PANEL A. Public Consumption

T+4

T+5

T+6

T+5

T+6

T+3

T+2

T+1

T-1

T-2

T-3

T-6

T+6

Previous Cycles

Current Cycle

T+4

Previous Cycles

T+5

-0.08

T+4

-0.08

T+3

-0.06

T+2

-0.06

T+1

-0.04

T-1

-0.02

T-2

-0.02

T-3

0.00

T-4

0.00

T-5

0.02

T-6

0.02

T-4

Latin America and the Caribbean 0.04

T-5

Middle Income Countries 0.04

Current Cycle

PANEL B. Real Investment Middle Income Countries

Previous Cycles

Current Cycle

Previous Cycles

T+3

T+2

T+1

T-1

T-2

T-3

T-4

T-5

T+6

T+5

T+4

-0.35

T+3

-0.35

T+2

-0.25

T+1

-0.25

-0.15

T-1

-0.15

T-2

-0.05

T-3

-0.05

T-4

0.05

T-5

0.05

T-6

0.15

T-6

Latin America and the Caribbean

0.15

Current Cycle

Notes: The figures depicted here represent the deviations from regional/group trend growth in public consumption and real investment on 13-quarter windows centered on previous and current troughs on real GDP. Sources: IMFâ&#x20AC;&#x2122;s International Financial Statistics â&#x20AC;&#x201C; IFS, National Statistical Institutes and Central Banks, Haver Analytics.

18 | LAC Success Put to the Test

LAC’s current economic cycle not only outperformed LAC’s own past patterns of recessionupturn, but it also outperformed the current cycle of the (non-LAC) MIC average. For starters, the growth decline in LAC was on average smaller than that of MICs. Moreover, the recovery phase in LAC not only started earlier (4 quarters after growth hit bottom) but was also swifter and stronger than that of the MIC average. For non-LAC MICs, a weak recovery in private consumption and investment is behind the slow transition towards historical levels of growth. The major role played by buoyant domestic demand in LAC’s recovery is confirmed in Figure 1.5. It shows that aggregate domestic demand has outpaced GDP throughout the cycle, while real net exports are moving along a declining trend, which was briefly interrupted during the 2008Q3-2009Q2 period. The rising gap between aggregate demand and net exports measured in real terms has been, of course, covered by terms-of-trade gains, although at a somewhat decreasing rate, as the current account surpluses have been declining alongside the recovery. FIGURE 1.5. Expansion in Domestic Demand and Lower Net Exports in LAC-7 LAC-7: Real GDP by Demand Component PPP-GDP Weighted Averages, Index 2005=100 140 Real Output

Domestic Demand

Net Exports

130 120 110 100 90 80

2010.03

2010.01

2009.03

2009.01

2008.03

2008.01

2007.03

2007.01

2006.03

2006.01

2005.03

2005.01

Notes: The indices of real GDP, domestic demand and net export are PPP-GDP weighted averages of the corresponding indices for the seven major countries in the region (Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela). Net exports are calculated as the ratio of exports to imports. Sources: National Statistical Institutes and Central Banks, Haver Analytics.

A disaggregation of real economic activity by sector reveals marked contrasts (Figure 1.6). In particular, services (as measured by the tertiary sector and/or retail trade) have been booming in the major LAC countries during the recovery phase and showed significant resiliency during the downturn (e.g., the “tertiary sector” declined by only 3 percent between 2008Q3 and 2009Q1). In contrast, manufacturing (as measured by industrial production and the secondary sector) fell sharply during the downturn (e.g., industrial production contracted by 11 percent between 2008Q3 and 2009Q1) and has tended to flatten out after the initial rebound.

| 19

The strong expansion of the non-traded sector (more specifically, services) when compared to the traded sector (mostly manufacturing) is arguably linked to the strong appreciation of the currencies in the larger LAC countries (Figure 1.7). Such appreciation may signal incipient symptoms of “Dutch Disease,” a phenomenon whereby non-commodity exports loose competitiveness and stagnate while the non-traded sector expands fast. In turn, the appreciation of the currencies reflects a powerful combination of surging capital inflows, rising terms of trade, and optimism regarding growth prospects—a combination that has not been seen in such a clear profile as in previous cycles. FIGURE 1.6. Expansion in Non-Traded Sectors PANEL A. Real GDP across Types of PANEL B. Industrial Production Activity and Retail Sales LAC-7: Real GDP by Type of Economic Activity PPP-GDP Weighted Averages, Index 2005 = 100

Industrial Production and Retail Sales in LAC-6 Real Prices, Weighted Averages, Index 2005=100

130

160 Primary

Secondary

Tertiary

Industrial Production

125

150

120

140

Retail Trade (Volume)

130

115

120 110 110 105

100

Feb-10

Dec-10

Apr-09

Jun-08

Aug-07

Oct-06

Dec-05

Feb-05

Apr-04

Jun-03

Aug-02

Oct-01

Feb-00

Dec-00

2010.03

2010.01

2009.03

2009.01

2008.03

2008.01

2007.03

2007.01

2006.03

2006.01

2005.03

2005.01

Notes: Panels A and B present PPP-GDP weighted averages. The six countries considered in Panel B were: Argentina, Brazil, Chile, Colombia, Mexico, and Peru. Nominal retail sales are deflated by the CPI. Sources: National Statistical Institutes and Central Banks, Haver Analytics, and Bloomberg.

In effect, the patterns of real exchange rate depreciation-appreciation in LAC in this cycle stands in contrast to previous cycles and also to the non-LAC MIC average. The current cycle for LAC featured a significant real appreciation of the currency before the peak in GDP (compared to depreciations in previous instances that tended to anticipate balance of payments crises), a smaller and much shorter-lived depreciation during the downturn phase of the cycle, and a stronger and more sustained strengthening of real exchange rates in the recovery phase. Perhaps more striking is the real exchange rate behavior in LAC compared to the MIC average. During the downturn, the real depreciation was significantly larger than in MIC (but also shorter-lived), while the appreciation during the upswing phase has been substantially greater. The strongest appreciation of the real exchange rate among LAC countries relative to MICs, may be explained by a combination of several factors. First, terms of trade effects in LAC are arguably stronger vis-à-vis other MICs (see Figure 1.9). Second, the more binding structural speed limits to long-run growth in LAC leads to overheating and a consequent tightening of monetary policy at an earlier stage of the recovery which, ceteris paribus, increases the 20 | LAC Success Put to the Test

interest rate differential and inducing more carry trade inflows. Third, the existence of higher real interest rates in the LAC (vis-à-vis other MICs) could also be attributed to fact that there are still some credibility gaps in the region left over from a past history of volatility and financial instability. Finally, exchange rates are on average more heavily managed in other MICs than in LAC. FIGURE 1.7. Credit and the Real Exchange Rate in the Current Recovery PANEL A. Real Effective Exchange Rate

T+4

T+5

T+6

T+5

T+6

T+3

T+2

T+1

T-1

T-2

T-3

T-6

T+6

T+5

T+3

T+2

T+4

Previous Cycles

Current Cycle

T+4

Previous Cycles

T+1

-0.12

T-1

-0.07

T-2

-0.07

T-3

-0.02

T-4

-0.02

T-5

0.03

T-6

0.03

T-4

Latin America and the Caribbean 0.08

T-5

Middle Income Countries 0.08

Current Cycle

PANEL B. Real Credit per Capita

Previous Cycles

Current Cycle

Previous Cycles

T+3

T+2

T+1

T-1

T+6

T+5

T+4

T+3

T+2

T+1

-0.25

-0.20

-0.25

T-1

-0.20

T-2

-0.15

T-3

-0.10

-0.15

T-4

-0.10

T-5

0.00 -0.05

T-6

0.00 -0.05

T-2

0.05

T-3

0.10

0.05

T-4

0.10

T-6

0.15

T-5

Latin America and the Caribbean

Middle Income Countries 0.15

Current Cycle

Notes: The figures depicted here represent the deviations from regional/group trend growth in real credit (per capita) and real effective exchange rate on 13-quarter windows centered on previous and current troughs on real GDP. Sources: IMF’s International Financial Statistics – IFS, National Statistical Institutes and Central Banks, Haver Analytics.

Another interesting feature of the current recovery in LAC is that it has not been credit-less. This stands in sharp contrast with past recovery patterns, where credit continued to contract (in real terms) or remained stagnant even as GDP growth recovered. The (past) patterns of

| 21

credit-less recovery were examined by Calvo, Izquierdo and Talvi (2006), who dubbed it Phoenix Miracle. The analysis in this report confirms that, in previous cycles, growth in credit per capita in the region was systematically below trend before the start of the economic downturn and remained at depressed levels throughout the recovery. This time around, while credit growth was below the historical average in the midst of the recession and hit a low point in T+2, it turned around quickly and was already growing above trend six quarters after the beginning of the recovery in economic activity (Figure 1.7). These patterns in credit in the current cycle arguably reflect factors associated with the new-found resiliency in the LAC region, including the fact that the balance sheets of the banking system was not impaired by the global crisis, that the demand for credit was quickly restored once the recovery was cemented, and that capital inflows resumed rapidly and strongly. In sharp contrast to LAC, the credit dynamics for the MIC average during the current cycle resemble LAC’s past episodes of credit-less recovery. The MIC version of the Phoenix Miracle in the current cycle arguably reflects the financial system weaknesses displayed mostly by ECA countries in the run-up to the crisis—bank credit being highly dependent of cross-border bank flows. Furthermore, foreign financial flows to the ECA region (heavily dependent on syndicated loans) have not fully recovered yet.7 One salient aspect of the credit dynamics in LAC during the pre-crisis years is the steady increase in personal and real estate credit. These types of credit—representing about 40 percent of total bank lending—have been growing at a much faster pace than total bank credit to the private sector in LAC-6 countries (Figure 1.8). Interestingly, the slowdown as well as the rebound in the growth of personal (consumer) credit preceded similar movements in total credit, while the growth of housing credit remained strong during the depths of the crisis and accelerated significantly during 2010. The contrast with the prolonged collapse in housing credit in advanced countries is remarkable. Figure 1.9 sheds light on the extent to which these credit patterns in LAC’s current cycle may be fueled by higher commodity prices and surging capital flows. Note first that fluctuations in non-FDI inflows are smaller and less volatile than those for the MIC average. Nevertheless, their recovery is also stronger. When compared with the past, the decline in non-FDI inflows to LAC during the current cycle is comparable to that of previous cycles. However, capital flows to LAC start to grow above trend in the fourth quarter of the current upturn, much earlier than in previous cycles. While FDI inflows remained roughly stable throughout the crisis, portfolio and other non-FDI inflows dried up during 2008Q4-2009Q1. Annualized gross inflows to LAC-6 reached nearly US$330 billion by 2010Q4, about US$80 billion higher than the pre-crisis peak reached in 2008Q1.

Bank credit per capita grew below trend among industrial countries during the “great recession” but appear to recover swiftly once real output upturn started showing signs of a recovery. While this credit pattern may reflect the aggressive liquidity injections and credit support programs engineered by central banks, it may arguably be more of a mirage. In effect, bank credit is only a fraction of total credit in advanced economies, and the pickup in bank credit may simply reflect the absorption into banks’ balance sheets of credit claims that were booked in the shadow banking field prior to the crisis and, hence, not an indication of overall credit recovery.

22 | LAC Success Put to the Test

FIGURE 1.8. Composition of Bank Credit to the Private Sector Real Credit Growth in LAC-6 Countries YoY Growth, %

45%

Total

Housing

Personal

35%

25%

15%

Dec-10

Jul-10

Feb-10

Sep-09

Apr-09

Nov-08

Jan-08

Jun-08

Aug-07

Oct-06

Mar-07

May-06

Jul-05

Dec-05

Feb-05

-5%

Notes: The figure depicts the (PPP-GDP) weighted average of the growth rates of (total, personal and housing) credit to the private sector for the six largest LAC countries (Argentina, Brazil, Chile, Colombia, Mexico, and Peru). Sources: National Statistical Institutes, Central Banks, and Superintendence of Banking.

As noted earlier and discussed at length in previous reports, the good performance of LAC during the period 2003-2008 was partly supported by very favorable terms of trade, which benefitted mainly countries in South America. After reaching record heights in 2008Q22008Q3, commodity prices took a nose dive when world output contracted but then rebounded rapidly, starting in 2009Q1. The terms of trade losses in LAC were significantly larger during the downturn phase of the current cycle, compared to previous cycles, but they also recovered with much greater strength, thus delineating a noticeably wider fluctuation range (Figure 1.9). Terms of trade for the LAC-6 were still on the rise when the downturn phase begun (around T-4) but fell precipitously and reached the lowest point in T-2, before the trough in economic activity. However, they were quickly back to trend levels just as economic growth started recovering.

Labor market adjustments: overall, a job-creating recovery The downturn phase of the current cycle for many of the larger LAC countries took place without significant job destruction while the recovery phase has featured a relatively fast reduction in unemployment and rising employment rates.8 Moreover, these overall improvements in the employment picture have occurred in a context of generally stable or rising labor participation rates (except for the notable cases of Ecuador and Mexico where workers dropped out of the labor force in significant numbers throughout the cycle for reasons

Unemployment in the region is expected to drop from 8.1 percent in 2009 to 7.5 percent in 2010 (OIT, 2010).

| 23

that are difficult to ascertain).9 These developments suggest an upward shift in labor demand for the region as a whole, where job creation has more than compensated a rising supply of workers. FIGURE 1.9. Capital Flows and Terms of Trade in the Current Cycle PANEL A. Capital Flows: Non-FDI Gross Inflows (Ratio to GDP)

T+4

T+5

T+6

T+5

T+6

T+3

T+2

T-6

T+6

T+5

T+3

T+2

T+4

Previous Cycles

Current Cycle

T+4

Previous Cycles

T+1

-0.25

T-1

-0.20

-0.25

T-2

-0.15

-0.20

T-3

-0.10

-0.15

T-4

-0.10

T-5

0.00 -0.05

T-6

0.00 -0.05

T+1

0.05

T-1

0.10

0.05

T-2

0.15

0.10

T-3

0.15

T-4

0.20

T-5

Latin America and the Caribbean

Middle Income Countries 0.20

Current Cycle

PANEL B. Terms of Trade

Previous Cycles

Current Cycle

Previous Cycles

T+3

T+2

T+1

T-1

T-2

T-3

T-4

T+6

-0.20

T+5

-0.20

T+4

-0.15

T+3

-0.10

-0.15

T+2

-0.10

T+1

-0.05

T-1

0.00

T-2

0.05

0.00

T-3

0.05

T-4

0.10

T-5

0.15

0.10

T-6

0.15

T-5

Latin America and the Caribbean 0.20

T-6

Middle Income Countries 0.20

Current Cycle

Notes: The figures depicted here represent the deviations from regional/group trend growth in non-FDI (gross) inflows (as ratio to GDP) and terms of trade on 13-quarter windows centered on previous and current troughs on real GDP. Sources: IMF’s Balance of Payments Statistics, Haver Analytics, National Statistical Institutes, and Central Banks.

Unemployment has already reached lower rates than those prevailing before the downturn for many LAC countries, specifically Argentina, Brazil, Ecuador, Peru, and Uruguay (Figure 1.10).10 However, this is not a generalized result. Unemployment rates in Chile and Colombia, 9

These cases invite further research. LAC’s labor participation rate during the first three quarters of 2010 was, on average, 59.7 percent —that is, 0.4 percentage points higher than the analogous period in 2009.

Peaks and troughs in real GDP were obtained applying the quarterly adaption of the Bry-Boschan algorithm (Harding and Pagan, 2002). This methodology is unable to identify downturn in economic activity in Uruguay

24 | LAC Success Put to the Test

for example, although declining, are still above pre-crisis levels while unemployment rates in Mexico and Venezuela have actually increased since the start of the economic downturn. FIGURE 1.10. Labor Market in Latin American Countries PANEL A. Unemployment Rate PANEL B. Participation Rate Participation Rate in LAC Countries

Unemployment Rate in LAC Countries 75%

15% Peak

Trought

Last

Peak

Trought

Last

70%

10% 65% 60%

5% 55%

Venezuela

Uruguay

Peru

Mexico

Ecuador

Chile

Brazil

Argentina

Venezuela

Uruguay

Peru

Mexico

Ecuador

Chile

Colombia

Brazil

Argentina

Colombia

50%

PANEL C. Employment Rate Employment Rate in LAC Countries 65% Peak

Trought

Last

60%

55%

Venezuela

Uruguay

Peru

Mexico

Ecuador

Chile

Colombia

Brazil

Argentina

50%

Notes: Peaks and troughs in real GDP were identified using Harding and Pagan’s BBQ algorithm. The peak in real GDP for Argentina, Brazil, Ecuador, Peru, and Uruguay was 2008q3; Chile was 2008q2, Colombia 2007q4, Mexico 2008q1, and Venezuela, 2008q4. The trough in real GDP was 2009q1 for Argentina, Brazil, Colombia, Mexico, and Uruguay, 2009q3 for Chile, Ecuador, and Peru, and 2009q1 for Venezuela. The last quarter available of information for real GDP across LAC countries was 2010q4 —except for Argentina (2010q3). Real GDP was seasonally adjusted using X12-ARIMA. Sources: Organización Internacional del Trabajo – OIT (2010).

during the global crisis. Hence, we date peaks and troughs in Uruguay as similar to those experienced in Argentina in order to include the former country in our sample.

| 25

Declining unemployment along with rising labor force participation rates accompanied the rapid expansion of employment observed during the recovery in many LAC countries, with Colombia and Peru registering the sharpest increases (Figure 1.10). At the other extreme is the particular case of Mexico,11 where the steady declines in labor force participation and employment throughout the entire cycle have also been accompanied by a persistent rise in the unemployment rate.12 Figure 1.11 sheds light on how labor market performance fared during the current recovery if compared to previous ones. It focuses on the evolution of employment and unemployment for Argentina, Brazil, and Mexico, the only countries for which data are available. The results are quite contrasting. For starters, while the employment picture in Brazil has improved vastly and at a fast pace in this recovery, especially if compared to previous ones, the labor market response has been quite sluggish in Mexico, with unemployment faring much worse than in previous recoveries.13 Unlike Brazil, Mexico is so far a clear case of a jobless recovery. Argentina, like Brazil, shows a less painful labor market adjustment than in the past, with the striking added feature of a great reduction in volatilityâ&#x20AC;&#x201D;the fluctuations in employment and unemployment during the current cycle completely pale in comparison to the dramatic swings observed around 2002Q2. Consistent with the sharp decline in manufacturing activity in LAC during the downturn (mentioned above and discussed at length in our previous reports), employment in the manufacturing sector dropped significantly in Argentina, Brazil, and Mexico during this recessionary phase, and has since then recovered to pre-crisis peak levels only in Brazil (Figure 1.12). In contrast, employment in services was barely affected during the downturn phase of the cycle in all three countries, and has been increasing significantly in Brazil during the recovery phase of the cycle. Consistent with these changes in employment, wages in retail trade (a proxy for services) relative to those in manufacturing have been increasing in Argentina and Brazil alongside the economic recovery. This suggests that the boom of economic activity in services documented above is putting upward wage pressures in these countries. In contrast, this relative wage has remained relatively stable in Mexico. In a break with history, the downward trend in informal employment observed in Argentina and Brazil during 2005-2008 continued unabated during the recession. In fact, informality further declined during the recent recovery in these countries (Figure 1.13, panel A). Interestingly, the shift towards formal employment occurred in all sectors of the economy at somewhat similar rates. Mexico, on the other hand, experienced a remarkably stable rate of informality over the last five years, but it too remained unaffected by the last recession-

The data used in this analysis is seasonally adjusted and index. Hence, it does not necessarily coincide with official data.

In Ecuador, at least there is a reduction in the unemployment rate since the cycleâ&#x20AC;&#x2122;s trough, even though both participation and employment rates have fallen steadily through the entire cycle.

The unemployment rate in Mexico continued growing for two more quarters after 2009Q2, and it declined mildly thereafter. In previous recoveries, unemployment steadily declined once the economic upturn began. Note that employment declined during current and previous cycles since the beginning of the downturn. Hence, employment destruction was higher in Mexico during the current recession-recovery cycle.

26 | LAC Success Put to the Test

recovery cycle, suggesting that the declines in employment and labor force participation mentioned earlier affected the informal and formal sectors proportionately. FIGURE 1.11. Dynamics of Labor Markets in LAC around Troughs in Real GDP PANEL A. Argentina Argentina: Unemployment Index Recession Trough = T

Argentina: Employment Index Recession Trough = T 115

110

112

100

109

106

103

100

T+4

T+5

T+6

T+5

T+6

T+5

T+6

T+3

T+4 T+4

T+2

2008-2009 recession

Previous recessions

T+1

T-1

T-2

T-3

T-4

T-5

T+6

T+5

T+4

T+3

T+2

T+1

T-1

T-2

T-3

T-4

T-5

T-6

2008-2009 recession

T-6

Previous recessions

PANEL B. Brazil Brazil: Employment Index Recession Trough = T

Brazil: Unemployment Index Recession Trough = T

104

120

103

110

102 100

101 90

2008-2009 recession

Previous recessions

2008-2009 recession

T+3

T+2

T+1

T-1

T-2

T-3

T-4

T-6

T+6

T+5

T+4

T+3

T+2

T+1

T-1

T-2

T-3

T-4

T-5

T-6

T-5

100

Previous recessions

PANEL C. Mexico Mexico: Unemployment Index Recession Trough = T

Mexico: Employment Index Recession Trough = T 104

120 110

102

100 100

90 80

Previous recessions

2008-2009 recession

T+3

T+2

T+1

T-1

T-2

T-3

T-4

T-5

T+6

T+5

T+4

T+3

T+2

T+1

T-1

T-2

T-3

T-4

T-5

T-6

2008-2009 recession

T-6

Previous recessions

Notes: All series are indexed to 100 at their corresponding trough in real GDP; quarters on x-axis; trough in output at t = T. Real GDP troughs take place in 2009q1 for Argentina, Brazil and Mexico. Previous troughs are: Argentina: 2002q2; Brazil: 1983q1, 1990q2, 1992q3, 1997q1, 2003q2; Mexico: 1988q2, 1995q2, 2002q1. All employment and unemployment quarterly series are seasonally adjusted. Sources: LCRCE staff calculations using Argentina’s Encuesta Permanente de Hogares (EPH), Brazil’s Pesquisa Mensal de Emprego (PME), and Mexico’s Encuesta Nacional de Ocupación y Empleo (ENOE).

| 27

FIGURE 1.12. Employment and Wages across Types of Activity PANEL A. Trends in Labor PANEL B. Trends in Wages Relative Wages

Employment as % of the Working Population Manufacturing and Services

Ratio between Wages in Retail Trade and Manufacturing 115

110

Pre-recession peak MEX

Recession Trough

Pre-recession peak ARG and BRA

105

110 Recession Trough

100

105 95 Pre-recession peak MEX

100 Pre-recession peak ARG and BRA

Argentina

Brazil

2010.03

2010.01

2009.03

2009.01

2008.03

2008.01

2007.03

2007.01

2006.03

2006.01

MEX Industry MEX Services

2005.03

2010.03

2010.01

2009.03

2009.01

2008.03

2008.01

BRA Industry BRA Services

2005.01

ARG Industry ARG Services

2007.03

2007.01

2006.03

2006.01

2005.03

2005.01

Mexico

Notes: All series are indexed to 100 at 2005q1 (2009q1) in Panel A (Panel B). Seasonally adjusted using X12-ARIMA. Sources: LCRCE staff calculations using: Argentina: Encuesta Permanente de Hogares (EPH), Brazil: Pesquisa Mensal de Emprego (PME), and Mexico: Encuesta Encuesta Nacional de Ocupación y Empleo (ENOE).

FIGURE 1.13. Employment and Relative Wages in Formal and Informal Sectors PANEL A. Trends in Labor PANEL B. Trends in Wages Relative Wages Ratio between Wages in Formal and Informal Sectors

Employment as % of the Working Population Formal and Informal Workers 135

105

Pre-recession peak MEX

125

103 101

115

Recession Trough

105

99 97

Pre-recession peak ARG and BRA

Recession Trough

Argentina

Brazil

2010.03

2010.01

2009.03

2009.01

2008.03

2008.01

2007.03

2007.01

MEX Informal MEX Formal

Pre-recession peak MEX

2006.03

2010.03

2010.01

2009.03

2009.01

2008.03

2008.01

2007.01

2007.03

BRA Informal BRA Formal

2006.01

ARG Informal ARG Formal

2006.03

2006.01

2005.03

2005.01

2005.03

Pre-recession peak ARG and BRA

2005.01

Mexico

Notes: A formal employee is defined in terms of access to social security. All series are indexed to 100 at 2009q1. Series are seasonally adjusted using X12-ARIMA. Sources: LCRCE staff calculations using Argentina’s Encuesta Permanente de Hogares (EPH), Brazil’s Pesquisa Mensal de Emprego (PME), and Mexico’s Encuesta Nacional de Ocupación y Empleo (ENOE).

The relative wage of formal to informal employees remained broadly constant since 2005 until the start of the recovery in Argentina, Brazil, and Mexico (Figure 1.13). However, this relative wage has tended to fall during the recovery phase. It started dropping as soon as the recovery started in Brazil and has fallen by a cumulative 10 percent during the recovery phase through 2010Q3. In Argentina, by contrast, it declined right after the recovery but started to 28 | LAC Success Put to the Test

increase soon thereafter. And in Mexico, it has started to decline a couple of quarters after the recovery began. The relative increase in formal employees together with the decline in their relative wages during the recovery points to a shift in the supply of labor from informal to formal employment. It is not obvious how this could be reconciled with the observed faster growth in services compared to manufacturing, and given that the service sector is perceived to be more intensive in informality than the manufacturing sector. One may thus put forward the hypothesis that the increase in labor supply is being met by a relatively greater expansion in the formal segments of a booming services sector (relative to a manufacturing sector that has flattened out after reaching pre-crisis peak levels).

The balance of risks: exogenous factors The current recovery in the LAC region, although very robust, is tied to developments in the global environment. There is considerable uncertainty on the way in which some key external factors may affect LAC as a whole, and different countries within the region. Special attention should placed on: the stronger than expected recovery in some of the advanced economies; the international spillovers of the natural and nuclear disaster in Japan; the global repercussions of the political turmoil in the Middle East and North Africa (MENA); and the ongoing sharp increases in commodity prices, particularly fuel and food, as well as the potential for greater volatility in these prices. These factors do not operate independently but rather interact in complex ways that cannot be fully unanticipated. They pose potential costs and benefits for the region as a whole and their effectsâ&#x20AC;&#x201D;particularly the effects of commodity price increasesâ&#x20AC;&#x201D;on individual countries within the region can be starkly asymmetric. In the rest of this section, we discuss the potential implications for LAC of the mentioned factors. Recovery in the developed world. It has been stronger than previously anticipated, particularly for Germany and the United States. At the same time, fears about a full-blown debt/financial crisis in peripheral Europe have subsided, although no clear final resolution has been yet put in place. These circumstances, combined with the threat that recent sharp increases in fuel prices can filter to higher core inflation, may prompt some of the major central banks to advance the timetable for raising interest rates. In fact, the European Central Bank (ECB) has already signaled that it could start normalizing policy rates as soon as April or May (compared to previous market expectations that hikes would take place not before the third quarter of 2011). In the United States, with growth and unemployment reductions exceeding expectations, analysts are envisioning a normalization of policy interest rates by late-2011 or early-2012 (compared to previous expectations of U.S. rate hikes in the second half of 2012).14 14

The U.S. economy expanded by 3.1 percent on an annualized basis 2010Q4 and the unemployment rate has recently fallen to 8.8 percent.

| 29

Recent events in Japan however have complicated these scenarios, given its importance in the world economy. Japan is the third largest economy in the world, representing about 9 percent of world GDP, and it is a key supplier of inputs to industries that are highly sensitive to the world business cycle—such as electronics and automobiles. At the time of the writing of this report, the spillovers of the damage of the earthquake and tsunami that hit the country on March 11 remain uncertain as the nuclear crisis is still unfolding. On the one hand, as Japan is part of global supply chains in many industries, the destruction of productive capacity can have worldwide implications. Disruptions in the production of certain goods can be severe to the extent that firms have few or non-existent alternative suppliers in the short run. On the other hand, the massive reconstruction of the country that needs to take place can certainly help the recovery in economic activity around the world and may put further upward pressures on commodity prices, particularly metals and fossil fuels. In any case, the eventual normalization of interest rates in the advanced world may have significant implications for developing countries, with positive and negative effects. On the positive side, it will have a dampening impact on capital flows to emerging markets, including the larger LAC economies, thereby mitigating exchange rate appreciation pressures and giving some relief to economies that are overheating. The impact would be stronger to the extent that yield curves, particularly in the U.S., steepen due to doubts about the political feasibility of restoring the fiscal process to a sound path. Whether eventually higher interest rates in rich countries pose a major threat of “sudden stops” or reversals in capital flows to LAC with disruptive domestic consequences, as observed in the past, is a matter of debate. But the combination of reduced currency mismatches achieved by the region, its position as a net creditor as regards to debt contracts vis-à-vis the rest of the world, and its frankly more robust monetary policy frameworks (including flexible exchange rates) makes the past syndrome of a sudden-stop a much less likely scenario. On the negative side, the normalization interest rates in the rich countries may slow down global economic growth, potentially reducing world demand for LAC exports.15 As noted earlier, however, this risk is somewhat reduced by the more diversified destination markets for LAC exports, including the trade links with emerging Asia. High and volatile commodity prices. After falling sharply yet briefly during the global financial crisis—in the second half of 2008—commodity prices have resumed their upward trend (in dollar terms) in the last twenty months or so (Figure 1.14). Since February 2009, international food prices have risen by more than 30 percent and agricultural raw material prices by more than 65 percent. During the same period, oil and metal prices have increased by around 100 percent. Specific agricultural commodities such as corn, maize, several types of oil (coconut, palm, among others), and specific metals and minerals (such as silver and tine) have seen their prices rise by more than 40 percent over the last 6 months. Virtually all commodities that matter for LAC’s net commodity exporters are partaking in this strong wave of price hikes, with the prices of many commodities already surpassing their pre-crisis peaks (Figure 1.15).

Higher world interest rates may also cool down somewhat commodity price increases.

30 | LAC Success Put to the Test

FIGURE 1.14. Rising Food and Fuel Prices in International Markets PANEL A. International Prices by Groups PANEL B. Commodity Prices Most of Commodities Relevant for LAC Evolution of Commodity Prices Constant US$ 2000, Index Jan-05 = 100

Commodity Prices Most Relevant Prices for LAC Countries

300

Food

Metals and Minerals

Raw Materials

Jan-05

Jan-11

Sep-10

Jan-10

May-10

Sep-09

Jan-09

May-09

Sep-08

Jan-08

May-08

Sep-07

Jan-07

May-07

Sep-06

Jan-06

May-06

Sep-05

Jan-05

May-05

Beverages

Oil

Copper

Soybean

Oil WTI Current US$

Jan-11

May-10

100

Sep-09

Jan-09

150

May-08

200

Sep-07

100

110 250

Jan-07

150

130 300

May-06

200

350

Sep-05

Wheat, Copper, and Soybean Index 01-Jan-05=100

150

250

Wheat

Notes: For Panel A, oil is the average of Brent, WTI and Dubai prices. Sources: World Bank’s Global Economic Monitor – GEM (Panel A) and Bloomberg (Panel B).

FIGURE 1.15. Changes in Commodity Prices Relative to Peak and 6 Months Ago PANEL A. Past 6 Months PANEL B. Relative to Peak Commodity Prices Ratio: Feb-11 / 6 Months Ago (Sep-10) 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.0

Phosphate rock Urea Natural gas Steel, rebar Rice Lead Gas Oil Fuel Oil Groundnut oil Diesel Fuel Coal Gasoline, Avg Butane Propane Crude oil, Avg Natural gas LNG Naphtha Heavy Fuel Barley Wheat, Avg Aluminum Soybean oil Coffee, Robusta Iron ore Soybeans Corn Sorghum Maize Palm oil Beef Copper Tin Copra Coconut oil Palmkernal oil Silver

0.2 Natural gas LNG Natural gas Rice Steel, rebar Urea Aluminum Barley Lead Butane Beef Soybeans Gasoline, Avg Wheat, Avg Propane Naphtha Diesel Fuel Gas Oil Heavy Fuel Copper Phosphate rock Fuel Oil Crude oil, Avg Soybean oil Coal Iron ore Coffee, Robusta Groundnut oil Sorghum Tin Palm oil Maize Corn Silver Coconut oil Copra Palmkernal oil

2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0

Commodity Prices Ratio: Feb-11 / 2008 Peak

Sources: World Bank’s Global Economic Monitor – GEM.

The recent turmoil in MENA—associated with rising popular demands for democratization— has added to upward pressures and volatility in oil prices as well as in prices of agricultural commodities that are sensitive to the price of oil (particularly via the cost of transport and fertilizer). Oil prices passed the 100 dollar per barrel mark after the onset of the mentioned political turbulence and have receded somewhat since then. The impact of a reduced oil | 31

supply coming from Libya should be somewhat contained given its small participation in world oil marketsâ&#x20AC;&#x201D;it is the 17th oil producer in the world and additional production by a country like Saudi Arabia can easily compensate. However, if the political turmoil spreads to other countries in MENA (such as Bahrain, Iran, or Saudi Arabia) oil prices might spike further to very high levels, with significant reverberations for global growth, especially considering the well-established negative correlation between supply-driven fuel price increases and US real economic activity. The political effervescence in MENA and the disasters in Japan have increased global uncertainty and this has been already reflected in greater volatility in financial asset and commodity markets (Figure 1.16). For example, the CBOE volatility index (VIX), a proxy for perceived uncertainty and risk aversion, rose by more than 50 percent from late-December 2010 to mid-March 2011. And the volatility of oil prices and other commodities increased substantially over the past 6 months. FIGURE 1.16. Volatility in World Capital Markets PANEL A. Financial Markets PANEL B. Commodity Markets Volatility in Commodity Markets

Volatility in Financial Markets 0.16

0.07 0.06

Sep-09 to Sep-10

0.14

Oct-10 to Mar-11

0.12

0.05

Sep-09 to Sep-10

Oct-10 to Mar-11

0.1

0.04

0.08

0.03

0.06

0.02

0.04 0.02

0.01

Oil

Raw Materials

Non-Energy Commodities

Base Metals

Metals and Minerals

Grains

Food

Energy

Beverages

VIX*

Yen Spot

Euro Spot

S&P/TSX (Canada)

DAX (Germany)

S&P 500 (US)

Agriculture

0 0

Notes: *The VIX is presented as the average in the period divided by 1000. Also, only in the case of VIX, the red bar represents the minimum value for the period Sep-09 to Sep-10 and the blue bar represents the maximum value for the period Oct-10 to Mar-11. For all other variables, volatility was defined as the standard deviation of the period divided by the average in that same period. Sources: World Bankâ&#x20AC;&#x2122;s Global Economic Monitor â&#x20AC;&#x201C; GEM and Bloomberg.

Given the recent developments in international prices of foods and fuels, the natural question is whether the world is back to a food crisis like the one experienced in 2008. During that episode, food prices reflected structural demand factors stemming from the fast-growing economies in emerging Asia and, as oil prices went up, the production of bio-fuels rose, further fueling upward pressures on food prices. In light of a strong post-crisis recovery in developing countries, such pressures seem still active nowadays and are likely to persist in the years to come. And as in the 2008 food crisis, the present setting is also characterized by low interest rates in advanced countries and global investors shifting portfolios towards riskier assets (with commodities appearing to belong to such class of assets). Furthermore, supply factors related to adverse climatic changes are affecting crop conditions (for instance in 32 | LAC Success Put to the Test

Argentina, Australia, China, and Colombia to mention some countries). In addition, protectionist measures have emerged this time around that are aggravating the situation—e.g., the ban on cereal exports imposed by Russia, a country that accounts for almost 15 percent of global wheat exports. Given that the current rise in food prices is in part sustained by structural demand factors, any disruption in the supply side has more important effects on prices, making them inherently more volatile. How do higher international food prices affect LAC? The effects come through various channels and operate at various levels, including aggregate effects via changes in the terms of trade, upward pressures on domestic prices, and uneven distributional effects across different segments of the population.16 Let us consider each of this separately. At the aggregate level, rising food and fuel prices have an asymmetric impact across the region, depending on whether the terms of trade improve or deteriorate. Under the ongoing, fairly generalized wave of commodity price increases, terms of trade gains are of course unequivocal for countries that are large exporters of both agricultural and non-agricultural commodities (e.g., Argentina, Brazil, and Chile). Some other countries in the region (e.g., Ecuador, Jamaica, and Peru) are net importers of cereals and other foodstuffs but are relatively large exporters of non-agricultural commodities. These countries are also net gainers (in the aggregate) and, hence, would have additional resources that can in principle be used to compensate the lower-income households that are net food consumers, for instance by temporarily scaling up their social assistance targeted programs. Recall, in this connection, that—if Mexico is included—more than 90 percent of the Latin American population lives in countries where the terms of trade have been on the rise. The situation is exactly the opposite for the typically small and rather numerous countries (mainly located in Central America and the Caribbean) that are net importers of foodstuffs and non-agricultural commodities, and are thus unequivocally suffering from deteriorating terms of trade. These countries have to manage the internal distributional complications of rising international prices of foods and fuels in the context of an overall reduction in aggregate resources. The asymmetry of terms of trade effects across countries is clearly depicted in Figure 1.17. The first panel shows the cumulative changes in the terms of trade for LAC countries for the period from 2002 to 2010 and confirms that the winners from terms of trade shifts are natural resource abundant countries that are typically located in South America—most notably Argentina, Chile, Ecuador, Paraguay, Peru, Uruguay, and Venezuela. And the losers are the natural resource poor countries, typically the small economies located in Central America and the Caribbean (Panel A of Figure 1.17). On the other hand, Panel B of Figure 1.17 depicts the evolution over time of the terms of trade for LAC’s net commodity exporters vis-à-vis the region’s net commodity importers. It shows that the steep yet short-lived decline (from mid16

For a detailed discussion of the short-run and long-run implications of increases in food prices for LAC see World Bank (2011b). From a more structural and medium-run point of view, LAC can be a significant part of the solution to the tight food situation in the world, given that is it abundant in hydro resources and un- or underexploited arable land.

| 33

2008 to January 2009) in commodity prices in the midst of the global crisis turned out to be a blip in an otherwise powerful wave of rising prices for virtually all of the region’s net commodity exporters. FIGURE 1.17. Changes in Terms of Trade PANEL A. From 2002Q1 to Present

PANEL B. Commodity Importers vs. Commodity Exporters Terms of Trade in LAC Countries Index 2002 = 100

Cumulative Change in Terms of Trade Monthly Data, Avg. 2002Q1 vs. Avg. 2010Q4 190

Venezuela Chile Ecuador Peru Bolivia Guyana Paraguay Argentina Trin. & Tob. Uruguay LAC Guatemala Mexico Nicaragua Colombia Brazil Panama Costa Rica Honduras Dom. Rep. Dominica Jamaica

LAC Commodity Importers

150 130 110 90 70

10%

40%

70%

100%

130%

Mar-02 Aug-02 Jan-03 Jun-03 Nov-03 Apr-04 Sep-04 Feb-05 Jul-05 Dec-05 May-06 Oct-06 Mar-07 Aug-07 Jan-08 Jun-08 Nov-08 Apr-09 Sep-09 Feb-10 Jul-10 Dec-10

-20%

LAC Commodity Exporters 170

Notes: The data of terms of trade indices is monthly and seasonally adjusted. Group averages reported in Panel B are simple averages. LAC’s net commodity exporters are Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Paraguay, Peru, Uruguay, and Venezuela. The group of commodity importers in the region is composed by Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, Haiti, Jamaica, Nicaragua, and Panama. Sources: World Bank’s Global Economic Monitor – GEM.

Regardless of whether the countries are net exporters or importers of foodstuffs and petroleum and petroleum-based fuels, the rise in the international prices of the latter can put upward pressures on the consumer price index (CPI). In effect, there are already clear signs that the food components of the CPI are on the rise in many LAC countries since about September 2010 (Figure 1.18). Central bankers in the region may be thus compelled to take tighten monetary policy more than otherwise so as to ensure that the second-round effects of the pass through of international prices to the CPI do not end up de-anchoring the expectations on domestic inflation. The upward pressures on the CPI are proportionately greater in countries where the share of food in the consumption basket is greater, which tends to be the case of poorer countries. In comparison to the rest of the world, the LAC region taken as a whole is not among the most vulnerable in this regard. Food represents about 27 percent of total consumption expenditure in LAC whereas it reaches 50 percent in India, 40 percent in China and, on average, 36 percent in ECA countries (Figure 1.19). Nevertheless, there is large heterogeneity within LAC with respect to the composition of the CPI, particularly in Central America and the Caribbean, which is heavily weighted in favor of foodstuffs. For instance, the share of food in the consumption basked of Haiti reaches almost 60 percent and 50 percent in Jamaica and St. Lucia. Richer countries, like Brazil and Chile, stand at the other end of the spectrum in LAC, with the share of food in the consumer basket at around 21 percent. 34 | LAC Success Put to the Test

FIGURE 1.18. Food vs. Overall CPI Inflation Food and Overall CPI Inflation : LAC-7 + URY YoY Variation, Medians 16% Food Inflation 14% Overall CPI Inflation 12% 10% 8% 6% 4% 2%

Jan-11

Jul-10

Jan-10

Jul-09

Jan-09

Jul-08

Jan-08

Jul-07

Jan-07

Jul-06

Jan-06

Jul-05

Jan-05

Notes: The LAC countries considered in this graph are Argentina, Brazil, Chile, Colombia, Mexico, Peru, Uruguay, and Venezuela. There is a change in the methodology of calculation for both food and overall PCI index for Chile since January 2009. Sources: Bloomberg and Instituto Nacional de Estadísticas de Chile – INE.

FIGURE 1.19. Share of Food in Consumption Baskets PANEL A. Across Regions PANEL B. Within LAC Food Expenditure as % of Total Consumption Within LAC Countries

Food Expenditure as % of Total Consumption Weighted Averages 70%

60%

50%

50% 40%

40%

30%

20%

20% 10%

10%

High Income

South Africa

LAC

East Asian Tigers

ECA

China

India

Brazil Chile Panama Bahamas Colombia Trin. & Tob. Venezuela Ecuador Costa Rica Peru Argentina Mexico Dom. Rep. Guatemala Bolivia Nicaragua St. Lucia Jamaica Haiti

0% 0%

Notes: We used the latest available figure for each country, in the case of national level indicators. Weighted averages (2007 Nominal GDP in USD Billions) were used in the case of the regional numbers. The years we used, per country, are: Bahamas – 2001; Argentina – 2004; Bolivia – 2004; Brazil – 2002; Chile – 2006; Colombia – 2006; Costa Rica – 2004; Dom. Rep. – 2007; Ecuador – 2005; Guatemala – 1998; Jamaica – 1995; Mexico – 2004; Nicaragua – 2001; Panama – 1999; Peru – 2005; Trin. & Tob. – Before 1990; Venezuela – Before 1990; Haiti – 2000; St. Lucia – Before 1990. Sources: Food and Agriculture Organization – FAO (2010) and IMF's World Economic Outlook – WEO (October 2010).

Moreover, pronounced increases in the (socially sensitive) domestic prices of foods and fuels can have very regressive distributional consequences and thus trigger social tensions. They | 35

also represent a threat to the nutrition and livelihoods of the vulnerable poor, especially those low-income households in urban areas whose incomes are not derived from the agricultural sector, for whom food constitute a large share of expenditure, and that are not protected by social assistance programs.17 Regressive distributional effects can materialize even in countries that register terms of trade gains but have very high poverty rates (such as Bolivia), especially if they fail to put in place adequately focused compensatory social measures. The adverse consequences can be greater in countries that experience deteriorating terms of trade and lack adequate fiscal space (due to a weak revenue base and/or high levels of public sector indebtedness). This latter category tends to include the smaller and poorer countries of Central America and the Caribbean, including—but not restricted to—El Salvador, Grenada, Guatemala, Haiti, Nicaragua, St. Vincent & the Grenadines, and Suriname. In general, countries in the region that have wellestablished systems of conditional cash transfers (such a Bolsa Familia in Brazil, or Oportunidades in Mexico) are in a better position to mitigate the regressive distributional implications of higher food and fuel prices.18 Figure 1.20 helps identify the most vulnerable countries in the region to rising food prices according to the criteria mentioned above (poverty levels, external dependence of food, overall changes in terms of trade, and fiscal space).19

The balance of risks: macro-financial tensions at home As the recovery matures in the larger countries in LAC, the balance of risks as such has been shifting towards challenges where home-grown dynamics play a relatively greater role. These have been playing out mainly in two arenas. On the one hand, as the cyclical upturn matures, GDP growth is beginning to hit capacity constraints in several countries, giving rise to inflationary pressures. On the other, the combination of high and volatile commodity prices and an arguably significant inflow of potentially volatile capital (for instance, the capital that flows in solely to arbitrage the interest rate differential and speculate on cross-currency movements), is threatening to induce an “excessive” appreciation of exchange rates (above and beyond the appreciation that may be required in equilibrium by fundamental factors) that 17

The share of food in total consumption expenditure for the bottom quintile of the population is estimated to range from 83 percent in Honduras to 32 percent in Brazil, whereas those of the top quintiles range from 25 to 7 percent in these two countries (World Bank, 2011b). See “Did Latin America Learn to Shield the Poor from Economic Shocks” (LAC-PREM Poverty Reduction and Gender Department, October 2010) for more details on the poverty impact of the global recent crisis.

For instance, Brazil raised the basic benefits of Bolsa Familia by 8 percent and the transfer per child by 13 percent during the 2008 food crisis (although this measure was actually planned before the crisis). Although it did not fully protect the poor, that policy response helped mitigate the impact on rising food prices on the very poor (Ferreira, Fruttero, Leite, and Luchetti, 2011).

The solid lines in Figure 1.20 indicate the most vulnerable countries are those where the percentage of population in moderate poverty exceeds 30 percent (horizontal blue line that crosses the 30 level at the y-axis) and are net importers of food. Given that even countries that are net exporters of food can have a distributional impact and social tensions resulting from rising food prices, the figure has a diagonal solid line which implies that the criterion of higher poverty outweighs that of being a net importer of food in the classification of vulnerability.

36 | LAC Success Put to the Test

can undercut export diversification and long-term growth and can lead to an unduly imprudent expansion of financial activity at home. The key challenges and tensions for short-term macroeconomic and financial policy revolve around these two big issues and will be discussed in the final section of this report. The rest of this section briefly characterizes and documents these two dynamics. FIGURE 1.20. Poverty, Net Food Imports, and Public Policy Moderate Poverty % Population Living Under US$ 4 Per Day

Poverty, Net Agricultural Imports, and Public Policy 100 90

HTI

80 70 NIC

GTM

HND

GUY

BOL

BLZ

SUR VEN TTO

SLV GRD DR VCT JAM BRA COL MEX LCA CRI KNA ARG ATG

PRY

30 20 10

URY

ECU PER

PAN

CHL

0 -35

-25

-15

-5

Net Agricultural Imports as % of GDP Average 2005-2009

Notes: The countries labeled in orange in the scatter plot are those that are net exporters of non-agricultural commodities or have reasonable fiscal spaces. Countries in the region that are the most sensitive/vulnerable to rising food prices are those that have more than 30 percent of the population living under US$ 4 per day and that are net importers of food. In the graph, note that the diagonal solid line signals the fact that the poverty constraint is more binding than the net importer/exporter status. Sources: World Bank’s World Development Indicators – WDI (December 2010), IMF's World Economic Outlook – WEO (October 2010), World Bank’s LCSPP.

Closing output gaps and inflationary pressures. The recovery in several LAC countries is already giving signs of overheating, as business cycles mature and long-run capacity constraints to non-inflationary growth start to bind. This appears to be the more clearly the case for Brazil, Panama, Paraguay, and Uruguay, where a significant difference between actual and potential output seems to be materializing and inflationary pressures are already being felt. Peru appears to be entering that stage, although inflation remains comparatively subdued. Argentina, by contrast, has an inflation rate that is well above that in the inflationtargeting countries (Brazil, Chile, Colombia, Mexico, and Peru) but simple measures of the output gap do not suggest conclusively that capacity constraints are already firmly binding. And Bolivia appears to be a case where inflation is mainly driven by supply-side (food and fuel) price shocks but where the output gap has seemingly not yet fully closed (Figure 1.21). As noted earlier, a rising excess of domestic demand over output in LAC-6 suggests that inflationary pressures are stemming largely from a buoyant domestic demand (Figure 1.22).

| 37

FIGURE 1.21. Output Gap and Inflationary Pressures Output Gap and Inflation LAC Countries CPI Inflation Rate (at Feb-11) 3 Months Moving Average, YoY

12% ARG

10%

BOL

PRY URY

BRA CRI

4% COL

PER

SLV

PAN

MEX ECU CHL

0% -2%

Output Gap 2010q3

Notes: The area inside the box represents the range between the lowest and highest midpoints among inflation targeting countries. Sources: National Statistical Institutes and Central Banks, Haver Analytics.

Currency appreciation. Capital flows to emerging markets, mainly East Asia and Latin America, have surged, driven by lower global risk aversion, interest rate differentials, and strong growth prospects in emerging markets vis-à-vis advanced nations. These inflows are adding to currency appreciation pressures, thereby significantly exacerbating the appreciation pressures associated with booming commodity prices, which was discussed and documented earlier, and threaten to fuel credit over-expansions and stretch asset price increases. In fact, gross non-FDI capital flow to LAC in the third quarter of 2010 were about 30 percent higher than the pre-crisis peak reached towards the end on 2007. And the real effective exchange rate of the larger LAC countries appreciated by a cumulative 18 percent between its lowest level reached around March 2009 and that of December 2010 (Figure 1.23). Currency appreciation pressures have prompted monetary authorities in several LAC countries to intervene heavily in foreign exchange markets. Such interventions seek to not only smooth out short-run exchange rate fluctuations but also avoid an appreciation of their currencies to the extent that they are not driven by “fundamentals.” In addition, countries in the region are broadening the macroeconomic policy toolkit by including macro-prudential measures to prevent the materialization of excesses in domestic financial markets and, in some cases, also to complement the cycle-management objectives of monetary policy. These measures have ranged from taxation of financial transactions (IOF) in Brazil, increases in reserve requirements (Brazil, Colombia, and Peru), dynamic provisioning requirements (Bolivia, Colombia, Peru, and Uruguay), caps on credit growth (Brazil), and limits on foreign exchange positions (Brazil, Colombia, Mexico, and Peru), among many others (Table 1.1). The net effects of these instruments are difficult to evaluate given the lack of counter-factuals. However, measures of foreign exchange market pressures, which take into account both actual currency appreciation and international reserve accumulation, suggest that the strength of capital inflows has not yet subsided, despite the mentioned battery of macro-prudential interventions (Figure 1.24). 38 | LAC Success Put to the Test

FIGURE 1.22. Gaps in Quarterly Output and Domestic Demand PANEL A. Real GDP PANEL B. Domestic Demand Domestic Demand

Real GDP 5%

2% 1%

-1%

-2%

-3%

-4%

2010.04

2010.02

2009.04

2009.02

2008.04

2008.02

2007.04

2007.02

2006.04

2006.02

2005.02

2010.04

2010.02

2009.04

2009.02

2008.04

2008.02

2007.04

2007.02

2006.04

2006.02

2005.04

2005.02

2005.04

-5%

PANEL C. Net Exports (X,M) Net Exports

15% 10% 5% 0% -5% -10% -15% -20% Exports

Imports

2010.04

2010.02

2009.04

2009.02

2008.04

2008.02

2007.04

2007.02

2006.04

2006.02

2005.04

2005.02

-25%

Notes: The figure depicts the PPP-GDP weighted average of gaps in real output, domestic demand and net exports for LAC-6 countries. These gaps are computed as deviations in real output, domestic demand and net exports from their corresponding band-pass filter trends. The six countries in the region are Argentina, Brazil, Chile, Colombia, Mexico, and Peru. Sources: National Statistical Institutes and Central Banks, Haver Analytics.

Managing the maturing recovery phase of the cycle The complexities facing macro-financial policy have risen as the recovery matures in many of the larger LAC countries. This is simply because the scope for policy tradeoffs and tensions | 39

has widened considerably compared to what it was during the downturn phase of the cycle. Back then, trade-offs were mild and there was not much room for policy inconsistencies in managing the downturn (late-2008 and 2009). Counter-cyclical policy then called for an expansion of fiscal spending—always politically easier to implement than a contraction—and the unfolding of public sector support to private credit. It also called for the lowering of monetary policy interest rates to stimulate domestic economic activity, and such monetary easing was consistent with, and supportive of, a needed depreciation of the currency. FIGURE 1.23. Surging Capital Inflows PANEL A. Gross Capital Inflows

PANEL B. Real Exchange Rates

Gross Inflows to LAC-7 Countries In US$ Billions

Real Effective Exchange Rate Weighted Averages, Index Jan-05 = 100 120

350 Gross FDI Inflows

300

Gross Non-FDI Inflows

115 110

250

105 200

100

150

100

China High Income

East Asian Tigers LAC

Dec-10

Jul-10

Feb-10

Sep-09

Apr-09

Nov-08

Jan-08 2010.03

2010.01

2009.03

2009.01

2008.03

2008.01

2007.03

2007.01

2006.03

2006.01

2005.03

2005.01

2004.03

2004.01

2003.03

2003.01

2002.03

2002.01

-50

Jun-08

ECA Euro Area

Notes: Panel A shows the annualized capital inflows to LAC-7. In the case of Panel B, weighted averages were calculated using the 2007 nominal GDP in USD Billions. In that same Panel, an increase means an appreciation of the REER. Sources: IMF’s Balance of Payments Statistics, National Statistical Institutes, and Central Banks (Panel A), IMF’s International Financial Statistics – IFS and IMF's World Economic Outlook – WEO (October 2010) (Panel B).

In the present scenario, by contrast, counter-cyclical policy calls for a significant increase in fiscal savings and actions to tame credit expansion—neither of which is a politically popular proposition. It also calls for an increase in policy interest rates so as to preempt the unhinging of inflation expectations and avoid economic overheating. But this works directly at crosspurposes with the desire to avoid an “excessive” appreciation of the real exchange rate relative to its long-run equilibrium level.20 In addition, fiscal policy has to be deployed judiciously to protect the vulnerable poor and mitigate the regressive distributional effects of sharp rises in socially sensitive prices of foods and fuels. Under these circumstances, striking a reasonable balance in the midst of tradeoffs and tensions is a major challenge and, as a result, the premium on skillful macro-financial policy management has risen dramatically. The spotlight is thus on fiscal, monetary, and financial sector authorities, who are compelled to shift from a “crisis management” mode to a “mature cycle management” mode. 20

A typically thorny situation in this regard is obtained when policy makers intervene in the foreign exchange market to dampen the appreciation of the currency and at the same time sterilize the monetary expansion that results from such an intervention. The side effect of sterilization is, however, that it leads to higher interest rates and, as a consequence, ceteris paribus, larger interest rate differentials arise, generating a vicious circle of capital flows-interest rates-currency appreciation.

40 | LAC Success Put to the Test

FIGURE 1.24. Exchange Market Pressures in LAC PANEL A. Brazil

PANEL B. Chile Chile

Brazil 4

Change in Exchange Rate

Change in Exchange Rate 3

Change in Foreign Reserves

Exchange Market Pressure Index

Apr-09

Mar-10

Apr-09

Mar-10

Feb-11

May-08

Jun-07

Jul-06

Aug-05

May-08

PANEL C. Colombia

Sep-04

Feb-00

Feb-11

Mar-10

Aug-05

Apr-09

-3

May-08

-6

Jun-07

-2

Jul-06

-4

Sep-04

-1

Oct-03

-2

Nov-02

Dec-01

Jan-01

Feb-00

Oct-03

Exchange Market Pressure Index

Nov-02

Dec-01

Change in Foreign Reserves

Jan-01

PANEL D. Peru

Colombia

Peru

6 Change in Exchange Rate

Change in Foreign Reserves 4

Exchange Market Pressure Index

Change in Exchange Rate

Change in Foreign Reserves

Exchange Market Pressure Index 3

1 -2 0 -4

-1

Feb-11

Jun-07

Jul-06

Aug-05

Sep-04

Oct-03

Dec-01

Nov-02

Jan-01

Feb-00

Feb-11

Mar-10

Apr-09

-2

May-08

Jul-06

Jun-07

Aug-05

Sep-04

Oct-03

Nov-02

Dec-01

Jan-01

Feb-00

-6

Notes: The Exchange Market Pressure (EMP) index is the weighted average of year-on-year percentage changes in: (a) the nominal exchange rate of the local currency vis-à-vis the US dollar (such that an increase represents an appreciation of the LAC currency), and (b) the level of international reserves. The weights are given by the inverse of the annual standard deviation of the changes in the nominal exchange rate and the standard deviation of the changes in reserves. An increase in the Exchange Market Pressure index signals appreciation pressures and/or accumulation of reserves. Sources: LCRCE Staff calculations based on IMF’s International Financial Statistics – IFS.

To successfully meet the mentioned challenges, policy makers need to put in place a suitable mix of monetary, fiscal, and macro-prudential policies. While identifying the “right” mix in specific countries is a matter of heated debate—where reasonable people can reasonably disagree—there is much less controversy on the proposition that there is no policy silver bullet and that policy extremes (“corner solutions”) are either undesirable—from the technical viewpoint—or unfeasible—from the practical and political viewpoint.

| 41

Clearly, if there were no valid concerns about a possibly “excessive” appreciation of the currency, cycle management could much more easily focus on the risks of economic overheating and the associated inflation pressures. The maneuvering room for monetary policy tightening would be in that case much greater (given any fiscal policy stance) as the side effects on the currency could be ignored. But concerns about “excessive” currency appreciation can be valid to the extent that such appreciation reflects distortions instead of fundamental factors. That would be the case, for instance, if the strengthening of the currency was driven by transitory commodity price increases and/or “frothy” capital inflows (i.e., capital inflows not driven by fundamental factors but, say, “irrational exuberance” among moody investors). Concerns would in principle be reinforced if, in addition, the temporary “overshooting” appreciation of the currency leads to permanently adverse effects on export diversification and long-run growth. The revealed preferences of LAC policy makers described in the previous section suggest that “excessive” currency appreciation is in fact one of the concerns among policy makers, and it is constraining the maneuvering room for monetary policy in the face of economic overheating and inflation pressures. Confronted with the mentioned tradeoffs, central bankers in the fast-recovering countries of the region have avoided the extremes in policy responses and have rather adopted a hybrid approach. Let us elaborate on this point. Central bankers, for instance, have stayed away from the corner solution of allowing the exchange rate float freely. Under that approach, other things equal, the local currency would appreciate in an overshooting fashion and up to the point where it can be expected to subsequently depreciate, thereby justifying the excess of the peso interest rate over the dollar interest rate. While conceptually clean, this corner solution carries the considerable risk of fueling an unsustainable consumption and credit boom. In addition, it entails a major firstmover disadvantage that, in turn, reflects international coordination failures. In effect, the extent of local currency appreciation would be significantly greater if the country in question is the only one to allow its currency to freely float while others do not. Policy makers in the fast growing and financially globalized LAC countries have also stayed away from a purely orthodox approach which, in theory, could be a first-best from the individual country point of view. This would consist in engineering such a credible containment of domestic demand—through very tight fiscal and credit policies—so that enough room is opened up for central banks to lower interest rates to international levels without undesirable inflationary consequences. While this theoretical option has a major firstmover advantage—it would put the country in its first-best position independently of what other countries do—it is arguably unfeasible on practical grounds, for it would require such a massive domestic demand compression as to render it indigestible by a democratic polity. It is not surprising that policy makers in the LAC-6 have chosen a pragmatic “hybrid” policy path. This hybrid approach reflects a quest for aligning the conflicting objectives of keeping inflation expectations anchored in the face of economic overheating and rising international prices of foods and fuels, on the one hand, and avoiding an “excessive appreciation” of the local currency in the face of high and potentially volatile commodity prices and capital inflows, on the other. The hybrid approach has taken different shapes across countries but it has in general involved some combination of: intervention in foreign exchange markets (and 42 | LAC Success Put to the Test

consequent international reserve accumulation), sterilization, significant monetary policy tightening, a measure of fiscal policy tightening, a willingness to allow inflation to transitorily stay close to or slightly above the upper band of the inflation target and, as noted earlier, the application of a battery of broadly-defined macro-prudential interventions, including controls on capital inflows (Table 1.1). TABLE 1.1. Macro-Prudential Measures in LAC and other Emerging Markets Policies Monetary Policy Exchange Rate Policy

Fiscal Policy

Types of Measures Latin America I. Macroeconomic Policies Policy rate tightening FX intervention Higher ceilings to foreign investment of pension funds

Taxes on capital inflows

Brazil, Chile, Colombia, Mexico, Peru Argentina, Brazil, Chile, Colombia, Mexico Chile, Colombia, Mexico, Peru

Emerging Markets China, India, Russia China, India, South Africa

Brazil: IOF (6%) on financial transactions, shortterm loans and issuance of securities.

II. Macro-Prudential Policies

Measures to Strengthen Balance Sheets and Capital of Financial Intermediaries

Measures to Manage Credit Growth over the Cycle

Countercyclical capital requirements

Brazil, Uruguay

Counter-cyclical provisioning

Bolivia, Colombia, Peru, Uruguay

Croatia, India, Malaysia, Turkey

Adjustments to risk weights Bolivia, Colombia, Peru

Tighter loan-loss provisioning Loan-to-deposit ceilings Limits to net open positions of financial institutions

Brazil, Colombia, Mexico, Peru

Reserve requirements

Brazil, Colombia, Peru

China, Korea

China, India, Indonesia, Russia, South Africa, Turkey China, Hong Kong (1991), Korea (2002), Malaysia (1995), Singapore (1996), Thailand (2003)

LTV ceilings on mortgage lending Caps on ratios to debt service to income for household lending Liquidity requirements on credit expansion

China, India

Hong Kong, Korea (2002) Brazil

Croatia, Estonia

Sources: Moreno (2011), Crowe et al. (2011), and Calderon and ServĂŠn (2011).

While a hybrid approach appears as a reasonable compromise in the policy response, given the circumstances and tradeoffs, there is arguably significant room for improvement. So far, the approach has tended to over-rely on monetary policy, which has been reasonably proactive in raising interest rates (Figure 1.25).

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FIGURE 1.25. Monetary and Fiscal Policies in the Recovery PANEL A. Policy Rates Monetary Policy Rates Inflation-Targeting LAC Countries 16% 14% 12% 10% 8% 6% 4% 2%

Jan-11

Apr-11

Jul-10

Peru

Oct-10

Jan-10

Colombia

Apr-10

Jul-09

Oct-09

Jan-09

Chile

Apr-09

Jul-08

Brazil

Oct-08

Jan-08

USA

Apr-08

Jul-07

Oct-07

Mexico

PANEL B. Cyclically-Adjusted Primary Expenditure

PANEL C. Cyclically-Adjusted Primary Balance and GDP Growth

Primary Expenditure % of GDP, LAC-6 Countries

Primary Balance and GDP Gowth LAC-6 Countries

20%

10% 8%

18% 17%

4% 2% 1%

0% -2%

16%

GDP Growth QoQ, Saar

Primary Balance % of GDP

19%

-4% -6%

2010.04

-8%

2010.02

2009.04

2009.02

2008.04

2008.02

2007.04

Primary Balance

2007.02

2006.04

2006.02

2004.04

2010.04

2010.02

2009.04

2009.02

2008.04

2008.02

2007.04

2007.02

2006.04

2006.02

2005.04

2005.02

2004.04

2005.04

GDP Growth

-1%

2005.02

15%

Notes: The figures in Panels B and C are the cyclically-adjusted primary expenditure and primary balance for the major six LAC countries (Argentina, Brazil, Chile, Colombia, Mexico, and Peru). Sources: Bloomberg (Panel A); Haver Analytics, National Statistical Institutes, and Central Banks (Panels B and C).

To be sure, there is a valid debate on whether central banks in the region may be falling behind the curve, with some market analysts tending to think that such is indeed the caseâ&#x20AC;&#x201D; i.e., that policy interest rates in the region are somewhat below the levels needed to firmly tame inflation risks. Be that as it may, the fact of the matter is that the credibility of many central banks in LAC remains high, such that neither macroeconomists nor market analysts are at this stage seriously worried about a scenario where inflation expectations unravel in the inflation targeting countries in LAC. What is less subject to debate is that, if anything, fiscal policy has fallen behind the curve. Fiscal policy has become pro-cyclical in the recovery phase of the cycle, thereby adding complications to the policy tensions and tradeoffs. In effect, primary expenditure in LAC-6 44 | LAC Success Put to the Test

countries, although at slightly lower levels as a percent of GDP than in early-2010, remains significantly more expansionary than in the pre-crisis years (Figure 1.25). Similarly, the primary balance, although swinging to a surplus of about 1 percent of GDP in 2010 (from the slight deficit that obtained in the depths of the crisis), remains at a much lower level than that observed in the pre-crisis period. In light of these facts, it is difficult to escape the conclusion that the current fiscal stance is pro-cyclical, especially considering that GDP has recovered strongly and is now bumping against capacity constraints in several of the LAC-6 and that commodity prices have rebounded to levels that are equal of higher than those observed before the crisis. In sum, the policy mix has become unbalanced, with monetary policy overburdened and fiscal policy falling short of the contribution it should provide. The first obvious direction in which the hybrid approach should be improved is, therefore, through higher fiscal savings, which should be achieved without endangering social policy. The latter, as noted, will have to become even more active in order to limit the regressive distributional consequences and effects on the vulnerable poor of higher prices of foods and fuels. The need to raise fiscal primary surpluses is clearly greater in countries that are experiencing a major commodity related windfall and/or copious short-term capital inflows. The second direction for improvement in the hybrid approach points to a more systematically complementing monetary policy with the judicious application of macro-prudential policies. This is crucial to forestall the undesirable systemic financial vulnerabilities that can arise down the line as a result of asset bubbles or imprudent credit expansion. It requires, however, a better understanding of the degree of effectiveness of alternative macro-prudential tools, which constitutes a pending and pressing agenda for the region. The third direction in which the hybrid approach can be improved is by accepting a more appreciated level of the local currency, inasmuch as it is an unavoidable part of the adjustment process that is warranted by the powerful combination of improved growth prospects, rising terms of trade, and strong (non-frothy) capital inflows, including FDI. It is important, therefore, not to confuse the fundamentals-driven real appreciation that is required in equilibrium from currency “excessive” appreciation. The latter justifies some elements of the hybrid approach. The former rather calls for other types of policies—namely, structural and microeconomic policies—geared at raising economic efficiency and productivity growth over the medium-term. For LAC, managing the cycle appropriately is necessary not just to avoid unnecessary shortrun perturbations that can derail inflation expectations and amplify output fluctuations. It is also essential to establish the appropriate conditions for the region to be better positioned to tackle its structural growth and equity challenges. The very fact the LAC is confronted at this stage with inflationary pressures arising from economic overheating is a clear reminder of a rather sad reality—namely, that the region tends to bump against “structural speed limits” at

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comparatively low growth rates.21 While the high-performing economies of emerging Asia can sustain annual growth rates in the 6-9 percent range without inflationary consequences, in most of LAC the non-inflationary growth rates that can be sustained over long periods tend to hover below 5 percent. This is a key reason why sustained and high growth has eluded LAC for more than a century. It is a stark illustration of the fact that the productive capacity in LAC lacks the efficiency and flexibility to accommodate robust long-run growth rates. LAC had a strong growth period before the crisis. It performed admirably well during the crisis—demonstrating that it possesses a much improved macro-financial “immune system.”22 And has had a stellar post-crisis economic recovery to date, including, as noted, an unusual (compared to its own history) ability to generate jobs in the process. LAC has also begun to make progress in the equity front. More than 50 million Latin Americans were lifted out of moderate poverty between 2002 and 2008.23 And while income inequality continues to be among the highest in the world, at least 12 countries in the region registered non-trivial declines in the Gini coefficient.24 This reflects notable improvements in social policy, especially in the social assistance field (Figure 1.26). While there is no substitute for a pro-active tightening of monetary policy in order to appropriately manage and stabilize the current phase of the cycle, there is room to improve the policy mix within the hybrid approach, along the three mentioned direction. Having reduced it macroeconomic and financial vulnerability, having taken important steps forward in its equity agenda, and having walked ahead of many other emerging economies towards the consolidation of democratic institutions, LAC is unprecedentedly well positioned to design and embrace a vigorous growth agenda—one that carries greater legitimacy and is not held hostage, as was the case in the past, to overriding concerns with macro and financial instability. The effectiveness to which the economic cycle is managed at this juncture will determine whether LAC can break away from the historical pattern of booms followed by busts. Skilful macro-financial policy is necessary—although far from sufficient—to be able to turn what has to date been a cyclical recovery into a higher rate of trend growth. That will of course require, in addition, determined micro-economic policy reforms to relax the mentioned structural speed limits to growth.25 But for that too, the present juncture is auspicious, 21

The term “structural speed limits” is borrowed from Alberto Ramos, Vice-President in the Emerging Markets Economic Research Group at Goldman Sachs.

The improvements in the region’s macro-financial immune system were extensively discussed in our 2009 and 2010 bi-annual reports, issued in the context of the IMF-WB Spring and Annual Meetings.

Moderate poverty is defined as living with less than US$4 per day on a purchasing power adjusted basis.

A short report produced for the 2011 Spring Meetings by the World Bank’s LCSPP Unit documents the recent trends in poverty and inequality in the LAC region (see The World Bank, 2011a)

Some constraints to long-term growth in LAC countries are no mystery and are clearly binding. Low savings and investment rates limit the expansion of productive capacity, which translates into insufficient (and often inefficient) provision of physical infrastructure. Low quality of education poses limits to the development of human capital. Moreover, leveraging to the more dynamic growth poles of the world economy requires the pursuit of innovation (institutions and policies to adopt and adapt technologies, R&D spending, etc.). Fostering deeper financial markets is also key—to ensure a prudent intermediation a higher steady-state level of inflows of

46 | LAC Success Put to the Test

especially for the LAC countries that are experiencing a formidable windfall from high commodity prices. The windfall can be used to invest in growth enhancing assets without endangering fiscal and debt viability if—and this is a big if—commodity exporting countries manage to save a large fraction of the windfall, and then invest those savings at a pace that is consistent with the country’s absorptive capacity and in high social rate of return projects and programs.26 FIGURE 1.26. Progress in the Equity Agenda PANEL A. Poverty Rates and Growth

PANEL B. GINI Coefficient

Per Capita GDP Growth and Poverty LAC Countries

GINI Coefficient Cumulative Change From 2009 to 1995

45 40

9,000 8,000

35 7,000 30

6,000 5,000

25 Poverty Headcount

GDP Per Capita

4,000 3,000

2010

2008

2006

2004

2002

2000

1998

1996

1994

GDP Per Capita US Dollars

Moderate Poverty Rate US$ 4 a Day

10,000

Costa Rica Dom. Rep. Colombia Uruguay Honduras Bolivia Chile El Salvador Argentina Panama LAC Mexico Brazil Peru Paraguay

-0.1

-0.05

0.05

0.1

Notes: The countries included in Panel A are Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Domincan Republic, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, Paraguay, Peru, Uruguay, and Venezuela. Sources: “Did Latin America Learn to Shield the Poor from Economic Shocks?” LAC-PREM Poverty Reduction and Gender Department, October 2010 (Panel A), and LCSPP based on Socio-Economic Database for Latin America and the Caribbean (CEDLAS and The World Bank) (Panel B).

foreign capital and a larger pool of domestic savings, while providing a richer menu of saving instruments to investors. 26

Commodity exporting countries in the region need to save in order to dampen cyclical fluctuations in public spending and economic activity as well as to transform assets under ground into growth enhancing assets, thereby avoiding the depletion of national wealth. This, however, requires the solution of complex collective action problems so as to establish a path for saving and investment that is consistent with equity across generations. The issues associated with the management of natural resource abundance and commodity windfalls is discussed in detail in the 2010 Regional Flagship Study on Natural Resources in the Latin America and the Caribbean: Beyond Booms and Busts? produced by the World Bank’s Chief Economist Office for Latin America.

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48 | LAC Success Put to the Test

Part Two Sluggish Recovery in the Caribbean

Abstract The Caribbean was severely affected by the global financial crisis in 2009, and is now experiencing a rather sluggish recovery compared to the rest of Latin America. The pace of recovery is particularly slow in the English Speaking Caribbean (ESC) nations, where average growth in 2010 is estimated at only 0.6 percent--as opposed to the 2.3 percent for the Non-English Speaking Caribbean and 6.0 percent for the LAC region as a whole. This part of the report documents that poor performance of the Caribbean, and especially ESC countries, and highlights that it is partly explained by the sub-region's strong linkages to the epicenter of the crisis (i.e., the United States and other industrialized countries) in terms of foreign investment flows, trade, and remittances. It also argues that the lack of export diversification in the Caribbean across markets rendered its countries more vulnerable to from external demand shocks, and that the generally small size of the economies and their geographic location makes them vulnerable to natural disasters. This, combined with a limited fiscal space, greatly reduced their ability to cushion the shocks and dampen the business cycle.

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50 | LAC Success Put to the Test

Introduction The Caribbean region was hit hard by the global financial crisis in 2008 and is currently experiencing a rather sluggish recovery when compared to the rest of the LAC region.27 For instance, real economic activity in the Caribbean only contracted 0.2 percent in 2009 thanks in part to the cushion provided by the 3.5 percent growth in the Dominican Republic, which is the largest economy of the group.28 However, growth among English-Speaking Caribbean countries (ESC) in 2009 was not only negative (-3.6 percent) but also lower than the average for the LAC region (-1.8 percent).29 Projected growth rates for 2010 suggest a sluggish recovery. In contrast to the estimated growth of 6 percent for the LAC region in 2010, it is expected that the Caribbean region had grown 2.3 percent and ESC countries only a meager 0.6 percent.30 The worst performers in the Caribbean during 2010 were Haiti (hardly hit by the January 2010 earthquake and expected to register a contraction of 8.5 percent), Antigua & Barbuda (-4.1 percent), St. Kitts & Nevis (-1.5 percent), Barbados (-0.5 percent), and Jamaica (-0.1 percent). This sluggish recovery of the Caribbean can be attributed to both external and domestic factors. On the one hand, the Caribbean has strong linkages with the epicenter of the crisis (the United States) in trade, FDI inflows, tourism receipts, and remittances. On the other hand, the lack of fiscal space and market diversification constrain the policy response. Medium-term growth in the Caribbean may be unable to offset the losses experienced during three years of slowdown. Hence, the region should reconsider its income generation processes and shock-coping strategies to avoid consequences of this magnitude in the future. The goal of this second part of the report is to shed light on the heterogeneous impact of the global financial crisis and the following recession and recovery phases among Caribbean nations relative to other LAC countries. Moreover, it sheds light on the factors behind the slow recovery of the ESC countries as well as the potential vulnerabilities and constraints that may further jeopardize the response of the Caribbean region to shocks.

The Caribbean region includes the following 15 countries: Antigua and Barbuda, Bahamas, Barbados, Belize, Dominica, Dominican Republic, Grenada, Guyana, Haiti, Jamaica, St. Kitts & Nevis, Saint Lucia, St. Vincent & the Grenadines, Suriname, and Trinidad & Tobago.

The Dominican Republic represents approximately 40 percent of the Caribbean GDP.

The English Speaking Caribbean is the term used in this paper to refer to the independent Anglophone Caribbean countries, formerly referred to as the British West Indies.

Estimations and projections for the LAC region are from LAC Consensus Forecasts of March 2011.

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How did the Caribbean fare during the recent global financial crisis? Growth Performance. 31 In our 2010 report, growth collapses (as measured by the difference between the real GDP growth rate in 2009 and 2007) were calculated to measure the impact of the global crisis on economic activity. Panel A of Figure 2.1 shows that the collapse of real economic activity among ESC countries (7 percentage points) was as large as that of LAC-6 countries (7 and 7.6 percentage points, respectively) while that of Non-English-Speaking Caribbean nations (NESC) was comparable to the collapse in the US (4.4 and 4.6 percentage points, respectively). We should note that although the collapse of NESC was lower than that of ESC, it is explained to some extent by a collapse of 5 percentage points in the Dominican Republic. FIGURE 2.1. Growth Performance in the Caribbean PANEL A. Growth Collapse PANEL B. Growth before and after the Peak of the Crisis GDP Growth before/after the Peak of the Crisis LAC Countries and the US

Growth Collapse in LAC 2009 vs. 2007 0%

-1%

-2%

-3% 2% -4% 0%

-5% -6%

-2%

-7%

-4% Average 2006-08

-8% LAC-6

ESC

Caribbean

NESC

2009

Average 2010-12

-6% ESC

LAC-6

Caribbean

NESC

Notes: Growth collapse in Panel A is computed as the difference between real GDP growth in 2009 and in 2007. In Panel B, the 3-year average before the peak corresponds to the period 2006-8 while the period after the peak is 2010-12. Sources: IMF's World Economic Outlook â&#x20AC;&#x201C; WEO (October 2010) and Consensus Forecasts (February 2011).

After registering a large collapse in 2009, LAC-6 countries are now enjoying a swift and strong post-crisis recovery, as documented in the first Part of this report, which stand in sharp contrast to many Caribbean countries and to ESC countries in particular (Panel B of Figure 2.1). Average growth rates for 2010-2012 for LAC-6 countries are projected to surpass that registered in 20062008, whereas real GDP growth for ESC countries in 2010-2012 may not even reach half of precrisis growth rates (Panel B of Figure 2.1). The performance of NESC countries is somewhere in between these two regions with an improvement in growth performance, but not yet at pre-crisis growth rates. Hence, while LAC and, to a lesser extent, NESC are embarked in a post-crisis growth path, ESC countries are clearly lagging behind.

LAC-6 countries include: Argentina, Brazil, Chile, Colombia, Mexico and Peru. These countries represent approximately 88 percent of the overall GDP in the LAC region.

52 | LAC Success Put to the Test

Figure 2.2 depicts the post-crisis growth outlook and pre-crisis forecasts to shed light on the output costs of the global financial crisis. English as well as Non-English speaking countries in the Caribbean are expected to growth below previously projected trends while LAC countries and the U.S. are expected to growth beyond those pre-crisis estimations (Panels A through D of Figure 2.2). Consequently, GDP itself has recovered to some extent and it is being closer to precrisis trends in LAC and the US. In contrast, Caribbean countries seem to have suffered more permanent losses. FIGURE 2.2. Medium-Term Projections Before and After the Crisis PANEL A. Growth in LAC-6 PANEL B. Growth in the US United States

LAC-6 Countries 5%

8% LAC-6 Post-Crisis

LAC-6 Pre-Crisis

5% 4%

2% 0%

1% 0%

-1%

-2%

US Post-Crisis

US Pre-Crisis

-3%

-3% 2000

2002

2004

2006

2008

2010

2000

2012

PANEL C. Growth in ESC

2002

2004

2006

2008

2010

2012

PANEL D. Growth in NESC

ESC Countries

NESC Countries

10%

9% 8%

6% 7% 4%

4% 3%

-2% 2% -4% ESC Post-Crisis

NESC Post-Crisis

ESC Pre-Crisis

NESC Pre-Crisis

-6%

0% 2000

2002

2004

2006

2008

2010

2012

2000

2002

2004

2006

2008

2010

2012

Note: The pre-crisis projections refer to the WEO projections as of October 2008. The post-crisis projections refer to actual and projected data from Consensus Forecasts (February 2011). Source: IMF's World Economic Outlook â&#x20AC;&#x201C; WEO (October 2008) and Consensus Forecasts (February 2011).

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In addition, Figure 2.3 shows the estimated average "growth losses" due to the crisis for the period 2008-12. ESC countries were the most affected, losing approximately 2.5 percentage points of growth per year. They are followed by NESC countries, although the earthquake in Haiti is one of the main reasons behind this sluggish performance. In contrast, LAC and the United States are estimated to lose, on average, 0.5 percentage points of growth per year. FIGURE 2.3. Comparison between Pre-Crisis and Post-Crisis Estimated Growth Average Annual GDP Growth during 2008-12 LAC Countries 6% Post-Crisis

Pre-Crisis

5% 4% 3% 2% 1% 0% LAC-6

Caribbean

ESC

NESC

Notes: The annual average "growth loss" is the difference between the growth for 2008-12 estimated before the crisis (as of October 2008) and the most recent estimates and forecasts after the crisis. Sources: IMF's World Economic Outlook â&#x20AC;&#x201C; WEO (October 2008) and Consensus Forecast (February 2011).

Notice however that there is heterogeneity in the growth performance across Caribbean nations. The largest growth collapses were observed in Antigua & Barbuda and Grenada whereas collapses in St. Kitts & Nevis, Barbados, St. Vincent, and the Grenadines were significantly smaller. Among ESC countries, only Belize, Dominica, and Guyana had a growth collapse that was lower than that of the U.S. In addition, countries with the largest growth collapses in the Caribbean are experiencing a slow recovery (e.g. Antigua & Barbuda, Trinidad & Tobago, and St. Kitts & Nevis) as opposed for instance to a swift and strong recovery in Mexico (the worst performer in LAC-6 during the global financial crisis) and the U.S. (Table 2.1). While the average growth rate for the period 2010-2012 is expected to be positive for all Caribbean countries, it remains at depressed levels. For example, a meager growth of 0.5 and 0.2 percent per annum is projected for Antigua & Barbuda and St. Kitts & Nevis.32 What is the impact of the crisis in poverty levels? High levels of poverty are always a concern among Caribbean nations, where moderate poverty ranges from 30 percent of the population in Jamaica to 90 percent in Haiti. Moreover, extreme poverty is significant in the region: more than 70 percent of the population is considered extremely poor in Haiti and even

In general, post-crisis growth rates (2010-2012) in LAC and NESC are expected to be higher than that in the US, whereas the growth of ESC is not nearly half of these two groups over the same time period (Table 2.1).

54 | LAC Success Put to the Test

in countries like St. Lucia —with GNI per capita corresponding to that of an upper-middleincome country— it reaches about 40 percent of the population. 33 TABLE 2.1. Recovery, Pre-Crisis Growth and Opportunity Costs

LAC-6 Argentina Brazil Chile Colombia Mexico Peru Caribbean ESC Antigua and Barbuda Bahamas, The Barbados Belize Dominica Grenada Guyana Jamaica St. Kitts and Nevis St. Lucia St. Vct. & Grns. Trinidad and Tobago NESC Dominican Republic Haiti Suriname United States

Pre-Crisis Growth Post-Crisis Estimates Growth Estimates (2008-12) (2008-12)

Opportunity Cost (Avg. Growth Loss Per Year) Post-Crisis vs. Pre-Crisis

Recovery (Avg. 2010-12)

Recovery vs. Pre-Crisis

III = II - I

VI = IV - V

4.80% 8.00% 5.10% 4.30% 5.40% 3.20% 8.80% 5.60% 4.00% 7.10% 1.20% 2.40% 3.20% 3.50% 1.60% 4.70% 1.20% 3.80% 2.30% 5.00% 6.80% 7.30% 8.10% 2.10% 5.00% 1.50%

5.30% 6.30% 5.50% 5.50% 4.50% 4.60% 7.10% 3.30% 1.70% 0.50% 1.50% 1.70% 2.30% 2.30% 1.90% 3.10% 1.20% 0.20% 2.30% 1.70% 2.10% 5.00% 5.30% 3.20% 4.80% 3.10%

0.40% -1.70% 0.40% 1.20% -0.90% 1.30% -1.70% -2.30% -2.20% -6.60% 0.30% -0.70% -1.00% -1.20% 0.30% -1.60% 0.00% -3.60% 0.00% -3.30% -4.70% -2.30% -2.90% 1.10% -0.20% 1.60%

3.50% 5.30% 4.30% 3.70% 3.40% 1.70% 6.40% 2.50% 0.50% -1.10% -0.30% -0.10% 2.10% 2.00% 0.10% 2.80% -0.10% -0.10% 0.50% 0.70% 1.00% 4.60% 4.90% 2.70% 4.60% 1.40%

4.10% 3.80% 4.20% 4.50% 4.60% 3.40% 7.10% 4.20% 3.00% 3.90% 1.50% 2.30% 2.80% 2.90% 4.30% 4.40% 1.70% 2.50% 3.40% 4.70% 4.20% 5.50% 5.80% 3.70% 5.10% 1.90%

-0.50% 1.50% 0.10% -0.80% -1.20% -1.60% -0.70% -1.70% -2.50% -5.10% -1.80% -2.40% -0.70% -0.90% -4.20% -1.60% -1.80% -2.60% -2.90% -4.00% -3.20% -0.90% -0.90% -1.00% -0.50% -0.50%

Pre-Crisis (Avg. Growth 2006-08)

Sources: Based on data from IMF's World Economic Outlook – WEO (October 2010) and Consensus Forecasts (February 2011).

The global financial crisis, although affecting severely the region, has not reversed the declining trend in poverty ratios among Caribbean countries. Panel A of Figure 2.4 shows that while poverty declined steadily among LAC-6 countries after 2009, it actually increased for the Caribbean-7 in 2010 due to the consequences of the Haitian earthquake.34 However, once 33

Moderate and extreme poverty rates are defined following World Bank (2009): moderate poverty is defined as the percentage of people living under US$ 4 per day (PPP adjusted), whereas extreme poverty considers those living under US$ 2 per day. 34 It should be noted that these calculations were conducted using real GDP growth projections from Consensus Forecasts and the estimated growth elasticities of poverty for the LAC region in World Bank (2009). In addition, we should note that the Caribbean-7 refers to Dominican Republic, Guyana, Haiti, Jamaica, St. Lucia, Suriname and Trinidad & Tobago. The Caribbean-6 excludes Haiti and the Caribbean-5 excludes Haiti and Dominican Republic.

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Haiti is excluded from these statistics, we observe declining trends in poverty for the Caribbean-6. Nevertheless, there is a wider gap between the poverty rates pre- and post-crisis if compared to LAC-6 countries. (Panel B of Figure 2.4). Moreover, ESC countries may experience some deterioration in poverty rates as a result of the sharp decline in growth rates experienced during the crisis and the sluggish recovery afterwards, which is expected to remain weak over the medium term. FIGURE 2.4. Simulations of Poverty Rates PANEL A. LAC-6 vs. Caribbean-7

PANEL B. LAC-6 vs. Caribbean-6

Simulations of Poverty Rates LAC-6 vs. Caribbean-7

Simulations of Poverty Rates LAC-6 vs. Caribbean-6

60%

39%

58.0% 53.5%

55% Caribbean-7 After Crisis Caribbean-7 Before Crisis LAC-6 After Crisis LAC-6 Before Crisis

50% 45%

51.0%

37.8%

37% 35% 33%

40%

31%

35%

29%

Caribbean-6 (without Haiti) After Crisis Caribbean-6 (without Haiti) Before Crisis LAC-6 After Crisis LAC-6 Before Crisis

33.3%

31.3%

31.0% 31.0%

27.2%

30%

27.2% 26.4%

25% 2007

2008

2009

2010

2011

2012

27%

26.4%

25% 2007

2008

2009

2010

2011

2012

Notes: The simulated poverty rates were calculated using elasticities from World Bank (2009). Caribbean-7 includes: Dominican Republic, Guyana, Haiti, Jamaica, St. Lucia, Suriname and Trinidad & Tobago. Caribbean-6 is the group that excludes Haiti from the Caribbean-7. Sources: Based on data from World Bank’s World Development Indicators – WDI (December 2010), Povcalnet, IMF's World Economic Outlook – WEO (October 2008), and Consensus Forecasts (March 2011).

What explains the strong impact of the crisis in the Caribbean? In order to understand why the Caribbean was deeply affected by the global financial crisis and it is currently experiencing a sluggish recovery, analogous to what is done in Part I, one should zoom in at the channels of transmission that are likely to have magnified the large external shock. Figure 2.5 shows that the crisis originated in advanced economies was transmitted to the Caribbean through four main channels: higher costs of credit, a decline in capital inflows, lower external demand, and reduced remittance inflows.35 Structural factors of these economies, such as the concentration of exports in markets and products, have also an amplified the impact of the crisis on the region. Moreover, in contrast to the response of many LAC-6 countries, Caribbean nations typically lacked the space for counter-cyclical policies, reducing substantially their capacity to cope with external shocks.

These channels were also at play in the transmission of the crisis in Central and South American countries but to different degrees.

56 | LAC Success Put to the Test

FIGURE 2.5. “Traffic Light” Transmission Channels of the Crisis to the Caribbean Deepening of Housing Crisis, Collapse in Stock Markets & International Banks Deepening of housing crisis, collapse in stock markets & international banks Transmission Transmission of the Crisis of the crisis in developed in Developed nations Nations

From From developed developed nations to the nations to the Caribbean Caribbean

Increase in Credit Increase in credit constraints constraints

Increase in cost of Increase in cost of credit for the credit for Caribbean Caribbean countries

Constrained Constrained access to access to additional additional financing financing Transmission of the Crisis Transmission of the crisis in in the the Caribbean Caribbean Economies economies

Loss of Investment Loss of investment Confidence confidence

Reduction of FDI Reduction of FDI inflows to the inflows to the Caribbean Caribbean

Cancellation/reduction Cancellation/reduction of investment projects of investment projects

Limited increase in public Limited increase in public expenditure/consumption to expenditure/consumption to stimulate the economy stimulate the economy

Decrease in Decrease in investment Investment

Lower Global Lower global Demand demand

Higher Higher unemployment Unemployment

Lower demand for tourism Lower demand for tourism and exports for the Caribbean and exports of the Caribbean

Contraction Contraction of the of the export export and and tourism tourism industries industries

Increase in Increase in unemployment Unemployment

Fall in remittances Fall in remittances and migrant workers lose their as migrant workers jobs lose their jobs Fall in Fall in consumption consumption of poor of poor households households

Decrease in Decrease in consumption consumption Decrease in Decrease in exports exports

Fall in total output Fall in total output

Increase in Increase in poverty levels Poverty Levels

Sources: Kouame and Reyes (2011).

Rising costs of foreign credit Sovereign spreads in the LAC region increased significantly after the collapse of Lehman Brothers in September 2008, and particularly so for Caribbean nations. Spreads for the Caribbean countries increased, on average, by more than 700 basis points between September and October of 2008 while that of the rest of LAC only rose by 300 basis points (Panel A of Figure 2.6). The large increase in spreads for the Caribbean during October was driven in part by 1000 basis points rise for the Dominican Republic.36 The other three Caribbean nations with an EMBI index experienced large increases in spreads in the subsequent months. Belize posted its highest spread increase by December 2008 (over 1000 basis points increase relative to September 2008) while Jamaica’s spread increased almost 700 basis points over the same 36

Sovereign spreads in Belize, Jamaica, and Trinidad & Tobago experienced an increase of approximately 200 basis points in the month of October 2008.

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period. Finally, Trinidad and Tobagoâ&#x20AC;&#x2122;s sovereign spread continued growing at the beginning of 2009 (more than 600 bps by February). FIGURE 2.6. Debt and EMBI Spreads PANEL A. EMBI Spreads

PANEL B. Public Debt

EMBI Spreads: Caribbean vs. LAC-6 + URY Spreads in Basis Points

Public Debt in Selected Caribbean Countries Average 2005-07, % of GDP

1,800

200

EMBI LAC6+URY

1,600

EMBI Caribbean

160

1,400 1,200

120

1,000

800 40

600

Suriname

Trin. & Tob.

St. Lucia

Dom. Rep.

St. Vct. & Grens.

Barbados

Belize

Dominica

Jamaica

Grenada

Ant. & Barb.

Apr-11

Jan-11

Oct-10

Jul-10

Jan-10

Apr-10

Jul-09

Oct-09

Jan-09

Apr-09

Jul-08

Oct-08

Jan-08

Apr-08

Guyana

200

St. Kt. & Nev.

400

Notes: In Panel A, the Caribbean average includes Belize, Dominican Republic, and Jamaica. Averages are weighted by the 2007 nominal GDP in USD. In Panel B, public debt includes external and domestic. Sources: IMF's World Economic Outlook â&#x20AC;&#x201C; WEO (October 2010) and Bloomberg.

These increases in spreads can potentially affect not only the public sector but also the private sector in the affected countries. For the private sector, access to new sources of financing becomes more expensive, and hence investment decisions can be postponed. For the public sector, debt rollover might become an important issue. In particular, most Caribbean nations exhibit high debt levels. Panel A of Figure 2.6 shows that more than half of these countries have public debt levels that are comparable to the size of their economies, and the size of public liabilities exceeds the value of output in five of them (St. Kitts & Nevis, Guyana, Grenada, Jamaica, and Antigua & Barbuda). Further analysis on the exposure of Caribbean debt to interest rate risks can shed light whether high spreads can potentially limit their capacity to implement appropriate policy-responses to shocks.

Reduced net capital inflows Capital flows declined significantly in the aftermath of the collapse of Lehman Brothers. For Caribbean nations however this collapse in flows had more widespread consequences than for other LAC countries to the extent that the decline of FDI flows was significantly more pronounced for them. While average net FDI inflows to LAC-6 countries declined in 2009 (relative to 2007) by less than 1 percentage point of GDP, the average decline among Caribbean nations exceeded 4 percentage points of GDP (Figure 2.7). The collapse in net FDI was even larger in Antigua and Barbuda (17.8 percentage points of GDP), St. Lucia (nearly 12 pp), and Grenada (10 pp). 58 | LAC Success Put to the Test

Foreign direct investment (FDI) constitutes an important element of support of the production base of Caribbean countries. Net FDI inflows to the Caribbean have tripled over the last 20 years —climbing from 1.8 percent of GDP in 1990 to 6.4 percent in 2008, with many of the Caribbean nations are among the largest (net) recipients of FDI as a share of GDP in the LAC regions (e.g. 31 percent in St. Kitts & Nevis and 27 percent in St. Vincent and the Grenadines in 2008). Hence, it is not surprising that the Caribbean countries with the largest growth collapse in 2009 also experienced the largest contraction in (net) FDI. FIGURE 2.7. Net FDI Inflows to LAC Countries Foreign Direct Investment Net Inflows, % of GDP 35% 30%

2009

25%

KNA

20%

VCT LCA

15%

GRD

DMA

ATG

10% 5% 0%

BRB CHL DOM JAM MEX PER HTITTO COL ARG BRA

BLZ

10%

15%

20%

25%

30%

35%

2007

Sources: World Bank’s World Development Indicators – WDI (December 2010).

Sharp decline in external demand Exports of goods and services fell as much as 11 percent in the Caribbean in 2009 relative to 2007 while the decline among ESC countries was estimated at 14 percent.37 Exports of travel services also took a significant hit, where we observed a widespread contraction in revenues from travel services across Caribbean nations. For instance, there were contractions in travel receipts as high as 33 percent in St. Kitts & Nevis. (Panel Aof Figure 2.8). This decline in external demand for Caribbean products was probably amplified by a lack of diversification in not only products but also partners. For instance, the decline in tourism inflows can be associated to the high dependence on developed countries such as those in North America and in Europe. Panel B of Figure 2.9 shows that the percentage of tourists arriving from North America and Europe fluctuates between 45 percent (Dominica) and 95 37

Guyana and Trinidad & Tobago are excluded from these figures due to lack of information. Also, the reported figures refer to current values from Balance of Payment as there is no information on export volumes for most Caribbean countries.

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percent (Jamaica) across countries in the region. The narrow set of trading partners for goods and services have also limited the region’s capacity of to withstand shocks due to a limited hedging capacity. Once more, advanced nations, and particularly the United States, are the main destination for Caribbean exports while trade within the Caribbean is important for the smaller ESC countries (Figure 2.8). This renders Caribbean nations highly vulnerable to changes in global demand and particularly demand from developed countries. FIGURE 2.8. Tourism PANEL A. Travel Services Exports

PANEL B. Tourist arrivals

Travel Exports % Change from 2009 to 2007

Dominica

USA

Grenada

St. Vct. & Grens.

Canada

Trin. & Tob.

Dom. Rep.

St. Kt. & Nev. St. Vct. & Grens. Bahamas Belize Barbados Ant. & Barb. Grenada Dominica Argentina Suriname St. Lucia Dom. Rep. Jamaica Haiti Mexico Chile Brazil Peru Colombia

-40%

Guyana

-30%

St. Lucia

-20%

Barbados

0% -10%

Ant. & Barb.

10%

Europe

Belize

20%

100 90 80 70 60 50 40 30 20 10 0

Bahamas

65.8%

Jamaica

30%

Tourist Arrivals in the Caribbean by Origin % of Total Tourist Arrivals

Notes: The countries reported in panel A are those that have data available on the value of exports for 2009 Sources: World Bank’s World Development Indicators – WDI (December 2010)

Contraction in real activity of advanced countries reduced the inflow of remittances The dynamic flow of remittances to Caribbean countries is a particular strength of the region as it constitutes an important instrument of growth and consumption smoothing for an area subject to natural hazards and external shocks.38 Remittances to the Caribbean region totaled 7.3 percent of GDP during 2005-2008, with Caribbean nations among the largest recipients of remittances as a percentage of GDP in the LAC region.39 As documented by Fajnzylber and Lopez (2008), remittances tend to increase when the receiving country experiences a downturn and to decline when the downturn hits the source country. Remittance inflows to the Caribbean typically come from North America, Europe, and other Caribbean countries (Panel A of Figure 2.10). In particular, the United States is the most important source country of remittances to the region with a contribution that fluctuates from 42 percent of total remittance receipts in Dominica to 79 percent in Belize. Nevertheless, 38

Fajnzyber and Lopez (2008) have extensively documented that remittances help reduce growth volatility and allow countries to adjust faster to external shocks due to their counter-cyclical behavior.

Three Caribbean nations are among the top 5 recipients as a share of GDP in the region: Guyana (24.1 percent of GDP), Haiti (19.6 percent), and Jamaica (14.9 percent).

60 | LAC Success Put to the Test

there is an important amount of intra-regional remittance flows which are sensitive not only to global shocks but also to regional or large country shocks within the region.40 FIGURE 2.9. Exports of Commodities of the Caribbean by Main Destination Exports of Commodities by Main Destination % of Commodity Exports to the World in 2009 100% 80% 60% 40% 20%

USA

Suriname

Ant. & Barb.

Belize

Barbados

Trin. & Tob.

Guyana

European Union

Jamaica

Bahamas

Dom. Rep.

Grenada

Canada

St. Vct. & Grens.

Caribbean

Dominica

St. Lucia

St. Kt. & Nev.

Notes: Figures reported correspond to the year 2009 or the latest year available. Sources: Based on data from UN COMTRADE database for the SITC Revision 3 and One Caribbean.

FIGURE 2.10. Remittances PANEL A. Concentration

PANEL B. Trends

Remittances to the Caribbean by Origin % of Total Remittances Receipts

Trend of Remittances in the Caribbean US$ Millions

100%

8,000

80%

7,000

Caribbean

ESC

NESC

6,000

60%

5,000 40% 4,000

Caribbean

Europe

North America

Trin. & Tob.

Suriname

Jamaica

Haiti

Guyana

Grenada

Dom. Rep.

Dominica

Belize

2,000

Barbados

3,000

Ant. & Barb.

20%

1,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Sources: Panel A is based on estimations from Ratha and Shaw (2007). Panel B, World Bankâ&#x20AC;&#x2122;s World Development Indicators â&#x20AC;&#x201C; WDI (December 2010)

For instance, Haiti receives considerable flows of remittances from the Dominican Republic (12 percent of its total). Other examples are: Dominica from Antigua & Barbuda (8 percent of total remittances) and Grenada from Trinidad & Tobago (14 percent).

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Given that the global financial crisis hit hardly many of the source countries of remittances to the Caribbean, there was a significant deceleration in remittance receipts, which particularly affected ESC countries. Remittances dropped by as much as 8.4 percent between 2009 and 2007 and by 22 percent in the ESC countries, making them another important factor to explain the contractionary effects of the crisis (Panel B of Figure 2.10).

Domestic constraints limit the ability to cope with shocks In order to understand the post-crisis growth performance, one should also analyze domestic constraints that could have potentially hindered a rapid recovery. Four areas of attention can be identified for Caribbean countries: (i) lack of connectivity of the Caribbean nations to allow them economies of scale and lack of diversification of the production base, and (ii) limited fiscal space. Notice that these constraints might also have amplified the transmission of external shocks to these countries.

Economies of scale and diversification of economic linkages Individual Caribbean countries are very small and have limited opportunities to diversify their production base. Their economies tend to be highly concentrated in a few sectors, with tourism as an important source of income. Improving their connectivity to each other in the Caribbean region through the promotion of trade integration could facilitate the generation of economies of scale, thus potentially reducing costs and allowing them to be more competitive. At the same time, the smaller size of these countries plays a role in constraining a greater degree of diversification across markets. In particular and as already mentioned, they are highly dependent on developed countries. Kouame and Reyes (2011) document a statistically high degree of synchronization between business cycles in the Caribbean and the U.S. as well as a high co-movement between their exports and investments with the U.S. business cycle. Furthermore, they show a lack of linkages with new emerging global growth poles. In other words, Caribbean countries seem to be highly exposed to economic fluctuations in few markets with little possibility of hedges through other markets.

Limited fiscal space High public debt burden and large shares of earmarked expenditures (payroll, interest payments, and pensions) in Caribbean countries limit their capacity not only to conduct counter-cyclical policies but also their allocation of resources to emergency programs. Panel A of Figure 2.11 shows that seven of the Caribbean economies have more than 50 percent of fiscal expenditures allocated to wages, interest payments, and pension, thus leaving limited room for discretionary spending. In addition, fiscal accounts significantly deteriorated in most Caribbean nations in 2009 (Panel B of Figure 2.11).

62 | LAC Success Put to the Test

FIGURE 2.11. Limited Fiscal Space PANEL A. Fixed Fiscal Expenditures

PANEL B. Government Revenue

Fixed Fiscal Expenditures in 2007 Wages, Interests, and Pensions: % of Total Revenue

General Government Overall Balance % of GDP

80%

70%

60%

40%

2009

50% 30% 20%

DMA SUR COL BRA DOMPER VCT ARGHTI MEX GRD GUY BHS LCA TTO BRB JAM KNA

-5 -10

10%

BLZ

CHL

-15

Bahamas

Dom. Rep.

Trin. & Tob.

Guyana

Barbados

Grenada

Dominica

Belize

St. Lucia

St. Kt. & Nev.

St. Vct. & Grens.

Jamaica

Ant. & Barb.

ATG

-20 -25 -25

-20

-15

-10

-5

2007

Notes: Panel A data refer to 2007, except for Barbados, where the data refer to FY 06/07. Also in that same panel, fixed expenditures for Jamaica, Trinidad and Tobago, Bahamas and Dominican Republic do not include pensions as data was not available. Sources: LCSPE database, Official Government Statistics (Panel A) and IMF's World Economic Outlook â&#x20AC;&#x201C; WEO (October 2008) (Panel B).

Concluding remarks The Caribbean model of economic growth based on exports to advanced nations renders these countries highly vulnerable to external shocks, and particularly so to demand shocks from these countries. In particular, their tight linkages to the economic cycle of countries at the epicenter of the global financial crisis of 2008 (e.g. the United States), is at the core of explanations to the performance of the region was during the global downturn that ensued. At the same time, a weak interconnectedness of the region to nations that are currently driving global growth during this post-crisis period (e.g. China, India, and Brazil) has hindered a more rapid and strong recovery in the region. In other words, a greater diversification of Caribbean exports of goods and services towards other dynamic world regions would make them less vulnerable to some forms of external shocks. Nevertheless, achieving such task is not an easy job and significant policy actions should be on the agenda. In addition to structural factors such as export diversification, business cycle management in the Caribbean is still typically constrained by limited fiscal space (signaled by sustained deficits, excessive debt burden, and a large share of non-flexible expenditures), which hinders their ability to respond counter-cyclically during economic downturns. The unsustainable fiscal position in many countries of the region renders access to capital markets costly, thus curtailing their access to additional financing in times of crisis. Therefore, it is important for Caribbean nations to | 63

engage in better fiscal and debt management practices. These practices can for example focus on the build-up of policy buffers to manage the cycle. More targeted programs that facilitate the identification of population at higher risk during the turbulent times can also be good idea â&#x20AC;&#x201D;i.e. emergency employment projects, creation of emergency funds for tourism and export sectors, among others.41

Kouame and Reyes (2011) discuss examples of targeted programs in other emerging market economies (e.g. Philippines) and propose different types of emergency funds that may be more appropriate for the Caribbean environment: a remittances-based emergency fund, tourism-emergency fund, and a commodity export fund. The discussion of these recommendations can be seen in more detail in the paper.

64 | LAC Success Put to the Test

REFERENCES Calderon, C., and L. Serven, 2011. “Characterizing financial cycles in LAC: Protracted and more abrupt?” Washington, DC: The World Bank, manuscript. Calvo, G.A., A. Izquierdo, and E. Talvi, 2006. “Sudden Stops and Phoenix Miracles in Emerging Markets.” The American Economic Review 96(2), 405-410. Claessens, S., M.A. Kose, and M.E. Terrones, 2009. “What happens during recessions, crunches and busts?” Economic Policy 24, 653-700. Claessens, S., M.A. Kose, and M.E. Terrones, 2010a. “Financial cycles: What? How? When?” In: Clarida, R., and F. Giavazzi (eds.) NBER International Seminar on Macroeconomics. Claessens, S., M.A. Kose, and M.E. Terrones, 2010b. “How Do Business and Financial Cycles Interact?” Washington, DC: IMF, Mimeo. Crowe, C., G. Dell’Ariccia, D. Igan, and P. Rabanal, 2011. “Policies for Macro-Financial Stability: Options to Deal with Real Estate Booms.” IMF Staff Discussion Note SDN/11/02, February. de la Torre, A., C. Calderon, T. Didier, E. Levy-Yeyati, and S. Schmukler, 2010. " Globalized, Resilient, Dynamic: The New Face of Latin America and the Caribbean," Washington, DC: The World Bank, Mimeo. Engel, J., D. Haugh, and A. Pagan, 2005. “Some methods for assessing the need for nonlinear models in business cycle analysis." International Journal of Forecasting 21(4), 651-662. Fajnzyber, Pablo and Humberto Lopez. 2008. The Development Impact of Remittances in Latin America. Remittances and Development: Lessons from Latin America. Fajnzyber & Lopez, Eds. The World Bank: Washington DC. Ferreira, F., A. Fruttero, P. Leite, and L. Lucchetti, 2011. “Impact of shocks and role of social protection: the case of Brazil.” Washington, DC: The World Bank, manuscript. Harding, D., Pagan, A., 2002a. “Dissecting the cycle: a methodological investigation.” Journal of Monetary Economics 29, 365-381.

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Kouame, A.T., and M.I. Reyes, 2011. “Slow Recovery in the Caribbean after the Global Financial Crisis: Can the Region Strike Back?” Washington, DC: The World Bank, manuscript. Moreno, R., 2011. “Policymaking from a macroprudential perspective in emerging markets.” BIS Working Papers No. 336, January. OIT, 2010. “Panorama Laboral 2010: America Latina y el Caribe.” Lima: Organización Internacional del Trabajo / Oficina Regional para América Latina y el Caribe. Ratha, Dilip and William Shaw. 2007. South-South Migration and Remittances. World Bank Working Paper No. 102. The World Bank: Washington DC. World Bank, 2009. How Has Poverty Evolved in Latin America and How is it Likely to be Affected by the Economic Crisis? The World Bank, LCSPP. Washington DC. World Bank, 2011a. “Poverty and Labor Brief: Recent Inequality Trends in Latin America.” Washington, DC: The World Bank, Latin America and the Caribbean Region, manuscript. World Bank, 2011b. “High Food Prices: Latin America and the Caribbean Responses to a New Normal.” Washington, DC: The World Bank, Latin America and the Caribbean Region, manuscript.

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