Brazilian president Luiz Inacio Lula Da Silva’s quip in mid-2008 that the global financial crisis was the west’s problem – "Bush’s crisis", as he famously put it – might have gone down in history for its sheer conceit. By the end of that year, Brazil had suffered its sharpest slump in a decade, snuffing out any lingering belief that Latin America’s largest economy was immune to the crisis then sweeping the globe.
But eighteen months on, rather than being derided for its arrogance, Lula’s jibe has taken on new meaning for much of Latin America – not just Brazil – as the region stages an unprecedented rebound, following its worst recession in a generation.
Latin America withstood the onslaught of the crisis remarkably well – in sharp contrast to previous bouts of global financial turmoil. Across the region, a combination of healthy foreign exchange reserves, improved current accounts and healthier fiscal positions helped Latin economies on the way into the crisis; and when disaster finally struck, flexible exchange rates and strong banking systems helped absorb the impact, while pump priming and a large monetary impulse have since nudged the region towards a solid recovery.
The Institute of International Finance (IIF) forecasts output in the region will surge by 4.8% this year, led by Brazil, Chile and Peru, following a 2.3% contraction in 2009. And confidence abounds. Brazil’s finance minister Guido Mantega says Brazil is on course for 5.2% growth this year, its best economic performance since 2007, when GDP increased 6%. And Mexico – despite last year having suffered a 6.5% contraction, its worst slump since 1932 – has raised its estimate for 2010 economic growth to 3.9%, citing signs of recovery in internal and external demand.
"I think in general things are going well in Latin America," Guillermo Ortiz, Mexico’s former central bank governor tells Emerging Markets. "The crisis caught the continent in a much better position. It only really hit Latin America’s real economy."
NOT SO FAST
Yet broader economic conditions remain weak: despite a rebound in trade, Latin America’s export contraction hasn’t let up, especially for non-commodities; remittances – a key source of revenue across the continent – are likely to remain constrained because of persistent unemployment in the developed world; and fiscal expansion is pushing up deficits that will be increasingly hard to finance. Before the world economy fully recovers many countries will either have to curb expenditures, raise taxes, or both.
"Latin America weathered this crisis fairly well – it’s the first time in a long time. But I feel fairly strongly that policy-makers are now too complacent," says Claudio Loser, senior fellow at the Inter-American Dialogue and former western hemisphere head at the IMF. "The euphoria is not justified."
The sharp improvement in external factors in early 2009 led to a substantial turnaround in capital flows. As a result, the emphasis of immediate macroeconomic policy shifted dramatically from recession fighting to coping with a strong rebound in capital inflows, booming asset prices and credit and rapidly appreciating currencies – in short, preventing overheating.
Nicolás Eyzaguirre, the IMF’s Western Hemisphere director, says: "The stage is set for a bubble to develop. There is obviously the risk that markets get ahead of themselves and take a transitory situation as more permanent in nature."
"Economies could grow more than they are able to sustainably," adds Eyzaguirre. "Fiscal outlays could take an overly positive reading of the future."
Gray Newman, managing director and senior Latin America economist at Morgan Stanley, also believes that widespread over-exuberance could cloud the policy perspective. "The market has focused so much on the cycle. But what’s not acceptable is for policy-makers to fall into the trap of following market participants. The problem is when policy-makers begin to get caught up in the euphoria of the investment community – that’s the risk for 2010/2011."
The contrast in attitudes today between the region’s central banks and finance ministries coming out of the crisis is striking, says Liliana Rojas-Suarez, senior fellow at the Center for Global Development and a former chief economist at Deutsche Bank. The former are "extremely aware of dangers and are not complacent at all. But when we move to the fiscal side the situation is very different: politics start playing a much larger role."
FISCAL FIDDLE
Unwinding fiscal policy would reduce demand from the private sector and so "reduce the risk of overheating," according to Alejandro Izquierdo, principal economist at the IDB’s research department.
Countries that pursued fiscal expansion during the crisis must rein in spending while the going is good, he warns. "This is the time to start cutting back. You need to unwind in the good times or else you can’t have counter-cyclical policy in the next crisis. And you can only have counter-cyclical policies in a crisis if you have credibility."
At the outset of the crisis, Latin America found it difficult to implement counter-cyclical fiscal policies, Rojas-Suarez points out. Only Chile and Peru undertook fiscal stimulus without risking the sustainability of their public debt.
In contrast, Brazil, which undertook a significant expansion, there is a source of growing concern over policy-makers’ ability to reverse fiscal stimulus – including curtailing lending from state development bank BNDES – especially in an election year.
"Latin American found it very difficult to adopt expansionary policies, but they’re going to find it even harder to contract the fiscal stance," says Rojas-Suarez. "It’s time to start talking about exit strategies."
Brazil’s finance minister Guido Mantega insists that the situation is manageable. "We are going to be on target, because the country is fiscally responsible and has little external vulnerability," he tells Emerging Markets in an interview.
But that view is not universal. "I fear for Brazil," says Rojas Suarez. "If they don’t reverse the fiscal expansion they are going to find themselves in a situation where the fiscal position could be compromised."
"Investors are now clearly differentiating countries, but they have not yet priced in the potential for a fiscal problem in Brazil. But it’s there," she adds.
Brazilian authorities have shown little intention of changing expansionary policy apart from phasing out a series of tax breaks that fuelled the consumer market in times of crisis.
Fitch notes that the country’s gross general government debt burden of over 70% of GDP will remain roughly 30% above Mexico’s, hammering home the need for Brazil to unwind its expansion as the economic recovery takes hold.
Still, fiscal policy is only one – albeit critical –part of the story. As Eyzaguirre notes: "You can have fiscal policy in check, but if financial intermediation gets too bullish, you get a private credit boom and you could end up with a bubble very easily."
He says authorities should also focus on monetary, exchange rate and prudential regulations. "You can’t put all the weight on one policy. You can’t just do fiscal or monetary or exchange rate or prudential or capital controls. You have to do a little bit of everything."
EXTERNAL FACTORS
But perhaps a bigger concern is Latin America’s vulnerability to external factors – a reality which remains largely undiminished and increasingly ignored.
Morgan Stanley’s Newman notes that although the downturn turned out to be shorter than expected, it was interrupted and reversed principally by a significant turnaround in China.
"It was a significant policy reaction from the Chinese authorities that began to turn this around in the first months of 2009," he says. Had the downturn lasted significantly longer, "the region would have suffered disproportionately more than some of the developed countries. We shouldn’t forget that."
Newman says that "some of the glow that is surrounding emerging markets today could rub off" if the global economic recovery stalls. He says: "Let’s not confuse what has been some of the very strong cyclical positives for the region with some of the [structural reform] agenda that has yet to be resolved."
Says Rojas-Suarez: "The real story is that Latin America is following the global cycle. We should not have illusions that Latin America on its own has been able to avert a major collapse. This is an illusion. The truth is that the lion’s share has been determined by international conditions."
SCENARIO PLANNING
The IDB’s Izquierdo, together with Ernesto Talvi, executive director of CERES, a Uruguay based think tank, argue in a recent paper ("The Aftermath of the Crisis") that strong fundamentals at the country level might alone not be enough to stave off crisis.
Although improved fundamentals played a role, the "key innovation" during the past crisis was "the readiness" of international financial institutions – principally the IMF –to act as lender of last resort at the height of the turmoil.
Izquidero and Talvi lay out two scenarios for the global economy which could have vastly different consequences for Latin America (see chart). Under the benign scenario, China maintains double-digit growth while developed economies expand their output around 2% a year. Global liquidity stays abundant, international capital keeps flowing, and commodity prices recover further. The result would be roughly 3% average growth for Latin America’s biggest economies in 2010, increasing to a yearly average of 5% from 2011 – 2014.
But they present a sobering – and equally plausible – alternate scenario. In it, increasing private sector demand in industrial countries and inflationary pressures signals the end of quantitative easing and triggers tighter monetary policy – and substantially higher real interest rates in rich countries. This leads to a crowding out of capital flows in 2011 and beyond.
Under this scenario, growth in China decelerates sharply, bringing commodity prices down and resulting in widening spreads on emerging market debt. As in the benign scenario, average GDP growth for Latin America would be 3% in 2010, but it would peak in 2011, and then drop to below 2% by 2014 as external conditions for emerging markets deteriorate.
"In this less benign global scenario, fiscal consolidation is less likely to take place," says Izquierdo.
The risks of another global downturn can hardly be discounted. A growing number of prominent voices – including Harvard economist Ken Rogoff – are warning of a potential crash for China’s economy. Fearing overheating, authorities have raised banks’ reserve requirements twice this year after economic growth surge and property prices rallied.
All the more reason for policy-makers to take heed. Says Ortiz: "We need to take advantages of these better times in Latin America to continue the process of fiscal consolidation, to keep bringing down debt to GDP levels, continuing being more efficient in our economies, pushing through badly needed structural reforms."