Latin America has split into two regions with divergent growth paths as a result of the global crisis, the IDB claimed in a report released yesterday.
The report, One Region, Two Speeds, identifies two groups of countries – a “Mexican cluster” and “Brazilian cluster” – whose economic fortunes are bound up with the prospects of industrial countries and emerging markets respectively.
“You have to speak of two speeds of growth for Latin America,” IDB president Luis Alberto Moreno told Emerging Markets in an interview. “Those of South America, which have had most of the tail winds from high commodity demand, and those of Central America and the Caribbean which are largely connected to the US.”
Growth forecasts for the Brazilian group are substantially higher in 2011, at 4.4%, than the 2.7% expected for the Mexican one.
This dichotomy provides “a very different perspective in terms of how growth may evolve and very different policy recommendations for each group,” Alejandro Izquierdo, principal economist in the IDB’s research department and one of the authors of the report, told Emerging Markets.
For the net commodity-exporting Brazilian cluster countries, “the typical overheating issues are at stake. It’s important for them to show they can implement counter-cyclical fiscal policies in good times.
“It’s very easy to go this way when we’re in the crisis but it is more difficult politically [in good times]. The region still has to show it can do that.” Izquierdo added that for this group “monetary policy – even though it’s OK to start raising interest rates – has to take a back seat to fiscal policy and macro-prudential regulation.”
“Fiscal policy is the first tool,” said Izquierdo, who coordinated the research with Ernesto Talvi, director of CERES, a Uruguay-based research institute.
Izquierdo pointed out that while standard inflation-targeting prescriptions for this group would call for a hike in interest rates, this “would backfire for these countries to the extent that they have open capital accounts” and that tightening monetary policy “if anything brings in more capital inflows and makes the overheating issue more difficult to tackle.”
In sharp contrast, Mexican cluster countries are growing at slower than pre-crisis rates because of a slump in the industrialised world. As a result “fiscal issues become more important but from a sustainability point of view,” Izquierdo said.
He also pointed out that many countries in the Mexican cluster had been financing large current account deficits with foreign direct investment – which has declined for this region in favour of the Brazilian cluster. Meanwhile financial flows “have increased dramatically” for both clusters.
“Even though FDI has been falling, financial flows have been compensating. Of course you’re now switching financing of deficits to more volatile flows so that’s introducing a new source of vulnerability,” said Izquierdo.
While in 2006, only one third of capital inflows were non-FDI, they now account for more than half (55%) of the total.
Izquierdo said the Mexican cluster faced the challenge of “being very creative when it comes to their trading partners,” diversifying away from a sluggish US economy. “If they can’t place their products in Asia, they can use the back door and link their trade to the Brazilian cluster,” he said.
The report takes as its baseline a smooth rebalancing of the global economy in the wake of the global crisis. But Izquierdo warned: “You cannot neglect that you will see currency wars, trade wars. If Europe is not successful in containing its crisis, that will also probably affect spreads for Latin countries.”