While sky-high prices may have endowed some of Latin America’s commodity exporters with healthy fiscal surpluses, much of Central America is being hit by a double blow from raging inflation and weakening exports to the US. Rampant credit growth, soaring food and oil prices as well as the plummeting dollar have pushed inflation to perilously high levels, cutting growth forecasts this year and unleashing a torrent of social unrest.
The region’s external weaknesses are clear: the IMF estimates a 1% drop in US growth will lead to a 0.5% slowdown in the region. In addition, as a net importer of energy and food, Central America faces powerful economic headwinds blowing from many directions. Record price rises for wheat, corn, soy, sugar and food oil, which form the bulk of consumer price indices in the region, have pushed inflation to record highs.
Nicaraguan prices jumped 16.9% in 2007 – the highest jump in the region – on the back of the soaring cost of imported commodities. The outlook has deteriorated further this year: rising food and power costs caused annual prices to hit 8.8% in February, higher than both January’s 8.4% level and the 4–7% target range for 2008.
In Panama, inflation reached a record 7.6% year-on-year in January against an average of 1.1% over the past 20 years. With El Salvador’s oil import bill rising 20% so far this year, inflation increased 0.8% in February, pushing the annual rate to 5.8% – the highest in a decade.
Blistering price rises threaten macroeconomic stability and have exposed the gaping structural weaknesses of the region. “Governments are not trying to fight against such international conditions because they don’t have the power over external pressures,” says Felix Delgado, Central America economist at the consultancy LatinSource.
As officially dollarized economies with open capital accounts, Panama and El Salvador have in effect outsourced monetary policy to the US Federal Reserve. As a result, these countries are unfortunate victims of the US central bank’s recent moves to unlock vast amounts of liquidity, which has led to an unwanted monetary surplus while amplifying already blistering credit growth. “Inflation is indeed being exacerbated by the monetary easing in the US,” says Carl Ross, head of emerging markets research at Bear Stearns.
In addition, Guatemala’s central bank is unable to use currency appreciation to fight inflation since 80% of the financial system is dollarized. Similarly high levels dominate in Nicaragua, Belize and Honduras.
Monetary misrule
In Costa Rica, dollarization fell gradually to a more modest 41% at the end of last year, and since October 2006 the central bank has abandoned the crawling peg exchange rate in favour of a currency band and an inflation-targeting mandate.
But Costa Rica’s monetary policy tools are stuck between a rock and a hard place. “Interest rate increases intended to curb inflation could potentially attract short-term capital inflows and consequently expand the monetary base, and thereby fuel inflation,” says Casey Reckman, Latin American sovereigns analyst at ratings agency Fitch. “Conversely, interest rate reductions aimed at discouraging short-term capital inflows could stimulate domestic consumption and increase pressure on prices.”
To date, the monetary regime has opted to use its benchmark overnight interest rate to manage capital inflows, prioritizing the consolidation of the flexible exchange rate system rather than curbing inflation. But this policy direction has received criticism: “The central bank is too scared about capital inflows; the financial system is not that exposed, and it should concentrate on inflation more,” says Pablo Rodas-Martini, chief economist at the Central American Bank for Economic Integration (CABEI).
Interest rates are now artificially low at 3.5%, increasing the flow of easy money as negative real rates on deposits have spurred domestic demand.
Costa Rica as well as other economies in the region faces a battle against stubbornly sensitive inflationary expectations among the impoverished masses, who fear household costs are under the grip of uncontrollable external forces. As a result, regional central banks need to “focus economic agents on core inflation measures”, which separate out elements of the consumer price index that are more vulnerable to external shocks, says Reckman.
But the lack of monetary policy action against price performance will only continue to fuel inflation expectations. Indeed, there are few signs that fiscal tightening to reduce the glut in money supply is likely this year. In fact, the region has fiscally out-performed over the last two years, and in order to offset deteriorating exports, analysts expect “governments to hike social spending in crucial developmental areas this year”, says Delgado.
Costa Rica is targeting a 0.5% deficit compared with last year’s 0.5% surplus, while El Salvador was busy in 2007 cleaning up its non-financial public-sector deficit to 0.3% of GDP and plans to hike spending this year. Without further tax reforms this year, analysts maintain it is unlikely Guatemala will be able to reduce its current 1.5% deficit.
Panama’s peril
Meanwhile, Panama intends to spend the fruits of its 3.5% surplus last year on reducing import tariffs on food, increasing the mortgage subsidy and curbing taxes. The country was Central America’s runaway success story last year, with the economy surging 11.2% on the back of a construction boom and canal expansion.
But strong domestic demand and double-digit credit expansion sparked a decade-high spike in inflation – at 7.6% year-on-year in January – which in turn led to widespread calls for wage hikes. The government eventually yielded to a 26% pay rise for doctors in December, following a one-month strike.
In February, demonstrations by the construction worker’s union, Suntracs, over food price rises and poor working conditions descended into violence. Protesters throughout the country responded sympathetically to the union’s calls, dealing a blow to the government. Authorities are now under pressure to give in to further demands for wage increases and to impose price controls, following the example of Latin America’s economic deviants Argentina and Venezuela.
“A decrease in central government spending would help stem inflation, but this is unlikely in the run-up to [2009 presidential] elections coupled with the need for infrastructure to keep pace with the rate of economic growth,” says Ross.
Promisingly, Congress is discussing a fiscal reform law to set a 1% cap on the fiscal deficit and a 35% of GDP target for public-sector debt – a move which could prove a boon for stable price performance in the medium and long term.
Confidence postponed
While Rodas-Martini has confidence in the fiscal discipline of Central America’s policy-makers, he fears a long history of wages indexed to inflation will further exacerbate inflation in the near term. “Higher wage demands in Central America will be ever present, but this is due to external factors that are pushing up inflation. But governments should refrain from ruling by decree else this will create more problems,” says Rodas-Martini.
Ominously, there are indications that rising prices may also be undermining pro-market forces in the region. Stubborn inflation is weighing on the popularity of the ruling pro-market Arena party in El Salvador and could spark a political lurch to the left. Early polling for the 2009 national elections indicates that the former guerrilla group FMLN could bring the administration’s 20-year grip on power to an end. The party is seeking to connect high food costs as a failure of free market economics.
“This is a worrying development; it is a reflection of the social discontent caused by inflation,” says Reckman.
Central America’s infant policy tools to ward off commodity price pressures and external weaknesses have left governments with little choice but to accept these pressures as a fact of life. “The governments’ response is to just wait for international prices to normalize,” says Delgado.
What’s more, countries are powering ahead with higher spending this year to sustain the region’s economic growth targets – despite the inflationary fallout. “Policy-makers will not sacrifice their economic growth when the US is slowing, just for the inflation target,” he continues.
But strong headline economic figures are scant consolation for poor households struggling with mouths to feed. Such social discontent could destabilize regional governments this year – a prospect which demands urgent action on key structural reforms.
“These inflationary challenges mean governments should focus on diversifying exports and improving conditions for FDI. This is now more urgent than ever,” Rodas-Martini concludes.