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Emerging Markets

Lessons learned

The financial crisis shows that Latin America’s policy-makers have done their homework, says Chile’s central bank governor Jose de Gergorio

For Latin Americans, their region’s economic performance over the last 12 months has been a pleasant surprise. Initially sceptical of their leaders’ reassurances about the impact of the international recession, they steeled themselves for a worse fate than they have, in fact, suffered.

In the past, trouble in industrialized economies has, after all, spelled even bigger trouble for Latin America. Yet, as of July, the IMF was forecasting that the region would contract by 2.6% this year as compared to 3.8% in advanced economies.

There are a number of reasons for this muted impact, but according to Jose de Gregorio, governor of Chile’s central bank, they all come down to one factor: lessons learned. The region still has pending tasks relating mainly to its comparatively low income level, he says, but the current crisis shows that it has done an important part of its homework.

Two of those lessons – the importance of controlling inflation and of exchange-rate flexibility – have had a direct impact on the ability of the region’s central banks to use monetary policy to mitigate the impact of the crisis. “When you go into a crisis with high inflation and exchange-rate rigidity, the currency depreciates and inflation climbs... and the possibility of implementing expansive monetary policy is much more limited,” notes de Gregorio.


Over the past 10 years, most of the region’s main economies have, indeed, achieved important reductions in inflation, in some cases through inflation-targeting monetary policies. In 1997, in the run-up to the Asian financial crisis, inflation in the region averaged 10.7%, according to the UN Economic Commission for Latin America and the Caribbean (ECLAC), and, in countries like Mexico, Colombia and Uruguay, it was running at close to 15%. However, by 2007, the average was down to 6.4%.

Exchange-rate flexibility has also been extremely important. “We’ve learned that trying to play with the exchange rate to create temporary effects isn’t a good idea,” says de Gregorio.

Fiscal policy has helped too, he adds. “In the past, Latin American countries lived on the edge of insolvency, but they’ve realized that if they want to be less vulnerable... they can’t have policies that keep them on that edge, because when there’s a crisis... that means fiscal contraction instead of an expansion like we’ve seen today.”

The region’s financial systems have also stood the test of the crisis. That is partly because they still lack the complexity of markets in industrialized countries but also because of strict regulation introduced as a result of lesions learned during previous crises.

Washington Consensus effect

Indeed, according to de Gregorio, much of the region’s performance in the face of the current crisis can be attributed to economic reforms implemented in the 1990s – commonly referred to as the Washington Consensus – and, in Chile’s case, even earlier. “Many people criticized those reforms, but part of what we’re enjoying today is their result,” states de Gregorio.

According to Marcos Buscaglia, Citigroup’s director of research and markets for the southern cone of Latin America, Chile is a prime example of the benefits of those reforms. As a small open economy, it was, on paper, one of the most vulnerable in Latin America to the international recession, he told a recent seminar in Santiago.

Indeed, according to the latest central bank forecasts, Chile’s GDP will contract by between 1.5% and 2.0% this year. However, without monetary stimulus, which has been among the most aggressive in Latin America, and a fiscal injection equivalent to 2.8% of GDP – financed out of past savings – output would have plummeted catastrophically as it did in the debt crisis of the early 1980s, suggests Buscaglia.

Led by Brazil, Latin America now appears to be rebounding from the crisis. The question, according to de Gregorio, is the duration and strength of the recovery. This will, he says, depend crucially on the economic policies adopted by different countries.

The risk factors

The main short-term challenge for the region’s central banks is to ensure that the recovery is sustained, he says. That implies balancing two opposing risks.

One is inflation. According to de Gregorio, that isn’t an immediate threat but calls for a watchful eye. “It could make sustained recovery more difficult because dealing with inflationary pressures is much more costly once they’re already installed.”

The other is the so-called ‘Great Depression risk’ or, in other words, that of starting to tighten monetary policy too soon. Much will depend on the situation in individual Latin American countries, suggests de Gregorio – “It’s very different to start raising interest rates from 0.5% or from 5%.”

In the medium term, he foresees that the equilibrium interest rate in Latin America, as in the rest of the world, will be lower than in the past, reflecting the need for higher savings. However, in the short term, he envisages the maintenance, rather than withdrawal, of monetary stimulus.

Some countries still have room to reduce interest rates and others may still introduce non-conventional measures, such as a guaranteed-rate lending facility for commercial banks launched by the Chilean central bank in July, or quantitative easing, while some may start to tighten monetary policy, he says.

According to Buscaglia, Chile – with a benchmark interest rate currently at 0.5% – will be one of the first Latin American countries to tighten its monetary policy although, according to the central bank, this is unlikely to occur before the second quarter of next year.

Another challenge for the region’s central banks, according to de Gregorio, is their role in safeguarding financial stability. “As financial markets innovate and deepen, it will be very important to look at how to accompany that process as regards regulation,” he concludes.

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