Western Hemisphere
Regional Economic Outlook: Stunted by Uncertainty
October 2019
- Outlook for Latin America and the Caribbean: Stunted by Uncertainty
- Capital Flows to Latin America in the Aftermath of the Commodities Super-Cycle
- Sovereign Spreads and Fiscal Consolidations
- Labor Market Dynamics and Informality over the Business Cycle in LAC
- Spillovers to Latin America from Growth Slowdowns in China and the United States
Outlook for Latin America and the Caribbean: Stunted by Uncertainty
Growth in Latin America and the Caribbean (LAC) has slowed from 1.0 percent in 2018 to 0.2 percent in 2019, but a tentative pick-up to 1.8 percent is expected in 2020. External factors remain a headwind to economic prospects in the region, led by sluggish global growth, subdued commodity prices, and volatile capital flows, although easier global financial conditions provide some respite. Policy uncertainty in some large LAC countries continues to be a drag on growth, while Venezuela’s economic and humanitarian crisis continues to drive large migration flows to other countries in the region. Against this backdrop, the LAC economies will need to rely on domestic sources of growth to accelerate the recovery, which hinges on a pickup in private consumption and investment anchored on a rebound in business and consumer confidence. Risks to the outlook remain skewed to the downside, including further falls in global growth and commodity prices, spikes in risk premiums, heightened domestic policy uncertainty, contagion from the financial turmoil in Argentina, and natural disasters. Given the challenging global environment and still negative output gaps in the region, policies will need to strike a balance between supporting growth and rebuilding policy space. Fiscal consolidation to lower public debt remains a priority in several countries. Monetary policy can continue to support growth given the stable inflation outlook and well-anchored expectations. Corporate vulnerabilities require enhanced surveillance. Structural reforms, aimed at greater openness to trade and investment, bolstering competitiveness, and addressing stringent labor market regulations, remain an imperative.
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Capital Flows to Latin America in the Aftermath of the Commodities Super-Cycle
Countries in Latin America and the Caribbean (LAC) rely on volatile capital inflows to finance investment, which poses important challenges. After the end of the commodity super cycle in 2014, capital flows to the region have declined and their composition has become riskier, with a larger prominence of portfolio flows. Moreover, the sensitivity of capital inflows to global financial conditions and growth differentials has increased in recent years, increasing the likelihood of a sudden stop in capital flows if growth in the region continues to falter and global financial conditions tighten. The analysis in this chapter shows that countries with floating exchange rate regimes tend to experience shorter and less costly sudden stops in capital flows, while a tightening of monetary policy following a sudden stop episode is also associated with a reduction in the duration of sudden stops and the ensuing deceleration in growth. Tighter capital controls, however, do not have statistically significant effects on the duration of sudden stops.
Sovereign Spreads and Fiscal Consolidations
Lower commodity prices, mediocre growth, and a prolonged period of low global interest rates have contributed to rising public debt in many countries in Latin America and the Caribbean (LAC). Against this backdrop, and amid a more challenging external environment, financial markets’ perception of credit risk in LAC has deteriorated somewhat. This has led policymakers in many of these economies to announce fiscal consolidation measures aimed at reducing public debt and improving confidence in the sovereign, as measured by sovereign bond spreads. Nevertheless, empirical evidence quantifying the effects of fiscal policy on sovereign spreads has been elusive. Using a new database on fiscal policy news, this chapter investigates the effects of fiscal consolidation announcements on sovereign spreads in LAC during 2000–18. Our results show that sovereign spreads decline significantly following news that fiscal consolidation measures have been approved by Congress, particularly in periods of high sovereign spreads or in countries under an IMF program. In addition, fiscal adjustment packages are more effective—leading to smaller output losses and larger reductions in the public debt-to-GDP ratio—when sovereign spreads significantly decline following the announcement. These results constitute direct evidence that if confronted with a situation of fiscal stress, credible consolidation efforts get rewarded. These confidence effects are crucial in mitigating the drag on economic activity in the aftermath of fiscal consolidation.
Labor Market Dynamics and Informality over the Business Cycle in LAC
Labor markets in Latin America and the Caribbean (LAC) are characterized by high levels of informality, low female participation rates, and relatively rigid employment protection legislation. Our results show that informality plays an important role in the dynamics of labor markets in the region. Informality is countercyclical, and the formal/informal adjustment margin reduces the importance of the employment/unemployment margin, that is, informality dampens the usual Okun’s coefficient relating unemployment to cyclical changes in GDP. However, evidence suggests that informality makes the adjustment to shocks slower, with negative impact on growth. We find that higher redundancy costs, cumbersome dismissal regulations and high minimum wages are associated with increased informality. Also, changes in aggregate participation rates are positively related to changes in GDP, but we find some evidence that the female participation rate is countercyclical in recessions in LAC.
Spillovers to Latin America from Growth Slowdowns in China and the United States
Economic activity in China and the United States is projected to slow down going forward due to cyclical forces, population aging, and sluggish productivity growth. Moreover, their heightened trade and technology tensions could lead to a faster slowdown in the near term. These developments will likely have spillovers to other countries, including to Latin America. This chapter seeks to quantify these spillovers using empirical and model-based techniques. The results show larger spillovers for countries that are more exposed to China or the United States through trade, commodity prices, and financial flows. For example, a temporary fall of 1 percentage point in China’s growth would reduce growth in Chile and Peru—the two countries most exposed to China—by 0.2–0.3 percentage points. A similar US shock would lower growth in Costa Rica and Mexico by 0.5 percentage points. These spillovers could be significantly larger if the slowdowns in China and the United States also lead to tighter financial conditions in emerging market economies, including in Latin America.