Managing Abundance to Avoid ABust in Latin America

Latin American (LA) economies today are at a challenging juncture as key global conditions have aligned in very exceptional ways， representing a double tailwind for many countries of the region. These countries must figure out how to best respond to a sustained period of unusually easy foreign financing conditions and large capital inflows. At the same time， they face high world prices for their commodity exports， another source of abundance that is likely to be persistent but not permanent. Such conditions are， of course， in many ways favorable， creating opportunities with important upsides. But such conditions can also lead to an accumulation of important vulnerabilities for the future. There are challenges both while these conditions persist and during the transition after they end because severe dislocations and crises may arise if the good times are improperly managed. Indeed， some of Latin America’s own past experiences with the “problems of plenty” have illustrated that good times can be followed by bad endings.Indeed， one key concern in Latin America should be that the double tailwinds of easy money and high commodity prices may lead to financial exuberance and external vulnerabilities， heightening the risks of costly sudden reversals. Past experience has showcased how both market and regulatory failures can lead to excess absorption and accumulation of risks in private balance sheets. Moreover， the external current accounts in Latin America have shown in the past a significant propensity to overshoot under similar conditions.Relative to the past， many LA countries today have better policy frameworks， a development that reduces the chances of excesses and risks and thereby makes them more attractive to foreign capital. Improved fundamentals in the region likely have brought a permanent shift in investors’ portfolio allocations. At the same time， they reduce the vulnerabilities associated with larger capital inflows. Especially relevant is the greater degree of exchange rate flexibility accompanied by relatively successful inflation targeting frameworks as an alternative nominal anchor. Bank supervision has progressed greatly in controlling currency mismatches， at least on banks’ balance sheets. In some cases， the degree of fiscal policy has been reduced. Moreover， the level of public debt has been brought down considerably， reducing vulnerabilities in general.The problem that Latin America now faces from external factors is on a scale of uncharted dimensions. First， the global setting implies that the region has unusually ample access to cheap foreign financing，a combination of persistently very low interest rates in advanced countries and higher risk tolerance from international investors—while at the same time some countries outside the region have policies in place that represent strong barriers to capital inflows and wider current account deficits. Second， strong growth in Asia， coupled with supply constraints， has sustained high commodity prices， bringing terms of trade for LA commodity exporters that are unusually favorable but unlikely to be fully sustained.It is essential to recognize that key characteristics of LA countries today make the challenges and policy discussions different from many emerging market (EM) countries of other regions. This note emphasizes especially the larger economies of LA， those which in general are characterized by a high degree of financial integration with the global market and by having important commodity exporting sectors. These LA countries have open capital accounts and most have highly flexible exchange rate regimes. Many of them have fiscal policy rules to ensure debt sustainability. Crucially， these countries normally have external current accounts that are in deficit. Much of this stands in sharp contrast with the situation of a number of Asian economies today， with their current account surpluses， less flexible exchange rates and more aggressive foreign exchange market intervention policies， and less open capital accounts.I A global liquidity flood and terms of trade bonanza for Latin AmericaIn a multi-speed global recovery such as the current one， real exchange rates and current accounts would be expected to respond differently across countries， with an appreciation and a larger deficit in economies with stronger cyclical positions. The dual of this is that net exports should play a greater role in the recovery of countries with weaker cyclical positions， with the rest playing the counterpart role in global rebalancing. Capital flows would be expected to be redirected from cyclically lagging to leading countries.However， the current global circumstances are conducive to dynamics in Latin America beyond the usual cyclical reaction， with overly strong capital inflows， large current account deficits， and currency overvaluation. The constrained policy mix in advanced economies (AE) is expected to produce unusually strong， deep， and long-lasting monetary stimuli， while the behavior of a systemic group of EMs outside the region has limited the adjustment in their external positions， increasing the required global rebalancing efforts of more flexible countries. Moreover， a group of important EMs has been successful in maintain- ing growth， underpinned by substantial policy stimuli in some cases， which in turn has sustained commodity prices at a high level.Low interest rates in AE are a strong push factor for capital flows， one linked to a sluggish recovery that is held back by lingering private debt-overhang problems and limited space， both political and economic， for fiscal stimulus. In the run up to the global financial crisis， conditions in advanced economies were on an unsustainable path， and the corrections that ensued were exacerbated by the dislocations produced by the crisis and the prolonged process of balance sheet repair. The global financial crisis opened large output gaps in advanced economies and required， inter alia， a substantial loosening of monetary conditions. However， political constraints have created a situation where efforts needed for a fiscal consolidation over the medium term seem trapped in gridlock， while the scope for greater fiscal stimulus in the short term has either been limited or tilted to a less effective design. The lack of progress in medium-term fiscal consolidation may add to contractionary headwinds through upward pressures in long-term interest rates， and could exacerbate future upward movements in rates once private sector demand takes hold， an important risk for Latin America. Moreover， the slow progress in resolving the debt overhang in the household sector and balance sheet repair of financial institutions also has held back private spending and led to an unusually heavy reliance on easy monetary policy. This combination of economic， political and legal constraints has translated into dependence by AEs on monetary policy beyond what would be expected under a policy mix that provided further fiscal stimulus until the output gap has significantly narrowed and faster repair of balance sheets. This， in turn， has generated unusually lax foreign financing conditions for emerging markets， which are expected to be protracted， but could reverse quickly once the recovery in AEs gains footing.In addition to low policy interest rates in advanced economies， financing conditions for EMs today are easy because global risk appetite has recovered strongly. This is reflected in very low risk premier for many EM countries， including in LA， with sovereign spreads near their record low levels of early 2007. This， on top of low interest rates in AEs， means very low borrowing costs for LA. In past episodes in which there were both low interest rates and high risk appetite， capital flows to EMs increased considerably.II Why is today’s easy foreign money a concern for Latin America?Easy external financing conditions and high terms of trade provide a good opportunity to finance investment and consumption and to improve balance sheet resilience through debt management. Moreover， the larger capital inflows into the region are partly associated with improvements in fundamentals and therefore represent a permanent shift in investors’ portfolio allocations. As such， some equilibrium appreciation of real exchange rates would be expected to ensue. The traditional macro configuration of this process， involving both a permanent and transitory component， includes some widening of the current account deficit， some exchange rate appreciation， along with greater net capital inflows to finance the larger current account deficit. High commodity terms of trade open opportunities that are similar in certain macro effects: they provide higher income to spur consumption while also raising incentives for real investment to expand production of commodities， also adding to domestic demand. Moreover， high commodity export prices tend to lead to appreciation of the real exchange rate.However， the intensity of current global circumstances， with an important transitory component， could be conducive to the buildup of substantial vulnerabilities and heightened risks of setbacks， as the double tailwinds can provide a 1 sense of strength. Two distinct albeit related risks are critical: an eventual high external current account deficit and the possibility of excess domestic intermediation of the financial system.In contrast to the situation of some other EMs， external current account deficits in LA pose a constraint to the region’s role in global rebalancing without overstretching into vulnerable external positions. Structural features in LA are a distinct differentiating factor from other EMs. These include tendencies in national rates of saving and investment that place the region in a more vulnerable position because of current account deficits， open capital accounts that leave countries widely exposed to the current exceptional easy money circumstances， and low levels of sovereign debt that make the region an attractive destination for inflows. In this context， the current juncture of prolonged easy money has the potential to substantially widen external deficits in LA， bringing the region closer to a risky external position. As noted above， the size of the required global rebalancing is clearly too large to be absorbed only by Latin America. In this context， policies that tend to limit excess absorption and current account deficits for a systemic group of EMs with existing current account deficits， including in some circumstances temporary capital account restrictions， can help enhance global stability. This is particularly relevant in a world of substantial capital account restrictions among systemic EMs and second-best policy responses in many AEs.Large external current account deficits have been and may continue to be a critical vulnerability for LA， the size of the current account deficit merits attention separate from assessments of real exchange rates. In theory one might think of a simple mapping between current account deficits and real exchange rates， or some concept of real exchange rate misalignment. But in practice， the latter is a much more difficult metric to operationalize in terms of risk， in part because of the challenges in assessing equilibrium real exchange rates. In fact， if there is one statistic that has shown to be robust in determining the likelihood of current account reversal episodes， a rapid and large retrenchment of a current account， it is the initial size of the current account deficit in EMs. And fast adjustments of the current account are almost always painful in terms of the real economy. Moreover， once the drag from the debt overhang is worked out and the recovery takes hold in advanced economies， EMs may have to cope with a swift increase in foreign interest rates. This process could be rapid and substantial when markets reassess prospects of long-term interest rates. Moreover， difficulties in a handful of countries with large imbalances could be enough to generate crosscountry contagion to others with more moderate imbalances.In the past， LA’s external current account deficits became excessive under easy external financing conditions as a result of traditional distortions and externalities， as well as policy slippages. Distortions can affect the financial sector， foreign investors， and domestic borrowers. Financial intermediation can be procyclical and exacerbate the expansionary effect of capital inflows. Corporate financing can become excessive if individual borrowers undertake similar actions that increase aggregate risk but are not internalized at the individual level， and foreign investors are willing to lend under those circumstances. Fiscal policy may become dangerously procyclical as revenues boom， and underlying current account balances may weaken substantially， even though headline fiscal and current account balances may not appear overly vulnerable at current commodity export prices. Moreover， even if financial sector vulnerabilities could be contained， corporate can have direct access to foreign financing to undertake investments that， even if FDI， could pose excessive external risks. The region has shown in the past that it can be prone to excess domestic demand when foreign financing conditions are lax， linked in part to relatively open capital accounts and to access to credit by otherwise liquidity constrained agents.The second critical concern is excessive risk taking in the financial sector leading to potential vulnerabilities. The financial sector is particularly susceptible to playing an amplifying role in the development of credit and asset bubbles and excess absorption， potentially exacerbating the impact during the later reversal of capital flows. But even if prudential measures could dampen the amplifying effect of the financial sector， corporate would still face easy foreign financing conditions and could be able to borrow directly from abroad， thus bypassing the domestic financial system. Such corporate could be prone to over-leveraging and excessive currency and maturity mismatches which， in turn， would pose risks to the domestic banks that are exposed to those companies.III How should Latin America build its policy response?The unusual magnitude and expected duration of today’s easy foreign financing conditions and high terms of trade for LA may require the use of many or even all policy margins， albeit in different degrees and sequencings. The appropriate set of policy responses for a Latin American economy over the next few years， while exceptional conditions persist， will depend on the nature of concerns and vulnerabilities， which in turn depend on structural and other initial conditions， including， critically， the stage in the economic cycle. In all cases， a priority is to set macroeconomic policies right. Indeed， one key message of this section is that fiscal policy needs to shift gears， leaving behind its expansionary bias during the global recession. Saving temporary fiscal revenues is paramount at the current juncture. That said， capital account restrictions could be needed in some cases， but they cannot substitute for the necessary adjustments in macroeconomic policies. They should be seen with a macroeconomic stability motivation in mind–to avoid excessive risk from large current account deficits–rather than an aim of targeting the exchange rate. Indeed the success of policies to confront today’s environment cannot be defined in simple terms of the level of the exchange rate. In practice， the policy response is likely to need to advance on many fronts， in overlapping timeframes and at varying speeds， because of implementation lags and constraints， including in the fiscal and macro-prudential policy fronts. This means that a range of policy sequencings， depending on country circumstances， can help reduce the risk of boom-busts and thereby contribute to global stability.The most essential and high priority lines of action are to align the macro policy stance and monetary/fiscal policy mix， allow the exchange rate to move in line with the country’s cyclical position， and strengthen macro-prudential financial regulation and supervision. As discussed below， the policy stance needs to reflect that in times of private sector exuberance， the public sector should not itself add more fuel to the fire. The policy mix needs to avoid placing too much of a burden on monetary policy since higher policy interest rates would attract carry trade inflows. In this context， fiscal policy should avoid being procyclical， that is， at least aim to be acyclical， and should be countercyclical if public debt is at vulnerable levels. Currency appreciation is generally desirable on cyclical and “defensive” grounds (to avoid one-sided bets)， although FX market intervention also has some role in the response， particularly after a substantial degree of appreciation has been allowed and one-sided bets have subsided. Macro-prudential policies will be an essential pillar of the policy response in all configurations.IV Concluding remarksThe Latin American region is facing exceptional global circumstances that are causing large and prolonged capital inflows into the region and high terms of trade. The appropriate policy response for Latin America to this exceptional alignment of global circumstances is an array of policies: allowing flexible exchange rate regimes to play their cyclical role and defensive part against easy foreign financing; pursuing fiscal policies that are at least acyclical; proactively strengthening micro-prudential frameworks and introducing macroprudential policies that shield the financial sector and reduce pro-cyclicality; and， in some circumstances， to avoid excessive risk from large current account deficits， using capital account restrictions to preserve macroeconomic stability. Such potential temporary recourse to capital account restrictions in Latin America should be seen as a defensive move to prevent future crises， thereby contributing to global stability in a world of second-best policies. In practice， the policy response is likely to need to advance on many fronts at varying speeds because of implementation constraints and lags， including on the fiscal and macro-prudential policy fronts. Capital account restrictions， however， should not substitute for essential adjustments to macroeconomic policies and the strengthening of macro-prudential policies.(Author: from International Monetary Fund)