Policy Trade-offs for Unprecedented Times
After an Indian summer that lasted well over a year into the financial crisis that started in the United States, by mid 2008, and especially after the collapse of Lehman Brothers, the global crisis caught up with Latin America and the Caribbean, putting an end to one of the most buoyant periods in its recent history. Since then, currencies have depreciated sharply, stock prices have experienced severe falls, and growth forecasts have been revised dramatically downward, with the region now expected to display negative rates of growth in 2009.
However, something appears to be different this time. After all, although the region was hit hard, it has so far withstood the crisis without major financial turbulences. Generally speaking, the region has to date avoided currency and debt crises and bank runs, so typical of previous episodes of global financial turbulence (1982, 1998, and 2001). The ability of the region to resist an extremely severe external shock without major crises appears to suggest that it has now graduated from being exceptional and has earned the “privilege of normality”.
Why the “privilege of normality”? Because, in contrast to past episodes of global financial turbulence, the region entered the current global crisis with much stronger fundamentals: low inflation, twin external and fiscal surpluses, a sound banking system, a large stock of international liquidity and more flexible exchange rate regimes. Stronger fundamentals have allowed governments to respond with “standard” countercyclical monetary and fiscal policies to mitigate the impact of adverse external shocks, in sharp contrast with past episodes of financial turbulence, when countries in the region reacted procyclically, raising interest rates and tightening fiscal policy in response to a worsening global scenario.
This time, as a result of the combination of fundamental strength and the associated ability to pursue countercyclical policies, the region is expected to withstand the global storm better than in the past, and than other emerging economies. In fact, the case could be made that the impact of the global crisis will be short lived, a relatively deep recession expected in 2009 followed by a return to positive growth in 2010. Equally importantly, the case could be made that this time the impact will be mostly limited to the real sector, and liquidity crises and economic collapses will be largely prevented.
So far events appear to be validating this view. Or do they? This report will argue that this view is essentially correct only under the assumption that the recession in the United States bottoms out in the first half of 2009 and the economy starts a relatively strong recovery thereafter—the so called V-shaped recovery. A recovery like this in the US will in turn improve the outlook for industrial country growth, commodity prices and global financial conditions, key external drivers of Latin America and the Caribbean’s economic fluctuations. In such a scenario, the region will be out of the woods relatively unscathed.
This might well be the case. However, the evidence available from previous severe financial crises suggests that they tend to be deeper and last longer than run-of-the-mill recessions. On average, during these episodes it takes about four years for output to return to pre-crisis levels.
As this report will illustrate, a moderate perturbation from the V-shaped scenario, i.e., a more protracted L-shaped recovery although not a deeper recession, consistent with the evidence on financial crises, may deteriorate significantly key macro fundamentals in the region—fiscal, banking and liquidity indicators. Importantly, a key feature of this alternative scenario is that the deterioration in fundamentals is gradual and therefore problems may not become evident until it is too late.
The aim in this report is to not to be pessimistic or raise unnecessary alarms. Rather, the purpose is to heighten awareness of how perfectly feasible alternative scenarios can dramatically change outcomes, and to call attention to the risks faced in such a case. Thus, the challenge for the region’s countries—and for the international financial institutions engaged in the region—is to anticipate potential problems early on so as to act in a timely fashion; and if so needed, to design policies to prevent countries from entering into financially hazardous territory where they can be exposed to a financial crisis and a major economic collapse. Given the region’s past history, complacency is a luxury that policymakers and multilateral institutions cannot afford. It is not a question of optimism or pessimism, but of caution and prudence in assessing options and risks during unprecedented times. The analysis presented here should be useful to that task.
The analysis is carried out from a regional perspective. Given data limitations, in what follows the “region” consists of the seven largest countries, namely, Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela (henceforth LAC-7), which together account for 91 percent of the region’s GDP.5 Carrying out the analysis from a regional perspective proves to be a useful abstraction since it permits identification of common risks, challenges and policy trade-offs. However, it must be stressed that heterogeneity is a key element accounting for the dynamics of each country’s performance. Although performance will depend crucially on external factors common to all countries, such as the duration and deepness of the global crisis, it will also depend critically on idiosyncratic country characteristics, i.e., the strength of their fundamentals and the appropriateness of their policy responses.
The rest of this report proceeds as follows. Section 2 reviews the region’s economic performance and the evolution of key macro fundamentals in the five-year period preceding the Lehman collapse. Section 3 describes the immediate impact on the region of the post-Lehman world and what may be called the predominant view as to how the region will withstand this more virulent phase of the global crisis. Sections 4 and 5 develop an analytical framework that highlights the importance of liquidity issues— key under precarious access to credit markets and often neglected in policy analysis. This framework is used to evaluate the predominant views on the region. To do this, two alternative scenarios are constructed for the global economy. A key result is that that under a moderately less favorable global scenario than the one currently being discounted by the markets, the region’s outlook may change very significantly. Section 6 concludes with an analysis of the relevant policy trade-offs for the region and some policy principles that emerge from the framework of this report.
For detailed information, please find the IDB report: www.thedialogue.org/uploads/Op_Eds/Policy_Trade-off_for_Unprecedented_Times.pdf.
