By Zaahira Wyne, Shimelse Ali and Bennett Stancil
If (a big if) the global economy proves resilient, economic trends in Latin America appear favorable. Growth is expected to stay robust, though it decelerated in the second half of 2011 and is projected to slow further in 2012. Unemployment is gradually declining, foreign direct investment growth has continued, and fiscal balances remain solid.
But there are still big external risks. Despite Latin America’s limited trade linkages with Europe, the financial fallout from a eurozone breakup, for example, would be extreme and difficult to predict—and bound to severely affect all emerging markets. Policymakers should continue to adopt a prudent fiscal and monetary policy stance and be prepared to respond to another serious global economic downturn, even as they work towards addressing a number of structural challenges.
Promising Domestic Trends
As a whole, Latin America’s near-term domestic economic and fiscal outlook is promising. Supported by strong external demand from other emerging economies and robust domestic demand―which outpaced GDP growth in each of the last two years―as well as high commodity prices, GDP over the first nine months of 2011 grew by nearly 5 percent. However, growth slowed down significantly in the second half of the year, due in large part to policy tightening implemented in response to overheating and weak growth in advanced economies. For example, Brazil’s year-on-year quarterly GDP growth slowed from 4.2 percent and 3.3 percent in the first and second quarter of 2011 to 2.2 percent in the third quarter.
Various estimates for 2011 and forecasts for 2012 underline this trend of moderating growth. According to the International Monetary Fund ( (NYSE:IMF)), Latin America grew by an estimated 4.5 percent in 2011 and is projected to grow by a still-strong 4 percent in 2012. The Economist Intelligence Unit and World Bank, however, see the region’s growth slowing down from 4 and 4.2 percent in 2011 to 3.5 and 3.6 percent in 2012, respectively. Still, estimated growth in 2011 for most of Latin America’s major economies, with the notable exception of Brazil, is projected to be higher than that observed in the decade before the Great Recession (see figure 1).
(Click charts to expand)
Unemployment in the region is declining, though only gradually. In Latin America’s ten largest economies, the unemployment rate is expected to edge downward from 9 percent in 2009 to 8 percent in 2011, though some economies such as Mexico will likely face an unemployment rate higher than that observed in 2008.
With net commodity exports accounting for a large share of GDP in Latin America (10 percent of GDP in South America1), the region has benefitted greatly from high commodity prices—agriculture and energy prices in dollars (adjusted for the U.S Consumer Price Index) have increased by 147 percent and 400 percent, respectively, since 2002. The IMF’s price indices for food and industrial inputs (raw materials) both jumped by more than 20 percent in 2011, as compared to 2010.
Although the turbulence in Europe and the United States significantly reduced portfolio flows to the region, foreign direct investment (FDI), which is less volatile than other financial flows and accounts for a large share of those flows to the region, remained resilient. The latest data from the World Bank shows that net FDI inflows to Latin America rose by an estimated 29 percent in 2011—the strongest growth posted among developing regions—after increasing by 43 percent in 2010. Portfolio inflows fell by 60 percent, after staying flat in 2010.
Furthermore, while advanced economies continue to struggle with large deficits, public debts, and, in a few cases, unsustainable debt costs, the fiscal outlook for Latin America is generally strong. In total, debt has stayed around 50 percent of the region’s aggregate GDP; of the 10 largest economies, only Brazil has debt above this threshold (65 percent). And most countries in South America and Central America are projected to run small fiscal deficits this year and to have room to administer stimulus if needed. However, policy space is generally more limited in 2011 and 2012 as compared to 2008. For example, according to the World Bank, the average fiscal deficit in Latin America in 2011–12 is expected to be 1.4 percentage points higher than that during 2004–08, partly reflecting higher spending during the recent financial crisis.
Latin America’s relatively bright domestic outlook owes much to the region’s stronger macroeconomic fundamentals. Over the past decade, Latin America has improved its macroeconomic management, adopting inflation targeting and more flexible exchange rate regimes that help moderate the impact of large swings in capital inflows and following fiscal and debt sustainability rules. An accumulation of foreign reserves has, moreover, helped cushion Latin America’s balance of payments. These buffers helped the region weather the 2009 recession relatively better than the rest of the world when compared to previous global recessions. But Latin America still trailed behind other emerging regions; GDP shrunk by 1.7 percent, while Asia, the Middle East, and Africa continued to grow.
Though the region remains weak competitively—the modest gains observed in recent years have lagged those of other emerging regions such as Asia and Eastern Europe—several of the largest economies in Latin America (pdf) rose in the World Economic Forum’s 2011–2012 Global Competitiveness Report rankings. Mexico rose eight spots in the rankings thanks to its large domestic market, developed transportation infrastructure, and efforts to ease regulatory burdens on new businesses. Brazil moved up five spots, in part because it has one of the region’s highest rates of technology adoption and innovation.
The region, however, still faces major challenges, including weak institutions, underdeveloped infrastructure, and low levels of competition in many sectors.
While overheating pressures have eased due to slowing growth, inflation is estimated to have increased in 23 of the 33 Latin American economies in 2011 and remains just under 6.7 percent, which is only a shade below the region’s average inflation rate of 7 percent over the past decade. But this average masks a wide range in South America; inflation is under 4 percent in Chile, Colombia, and Peru, but 6 percent in Brazil (which is above the 4.5 percent official target), an overheating risk several months ago, and 25 percent in Venezuela.
By far the largest risks are external. They could be extreme if the eurozone breaks up or less severe if growth in Asia is curtailed. Trade and financial linkages with Europe suggest, however, that the region is not as exposed as other developing regions. The European Union accounts for 13 percent of Latin America’s exports. Other areas of the developing world such as Asia and the Middle East are much more dependent on the EU as an export market, sending 50 percent and 20 percent of their exports there, respectively. But there are cross-country differences (see figure 2); the EU accounts for 20 percent of exports from countries such as Panama, Brazil, and Peru and as little as 5 percent from Mexico.
But if the United States suffers another recession—most likely triggered by deterioration in the European debt crisis—Latin America’s exports would take a bigger hit. The United States accounts for 40 percent of Latin America’s exports, three times the EU’s share. Recent data suggest that the slowdown in the United States and European Union may have in fact already affected Latin America’s export growth. The change in the three-months moving average for exports (3m/3m, percent change), a measure of export growth momentum, has been negative since June. A global slowdown would also put downward pressure on commodity prices, potentially another important source of shocks in Latin America.
The region appears to be less financially exposed than emerging Asia, Eastern Europe, and the Middle East, to European banks, though a full-blown banking crisis in Europe would have far-reaching global repercussions and would be bound to affect Latin America. Credit flows from European banks are modest compared to those for other regions. For example, European banks’ foreign claims account for around 14 percent of Latin America’s GDP, compared to 40 percent of Central and Eastern Europe’s GDP. According to the World Bank, moreover, a severe European crisis affecting two large eurozone economies would lower Latin America’s GDP by about 3 percent in 2012 relative to its baseline—a significant impact, but less so than for other developing regions.
Given the prevalence of external risks, the economies of Latin America should continue to pursue appropriate fiscal and monetary policies in order to preserve their room for maneuver. They may again find themselves forced to navigate a narrow strait between sustaining domestic demand in a downturn and controlling inflationary pressures.
In the medium term, the region’s disappointing productivity growth raises questions about the sustainability of its recent progress. Latin America should continue to focus on improving its competitiveness and will especially have to address the innovation gap, where it trails many other developing regions, by mobilizing public and private resources for education and research and development.
Zaahira Wyne is the managing editor of the International Economic Bulletin. Shimelse Ali is an economist in Carnegie’s International Economics Program. Bennett Stancil is a researcher in Carnegie’s International Economics Program.