The New Face of LAC and Challenges Ahead: Capital Inflows and Commodities

1. The New Face of LAC and Challenges Ahead:Capital Inflows and Commodities Augusto de la Torre XXI Seminario Anual CIES 2010 Lima, Perú 17 de diciembre del 2010 Chief Economist Office Latin America and the Caribbean The World Bank 1

2. Agenda • LAC breaking with the past: financially globalized yet resilient • Resilience through the cycle • Driving forces of resilience and performance • Policy-related and exogenous • Policy challenges • Dealing with frothy capital inflows • Harnessing benefits/avoiding risks of natural resource abundance

3. LAC breaking with the past: financially globalized yet resilient

4. Defining and measuring resilience • Definition – resilience is the ability to: • Withstand the initial external shock • Engineer a fast and strong recovery • Conduct counter-cyclical policies in bad and good times • Measurement – indirectly, through an outcome variable (GDP) that actually reflects a combination of factors … • Size of the shock • Degree of exposure to the shock • Extent of resilience per se (“relative” resilience) • … which we sort out through econometric techniques and using appropriate comparators

5. Exposure to the shock: degree of financial globalization Note: Financial openness is the amount of inflows and outflows of capital as a percentage of GDP. In this graph, Central America excludes Panama (an outlier due to its condition as offshore financial center). Source: IMF’s BOP

6. Exposure to the shock: degree of trade openness Note: Trade openness is the sum of exports and imports as a percentage of GDP. Source: IMF’s WDI

7. Resilience: benchmarking LAC through the cycle Resilience in the downturn: not worse than the Asian Tigers • Downturn was highly synchronized around the globe • LAC was not immune, but its growth collapse (6.5 pp) was comparable to that of the East Asian Tigers and significantly smaller than that of ECA (13 pp) • Within LAC, the collapse was largest where trade openness is highest – the Caribbean (8.7 pp) -- and smallest in the less financially globalized countries of South America (6.2 pp) Resilience in the rebound: fast and strong growth recovery • LAC’s recession was shorter compared to previous crises and the MIC average • Brazil led the LAC pack: industrial production started to recover in 3 months! • Strong recovery: like other non-ECA MICs, LAC’s GDP in 2010 will be above its 2008 level (ECA: 1.7% below; HICs: 0.2% below) • LAC’s GDP will be closer to potential than the East Asian Tigers (who have higher potential) • Brazil, Peru, Argentina, Uruguay, Panama, and Dominican Republic lead the LAC pack

8. 2009 growth collapse: LAC no worse than the East Asian Tigers, but particularly bad for the Caribbean Notes: Growth collapses are defined as growth in 2009 minus growth in 2007. Country groupings are simple averages. Haiti is not included among Caribbean countries. Source: IMF's WEO (October 2010)

9. Resilience: benchmarking LAC through the cycle Resilience in the downturn: not worse than the Asian Tigers • Downturn was highly synchronized around the globe • LAC was not immune, but its growth collapse (6.5 pp) was comparable to that of the East Asian Tigers and significantly smaller than that of ECA (13 pp) • Within LAC, the collapse was largest where trade openness is highest – the Caribbean (8.7 pp) -- and smallest in the less financially globalized countries of South America (6.2 pp) Resilience in the rebound: fast and strong growth recovery • LAC’s recession was shorter compared to previous crises and the MIC average • Brazil led the LAC pack: industrial production started to recover in 3 months! • Strong recovery: like other non-ECA MICs, LAC’s GDP in 2010 will be above its 2008 level (ECA: 1.7% below; HICs: 0.2% below) • LAC’s GDP will be closer to potential than the East Asian Tigers (who have higher potential) • Best performers are the financially globalized commodity exporters like BRA, PER, and URU

10. Size and duration of downturn: LAC better than its past and ahead of the MIC average Cyclical Growth Dynamics in a Comparative Setting Notes: In the figures, period T stands for the Peak year in GDP business cycles. The sample of LAC countries includes: Argentina, Brazil, Chile, Colombia, Costa Rica, Ecuador, Mexico, Peru, and Venezuela. Sources: Calderón and Servén (2010), EIU, Haver Analytics, LAC Central Banks and Statistical Offices.

11. Heterogeneity across LAC countries in terms of the length of the recession (based on IP indexes) Sources: World Bank’s Global Economic Monitor (Oct 2010).

12. Strength of the recovery: LAC recovering potential output faster than the Tigers Notes: Trend GDP, used in Panels B and C, is defined as the GDP that each country would have attained if it had grown between 2008 and 2010 at the same pace as in between 2000 and 2007. Sources: Didier, Hevia, and Schmukler (2010).

13. Strength of the recovery: LAC growth in 2010 trails East Asia, but some LAC countries with Asian-like growth rates Country groupings are weighted averages. Haiti is not included among the Caribbean countries. Source: Consensus Forecasts (November 2010).

14. LAC: 2010 growth recovery has vastly exceeded expectations… Source: Consensus Forecasts (March 2009 and November 2010).

15. … especially among the most financially globalized commodity exporting LAC countries Source: Consensus Forecasts (March 2009 and November 2010).

16. Resilience: benchmarking LAC through the cycle (2) Shielding the poor • While a year ago 10 million people were expected to fall into poverty ($4 a day) in 2009, we now know (actual data) that only 2.1 million people did • Poverty increased mainly in Mexico and some Central American Countries; it actually continued to decline (at a lower rate) in Brazil, Peru, Uruguay • If poverty reduction is as elastic to growth as it was during the 2000-2007 expansion, 7 million Latinos will climb out of moderate poverty in 2010 Unexpectedly strong labor market performance • During 2009, the LAC unemployment rate increased much less than in ECA and slightly more than in the East Asian Tigers ... • ... the increase in unemployment given the decline in GDP was much milder than in previous crises • ... the trend towards labor market formalization was not reversed … • … and all this despite constant or increasing real average wages

17. Shielding the poor: milder increase in poverty compared to the past and heterogeneous effects within the region Source: The World Bank, 2010. “Did Latin America learn to shield its poor from economic shocks?” Washington, DC: The World Bank, Latin America and the Caribbean Poverty Sector (LCSPP)

18. Resilience: benchmarking LAC through the cycle (2) Shielding the poor • While a year ago 10 million people were expected to fall into poverty ($4 a day) in 2009, we now know (actual data) that only 2.1 million people did • Poverty increased mainly in Mexico and some Central American Countries; it actually continued to decline (at a lower rate) in Brazil, Peru, Uruguay • If poverty reduction is as elastic to growth as it was during the 2000-2007 expansion, 7 million Latinos will climb out of moderate poverty in 2010 Unexpectedly strong labor market performance • During 2009, the LAC unemployment rate increased much less than in ECA and slightly more than in the East Asian Tigers ... • ... the increase in unemployment given the decline in GDP was much milder than in previous crises • ... the trend towards labor market formalization was not reversed … • … and all this despite constant or increasing real average wages

19. Labor market performance: unemployment less responsive to the downturn than previously in most of LAC Note: Previous recession periods are: Argentina (1998.Q4 – 2002.Q2); Brazil (1997.Q4 – 1998.Q2); Chile (1998.Q3 – 1999.Q4); Colombia (1998.Q3 – 1999.Q4); Mexico (1995.Q1 – 1996.Q1), and Peru (1997.Q2 – 1999.Q1). Current recession periods are: Argentina (2008.Q3 – 2009.Q2); Brazil (2008.Q4 – 2009.Q2); Chile (2008.Q3 – 2009.Q3); Colombia (2008.Q3 – 2009.Q2); Mexico (2008.Q2 – 2009.Q2), and Peru (2008.Q2 – 2009.Q1). Source: LCRCE Staff calculations based on National Statistical Institutes data.

20. Driving forces of resilience and performance

21. Driving forces • Policy related • Silent revolution in macro policy frameworks • Safer international financial integration • Diversification of export markets – the China connection! • Exogenous • Terms of trade • Return of risk appetite in financial centers

22. The driving forces: policy-driven Silent revolution in macro-financial policy frameworks • In a break with history, what used to be shock amplifiers were turned into cushions: currency, banking system, fiscal process • … and this enabled counter-cyclical policies, particularly in monetary policy and to a lesser extent in fiscal policy • No financial crises at home this time around

23. LAC breaking with history: countercyclical macro policy Notes: Panel C reports the average quarterly variation (in percentage points of GDP) of the cyclically-adjusted primary balance of LAC-6 countries during the global downturn associated to the 2008 - 2009 financial crisis and during previous crisis. Negative (positive) values indicate an expansion (contraction) in discretionary fiscal policy. Sources: IMF’s “Fiscal Monitor: Navigating the Fiscal Challenges Ahead” (May 2010), ECLAC, and Bloomberg for Panels A and B; and LCRCE staff calculations based on Haver Analytics, Datastream in Panel C.

24. LAC and the East Asian Tigers: Flexible exchange rates cushioned the shock this time… Notes: This figure depicts the behavior of the nominal exchange rate around crises episodes of external origin to the region in question. Sources: Didier, Hevia, and Schmukler (2010).

25. … not least because reduced currency mismatches helped dispel the “fear of floating” in most of LAC Sources: Gozzi et al (2009), Reinhart, Rogoff and Savastano (2003), IFS.

26. LAC breaking with history: no systemic damage at home Financial Crises Around the World

27. The driving forces: policy-driven (2) Safer international integration… • The region became a net creditor in debt and a net debtor in equity … in the midst of financial re-coupling • While EM policy fundamentals boost economic resilience, they are not the main drivers of financial asset performance • EM asset returns have become more sensitive to common factors than to differences in EM fundamentals • The co-movement of asset returns across the world has increased over time, reducing the gains of international portfolio diversification

28. LAC has migrated towards a safer form of integration into international financial markets Note: The net debt position (vis-à-vis ROW) is the sum of debt assets and reserves minus debt liabilities. In turn, the net equity position (vis-à-vis ROW) is the sum of net FDI assets and net portfolio equity assets. The sample ranges from 1990 to 2008. Source: Lane and Milesi-Ferretti (2007).

29. The driving forces: policy-driven (2) Safer international integration… • The region became a net creditor in debt and a net debtor in equity … in the midst of financial re-coupling • While EM policy fundamentals boost economic resilience, they are not the main drivers of financial asset performance • EM asset returns have become more sensitive to common factors than to differences in EM fundamentals • The co-movement of asset returns across the world has increased over time, reducing the gains of international portfolio diversification

30. The variance of EM asset return is increasingly explained by common factors Notes: A principal component is estimated for returns on equities, on foreign exchange spot contracts, and on CDS sovereign spreads. Then, country-specific returns for each asset class are regressed on its associated PC1 in order to get an R-squared. The average R-squared is being reported for countries within each region. See Levy Yeyati (2010) for more details. Sources: Bloomberg.

31. The driving forces: policy-driven (2) Diversification of export markets • The share of the US and Europe in many LAC country exports has fallen, as that of Asia has been rising Real de-coupling from HIC and increased coupling with China • Over time, economic activity in EMs has become less sensitive to economic activity in HICs, and more sensitive to economic activity in China

32. The China connection: LAC countries has been sharply intensifying trade and FDI links to Asia Source: IMF’s Direction of Trade Statistics (DOTS).

33. Real de-coupling: growth in EMs has become more sensitive to China and less sensitive to the G-7 Notes: The late period goes from 2000 to 2009. Median sample estimations report the median values from country-by-country regressions. G-7 growth was computed as the average of individual growth rates weighed by the dollar GDP in the previous year. Non-Euro Advanced Economies include Australia, New Zealand, Norway, and Sweden. For panel regressions, ***,** and * denotes significance at a 1%, 5% and 10% respectively. P-values are reported in parentheses. Sources: IMF's IFS.

34. The co-movement of growth between LAC countries and China has been clearly trending upward… Source: National Authorities. Note: Solid colors reflect correlation values significant at a 10% confidence interval.

35. The driving forces: exogenous factors Rebound in commodity prices • Commodity prices started rebounding in Jan 09 and are at their 2007 level • Asymmetric effects on the region (South America vs. Central America) Pronounced move towards risk appetite in financial markets • The comeback of risk appetite has contributed to strong capital inflows to LAC, and intensified the strength of the recovery • Capital inflows to the region in 2010 are already higher than those observed in 2007

36. Commodity prices rebounded quickly, with asymmetric effects across the region Around 93% of LAC’s population and 97% of its economic activity is in countries which are net exporters…. Source: Bloomberg.

37. The driving forces: exogenous factors Rebound in commodity prices • Commodity prices started rebounding in Jan 09 and are at their 2007 level • Asymmetric effects on the region (South America vs. Central America) Pronounced move towards risk appetite in financial markets • The comeback of risk appetite has contributed to strong capital inflows to LAC, and intensified the strength of the recovery • Capital inflows to the region in 2010 are already higher than those observed in 2007.

38. A swing from risk aversion to risk appetite is boosting capital flows to EMs Sources: Bloomberg

39. Capital flows to LAC have surged in 2010 to levels higher than those observed in 2007 Source: National BOP data. LAC-7 countries comprise Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela.

40. Policy challenges (Assuming the HICs do not drag all down)

41. Capital inflows - where is the problem? • Surging capital flows to LAC are a problem inasmuch as they entail: • Distortions that give rise to global imbalances – an international coordination failure • Mood swings/exuberance that underpin “frothy” and unduly volatile flows – a collective cognition failure • Potentially lasting impact on the LT growth and systemic stability of the recipient countries – negative externalities • Uncoordinated responses to global imbalances and center-periphery asymmetries in output gaps… • …raise currency appreciation pressures in LAC more than otherwise… • FX intervention to resist currency appreciation is the dominant response in the larger LAC countries • Monetary policy is currently over-burdened

42. Capital inflows surge and global rebalancing Interest rate differentials / risk appetite comeback “Frothy” capital inflow surge to EMs HIC-EM asymmetry: output gap & inflation pressures EM resistance to appreciation (to dollar depreciation) Global imbalances Lower than otherwise interest rates in HICs  QE2 • Global coordination failure • What is good for a particular nation is not necessarily good for the world

43. Currency appreciation pressures are already felt and bound to intensify in several LAC countries… Note: The Exchange Market Pressure Index is the weighted average of year-on-year percentage changes in: (a) the nominal exchange rate of the local currency vis-à-vis the US dollar (such that an increase represents an appreciation of the LAC currency), and (b) the level of international reserves. The weights are given by the inverse of the annual standard deviation of the changes in the nominal exchange rate and the standard deviation of the changes in reserves. An increase in the Exchange Market Pressure index signals appreciation pressures and/or accumulation of reserves. Source: LCRCE Staff calculations based on IMF’s IFS. Figures updated until October 2010

44. Policy options: two unpalatable corner solutions • Allow an overshooting appreciation of the nominal exchange rate until the interest rate differential reflects expected depreciation • Pros: conceptually clean; consistent with low inflation target; and easy to implement, at least technically • Cons: (i) consumption feast now with adverse growth effects later (irreversiblilities and non-fundamentals driven inflows) (ii) first-mover disadvantage: an even greater appreciation would be needed if the emerging country is the only one to do it (prisoner’s dilemma) • Lower policy interest rates until differential disappears and let inflation do the trick • Pros: it would result in less real exchange rate overshooting (inflation adjusts sluggishly compared to the nominal exchange rate) • Cons: it would sacrifice 20 years of monetary virtuousness, with lasting adverse effects on central bank credibility

45. First-best solution: tectonic change in policy mix • Loosen monetaryto eliminate interest rate differential… • … andtighten fiscal and macro-prudential policiessufficiently to anchor inflation expectations • Macro-prudential policy • To induce the internalization of risks both to the financial sector and the economy, thereby affecting the business cycle itself • Options: counter-cyclical provisions/capital; lower LTV ratios; tax on whole-sale ST funding; tax on external & domestic credit; etc. • Pros: (i) gets individual country to its first-best (first mover advantage); (ii) increased inflows, if any, would tend to be of the good kind (FDI) • Cons: (i) self-defeating in the aggregate if everybody does it; (ii) major political economy constraints to implementation

46. The pragmatic hybrid solution can be improved • The hybrid approach – do a little bit of every thing according to what is politically and technically feasible … • FX intervention; tolerance on inflation targets to dampen increases in interest rates; controls on inflows; some taming of fiscal expansion; some macro-prudential • … can be improved by rebalancing in favor of fiscal and, especially, macro-prudential policies to relieve burden on central banks • Fiscal policy has become pro-cyclical in many LAC countries during 2010 • Macro-prudential – LAC is in a learning-by-doing mode • Pros: option value of wait and see; limit first mover disadvantage • Cons: larger scope for distortions/dead-weight losses associated with expanded use of macro prudential to compensate for insufficient fiscal • Some global coordination may be forthcoming (G20) and would help, but • Further push is needed to ensure it happens and LAC should play a role in that push • Even if happens, it would be insufficient to solve LAC’s policy mix problem

47. Can LAC break with its past and use its natural resources to turn the cyclical recovery into higher long-run growth? Source: Maddison (2009) and IFS’s WEO (October 2010)

48. The latest commodity price boom has been unusually broad-based and long-lasting The most comprehensive in terms of the number of commodities it affected… … and the number of countries it benefited For LAC, it has been the longest lasting boom since records have been kept LAC-7 Economies: Share of Commodities Experiencing a Boom Source: World Bank staff calculations based on export commodity price data from Cunha, Prada and Sinnott (2009a, 2009b). Note: The figure represents the share of the LAC-7 economies Top 16 commodities experiencing a price “boom” for each period of time. Booms and bust in commodity prices were defined following the Bry-Brochan cycle dating exercise. The figure also shows the boom-bust intervals for the overall commodities index.

49. Natural resource curse hypothesis: should LAC worry about becoming the granary and mine of China? Three valid concerns … • Productivity/growth trap • Technical upgrading, spillovers, linkages, diversification? • Institutional/political trap • Rent-seeking behavior, institutional capture, reduced resource mobilization efforts? • Complications associated with decentralization (ear-marking)? • Environmental and social sustainability And one red herring (Prebisch-Singer Hypothesis) • Recent econometric evidence does not support theory that commodity prices are on downward trend and, even if so, that it would adversely affect growth

50. Long term savings – needed to convert natural capital into other forms of wealth … even if prices were not volatile • Sad reality: savings negatively correlated with resource rents • Too much of the rent is consumed, not invested • Harsh reality: difficult to save • High social discount rate, given pressing development needs • Difficulties in organizing collective action in inter-temporal horizon • The pace of local investment of LT savings matter – to avoid Dutch Disease