On May 16, the Brookings Global-CERES Economic and Social Policy in Latin America Initiative hosted a panel discussion on the implications of these new global and regional trends for the political and macroeconomic outlook in Latin America, including whether these new trends could reverse the institutional, economic, and social progress of the last 20 years.

      

 

 

As the committee has been claiming in past statements, the region has been facing a confluence of adverse events since at least the year 2013. These have come as waves: an event materializes, then there is a period of calm and then another comes. Until mid-2016, these (interrelated) events included: (1) the lack of dynamism in advanced economies; 2) China’s economic slowdown; 3) the sharp fall in the price of the region’s export commodities; 4) the appreciation of the dollar; and 5) the fall in capital flows. Unlike other periods of financial turbulence due to external factors, since 2013 these events have been long lasting. This implies that their effects on the region have been accumulating and the economies have been weakening even in a context of low interest rates and broad international liquidity.

Since mid-2016, a new wave of political developments in advanced countries has been shaking Latin America. This time the characteristics are different because they refer to the growth of the political movements that promote a reduction of globalization. In the United Kingdom, the Brexit phenomenon started this new trend and the presidential election in the United States cemented it.

This trend is still materializing because elections in other European countries could further strengthen anti-globalization positions in the advanced world.

Of all these developments, the most relevant has been Donald Trump’s election victory in the U.S. as he, with his campaign statements, has shaken the reigning political orthodoxy in both the Democratic and Republican parties. Although there is considerable uncertainty about the policies of a future Trump administration, as it has not yet begun, economic and financial variables have begun to anticipate what are considered to be the main consequences for the U.S. economy. For example, one month after the election, the dollar has strengthened 10 percent against the yen and 6 percent against the euro, the Dow has risen 7.7 percent, the volatility implied by the VIX is at nearly historically low levels and the consumer confidence index jumped 4.5 percent in December.

The perspectives of the future U.S. administration are associated with the following developments. First, the new administration is expected to reduce the tax burden on businesses and individuals, to adopt tax incentives to promote employment at the level of specific sectors and/or companies, and to try to implement a strong expansion of public expenditure on infrastructure. The result of this fiscal stimulus, which is expected to have no strong opposition in the U.S. Congress, will be a possibly significant increase in the fiscal deficit but also an expansion of aggregate demand. That is why different analysts of the U.S. economy are anticipating a higher rate of growth, at least in the short term.

However, these expectations have raised the yield on U.S. Treasury bonds in the long run. In particular, the possibility that the U.S. Treasury may resort to a significant issuance of “ultra-long-term” maturity bonds (over 30 years) may fuel the expectation of a steepening in the yield curve of U.S. Treasury bonds. The increase in the U.S. interest rate coincides with the beginning of a more rapid normalization period of the Federal Reserve’s monetary policy, with expected increases in short-term interest rates of between 50 and 100 basis points during 2017. Upward pressure on interest rates is also fueled by rising U.S. Treasury bond sales by China’s central bank, one of its biggest holders.

Second, the future Trump administration is expected to demonstrate greater trade protectionism, particularly toward China and Mexico, and to withdraw from the Trans-Pacific Partnership. As in the previous case, it is possible that greater protectionism in the U.S. may be expansive for the economy in the short-term, although it will probably generate very negative effects for the global economy. In addition, the apparent short-term success of such policies is likely to drive further growth of other anti-globalization and anti-system movements in the other advanced economies, particularly in Europe.

A sudden shift in policy by the world’s largest economy leads to worrying implications for the global economic outlook. First, fiscal expansion, as noted above, will increase international interest rates and this, as on previous occasions, may lead to greater volatility in capital flows affecting both emerging and advanced economies. Second, the more protectionist approach that is less interested in global coordination may increase the volatility of exchange rates between the major currencies (e.g., the U.S. dollar/euro rate), reviving the possibility of competitive devaluations at the global level. As a result, capital markets can easily experience severe turbulence.

As this committee has emphasized in its last statements, the Chinese economy has been facing severe difficulties prior to the presidential election in the U.S. These financial difficulties are largely the result of an extensive fiscal and monetary stimulus program that has led to an oversized formal and informal financial system. The consequent sharp decline in the rate of growth and the capital flows reversal has generated a steady reduction in the large stock of its international reserves, in order to contain a rapid depreciation of the renminbi. The committee believes that one of the main risks that would result from the adoption of more protectionist measures by the U.S. directed in particular toward China is that it might significantly aggravate a situation of pre-existing fragility. For example, a depreciation of the renminbi can be interpreted by the U.S. administration as currency manipulation.

This situation occurs in a context of increasing protectionism that has already been occurring, and is relatively sophisticated using para-tariff measures in the context of World Trade Organization rules. In fact, one of the salient features of the global economy has been the decline of world trade. For example, since 2008 the volume of global exports, as a measure of trade volume, has reduced its growth rate to half of what it was historically, even lower than the growth rate of global output.

In addition, Trump has announced the intention to relax existing environmental restrictions to the use of fracking techniques and the construction of oil and gas pipelines. This could lead to a significant expansion in the supply of unconventional hydrocarbons in the U.S., which, coupled with the effect of slower growth in China, could further depress international prices for energy products or, at least, keep them at low levels for an extended period.

Emerging economies are passive observers of these developments. With less flexibility of response than advanced economies, and in many cases with current account deficits, the emerging world and in particular Latin America is particularly exposed to the risks arising from the new policy approach in the north.

2.      What does this mean for the region?

The changes in the global economic scenario described in the previous section will affect the region through four main channels: 1) a likely increase in international interest rates; 2) additional difficulties in China’s economy due to its financial weaknesses; (3) increased U.S. protectionism and, in particular, its effect on the Chinese economy; and 4) a greater degree of uncertainty about the evolution of the main economic variables, including the exchange rates between major currencies.

Since 2013, the external scenario has progressively become more unfavorable. Capital flows to Latin America had been declining even before the U.S. presidential election, even at low interest rates. The reduction in capital inflows coexisted with a significant drop in commodity prices, but the impact was not so strong because, as international interest rates remained low, market liquidity was broad. Thus, despite the deterioration in the external scenario, the public and private sectors in the region have not suffered a serious interruption in their access to financing because central markets exhibited near zero or even negative real yields. The search for yields prompted international investors to provide the necessary financing to the region so that maturities could be refinanced even without new investment projects, especially in countries with stagnant or falling economic activity (e.g., Brazil).

If international interest rates increase, the region may now face a combination of factors that has generated serious problems in the past: (1) reduction of capital flows; (2) deterioration of terms of trade; and (3) an increase in the cost of financing for the public and private sectors.

The impact of a possible increase in the U.S. interest rate, and a possible appreciation of the dollar, will depend on the specific characteristics of each economy in the region, in particular the size and composition of public and private debt, and the space and credibility of the central bank to respond with a flexible monetary policy. For example, to the extent that debt is denominated mostly in foreign currency, the impact of an increase in the international interest rate will have a direct effect on the cost of financing. In addition, appreciation of the dollar will magnify this impact, measured in real terms. Faced with greater dollarization of debt, monetary policy will face more pressure to avoid significant movements in the exchange rate.

In the case of countries where debt is denominated in local currency, the effect of an increase in the international interest rate will depend on its transmission to domestic interest rates, inflation conditions, and the level of domestic indebtedness. In some countries, such as Brazil and Colombia, central banks raised interest rates to avoid losing control of inflation expectations, given the very severe devaluation that took place after 2013, even in a context of low international interest rates. In Brazil, once the effect of inflation rates began to subside, the domestic interest rate has begun to fall from very high levels, despite an increase in costs of financing in foreign currency.

Another important element in analyzing the effects of an increase in the U.S. interest rate on the region is the adequacy of the stock of international reserves, which was instrumental in limiting the effects of the global financial crisis of 2008-2009. In this sense, the situation of the different countries in the region is varied. At one extreme are Argentina, Ecuador, and Venezuela with low levels of international reserves as a proportion of their short-term debt, and in the other are Bolivia, Chile (including the government’s international assets), and Peru. The accumulation of reserves in Brazil, Colombia, and Mexico has also been significant.

The region’s ability to face more adverse external financial conditions such as what we have described will depend significantly on the economies’ fiscal positions. In the clear majority of the countries of the region, the structural fiscal position has deteriorated, particularly in Argentina and Brazil. In the case of Argentina, where there is a high degree of dollarization of public debt, this entails a high need for financing in foreign currency.

The second channel of transmission from the new external scenario to the region is commercial. In the committee’s view, the increased risks of increased protectionism are related to the effects on the economies of Mexico and China. At present, there are doubts about the permanence of the region’s free trade agreements with the U.S., with NAFTA (which affects particularly Mexico) having the greatest uncertainty. The potential increase of tariffs on products imported by the U.S. that it considers to be competition to the products manufactured domestically. However, the committee believes that the integration that already exists in the value chains of goods manufactured in NAFTA will act in the direction of reducing protectionist pressures toward Mexico. However, the simple uncertainty that has been generated based on the campaign statements can cause a halt to direct foreign investment in Mexico.

Greater protectionism toward China, on the other hand, can have a very significant impact on the region. In some cases, the destabilization of China’s already fragile situation will have a direct effect on economies that have tightened direct financial ties with China. For example, Ecuador and Venezuela, which have increasingly used China’s financing (between 15 percent and 25 percent of GDP, respectively, up to 2015), may face sudden stop in capital flows from that country.

A possible additional deterioration in the Chinese economy will affect the countries of the region that export commodities through a decline of these commodities’ prices. This phenomenon could be aggravated in the event of a significant dismantling of environmental restrictions in the U.S. Especially in the area of hydrocarbons, the eventual adoption of a less environmentalist position by the future U.S. administration may result in an increase in the supply of these products.

3.      Challenges and recommendations from the perspective of the Latin American experience

In the committee’s opinion, the external scenario facing the region in the coming years will be challenging. In this context, the region’s potential growth has declined reflecting a low rate of productivity and, in several countries, high levels of tax pressure. The space to use fiscal policy to stimulate the economy has been reduced. The committee’s recommendations should be seen as a contribution to reducing the adverse impact of the challenges discussed in the previous sections. These recommendations are valid in general, but particularly in a period where the external situation is subject to significant volatility and uncertainty.

Fiscal, monetary, and debt management policies

Several analysts suggest that Latin America should take advantage of the high liquidity and low international interest rates, while it lasts, to finance long-term and low-cost ambitious infrastructure programs that, in the short term, would mitigate the effect of low external demand and, in the medium term, contribute to improvements in productivity.

However, the committee emphasizes that most of the countries of the region have increased their structural fiscal deficit, compared to the average of the previous decade, and several have rapidly increased their level of public debt and, in some countries, foreign indebtedness with China has been significant and this is not incorporated into conventional databases. In addition, for a significant number of countries foreign debt increased sharply. In the past, during difficult times, private debt was nationalized, suggesting that, in some circumstances, external private indebtedness generates a contingent liability for the public sector.

In these circumstances, the committee recommends fiscal prudence. Some governments, such as Brazil and Colombia, are in the process of implementing fiscal consolidation measures. In Brazil, fiscal consolidation is being attacked by a ceiling on public spending and a reform of the social security system, while in Colombia a tax reform is being discussed that partially compensates for the loss of tax revenue generated by the drop of prices of raw materials.

However, greater fiscal prudence does not preclude taking advantage of the situation to finance carefully selected and executed investment programs, under reliable institutional structures, and making greater use of the financial and technical capacity of the World Bank, IADB (Inter- American Development Bank), and CAF (Andean Development Corporation – Development Bank of Latin America) for these purposes.

As long as international interest rates remain relatively low, active management of the public debt structure can significantly contribute to reducing external vulnerability. This includes taking measures to improve the maturity profile of indebtedness, avoiding concentration of maturing debt. It is also a priority to reduce exposure to exchange rate volatility and to strengthen the adequacy of international reserves.

As noted above, the region exhibits weaknesses in productivity that significantly limit its growth potential. The region will not grow again at the rates observed during the years of the commodity price boom if productivity does not increase. However, the current global scenario coupled with the risks described above have weakened demand and capacity gaps have widened. In this context, a demand stimulus is justified. As mentioned above, fiscal space is limited and therefore, this should be done on the monetary side. However, the effectiveness of monetary policy in periods of turbulence depends fundamentally on its credibility, and therefore timing and magnitude should depend on the conditions of each country. And even more, credibility will be determined by the long-term sustainability of the fiscal position.

The economic weakness with respect to their full capacity has been reflected, in most countries, in inflationary trajectories consistent with their goals. After facing serious challenges from the massive exchange rate depreciations that have taken place since the beginning of 2013, with risky consequences on the anchoring of inflation expectations. Today, there are opportunities for monetary stimulus that should contribute to an economic recovery, in the context of price stability. In a scenario of well-anchored inflationary expectations, the “fear of floating” should not hinder the conduct of monetary policy.

Regional integration

Those who have always been in favor of practicing protectionism in our region feel emboldened by the protectionist and nationalist announcements that are now coming in from the developed world. The committee considers, however, that it would be very inconvenient to give in to these temptations.

On the contrary, Latin America’s response should be that of greater regional integration, as a way of energizing our economies in the short-term and preparing them for a more efficient integration into the global economy, when the current protectionist tendencies of the developed world pass. In fact, deep regional integration, which tends toward the free movement of goods, services, people and capital in the region, would in the short term mitigate the adverse effects of the low dynamism of global trade, which may be aggravated if the protectionist announcements in the first world become reality, as well as any reduction of capital flows to the region. And, by increasing the regional productive efficiency, our region would become a more productive and competitive area for its global insertion. The fruits would be especially appreciated when global trade exceeds the current prostration period.

The committee notes that the conditions for a significant boost to these open integration objectives are being met. On the one hand, there are two groups of countries that have already opted for an aggressive strategy of this nature: the members of the Central American Common Market and those of the Pacific Alliance. Central America is already characterized by significant mobility of goods, services, capital and people within that sub-region, as well as considerable commercial and financial integration with the rest of the world. The Pacific Alliance, for its part, is proceeding with an ambitious agenda in the same direction.

Both groups have dismantled most of their mutual trade, harmonized their rules of origin and allowed accumulation, thereby facilitating the emergence of regional value chains. The banking and insurance market is virtually integrated in Central America and Colombia. To make this process more efficient and at the same time reduce the risks of financial contagion, the Council of Regulators and Supervisors of Central America and Colombia works closely in financial supervision and has made progress in harmonizing regulations. For its part, the Pacific Alliance has initiated an ambitious process of integration of its Stock Exchanges. The committee also notes the corporate interest acquired by Bovespa in three of the Pacific Alliance’s exchanges, indicating the interest and potential of an aggressive process of regional financial integration. The timing is very appropriate, given the risks of a significant reduction of capital flows to the region and the withdrawal of several global banks as a result of their weakening since the 2008 crisis and the regulations of Basel III.

For their part, the members of Mercosur are beginning to rethink their regional integration strategies. This is particularly true in the case of the new Argentine Government, but there is also a change in the new Brazilian government. These changes, accentuated by an adverse global environment, could result in a gradual convergence between Mercosur and the Pacific Alliance, as proposed by the Chilean Government. As many observers have pointed out, what is most lacking in Latin American integration is precisely the establishment of stronger trade and financial ties between the countries of the Southern Cone and those of the North.

Multilateral organizations

Finally, it is expected that international financial institutions play a more aggressive precautionary role vis-à-vis the new risks of the global environment. In particular, the capitalized International Monetary Fund (IMF) should be more proactive in offering the contingent credit line to countries with sound fundamentals. The committee considers that the time has come to envisage that the Fund automatically pre-qualify countries that could benefit from unconditional and immediate access to this facility, without the need for an application or commitment fee, in return for a disbursement interest rate that is higher than the current one.

And, as already mentioned, the World Bank, IADB, and CAF should take advantage of the low interest rate environment, while it lasts, to channel low-cost and very long-term resources to well-studied and managed infrastructure projects in the region.

The region should, as a complement, strengthen its regional financial institutions (CAF and the Latin American Reserves Fund (FLAR). As the committee has noted, turning the FLAR into a first-instance regional monetary fund (with the IMF as the lender of last resort) would be a logical development of the agreed principles for the international financial architecture and would be very timely given the risks that are noticed in the international financial market.

The Latin American Committee on Financial Issues (CLAAF) is grateful to the Center for Global Development (CGD), the Banco de la Ciudad de Buenos Aires, the Banco de Desarrollo de America Latina (CAF), the Latin American Reserve Fund (FLAR) and the Central Bank of Chile for their financial support of its activities. The committee is fully independent and autonomous in the drafting of its Statements.

      

 

 

We should not be surprised that Latin America’s “red tide” is receding. Historical evidence from the last 40 years shows that political cycles within the region are highly synchronized, and tend to reflect economic booms and busts.

Author

Ernesto Talvi

Director - Brookings Global – CERES Economic and Social Policy in Latin America Initiative

Nonresident Senior Fellow - Global Economy and Development

@Ernesto_Talvi

But this period turned out to be the proverbial calm before the storm. The party was cut short in the early 1980s, when then-Federal Reserve Chairman Paul Volcker took away the punch bowl, by engineering a sudden interest-rate hike to stem inflation. The “Volcker shock” created a triple whammy: the US entered a deep recession; commodity prices plummeted; and Latin America’s capital inflows abruptly reversed, shifting toward US dollar-denominated instruments that offered better yields.

What followed was a “lost decade” of economic depression, stagnant growth, and currency, debt, and banking crises, as Latin American countries’ output contracted or collapsed. This severe downturn created widespread social discontent, and with the fall of the Berlin Wall and the end of US support for military regimes in the region, every Latin American dictatorship except Cuba’s was upended.

For the most part, center-right, democratically elected governments replaced the military dictatorships, and they exchanged the previous economic paradigm – import substitution, state intervention, and overregulation – for the Washington Consensus, which called for fiscal discipline, price stability, trade and financial liberalization, privatization, and deregulation.

By the early 1990s, the 1989 Brady Plan had resolved Latin America’s debt crisis by providing debt relief in exchange for economic reforms, and interest rates in the US had fallen. Foreign capital flooded in again, and the new consensus view was that bond-driven capital inflows would impose market discipline on Latin America’s historically profligate governments, because, presumably, only credit-worthy agents would be able to borrow. Another bonanza ensued, which Latin American policymakers at the time attributed to the Washington Consensus.

Democracy, together with sensible and credible economic policies, seemed to have finally done the trick. But then came the 1997 Asian financial crisis and the 1998 ruble crisis, in which the Russian government defaulted on its debt. Capital fled emerging markets, sending Latin American countries into another nosedive and resulting in economic depression and more currency, debt, and banking crises.

In the early 2000s, Latin America’s economic malaise again gave rise to social discontent, and center-right governments started to fall like dominos, to be replaced by center-left – and, in some cases, populist – administrations.

The new center-left governments, unlike their populist peers, did not repudiate previous commitments to fiscal discipline, low inflation, and open markets. Rather, they built lavish social-welfare and economic-redistribution programs on top of those commitments. This was possible only because of the boom in commodity prices that began in 2003, and the surge in capital inflows until 2012, as developed-country investors searched for yield in the wake of the 2008 global financial crisis.

Once again, high commodity prices and cheap, abundant capital had fueled a decade-long economic boom. And once again, governments in the region attributed their economic success to the reigning paradigm, which this time combined economic orthodoxy with redistributive policies. What’s more, center-right governments had peacefully transferred power to the newly elected center-left governments, which led many people to believe that this time would be different.

They were wrong. Starting in 2012, Latin American economies cooled significantly, owing to the European debt crisis, China’s slowdown, collapsing commodity prices, and capital flight from emerging markets, as rattled investors sought refuge in safe assets. Some Latin American countries faltered, and others fell into deep recessions.

Latin American governments had again convinced not only themselves, but also voters, that their policies were behind the previous boom. When voters’ expectations clashed with the new socioeconomic reality, they took to the streets to protest. Corruption scandals in some countries added fuel to the fire, and a new crop of center-right governments was elected.

Latin America’s 40-year history of political swings between center-right and center-left governments is evolutionary: each new stage builds upon the previous one. Much like creative destruction, evolution preserves what works, discards what does not, and sometimes adds new, disruptive features.

Assuming this pattern holds, what can we expect from the new crop of mostly center-right, mainstream Latin American governments?

Most likely, they will continue the evolutionary process, by preserving some of the basic Washington Consensus tenets, while pursuing new redistribution policies when feasible. But resources will be scarce, so they will need to redesign social-spending programs and infrastructure projects to maximize efficiency and get more bang for their buck. I call this new paradigm “intelligent austerity.” If Latin American governments implement it successfully, they truly will deserve to claim credit for the economic gains that result.

      

 

 

If the answer to this question is no, then clearly something has gone wrong in Brazil. Why? Because Rousseff was not removed over her administration’s economic mismanagement. Neither was she ousted over her involvement in corruption scandals, kickback schemes or obstruction of justice in the Petrobras case, as the evidence to corroborate these charges is nonexistent. The truth of the matter is that Rousseff was ousted over having overseen two types of allegedly unlawful budgetary maneuvers: (1) “pedaladas fiscais,” the delay of repayments to state banks intended to mask the fiscal deficit, and (2) issuing decrees to open supplementary lines of credit without congressional approval.

Let’s begin by looking at the legal framework. In Brazil, the president can only be removed from office via impeachment—revoking the popular mandate that elected her in the first place—when there is evidence that she actively committed a so-called “crime of responsibility.” This is clearly stated by article 85 of the Brazilian Federal Constitution. Crimes of responsibility are defined exhaustively by Law 10179/50 and are not open to interpretation by extension or analogy.

While there exists a legitimate debate about whether the budget tricks Rousseff was accused of truly constitute impeachable offenses, the fact is Brazil’s Supreme Court laid the matter to rest this past April—before the case was tried in the Lower House but after a special commission recommended impeachment—when it denied the attorney general’s motion to nullify the impeachment case on due process grounds. The Supreme Court does not have the authority to rule on the political merits of an impeachment, but it does have the last word on technical and procedural matters. Even though it has been argued that neither fiscal “peddling” nor the unauthorized decrees can be unambiguously considered impeachable offenses and therefore that the removal may have been unconstitutional, by letting it run its course the Supreme Court effectively ratified the formal legitimacy of the impeachment trial.

Formal legitimacy notwithstanding, the process in question may still have been tainted by illegitimacy of origin. Indeed, the case has all the markings of an impeachment born out of a political decision to sack a highly unpopular president that had lost parliamentary majorities, incapable of governing a country mired in a deep economic crisis and unwilling to halt the criminal probes weighing on her accusers. Once this decision was made, what followed was simply the search for a pretext that would comply with the formal requirements of an impeachment. The budgetary irregularities that officially led to Rousseff’s downfall likely would never have seen the light of day had the economic and political context been different—especially as this sort of creative accounting has been standard in all of Brazil’s past administrations.

In other words, formal devices were used to recreate the consequences that low public approval and/or the loss of a congressional majority would have in a parliamentary regime. In the end, this amounts to a de facto “parliamentarization” of a presidential system. What’s wrong with that? According to the Brazilian Constitution, neither low public approval nor the loss of a congressional majority constitute impeachable offenses. Unlike the vote of no-confidence or a censure motion—which are features of parliamentary systems—impeachment is a legal procedure, not a political one.

The question we should ask ourselves is whether this practice of de facto “parliamentarizing” presidential systems is truly healthy for democracy. One may think that what Brazil needs is a switch to a parliamentary regime de jure. However, it has been well established that the state of the economy strongly influences electoral results, such that high economic volatility translates directly into high political volatility. In light of the elevated structural economic volatility to which both Brazil and much of Latin America are subjected to—because these economies are exposed to commodity price fluctuations and other external shocks to a greater extent than countries in other regions—parliamentarism might deliver even more unstable politics than the current system.

Which means that, at least for Brazil, presidentialism may be the most sensible choice. But if so, then we must abide by presidentialism’s rules of the game, both formally and in spirit, even if at times they operate against our best interests or we wished they were different. Otherwise we risk making a mockery of institutions and, as the saying in Spanish goes, “he who plays with fire, eventually gets burned.”

      

 

 

For the better part of the past decade, close to 80 percent of countries in Latin America were ruled by center-left and populist governments. However, this hegemony seems to be coming to an end, with center-right parties recently rising to power in Argentina, Brazil, Guatemala, Paraguay, and Peru. Should this come as a surprise? The short answer is no.

A longstanding literature in political science research has documented the existence of an economic vote (Lewis-Beck and Stegmaier, 2000). Namely, substantial evidence reveals voters in democratic countries systematically reelect incumbent governments in times of economic boom and oust them in times of economic slowdown, recession, or crisis.

So the state of the economy influences our political choices. At the same time, economies today are more interconnected than ever before. It follows that countries with synchronized business cycles should display synchronized political cycles as well (Kayser, 2009). To the extent that output fluctuations in commodity-exporting Latin American countries are to a large degree driven by common external factors (Calvo, Leiderman, and Reinhart, 1993; Izquierdo, Romero, and Talvi, 2008), economic booms and busts should then give rise to common political cycles.

1.2 Lessons of Modern History

In this essay, we provide 40 years of historical evidence that lend support to the preceding hypothesis–namely, that political cycles in Latin America are highly synchronized, mirroring economic booms and busts largely driven by common external factors.

1974-1989

The period between 1974 and 1981 was an expansionary one for Latin America. The region grew at an annual rate of 4.1 percent, compared to a historical average of 2.8 percent per year. When the price of oil rose sharply in the 1970s, the resulting “petrodollars” were recycled to emerging economies–and in massive amounts to Latin America–in the form of bank lending. These inflows financed huge increases in public spending and real estate booms across the board, fueling an economic bonanza that propped up the military dictatorships plaguing the continent. At the time, the reestablishment of stability and order by authoritarian regimes was credited with bringing about the economic boom.

And then came the “Volcker shock” as the U.S. Federal Reserve engineered a sudden hike in interest rates to 20 percent in order to defeat inflation, which at the time hovered at around 15 percent. This created a triple whammy for Latin America: the U.S. went into a deep recession, commodity prices plummeted, and capital inflows to the region came to a sudden stop and began flooding out of the region, attracted by handsome yields offered by U.S. dollar-denominated instruments. The result was a “lost decade” of economic depression and stagnant growth, with many countries suffering output contraction and collapse, along with currency, debt, and banking crises.

The political mirror image of the severe economic downturn and widespread social discontent from 1982 to1989–aided in the late 1980s by the fall of the Berlin Wall, the end of the Cold War, and the end of U.S. support for military regimes in the region–was the eventual toppling of every dictatorship in the region (except Cuba). These were replaced by democratically-elected governments, mostly to the center-right of the political spectrum, which in turn swapped the prevailing economic paradigm of import substitution, high government intervention, and overregulation for the Washington consensus: fiscal discipline, low inflation, trade and financial liberalization, privatization, and deregulation.

80% of LAC governments were military dictatorships
(1974-1989)

1990-2003

In the early 1990s, with newly democratically-elected governments installed, the debt crisis resolved through the Brady plan, and the return of low interest rates in the U.S., Latin America was again flooded by foreign capital–this time, mostly in the form of public and private sector bond lending. The consensus at the time was that these bond-driven capital inflows would bring market discipline to an ever-so-profligate region (i.e., only credit-worthy agents would be able to borrow). The ensuing bonanza was interpreted by many as definitive proof of the might of the Washington consensus policies. The combination of sensible and credible policies with democracy seemed to have finally done the trick.

And then came the Asian crisis of 1997 and the Russian default of 1998, and the huge flight of capital from emerging markets that sent Latin American countries into another nosedive. Once again: recession, depression, and wholesale currency, debt, and banking crises.

By the early 2000s, with economic malaise and social discontent in high gear, center-right governments started to fall like dominoes and were replaced by center–left–or, in some cases, populist–governments in most of Latin America.

70% of LAC governments were center-right (1990-2003)

2004-2014

The new crop of center-left governments did not repudiate the previous commitment to fiscal discipline, low inflation, and open markets. Rather, they built on top of it and enacted massive social redistribution programs (mostly targeted to the very poorest). These programs could only be financed owing to booming commodity prices–since 2003–and to a surge in capital inflows that peaked in 2011, as investors in developed countries searched for yield. Once again, high commodity prices and cheap and abundant capital fueled a decade-long economic boom. Once again, governments attributed their success to the policies of the reigning paradigm, one that–in this case–combined economic orthodoxy with social redistribution.

And then came the Eurozone crisis and a severe economic slowdown in China, a collapse in commodity prices, and capital flight from emerging markets as investors sought refuge in safe assets. Starting in 2012 Latin America cooled off significantly, with some countries faltering and others falling into deep recessions. After a decade of stellar growth and bright expectations, governments had willfully lulled themselves and voters into thinking their own actions were behind the boom. Dashed expectations turned into social discontent and resulted in massive street protests convened through social media. In some countries, corruption scandals added fuel to an already-sweltering fire. This malaise within Latin America has arisen at a time when the foundations of the liberal world order are being weakened by secessionist, nationalist, isolationist, and populist movements throughout the U.S. and Europe.

80% of LAC governments were center-left or populist (2004-2014)

The political mirror image of this socioeconomic slump has been a return to center-right governments. Upon closer inspection, what the region is really witnessing is a repeat of past cycles: a repudiation of incumbents, regardless of their politics. It is only because the 2000s were dominated by left-of-center and populist governments that we are now seeing a swing to the right.

1.3 What’s next?

The history of political cycles and paradigm shifts just described–from center-right to center-left and back to center-right–can be said to be evolutionary, constructed out of building blocks, with each new stage building on top of the previous one. Much like creative destruction, evolution is all about preserving what works, discarding what doesn’t, and adding new, sometimes disruptive features.

By contrast, populism is about regime change: revolution, not evolution. Populist governments repealed the Washington consensus in favor of fiscal profligacy, high inflation, and extensive government intervention. Instead of espousing sensible redistribution policies such as conditional cash transfers (which aim to build human capital in order to empower the poor), populist governments redistributed wealth through what were essentially handouts that were used as a means for gaining and preserving political power. As populist regimes fail and are replaced by mainstream governments, the region is going to witness a counterrevolutionary paradigm shift rather than an evolutionary shift. The best example of this phenomenon is the end of Kirchnerismo and the dawn of Mauricio Macri’s Argentina.

What policy options might the new crop of (mostly center-right) mainstream governments adopt in these times of fiscal hardship? A return to early-1980s or late-1990s-style fiscal austerity and monetary tightening seems unlikely. Instead, the new paradigm will continue to build upon what came before, preserving some of the basic tenets of the Washington consensus as well as–when feasible–the social redistribution policies enacted by center-left governments. But since resources are going to be scarce, social spending programs–and, incidentally, also infrastructure spending–will have to be redesigned with efficiency in mind, to get more bang for the buck. We have termed this new paradigm intelligent austerity (Talvi, 2016).

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Developing Economies

11 Global Debates

Wednesday, October 5, 2016

      

 

 

On April 21, the Brookings Global-CERES Economic and Social Policy in Latin America Initiative (ESPLA) and the Development Bank of Latin America (CAF) co-hosted Pablo Sanguinetti, chief economist at CAF, for a short presentation of the report. Following Sanguinetti’s remarks, Matthew M. Taylor, associate professor at American University, and Jorge Luis Silva Mendez, public sector specialist at the World Bank, discussed the topic. Elaine Kamarck, founding director of the Center for Effective Public Management and senior fellow at the Brookings Institution,moderated the discussion.

      

 

 

Importantly, the expected slowdown largely reflects the impact of more difficult external economic environment on African economies and, in particular, the effects of a sharp drop in commodity prices, the slowdown in China, and of tighter financial conditions.

Source: IMF World Economic Outlook, April 2016 and Sub-Saharan Africa Regional Economic Outlook, October 2015

The lower growth forecasts are on the back of a long robust growth period in the region. Between 2004 and 2011, sub-Saharan Africa experienced 6.2 percent growth. Since 2012, however, growth in the region slowed down to 4.5 percent  between 2012 and 2015. Africa is not alone, though: This pattern of boom and subsequent slowdown was observed in every emerging region in the globe. This doesn’t mean that these changes are insignificant, though. If the IMF forecasts for 2016 materialize, sub-Saharan Africa will experience a growth reversal of 2 percentage points in 2012-2016 compared to 2004-2011.

Figure 2. Growth in Sub-Saharan Africa (annual GDP growth, in real terms)

Source: IMF World Economic Outlook

But how much of the region’s growth is driven by external factors?

To answer this question, the Africa Growth Initiative has partnered with Brookings-CERES Economic and Social Policy in Latin America Initiative (ESPLA) to study the role of external factors in explaining output fluctuations in sub-Saharan Africa. The analysis focuses on the seven largest economies (SSA-7), which account for three quarters of sub-Saharan Africa’s GDP (Angola, Ghana, Kenya, Nigeria, South Africa, Ethiopia, and Tanzania). For this more detailed analysis, see here.

The key, initial findings of the study are:

Almost half of sub-Saharan Africa’s output fluctuations since 1998 can be explained by a small set of external factors—namely, GDP growth in G-7 countries, GDP growth in China, oil and non-oil commodity prices, and borrowing costs for emerging economies in international capital markets.

Figure 3 illustrates that this small set of external variables help explain about 44 percent of sub-Saharan Africa’s output variance. As a result, both the boom experienced between 2004 and 2011 and the sharp deceleration observed since 2012 can, to a large extent, be attributed to significant changes in the external environment, from extremely favorable in the former period to more adverse in the latter.

Figure 3. Sub-Saharan Africa’s Business Cycle: The Role of External Factors (annual GDP growth, in real terms, for SSA-7)

Data sources: IMF and authors’ calculations.



Note: Predicted GDP growth corresponds to the prediction of a vector error correction model using only the observed external factors from Q1.1998 to Q4.2014. For technical details, see “Booms and Busts in Latin America: The Role of External Factors” (Izquierdo, Romero and Talvi 2008).

Key downside risks for sub-Saharan Africa’s growth include a sharp slowdown in China’s growth, a further decline in commodity prices, and a tightening in international financial conditions for emerging economies. Whereas permanently lower commodity prices and tighter financial conditions for emerging economies would only have temporary effects on sub-Saharan Africa’s output growth, a permanent Chinese slowdown would have a larger and persistent effect, as seen in Figure 4.

Figure 4. Counterfactual Scenarios for SSA Growth (annual GDP growth, in real terms, in SSA-7)

Data sources: IMF and authors’ calculations.
Note: The baseline scenario corresponds to the prediction of the model when external factors are assumed to evolve according to market expectations. The China shock is a reduction in growth from 6.5% to 4%; the financial shock is an increase of 300 bps above baseline EMBI+ levels; the commodities shock is a price fall of 20% below baseline levels; the combined shock combines all of the above simultaneously.

Given the importance of external factors in explaining output fluctuations in sub-Saharan Africa, a key policy recommendation is that in order to properly evaluate a country’s fundamentals, policymakers should work with structural indicators of sustainability. For instance, the structural fiscal and current account balances are the fiscal and current account positions that would result when the key external drivers of the business cycle of sub-Saharan Africa such as commodity prices are computed at their long-run values.

Fiscal sustainability refers to the ability to run fiscal deficits and pile up public debt without compromising a country’s perceived solvency. Figure 5 shows that during the boom period (2004-2011), the observed fiscal balance was consistently above the structural fiscal balance and thus conveyed the impression that the fiscal position was stronger than it actually was. As commodity prices declined and output growth decelerated during the cooling-off period (since 2012), the observed fiscal balance began moving towards the structural fiscal balance, revealing that the underlying fiscal position was actually weaker than the observed one.

Figure 5. Structural Fiscal Balance (% of GDP)

Data sources: IMF and authors’ calculations.
Note: The structural fiscal balance is calculated by performing a linear estimation on observed fiscal revenues between 1998 and 2003, before the boom began, and extrapolating from then on.

External sustainability refers to the ability to sustain excess spending over income with external capital inflows. Figure 6 shows that during the boom period (2004-2011), the observed current account balance was consistently above the structural current account balance and thus conveyed the impression that the external position was stronger than it actually was. As commodity prices declined during the cooling-off period (since 2012), the observed current account balance began moving towards the structural current account balance, revealing that the underlying external position was actually weaker than the observed one.

Figure 6. Structural Current Account Balance (% of GDP)

Data sources: IMF and authors’ calculations.
Note: The adjusted current account balance is calculated by using the average of export and import prices observed between 1992 and 2003, before the boom began.

These findings shed some light on the “Africa Rising” narrative—the recent economic boom cycle in sub-Saharan Africa. In particular, they highlight the important role of external factors, which accounted for almost half of the region’s output fluctuations. They also point to the need for policymakers to be cautious in boom periods and rely on structural economic indicators that are less sensitive to the boom-bust cycle of external factors such as commodity prices.

In Foresight Africa: Top Priorities for the Continent in 2016 publications, we have highlighted some policy responses to changes in the external environment. These policy responses include a mix of short-term and medium-term measures such as fiscal, monetary, and exchange rate policy to absorb external shocks as well as increased domestic revenue mobilization and structural reforms to diversify African economies away from commodities.

Indirectly, the findings above emphasize the important role of domestic policies in explaining Africa’s growth. If external factors explain half of output fluctuations, then it is crucial to make sure we get “the other half” of domestic factors right. Now that we are in a bust cycle, the political appetite for policy reforms should be higher. Now is the time for implementation.

      

 

 

On April 12, the Brookings Global-CERES Economic and Social Policy in Latin America Initiative (ESPLA) and the Integration and Trade Sector at the Inter-American Development Bank hosted a panel discussion on the future of trade in the Americas.