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Region must err on the side of caution


ALEJANDRO WERNER

Region must err on the side of caution

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IT’S BEEN A ROUGH START TO2016, as seen by the recent bouts of financial volatility, stemming from uncertainties related to the slowdown in China, lower commodity prices, and divergent monetary policy in advanced economies.

The global recovery continues to struggle to gain its footing, with strains in some large emerging market economies weighing on growth prospects. For Latin America and the Caribbean, growth in 2016 is now expected to be negative for the second consecutive year – the first time since the debt crisis of 1982-1983, which triggered the “lost decade” for the region.

The regional recession, however, masks the fact that most countries continue to grow modestly but sure. In particular, country specific developments are being determined by the interplay between external shocks and domestic fundamentals. While countries with strong policy frameworks have been adjusting to external shocks smoothly, countries with weaker domestic fundamentals are experiencing significant downturns.

The sizeable decline in commodity prices (about 30 to 50 per cent relative to its peak depending on the country) has led to significant losses in export revenues.

However, the sizes of the terms of trade shocks relative to the sizes of these economies (less than one per cent of Gross Domestic Product for Argentina, Brazil, and Mexico in 2015 and 2016) are not enough to explain the severity of contraction in some cases.

Indeed, our negative growth projection is driven by four countries (Argentina, Brazil, Ecuador, and Venezuela), as the decline in commodity prices in combination with macroeconomic imbalances and microeconomic distortions has led to sharp declines in private investment.

Overall, over the medium term, growth is expected to remain tepid, highlighting the importance of resolving domestic challenges. The regional outlook also hides important sub-regional differences.

While South America is heavily affected by the decline in commodity prices, Mexico, Central America, and the Caribbean are beneficiaries of the strengthening United States (US) economy and, in most cases, of the oil price decline.

Mexico is expected to continue to recover at a moderate pace, supported by healthy private domestic demand and spillovers from a strong US economy.

The depreciation of the peso and lower electricity prices should boost manufacturing production and exports.

The recent decline in oil prices will have only a limited effect on public finances in 2016 as oil price risk has been hedged for that year. However, if the oil price shock is persistent, it would increase the fiscal consolidation burden in the medium term.

Central America and the Dominican Republic have benefited from the oil price decline, stronger US growth, and higher remittances, but the recent softening of world coffee and banana prices could reduce this impulse. While tourism-based Caribbean countries also benefit from the low energy costs and recovery in the US, declining prices for oil, gold, and alumina have worsened the outlook for commodity intensive countries in the Caribbean.

The increase in US interest rates last December had limited impact on US and Latin American asset prices, confirming that markets had largely priced in the decision.

Remaining risks are related to the expected path of interest rates, where uncertainty or sudden revisions could cause the term premium to increase – a source of substantial spillovers to long-term interest rates in the region.

The region remains particularly vulnerable to a stronger than expected slowdown in China – a main trading partner for the region – and to further declines in commodity prices.

Closer to home, a further deterioration of the situation in Brazil could lead to a sudden re-pricing of regional assets, as well as reduced demand for exports among trading partners in MERCOSUR.

The recovery in investment could be delayed given high corporate leverage in the region. With medium-term growth expected to remain low, corporations may need to adjust their balance sheets, weakening prospects for private investment.

Large depreciations have created tensions even for the region’s most well established inflation targeting central banks.

As falling exchange rates raised domestic inflation, central banks held their fire and kept monetary conditions adequately loose to support weak domestic demand. But a continued deterioration of global commodity prices has made depreciations unprecedentedly persistent, causing inflation to remain above central bank targets for prolonged periods, except in Mexico.

While clear communication has helped keep inflation expectations well anchored, recent upticks have led central banks to respond with modest rate hikes. With current accounts in deficit throughout the region, further external adjustment will likely be needed, putting further pressure on exchange rates and making the job of central banks challenging, particularly in the absence of aggregate demand pressures.

In a global environment that is expected to remain subdued, we expect the region to grow at a slow pace for an extended period. This year will be a time for regional policymakers to err on the side of caution: adjustment should be allowed to continue and buffers should be preserved.

The regional outlook will only start to look more promising when the domestic challenges facing the contracting economies have been resolved.

Alejandro Werner is director of the International Monetary Fund’s Western Hemisphere Department which monitors countries, including Barbados.

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