Latin America and the Caribbean suffered the highest death toll from COVID-19 of all developing regions, even more so when considering excess mortality relative to a normal year instead of the official number of deaths attributable to COVID-19. The region also experienced the largest decline in GDP (gross domestic product). Health and economic costs have varied across countries so far, but there is no doubt that the region has suffered disproportionately. And as new variants of the virus emerge and vaccine shortages persist, the pandemic is not over for this region yet.
In this context, governments are confronted with a firefighting act. Public spending is badly needed to support healthcare systems, offset the learning losses from prolonged school closures, assist households whose earnings have dropped precipitously and prevent otherwise viable businesses from closing. However, public spending is constrained. Public debt levels have increased dramatically across most of the region, with most countries having limited fiscal space and credit-rating downgrades looming on the horizon. In a region that experienced widespread social unrest before the pandemic, trying to restore fiscal balances through tax hikes can be met with fierce resistance. And taxing the rich, while appealing in principle, is challenging when avoidance and evasion are widespread.
Even before the pandemic, Latin America and the Caribbean struggled. After the golden decade associated with the commodity-price super-cycle, the region had entered a trajectory of declining growth and stagnant social indicators. It is well understood that significant economic reforms are needed to boost productivity growth in the region so that more and better jobs are created, household incomes are lifted, the tax base is increased, and basic services can be properly funded. However, pushing for economic reforms in the current economic context and after a period of social unrest could be politically difficult. What is needed is relatively clear; how to get there is absolutely not.
In the latest edition of our semiannual report on Latin America and the Caribbean entitled “Renewing with Growth”1World Bank Group: Open Knowledge Repository: “Renewing with Growth”, March 29, 2021. , we discuss whether technological disruption could boost productivity in the region without facing the political and social tensions associated with economic reforms. Two ongoing disruptions are the focus of the report: the accelerated digitization brought about by the pandemic and the emerging opportunities for increased competition in the electricity sector.
Doom and gloom or structural transformation?
The thought of a vigorous bounce back may seem misplaced at a time when children have been out of school for months, many adults have lost their jobs, informality has risen, governments are overindebted and zombie firms abound. And yet, history offers reasons for optimism. World War I led to an enormous loss of physical and human capital; it was followed by the Spanish Flu, which was even more lethal than COVID-19. And yet, what came right after was the Roaring Twenties. The destruction and carnage were also enormous during World War II. But what followed was one of the longest and strongest growth spells ever.
In the same vein, there could be a silver lining to the COVID-19 crisis. A shock of this magnitude does not call for a return to the previous equilibrium but may instead trigger a permanent change in the structure of the economy. One important dimension of that change is related to the sectoral composition of economic activity. In the short term, the pandemic has led to the collapse of tourism and a range of personal services but to a boom in information technology, finance and logistics, among others. Some of this structural change may not be reverted.
The time dynamics of structural shocks of this sort are relatively straightforward. If the contracting sectors represent a large share of the domestic economy, as is the case with tourism in many Caribbean countries, the negative growth impact of the crisis can be dramatic. If neither the contracting nor the expanding sectors are large to begin with, as was probably the case in Paraguay, the impact is more muted. Finally, if the expanding sector is large to begin with, the crisis may entail reallocation costs in the short run but should eventually lead to higher output.
Take the case of Argentina. In 2020, its GDP may have declined by a staggering US$56 billion. But over the same period, the market values of its three biggest technology firms—Mercado Libre, Globant and Despegar—increased by an even more sizeable US$66 billion. The latter are not counted as GDP, and rightly so. These notional capital gains were not all generated domestically; they have not been converted into actual incomes, and many of the beneficiaries are not residents. But it is not totally inaccurate to say that the expanding sectors of Argentina created more value than the contracting sectors lost. On the other hand, these gains and losses were very unevenly distributed across the population, with most of the gains remaining outside the reach of domestic tax authorities.
The dynamic effects just discussed are a manifestation of broader composition effects. Labor productivity varies across sectors, with the overall labor productivity of an economy being a weighted average of its sectoral productivities. Algebraically, weights are given by the shares of the sectors in total employment. Because the COVID-19 crisis has led some sectors to contract and others to expand, the weights have changed, and as a result, overall labor productivity may change as well.
Rigorously quantifying this possible composition effect would require a full, computable general-equilibrium model for each country. Short of that, a simple methodology can be used to produce an approximate estimate. This methodology amounts to computing labor productivity for all sectors and generating two weighted averages, one with the sectoral shares of economic activity observed before the crisis, the other after the crisis.
The data needed for such a calculation is available for only a handful of countries. But it is interesting to note that for a majority of them, the composition effects from the structural changes triggered by the COVID-19 crisis are generally positive and sizeable (Figure 1).
Needless to say, these figures are tentative at best, and whatever the real sizes of the effects are, it may take time for them to materialize. But the results suggest that structural transformation is one way in which the pandemic may have boosted the long-term growth prospects of the region. And this may be happening without the need for polarizing discussions on economic reforms.
The promise of digitization
The sectors expanding as a result of the COVID-19 crisis matter not only because of their higher productivity but also because of the impacts they could have across the rest of the economy. Slow economic growth in Latin America and the Caribbean has often been attributed to limited competition and excessive insider power. Addressing the pandemic has required a much greater reliance on electronic platforms to work, trade and communicate. And these may, in turn, create disruption in sectors and markets into which policy reforms have often failed to make inroads.
Limited competition in the region is partly the result of a long history of import substitution and populist policies. The relatively small size of most of the economies in the region, the strong links between economic elites and political leaders and the veto power of key interest groups have undermined attempts to change the status quo. While many countries have competent technocracies, progress in moving toward more efficient economies has been patchy at best.
For example, there have been multiple efforts to modernize the financial sector in Latin America and the Caribbean, but access to finance remains dismally low. The region has also signed an almost record number of free-trade agreements, but its ratio of international trade to GDP remains one of the lowest in the world. Despite pension-system reforms and attempts to extend the coverage of social-protection programs, labor markets remain deeply segmented, and informality is most often the norm.
Accelerated digitization is bound to impact multiple areas of the economy—and not only those just mentioned. But in their cases, it could unlock much-needed change without having to embark on politically costly discussions about further economic reforms. Three benefits of digitization are:
- Financial innovations allow large technology firms and telecom operators to provide cheap and reliable payment solutions to households of modest means and informal-sector firms. This is a market segment typically neglected by established banks because it is too costly to service. Proper regulation can help protect the data of those who use these new services and minimize systemic risks for the financial sector. The digital and institutional architecture adopted by India, including the introduction of “payment banks”, is very promising in this respect.
- Trading platforms connect customers and suppliers directly, allowing them to bypass intermediaries and reduce the risk of unsolicited payments along the way. What trade-facilitation reforms painstakingly try to accomplish at customs offices and border posts can instantly happen when buying and selling through the internet. Combined with proper training and financing solutions, trading platforms can be game-changers even for disadvantaged rural communities, as shown by the experience of China’s Taobao villages.
- Logistics solutions are becoming an important source of employment for low-skilled workers throughout the region. Shared-vehicle drivers and delivery personnel have become ubiquitous across cities in Latin America and the Caribbean. For now, many of these jobs are precarious and offer no benefits. But it does not need to be this way. The technology companies offering logistics solutions have full information on the number of hours worked and the earnings made by every one of their associates. With this kind of information, the formalization of employment could be vastly expanded.
A quantum jump in the penetration of digital tools is taking place globally, and the trend is unlikely to be reverted once contagion risks subside. However, Latin America and the Caribbean is not ideally positioned to seize this opportunity. Its overall ranking across developing regions varies depending on the indicator considered – from the availability of digital infrastructure to the cost of accessing the internet to the capacity of firms and governments to tap its potential. The region is almost consistently behind Europe and Central Asia, and East Asia and the Pacific. On some of the indicators, it even lags much poorer regions.
At the same time, the readiness for digitization varies dramatically across the region. In some countries—especially in Central America and the Andean subregion—the low availability of infrastructure and the high cost of service imply that large segments of the population are in practice excluded from digital transformation. The assessment is more positive for countries in the Southern Cone, Brazil, Costa Rica and, to some extent, Mexico. Some of these are relatively close to advanced economies on indicators such as reliance on e-government.
Taken together, the indicators considered for the benchmarking exercise in our report suggest that half of the region’s population may fail to benefit fully from the transformations brought about by digitization. Not everybody has access to the internet, and for those who do, the cost of a broadband package may be unaffordable.
Against the odds, half a dozen countries in the region have recently seen the emergence of local unicorns. These are privately held technological companies backed by venture funds and investors with valuations that exceed US$1billion. Analysis of firm dynamics has highlighted the importance of new entrants that grow very rapidly, the so-called “gazelles”. These firms are engines of creative destruction, generating employment in large numbers, creating considerable value and crowding out low-productivity competitors. It can be argued that unicorns are the ultimate gazelles of economic development.
On both the number and market value of their unicorns, Argentina, Brazil, Colombia and Uruguay stand on par with the leading countries in technological innovation (Figure 2). Together with Mexico, they account for three dozen unicorns out of more than 500 globally. Technological companies like these can only gain from the accelerated structural transformation triggered by the COVID-19 crisis. The stories of the Latin unicorns—their founders, the sectors in which they operate, their trajectories—offer valuable insights into the promise of digitization for the region.
More energy to the region
Technological disruption can be a driver of change not only in the case of digitization but also other innovations that may bring in greater market competition and increase economic efficiency. Electricity production, a sector undergoing a deep transformation around the world, is a case in point. Because electricity is an input to most economic activities, because it matters so much for household wellbeing, and because it is central to sustainable development, reducing its cost and increasing its cleanliness could be transformational.
In large part thanks to its rich endowment in hydropower, Latin America and the Caribbean has the cleanest electricity generation matrix of all developing regions. Important differences remain across countries, with small islands suffering from their dependence on diesel and fuel oil. But overall, given that the cost of generation from renewable sources is lower, the region should have the cheapest electricity in the developing world. Its advantage relative to other developing regions would even widen if a hypothetical carbon tax were applied across the board to penalize emissions.
Instead, the Latin America and the Caribbean region has the most expensive electricity in the developing world. This paradox is partly due to the high prevalence of energy subsidies elsewhere. But regardless of what countries in other regions do, firms and households in Latin America and the Caribbean pay substantially more for the electricity they use than it would cost to produce it based on the existing generation matrix, and this even if a hypothetical carbon tax were included in the cost (Figure 3).
Except in a few countries, the gap between high electricity prices and potentially low generation costs is not due to fiscal policy. The indirect taxes charged to electricity bills rarely exceed 20 percent. In most of the region, electricity tariffs are subsidized—directly in the case of consumers of modest means and indirectly through the provision of cheap natural gas for electricity generation.
The main reason why electricity is more expensive in Latin America and the Caribbean than its generation matrix would allow is the inefficiency of many of its electricity systems. This inefficiency manifests itself in the frequency and duration of power outages, magnitude of technical and commercial losses, over-staffing of state-owned utilities and exercise of market power by private generators. However, addressing inefficiencies through policy reforms may be challenging at a time when economies are barely recovering from the COVID-19 crisis and in the aftermath of a period of intense social unrest.
An alternative is to leverage technology-based solutions to increase competition in the sector, bringing electricity prices down and increasing the share generated from renewable sources. One of these solutions is distributed generation. Most electricity systems comprise just a few large power generators—such as hydroelectric dams or thermal-power plants. But firms such as paper-pulp mills and sugar mills often generate electricity for their own uses, at times beyond their own needs. And it is also increasingly feasible for households to install rooftop solar systems and consume their own electricity.
An energy transition can, therefore, be envisioned—going from a few dozen large utilities to millions of smaller private units that sell electricity to the grid or buy from it depending on the hour of the day or the month of the year. This is not just a hypothetical scenario, as distributed-generation capacity is rapidly expanding in Latin America and the Caribbean. However, if the policies in place for decentralized units to buy and sell electricity are not well designed, this trend may fail to make a difference or, even worse, become a source of new problems. An important issue in this respect is determining the price at which electricity should be sold to the grid and bought from it.
Another mechanism to increase competition in national electricity systems is international electricity trade. Latin America and the Caribbean is the developing region with the best interconnection infrastructure across countries. Multiple transmission lines already exist in Central America, the Andes and the Atlantic subregion. Several more are under construction or have been planned. Given the size of the region, a fully integrated electricity market—as in the European Union – would probably be technically inefficient. But three subregional markets can certainly be envisioned.
Cross-border electricity trade can increase efficiency for three reasons. The first one is that different countries have different excess generation capacities relative to their needs. Those with systemic surpluses would gain if they could export their electricity, while those facing shortages would benefit from importing. A second potential source of mutual gains is the different cost of generation across countries. Electricity tends to be cheaper when the generation matrix is cleaner, as well as in countries where the overall efficiency of the system is higher. The third reason why cross-border trade can be mutually beneficial is the potentially diverse time profile of electricity consumption across countries. Economic and social characteristics, together with climate, shape the seasonality of electricity use during the year, and the distribution of demand peaks during the day.
Information on installed capacity, generation costs and consumption profiles across countries can be used to simulate how much could be gained from cross-border electricity trade. The results show that electricity prices would fall in each of the three subregions, with the Andean subregion benefitting the most.
The capacity of international transmission lines is not the main constraint to cross-border electricity trade, however. Building the institutional arrangements that make trade possible may be more demanding. These arrangements deal with issues such as the commitment to effectively purchase electricity from neighboring countries and the prices at which transactions should occur.
1 World Bank Group: Open Knowledge Repository: “Renewing with Growth”, March 29, 2021. (https://openknowledge.worldbank.org/handle/10986/35329)