By William F. Maloney, Chief Economist, Latin American and the Caribbean, World Bank
Latin America needs to transcend what might be termed “resilient mediocrity”—the region has done relatively well when faced with severe shocks, but growth is insufficient to reduce poverty or social tensions. While the reform agenda remains lengthy, three interrelated items merit particular attention to stimulate growth, further increase resilience and help meet the challenge of climate change: increasing the level of competition, strengthening the capabilities of entrepreneurs to meet and benefit from this competition, and deepening financial markets to facilitate needed investment and diffuse risk.
The good news is that the pandemic marked the second major global crisis that did not lead to a severe meltdown of the region’s economies. The stronger institutionality of central banks, ministries of finance and bank-supervisory agencies has led to more robust macro buffering and provisioning. The foreign-denominated component of debt was only 35 percent in 2021, compared to 45 percent in 2007 and 60 percent in 2004. Reserve positions rose as a share of GDP (gross domestic product) to 20 percent in 2021 from 7 percent in 1982, 12 percent in 2004 and 14 percent in 2007. All of these positive financial developments have reduced the problem of unsustainable currency mismatches that have exacerbated crises in the past.
Now that we have left 2022 behind and entered 2023, the international economy is moving in a way that is less likely to stress this resilience further. The declining pressure on the Fed (US Federal Reserve) for sharper interest-rate rises due to retreating inflation, the re-opening of China and the fall in energy prices in Europe will all temper the expected growth slump in 2023 as well as the rising debt payments. The region has a reasonable chance of managing the increased debt accumulated during the pandemic.
Further, macroeconomic management has been impressive on the price-stability side; with the exceptions of Venezuela and Argentina, this has not been a “Latin inflation” episode like those of the past. Most Latin American countries are near or below OECD (Organisation for Economic Co-operation and Development) levels, and Brazil, Mexico and Chile responded far earlier to the inflation threat than the Fed—and very aggressively by historical standards. At present, the region has shown high-quality macroeconomic management and institutional responsiveness despite heightened political polarization.
That said, growth has remained mediocre for two decades and shows no signs of acceleration. While it exceeded expectations for 2022 at 3.6 percent, January World Bank forecasts for 2023 and 2024 are still 1.3 percent and 2.4 percent, respectively.1 These low rates might be dismissed as lingering side effects of COVID, but they echo those of the decade of the 2010s, when the region grew at 2.2 percent while the world grew at 3.1 percent—arguably another lost decade. The flattening of productivity growth, combined with modest progress on poverty and inequality, has led to challenges to the market-centered model across many of the region’s countries.
This model has, in fact, served the region well. Much of the increased resilience is precisely due to its influence—but the disappointing growth rates are undeniable. Although many reforms remain pending, three interacting agenda items are arguably central.
First, the role of openness and competition has come under reconsideration, as even free-trade agreements are under scrutiny. However, the region also experienced low competition in the past that yielded poor innovation—whether measured as the introduction of new products and processes or inventions—and growth. Those failures eventually led to the current model. Indeed, during the import-substitution period, the region had some of the highest effective rates of protection in the world. As an example, Ford Motor Argentina began producing the iconic Falcon sedan in 1962. It reached its highest sales in 1980—10 years after the car had been discontinued in the United States—and production finally stopped in 1992, when increased competition offered consumers more updated technology and performance. Examples of this kind abound.
The debate around whether current levels of competition are too much or too little is muddied by the heterogeneity of experiences across sectors. For example, Colombia’s auto-parts sector has been evidently ravaged by Chinese import competition, and manufacturing is coming under pressure across the region, shedding high-paying jobs. On the other hand, Jan De Loecker and Jan Eeckhout (2018) show that the dramatically increasing markups in the US and Europe over the last 40 years, perhaps the best proxy for lack of competitive pressure, are just now approaching the “normal” very high levels in Latin America (Figure 1). The region remains among the lowest in imports as a share of GDP, and highly protected sectors are still visible in energy, communications and many consumer sectors. Increasingly, academic literature has documented the positive impacts of increased competition on economic performance. For instance, trade liberalization has been shown to lower markups and improve productivity in Colombia,2 and a recent initiative at the World Bank’s Latin American division has presented evidence from Peru that court cases brought by anti-trust agencies have accomplished the same.3 The fair bet is that there is much further progress yet to make on this front.
But the second agenda item is precisely related to how Latin American firms respond to more competition, and this appears to depend on workers’ and firms’ capabilities. A well-cited conceptual framework developed by Harvard University’s Philippe Aghion and his collaborators4 notes two types of reactions to increased competition. Those firms close to the technological and managerial frontiers—“leading firms”—are able to invest in innovation to “escape” competition by lowering costs, changing products or increasing quality. However, “lagging” firms—those further from the frontiers—behave more in the way that Austrian economist Josef Schumpeter imagined 100 years ago: The reduced rents lead to a halt in innovation and even contraction of the firm. For the US and France, the share of all manufacturing firms that are leaders is around 50 percent, and they command a large share of the value added in a sector. In China, research suggests this number is closer to 25 percent. In Chile, World Bank work suggests that the share is around 10 percent, encompassing only about 25 percent of value added, while the remaining firms decrease their innovation on average.5 This makes sense. From the point of view of global competition, what’s relevant is the share of firms that are close to the globalfrontier, and developing countries are farther from it, almost by definition. But, as Aghion notes, the implication is that countries with fewer manufacturing leaders will get much less of a growth kick out of increased competition than those with more.
What this implies is that increased competition will have more salutary effects the higher the level of a firm’s ability to innovate and that improving these capabilities should be part of the competition reform package. And here is where we face shortfalls. At the most basic level, the region’s chronically low-quality public education leaves too many behind and is a major barrier to growth: 29 percent of firms report that growth is stymied by a lack of qualified employees, compared to 12 percent in East Asia, and there is a perennial shortfall in both midlevel technically skilled talent and engineers. Surveys of firms’ management teams suggest the region’s entrepreneurs, on average, are closer to Kenya or India than to advanced countries, and they are not well supported by innovation- or productivity-related institutions such as university research departments or business-consulting services. Hence, when confronted with increased competition, many potentially viable firms find themselves ill-equipped to develop survival strategies, let alone innovate their ways to profitability.
The third agenda item is access to finance for those firms that do seek to innovate. Part of the challenge can be seen through the lens of the rise in product quality that, like rises in productivity, occurs across the development process. A recent World Bank article showed that quality upgrading, measured by the export prices of countries’ goods—be they wine or cellular telephones—commanded in the US market, is related to the ability to diversify risks in the financial sector.6 Figure 2 shows the positive relationship between the growth rate of quality and the variance in the growth rate of prices—a proxy for risk—much as we find with financial assets. As an example, the quality of mobile handsets has risen sharply over time, but the price of Nokia’s handsets varied so much that it had to exit the market—high tech is a risky business. Low-end manufactured goods and commodities show less variance and also less quality growth potential. The report shows that countries with deep financial markets engage in both riskier processes within product categories and riskier products, and hence they grow faster.
Latin America’s position in the lower half of this curve is partly the result of insufficient progress in financial development. Part of the increased macro-resilience of the region is due to the deepening of domestic capital markets both in volume and coverage over the past decades, including institutional investors having grown more important relative to banks, diversifying the system. This has resulted from improvements in the enabling environment, reductions in macro-volatility, financial liberalization, better supervision and regulation, and advances in infrastructure (including trade, payment, custody, clearing and settlement).7 However, the region’s financial sectors remain underdeveloped, measured as a share of GDP by international comparison, and heavily tilted toward consumption and less toward long-term finance for firms. The roots of particularly the short-maturity structure of debt are many. Even the region’s strongest countries have relatively weak collateral laws—including the creation of secured transactions, monitoring of collateral and enforcement of contracts; prudential regulations often penalize maturity and duration mismatches. A substantial reform effort remains.
These considerations of competition, capability and finance are relevant not only to the growth debate but also to meeting the global climate challenge in a pro-growth way. Both adapting technologies to mitigate carbon emissions and taking advantage of the region’s tremendous potential as a renewable-energy exporter are fundamentally innovation agendas, and adopting the technologies developed abroad will be critical.8 Being prepared to do this will require an open stance toward the global economy, entrepreneurs capable of recognizing opportunities and exploiting them, and a system of finance that permits diversification of risk. All three are necessary. Without competition, there is no impetus to move beyond the region’s Ford Falcons. But countries without capable entrepreneurs and workers cannot meet the challenges of competing. And without well-developed financial sectors, those capable entrepreneurs will not be able to place the bets that are intrinsic to development.
1 The World Bank: “Global Economic Prospects: Latin America and the Caribbean,” January 2023.
2 Review of Economic Dynamics: “Trade and market selection: Evidence from manufacturing plants in Colombia,” Marcela Eslava, John Haltiwanger, Adriana Kugler and Maurice Kugler, January 2013, Volume 16, Issue 1, Pages 135-158.
3 Review of Economics and Statistics: “Competition and Productivity: Evidence from Peruvian Municipalities,” Marc Schiffbauer, James Sampi and Javier Coronado, November 15, 2022, Pages 1-45.
4 Oxford Academic/The Quarterly Journal of Economics: “Competition and Innovation: an Inverted-U Relationship,” Philippe Aghion, Nick Bloom, Richard Blundell, Rachel Griffith and Peter Howitt, May 1, 2005, Volume 120, Issue 2, Pages 701-728.
5 American Economic Association/American Economic Review: Insights: “Proximity to the Frontier, Markups, and the Response of Innovation to Foreign Competition: Evidence from Matched Production-Innovation Surveys in Chile,” Ana Paula Cusolito, Alvaro Garcia-Marin and William F. Maloney (forthcoming).
6 National Bureau of Economic Research (NBER): “Growth and Risk: A View from International Trade,” Pravin Krishna, Andrei A. Levchenko, Lin Ma and William F. Maloney, February 2023, Working Paper 30915.
7 The World Bank: “Financial Development in Latin America and the Caribbean: the Road Ahead,” Augusto de la Torre, Alain Ize and Sergio L. Schmukler, 2012.
8 The World Bank: “Consolidating the Recovery: Seizing Green Growth Opportunities,” World Bank Latin American and Caribbean Region, April 2022.