Home Finance The Challenging Outlook for Latin America and the Caribbean: Opportunities for Reform

The Challenging Outlook for Latin America and the Caribbean: Opportunities for Reform

by internationalbanker

By William F. Maloney, Chief Economist, Latin America and the Caribbean, World Bank

 

 

 

 

The Latin America and the Caribbean (LAC) region is emerging from a COVID-induced recession that ranks among the most severe in a century. The scars on the economy and society will take years to fade, but as governments learn to manage sequential pandemics, attention will turn to the longer-term prospects of the region.

The social costs from the first wave of the pandemic have been devastating. Poverty rates (excluding Brazil)—measured at $US5.5 per day—rose from 24 to 26.7 percent in 2021. Schools were closed more days than in almost any other region, leading to a loss of 1 to 1.5 years of schooling, with the most severe losses accrued by lower-income students without access to computers or connectivity. Unremedied, this will have long-term, adverse effects on growth and social equity.

The economic recovery was stronger than predicted in mid-2021 but weaker than favorable tailwinds would dictate, and challenges to its consolidation have been manifold and unpredictable. Forecasts of 2021 regional growth were progressively upgraded over the summer and fall, and 2021 ended at 6.7 percent, largely recovering 2020 losses. However, given the robust recoveries in principal trading partners, low global borrowing rates and prospects of another commodity super-cycle, history would suggest that growth rates should have been 1 to 1.5 percentage points higher.

The region faces several potential short-run challenges. First, clearly, any recurrence of the virus will lead to declines in economic activity, particularly in service sectors. This would occur not only because of lockdowns but also fears of the infection reducing economic activity. The arrival of the Omicron variant was, hence, unwelcome news; cases rose sharply in December and January and are now 30 percent above the previous COVID peak in June 2021. The good news is that the vaccination drive has dramatically picked up steam over the last six months: as of mid-January 2022, 60 percent of the population was fully vaccinated and 72 percent partially, with Chile among the most vaccinated countries in the world. The World Bank has been active both in financing vaccines and brokering deals with providers. As elsewhere, this will presumably reduce the incidence of severe illness and, as in the United States, dampen the negative repercussions on the economy. Still, 14 out of 32 countries will not meet the targets of 70-percent vaccination by mid-2022. These are concentrated mostly in the Caribbean, which according to the World Bank’s High Frequency surveys, show high rates of vaccine resistance that will prolong the stalled recovery in tourism. More generally, the region will need to strengthen the capacity of its healthcare systems and ensure resources are available to maintain comprehensive and flexible approaches in using a variety of tools. 

On the financial front, there are three principal short-to-medium-term concerns:

First, high levels of private-sector debt and lack of clarity on banks’ balance sheets could weaken financial-sector stability. World Bank Pulse Surveys suggest that in many countries, 40 to 60 percent of firms are in arrears as a result of pandemic-driven falls in revenues. This overhang will, in the best case, dampen investment and, in the worst, leave a residual of zombie firms that are effectively bankrupt but still in operation. To the degree that banking systems are forbearing debt payments, this could also be creating a de-transparentization of the financial sector, where the system’s true level of nonperforming loans is hard to discern. Governments will need to streamline presently unwieldy debt-resolution mechanisms, monitor systemic soundness and be vigilant on both the firms’ debt and banks’ balance-sheet fronts.

Second, should global inflation pressures continue to resist being temporary, global borrowing rates will rise, depressing demand and challenging budget management. During the pandemic, many governments extended support to both families and firms while revenues fell, leading to large public-sector deficits. The average ratio of public debt to gross domestic product (GDP) has risen dramatically over the past two years by 15 points to 75 percent, leading to reduced ability to borrow abroad and complicating fiscal management going forward. In many cases, this has led to ratings downgrades and potentially raised borrowing costs. At present, the fiscal situations of most countries appear sustainable but will be complicated by sharply increasing international borrowing costs.

Third, domestic inflation has been rising, leading to the central-bank tightening that we have seen over the last months in most major countries. In the first year of the pandemic, average inflation in Brazil, Chile, Colombia, Mexico and Peru—the LA5—was below the average for other emerging-market economies. It is now higher, averaging 8 percent year-on-year in October. Some outlets have set inflation expectations for LAC as the highest in the world for 2022 at 10.5 percent. To some degree, this is driven by the same supply-side bottlenecks and demand shocks visible elsewhere. However, the tightening of international liquidity has also led to currency depreciations in the larger countries ranging from 1 to 5 percent, which pass through to the prices of imports. The monetary authorities of the region have responded cautiously but increasingly actively over the last three months.

Of longer-term consequence, the COVID-19 crisis came on top of another “lost decade” of low growth, suggesting that deeper structural problems need to be addressed. From 2010 to the outbreak of the pandemic, LAC grew at 2.2 percent per year, while the world grew at 3.1 percent. The forecasts for 2022 and 2023 are similarly modest at 2.6 and 2.7 percent, respectively. This lackluster recovery, together with the low growth rates of the previous decade, suggests structural problems are internal to the region and point to the urgency of addressing the list of long-recognized growth-impeding internal shortfalls in infrastructure, education, energy policy, firm capabilities and innovation while confronting new climate-change challenges. The situation is by no means uniformly bleak across countries and industries, and, historically, green shoots often arise from crises, triggering large-scale economic restructuring. As an example, while hospitality and personal services have suffered greatly, accelerated digitization brought about by the need to socially distance could help boost sectors such as information technology, finance and logistics, and these may, in turn, enhance market competition and increase economic efficiency. This may help accelerate the inflow of venture capital into digital service sectors. As discussed below, there are also opportunities in emerging green technologies, where Latin America is likely to have a comparative advantage.

However, the region faces a set of challenges exacerbated by COVID. First, remedying educational losses and building infrastructure—green, digital or otherwise—takes resources from now very cash-constrained governments. This puts governance, particularly in public finance, squarely on the reform agenda. There is room in many countries to raise more revenues. A very promising agenda over the medium term is the better use of available resources on several fronts. Estimated inefficiencies in procurement, civil service and targeted transfers in LAC represent an average amount of waste in the region of 4.4 percent of GDP—larger than the current average spending on health and almost as large as the average spending on education—and accounts for about 16 percent of usual government spending. Public procurement of goods, services and capital equipment accounts for, on average, 30 percent of spending, and World Bank simulations have estimated possible savings of 16 to 22 percent with straightforward modifications in practices and without changing existing procurement laws. The average wage bill consumes 29 percent of general government spending, and human-resources inefficiencies are estimated to cost 1.2 percent of GDP. Reforming government human resources and management is a neglected effort on which the World Bank has undertaken substantial research recently. Finally, about 30 percent of public spending on average in LAC consists of transfers, including social programs, subsidies (mostly energy) and contributory pensions; inefficiencies through mistargeting and waste are estimated at 1.7 percent of GDP.

Beyond this agenda, the World Bank’s semi-annual report Recovering Growth: Rebuilding Dynamic Post‐COVID-19 Economies amid Fiscal Constraints1 highlights reforms in healthcare, education, energy transfers and innovation spending and infrastructure, with both shifting the composition of spending and improving the efficiency of delivery advancing growth, equity and confidence in government.

A second area to revisit is how to mobilize the private sector to, for instance, help finance large-scale investments in infrastructure and energy. Public investment in infrastructure as a share of GDP has fallen by two-thirds since the 1980s and has not been offset by public-private partnerships (PPPs) or other private funding mechanisms. This overall drop has had adverse impacts on competitiveness, growth and equality. Studies have identified barriers to better use of existing resources, including weak planning, project appraisal and preparation capacity; overly rigid or myopic budgeting designed to control fiscal deficits rather than promote efficient spending; difficulties with budget execution; unclear project sustainability, often due to imbalances between capital and current spending on infrastructure—frequently arising, again, from overly rigid budgets and suboptimal planning; weak procurement practices; and, finally, often uncompetitive construction industries. Savings in traditional infrastructure are potentially large. Expansion of digital infrastructure is relatively cheap and could increase productivity, connect rural areas and build in resilience to future crises—for instance, through broader access to distance learning. Clearly, getting the incentives right in complex political and economic environments has been a challenge, but progress is being made on this front. Colombia’s 4G and 5G frameworks have been credited with raising unprecedented private financing and merit close attention to learn from and emulate elsewhere.

Finally, Latin America faces both challenges and opportunities in the green transition. On the mitigation front, despite the fact that LAC contributes relatively little to global carbon emissions, the region will need to prepare, both in policies and certification mechanisms, to meet the likely carbon border adjustment measures (CBAMs) or other environmentally related taxes and barriers, particularly in agriculture. That said, the region also has a comparative advantage in the green economy and, hence, opportunities to actively pursue: It has the cleanest energy matrix in the world, which both gives an edge to traditional sectors and also offers opportunities in new sectors such as green hydrogen; it is rich in mining resources, such as lithium, that are central to the decarbonization agenda; its forests have the potential to serve as a region-wide carbon sink; and as the world’s first net food exporter, it has the potential to lead in low-emissions food.

This transition will require substantial investments, both public and private. On the public side, redirecting energy subsidies potentially offers substantial resources. Depending on global energy prices, energy subsidies can cost several points of GDP and remain poorly targeted: 40 to 60 percent of electricity subsidies, for example, go to the top 20 percent of the income distribution. Moving away from general subsidies and providing targeted support to vulnerable populations would free up resources to explore conservation measures, sources of low cost and environmentally sustainable power, or other green infrastructure.

It is important to remember that in addition to shifting incentives—for instance, through carbon taxes or redirecting extant energy subsidies towards green projects—both the adaptation and mitigation agendas are fundamentally technology-adoption agendas, and, hence, improving the functioning of LAC’s innovation systems is an important complement.2 As Marcello Estevão noted in these pages in 2020, technology transfer is essential to taking advantage of the opportunities offered by the green transition.

This points to a longer-term agenda of learning how to accumulate the technological and entrepreneurial capabilities needed to leverage the region’s areas of comparative advantage to generate diversification and productivity growth. As an example, copper provided a strong foundation for diversification in the US and Japan, while Latin America has had difficulty moving beyond extraction.3 Hence, the problem is not the celebrated resource curse, for which evidence is scarce in any case, but rather one of identifying and adapting (and eventually inventing new) technologies that other resource producers managed to overcome. Nor has LAC’s manufacturing sector proved to be an automatic high-growth sector, introducing new-to-the-world technologies or products. Addressing this underperformance will require, at the most basic, severing the Gordian Knot that has prevented progress in education, particularly in technical areas—it is hard to be technologically bullish in a region where standardized test scores continue to be low, only a third of high-school graduates meet the minimum standards for science, and higher education (while very costly) produces relatively few engineers or the technical staff that are ubiquitous in those economies that are successfully catching up. Beyond this are the challenges of improving managerial practices as well as entrepreneurial and innovation ecosystems, which have been explored over the last decade in the World Bank Productivity Project.4

Hence, the outlook for Latin America and the Caribbean is decidedly mixed. Governments have responded agilely and generously during the COVID crisis to mitigate the shocks and will have to be creative in approaching the scars left on families and firms. New variants of the virus, private-sector stress, rising financial-sector opaqueness, global difficulty in taming the inflation that brings higher borrowing rates and complicates debt management all pose short-term challenges to fiscal management and recovery. However, the fact that growth was low before COVID and is projected to remain low over the next few years urges us not to lose sight of the longer-term reform agenda that is critical to both greater growth and equity.

 

References

1 World Bank Group: “Recovering Growth: Rebuilding Dynamic Post‐COVID-19 Economies amid Fiscal Constraints,” October 6, 2021.
2 International Banker: “Climate Solutions Lie Within Our Grasp—If We Can Transfer Technology Rapidly,” Marcello Estevão, March 26, 2020.
3 World Bank Group: “Learning to Learn: Experimentation, Entrepreneurial Capital, and Development,” William F. Maloney and Andres Zambrano, December 2021.
4 The World Bank: “The World Bank Productivity Project.”

 

 

ABOUT THE AUTHOR
William F. Maloney is the Chief Economist for the Latin America and Caribbean (LAC) region at the World Bank. Maloney joined the Bank in 1998 and has held various positions, including Lead Economist in the Office of the Chief Economist for Latin America, Lead Economist in the Development Economics Research Group and Chief Economist for Trade and Competitiveness.

 

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