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Parting Shot: Reversal of fortune

May 1, 2013

The benefits of the commodity boom are set to fade – even if prices don’t fall sharply, warns Claudio Loser. Latin America’s blessing could soon become its curse

For commodity exports, high prices with high volatility are the new norm. Prices have declined by more than 10% from their recent peak in February, but are almost twice as high as 10 years ago, and 70% higher than in 2008. Rising terms of trade have led to growing prosperity, to an extent not observed in many years.

Policymakers in Latin America are nervous because of higher inflation, increased public sector deficits, and external current account gaps. But fundamentally they feel comfortable because of the resiliency shown in recent years, and because of a benign world outlook. As the rise in commodity prices slows and the volatility of these prices increases in the years to come, can this prosperity be maintained, or will it end?

This issue is even more relevant if prices trend down, as has happened with some commodities already. Unfortunately, it will not be easy. A reversal of prices would have a major impact on disposable income, and thus on growth through the normal channels into the domestic economy.

A slowdown in the advanced world and the larger emerging economies would cause a shock. The past may repeat itself with periods of growth and prosperity followed by times of crisis and reform. The last 200 years bear witness to this pattern.

It has been customary to view the impact of commodity prices on developing economies in terms of their impact on GDP growth. In fact, it is crucial also to capture the increase in disposable income directly generated by higher export prices, captured by Gross Domestic Income (GDI). The effect of these gains is significant: Latin America’s increase in GDI, not directly reflected in GDP numbers, has been 14% of GDP since 2000. That is even higher in other regions.

In addition to this effect, the increase in real output generated by higher prices – the multiplier effect of exports – is also relevant. The combined effect of terms of trade changes on GDI and the GDP multiplier is roughly 1.7% of GDP a year in Latin America between 2000 and 2012. This is one third of growth in GDI of 4.5%. In Africa and in the Middle East, it accounts for about half of GDI growth.

On the basis of these estimates, if terms of trade were simply to stabilize at the current high levels, the multiplier effect would disappear, and there would be no additional gains in GDI in excess of GDP. As a consequence, GDP (and GDI) growth rates in Latin America would tend to fall to a rather mediocre trend growth rate of about 2% to 2.5%, from 3.7% (and 4.6% growth in GDI) in the past decade.

A steep but not unusual decline in terms of trade of 10% would result in a one-time decline in income of 5% in Latin America, with grave consequences for public finances and the external accounts. Growth rates could then converge to the lower path of growth just mentioned.

These numbers are not cast in stone but are indicative of the fragility of the outlook for the region, even though countries like Mexico are less exposed to this danger.

The last several years of commodity-led prosperity have resulted in a degree of complacency in Latin America that is misplaced. The impact of lower terms of trade can be staggering. Prices will continue to fluctuate, and may even show a secular downward trend.

It is essential for policymakers to prepare. Fiscal discipline, including structural rules like in Chile, a competitive private sector, better education, and a well-protected financial system are of the essence to survive. Otherwise, volatility will take over, with lower economic growth and increased poverty, reversing a course that many wrongly assumed would continue indefinitely. LF

Claudio Loser is president of Centennial Group Latin America, advisor to the Emerging Markets Forum, and senior fellow at the Inter-American Dialogue. From 1994 to 2002 he was director of the Western Hemisphere at the International Monetary Fund.

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