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Guillermo Calvo: A matter of choice

Sep 1, 2013

Latin America’s resilience to the global financial crisis may have been little more than a fluke. As a period of rapid expansion draws to an end, its fundamentals are now weaker than in 2008 – and the region more vulnerable. By Guillermo Calvo

Latin America’s resilience to the 2008 global financial crisis was as surprising as the crisis itself. It seemed an improbable outcome, especially given the fate of emerging markets following the 1998 Russian crisis. Back then, it took roughly five years for spreads to return to their pre-crisis levels, and that episode involved only emerging market economies – relatively minor players in global capital markets.

A reasonable inference was that the emerging market turmoil in the wake of the Russian crisis was a function of weak market institutions in the emerging world. So, one might have reasonably assumed that the impact on emerging markets of a major crisis in the developed world would be Armageddon.

Yet, Latin America sailed through the 2008/2009 episode virtually unscathed and has since grown at an unprecedented rate. There are, however, a number of important reasons to be less sanguine today about the prospects of emerging markets and LatAm, in particular.

Granted, LatAm faced the Lehman episode with much stronger fundamentals than in 1998. For instance, the region boasted a positive current account balance – a phenomenon that began in 2003 and which had not been seen since 1980. This gave the region space to partially offset the external blow and, in sharp contrast to 1998, to implement counter-cyclical measures.

However, this stronger stance also coincided with a period of skyrocketing terms of trade. Although the terms-of-trade trend has not yet reversed, the region’s current account has already plunged into negative territory.

LatAm’s resiliency may therefore have been little more than a fluke – a lucky turn of events in which strong fundamentals arose from expenditure that lagged an unexpected terms of trade bonanza. But spending will eventually catch up with income and the region will return to business as usual. Studies by the IDB show that LatAm’s fiscal deficit is unsustainable, except under the most optimistic scenarios.

Another important factor is that the aftermath of the Lehman episode saw developed world central banks undertake unprecedented counter-cyclical measures, which led to a rapid recovery of financial indicators. Indeed, the rapid recovery of LatAm’s financial indicators following the Lehman episode was to a large extent down to the largesse of developed world central banks.

Today, external conditions are becoming riskier. China’s growth slowdown suggests that terms of trade are unlikely to keep rising. The US economy is starting to pick up and interest rates on 10-year Treasury bonds have risen beyond expectations. Historically, this has been bad news for the region.

The change in the global environment has already been reflected in currency devaluation and tighter financial conditions across the region. This appears to have exacerbated already declining growth rates and fueled inflationary pressures.

In addition to weaker emerging market fundamentals relative to 2008, persistently low policy interest rates in the developed world may have given rise to capital flows in search of liquid assets in the emerging markets. Such demand would, therefore, be highly sensitive to a change in US monetary policy.

Under these conditions, US monetary tightening raises the serious risk to emerging markets of a sudden stop – an abrupt contraction in capital inflows. Such a risk was most starkly illustrated in Mexico’s 1994/1995 Tequila crisis. Moreover, because such an episode would occur amid improving US economic prospects, it is unlikely that there would be any easing of US monetary policy, as in 2008.

This all suggests that a period of buoyant expansion for Latin America may have come to an end.

This is a low-saving region: even in a relatively benign scenario where there is no sudden stop, lower access to foreign savings is nevertheless likely to stall growth –and fuel social unrest.

This raises serious questions about the nature and quality of the ensuing political response. Will populism prevail? Are political leaders prepared to adopt or sustain pro-poverty growth policies based on higher saving and investment rates? Will a new generation of leaders be able to convince their constituents that this is the way to go?

To do so will require tough short-run adjustments that governments were unable to implement during the boom years. The region’s prospects for the years ahead depend on the answer to these questions. LF

Guillermo Calvo is professor of economics and international and public affairs at Columbia University

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