Following a rough start at the beginning of the year, both external and domestic conditions in Latin America and the Caribbean have improved. But the outlook for the region is still uncertain.
Commodity prices have recovered since their February 2016 trough, but they are still expected to remain low for the foreseeable future. This has been accompanied by a brake—or even a reversal—in the large exchange rate depreciations in some of the largest economies in the region.
Most recently, the U.K. referendum on Brexit led to a sharp increase in volatility in global financial markets, especially in equity prices and exchange rates. While direct trade exposures of countries in Latin America and the Caribbean to the U.K. are small (on average about 1 percent of total exports), the region is exposed to the broader slowdown in the rest of the world—through trade and financial linkages—and fickle investor sentiment. At the same time, however, a more gradual pace of monetary normalization in the United States, with compressed U.S. term premium, should help contain funding cost pressures for both the public and private sector.
Taking all this into account, the growth outlook for the region for 2016 and 2017 has been revised up modestly—by 0.1 percentage points both years relative to the April 2016 forecasts (see table). Following the small contraction of activity in the region in 2015, we expect economic activity to contract by 0.4 percent this year (slightly better than the -0.5 percent envisaged in the April 2016 projections), followed by a modest rebound in growth in 2017 to 1.6 percent. But frequent bouts of increased financial market volatility, even if short-lived, are a constant reminder that benign market conditions can flip overnight. Such global volatility could also feed into corporate sector vulnerabilities, given increased debt burdens and lower profitability.
Mixed growth performance
Growth performances continue to differ across the region, due to a combination of external and domestic forces.
South America: an interplay between trade and domestic factors
Chile, Peru, and Colombia continue an orderly adjustment in response to a relatively sizable terms-of-trade shock (sharp drop in export revenues).
Chile’s growth outlook was revised slightly up to 1.7 percent in 2016 as momentum into the year was stronger than anticipated. The investment outlook, however, remains weak, with lower and more uncertain copper prices stalling mining investment, and weak external demand and uncertainties related to an incomplete delivery of the reform agenda delaying non-mining investment. Overall, monetary accommodation and a credible fiscal framework have helped smooth the impact of low copper prices and weak global demand.
In Peru, growth has been supported by increased production in primary sectors, as long-planned mining projects came online, and is expected to gain further momentum in 2016 (3.7 percent) and 2017 (4.1 percent). Continuing with education reforms, increasing labor market flexibility, reducing red tape, and rationalizing fiscal decentralization are the policy priorities.
In Colombia, a coordinated fiscal and monetary policy tightening will help contain the current account deficit and inflationary effects from weather-related and exchange rate shocks. Recent advances in the peace process have increased prospects of a near-term final agreement, which would further boost market confidence and spur growth. The authorities’ infrastructure agenda is on track and should also help boost growth over the medium-term.
In Brazil, GDP continued to contract in the first quarter, but by a lesser extent than expected, implying that the widely anticipated contraction for 2016 will be less sharp than previously envisaged. The economy is expected to hit bottom this year, and 2017 should see some positive growth in economic activity, although the elevated level of unemployment will be a drag on domestic demand. The interim government has outlined a gradual deficit reduction strategy that aims to curtail unsustainable spending pressures over the medium term. The proposed consolidation strategy has been broadly welcomed by markets, and the government needs to focus on overcoming implementation challenges.
In Argentina, the transition to a more coherent and credible macroeconomic policy framework continues, and should bolster medium-term growth prospects, although the adverse impact on activity in the near term has been greater than previously expected. The relative price adjustment in the first half of 2016—following the exchange rate depreciation and increase in utilities tariffs—has accelerated inflation and hurt private consumption. Economic activity is now likely to begin recovering toward the end of 2016, as inflation moderates gradually, spending is boosted, and interest rates are lowered. The easier monetary and fiscal policy stance is expected to support growth in 2017, but would make meeting inflation and fiscal targets announced earlier this year more challenging.
In Ecuador, in addition to the adverse impact of the April earthquake, the economy continues to endure the effects of low oil prices, a strong U.S. dollar, and tight financing conditions. It is expected to contract this year, but at a milder pace than projected earlier, due to the relative recovery in oil prices and more availability of external financing (mainly from China). Financing provided by the IMF under the Rapid Financing Instrument should help the country meet balance of payments needs due to the damages caused by the earthquake.
In Uruguay, growth has come to a virtual halt. However, with inflation well above the target range and public debt rising, there is little room for countercyclical policies. Efforts should focus on structural reforms, such as improving the quality and enrollment of secondary education, upgrading infrastructure, and enhancing labor market efficiency to better tie wages to productivity, to boost the economy’s productive potential.
Venezuela’s economic condition continues to deteriorate, as policy distortions and fiscal imbalances remain unaddressed. Economic activity is expected to contract by 10 percent in 2016, and inflation is expected to exceed 700 percent, marking the worst growth and inflation performance in the world.
Mexico, Central America, and the Caribbean: benefiting from the U.S. recovery
Mexico is expected to continue growing at a moderate pace, although a relatively weak performance of U.S. industrial production would increase risks. It will be important to proceed with planned fiscal consolidation and the restructuring of Pemex (the state-owned oil company) to maintain market confidence. The central bank increased policy rates recently to ensure that inflation remains close to the target. In the context of ongoing fiscal consolidation and well-anchored inflation expectations, it would be important to keep the monetary policy stance relatively accommodative.
Central America and the Dominican Republic have continued to benefit from low oil prices, a stronger U.S. growth, and higher remittances, despite a small downward revision related to the the U.S. outlook. These countries should use the relatively favorable external conditions to strengthen their fiscal positions (Costa Rica, El Salvador), protect financial stability (Honduras, Panama), and adopt reforms to boost potential growth.
Likewise, tourism-based countries in the Caribbean are benefiting from the U.S. recovery, although risks are increasing from Zika, the withdrawal of global banks, and Brexit. Conversely, still low commodity prices continue to weigh on growth prospects for commodity-based economies in the Caribbean. Addressing fiscal vulnerabilities, strengthening the financial sector, and boosting long-run growth are the key policy objectives for most countries.
How to stabilize and boost growth
Given the sizable terms-of-trade shocks and increased volatility in global financial markets, exchange rate flexibility remains the first line of defense. Reassuringly, in countries with well-established inflation-targeting frameworks, large exchange rate depreciations have had a relatively limited pass-through to domestic inflation (see Chart 1). Clear central bank communication continues to be key in keeping inflation expectations well anchored.
Fiscal space remains limited across most countries in the region, and particularly so for commodity exporters, given still low commodity prices and recent bouts of volatility. Preserving policy buffers remains vital in case further risks materialize. A faster pace of adjustment is warranted for countries with large debt burdens and sizable market pressures (see Chart 2). Countries benefiting from a positive external environment and decent growth should also use this period to strengthen their fiscal positions.
Finally, now would be the right time to address bottlenecks to reinvigorate potential growth in the region. Policies aiming at improving education and infrastructure, and strengthening the rule of law would help support growth and increase resilience to shocks.
Filed under: Caribbean, Economic outlook, Emerging Markets, IMF, International Monetary Fund, Investment, Latin America, South America, trade, Transition | Tagged: Argentina, Brazil, Brexit, Central America, Chile, Colombia, Dominican Republic, Ecuador, exchange rate depreciation, export revenues, GDP, growth potential, IMF, iMFdirect, International Monetary Fund, Mexico, Peru, trade, Uruguay, Venezuela |