Latin America had a golden decade from 2002 to 2012, mostly thanks to favorable external conditions. Its commodity exports prices raised almost continuously, there were abundant capital inflows and low international interest rates. This golden decade has come to an end, even while no sudden worsening of external conditions is expected.

Latin America grew at more than 5 percent annually from 2003 to 2011, converging toward industrialized countries’ gross domestic product (GDP) per capita (see Figure 1). This was in sharp contrast to what had happened in the previous two centuries, when divergence was the name of the game (see Figure 2).

Many analysts and market players wondered if we were witnessing a turning point, as has happened in the Asian NIC´s¹ since the sixties (see Figure 2), and Latin America would conform in the future to the convergence prediction of neoclassical economics. Words of euphoria (“The New Latin America,” “The Latin American Decade,” and the like) came from many quarters, and investors flooded the region with Foreign Direct Investments and portfolio inflows. A few commentators, mostly from academic circles, were more subdued; noting that behind the boom was a large and continuous increase in terms of trade and exceptionally high international liquidity. The more skeptical ones warned that when these external propellers came to an end—as they had to do eventually—the euphoria could end up in tears, as had often happened after previous booms in Latin America.

The day of reckoning is here. Growth in terms of trade (fueled by the spectacular growth in real commodity prices from 2003 to 2011) has come to an end (see Figure 3). Most commodity prices have fallen from their peak in 2011. It seems unlikely, though not fully improbable, that they would come back to the low levels of the nineties, but few would bet now that they could hike again as they did in the golden period from 2003 to 2011.

Moreover, as the US recovery consolidates and Europe comes slowly out of recession, international liquidity will eventually tighten. It took only an announcement of “tapering the taper” from the Federal Reserve System in May 2013 to generate significant market turbulence and capital outflows from many developing countries, including most in Latin America. Though recent announcements from the Federal Reserve System and additional liquidity from European Central Bank have calmed the markets, Latin America cannot count on an indefinite flood of capital inflows and extra low international interest rates going forward.

So far, this time has been somewhat, though not totally, different from the past. Neither the extreme optimists nor the catastrophists are being proven right. Latin America has gone back to mediocre historical growth rates since 2012, and Venezuela and Argentina have been suffering acute stress and fighting desperately a sharp reserve drop (see Figure 4), with imposition of all types of controls on capital outflows. However, for the rest of the region the word crisis seems to have disappeared from current discussions and concerns.

Why This Time Was Different: Building Resilience

In contrast with previous episodes, Latin American countries came out, on average, relatively unscathed from the 2008/2009 global crisis and have resisted relatively well subsequent market volatility. Financial contagion was low. Though capital inflows receded somewhat for a while, the region was far from experiencing a sudden stop, as had happened in several other episodes of international market turbulence. Many countries in the region avoided altogether a drop in credit, and in others there was a fast recovery after an initial sharp fall, also in sharp contrast with past experiences of prolonged credit crunches and with what happened in the developed countries. There were no bank failures in Latin America, while many banks had to be rescued i the United States and Europe. In summary, and contrary to what used to happen in periods of more modest international market turbulence, there was a very mild financial contagion from what proved to be the largest global financial crisis since the Great Depression.

To be sure, Latin American economies did suffer a major slowdown in 2009 as a consequence of the global crisis, as evidenced in Figure 1. But the channel of transmission was mostly the sharp fall that took place in global trade, and not financial contagion, as was often the case before. The fact that there was no financial crisis in the region, nor a sudden stop of capital inflows, nor major credit crunches, facilitated a very rapid recovery in 2010. This was no mean achievement and in marked contrast with Latin American past history. Furthermore, the contrast with what happened this time in the United States and Europe was impressive.

These facts suggest a potential turning point with respect to a history of high volatility and proneness to financial crisis in the region. To assess their relative strength vis-à-vis potential new adverse shocks in the future, it is important to understand why it was different this time.

Latin America was traditionally highly vulnerable to changes in mood in international financial markets, due to a combination of several factors:

1. High external liquidity risks, due to large current account deficits and short-term external debt, coupled with relatively low international reserves. 

2. High balance sheet risks, due to large currency mismatches in both government and corporate balance sheets (in non-tradable sectors).

3. High financial-sector risks, due to poorly capitalized and weakly regulated and supervised banks, used to engage in large credit booms and busts, intermediating highly volatile capital inflows.

4. High fiscal risks, due to high fiscal deficits and public debt in foreign currencies, which translated into liquidity and balance sheet risks for the government.

When the Lehman Brothers shock took place, there had been important advances in all these areas, taking advantage of the previous boom conditions. First, external liquidity risks were at an all-time low. Reserves were much higher than short-term debt and current account deficits much lower than in the past. Second, balance sheet risks had been sharply reduced. Third, banks were well capitalized and provisioned, and credit booms had been modest. Fourth, fiscal vulnerabilities were lower than in the past. Figure 5 shows that public debt/GDP ratios were around or below 60 percent for all major countries. Brazil’s and Argentina’s were the highest, and Chile’s and Peru’s the lowest (around or below 20 percent). Furthermore, Figure 6 shows that Chile and Peru had fiscal surpluses and the rest of the large LAC countries had modest deficits around 2007/2008. It is to be noted, however, that by 2013 fiscal balances had deteriorated in most countries, notably in Venezuela, where the deficit was around 15 percent of GDP. Argentine and Mexican deficits had also increased to about 4 percent.

In addition, the floating exchange rate regimes in several countries (Brazil, Chile, Colombia, Peru, and Mexico) permitted an automatic exchange rate depreciation and the use of countercyclical monetary policies, thus helping to absorb the external shock without a major contraction in activity. Central banks in these countries had largely overcome their traditional “fear of floating” because inflation rates and inflationary expectations had come down—so there was less fear of the inflationary pass-through of nominal devaluations that characterized our history—and currency mismatches had been reduced, avoiding the adverse balance sheet effects that often led to bankruptcies after abrupt nominal devaluations. Within this group of countries, Brazil was less able to apply a countercyclical monetary policy, because some inflationary pressures survived.

Even more important, as already mentioned, there were no financial crises in the region (no bank failures and no significant credit crunches), in sharp contrast to what was happening in the United States and Europe. Banks were well capitalized and provisioned, and credit growth during the boom had been modest. In addition, a lower degree of financial integration and sound prudential regulations had precluded the accumulation of toxic assets that had rendered so fragile US and European banks. Most Latin American countries thus appear to have learned from their previous history of frequent and costly banking crises.

However, even with these caveats, it remains true that most countries in the region appear to be today more resilient to adverse external shocks, especially to financial shocks, than in past decades.

Why This Time Was, However, Not Completely Different: Dutch Disease, Low Productivity Growth, and Complacency.

The fact that the region has returned to its modest historical average growth rates, or even lower, since 2012 suggests that this time is not, however, entirely different from the past. Indeed, the reversal of external push factors that has taken place (no further terms of trade gains and lower world growth) fully explains the significant slowdown experienced by the region since 2012, and recent growth rates seem close to potential, based on current investment rates and total factor productivity (TFP) growth, under present external conditions.² Furthermore, several countries accumulated Dutch Disease symptoms during the boom that may negatively affect their medium-term growth.

The analysis of Latin American performance during the past decade supports either a moderately positive or a moderately negative view of the region’s future growth prospects. The glass looks half full when looked at through the lens of vulnerability to crises. The average performance of the region during the 2008/2009 global crisis and its fast recovery were truly outstanding and seem to mark a departure from past trends. This time was definitively different in this regard. Most Latin American countries (except for Venezuela and Argentina) seem to have learned from the high frequency and costs of past currency, banking, and fiscal crises. They did take advantage of the boom period from 2003 to 2008 in significantly reducing currency mismatches, liquidity risks, and financial-sector risks. It seems likely that such reduced macro/financial vulnerabilities will characterize the new Latin American landscape going forward, with exceptions.

Furthermore, flexible exchange rates helped absorb the adverse external 2009 shock in Brazil, Colombia, Chile, Peru, and Mexico and permitted their use of countercyclical monetary policies for the first time in decades. This notwithstanding, there were significant Dutch Disease symptoms, especially in Brazil and Colombia, that may affect their capacity to recover from an eventual further drop of commodity prices. Chile and Peru have also been successful in applying countercyclical fiscal policies, and the other large countries, except for Venezuela, avoided the strong procyclical fiscal policies that characterized their previous history, though there was some fiscal loosening after 2009.

However, the glass looks half empty when looked at through the lens of productivity growth. Performance on this front continues to be disappointing, and modest progress in basic productivity determinants (in particular the continued low pace of innovation and poor quality of basic education in all countries, but also the infrastructure lags, excessive red tape, low access to credit by SMEs, and low quality of institutions in many of them) does not bode well for the future. In this sense, this time was not different. Latin America did not take advantage of the recent boom to strengthen most of its key long-term growth fundamentals.

__________________________________________

1. Newly Industrialized Countries

2. See Brookings Institution (2013) and World Bank,(2013b).

The blog was created in base of the Guillermo Perry and Alejandro Forero Rojas' paper "Latin America: The Day After. Is This Time Different?", and was first published in the Center for Global Development Blog.