Latin America has the foundations for growth. Here's 3 ways it can build on them

Economic growth
Macroeconomics - Economic growth - Monetary Policy

Image: REUTERS/Fredy Builes

The city of Medellin used to be synonymous with drugs and violence. Not any more

The World Economic Forum meeting in Medellin in Colombia has strong symbolic connotations. Medellin used to be synonymous with guerrilla warfare, paramilitary violence and drug-related atrocities.

Not any more. Colombia and Medellin has transformed over the last decade. A strong surge to restore security, with strong support from the United States and the international community, has laid the foundations. The military and the police force are much better anchored in the local community. The guerrillas involvement in kidnapping, extortion and drug trafficking has undermined their legitimacy. At the same time, improved governance has strengthened the credibility of the democratic system and the elected governments.

Economic reforms have laid the foundations for growth. Macro-economic stability has been improved. The public debt level and inflation has been kept under control. The third component in the transformation has been an effort to improve social cohesion.

Growth in numbers

Now the global environment is challenging the progress that has been made in Colombia and Latin America. Over the last decade, growth has been averaging 4-5%, but for the coming years the IMF, OECD and others are arguing that growth is going to remain around 2-3%. Given that population growth is between 1-2% in most of Latin America, the per capita improvement is not going to be transformational in terms of poverty reduction. Without fundamental reforms, the per capita growth level will be in line with Germany and France, but with a Latin American macro-economic risk level.

There are two major factors changing the economic environment. The world economy has entered a period of slow growth. When China is shifting from investment-led growth towards a more sustainable path, demand will be weaker in the global economy. At the same time growth in advanced countries has been low. The combination of low productivity growth, demographic factors weighing on the labour supply and lack of demand in the aftermath of the Lehman-crises has reduced growth in industrial countries by at least 1 percentage point. Low global growth is hurting Latin America.

A second factor that is hurting Latin America is the rapid decline of commodity prices. To a degree this is an indirect effect of the slowdown in China. China has been contributing some 60-80% of the demand growth for various commodities over the last decade. That period now has come to an end.

Demand is no longer outrunning supply

There has also been a hefty increase in supply and production capacity for oil, iron ore, copper and soya beans. The demand is no longer outrunning supply and there has to be an adjustment period. It might be that we have passed the bottom of that cycle, but that remains to seen. The fact that shale oil has revolutionized production in the US and that Iran has re-entered the market means that production can start to increase if prices are moving upwards. The underlying conflict between Iran and Saudi Arabia also undermines OPECs ability to influence the prices.

In addition to the slow global recovery and the commodity prices, some of the Latin American countries have added substantial political uncertainty at exactly the wrong point in time. The collapse of the presidential administration of Dilma Rousseff in Brazil and downfall of Cristina Fernandez de Kirshner in Argentina has added political uncertainty. If the new administrations in Brazil and Argentina are able to rebuild credibility in the markets, that would be a step in the right direction.

If we do not see a fundamental recovery of commodity prices and if the world economy doesn't enter a strong recovery, Latin America will have to manage on its own.

To shift to a path of a 4-5% long-term growth, some deep structural reforms will be necessary. Let me outline the most important steps forward.

  • Colombia, Brazil, Mexico and Argentina all need to increase their degree of openness. The productivity growth in the domestic sector has been low because the regulatory barriers are heavy and that competition pressure is too weak. This is particularly true for the service sector. Banking, corporate service, retail sales, tourism, insurance, transportation, telecommunications and power production are just a few examples of sectors where regulatory reforms could increase productivity growth. The underlying theme of the World Economic Forum meeting in Medellin in Colombia is how Latin America could use the Fourth Industrial Revolution. The 4IR is a real opportunity: digitalization leads to increased competition and can circumvent traditional barriers. This is why governments should trailblaze the way for the digital revolution.
  • On the external side, the dramatic depreciation of currencies creates an opportunity. The relative cost level is now competitive. The Colombian peso has fallen some 75% against the dollar during the last two years and many of the other currencies have also taken a heavy beating in the markets. If this is going to bring any stronger competitive position in the long run there is an urgent need for economic reforms. If everything remains the same, history is likely to repeat itself, and that implies that higher inflation and domestic contraction will dominate in the short term and increasing costs will start to undermine competitiveness. To attract foreign direct investments and investments in production from international companies, there has to be reform. The informal trade barriers have to be reduced, the tax regimes have to be made more attractive and the long-term stability of investment conditions improved.
  • To reduce the risk of a new negative circle of cost increases, undermining the depreciation with higher wage increases and weak productivity labour market reforms should be high up on the agenda. Colombia, Argentina, Brazil and Mexico could benefit from greater flexibility on the labour market.
  • Another core area of reform is education. Latin American countries need to raise the skills of the labour force to be able to improve productivity growth. The OECD and IMF have pointed out that all levels of the education system underperform. To improve social cohesion and social mobility, investments in comprehensive education on a broad scale is necessary. Also, in the field of education, 4IR can play a crucial role. To give students access to education, improve the standard of education and increase access to student loans the digital disrupters can play a crucial role and the governments should do what they can to support this development.

The World Economic Forum meeting in Medellin has a strong symbolic meaning. Security, growth and cohesion are building a new future for Medellin and Colombia. With the right political leadership and a willingness to reform, this could be a long-term transformation. The 4IR can both disrupt and transform Latin America.

This post first published in the World Economic Forum Blog, on June 20, 2016.

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