Latin America and the Caribbean is expected to grow again this year after suffering a significant GDP contraction of -1.3 percent in 2016. Still, with a global environment that remains rather neutral to growth in the region, policy makers will need to walk a fine line to increase growth while ensuring protection of the most vulnerable.
In its latest semiannual report, “Between a Rock and a Hard Place: The Monetary Policy Dilemma in Latin America and the Caribbean,” the World Bank’s Chief Economist Office for Latin America and the Caribbean explores the potential of monetary policy to support growth without risking hard-won gains in the battle against inflation.
For Latin America and the Caribbean, market analysts forecast GDP growth of 1.2 percent for 2017 and 2.3 percent for 2018. The recovery will be led by a rebound in Argentina and Brazil. Argentina is expected to grow by 2.8 percent in 2017 and 3.0 percent in 2018. Brazil is expected to grow 0.7 percent in 2017 and 2.3 in 2018, after contracting for two consecutive years. Mexico will likely continue to grow above 2 percent in 2017 and 2018. Growth in Central America and the Caribbean is expected to remain at just below 4 percent in both 2017 and 2018.
“External drivers of growth, such as high commodity prices, aren’t playing a major role and the region will need to rely on homegrown sources for growth,” said Carlos Vegh, World Bank Chief Economist for Latin America and the Caribbean. “Reforms in labor markets and education, higher infrastructure spending and addressing the fiscal situation are key.”
The report finds that 28 out of 32 countries in the region will show a negative overall fiscal balance in 2017. Average debt ratios are expected to stand at 58.7 percent of GDP, with six countries having ratios above 80 percent. Finally, the recent string of natural disasters in the region will only add to existing fiscal pressures in light of the staggering losses.
“While countries in the region still need to make fiscal adjustments to adapt to the new post-commodity boom reality, many countries are right to do it gradually and thus avoid a new recession,” said Vegh. “This naturally tends to put more of the burden on monetary policy to help reactivate the economy.”
The report identifies a critical monetary policy dilemma faced by countries in Latin America and the Caribbean. Industrialized nations can reduce interest rates to stimulate the economy without worrying about currency depreciation, a rise in inflation or macroeconomic instability. But this countercyclical monetary policy is not as easy an option in the region – something reflected in the fact that several countries in South America are still procyclical. While raising interest rates in bad times helps prevent currency depreciation and keep inflation in check, it ultimately also weakens the economy.
How can emerging markets such as those in Latin America solve this fundamental monetary policy dilemma? The answer, according to the report, is central bank independence,
low levels of dollarization and credibility in the markets. This takes time, but countries such as Chile are already able to adopt countercyclical monetary policy during economic downturns without the fear of potentially making things worse for those most vulnerable.
The report also notes that other financial instruments, such as lowering legal reserve requirements to stimulate the economy in bad times, have proven helpful in countries that are still procyclical. These measures can help them respond countercyclically to a slowdown.