How to stop hot money burning Latin America's growth prospects

Capital inflows used to have a very pronounced affect in Latin America, given their association with the financial instability of the 1990s. The region used to be regularly shaken by what one economist called "sudden stops", massive reversals in capital inflows, says Augusto de la Torre, chief economist for Latin American and the Caribbean at the World Bank.

“Our analysis shows that the region is now more integrated into international capital markets and inflows are not nearly as vulnerable today,” says Mr de la Torre. Residents used to save in dollars because of credibility issues with local currencies. Financial dollarisation is slowly disappearing in the region. “More flexible exchange rates mean that currency movements, instead of amplifying shocks, have now become a shock absorber. Today, the fear of currency depreciation has been replaced by a fear of appreciation. The concept of sudden stops has to be revisited."

Harvesting value

This change is owing in part to the fact that Latin America has gone from being a very large net debtor to the world to being a creditor. Moreover, there is much more equity investment. “Surprisingly, we are more reliant on foreign direct investment [FDI] than south-east Asia. FDI is a very different animal to debt, which is subject to refinancing and currency risk as well as amortisation. Equity capital shares risks with investors, creating robustness,” says Mr de la Torre.

In 2008 to 2009, FDI flows to Latin America were incredibly resilient. At the same time, there were huge reversals and volatility in non-FDI flows. There is the perception that FDI has been largely related to extractive industries in Latin America, but that is not the full picture.

“When I recently looked at FDI by sectors I was surprised to find how much has been going into non-extractive industries: much more than I expected. This needs to be better understood and documented,” says Mr de la Torre.

Traditionally, Latin America has not been able to harvest a lot of value added from FDI, which can be an effective vehicle for the transfer of technology and learning. This is a challenge for the region. “Why don’t multinationals use their operations in Latin America more for research and development, for example? That is starting to change and, for example, Intel is creating a facility for some aspects of its operation in Costa Rica. But we need more,” says Mr de la Torre.

Policy coordination

If FDI is welcome, short-term capital flows are subject to volatility and reversals. A recent International Monetary Fund report highlighted that the time may be approaching for rich countries, especially the US, to raise rates.

“If there is no global coordination on the issue of short-term flows – and it will be very difficult to achieve this – what should be the best local response?” asks Mr de la Torre. In Latin America, authorities are developing diverse policies. There is greater consensus on what not to do than what to do. This has resulted in a hybrid of policies – a bit of everything, as Mr de la Torre describes it.

A number of solutions have been discarded. One answer would have been an immense fiscal adjustment to create room for central banks to lower interest rates, but that is politically impossible and risks increasing inflation. Allowing currencies to float freely might have led to strong appreciation and adversely affect competitiveness and possibly financial stability. That is why intervention has been popular.

“If you think capital inflows are a short-term phenomenon that will be reversed, it’s sensible to take long-dollar positions. The problem is that it is not cost-free to intervene in markets and sterilise intervention through debt issuance,” says Mr de la Torre.

A second policy is to stimulate pension funds to invest more abroad, as Colombia and Peru are doing and Chile has already done. A third option is experimentation with macro-prudential policies, including taxation. Mr de la Torre thinks that if socially undesirable bubbles are building in the economy, such tools could be used to prevent them.

Long road ahead

Conversations with the market, providing information and guidance on expectations, can help authorities implement macro policies. “The problem with markets sometimes is that they don’t coordinate appropriately and can synchronise to create asset bubbles. The role of authorities is to seek to coordinate markets to create a more sustainable trajectory so announcements on policy matters are important,” says Mr de la Torre.

These decisions are being taken as potential growth rates for the region are coming down. The strength of the external tailwinds in the past 10 years was consistent with a gross domestic product (GDP) growth of between 5% and 6%. Today, they provide for between 3.5% and 4% GDP growth.

“Latin America is bumping against constraints and if we start to try to accelerate, we generate inflation. Central bankers are going to be pressured by society to stimulate growth in the short run and they will not be able to do that without generating inflation. I think they will prevail in keeping inflation targeting as their core mandate, but it will be a challenge,” says Mr de la Torre.

How can Latin America raise non-inflationary growth? Mr de la Torre thinks that this will require reforms in many areas including fiscal structures, education and infrastructure.