William F Maloney: Reviving Latam’s growth in uncertain times

Latin America is returning to a new normal that might be termed ‘resilient mediocrity’. On average, gross domestic product (GDP) and employment losses during the Covid-19 pandemic have been recovered. Poverty rates have fallen to pre-Covid levels, most big countries are inoculated at global rates, and although the lost year and a half of learning will have long-term impacts on growth and equity, Latin America’s children are back at school. The unwelcome guest at policy discussions is inflation and, as everywhere, the duration of the visit is proving longer than expected. But this is not a ‘Latin inflation’ episode of the past: most countries are near or below Organisation for Economic Co-operation and Development (OECD) levels with a median rate as of 6% in the first half of 2022.

However, the region faces two finance-related challenges. First, in the short term, the average 10% of GDP rise in debt accumulated during the pandemic – and corresponding budget deficits – grow harder to manage as global and domestic interest rates rise and growth cools.

That said, Latin America is far more resilient than in the past and it has navigated both this and the global financial crisis (GFC) of 2007 generally without major mishap. The stronger institutionality in central banks, ministries of finance and bank supervisory agencies has led to stronger buffers and preventative actions. The foreign-denominated component of debt was only 35% in 2021, compared with 45% in 2007 and 60% in 2004, while reserves as a share of GDP have risen from 12% in 2004 to 14% by 2007 and 20% in 2021. All reduce the probability of the unsustainable currency mismatches that have ignited past crises. At the micro level, although the stress on firms and families during the pandemic raised concerns of a rise in non-performing or reprogrammed loans, neither are currently high compared with either the GFC or the peak of the pandemic.

Finally, central banks reacted early and aggressively, relative to previous inflation episodes: Brazil began fiscal tightening in March 2021, a full year before the Federal Reserve, Mexico in June and Chile in July. Success in achieving some easing of inflation in both Brazil and Chile has now led authorities to signal caps on further rate rises. These countries may be at the beginning of what World Bank research terms “the cycle within a cycle”, where after initial sharp rises, there is a pulling-back to avoid damaging the economy.

The second, and more preoccupying challenge, is that growth has been mediocre for two decades and shows no signs of acceleration. While GDP growth exceeded expectations for 2022 at 3%, forecasts for 2023 and 2024 are 1.6% and 2.5%, respectively. These low rates might be dismissed as lingering side effects of Covid-19, but they echo those of the 2010s, when the region grew at 2.2% while the world grew at 3.1% – arguably another lost decade. These rates are too low to make progress on poverty or facilitate social mobility.

History of reforms

Past reforms have borne fruit, but the pending reform agenda remains long, including in the financial sector. Part of the increased macro-resilience of the region is supported by the deepening and diversification of domestic capital markets over the past decades that have precisely resulted from improvements in the enabling environment, reductions in macro-volatility, financial liberalisation, better supervision and regulation, and advances in financial infrastructure. Financial inclusion had also risen, giving more poor households access to credit.

However, financial markets remain shallow compared to comparable countries, and hence are unable to provide the risk diversification and liquidity necessary for firms contemplating increasingly complex investments of long gestation. Credit to the private sector by financial institutions and stock market capitalisation as a share of GDP – even in Chile, Brazil and Peru – are roughly half of that found in comparable countries such as South Korea, Malaysia and Thailand, and are tilted toward consumption instead of long-term finance for firms or infrastructure.

Root cause

The roots of both the slow deepening and particularly short maturity structure are many, and constitute a reform agenda in themselves. Collateral laws need to be strengthened, including the creation of secured transactions and the monitoring of collateral. Contract enforcement costs 30% more in both time and share of the claim recovered than in the OECD; insolvency resolution takes almost twice as long, and investors can expect to recover only 30 cents on the dollar, compared with 71 for the OECD. The region also lags in the depth of financial reporting standards. Progress on these and other fronts could contribute to deepening financial markets and extending maturities. 

However, in the medium term, even these reforms are unlikely to redress the formidable challenge in the financing of public infrastructure, which is a perennial drag on growth. Public investment hovers at around 4%, while in east Asia, Africa and the Middle East, it is closer to between 7% and 8%, with infrastructure spending correspondingly lower. Public-private partnerships have mobilised some, but insufficient, resources and the increased political and economic risk have made foreign investors even more reluctant to engage in long-term projects, leaving the government as the financer of last resort. 

Moving forward

The need to meet the infrastructure challenge, manage the higher debt burden and redress long-standing social needs has thus moved generating fiscal space to the centre of the policy debate, again posing an extended reform agenda on multiple fronts. Estimates of the savings from reforming procurement practices, improving human resource policies and redressing leakages in transfer programmes add up to around 4.5% of GDP on average and could constitute the leading edge of campaigns to modernise the public sector. New fiscal reforms seek to mobilise resources, balancing progressivity, resource collection and impact on growth in the process. The World Bank’s work shows that in emerging markets these trade-offs may differ from those seen in advanced economies, and an important research agenda remains.

In addition, the increased political and economic uncertainty is leading firms to pause investments. But, more fundamentally, the ability of firms to evaluate, structure and manage the risk of projects may be limiting the demand for credit over the longer term. Historical evidence and the recent lacklustre scores on the World Management Survey suggest that the region has been and still is lacking in both technical and entrepreneurial skills. The implications may extend from, at the most basic level, an unfamiliarity with the accounting and reporting requisites for lending, to an inability to identify, adapt and execute the complex and risky projects that drive growth today. 

Both finance and managerial capabilities come together as countries seek to increase the competition that is known to both cull weaker firms and incentivise the stronger to innovate and grow. Recent research from Chile shows that only the top 10% most sophisticated firms increased innovation in response to more Chinese competition; the others decreased it.

Similarly, field visits with small and medium-sized enterprises in Colombia’s auto parts sector reveal a minority of firms able to formulate a strategy to meet Chinese imports and who reported problems of financing with long-term credit, and a large segment for whom a strategy was elusive and who were likely to contract. Clearly it is important to increase access to finance for the leading firms, but so is increasing the share of leaders who will positively respond to competition by investing in upgrading. Consulting services can help, as can strengthening the supporting entrepreneurial systems. Over the longer term, expanding the pipeline from basic to technical and entrepreneurial education will be necessary to generate a larger cadre of world-class entrepreneurs. 

The positive steps that Latin America and the Caribbean have taken over the past few decades have left the region more resistant to short-term economic shocks. But further reforms to the business climate and financial system, as well as strengthening the capabilities of entrepreneurs and their support systems, will be necessary to lift growth and take advantage of new opportunities, for example, in emerging green technologies, and thrive in a global economy that is becoming ever more technologically sophisticated and competitive. 

William F Maloney is chief economist for Latin America and Caribbean at the World Bank.