Tue | Sep 18, 2018

Fiscal vulnerabilities in Latin America

Published:Friday | December 19, 2014 | 12:00 AM
An aerial view shows PDVSA's Puerto La Cruz refinery complex at Anzoategui, Venezuela. Walter Molano says that after 2008, countries such as Venezuela spent massively on energy subsidies, taking the form of virtually free gasolene. - File

Dr Walter T. Molano, Guest Columnist

The past decade has been unprecedented for Latin America. Millions of households were pulled out of poverty. There has never been so much access to credit for the middle class and below. Most economies have tripled in size. Exports rose 160 per cent in volume and 270 per cent in value. Public external debt collapsed.

On top of that, most of the governments and societies learned to survive with flexible exchange rate regimes.

This allowed central banks to wean themselves off currency nominal anchors, allowing many of them to achieve low single-digit inflation rates by using advanced monetary tools, such as inflation targeting.

These are the main reasons why some analysts argue that Latin America is well prepared to weather the looming change in United States monetary policy.

Capital flows into Latin America may decline, but the countries should be able to maintain stability, or so they argue.

However, one of the silent problems plaguing Latin America has been the sharp deterioration of its fiscal position. This may open an unexpected window of vulnerability, which could destabilise the region.

Latin America was in terrible shape at the start of the millennium. The emerging markets were buffeted by a series of crises for the latter half of the 1990s.

Within two years after the start of the new millennium, Argentina and Ecuador would default on their external financial obligations, and Uruguay would be forced to restructure its foreign debt.

Many people whispered that the region was on the cusp of another Lost Decade. However, two external shocks occurred.

Halfway through 2001, China became a member of the World Trade Organisation and the developed world embarked on an aggressive monetary expansion programme.

At first, the monetary expansion was driven by the collapse of the dot.com bubble, then by concerns about the millennium bug and later by the terrorist attacks of 9/11.

The combined effect of the shocks was a sharp rise in commodity prices and a tidal wave of capital inflows into the emerging world. International reserves soared as the funds poured in. Fiscal balances moved into the black as government revenues spiked.

Temporary improvements

At first, most of the governments considered the improvement in the external environment to be transitory. In the past, they had seen temporary improvements in terms of trade suddenly evaporate, leaving their economies badly exposed.

Between 2003 and 2008, the region posted a primary fiscal surplus of 2.7 per cent of GDP. However, the situation changed drastically at the end of 2008 with the onset of the US financial crisis. There were worries that China would be dragged down by the downturn, but suddenly it appeared to have decoupled from the West.

As a result, commodity prices recovered the ground that they initially lost. This was accompanied by an unparalleled expansion of the money supply by the US central bank, the Federal Reserve.

The Fed slashed interest rates to zero and launched an enormous quantitative easing programme. The improvement in the external environment no longer seemed transitory. It was permanent.

The authorities had the green light to embark on countercyclical fiscal policies. Government spending across the region went up by four per cent of GDP, thus pushing the combined primary balance firmly into the red.

Some countries, such as Argentina and Venezuela, were the most egregious, especially by spending massively on energy subsidies. In Argentina, the subsidies took the form of virtually free electricity and gas. In Venezuela, It took the form of virtually free gasolene.

There were other massive spending increases across the board. Education allocations doubled, public employment went up by a quarter and there were some increases in public investment.

Unfortunately, the quality of the spending was poor. There was barely any improvement in education statistics. Health care remained horrible and infrastructure deteriorated. The latter was due to the larger demands placed on infrastructure through the addition of new users, such as cars and travellers.

This is one of the reasons why there has been no increase in Latin American productivity, despite the enormous expansion of government spending. Most of the outlays were directed to populist consumption-based spending, which made a large part of the population dependent on handouts and subsidies.

The question now arises, what will the region do when external conditions change and government spending has to be reined in?

It could be the double whammy of destabilising the economy and fuelling social discontent, both of which would be nasty outcomes.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC. wmolano@bcpsecurities.com.