September 18, 2006	Monday	Sha'aban 24, 1427

Latin America

THE economic expansion in Latin America gathered momentum in the first half of this year, with regional GDP on track to rise by 4.75 per cent in 2006 as a whole and by 4.25 per cent in 2007. Moreover, inflation largely remained subdued, anchored by credible monetary policy regimes in most of the larger countries. While external performance has continued to be supported by high prices for key commodity exports, domestic demand has become the main engine of growth. Convergence of inflation to targets has provided room to unwind previous monetary tightening in Brazil and Mexico, supporting a pickup in growth in both countries.

Unsettled conditions in global financial markets in May–June 2006 initially dampened Latin American equity prices and exchange rates, particularly in the most liquid markets like Brazil or in markets that had previously seen strong price run-ups like Colombian equities. However, markets have since recovered much of the lost ground, and Latin America’s expansionary momentum seems to have been little affected. This resilience seems to reflect in part reduced vulnerabilities, including a shift to current account surpluses, more flexible exchange rate regimes, higher reserve cushions, and strengthened fiscal positions across the region.

The Latin American economy achieved high growth for the third consecutive year in 2005, mainly led by exports. Investments have also accelerated the pace of growth. In terms of international balance of payments, current account balances in Latin America posted surpluses for the third consecutive year, mainly because international trade terms improved due to price increases in primary goods, and because of increases in incoming foreign remittances from workers abroad. Foreign reserves accumulated enormously, and so Brazil and Argentina repaid their borrowings from the IMF ahead of schedule.

However, according to most leading economists of the region, Latin America remains the slowest-growing region among developing countries, underscoring the need to reduce poverty and institute reforms that will appease frustrated populations. The region lags behind other regions in implementing measures that would raise economic openness. But resurgent private investment and strong domestic demand are propelling the region’s growth, while inflation has remained under control because of solid monetary policies in most large nations.

The region has the world’s second-largest reserves of hydrocarbons, but it has largely failed to respond to the increase in international prices since 2004 with higher production and investment. The Latin American economists are of the opinion that high oil prices are a major obstacle, especially for the impoverished countries. Latin American economies growth was reasonable despite the fact that it remained lower than that of Southeast Asia and China. There are a number of obstacles that have limited economic growth in Latin America, including health and education care and investment financing, as well as the need for greater political reforms and efforts to counter corruption and reduce high taxation. Many Latin American countries needed to create a more competitive atmosphere to attract foreign companies working in the oil sector.

Brazil

Brazil is Latin America’s largest economy. Economic recovery is now under way, underpinned by resilient private consumption and strong net exports. Investment is set to bounce back. Disinflation is ongoing. External vulnerability indicators have improved markedly, and the trade and current account balances continue to post robust surpluses. The policy mix remains tilted towards monetary restraint, despite the steady decline in interest rates. The consolidated primary budget surplus target is likely to be met, but the fiscal stance will become expansionary in 2006. There is growing concern that further reform is needed to arrest the increase in current expenditure commitments.

Economic Growth last year fell to 2½ per cent from nearly five per cent in 2004. High domestic real interest rates, a strengthening currency, and some spill over to business and consumer confidence from political scandals involving high officials of the ruling party all contributed to the slowdown. With more monetary easing probably yet to come, it is reasonable to expect an acceleration of real GDP growth to 3½ to four per cent for this year and next. However, further monetary easing needs to follow market sentiment that lower domestic interest rates are appropriate—not try to force interest rate declines that the market views as unsustainable. From this perspective, the recent resignation of Brazil’s highly effective finance minister and his replacement by someone less clearly dedicated to fiscal responsibility is not a positive development. The National Monetary Council has set an inflation target of 4.5 per cent for 2007, with a margin of two percentage points above and below the target. It also maintained the same target for next year. Inflation expectations in the 12 months to the end of June 2006 were within target levels. The central bank implements the council’s inflation guidelines but can pursue its own target within the established range. This year the central bank is pursuing a target of 5.1 per cent, although the maximum established by the council is seven per cent. While the central bank has frequently missed its inflation target in recent years, there are some indications next year’s target could be within reach. Consumer price increases have been slowing in recent weeks and the broader IGP inflation index, used to calculate future utility rate increases, has been falling for the past two months.

Pressures: Recent market pressures have provided a timely reminder that the global context is likely over time to become less friendly to emerging markets, with rising interest rates, less buoyant non-oil commodity prices, and reduced appetite for the riskier assets. This prospect poses the question of what further steps countries in Latin America could take to prepare for more testing conditions ahead. Disciplined fiscal policy should be at the core of an effective policy framework for dealing with this challenge. Taking advantage of cyclically strong revenues to raise the primary surplus in good times helps to lower public sector debt and provide a more robust basis to weather periods of weakness.

After suffering through the side effects of some tough monetary policy medicine in 2005, Brazil’s economy is feeling chipper these days. Despite a recent bout of “emerging markets blues”, Brazil should register real GDP growth in the vicinity of four per cent for 2006 as a whole. First quarter real GDP growth came in at 3.4 per cent compared to 2005’s first quarter, after expanding by just 1.4 per cent (year-over-year) during the fourth quarter of 2005. The acceleration in GDP growth was led by solid growth in personal consumption expenditures and new signs of life in business investment spending. Domestic demand is responding to a series of interest rate cuts dating back to September 2005, and the strong likelihood of further rate cuts leads us to expect an even faster pace of GDP growth over the coming quarters.

Brazil also continues to benefit from solid global economic growth, which continues to stimulate demand for Brazil’s exports of agricultural and industrial commodities, although what until mid-May had been a steady appreciation of the real has taken a toll on exports of consumer goods such as shoes, textiles, and autos. Consumer spending is serving as the key driver of Brazil’s accelerating pace of economic growth. Fuelled by falling interest rates, rapid household income growth, and readily available credit, Brazil’s consumers have taken a cue from their counterparts to the north. Spending on goods across the board is rising, with consumer durables such as appliances and automobiles in particular benefiting from lower interest rates and an explosion in consumer credit.

Labour: Not all of the news from the labour market is positive. In contrast to the robust job growth figures, Brazil’s unemployment rate has climbed back up over 10 per cent; May’s 10.2 per cent rate is a slight improvement over the 10.4 per cent rate posted in both April and March. It appears that much of the rising jobless rate is attributable to the effects of the stronger real on exporters of consumer goods, many of whom have shut production lines and lay-off workers in recent months. Further interest rate cuts and a weaker real is expected to provide some relief for such producers over the coming quarters, which will help drive the jobless rate back below 10 per cent.

Brazil’s external sector continues to undergo a positive transformation. Robust global economic growth and favourable commodity prices have helped generate healthy trade and current account surpluses. Despite some pullback in recent weeks, Brazil has been a beneficiary of ample global liquidity in recent years, as Brazil’s high interest rates have helped attract foreign capital, and the real has appreciated sharply. The central bank has taken advantage of the opportunity presented by this set of conditions to build up its level of international reserves. Moreover, Brazil has aggressively pared down its external debt, to the point that the ratio of external debt-to-exports is currently at its lowest level in over 25 years. A stronger external position leaves Brazil less vulnerable to any adverse effects of sharp swings in global capital flows than has been the case in the past.