Carib resilience to external economic shocks

A new study by the Inter-American Development Bank (IDB) says that Latin America and the Caribbean remain resilient to a possible slowdown in world economic growth that could stem from a deepening of the debt crisis in Europe and a deceleration in China.

The 2012 Macroeconomic Report, released in Montevideo, Uruguay, on Mar. 18, during the IDB’s annual meeting, outlines two major potential economic risks the region could face in the next year: a faster-than-expected deceleration of China’s economy and deepening economic problems in Europe.

Using a global economic model, the study says that even if both of these two major events were to occur, Latin America and the Caribbean might suffer only a relatively mild recession.

The study, presented to the IDB’s Board of Governors, “The World of Forking Paths,” offers a comprehensive analysis of potential risks affecting the region in the short and medium-term, providing an assessment of main macroeconomic vulnerabilities and strengths, as well as policy recommendations.

“We are cautiously optimistic for Latin America and the Caribbean. The region has grown strongly in the last couple of years and it has shown it is resilient to shocks,” said Santiago Levy, Vice President for Sectors and Knowledge for the IDB.

“Most importantly, the region has developed a set of policy tools that have proven to be effective during economic downturns,” he added.

The report notes that a number of countries, especially commodity exporters, have accumulated international reserves that would help cushion them from international financial turbulence and have reduced external liabilities.

Breaking with the past, the report says most countries were able to implement effective fiscal stimulus packages to smooth the last downturn, and have gained valuable experience in counter cyclical fiscal policymaking.

It says most of the larger economies in the region have adopted flexible exchange rate regimes that make it easier for them to smooth fluctuations.

It also says that several countries, in recent years, have implemented more sophisticated monetary policies and employed macro-prudential tools, such as the active use of bank-liquidity requirements and measures to slow currency appreciation, “which have all enhanced the region’s resilience against another possible international financial crisis.”

“Even though current economic scenarios do not anticipate a major crisis in Europe or a strong slowdown in China, the world is quite uncertain right now—it really is one of forking paths,” said Andrew Powell, Principal Advisor in the IDB’s Research Department and the coordinator of the report.

“Our report shows that resilience has increased for the region, but certain vulnerabilities remain and may limit the scope for countercyclical policies if the crisis were to worsen in Europe,” he added.

According to the report, Latin America and the Caribbean’s dependency on commodities remains high and a surge in capital inflows has increased private sector, foreign-currency portfolio liabilities.

Moreover, the presence of a large number of European banks could make the region’s banking sector vulnerable to a credit squeeze, the report says.

Under the stress scenarios outlined in the study, the report says Latin America and Caribbean external accounts remain resilient to external shocks, urging the region to continue to have access to external borrowing and to official sources if required.

The report says a series of micro and macro prudential regulations have reduced latent risks for problems in the financial sector, stemming from strong capital inflows and credit boom over the last few years.

The report also says one area of some concern is that most of the countries in the region have less room to implement a fiscal stimulus package today than in the wake of the 2008 financial crisis.

In contrast to the past, the report says most countries in the region, under a variety of exchange rate regimes, have managed to contain monetary growth and inflation despite external shocks.

“In the event of another major financial crisis, countries that utilize inflation-targeting may not have as much flexibility to lower policy interest rates but have ample room to employ non-conventional tools, such as lowering bank reserve requirements and introducing foreign currency auctions to increase domestic liquidity,” it says.

In addition, the report says a worsening of the crisis in Europe may lead major European banks in the region to accelerate asset sales and reduce lending.

It, therefore, urges regional banking regulators to monitor the behavior of all banks and develop rules to strengthen the corporate governance of local subsidiaries.

“Authorities may wish to monitor banking liquidity to ensure that there is no disruption in domestic financial markets, in the event of a negative external shock,” the report says.

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