After the pandemic and the invasion of Ukraine, a third shock – the tightening of financial conditions in developed economies – is hitting Latin America with constraints on accessing finance. It’s not going to be a short ride, warns Ilan Goldfajn, Director of the Western Hemisphere Department at the International Monetary Fund. But governments, he says, must not stop investing in clean energy, education, infrastructure and institutions today for sustainable – and inclusive – growth in the future.
The world has faced two major shocks over the past few years: the pandemic and the Russian invasion of Ukraine. The economy has recovered from the pandemic, but the consequence is high inflation. We are in a place where in order to be able to reduce this inflation, the global economy will end up having to decelerate.
The consequence for Latin America is that we are facing a third shock: the tightening of financial conditions. This is not a shock that we’ve never seen before like a pandemic a hundred years ago or the Russia war. Every time there is a tightening of financial conditions in developed economies, financial flows reverse toward safer assets, and Latin America starts to have net-negative flows. The dollar gets strong, and currencies depreciate in the region. Financial conditions also tighten in the region because you have inflation domestically, and so interest rates go up. Our calculation is that for every 1% of tightening outside the region, you get more than 1% tightening inside, and that eventually will lead to a deceleration of the region’s economy.
Image: Ilan Goldfajn
We’re going to face a period where access to finance will be limited. It has already started. Issuance has gone down. But more important than being able to still issue during this period is to have built up buffers for periods when the markets dry out. Countries that have enough reserves and have lines of credit, and that do not rely too much on hard-currency debts and have debts with long maturities, it is these countries that will be able to withstand this period of tightening financial conditions.
In general, the region is better prepared for this type of tightening than in the past. We have more capacity to absorb the shock through floating exchange rates. We have more credible and independent central banks. But the tightening cycle will still have an impact. You can be better prepared, but your currency can still depreciate, and your commodity prices go down. The region has a lot of commodity exports and commodities globally will go down. While the second shock of the Russian invasion of Ukraine was pretty bad for everybody, one advantage for commodities exporters was that you had a mitigating factor because you were exporting what the world needs. But the third shock, the tightening cycle, brings commodities down because the global economy will decelerate, and so that mitigating factor will disappear.
I’ve been telling authorities that they should be prepared for a longer ride with this financial tightening cycle because we are no longer in a world where shocks are very transitory. The Russian invasion is still ongoing. The pandemic is only now getting to a point that we can have normal lives after more than two years. The length of the financial tightening will depend on how persistent inflation is. So far, we’ve done well. Central banks are acting to bring down inflation. It usually takes more than 12 months to reduce high inflation, but there is the possibility that inflation will be more persistent if it gets into the wage negotiations and wages get into inflation. And then we will have what we call in central banking, the secondary effects of the shock, because it gets into the system, and it takes longer to go down. It’s not going to be a short ride.
When you have a period of high inflation like now, it is helpful to have both monetary and fiscal policy working in the same direction. And fiscal in the same direction means fiscal consolidation. The challenge is that you have to work on social needs at the same time. The only way to do this, especially now during the tightening shock, is to concentrate on inclusive consolidation. This means that your fiscal accounts must be in order, but you will need to make choices. You will need to use your revenues in a way to spend it in places where society is asking you, to reduce poverty, to concentrate on the most vulnerable people, and on gender, climate and income equality. It is the same thing with revenue. There are more progressive and more regressive ways of getting revenue. We know that there is a need for fiscal consolidation, but you need to consolidate thinking about the other dimensions, the social and the political dimensions. That’s the only way you’re going to have sustainable economic and social outcomes over time.
When you have social demands and fiscal constraints, the only way you can work on both is if you get the economy to grow. You cannot ignore the constraints in the short term. But over time, investing in education and productivity is the only way to no longer lose the decades but find the decades and grow. Education is essential for productivity, and productivity growth is essential for all sustainable economic growth. When you start growing, then things start to square up so you can give people the services they demand and deserve.
We cannot just live for shock after shock and see what we can do. We need to find space to deal with the medium and long term. That is the only way avert another lost decade. If we are prisoners of the short term or prisoners of the shock, we will never get ahead because we will be dealing with one crisis after the other.
Education is always referred to as the last priority because it’s not urgent tomorrow. It’s not urgent tomorrow, but if you don’t do it? If you don’t invest in infrastructure, you’re not going to have enough infrastructure. If you don’t start investing in clean energy, you’re not going to have a clean economy in the future. It’s the same with institution building. It’s always nice to use existing institutions to solve the short-term problem, but you need to give them independence, you need to have credibility, because that is the way you’re going to fight inflation in the future. Prisoners of the short term use all the margins they have to solve the short-term crisis, but that doesn’t allow you any space to think about your medium and long term.
We talk to countries about reforms, and they want to spend time on them. But reforms are sometimes very hard because emergencies come and there are political constraints. It’s very hard to be able to save time and energy and money for the future when the present is not easy. But to meet social demands and still be economically sustainable so that we can actually grow, the only way to do that is with productivity and growth. And this will not come from just thin air. It will come from quite a bit of investment. LF
Ilan Goldfajn is the director of the Western Hemisphere Department at the International Monetary Fund. This is an edited transcript of his comments in an interview with Charles Newbery.