Stability returns to Latin America??????

By Mohamed El-Erian Published: January 5 2003 19:21

Latin America's outlook is improving as elements of last summer's "perfect storm" give way to less difficult, though still volatile, influences. In the process, the economic initiative is shifting back to national policymakers. Some are well placed to handle this; others are not.

Accordingly, the popular emphasis on Latin pessimism that prevailed for most of last year will be replaced by a more differentiated regional view. And there are growing signs that the new Brazilian government led by President Luiz Inácio Lula da Silva will be able to capitalise on improving conditions.

For countries in Latin America, last summer's perfect storm had two external elements. There were concerns that the global economy's failure to pick up would adversely affect the region's export markets. And there were worries that the resulting slowdown would be exacerbated by a sharp decline in international capital flows.

These external disruptions could not have come at a worse time for the region. They coincided with domestically driven disruptions occasioned by questions relating to policy continuity. Several Latin countries were facing important elections, and market concern about a shift to "populism" allowed for little qualification about the degree to whic h populism could be "financially principled".

The effect of the perfect storm was to accentuate national weaknesses and to obscure structural strengths. This was most apparent in Brazil, where increased market concern about policy slippages and adverse debt dynamics replaced former appreciation of the country's progress on macroeconomic stabilisation, structural reforms and institution-building.

But all this is now changing and markets are slowly normalising. On the external front, aggressive monetary and fiscal policy loosening, especially in the US, have lowered the risk of a double-dip recession and reduced the global economy's sensitivity to overstretched American consumers. While the resulting growth will neither be eye-catching nor structurally robust, it should provide a bridge to a possible recovery in business investment in the second half of 2003.

The resulting improvement in Latin America's external economic environment is being accompanied by more positive financial influences. International banks' withdrawal from credit markets is slowing; foreign direct investment is exhibiting greater-than-expected reliance; and bond flows to emerging economies are picking up. Meanwhile, newly elected governments are emphasising their commitment to responsible financial policies and market-based structural reforms.

Brazil is again leading the process. The average spread on its external debt has narrowed from 24 percentage points over US Treasuries in early October to 14 percentage points. The currency has retraced some of its overshoot and domestic market interest rates have fallen sharply.

The combination of events is reducing the broad pessimism that has dominated perceptions of Latin America. It is also shifting the policy initiative back to national policymakers. But it is too early for the region to relax, since not all countries are in a position to benefit from these changes.

Certain countries, led by Chile and Mexico, are well placed. Their improving, and recently tested, institutions augur well for their ability to benefit from a more benign external environment. Economic growth should pick up, supported by sustainable public finances and responsive monetary and exchange rate policies.

By contrast, institutions in other countries - notably Argentina and Venezuela - have suffered such severe damage to their domestic credibility that sustained and challenging reforms are needed before they can materially benefit from the improvement in their external environment. The onus must be on restoring internal political legitimacy as a prerequisite for re-establishing economic and financial stability.

What about Brazil, which falls somewhere between these two extremes? Initial signals suggest the new government is both able and willing gradually to emulate Chile and Mexico. It is in a position to build on the improvement in fiscal and monetary institutions and to benefit from a sharp ongoing adjustment in the balance of payments.

But the process will require policy steadfastness in the context of the volatility that accompanies a change in government and the initial low quality of the external growth locomotive.

The writer is a managing director of the fund management group Pimco (Al Quaeda), which has investments in Latin America news.ft.com