As Latin American countries continue to grapple with the effects of two previous shocks, the pandemic and Russia’s invasion of Ukraine, they are facing a third shock: a tightening in global financial conditions.
Growth momentum is now underpinned by a return to pre-pandemic levels in the service sector and employment, and favorable external conditions such as high commodity prices, strong external demand and remittances, and a recovery in tourism. Reflected, it’s a plus. This has led to several upward revisions to growth this year.
But funding is becoming increasingly scarce and expensive as major central banks are raising interest rates to curb inflation. Capital inflows into emerging markets are slowing and external borrowing costs are rising. Emerging market domestic interest rates are also rising as central banks are raising interest rates to fight inflation, but also because investor appetite for risky assets is declining.
In Latin America, these factors will slow activity as rising borrowing costs impact domestic credit, consumer spending, and investment.
Earlier this year, a surge in commodity prices and solid growth momentum helped offset the impact of tighter global financial conditions. This is because investors have been drawn to regions hosting major commodity exporters amid global needs for food and energy supplies. But as the global economy slows, rising interest rates push commodity prices down, reducing their cushioning effect. An economic slowdown could also reduce exports, remittances and tourism to the region.
Uncertainty about global interest rates and whether inflation can be smoothly brought back under control (the so-called “soft landing”) means that volatility spikes and investor risk aversion are also possible. In other words, the transition to higher global interest rates could be bumpy.
solid growth and slowdown
We have raised our growth forecast for Latin America and the Caribbean this year to 3.5%, up from 3% in July, amid positive surprises in economic activity.
However, a change in wind direction ahead could cause growth to slow to 1.7% next year more quickly than forecasted in July.
Commodity exporters such as South America, Mexico and some Caribbean countries are likely to see growth halve next year as lower commodity prices amplify the impact of higher interest rates.
The economies of Central America, Panama and the Dominican Republic will also benefit from lower commodity prices, but will also slow as trade and remittances with the US weaken. The tourism-dependent Caribbean economies will continue to recover, albeit at a slower pace than expected in July, amid a weakening tourism outlook.
Fighting stubborn inflation
Despite slowing growth, Latin America will continue to face high inflation for some time.
A swift response by the region’s major central banks, which have hiked rates ahead of other emerging market and advanced economies, will help keep inflation down, but monetary policy will dampen domestic demand to put downward pressure on prices. This will take some time as it is necessary.
Price pressures have also increased recently, impacting items in the consumption basket other than food and energy. This is the case in Brazil, Chile, Colombia, Mexico and Peru, where inflation hit 10%, the highest level in two decades, testing the credibility of their hard-won inflation targeting framework.
Therefore, we have raised our inflation forecasts. Prices in these five countries are expected to reach around 7.8% by the end of the year and remain at around 4.9% by the end of next year in most cases, still above central bank tolerance.
Sound Banks, Debt Risk
Rising global interest rates will also test the resilience of private and public balance sheets. The region’s generally sound banking system has mitigated the risk of financial distress, and many countries have improved regulation and supervision.
But pockets of vulnerability remain. For example, corporate debt has increased significantly over the past decade, especially outside the banking system. Monitoring these vulnerabilities is key to identifying potential sources of stress and addressing them early.
The region’s high levels of foreign exchange reserves and strong central bank credibility will help cushion the impact of tight financial conditions, but public debt and funding needs remain high, resulting in higher borrowing costs. A rise in yields will test public finances through higher interest payments.
Tightrope walking
Central banks in the region have acted quickly, stabilizing long-term inflation expectations.
Looking ahead, monetary policy should maintain its course and not ease prematurely. Monetary policy is difficult to set amid high uncertainty, but it will be very costly if price stability has to be restored later if inflation takes hold.
Fiscal policy should focus on rebuilding policy space where needed. This will require curbing public spending, improving the design of the tax system, and strengthening the fiscal framework to ensure sustained discipline.
But because of the dire societal needs of the region, policies to reduce debt and deficits will only be effective and lasting if they are comprehensive – if they protect the poor.
Fiscal policy should go hand-in-hand with monetary policy and focus on supporting vulnerable groups, but not stimulating domestic demand, especially in the face of persistently high inflation and weakening growth, even with fiscal slack. . This will require careful adjustments to offset spending measures to protect the poor.
Getting this balancing act right is key to achieving inclusive and sustainable growth, and is the best way to build resilience to future shocks.
