Crisis Response in Latin America: Is the ‘Rainy Day’ At Hand? Eduardo Fernandez-Arias InterAmerican Development Bank Peter J. Montiel Williams College

Crisis transmission to Latin America Widespread uncertainty and collapsed productive asset values. Increased external borrowing costs and large capital outflows. Sharply reduced export demand. Adverse changes in terms of trade. Reduced flows of worker remittances

Reduced vulnerability Financial systems healthier. Central banks stronger, have enhanced credibility. More flexible exchange rate arrangements. Fiscal reforms have enhanced the flexibility of fiscal systems, many countries have demonstrated both the political will and economic ability to make significant fiscal adjustments.

Large stocks of international reserves accumulated as “rainy day funds.”

Bottom line: Sudden disruptions associated with banking and currency crises are less likely. Financial and macroeconomic policy institutions have more credibility (thereby making deviations from medium-term policy stances less disruptive to expectations). Policymakers have means at their disposal to counter shocks – in the form of large reserve stocks – that have not been available in the past.

On the other hand… Reforms have not been carried out uniformly throughout the region, and in many cases they are both recent and fragile. Some countries have implemented reforms that may have made them less resilient in the face of the types of shocks that the region is currently experiencing.

Most importantly… Although public debt stocks have been reduced significantly relative to the size of the relevant economies, they remain uncomfortably large for many countries in the region, and few countries have achieved a state of safe fiscal solvency.

Policy response Aside from financial-sector rescue policies several industrial countries, as well as China, have responded with very expansionary monetary and fiscal policies. Should Latin American countries follow suit?

Yes: Severe contractionary aggregate demand shock, little threat of inflation. No: Effectiveness of countercyclical policies may be more limited. Constraints on policy implementation.

Constraints Currency mismatches may limit feasible depreciation (“fear of floating”). Prospective fiscal insolvency. High cost of public borrowing.

The case for constrained fiscal expansion High prospective social benefits to public spending on infrastructure, health education. Low resource cost of such spending when resources are underemployed. Strong potential aggregate demand effects of such spending (nontraded-intensive, real depreciation, potential “crowding-in” effects of public investment).

Perhaps most important point: need for stabilization to avoid imperiling a still- fragile financial sector.

But is the “fiscal space” available? Based on simple fiscal sustainability exercise and current borrowing spreads, countercyclical fiscal policy is on the table: Strongest argument for fiscal space in Chile. More limited fiscal room for countercyclical expansion in Brazil, Colombia and Peru. For Venezuela, and to some extent Argentina and Mexico, any fiscal stimulus package would add to an already sizable deviation from a sustainable structural primary balance, which makes it potentially destabilizing.

Role for institutional reform? May be able to expand fiscal space by combining countercyclical spending with reform of fiscal institutions that makes future adjustment more credible. But political economy of reforming institutions while increasing the deficit is problematic: it may be easier to reform at a time when looser fiscal policy is required, but doing so at such a time may make the reform less credible if reversible.

Is the financing needed to implement the right policy available? Above ignored high cost of external borrowing (low global liquidity) and vulnerability to sudden stops of external finance. However: Aggregate market rollover of public debt in Latin America is less than 15% external. Weakness of external credit markets is being increasingly offset by official creditors. Countries have accumulated substantial “rainy- day” funds in the form of international reserves.

The rainy day is at hand Social opportunity cost of funds is high, government foreign borrowing costs are high, but financial returns on reserves are low. The implication is that there is a strong case for prudent countercyclical fiscal policy in the region directed toward productive public expenditures with reserves as a funding source.

Counterarguments to reserve financing: Need reserves to avoid real depreciation. Need reserves to protect against prolonged liquidity crisis.

But: Reduced vulnerability in the region to currency mismatches weakens the force of the first argument. Reserve indicators are at an all-time high and being supported by multilateral lenders. Reserve hoarding is beneficial only if duration of liquidity crunch is not too short (no need) or too long (no use).

Bottom line Well-managed public investment programs in Latin America would fill an important deficiency in the availability of productive public goods and would stimulate domestic aggregate demand, thereby minimizing the effects of the adverse external shocks that the crisis has generated for the region on real economic activity.

By doing so, it would safeguard the health of domestic financial sectors, avoiding the triggering of mechanisms that would greatly magnify both the real and financial effects of the crisis. The amount of “fiscal space” available to undertake such spending varies from country to country, but does not preclude policy action except in particular cases.

Relying on market borrowing at high cost to finance fiscal needs may be risky, but the cushion afforded by the foreign exchange reserves that were accumulated during pre-crisis years provides a source of financing that can be advantageously drawn upon by countries that are not constrained by currency mismatches or extensive exchange rate pass-through.

Role of multilateral institutions Support the right fiscal policy (stimulus or adjustment depending on fiscal space) Do so providing liquidity to supplement costly and precarious market funding available Multilateral liquidity supports a reserve-financed strategy in two equivalent ways: –Reserves support: Lending to (or backing up) reserves, then used to finance budget –Budget support: Lending directly to budget, thus avoiding the use of reserves to finance budget