The US recovery and Latin America: will tighter financial conditions overwhelm the boost from trade?
Remarks by Alexandre Tombini, Chief Representative for the Americas, Bank for International Settlements, at the OMFIF virtual panel on "Economics and diplomacy in the Americas under Biden", Wednesday 14 April 2021.
Could you give us an overview on what US developments mean for Latin America as a whole?
Sure.
To understand what all this means for Latin America, one needs to keep in mind the starting point. Economic growth had been lacklustre in most countries in the region even before Covid-19. The pandemic and the resulting economic and financial crisis then hit Latin America particularly hard, in three main ways.
First, there have been well over 20 million confirmed cases and over 700,000 registered deaths in the region, a truly awful record. Social distancing rules disrupted economic activity but were not particularly effective at stemming the spread of the virus.
Second, exports plummeted in the early days of the pandemic. Shutdowns in exports to the United States and other markets reduced export demand and disrupted the availability of inputs. Commodity prices tumbled.
Third, retrenchment by global investors hit Latin America particularly hard. Massive capital outflows went hand in hand with sharp depreciations, often despite significant FX intervention. The countries with the sharpest depreciation also saw large increases in domestic government bond yields as foreign investors, in particular, demanded a high premium to compensate for the lower dollar value of their investments. We will discuss more about capital flows in a Consultative Council for the Americas (CCA) report to be published tomorrow.
Fortunately, the financial sudden stop turned out to be rather short-lived. A swift and aggressive monetary and financial policy response, both in the advanced and emerging market economies (EMEs), succeeded in stabilising markets.
Fiscal policy, in turn, helped bridge income gaps. In Latin America, governments used both contingent instruments, such as credit guarantees, and transfers to the poor and workers in the informal sector. But, while necessary, the fiscal response also pushed up public debt levels. Large government deficits and high sovereign debt are probably the most important vulnerability in the region.
After this long introduction, let me return to the question of what US developments mean for the region. The US economy is staging a truly impressive recovery. The IMF predicts an expansion of 6.4% this year, which would leave US GDP significantly above pre-pandemic levels. There are two main reasons for this surge in growth. First, while the US did badly at containing the virus, it did very well at securing and distributing vaccines. Second, US fiscal policy is very expansionary. With the relatively conservative assumption of a fiscal multiplier of 0.5, the recent fiscal package would boost US growth by 2.5 percentage points this year and just over 1 percentage point next year. The infrastructure package currently under debate would produce another boost.
The fiscal package should boost output growth not only in the United States but around the globe. A semi-structural model of financial linkages suggests that it would lift growth in Europe by around 1 percentage point in both 2021 and 2022. For EMEs, including those in Latin America, our estimates point to much smaller spillovers. The reason is that tighter financial conditions at least partly offset the positive impact of increased export demand.
Bond yields have already started to increase. Yields on 10-year US Treasuries have increased by three quarters of a percentage point since the beginning of the year, and Latin America is already feeling the impact. Most countries in the region have seen the rates paid on local currency sovereign bonds increase since the beginning of the year. In Colombia, Mexico and Peru, yields have increased by approximately 1 percentage point since January; in Brazil, they have gone up by almost 3 percentage points. That said, spreads on dollar-denominated bonds have remained largely stable in most cases, suggesting that it is not sovereign risk that is at stake. EPFR data show outflows from bond funds invested in the region, although there has been some stabilisation in the last couple of weeks.
The big question is whether the negative impact of tighter financial conditions will outweigh the positive impact of higher US growth. The answer will clearly depend on whether the financial tightening will remain gradual and orderly. Any rise that is accompanied by an investor exodus from EMEs, as during the 2013 taper tantrum, will be clearly negative for Latin America. The answer will also depend on country characteristics. Countries with a lot of trade and limited financial linkages will benefit more than countries in the opposite situation.
On a positive note, over the medium term the region has a number of opportunities. First, the digitalisation of Latin American economies is proceeding quickly, and there is great potential. We have seen significant progress in the digitalisation of the financial sector in recent years. Many people have mobile phones but no bank account, indicating opportunity for further financial development. Second, the region is one of the best placed to develop a robust base of "green assets" to fulfil the growing mandates around the world to invest in assets that comply with environmental, social and governance (ESG) standards. Third, even the increase in social inequality could provide an opportunity. With the right policies in place, greater income equality could be a powerful driver of growth in the coming years.
Let me stop here. There are many other US policies that will affect Latin America. Trade is one example, the support for the IMF another. Perhaps we can come to these in the discussion.
You've seen the impact of global financial market developments, including the Fed, on emerging markets throughout your career. As a central bank Governor, you witnessed the taper tantrum first-hand. US longer-term rates have risen recently, and some expect further sharp increases given strong US growth and fiscal action. Some argue this could lead to a wave of debt stress in emerging markets and even contagion. Some say the benefits of US growth will outweigh the higher financing costs, especially for Latin America given its proximity to the United States. Others argue that conditions now are different than during the taper tantrum and markets are nowhere near as stretched now as then. How do you see it?
It is very hard to predict a taper tantrum-like event. The taper tantrum doesn't really stick out in terms of the size of the increase in yields. US yields went up by approximately 1 percentage point over a period of two months, and more if you take a longer window. But this is by no means unusual. If you prepare a list of the largest increases in US yields, the taper tantrum ranks in the top 20 or top 30, depending on window size and the like. But it never ranks at the top. Where it does stand out is in terms of the impact it had on EMEs.
The taper tantrum also doesn't stand out if you look at emerging market fundamentals. Yes, fundamentals were bad in some countries, especially those hit particularly hard. But they had been bad during other yield increases as well and markets somehow didn't care. So it is very hard to find an explanation for the taper tantrum based on pull factors.
Instead, one has to look at other push factors. The taper tantrum occurred at a time when things had calmed down after the Great Financial Crisis and the European sovereign debt crisis. The US economy was recovering, but growth was rather insipid, when Fed Chairman Bernanke stated on 22 May 2013 that the FOMC could envisage reducing the pace of asset purchases to ensure that the stance of monetary policy remained appropriate as the outlook for the labour market and inflation changed. For any normal person, ie somebody who is not a market professional or central banker, this sounds pretty obvious. Even so, the speech really shook the market.
So to what extent is the situation different today? Some things have not changed. Again, the rise in yields follows a period of extremely accommodative monetary policy, loose financial conditions and increased risk-taking. This makes markets very sensitive to news. But there are also differences. The US economy is growing at the fastest pace in decades. Inflation is going up rather than down. Between October 2020 and April 2021, five-year break-even inflation rates rose from 1.5% pa to over 2.5%. During the taper tantrum, US break-even rates actually fell. There has also been a shift in US attitudes towards EMEs. The new administration is much more cognisant of the importance of spillovers and spillbacks than they were some years ago. While individual EMEs, with the obvious exception of China, are relatively small in economic terms compared with the United States, taken together they do matter for the US economy.
The picture on the emerging market side is also quite mixed. Current account positions are in better shape, and international reserves have increased. But fiscal balances are deeply in the red, and sovereign debt has soared. Latin American authorities' ability to respond to an event similar to the taper tantrum is probably also more constrained today than in 2013. I fear that stretched fiscal balances, already low policy rates and inflation risks will sharply reduce policy space. Last year, central banks in the region were able to loosen policy significantly, even to purchase assets, without sacrificing their anti-inflationary credibility. But it will be much harder to maintain an expansionary policy domestically in an environment of higher global yields, especially in countries in which inflation is already on the rise.
Fiscal space in most countries is equally – or even more – limited. Increasing fiscal space is extremely important in this context. Legislating fiscal reforms that kick in in the future would provide some possible space while avoiding a sharp tightening of policy today. Similarly, getting structural reforms under way could boost investment, economic activity and, hence, fiscal soundness.
This limited policy space makes external lines of defence even more important. At the current juncture, the question is not so much whether countries will be able to keep servicing their external debt. External debt spreads have remained broadly stable as yields have increased, suggesting that investors are confident that they will be paid. The question is rather whether an investor retrenchment would lead to a sharp depreciation of the exchange rate and thus exacerbate funding conditions.
Given the dollar's dominant role in the global financial system, the Federal Reserve has played a key role in providing dollar liquidity. Its swap lines allow central banks benefiting from them to supply enough foreign currency if needed, without depleting international reserves. The Fed's FIMA Repo Facility is also helpful, at least for countries that hold enough US Treasury securities to make use of it.
However, not all countries qualify for swap lines or have large reserves. This is where the role of the IMF and other institutions is crucial. The US administration's support for broad SDR issuance is therefore welcome, especially because it could act as a catalyst: IMF lending can make other institutions and the private sector more willing to extend credit.
