A. David Knox
Despite the drop in production that followed the debt crisis of 1982, Latin America has very considerable weight in the world economy. The combined gross national product of Latin American countries is as large as that of Germany, and a fifth as large as that of the United States. In the long run, markets in the region can be expected to continue growing, if for no other reason than rapid population growth of about 2.5 percent a year.
Before the debt crisis of 1982, 18 percent of US exports went to Latin America. The economic contraction in Latin America reduced growth in the industrialized world by at least 1 percentage point and, as a result, some 400,000 jobs have been lost in the United States since 1982. Latin America’s imports—half of which come from the US—are now far below their pre-crisis levels. Given the region’s place in world trade and capital markets, a resumption of its growth is clearly in the interest of the world economy.
This article first reviews Latin America’s progress in the past two decades, pinpointing areas of current policy that are crucial for future adjustment and the resumption of growth. It then describes the World Bank’s work in the region.
Building economic power
The Latin American economies grew very rapidly after World War II, thanks to their immense natural resources (notably minerals, agriculture, and energy) and talented population. Between 1960 and 1980 production grew faster in Latin America than in the United States and for most people in the region the gap in income with the United States narrowed. Of course, different countries performed differently. Brazil, where over a third of the region’s population lives, outperformed the other countries by a wide margin. But Colombia, Mexico, and Venezuela, as well as several smaller countries, improved income per person at least as fast as the United States.
This growth in incomes went hand in hand with considerable social improvements. During the 1960s alone life expectancy at birth, the most meaningful single indicator of welfare, increased from 56 to 64 years, which is not far below the average for middle-income European countries such as Greece, Portugal, or Yugoslavia. Only 40 percent of the population had access to safe drinking water in 1960; over two thirds have such access now. And by the late 1970s most Latin American children attended primary schools.
At the spearhead of economic and social progress were the middle classes, whose importance has increased throughout the region. One way to illustrate their rise is to look at the ownership of cars and television sets. In 1960 about 5 percent of families owned a car; by the late 1970s more than 20 percent did so. In Brazil and Mexico nearly 30 percent of families now own cars. More than one half of Brazilian families own a television set; even in the poor Northeast nearly 30 percent of families have TV. The rise of the middle classes has a direct bearing on Latin America’s economic future, inasmuch as their political power—particularly on economic issues—has become very strong. As the recipients of subsidies on gasoline, electric power, housing, or interest rates that are made possible by increased borrowing, the middle classes often show themselves vociferously opposed to government plans for austerity measures.
Crisis and adjustment
The improvements described above were, however, interrupted. As the world economy entered into recession, export demand dropped and interest rates increased sharply; and, as commercial bank credits to Latin America were withheld in the wake of the Mexican debt crisis, most countries in the region had to adjust drastically.
The prospects for resuming growth in Latin America rest on both internal and external factors. Internal factors are of fundamental importance because they alone are within the power of governments and also because only successful internal adjustment can lead to sustained growth.
Adjustment is a word used in many different ways. In one sense adjustment is inescapable when external financing is curtailed and export demand falls, as was the case in 1982 and 1983. But a country can adjust in many different ways. It can cut imports or expand exports. It can reduce consumption and wages, or cut investment. It can raise taxes, or cut government spending. Usually elements of all these policies are combined. The particular combination chosen by a country strongly influences its prospects of sustained recovery.
In the first phase of adjustment virtually all Latin American countries had no choice but to reduce imports drastically. In the second phase some countries managed to expand exports more successfully than others. Brazil was most successful in this respect; its exports increased by nearly one quarter in value. The exports of Bolivia, Chile, Panama, and Uruguay declined while Peruvian exports stagnated. Differences in national export performance are strongly influenced in the short run by the composition of exports; Chile and Peru, for example, rely heavily on mineral exports for which world demand is now sluggish. But ultimately domestic policies, particularly exchange rate management, play a very important role. Brazil, for instance, has devalued its currency in real terms more than Mexico or Peru, both of whose exports performed poorly. Devaluation (and hence encouragement for exporters) is often avoided for fear it will exacerbate inflation. The potential conflict between stimulating exports and reducing inflation should not be underestimated, but it is nonetheless likely that failure to boost exports will eventually worsen rather than lessen inflation. Exports are vital for several reasons. First, while budget deficits are being cut and interest rates are high, exports provide one of the few, and in some countries the only, sound source of growth of output and employment. Second, exports are vital to improved debt-servicing capacity and to the restoration of creditworthiness. Third, since they add to the volume of production and hence make possible economies of scale, they stimulate improvements in productivity (see “Import substitution versus export promotion” by Anne 0. Krueger, Finance & Development, June 1985). Improvements in productivity (in agriculture, mining, and services, as well as in manufacturing) are at the root of the long-term growth process.
Since the autumn of 1982 most countries in the region have implemented adjustment programs; many have reduced their budget deficits sharply and strengthened their external accounts. The region’s current account deficit fell from $40 billion in 1982 to $3 billion in 1984, while its trade surplus increased from $9.6 billion to nearly $38 billion. In response to stringent cuts in imports in 1982 and 1983, the trade balance of the region’s oil importing countries swung from a deficit of $900 million in 1982 to a surplus of nearly $14 billion in 1984.
Though the fight against inflation has been less successful than adjustments to government budgets and in trade, some Latin American countries have made substantial progress toward sustained growth. Other countries have yet to come to terms with the need for adjustment. For the region as a whole, progress is reflected in the transition from a decline in GDP in 1982-83 to growth of about 3 percent in 1984. This barely exceeds the rate of population growth, yet it is a welcome change in trend.
The areas of policy that were crucial in the early 1980s will remain so in the years to come. Promoting exports requires continued attention to real exchange rates and to ways of rationalizing often stifling import restrictions. Further stabilization measures are needed to strengthen domestic capital markets, to bring down real domestic interest rates on a sustained basis, and thus to encourage productive investment. Not only is it necessary to reduce public deficits further but also to harness better the tremendous power of the public sector for development. Doing so will require rational decisions on public investment and hence, often, improvements in the structure of public sector management, as well as sustained political courage.
External factors are also vital. Domestic policies can enable a country to take advantage of improving world circumstances, but in general they cannot be expected to generate sustained growth and employment if external forces are adverse. This is truer now than before, because of the enormous weight of Latin America’s external debt—of about $360 billion as of June 1985. On average for the countries of the region, interest payments alone represent some 35 percent of exports of goods and services. Adding amortization on long-term debt to the interest payments due increases the burden to nearly 70 percent of exports in Argentina, nearly 60 percent in Brazil and Chile, and nearly 50 percent in Mexico. The rescheduling exercises—of which there have been more than 20 since August 1982—have helped alleviate the debt-service burden, and so have gradual reductions in spreads over the London Interbank Offered Rate (LIBOR) and in the commissions paid on both rescheduled and new debt.
Two questions persist, however:
• Are there prospects for resuming sustained growth when so large a share of export earnings (and, perhaps more important, so large a share of domestic savings) must be transferred abroad?
• Even if technically feasible, for how long can transfers be sustained before the social and political fabric of society breaks down?
Numerous projections have been made. To mention only a few, the International Monetary Fund, the Federal Reserve Bank of New York, the Institute for International Economics, Morgan Guaranty, and the World Bank have all independently prepared scenarios for the next five to ten years. (On the World Bank’s scenario, see “International capital flows and economic development” by Francis X. Colaço in this issue—Ed.) Consensus exists on two points: on the factors that are considered to be of crucial importance and on the assumptions under which sustained growth is feasible.
The crucial factors are obvious: first and foremost, the rate of growth of the industrialized countries and the related growth of world trade; second, the level of real interest rates; and third, the availability of external capital. There are other important factors, chiefly the trade policies of the industrialized countries. Most of the analyses referred to above imply that Latin America could resume sustained growth of 5 to 6 percent a year starting in 1987 or 1988 if the following external factors materialize: growth in the industrialized countries of 3 to 4 percent a year; LIBOR at 9 to 10 percent with global inflation of 5 to 6 percent a year; increases in commercial bank debt of 5 to 6 percent a year in current terms, at least through 1990; and no increase in protectionism in industrialized countries.
These magnitudes differ little in essence from those of the recent past. The growth of the combined GDP of industrial countries accelerated from 2.5 percent in 1983 to nearly 5 percent in 1984, to a large extent reflecting an increase of almost 7 percent in the GDP of the United States. GDP also increased in Japan and in Western Europe, from 3 percent and 1.5 percent, respectively, in 1983 to 6 percent and 2.5 percent in 1984. World trade expanded by 2 percent in 1983 (after a 2 percent drop in 1982) and increased by 9 percent in 1984. LIBOR averaged 9.9 percent in 1983 and rose to 11.2 percent in 1984. Net inflows of capital to Latin America, after declining from $19 billion in 1982 to $4.4 billion in 1983, rose to about $11 billion in 1984. Medium- and long-term external debt, including the consolidation of short-term credits with medium-term debt which took place in 1984, increased by an estimated 6 percent. While most of these developments are close to those of the projections, the uncertainty surrounding growth in the industrialized countries, and particularly in the United States, which has special importance for Latin American exports, casts a shadow over the region’s growth prospects.
Furthermore, protectionist pressures are not abating. The prospects for liberalizing restrictions on imports from Latin America are not promising, given the disagreement between industrialized and developing countries that surfaced at the Development Committee meeting in April 1985 and some hesitation about trade talks among industrialized nations. Trade liberalization is an important ingredient of economic adjustment in the industrialized nations themselves, and it is to be hoped that the momentum for a new round of global trade negotiations will not abate.
There remains the question of future capital flows to Latin America. Unless sufficient external capital is made available to countries that are following sound adjustment policies growth will falter, the risks of political unrest may increase, and the burden of debt servicing will grow once again. The international financing institutions have already raised their disbursements to the region, and whether they can raise them further will probably depend on their own capital increases. The World Bank disbursed $3.2 billion in Latin America in 1984, and the Inter-American Development Bank, $2.2 billion. On a net basis this amounted to $4 billion. Official export financing agencies also provide net lending of $1-2 billion a year. But altogether net official flows amount to only slightly over one percent of the region’s outstanding debt. The difference between these inflows and the amounts required in the projections must continue to be forthcoming from commercial banks if sustained economic growth is to be resumed.
Because growth must be driven by exports, for the reasons given above, a sound commonality of interests exists between the Latin American countries and the commercial banks: as exports expand, so does growth and employment creation, while creditworthiness improves. Countries that are more successful in their economic management will become better credit risks and will be more likely to attract external capital. All the projections mentioned above show that as growth resumes the ratio of debt to exports—a crucial indicator of creditworthiness—declines and so does the burden of interest payments on export earnings.
This outlook assumes that commercial banks will not pull out of Latin America. The Bank’s projections assume that the commercial banks should be able to reduce the Latin American share of their total assets while still increasing these assets by 5 to 6 percent a year in current terms, as noted above.
Until now, Latin America’s interdependence with the rest of the world has led to remarkably close cooperation between the commercial banks, the International Monetary Fund, the World Bank, the Inter-American Development Bank, the monetary authorities of major industrial countries, official export credit agencies, and, most important, the governments of the region. This cooperation has not been easy; the term “involuntary lending” is witness to the difficulties that had to be overcome. But without it, it is doubtful whether the region’s turnaround would have occurred. Projections suggest that the debt burden will remain heavy for many years to come. The room for maneuver will be very narrow. And thus the need for close cooperation will continue.
World Bank’s role
The Bank now offers a variety of assistance in Latin America. Traditionally, the Bank mainly invested borrowed funds in development projects in poorer countries, ranging from hydroelectric power plants, highways, ports, and pipelines, through factories, schools, and hospitals. Nowadays the Bank also finances credit programs for industry and agriculture that channel funds to private enterprises. Most of the investment projects supported by the Bank take several years to construct and all require complementary financing—because the Bank never finances 100 percent of a project, usually supplying only one half or less.
In recent years it has become clear that many countries lack the complementary fiscal resources needed to finance investments; furthermore, they acutely need external funds that can be disbursed quickly. In response the Bank has adopted a number of measures. First, it now devotes a small proportion of its lending to supporting macroeconomic and sectoral policy improvements, through fast-disbursing “structural adjustment loans” which are not tied to a particular investment project. The most recent examples in Latin America and the Caribbean are in Costa Rica and Jamaica. Where progress is apparent and further support is needed, several structural adjustment loans may be made consecutively, as has been the case in Jamaica.
Second, the Bank now makes sector loans to support policy improvements in important individual sectors of an economy. Large sector loans are supporting export development in Brazil and Mexico; they have financed badly needed raw materials and intermediate goods required by industrial exporters and have supported policy changes designed to make exports more attractive. The Bank has also made an agricultural sector loan to Brazil, after the government decided to reduce drastically its subsidies on farm credits, which had been a major source of inflation and economic distortions. A new sector loan of $300 million to Colombia will support the first phase of the government’s trade adjustment program. The program’s first objective is to promote exports, through measures to ease exporters’ access to imported inputs, rationalize import restrictions in general, and eliminate most export restrictions. The program will also improve the administrative mechanisms for trade management and formulate an action program for longer-term trade reform. The loan will be disbursed in two tranches; progress with the adjustment program will be closely monitored by the Bank, giving attention to trade policy performance and to the level and composition of public investment, which has crucial implications for future development. Other sector loans are contemplated for a number of countries.
Third, the Bank has accelerated disbursements of traditional loans in countries that meet certain performance criteria. The new procedures for this purpose include front-loading, that is, disbursing more during the first year or two of a project and correspondingly less in later years, as well as increases in the share of costs financed by the Bank.
The three types of changes just described have made it possible to increase Bank disbursements to Latin America and the Caribbean from $2 billion in 1982 to $2.5 billion in 1983, and $3.2 billion in 1984.
Meanwhile, the Bank has established closer relationships with commercial banks and continues to seek commercial bank cofinancing for its projects. Cofinancing has become more difficult to arrange since the advent of “involuntary lending” but it is still important and may become even more so as countries restore their creditworthiness. Under some cofinancing arrangements the World Bank participates in a syndicate to finance so-called B-loans. In some B-loans the Bank will pick up or guarantee the outer-year maturities. Or, as in the case of a cofinanced loan to Paraguay, the World Bank may (within a certain range) translate future interest rate fluctuations into changes in loan maturity and assume a contingent liability for the loan principal which might be deferred.
The Bank’s lending program and its policy recommendations are tailored to the individual circumstances of its borrower countries, and arise out of dialogue with the countries’ authorities. All of this work requires an in-depth knowledge of borrower countries. The Bank devotes some $6 million a year to economic and sector studies of Latin American and Caribbean countries—probably more than any other development or commercial institution in the world. It has recently stepped up its analysis of the public investment programs of some of the Latin American countries, and is also placing great emphasis on reviews of the productive sectors. Finally, the Bank has acquired considerable experience of particular public institutions in Latin America, and has helped to strengthen some of them.
Some of the initiatives mentioned are still new and may evolve quite rapidly. In addition, the Bank is seeking ways to monitor development policies and performance that will give information useful for mobilizing complementary sources of finance. One example is the structural adjustment loan to Costa Rica, where commercial bankers and other lenders (notably the US Agency for International Development) have tied their disbursements to those of the Bank, using the Bank’s monitoring. Similar approaches are being explored in other countries. At all stages of its efforts to mobilize complementary financial support for particular countries, the Bank works very closely with the Fund.
Latin America has become so important a part of the world economy that it has become a matter of self-interest for the industrialized world to help finance adjustment programs in the region. In the Bank’s judgment, the incipient recovery may lead to sustained growth in Latin America well before the end of this decade, while creditworthiness improves. Such progress could be achieved if growth in the industrialized countries reaches 3 to 4 percent a year; if interest rates remain around 9 to 10 percent; and if the international financial community continues its support. Such support is consistent with a gradual reduction in the Latin American share of commercial bank portfolios. However, increased protectionism could frustrate a recovery. Continued close cooperation between governments, the commercial banks, the Fund, the Bank, and other important actors will be absolutely essential in the years to come.
Announcing … WORLD DEVELOPMENT REPORT 1985
Eighth in the acclaimed annual series published by Oxford University Press for the World Bank
This comprehensive, informative publication focuses on the crucial role of international capital in economic development and explores financial links between industrial and developing countries. Featured in the World Development Report 1985:
For more information, see “International Capital Flows and Economic Development” on page 2 of this issue of Finance & Development.