By Osvaldo Kacef, Director of the Economic Development Division

Excess of Global Liquidity and Currency
Appreciation - Challenges of Latin American Macroeconomic Policy

Photo: Lorenzo Moscia, ECLAC

In 2010, Latin America and the Caribbean consolidated its recovery following the global financial crisis. Although there are differences among countries, generally speaking the region’s economies have higher levels of activity than before the crisis, while also maintaining a robust external position. This was the result of making room for countercyclical policies, as well as an improvement in the external situation. Nevertheless, the current scenario does have new (but familiar) challenges for which the region must prepare.

The room to implement public policies that were the engine behind the rapid recovery of the region’s economies will be affected by the need to tackle rising inflation and to rebuild the countercyclical response capacity.  Another concern is excess global liquidity, which will be a determining factor for monetary policy and fiscal policy in the region’s countries that are potential recipients of financial resources.

Greater global liquidity will intensify the trend of real appreciation for most of the region’s currencies seen in 2010.  This will affect the production of tradable goods (exports and products that compete with imports), and will combine with the projected lack of buoyancy in developed countries to have an adverse effect on external accounts.

This will not endanger growth, at least not in the short term. In fact, the region is expected to continue growing in 2011, although at a pace closer to potential GDP growth rates. However, a review of the region’s recent economic history points to some potential concerns that certain aspects of the current situation might suggest for the medium and long term.

It is not the first time that our region has received considerable inflows of short-term capital, with the corresponding appreciation in real exchange rates. In similar situations, we have seen capital inflows push up domestic demand, which results in a gradual worsening of external accounts, while currency appreciation contains inflationary pressure. Nonetheless, beyond the short terms the effects tend to be negative.

High levels of liquidity push down real exchange rates and push up commodity prices, thus encouraging: i) increased production of non-tradable goods to the detriment of tradable goods (with the subsequent worsening of the balance-of-payments current account), and ii) intense specialization in the production and export of  commodities. This may be exacerbated by the fact that China, which has a demand for commodities but is also a competitor in the manufacturing market, appreciates its currency more slowly that our region’s countries.

Specializing in commodities would increase the vulnerability of the region’s economies to external shocks, and would raise the volatility of macroeconomic aggregates, thus decreasing the capacity of economies to growth, generate productive employment and reduce inequality. The worsening of external accounts among the region’s economies would increase dependency on external savings to finance their growth, unlike what happened in the period 2003-2008. At that time, growth was accompanied by increased domestic savings and an external account surplus, and this formed the basis for the capacity for countercyclical action that made it possible to resume growth quickly.

The widening balance-of-payments current account deficit may push up external borrowing, which would make the region’s economies more vulnerable to financial shocks, insofar as growth would be increasingly based on external financing. The region’s economic history shows us that, in this context, a reversion of capital flows could interrupt growth and give rise to a painful period of adjustment (which our countries often suffered in the last few decades of the previous century).

Yet what can be done to tackle the situation? Some of the region’s countries have implemented or strengthened mechanisms to regulate the short-term capital inflows in order to reduce pressure on currency markets. This measure is in the right direction, but may not be enough. Central banks have therefore often opted to intervene in currency market by shoring up demand and attempting to limit the process of appreciation. Although this strategy has its own problems and limitations, it can enable a smoother transition, while a build-up of reserves will strengthen the economy’s external position.