Economic Survey of Latin America and the Caribbean 1997-1998

2. Macroeconomic policy

As in earlier years, the effort to consolidate the ground already won by the stabilization programmes in the Latin American and Caribbean countries has been the objective that has determined the general thrust of macroeconomic policy in 1997 and 1998. Within this general approach, however, it is possible to distinguish two periods characterized by differences in the availability of foreign capital and by policy-makers’ responses to the situation. The abrupt change in flows, generated by the deepening of the Asian crisis, marked the separation of the two periods.

For much of 1997, in what constituted the continuation of a trend that had taken shape in the second half of 1996, a plentiful supply of foreign resources was placed at the region's disposal, allowing it to boost domestic growth above the originally projected levels. In response to this sharper-than-expected upswing, and with fiscal deficits starting to show slight increases, the authorities began to modify their monetary targets to bring them into line with the increased demand for money.

The countries’ external accounts constituted the dark side of this otherwise bright picture, as the appreciation of the real exchange rate began to accelerate and the situation in the current account of the balance of payments started to deteriorate. Since international reserves were rising, however, these trends were not seen as a major cause of concern by policy-makers, at least until the second half of the year.

When the prospect of having an ample supply of inexpensive external financing vanished in October 1997, the question of the volatility of external credit flows and of the sustainability of the region's growth patterns came to the fore once again. From that point onward, macroeconomic policy returned to a more restrictive stance. At first, the aim of this change was to restore investors' confidence in stabilization programmes and to prevent capital flight. Later on, when the severity of the Asian crisis became apparent, adjustments were directed towards cooling down domestic demand and aligning it with the new external scenario of increasing uncertainty.

The reduction in revenues threatens fiscal equilibria

The fiscal sector is perhaps the area of macroeconomic policy that, from a regional perspective, has undergone the fewest qualitative changes during 1997 and 1998. From early 1997 on, many countries began to have difficulty in meeting their revenue targets; this was mainly because of decreases in non-tax income, whether in the form of capital revenues (especially income from privatizations) or of current receipts (as a consequence of lower sales volumes in State enterprises). All in all, the average decline in public-sector revenue amounted to half a percentage point of GDP. To make up for this loss of income, spending was cut by an average of 0.2 points of GDP, with most of the reduction being made in capital expenditures. Thus, the region's average fiscal deficit rose only slightly (from 1.0% to 1.2% of GDP) and was financed primarily with external resources. Although this deficit was relatively small, the overall figure for the region as a whole masks the existence of fiscal problems in a number of countries, particularly Bolivia, Brazil, Colombia, Ecuador, Guyana and Jamaica.

As of October 1997, with the worsening of the Asian crisis, countries of the region began to adopt measures of fiscal adjustment. These steps were aimed both at reducing expenditure to deal with large fiscal deficits and at counteracting declines in revenue. Brazil was the first country to react to the change in international conditions. While authorities in Brazil had tried earlier to apply fiscal adjustment measures without much success, they took advantage of the new situation to put forward a much more ambitious programme with the aim of reducing the deficit by more than 2% of GDP. As of mid-1998, however, they had not achieved the expected results; indeed, the deficit had widened even further.

Countries that suffered a decline in government revenue because of falling commodity export prices also implemented fiscal adjustment measures. The oil exporters were a prime example, since the price of petroleum on the international market was well below the figures used to prepare government budgets. Thus, Mexico carried out three expenditure cuts in the first half of 1998, achieving a saving of nearly 1% of GDP, while in Venezuela expenditures were reduced and a sales tax was introduced. In Chile, public revenue deteriorated because of the sharp fall in the price of copper in the second half of 1997; this obliged the Government to cut expenditures in 1998.

With the persistence of the Asian crisis, which turned out to be deeper than initially envisaged, other countries also perceived the necessity of implementing austerity measures. The Argentine Government, for example, has recently announced budget cuts to reduce the fiscal deficit and moderate domestic demand so as to keep the external deficit within a range that can be financed.

The overvaluation of local currencies has abated

Given the voluminous inflows of external financing received by the region in 1996 and in the first three quarters of 1997, in the great majority of the countries exchange rate policy focused more on controlling domestic inflation than on fostering external competitiveness. During this period, the use of the exchange rate as a "nominal anchor" to slow price rises had the effect of driving up the rate of real appreciation of Latin American currencies, but that trend has abated in 1998.

Despite a smaller inflation differential with respect to their trading partners outside the region, the countries of Latin America and the Caribbean, taken as a group, registered a real appreciation of their currencies of over 4% in 1997. The appreciation of the currencies of the seven countries with the most active financial markets in the region was particularly marked, reaching an average annualized rate of 8% in the second and third quarters of 1997. The rest of the countries recorded a much more moderate appreciation --an annualized rate of about 2%-- during those same months.

As was also true in 1996, the real appreciation of the countries’ currencies was primarily caused by financial factors that bore no apparent connection with the fundamentals of the real economy, i.e., growth, productivity and the terms of trade. The risk involved in a delinkage of financial factors from the fundamentals became glaringly evident in the wake of the crisis of October 1997, when international markets began to reassess the external sustainability of the growth and stabilization patterns of, initially, the most heavily exposed economies and, later, all the economies of the region.

Depending on the policy stance of the country, the currency market's behaviour led either to a nominal devaluation or to a loss of international reserves. In most cases, the nominal devaluation rate began to increase in the fourth quarter of 1997 and the first half of 1998, stopping the real appreciation of local currencies for the region as a whole. This result at the regional level, however, was the average of opposing trends among countries. At the two extremes, Venezuela saw a real appreciation of 14%, while Paraguay registered a real depreciation of nearly 20% (see figure I.2).

Monetary policy assumes a reactive stance

As the growth rates of the Latin American economies outpaced the original projections during the greater part of 1997, monetary authorities adopted a more accommodating stance. Thus, after having grown more slowly than GDP in the previous two years in most of the countries of the region, the supply of base money expanded rapidly during the first three quarters of 1997. This relaxation of monetary policy prompted a reactivation of domestic lending, whose effect on the growth of the money supply was even greater than the impact of the strong build-up of external assets.

It should be pointed out that this increase in the money supply was wholly attributable to stronger demand for local currency on the part of the general public and business as the volume of commercial transactions increased and the erosion of purchasing power subsided. Thus, rather than diminishing, as it would have in the presence of excess liquidity, the real interest rate on deposits rose by an average of over one percentage point to an annual rate of around 4%. Moreover, the increase in the money supply did nothing to impede the decline of inflation rates, as the surges that did occur were clearly attributable to supply factors, especially in the case of agricultural products affected by El Niño.

The Asian crisis put an abrupt end to this expansion of the money supply. In the final quarter of 1997, the remonetization of the region's economies slowed sharply, falling from an average annual rate of 15% in real terms to 8% between September and December. Brazil was the first country to tighten its monetary policy in October 1997, but the majority of the region's economies followed suit once the severity of the external shock and of the deterioration in external financial conditions became clear. Interest rates were raised sharply to try to prevent the loss of international reserves, and steps were taken to reduce liquidity on the interbank market (see figure I.3). It is expected that the resulting reduction in the money supply will, in conjunction with various fiscal adjustments, help check the expansion of domestic demand and thus slow GDP growth in the second half of 1998.

The domestic financial markets saw a continuation of the consolidation process that had begun in the aftermath of the banking crisis that overtook the major economies of Latin America in 1994 and 1995. The main exceptions were Paraguay, where the authorities had to step in and eventually liquidate two banks, and Jamaica, where much of the cost of a severe crisis in that country's banking system had to be absorbed into the government budget. Banking reforms moved ahead in most of the countries, however, as regulatory systems were strengthened in order to improve the prudential regulation and supervision of financial activities. The consolidation of Latin America's banking system was reflected in a reduction in the number of banking institutions in many countries as well as in the increasingly important role of foreign banks as stockholders and managers of domestic banking institutions. This trend was particularly notable in Argentina, Brazil, Colombia, Mexico and Venezuela, but is in evidence in a majority of the countries of the region.

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