A New Trade World: Routes for Latin America and the Caribbean to Grow

It never rains but it pours sometimes seems to be just too appropriate a motto for Latin America and the Caribbean. Just as Argentina and Brazil appear set to post positive growth this year, uncertainty regarding global protectionism and the prospects of higher U.S. interest rates could dampen growth prospects across the region, as explained in the 2017 IDB Latin American and Caribbean Macroeconomic Report. Growth may be about 1% for 2017 but the combination of greater U.S. stimulus, faster monetary normalization provoking a correction in asset prices and growing trade frictions would be negative for the region.[1] The impacts would be both direct (especially on Mexico) and indirect, in part through China and commodity prices, on other countries (see Figure 1).

Despite the current uncertainties, there have been several positive domestic developments. Many countries have pursued fiscal reform seeking higher efficiency in public spending. Tax reform efforts have been successful in cases such as Chile, Colombia, Jamaica, and Mexico, thereby boosting revenues and moving towards greater efficiency and equity. Brazil has passed a constitutional reform capping real expenditures and is working on the supporting legislation. The nature of fiscal future consolidation plans has also changed. Considering the explicit fiscal adjustment plans of 15 countries in Latin America and the Caribbean, those with higher tax burdens are focusing on cutting expenditure and greater emphasis is being placed on cutting current expenditures that will have less impact on growth.

It is often the detail of fiscal policy that is critical for its success. As discussed in our previous reports, the region responded to the global financial crisis with a fiscal impulse but an analysis of actual policies at that time showed that it was more a permanent increase in spending than a counter-cyclical response. Indeed, as output gaps became positive again, several countries pursued pro-cyclical fiscal expansions leading to higher debt levels and high deficits, particularly when growth receded. As commodity revenues also fell, many countries in the region have been forced to adopt fiscal adjustment programs. The fact that the composition of fiscal policies is now more appropriate is welcome news indeed.

Most of the larger economies have adopted inflation targeting regimes. A credible inflation target allows for exchange rate movements with relatively low pass- through to prices and nominal exchange rates have indeed been very flexible. This has provided a shock-absorber, which in many cases is boosting domestic production at the expense of imports: import penetration is falling (see Figure 2).

In more recent data, dollar export values are also rising, although the fall in commodity prices and the generally slower growth in global trade clearly had a severe impact. Still, the required external adjustment process is close to completion in the majority of countries, which should allow growth to come more easily.

Monetary policy remains finely balanced. Some have commented that as policy interest rates have been raised with GDP at less than potential, monetary policy has been pro-cyclical. But this ignores the role of the exchange rate. While interest rates may have been pro-cyclical, they have been a response to large nominal depreciations. It’s likely that the monetary stance, including exchange rate impacts, has been counter-cyclical.

But Latin America and the Caribbean needs to find ways to boost growth and without large budget outlays. Routes to Growth argues that deeper trade integration within the region would help. There are no less than 33 Preferential Trade Agreements (PTAs) involving the 26 regional members of the Inter-American Development Bank. In fact, about 80% of intra-regional trade is currently under some type of agreement. Perhaps surprisingly, the region is not far from a Free Trade Area (FTA) (see Figure 3).

But the amount of trade is relatively low. The patchwork of relatively small PTAs, each with its own set of rules of origin, and other regulations, precludes the region from reaping the rewards of the work already done. Actual trade is stifled by the complexity and inconsistencies between the different PTAs as well as some important missing links. A true Latin American and Caribbean FTA would be a market of some $5 trillion, the fourth largest economic block and fourth largest trading partner in the world.

Moreover, if the world does turn more protectionist, this could have serious impacts on the small open economies of the region. Deeper integration helps Latin America and the Caribbean in any scenario, but would be particularly beneficial in a more negative trade world.

But it is not enough to simply call for more Latin American and Caribbean integration. Indeed, history is littered with failed over-ambitious projects along those lines. The 2017 Macroeconomic Report therefore proposes a set of concrete policy actions that can be taken separately, at different speeds across countries, and with little cost; if completed, they would culminate in a LAC-FTA. Those actions can be summarized as follows:

1. Harmonize (and cumulate) Rules of Origin across existing PTAs.[2]
2. Fill in missing links with new Agreements (especially Mexico – Mercosur) ensuring Rules of Origin are harmonized and with cumulation
3. Improve trade facilitation and logistics requiring little fiscal outlays
4. Actions 1-3 would approximate a LAC-FTA in all but name; a final action would then be to formally convert the existing PTAs to an FTA with a harmonized agreement to lower any remaining tariffs to zero

This bottom up approach could be voluntary in nature. Assuming certain missing links were filled, countries would tend to join rather than be left out. The plan is focused on trade: other important topics such as movement of labor, investment, environment, finance might be left for further down the road.  And it would not require any ambitious plan regarding multilateral institutions. It could be handled through current government structures.

We may appear to be swimming against the tide by proposing integration while some industrialized economies seem to be moving in the opposite direction. But the effects of trade liberalization can be quite different in emerging economies than in their richer counterparts. As trade boomed in Latin America in the 2000s, inequality fell. Still, countries should be careful to address potential losers from a deeper integration process.

There is a strong case to deepen integration in the region and there is a concrete way to do it. Given constrained macroeconomic policies, higher world interest rates, and rising global trade frictions, Latin America and the Caribbean needs to find new ways to boost growth. Deeper integration in the region is a low hanging fruit and the time is ripe for the picking.

[1] The IMF January World Economic Outlook indicates 1.2% growth for Latin America and the Caribbean in 2017.

[2] Cumulation is a term used to describe a system that allows products originating from country A to be further processed or added to products originating in country B, just as if they had originated in country B.