Inflation, commodity prices, terms of trade, and fiscal sustainability in Latin America and the Caribbean

Since mid 2007 inflation in Latin America surged substantially, ending a 5 year long period of inflation reduction. Initially food and fuel prices accounted for the bulk of the increase in headline inflation, but progressively core inflation rose as well, indicating that the old price propagation mechanisms were still alive in spite of successful stabilization efforts in many countries of the region. Targets set by Central Banks have been surpassed in all countries with inflation targeting based monetary policies. The record is not better for the rest.

With a long inflationary experience and its consequences on growth, poverty and income distribution, during the 90s and the present decade many countries of the region adopted reforms and policy measures aimed at bringing inflation under control, and to a good extent they succeeded at it. Even more, for many the external conditions were favorable, and so the region managed to grow for six consecutive years at an average rate above 3% per capita, (something unheard of for about forty years), with current account surpluses, falling public external debt (as % of GDP) and strengthened fiscal solvency.

In the past, inflation in Latin America was very often caused by a mixture of external shocks intensified by domestic disequilibria which required aggregate demand control to reign it in. In turn, the current increase in inflation has its origins mainly, although not exclusively, in commodities world price increases and exogenous supply shocks, augmented recently by the Fed’s response to the subprime crisis, which materialized in a sharp depreciation of the US dollar. However, not every country in the region is affected equally by this commodity boom. Policy also has differed and so perspectives, in the event of price reversals and need to control inflation and its consequences, are not equal either.

As the following graph illustrates South America, especially Chile, Bolivia, Peru, Colombia and Venezuela, benefited the most, whereas Central America and some Caribbean countries exhibit a terms of trade deterioration.

Graph 1

image001_512_04.gif

Source:  Eclac, based on official data.

The mirror image of this unfavorable evolution for some of the poorer countries in the region is their heavy dependence on foods imports and high malnutrition levels. The recent increase in food prices (even if it is considered a recovery from very low levels as Ocampo and Parra article published in this site argues) will surely increase their poverty levels.

Graph 2

image002_512_05.gif

Source:  Eclac, based on official data.

In this context of increased global inflation and the pessimistic view on the world economy, the governments of the region face a threefold challenge: i) Decide the extent to which the external inflationary shocks will be accommodated and domestic demand will be controlled in order to reduce inflationary propagation, ii) Adopt fiscal and monetary policies which minimize the economic cost of inflation containment, iii) Adopt policies which mitigate the social effects of the external shock and of domestic anti-inflation policy.

The first challenge poses a difficult dilemma. Since a good share of inflation is “imported”, domestic policies will not be able to affect it, and will cause some domestic activity loss. Also, one must keep in mind that SMEs depend mostly on the domestic markets and generate a very significant share of total employment, hence the social impact should be evaluated. On the other hand, authorities cannot simply renounce to inflation control, since expectations will rise and the old dissemination and inflation-perpetuation mechanisms will again be at work, with all the negative consequences on poverty, income distribution and growth.

The second challenge carries its own complications. Although so far we’ve mentioned external and supply shocks as the main culprits for the recent rise in inflation, in some cases domestic disequilibria created further pressure. It is clear then, that under the present circumstances both monetary and fiscal policies have to work in a coordinated way to control inflation. That is no easy task, since public programs are normally planned for many years and current needs (social security, health, education, etc) have to be attended to, i.e. it is difficult to reduce expenditure.

So far central banks have reacted by raising monetary policy interest rates, albeit cautiously given the partially imported origin of the shock. Although Brazil exhibits a significantly positive real interest rate, they remain moderately positive in the other countries. The exception to this is Chile, where the monetary policy interest rate has lagged behind inflation since mid 2007, thus exhibiting a negative rate in real terms.

On the other hand, in general the fiscal stance has been expansionary during the last two years, with expenditures growing faster than revenues. Even more, although the current fiscal position is in surplus, the structural position (i.e. when expenditures and revenues are projected according to the trend values of their determinants) is not strong or even negative in some countries. As many commodity prices have tended to loose some of their gains in view of an expected slowing down of the global economy, it becomes even clearer that the observed rhythm of expenditure increases cannot continue without endangering fiscal sustainability.

The answer to the third challenge is even more complex and generalization more difficult. The capacity of governments to mitigate the social effects of inflation and of policies trying to control it, depend on their current position (surplus or deficit) and the fiscal space they have been able to gain based on the increase in public revenues created by the commodities boom. Where public debt was reduced and assets were accumulated, space for compensatory social programs that will not affect fiscal sustainability is more likely. This is also true if the government is running a surplus or a moderate deficit. Here, the case becomes one of selecting the best microeconomic tool, according to each country’s institutional and political reality. But such is not the case in countries whose budget exhibits a large deficit and fiscal sustainability was not enhanced during this period, or even worse, if they belong to the group of net losers of the commodity price boom. And among the latter some of the poorer countries of the region can be found.

In these cases the challenge is more complex. Social programs to compensate the effects of inflation and particularly commodity price increases may be at the expense of other valuable expenditures (education health, public investment in infrastructure, etc). The overall gain will be small, unless huge inefficiencies are eliminated in the process.

Another alternative is external borrowing. Multilaterals have not been very much in demand recently, so there is some space there. Official Development Assistance can also play an important role in some countries, especially among those where poverty incidence is high. The international capital market resources, on the other hand, may be difficult to tap for the poorer countries of the region, especially if the current uncertainty continues.

In any case, getting indebted to finance social programs is bad policy in the log run, since it means using long term financial funds to cover for short term current (i.e non capital) expenditures. This brings us to our last point.

Fiscal sustainability is a notion that exceeds a mathematical or actuarial formula which balances expenditures and revenues over time. Budgets which are apparently balanced in the short term may soon become unbalanced when the need arises to implement social programs to confront the effects of inflation and the effects of stabilization policies. Even more, if current social needs are not being satisfied, there will be legitimate claims for increased social expenditure. And in many countries of the region the fiscal burden is low, as the following graph illustrates.

Graph 3

image003_512_02.gif

Source: Eclac, based on official data

In such circumstances, the poor will be hit both by the consequences of price increases and that of anti-inflationary policies, since the compensatory social programs will be scarce. Growth will also suffer, since lower public revenues translate into less economic infrastructure.

In the medium and long term, as income per capita increases, new demands for social goods normally arise. And if social needs are not being satisfied or contributions (taxes) are not perceived as equitable from a distributive point of view, there will be a need to redesign the balance between taxes and expenditure. In short, for an important number of countries in Latin America a new fiscal covenant is needed. One broad enough to take into account the increasing needs of defense, social security, poverty reduction, equity and growth, to name just some of the most important. Such a covenant is the principal means of attaining fiscal sustainability in the medium and long run; the main contribution of fiscal policy to stability and growth.

2 Responses to "Inflation, commodity prices, terms of trade, and fiscal sustainability in Latin America and the Caribbean"

  1. Anonymous   September 29, 2008 at 10:21 pm

    martes 24 de junio de 2008Inflación en alimentos en América LatinaEn el mes de abril, el FMI y el Banco Mundial se reunieron para tratar el tema de la crisis crediticia en Washington pero trasladaron el eje de la discusión para llamar la atención sobre la ahora llamada crisis alimentaria mundial, preocupados por una oleada de disturbios que obligó a muchos países a tomar medidas comerciales tendientes a contener los efectos domésticos de la “agflación”.“Agflación” es la denominación que se le dio a la escalada de precios de las materias primas agrícolas como el maíz, trigo y soja y su efecto en el nivel general de precios. El aumento de los precios mundiales de los alimentos amenaza con propagar el hambre y genera tensiones sociales en una escala aún impredecible.Los precios de los alimentos básicos subieron un 83% en los últimos tres años, en promedio, con alzas en los casos del arroz, el trigo y el maíz muy superiores. El precio internacional del arroz elevó su precio un 81% en los primeros cinco meses del año respecto de igual periodo de 2007, alcanzando los 848 dólares la tonelada. El precio de exportación del trigo fue récord en marzo cuando el trigo de EEUU promedió 480 dólares la tonelada. En abril descendió, pero aún así se encuentra 126% por encima del valor de los primero cinco meses del año pasado. El precio del maíz continúa creciendo y promedia 46% por encima que un año atrás.Hacia el año 2006 la mayoría de los países de América Latina tenían controlada la inflación, pero el aumento en el precio de los commodities agroalimentarios y de la energía (por el elevado precio del petróleo) ha presionado a la suba en el índice general de precios, acelerando de manera sorprendente el nivel de inflación en buena parte de la región.En todos los países analizados hay una clara tendencia ascendente en el índice de precios general y de los alimentos y, particularmente, todos muestran una substancial aceleración a fines del año 2007 y principios del 2008, momento en el cual comenzó a expandirse fuertemente la especulación financiera hacia los sectores que elaboran productos primarios y también coincide con el fuerte crecimiento de la demanda de alimentos para la fabricación de biocombustibles, siendo esta última la fuente más grande de “nueva demanda” para los productos del agro en décadas.La mayoría de los países de América Latina evidencian aumentos en las tasas de inflación. En promedio pasaron de un nivel anual de 3,5% en el 2006, a tasas anuales que oscilaron entre el 6% y 7% para el 2007.El nivel promedio de inflación en los alimentos en los países bajo análisis fue de 5,4% durante el año 2006, mientras que para el año 2007 el mismo índice mostró una variación del orden del 11,6%, mostrando un aumento mayor al doble del registrado un año antes. A todo esto, los países con mayor inflación alimenticia durante el año 2007 fueron Costa Rica (21%), Bolivia (19,8%), Uruguay (18,1%), Chile (15,2%) y Brasil (11,9%), seguidos por Paraguay (9,1%), Colombia (8,5%), México (7,5%), Perú (6%) y Ecuador (5,7%).Claramente los precios de los alimentos están creciendo muchos más rápido que lo que refleja el nivel general. Lo anterior nos induce a pensar que el actual proceso de aceleración de la inflación que están viviendo los países de América Latina es causado, en mayor medida, por el fuerte aumento en el precio de los alimentos empujado, a su vez, por el incremento de los precios internacionales de las materias primas agrícolas.Al ver la tasa de inflación anual en los diferentes países tanto para 2006, como para 2007 y el primer cuatrimestre de 2008, salvo Paraguay (el cual tuvo un fuerte proceso inflacionario durante el 2006) el resto de los países aumentaron (y algunos casi duplicaron) su nivel de inflación durante el 2007 en relación al nivel alcanzado en 2006.También puede apreciarse que en países como México, Brasil, Colombia, Bolivia y Perú, en nivel de inflación durante el primer trimestre de 2008 casi representa la mitad del nivel obtenido durante 2007, lo que deja pensar que si continúa esa tendencia, la inflación durante 2008 será mayor que la del 2007.Parte del problema de la inflación que llega a la Argentina es mundial, es urgente, y avanza rápido también sobre las economías de los restantes países de América Latina, sean estos exportadores o importadores de productos alimenticios y pone en tensión a sus sociedades.Escépticos frente a las medidas que se puedan esperar desde las instituciones supranacionales como las Naciones Unidas para garantizar la soberanía alimentaria de los pueblos, sólo resta la cooperación entre las naciones y políticas domésticas como la seguida mediante las retenciones y límites a las exportaciones que son dos de las pocas herramientas que el Estado tiene a mano hoy para resistir el doble acecho de las rentas extraordinarias y las presiones del mercado mundial.Versión completa en http://www.ciepyc.unlp.edu.ar/htmls/newsletter/revista11/Ciepyc_n11_nota2.pdf

  2. Hector   October 3, 2008 at 1:36 am

    Graph 2 is UNUNDERSTANDABLE