Recovery Yes, But How Fast?

Overconfidence may put at risk the stability of Latin American economies.

The medicine is taking effect. The rescue packages and the stress tests applied to the financial sector in the United States have resuscitated confidence among the banks: interbank rates have returned to totally normal levels. Despite the rise in unemployment to 9.4%, confidence among consumers is on the rise. The stock market has moved from the state of depressive anguish of only three months ago to a frenzy that seems to presage better times.

Signs of recovery are not limited to the United States. Industrial sectors in other developed countries have begun to grow again after several months of steep falls. Japanese industrial production have grown in two consecutive months and German industry is also on the rise.

The spirit of revival is already being felt in Latin America. The pressures of currency depreciation seem to have been overcome. The swine flu shock only marginally raised the temperature of the Mexican exchange market. In Brazil, Chile and Colombia currencies have tended to appreciate. In the last three months, stock markets, from Mexico City to Buenos Aires have been bullish.

It is feasible that the world is on the threshold of the recovery, but this is not guaranteed. The housing market in the United States is still very depressed and will take several years to absorb the excess supply. In the Eurozone some sectors may have given signs of life, but consumers and investors are still very fearful and the health of the financial system is still an unknown.

The future of Latin America is looking better than a couple of months ago, but is far from an easy ride. For the storm cloud to disappear it is not enough for the world economy to recover: it has to be a rapid recovery. As a recent IDB

1 analysis found, it makes all the difference if the world economy reaches its pre-crisis levels of industrial production in 2010 or in 2013.

If world recovery is rapid the public debt ratio will rise on average from 27% of GDP in 2008 to 34% from 2010. But if world recovery lasts until 2013, governments will have to borrow more every year, which would take the average debt ratio to around 50% in four years.

This scenario could trigger a liquidity crisis in quite a few countries. If a country does not have sufficient international reserves to cover the service of the external debt, it could generate a stampede by everyone who believes that the reserves are not going to be there when needed. That possibility seems remote in view of the high levels of reserves held by countries. But IBD calculations show that four years is long enough for a liquidity crisis to break out in almost any country in which the government and the corporate sector have to refinance their short-term debts, as is already beginning to happen.

Since it is still too soon to know how long world recovery will take, the most prudent strategy for Latin American governments is not to embark on ambitious fiscal stimulus programs, but to refinance on long terms, as soon as possible, as much debt as possible. It is surprising that only Mexico and Colombia have so far used the flexible credit line of the International Monetary Fund, which is a cheap insurance against risks of illiquidity. Excessive optimism can cost dear.

 

1 Izquierdo, A. and E. Talvi (coordinators), “Policy Trade-Offs for Unprecedented Times.”