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Latin America’s Downside: Competitiveness

If Latin America is doing so well, why can’t it compete? A closer look at the reasons - and solutions.


After 59 months of uninterrupted expansion, investors in Latin America keep pinching themselves and wonder out loud, “When will it end?”  The recent financial market correction felt around the world on the heels of the U.S. sub-prime mortgage crisis brought many a dooms-dayer to the fore with predictions of currency slippage and spiking interest rates.  But Latin America is far less vulnerable than it used to be to contagion, politically inspired capital flight or drastic currency corrections.  Latin America will not fall from one fatal blow, but it does risk death by a thousand cuts if it fails to reform itself into a more competitive economy.  


It is difficult to understate the positive impact that the unusual combination of high commodity prices and low global interest rates have had upon Latin America’s economy since the present boom began in 2003.  China’s ability to sustain demand for raw materials on the one hand and keep global liquidity at record levels on the other has been a dual blessing to Latin America, known equally for its foreign debt crisis and rich natural resources.  

But this time around, Latin American macroeconomic structures are far better designed and administered to absorb and leverage the export windfall.  The reforms of the 90’s have proven their worth in this time of plenty.  By shrinking government, professionalizing monetary policy, floating currencies and freeing capital markets, the money entering the region is staying put.  Even in today’s populist social environment, political leaders have made fiscal discipline and conservative monetary policy hallmarks of their economic strategies.  President Evo Morales, hardly a captain of commerce, remarked soon after taking office that “inflation and corruption hurt the poor the most.” 

The combination of a reform legacy and fiscal prudence has produced some startling results.  Latin America enjoys negative capital flight, i.e. more off-shore savings are returning to the region than leaving.  Brazil, Venezuela and Peru are now net lenders on the world stage, with foreign reserves higher than their foreign public debt.  Mexico and Chile are poised to join the world’s club of creditors. 

Risk of default in today’s buoyant economic reality has dropped to an all-time low.  Dollar-based sovereign debt issued today by Peru or Colombia yields barely 2 percent above U.S. debt and even less than that in Chile and Mexico.  


If Latin America is doing so well, why can’t it compete?  Even the region’s economic darling, Chile, is dropping like a stone in global competitiveness rankings.  Competitiveness matters, certainly to investors and also to voters and politicians, when they can see beyond short-term concerns.  Return on investment in a country is driven by productivity, and in Latin America, productivity performance is the pits.  From 2003 to 2005, Latin American economies, when measured in dollars, expanded by an astonishing 53 percent but their productivity over the same three years grew less than 4 percent. The positive external shock to the region, due to the growth in demand and prices of commodities, is just that – an external shot in the arm providing temporary relief to Latin American consumers and domestic businesses.

Latin America owes its faltering competitiveness to the fact that it never swallowed the tough institutional reforms that it was fed with its Washington Consensus medicine of the 1990s.   Of the ten areas of reform outlined in the “Washington Consensus,” only two were properly executed in Latin America, another four were mismanaged and the four most difficult reforms were never touched.

The well-executed reforms of currency flotation and liberalization of foreign investment laws were successful in providing much of today’s macroeconomic stability.  But you can’t slap a coat of paint on a house and expect it to appreciate in value if the plumbing and foundation are falling apart.  The eight of ten unfinished reforms in the original Washington Consensus represent the to-do list for Latin America if it is to raise its competitiveness and long term economic standard of living. 

According to the tenets of the Washington Consensus, the nearly $300 billion in state asset privatization revenues generated in the 1990s were supposed to be invested in education, health and infrastructure.  Instead, much of the monies were wasted defending sinking currencies or pocketed by politicians and their cronies.  Curiously, now that the region has a fat wallet again, infrastructure spending has exploded.  The far less exciting realm of education reform still eludes political leaders.  For a developing part of the world, Latin America spends quite lavishly on public education.  Unfortunately, disproportionate spending on outdated universities, intransigent teacher unions and an emphasis on rote learning with little room for critical thinking all makes Latin American public education an underperforming white elephant. 


What have remained out of reach to all but a few countries are some fundamental reforms that strike at the backbone of an economy’s productivity.  One of these is tax reform.  Latin American tax systems are largely incapable of levying income tax because they are under-policed or excessively complex.  In Brazil, tax complexity bedevils small business to such a degree that it drives most under the table.  Over the last three years, some estimate that 80 percent of new job growth in Brazil has come from the informal economy.   With a narrow tax base, government must keep tax rates high, thereby driving more businesses out of the formal economy – a vicious cycle ensues.  That leaves value-added sales tax and corporate tax as the leading sources of government funding.  The first is regressive and helps keep in place Latin America’s appalling wealth polarization.  The second stifles business investment, the engine of economic growth. 

Even more perilous is the lack of fairness and oversight of Latin America’s legal system.  No institution in Latin America has evaded reform more effectively than the judiciary.  At best it acts as a cozy club protecting the well connected in government and business from the rule of law.  At worst, Latin America’s judicial system is boldly corrupt, handing out legal decisions to the highest bidder, often riding roughshod over the very laws it is designed to enforce. 

A weak judiciary cripples investor confidence in contract enforcement.  While big business can afford to navigate the courts, small and mid-size investors rarely enter the region from outside and domestic SMEs prefer to send their money abroad rather than invest at home.  Without predictable bankruptcy proceedings, unsecured credit is not issued, again holding back investment and growth, especially among small business. 

In such an uncertain legal environment, intellectual property laws have little teeth.  The result is chronic under-investment in the very regulatory-driven industries that Latin America so desperately needs, including infrastructure, R&D, technology and energy.  Latin America represents 7 percent of the global economy but produces only 0.25 percent of the world’s patents, less than some U.S. universities manage single-handedly. 


The combination of strong currencies and relatively open economies exposes the region’s weak sectors to fierce global competition.  As currencies in Chile, Brazil and Peru have appreciated markedly over the last three years, Chilean wineries, Brazilian auto parts makers and Peruvian clothing manufacturers have all lost global market share.  One sector’s success (mining, metals and agriculture) is another’s undoing if the cost of doing business goes up for everyone.  In 2003, when Brazil’s currency was considered 45 percent undervalued using the esteemed “Big Mac Index,” over 50 product categories made up 80 percent of its export volume.  In 2007, with a slightly overvalued currency by the same Big Mac index, Brazil’s top 80 percent of exports is now made up of 10 product categories, eight of which are primary or secondary goods. 

If Latin American growth continues to rely on a narrow list of capital-intensive (as opposed to labor-intensive) industries, unemployment will rise as weak sectors stop growing or collapse.  That could turn voters and industrial leaders towards protectionism and away from globalization.  Measures such as export taxes on successful sectors, already enacted by Kirschner in Argentina, could be joined by subsidies for weak industries, an historical favorite in Mexico and Brazil, and stiffer non-tariff barriers, as seen today in countries like El Salvador.  A democratic Latin America will have to respond to the pressures of voters and business. 

Today’s winning industries in Latin America, such as mining (which attracted an impressive 23 percent of global exploration investment in 2006), metals, energy and agrifood together provide little impetus to government to keep trade open.  Customers of mining, metals and energy are not going to throw up tariff barriers any time soon in a world of short supply and heavy demand.  Brazilian and Argentine agrifood sectors, which led the charge in the past to open European, American and Japanese markets through the Doha round, have largely given up on trade negotiations and may not even need them with burgeoning demand coming from China and Southern Asia.  Those in support of free trade in Latin America are losing political voice.


The nail in the coffin for free trade thinking in Latin America could come from a rejection by Washington politicians of proposed trade agreements with Peru, Colombia and Panama.  The 2006 defeat of a trade bill with Vietnam was the first time ever that the U.S. Congress spurned a free trade proposal.  If Latin America is similarly rebuffed, then the few remaining free traders in the region will lose their nerve and the pendulum could finally swing in favor of protectionists. 

That makes the Washington votes so crucial because a return to protectionism in Latin America will exacerbate the region’s reliance on a few commodity-driven industries, an unwelcome evolution that will bring volatility back to Latin America just when it was shrugging off sordid past and boasting of a new era.

John Price is president of InfoAmericas. Parts of this column are based on excerpts from Can Latin America Compete? (Palgrave 2008), which Price has co-edited with Jerry Haar.


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