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World Bank: Limited Sub-Prime Effect

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Latin America seems to have developed a stronger immune system against financial shocks.

BY AUGUSTO DE LA TORRE

Growth in the Latin America and Caribbean (LAC) region is expected to slow down gradually to 4.5 percent in 2008 due to stabilizing commodity prices and slower growth in global demand—explained by weakness in the U.S. demand arising from the adverse spillovers of the sub-prime crisis into the real economy.  However, the slowdown in Latin America and Caribbean growth is envisaged to be very much gradual thanks to strong projected growth in growth in Brazil and a recovery in growth for Mexico from a weak 2007.  Growth in the region will be supported by strong growth in other emerging economies and continued expansion in domestic demand buoyed by an environment of low inflation (except for Argentina and Venezuela), improved fiscal policy (in particular, Mexico) and appreciating currencies in the face of persistent strong capital inflows (especially to Brazil).

The Latin America and Caribbean was expected to grow at 5.1 percent for 2007, thus enjoying a fourth consecutive year of strong growth.  Along with a favorable external environment (high commodity prices and abundant global liquidity), growth and stability in the region to date have been underpinned by improved domestic macroeconomic policies and conditions—as reflected by reduced currency mismatches in government balance sheets, more robust monetary policy frameworks (reflecting a general move towards inflation targeting cum exchange rate flexibility), improvement in fiscal positions, and strong accumulation of international reserves.

KEY CHALLENGES

So far, the recent turmoil in the United States and developed country financial markets (due to the sub-prime crisis) appears to have had limited effects in Latin America and Caribbean.  The region seems to have developed a stronger immune system against financial shocks.  In previous episodes of financial turmoil (such as the 1998 Russian financial crisis) the volatility of Latin America and Caribbean sovereign spreads was higher than that of U.S. high-yield bonds. During the recent sub-prime crisis, the opposite is true, suggesting that Latin America and Caribbean assets are now perceived (on average) as significantly less risky than U.S. high-yield (junk) bonds, in line with a perception that important countries in the region are approaching investment grade status.  While U.S. financial market conditions have been in turmoil, capital flows to Latin America and Caribbean have continued supporting the rapid growth of asset prices—in particular, stock prices.

However, the risk of real contagion from the sub-prime crisis remains important.  In particular, the adverse effects of the sub-prime crisis on U.S. economic activity may affect growth in Latin America and Caribbean.  The extent to which individual countries are affected by stagnation in the North will depend on the intensity of their trade linkages with the U.S. economy, their reliance on primary exports, and their ability to retain access to financial resources in less favorable times.  In addition, the slowdown in the U.S. construction sector is likely to affect the flow of remittances to Latin America and Caribbean countries (especially, to Mexico and Central America), which would have a major negative impact on the poor.

INFLATION

Finally, average CPI inflation in the region, excluding Argentina and Venezuela, was likely to end at around 5.4 percent in 2007 and is estimated to be at approximately the same level in 2008. Argentina and Venezuela, by contrast, are envisaged to register double-digit inflation in 2008, in the context of rising public expenditure, subdued private investment, and potential supply constraints.  To be sure, the inflation projections are subject to upside risks, as rising food prices across the world may put upward pressures on local CPIs, with particularly significant adverse effects on the poor.

 © Copyright Latin Business Chronicle

Augusto de la Torre is the World Bank's chief economist for Latin American and the Caribbean. De la Torre, who headed the Central Bank of Ecuador during 1993-1996, was an economist with the International Monetary Fund from 1986 to 1992. He earned his M.A. and Ph.D. degrees in economics at the University of Notre Dame and holds a Licenciatura in Philosophy from the Catholic University of Ecuador. He wrote this outlook column for Latin Business Chronicle.

 

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