Despite Tighter External Conditions, Latin America and the Caribbean Hold Steady

April 9, 2014

  • Remittances and Foreign Direct Investment provide more reliable flows
  • Growth continues, albeit slow: 2.3% in 2014
  • Without productivity reforms the region could see social progress stall

WASHINGTON, April 9, 2014 – As international investors shift their focus back to advanced economies, particularly the United States, as a result of monetary policy normalization, emerging economies face much tighter financial conditions.  Still, the impact of this reversal in capital flows is less significant for Latin America and the Caribbean thanks to its new reliance on more stable international flows.

According to the latest semiannual report by the World Bank’s Office of the Chief Economist for the region, during the past decade, Foreign Direct Investment (FDI) and remittances have come to represent a far larger share of net flows into the region than the more volatile non-FDI flows. The report International Flows to Latin America: Rocking the Boat?" finds that these more stable flows, combined with the region’s improved macroeconomic and financial policy frameworks, give much of Latin America a much better capacity to absorb external shocks.

“In another clear break with history, the region has rebalanced its sources of financing away from portfolio and bank credit flows and towards FDI and remittances. This is part of a deeper restructuring away from debt and towards equity of the region’s asset-liability position vis-à-vis the rest or the world,” said World Bank’s Chief Economist for the region, Augusto de la Torre. “Partly because of this, we believe that international financial turbulence won’t cause the type of domestic crises it used to cause in the past.”

This good news does not allay concerns, however, over the region’s current slow growth pattern. According to the report, external factors, particularly lower prices of industrial metals, and increased uncertainty over China’s growth are taking a toll on the region’s growth, which is expected to be at 2.3 percent for 2014. That is slightly below the already low growth rate of 2.4 percent in 2013, and less than half of the 5 to 6 percent rates the region became accustomed to in the years prior to the global financial crisis of 2008.

There is, as usual, a great deal of heterogeneity in the region. Growth forecasts for 2014 range from negative 1 percent in Venezuela to nearly 7 percent in Panama, which is followed closely by Peru at 5.5 percent. Also above regional average are Chile and Colombia with expected growth above 3.5 percent.

Mexico and Brazil, the two largest economies in the region, deserve special mention. The former is envisaged to rebound from last year's unexpected slowdown, growing in 2014 at around 3 percent, above the region’s average. Moreover, the wave of recent bold reforms in Mexico—involving banking, education, telecommunications, tax, and energy—have raised investor optimism and improved growth prospects beyond 2014. In Brazil, consensus forecasts put growth for 2014 at or below 2 percent, as a reform agenda to avoid a low-growth/low-saving/low-investment scenario has not yet fully coalesced.

The cyclical decrease in growth in 2013-2014 is in large part due to global circumstances that regional policy makers do not control. The question is whether this cyclical decline is a symptom of a more permanent slowdown in longer-term growth,” said De la Torre. “Low growth equilibrium of around 2.5 percent would clearly be insufficient to sustain the pace of social progress to which the region became accustomed in the past decade.  In the absence of a vigorous growth-oriented reform agenda, the region could see social progress stall.”

One important contribution of the report is that it takes a look at FDI and remittances jointly, two flows often examined separately. And it makes important findings:

  • Both are more stable. FDI typically goes to factories and the like, which cannot be easily taken out of the country. Remittances are not only stable but are actually counter cyclical, increasing when economic conditions worsen in the recipient country.
  • Both FDI and remittances widen the external deficit and appreciate the real exchange rate, thus reducing external competitiveness.
  • Yet, they are fundamentally different in that FDI has the potential to raise productivity, whereas remittances, for all their benefits in terms of protecting households from poverty, do not.
  • Institutional quality drives both but in opposite directions. The quality of human and physical capital and a reliable contractual and business environment, for instance, pull FDI inflows that naturally leverage on the local workforce. By contrast, glaring deficiencies in the enabling environment push workers abroad, in the search of opportunities that are not found at home.

The report concludes that the countries in the region that have already managed to attract considerable FDI should strive to capitalize on potential positive externalities. Maximizing the learning spillovers and technology diffusion of FDI will help raise productivity and offset the lower external competitiveness that tends to be a side effect of the domestic demand-driven growth pattern that characterizes the region.

The countries in the region that rely heavily on remittances, on the other hand, face even more daunting challenges. To start with, they should focus on innovative policies to encourage households to use at least part of their remittance income toward asset building—particularly through investments in health, education, and housing. More fundamentally, the report says, those countries should put a premium on the hard task of continuously improving their domestic enabling environments to attract both their own workers and FDI, and then harness the productivity benefits of the efficient interaction between the two.

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