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Overheating, Inflation Threatens Region’s Economic Success

April 14, 2011

It is no secret now that Latin America is one of the world's best performing regional economies with growth averages that almost double the rates in high income countries.

After leaving behind a global economic crisis that bruised many around the world but did not inflict major trauma on the region's economies, Latin America is on a path to achieving 4-5 rate percent annually, similar to the East Asia Tigers. Meanwhile inflation rates are expected to remain below the two-digit mark, between 6 and 7 percent.

But its own success may be creating the conditions for future difficulties, according to a report on the region's economic outlook, presented at the World Bank's headquarters to a global audience via the Bank's social networks.

According to 'Latin America and the Caribbean's Success Put to the Test', the region faces risks linked to inflation, currency appreciation and the perspective of economic overheating from the economic recovery reaching a maturity phase.

This recovery, relying on the international front on an export bonanza and foreign investment, and on the domestic front on strong consumption and credit expansion, entails certain risks, the report argues.

Risk of Overheating

Monetary authorities face the delicate challenge of keeping -through higher interest rates- the inflationary genie under control, while avoiding attracting speculative capital following better rates. That could strengthen local currencies, leading to an "excessive" appreciation that may end up affecting export diversification and long term growth, while generating greater vulnerability in the financial sector, according to World Bank Chief Economist, Augusto de la Torre.

"As central banks raise interest rates to cool the economy and maintain inflationary pressures anchored, the interest rate differential increases, attracting short term capital inflows that create further pressure for currency appreciation in the region," de la Torre states in the report.

Regional prosperity is also linked to the recovery rate in advanced economies and rising commodity prices. But the recent natural and nuclear disaster in Japan and the implications from the political turmoil in the Middle East and North Africa, however, portend less favorable economic conditions.

In view of this scenario, the report offers the following recommendations:

Because the current policy mix seems to be unduly burdening monetary policy, with little help from the fiscal side, the first thing that needs to be done is a greater fiscal effort, particularly in countries experiencing a major commodity windfall. In other words, stepping up fiscal savings, or creating a "larger primary surplus" that protects the region from future shocks –such as the recent financial crisis– without endangering social programs.

"On the contrary, social policy should be more active and increasingly focused on protecting the poor and vulnerable from food and fuel price increases, mitigating the adverse consequences on distribution," the report indicates.

Since 1995, the Gini coefficient, a measure of income inequality, has fallen from 0.57 to 0.53 and the share of income held by the top ten percent of the population has declined from 46 to 42 percent. During this past decade the region has also lifted more than 50 million people out of poverty. What's more, during the recession, overall poverty did not increase and inequality fell.

To maintain these social gains and foster more vigorous long-term growth, governments in Latin America and the Caribbean need to address structural hurdles to greater growth, investing in infrastructure, innovation and human capital through improved coverage and quality of education and health, the report concludes. Where appropriate, fiscal policy should also expand targeted support programs to the most needy. Today, one out of every four children in the region still lives below the extreme poverty line.

Engaging Through Social Networks

The presentation of the report authored by de la Torre and his team was followed live around the world through an interactive webcast over the web and social networks. Before the opening, internauts from all over Latin America asked questions and de la Torre answered several of them.

@keremperez from Panama asked whether monetary pressure had an impact on countries like hers where national currency is the US dollar, and what would "the best macroprudential policy be".

De la Torre explained that Panama is one of the best performing countries in Latin America and that the expansion of the Panama Canal, along with a privileged geographic location, would create the conditions for the Isthmus nation to become South America's Singapore, "as long as economic policies continue in the right direction." In this sense, de la Torre added, "dollar usage is not an obstacle but an asset."

Mario Enrique from Peru asked over the Internet, what's the point of "discussing growth in a region with such diverse indicators that it seems we're talking about different continents?" According to Enrique, "the worst thing is that the 'region' does not proactively participate in the international setting of prices for its goods and services."

De la Torre indicated that Latin America is an important global producer of food and agricultural commodities, to the point that it could become part of the solution to the current international food crisis. "LAC is global food producer that has the potential to play a bigger role in light of its vast land and water resources, and it agricultural experience," he said.

De la Torre added that because of the various factors uniting the region -culture, race, language, geography – it makes sense to talk about a whole and of growth impacting that whole, as the report purports.