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In Spite of Persistent Global Volatility, Latin America and Caribbean Poised to Grow

April 18, 2012

  • Portfolio capital flows see eight-fold rise between early 2011 and 2012
  • Continued slowdown in Europe and sluggish U.S. recovery
  • Potential China and/or commodity prices downturn   

WASHINGTON, April 18, 2012 – Latin America and Caribbean (LAC) countries are forced to confront the new global reality of persistent volatility, resulting, among others, from wide fluctuations in capital flows in search of easy profits and with little concern for long-term horizons, according to the semiannual report by the World Bank Chief Economist Office for Latin America and the Caribbean released here today.
The report "Latin America Copes with Volatility, The Dark Side of Globalization" finds that portfolio flows to the region have surged in the first months of 2012. Investments from mutual funds in the largest seven LAC countries -- which fell markedly during the second half of 2011 – rose eight times in January and February of 2012, compared to the average monthly flows in the beginning of last year.
The magnitude of these flows is such that if Vanguard, one of many international asset management companies, decided to move 1 percent of its mutual funds to Colombia that would amount to a capital inflow equivalent to 6 percent of that country’s gross domestic product, the report explains.
“The problem is that this type of market-based, as opposed to bank-based, capital flows has not added to financial stability—as many had initially hoped. To the contrary, portfolio flows into and out of emerging economies tend to be pro-cyclical and seem to be increasingly respond to global factors, rather than country-specific ones,” said World Bank’s Chief Economist for the region, Augusto de la Torre. “International financial intermediation has tilted towards a herd behavior that is focused on short-term horizons and where being able to exit rapidly dominates over patient analysis of long-term prospects.”
An attractive choice for foreign investors, LAC has been growing and building up steam for more than a decade. Current growth forecasts for the region stand between 3.5 and 4 percent for 2012 and 2013, higher than those of Eastern Europe and Central Asia, and similar to those of East Asia. Inflation rates are expected to remain, on average, around 6.25 percent this year.
But even regions that seem to be in a position of strength, such as LAC, must learn to cope with volatility that originates elsewhere, especially if they hope to secure and further its recent gains. That is why it is essential to better understand the nature of the unprecedented challenge posed by today’s financial integration.
The report also evaluates the vulnerability of countries across LAC to three types of external shocks:

  • A slowdown in Europe and  slow recovery in the U.S.,
  • A downturn in China and/or a decline in commodity prices, and
  • A rise in risk aversion in international financial markets.

“In today’s financial world, more integration means more exposure to external volatility but not necessarily means more vulnerability. The risks are not in how much you are exposed but, more importantly, in how little policy response capacity you have to cope with such unpredictability,” said De la Torre. “Several countries in Latin America are exposed to both a slowdown in U.S., Europe and China and a reduction in commodity prices and investment. However, since policymakers in these countries have space to maneuver, their level of vulnerability remains low.”
Indeed, countries such as Brazil, Chile, Colombia, Mexico, Paraguay, Peru, and Uruguay have high exposure to external shocks and yet a relatively low vulnerability, the report says. Those countries count on healthy levels of foreign reserves and exchange rate flexibility that can help absorb shocks. They also have the capacity to respond at from various fronts, including fiscal, monetary and macro-prudential. The latter, which gained momentum in the aftermath of the 2008/09 crisis, refers to measures aimed at dampening excessive financial fluctuations and enhancing the resiliency of financial systems to them. Macro-prudential policy instruments include liquidity requirements, cycle-adjusted loan to value ratios, and taxes on short-term capital inflow surges.
On the other hand, there are countries such as Venezuela and Ecuador, mostly exposed to fluctuations in oil prices but highly vulnerable. Policymakers in these countries would clearly benefit from reforms oriented at building greater room to maneuver, particularly through fiscal buffers. Most English-speaking Caribbean countries are both highly exposed to external volatility and highly vulnerable, as their policy maneuvering room is severely limited by the countries’ size and openness as well as high levels of public debt.
Somewhere in the middle are the rest of LAC countries with significant levels of exposure to external fluctuations and moderate vulnerability. For these countries, small improvements in their monetary, fiscal, and macro-prudential policies can have large payoffs in terms of reduced vulnerability, the report argues.
The report also highlights that, adding to today’s complexities in financial globalization, is the rising role of the international asset management industry (particularly mutual funds, pension funds, and hedge funds). This industry is becoming the main conduit for cross-border capital movements, as compared to banks.
In times of high risk aversion and uncertainty, even the well managed countries with a strong set of policies are vulnerable to the whims of those investors, according to the report. When tensions subside, however, those countries are better able to recover fast and are better placed to reap the benefits of global integration for long-term growth with social equity.

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