Since 2003, Latin America has benefited from a rare combination of concurrently and uniquely favourable external factors, allowing the region to post above-trend real growth rates, improve social indicators, considerably strengthen external accounts, improve fiscal balances and debt ratios, accumulate a significant amount of foreign reserves and therefore visibly reduce its perennial vulnerability to external shocks and excessive dependence on international capital flows. Such favourable conditions contributed decisively to leverage the performance of local financial markets, strengthen most regional currencies, improve the balance sheet of both sovereigns and corporates, and reduce hard currency debt spreads to new lows.

The onus is now on regional policy makers to capitalize on this unique opportunity to decisively leave behind the lost decade of the 1980s and the sub-par performance of the 1990s. In this regard, we see no need to innovate on the policy front. Disciplined fiscal policy (eyeing further reduction of still relatively high debt levels) and conservative forward-looking monetary policy conducted by independent central banks (pursuing low and stable inflation), coupled with bold steps to implement structural macro and micro reforms could, in this propitious environment, bolster non-inflationary real gross domestic product (GDP) growth, investment and job creation. This stance would contribute to making significant inroads into much needed poverty reduction and still-skewed income and wealth distribution.

Furthermore, it is perhaps politically the right moment to be ambitious and press for the approval of much needed structural reforms, so as to extend the growth cycle and minimize external vulnerabilities. Moving without further delay and demagoguery in meeting the targets set for the UN Millennium Development Goals should also be the overriding guide and concern of Governments to change the human face of the hemisphere. We are optimistic that regional governments will rise to the occasion and take the reform path with conviction; however, we fear that complacency and nationalist inward-looking policies could gain renewed appeal in some countries. In our view, this could turn into a mistake of historical proportions, as opportunities like those presented over the last four years by the supportive external backdrop do not come very often.

The nurturing external financial environment could also overcome some of the main encumbrances of a large majority of countries in the region, such as local capital markets that lack depth and breadth, and economies that are relatively closed to foreign trade. Governments should capitalize on strong foreign interest in local markets to further liberalize local financial markets while developing the ability to borrow for the long term in local currencies. This could be a decisive step in mobilizing and channelling domestic savings into productive investment, auguring a new era of high and sustainable growth levels and of broader financial stability for a region that has seen more than its fair share of financial distress.

Opening to trade by reducing high levels of protection within clearly inefficient regional trade arrangements would give a technological and productivity shock to economies that so desperately need to boost investment levels and attract foreign capital to leverage development. In this regard, the United Nations and the World Trade Organization should play a pivotal role by disseminating best practices and bringing together countries in a genuine effort to achieve freer trade in goods and services, as that can be a powerful instrument to enfranchise and empower large segments of the population in less developed regions. It remains more imperative than ever to continue to invest in education to enhance the level of human capital and create knowledge-based societies. A more educated populace is also less susceptible to populist proposals and experimental/ heterodox policy platforms, and tends to demand more transparency, efficiency and accountability from its Government. The challenges are significant, but so are the opportunities presented by the current external environment. The key question is: "Will the region's policymakers rise to the occasion?" We hope some will, in order to place Latin America decisively into the global economy.

On many counts, the external environment faced by most Latin American countries in 2003-2006 was truly exceptional. The region benefited from a constellation of unlikely repeatable, favourable external developments, which included: abundant external liquidity; increased risk appetite; low global interest rates; a weakening dollar; rallying commodity prices; recovery of foreign direct investment (FDI) flows; strong growth in remittances; easy access to international capital markets for sovereigns and corporates; and strong above-trend global growth and export demand. Such external environment, the best in the last 30 years, has levered the macro performance of the region over the last four years while creating a positive forward momentum that should carry through into 2007.

A supportive external backdrop, allied with relatively sound macro policies on average-ranging from orthodox in Chile, Colombia, Brazil, Peru and Mexico, to irresolute in Ecuador and unconventional in Venezuela-has allowed real GDP growth in the region to rebound to 5.7% in 2004, up from almost zero growth during 2001-2002 and slightly over 2% in 2003. In 2005-2006, growth averaged an above-trend of 4.5%. However, while the growth performance during 2004-2006 (4.9% on average) was higher than the 2.7% average of the past two decades, unfortunately it was still considerably below the average of emerging market economies (7.5%) and pales when compared against the performance posted by emerging Asia (8.8%).


The macroeconomic fundamentals of Latin America improved markedly during 2003-2006, reducing some long-standing structural vulnerabilities, particularly in the external accounts. The external adjustment initiated in 2003 took place on the back of a major rally in commodity prices and a robust growth in export volume. The aggregate regional current account shifted into a small surplus in 2003, for the first time in over 35 years, and continued to improve every year until 2006. In fact, the account balance shifted from a $54-billion deficit in 2001 (2.8% of regional GDP) to an estimated $35-billion surplus in 2006 (about 1.2%)-a remarkable shift of about 4 percentage points of GDP. The swing was driven fully by a shift in the trade balance to a surplus of almost $100 billion in 2006, up from a $10-billion deficit in 2001. In addition, the volume of labour remittances increased from $26 billion in 2001 to $55 billion in 2006.

The significant wealth/income transfer observed since 2001 via terms of trade gains led to an increase in the domestic savings ratio by 4.9 percentage points of GDP over that period. However, such an increase in savings led to only a minor increase in the investment to GDP ratio (up 1% of GDP), with the rest being channelled abroad, i.e. exporting national savings as the current account moved into a surplus. Unfortunately, at 21% of GDP, investment is still the lowest of any region, particularly when compared with other emerging markets, such as Asia at 36% and Europe at 25%. Hence, it is no surprise that despite the recent acceleration, economic growth in the region continues to lag that of other more dynamic regions in the world.

Notwithstanding the favourable external conditions and stronger real GDP growth, on a cyclical adjusted basis, public sector savings did not improve much despite a significant increase in revenues; however, significant cross-country heterogeneity has been observed. Some countries have pursued notoriously loose and pro-cyclical fiscal stances (Ecuador, Venezuela), while others have conservatively saved most of the windfall revenues (Chile, Colombia). Consequently, with the notable exception of Chile, the automatic fiscal stabilizers did not work during the expansion cycle, and public sector savings did not increase as could have been the case (the central government fiscal balance improved marginally, from a 3.4% of GDP deficit in 2003 to 2.3% deficit in 2006).

Because the fiscal stance did not improve as warranted by the cycle, the ratio of public debt to GDP did not decline as would have been desirable and possible. Hence, the debt overhang in the region remains a significant policy constraint and source of future vulnerability. In other words, the region did not seize this unique opportunity to more aggressively de-leverage the sovereigns' balance sheets.

Notwithstanding, we reckon that many credits, such as Brazil, Mexico, Colombia and Venezuela, took advantage of the favourable external conditions to improve the profile of public debt stock and have prepaid some external debt while shifting financing to local sources. Furthermore, we reckon that the external debt-servicing capacity indicators of the region have improved markedly. This shift reflects the boom in exports, higher international reserve levels and smoother debt servicing profiles achieved through liability management. On the debt overhang issue, the involvement of the Bretton Woods institutions in spearheading debt relief efforts for highly indebted poor countries, particularly in Central America and the Caribbean, is commendable and should continue, but must be closely tied to the adoption of disciplined fiscal and monetary policies that can bring about opportunities for advancement and lasting improvements in social conditions.

Turning to the capital account of the balance of payments, private net capital inflows reached $13 billion only during 2005-2006, a far cry from the $70 billion average of 1996-1998. However, this shift reflects for the most part the healthy voluntary repayments of external debt by the private sector, not lack of market access. FDI hovered around $50 billion during 2005-2006, but is still about 75% of the average flows recorded for 1997-2001. In contrast to private capital's relative lack of enthusiasm with the region, private capital inflows into emerging Asia tripled from 2001-2003, reaching about $100 billion on average during 2004-2006. In light of the major adjustment in the current account, since 2002 Latin America increased its international reserves by $140 billion to close to $300 billion in 2006. Finally, inflation declined from 10.5% in 2003 to about 5.6% in 2006. The happy combination of declining inflation and growth revival was reflected in the buoyant performance of local markets (equities and fixed income).

The significant accumulation of international reserves, the abandonment of fixed or pegged foreign exchange rate regimes and the marked improvement of the external accounts and public debt composition should allow the region to better endure future external shocks. Although Latin America is more resilient today, it is certainly not immune to external shocks. For instance, the dangers of a potential fast-moving disorderly and disruptive adjustment to the macro imbalances in some of the largest economies are sources of risk that could magnify an eventual less supportive external backdrop. This goes to the heart of our long-standing view that the positive external shock of 2003-2006 should be treated as temporary and used as a unique opportunity to beef up immunity against a probable less friendly environment.

In our assessment, many Governments have perhaps not been ambitious enough in recent years to seize the opportunity provided by the strong global expansion cycle to implement reforms capable of closing the rapidly widening gap between prosperity in Asia and poverty in Latin America. Hence, one of the main risks for the region is that of complacency, i.e., its political leaders may not seize that unique opportunity provided to pursue important structural reforms and build policy resilience, so as to boost real GDP growth, reduce poverty and improve income distribution metrics. Regrettably, the region is still beset by low savings rates and human capital levels, rigid labour markets that lead to substantial levels of labour informality, high and distortionary tax burdens in some countries like Brazil, low investment ratios, poor and uncertain regulatory framework, and weak capacity to attract FDI, to name a few.

Some of these are perennial structural problems that need to be addressed in order to unleash the growth potential of the region. This would require a much more decisive drive on the structural reform front, improvements in microeconomic policies-e.g., regulatory framework, property rights, bankruptcy procedures, legal certainty, etc.-and a convincing and wholehearted attempt at trade liberalization. If implemented, this agenda carries the potential to generate a positive productivity shock that could lift growth rates to levels similar to emerging Asia, and lift the living standards in the region.
We hope it will!