Economic growth in Latin America in 2006 rose to 5.3% from 4.5% in 2005. Argentina, Colombia, Peru and Venezuela led this growth, while Brazil, Mexico and Chile saw below average gains and slowed from 2005. The worst performer in this group was Brazil - the region’s largest economy - with growth of 3.7%. Growth is expected decline to 4.2% for the region as a whole in 2007, although Brazil – and Chile – are expected to go against the trend and grow by 4% and 5% respectively. In this article, Alfredo Coutino, Senior Economist for Latin America for Moody´s Economy.com and Juan Pablo Fuentes, Economist, explain why Latin America enjoyed four consecutive years of growth to 2006 and why the good times should continue – at least for this year.

In 2006 Latin America saw its fourth consecutive year of expansion, with lower inflation and steady improvement in external accounts. After two years of stagflation in 2001 and 2002, the region’s economy took off, thanks mainly to domestic demand and highly supportive external factors. Favorable conditions in commodity and capital markets generated an extraordinary improvement in the region’s external accounts; this not only increased the availability of financial resources, but also stimulated domestic saving. Even though the region continues to depend on commodity exports of primary goods, minerals, and energy products, the accumulation of fixed capital has boosted productive capacity over the past few years. The increasing flows of export revenues and governments’ efforts to make the public sector more efficient have resulted in a significant improvement in fiscal accounts. Thus, last year Latin America registered one of the highest advances in economic terms, including a reduction in poverty.

Recent Performance
Economic growth in Latin America in 2006 was stronger than expected at the beginning of last year, coming in at 5.3%, up from 4.5% in 2005. Argentina, Colombia, Peru and Venezuela led growth, while Brazil, Mexico and Chile saw below average gains and slowed from 2005. These seven largest economies account for over 90% of total GDP in Latin America, including the Caribbean. Venezuela was the top performer in the region, with GDP growth of 10.3% in 2006. Argentina, Peru and Colombia followed closely with growth rates of 8.5%, 8.0% and 6.8% respectively. Meanwhile, Mexico and Chile reported growth of 4.8% and 4.0%, respectively. The worst performer in this group was Brazil—the region’s largest economy—with growth of 3.7%. Growth was about 5% in Central America and close to 7% in the Caribbean.

Domestic sources were the main drivers of the expansion, complemented by the extended boom in commodity markets. Domestic absorption continued to strengthen last year, particularly private consumption and investment. Domestic demand has increased as a result of both domestic policies and the expansionary impact of increased capital inflows. Monetary policy was favorable last year in most Latin American countries, contributing to growth in consumption and investment, although a few countries saw tightening. In addition fiscal policy was expansionary last year in most of the region as a result of the political process. On the external side, high commodity prices and strong demand were positives for Latin America in 2006. Although the direct impact of export revenues on aggregate demand was not significant, given that export volumes did not increase significantly, the indirect impact on the regional economy through the multiplier effect was important.

In addition, increased productive capacity has supported Latin America’s expansion in the past few years. Both public and private savings have contributed; governments have been making extra efforts to maintain fiscal accounts with small deficits or surpluses, and the private sector has also invested in industrial expansion. As a result, fixed investment increased from 17% of GDP in 2003 to 21% in 2006. Even more, since current account surpluses have been expanding, implying negative external saving, most of the accumulation of capital has been financed by domestic saving, which increased to almost 25% of GDP in 2006, from 21% in 2003. Positive current accounts have also allowed the region to export capital, with Brazil and Mexico leading the investment abroad.
 
Inflation in the region has been tamed thanks to consistent and persistent monetary discipline. In countries with independent monetary institutions, inflation has been under control and slowing. The exceptions are Argentina and Venezuela, countries with no monetary independence; in these nations inflation has not slowed. Slower economic growth has reduced price pressures in most of Latin America, with inflation declining from 12% in 2002 to 6% in 2005 and below 5% last year.

Although some commodity prices have fallen, they remain near their record highs. The commodity boom, combined with sturdy global economic growth , has led to a substantial improvement in external accounts in Latin America, reducing financing requirements. This, in turn, has resulted in a dramatic improvement in the region’s financial position and credit worthiness. These factors have also allowed the region to reduce real interest rates, stimulating domestic demand. Increasing capital inflows to Latin America have also strengthened local currencies, even though central banks have tried to limit currency appreciation through interventions in the market. As a result foreign reserves have reached record highs, totaling almost $200 billion in Brazil and Mexico combined.
 
The ongoing external surplus has also prompted a substantial improvement in countries’ fiscal accounts. Fiscal revenues in countries like Venezuela and Mexico (oil), Chile and Peru (copper) and Brazil and Argentina (primary goods) have soared as a result of high commodity prices. Meanwhile, the strong economic expansion has generated extra tax revenues at the same time that interest payments have been measurably declining due to lower interest rates and reduced debt levels. As a result, many governments in the region have been able to significantly increase spending without compromising their fiscal situations. Argentina, Brazil, Venezuela, Mexico and Peru reported strong government spending growth in 2006—this partially explains the ongoing boom in construction in almost every country in the region. Latin America's fiscal balance has steadily improved over the last five years, from a deficit of 3.3% of GDP in 2001 to a very small deficit of just 0.3% in 2006.

Prospects
Latin America has certainly benefited from favorable external conditions in the past few years. Now the region is making efforts to expand its productive capacity, although the pace is slow. The process of structural change continues in most Latin American countries, although some threats have emerged in Venezuela, Bolivia and Ecuador. However, nothing lasts forever—external conditions have moderated and look to become even less favorable in the coming years.

Given these circumstances, will the good times continue in Latin America? The short answer is yes, at least for this year, since domestic conditions are not expected to change dramatically. However, the external environment is clearly changing for the worst, which means more challenging economic and financial conditions. On the positive side, the region’s economic fundamentals remain solid. Inflation is low and under control in most cases, with the notable exceptions of Venezuela and Argentina . External and fiscal balances remain in good shape, and capital continues to flow to the region. International reserves have reached record-high levels and debt ratios look better than they have in the past.
 
On the domestic side, some countries are starting to face internal pressures from either domestic demand or supply restrictions. As noted earlier inflation is very high in Venezuela and Argentina—countries at greater risk of a recession in the near term—and some inflation pressures have emerged lately in Colombia and Mexico. Excessive domestic demand in some countries has put output capacity under strain, with imports filling the widening gap between absorption and local production. This is indicative of the lack of productive investment that still exists in many countries. Despite the region’s positive economic performance of the last few years, Latin America still lags Asia as a preferred location for foreign direct investment. In this regard, it is extremely important for Latin America nations to continue undertaking structural reforms to strengthen the fundamental sources of growth: savings/investment, productivity growth and technological change. Even though productive capacity has expanded, fixed investment needs to increase by about five percentage points of GDP, to around 25% or 26%, to sustain a steady growth path.

Given external restrictions and the development of some domestic pressures, we anticipate a moderation in the Latin American expansion this year. Overall regional growth will decelerate to 4.2% from 5.3% last year. Among the seven biggest economies Mexico (2% real GDP growth in 2007), Argentina (6%) and Venezuela (6%) will lead the slowdown, while Brazil (4%) and Chile (5%) will be the only two countries reporting an acceleration in growth. Growth will hold roughly steady in Peru (7%) and Columbia (6%). The divergence in growth patterns has more to do with economic cycles than any fundamental difference. However, beyond 2007, fundamentals will deteriorate in Venezuela and Argentina, making these economies more susceptible to external shocks. In general, the medium-term regional outlook is for a moderation in growth, with economies moving toward their potential growth rates.
 
With the exceptions of Argentina and Venezuela, inflation will remain tame, with potential transitory rebounds in Mexico, Brazil and Colombia. We do not expect a return to the inflationary episodes of the past. Particularly in the largest economies, which maintain a greater degree of openness, international prices will tend to drive domestic price movements, for better or worse. Given the openness of the region, excess demand will be accommodated more through imports and less through inflation.

With elections out of the way, except in Argentina, fiscal stimulus has faded. The threat of social disruption due to concern over globalization will remain, however. Nevertheless, new governments, including those that have recently won reelection, will not generally threaten the continuation of macroeconomic discipline as a necessary condition to promote social progress. Threats to free-market policies have arisen only in Venezuela, Bolivia and Ecuador. However, efforts in these nations to expand government participation in the economy through nationalization have produced a negative response from international markets.

  
© 2007 Moody's Economy.com, Inc./Brazil Political Comment
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