Why should the United States and its businesses be concerned with fiscal policies in Latin America? Because fiscal policies affect more than just the domestic performance of the country in question and because unsustainable fiscal policies can impact investment opportunities and trade relationships among other countries.
arge public sector deficits in some Latin American countries have received considerable attention over the past few years. Indeed, in spite of gains achieved during the early 1990s, the recent trend in public sector accounts in many countries has been toward larger deficits rather than toward reducing shortfalls. Weaknesses in government accounts and the failure to extend liberalizing reforms to governments themselves have made Latin American countries especially vulnerable to financial market swings. Amid the Asian economic crisis and investor uncertainty toward emerging markets, these swings played a role in increasing deficits and, in some cases, precipitating currency crises in Latin America.
From a U.S. perspective, the topic has important relevance because of the growing relationship between Latin America and the United States. Public sector finance can significantly influence economic performance and play a role in triggering financial difficulties. Thus, knowing the issues and problems associated with public sector finance in Latin America is important information for U.S. businesses and policymakers.
What’s all the fuss?
An important trend in most Latin American countries over the past decade has been toward an improved budget balance as measured by the primary balance (revenues minus expenditures only). The primary deficit in Latin America and the Caribbean (comprising 26 countries) was substantially reduced to an unweighted average of 1.7 percent of gross domestic product (GDP) in 1997 from 5.7 percent in 1988, and major economies in Latin America performed slightly better than the region as a whole (see Chart 1). These results place the region in a position only modestly worse than the advanced industrial countries, which in 1997 averaged a deficit of 1.1 percent of GDP. Why then does the fiscal position of Latin American governments receive so much scrutiny? The answer lies mainly in the region’s potential to undergo rapid economic swings, which ultimately bring budgetary shifts. These swings, which often require additional debt financing, are reflected in the real economy as well as government accounts.
Determinants of policy credibility
Despite gains in the past few decades, fiscal concerns continue to plague the region — and fiscal deficits in some Latin American countries have worsened. But why, despite so many efforts during this time, have regional governments been unable to implement effective and sustainable fiscal adjustment? Latin American governments have ample experience with belt tightening. Cost cutting and structural adjustment programs were the norm during the 1980s as countries struggled against high inflation and worked to restructure their economies along market lines. One study in the 1980s noted, however, that all these adjustment efforts failed to give a convincing signal of an underlying change in the economic policy regime.
Going forward, fiscal policy too must implement fundamental changes in order to be enduring, effective and credible. Since many other structural adjustment measures have already been put into place, fiscal policy is often a missing link in economic policy credibility.
The notion of sustainable public sector finance connotes more than producing short-term surpluses from favorable economic fundamentals or through harsh cuts. It also implies identifying the debt burden and structure that is manageable for each individual country’s output and spending needs, an achievement that necessarily looks toward a medium-term horizon.
While Latin American countries are generally considered to be highly indebted, most countries substantially reduced and restructured their debt load in the 1980s. As a result, the average ratio of external debt to gross national product (GNP) fell from 65 percent in 1987 to 35 percent in 1997. Among the larger economies in Latin America, only Ecuador had a ratio of external debt to GNP exceeding 60 percent. The average external debt ratio in all Latin American countries was considerably lower at 37 percent of GNP in 1998 (see Chart 2).
But interest and principal payments on this debt weigh heavily on government accounts despite the comparatively lower debt loads and restructurings. In 1996, the average debt service ratio for Latin American countries was almost 38 percent, meaning that the interest payments on foreign debt were equivalent to nearly two-fifths of exports of goods and services. According to the World Bank, Argentina (52 percent), Brazil (46 percent), Mexico (45 percent) and Peru (40 percent) carried the highest burdens in the region.
When they project budget shortfalls, Latin American governments must resort to new deficit financing, often paying the higher premiums demanded by market participants in exchange for the increase in sovereign or transfer risk. Funds of this sort are often short-term loans, which can create problems if investors begin to shy away from that country’s debt, as happened in Asia in 1997 and Russia in 1998.
2Source: ADB Statistics and Quantitative Analysis Unit based on official statistics of member countries; data for Brazil (1994–97) from Brazilian Central Bank.
Another consideration in the debt question is the recent increase in domestic debt issued by the public sector in the region. Latin America’s economic stabilization in the 1990s led to increased use of domestic financial markets. Although most countries still rely on external borrowing for the bulk of their financing needs, domestic debt has been increasing. Between 1995 and 1998, domestic debt in Brazil rose from 43 percent to 54 percent of GDP; in Chile it rose from 29 percent to 34 percent of GDP. The percentage more than doubled in Colombia and Ecuador, although from a much smaller base.
Even though default risk on sovereign domestic debt is generally quite low and transfer risk is not present, the rapid increase in public sector domestic debt presents potential concerns. For countries that do issue domestic debt, the danger of short-term issuance is also present. For instance, it was the refusal of investors who held domestic debt in Mexico in 1994 to roll over their paper that contributed to the peso crisis. Nevertheless, the limited nature of capital markets and banking systems, as well as low domestic savings, means that domestic borrowing is not a significant option in most Latin countries.
Mechanics of a budget
Countries run budget deficits when their spending outpaces revenue, similar to a person with a checking account. But unlike individuals who earn salaries, countries can rarely depend on a steady state in revenue. Additionally, Latin American governments must cope with volatility in the domestic and, sometimes, the global economy. Central government revenue has grown substantially in absolute terms since 1980; but the predominant experience has been a pattern of erratic revenue increases, often growing more slowly than expenditures and less sustained by tax collection than in the industrialized countries. Relative to the overall size of the economy, though, there has been considerable volatility and variation among countries. Fluctuations in economic performance have produced a situation in which growth has been punctuated with significant swings even in the countries where revenue increased as a percentage of GDP.
Source: World Bank
A study of government revenue in countries that are members of the Organisation for Economic Cooperation and Development (OECD) found that these countries take in more revenue relative to the size of their economies and are better at collecting taxes than their counterparts in Latin America. While the more industrialized countries averaged tax revenue collection equivalent to 23 percent of GDP, governments in Latin America collected less than two-thirds of that amount — or approximately 15 percent of GDP. The disparities were marked for income tax and social security tax collection; OECD governments collected at least twice the amount taken in by Latin American governments as a share of GDP. But Latin American governments performed better in some areas, collecting slightly more indirect taxes and considerably more nontax revenue.
Spending patterns in the region also reflect a high degree of volatility although this pattern has calmed somewhat since some countries have achieved price stability. Once high or hyperinflation was halted, Latin American governments lost the use of an important adjustment tool that could be used without regard to legislative approval. In the past, governments could reduce their debts by postponing payment until inflation had reduced the value of the obligation. Governments now face the more politically problematic task of implementing cuts in public spending.
In Argentina, Brazil and Peru, the pattern of volatility ended once relative price stability was achieved and expenditures reached a plateau. The plateau effect may well reflect the absence of the inflation tax as a means of fiscal adjustment after achieving relative price stability, but it also signals the difficulty that governments have encountered in making cuts. In Colombia, Ecuador and Venezuela, expenditures continued to rise through 1997 without clear evidence of topping out. Of this group, oil-dependent Venezuela is the most erratic, with a sharp rise in expenditures since 1995.
Chile and Mexico made dramatic spending cuts between 1984 and 1990. Chile cut expenditures from 32.5 percent to 20.3 percent of GDP, a level they have maintained since then. Mexico cut its nominal expenditures in half between 1987 and 1993, with only a slight subsequent rise.
There are several important differences between spending patterns in Latin America and the OECD countries. In Latin America, interest payments and wage payments take on a proportionally greater weight than in the OECD countries. Interest payments are the result of previous borrowing decisions and will rise along with interest rates. Meanwhile, it is politically difficult to reduce wage expenditures because powerful public sector unions work to preserve wages and employment levels, especially where the private sector does not provide much alternative. The lower level of social welfare spending in Latin America reflects less developed social welfare systems, although there is a wide range of spending levels in the region.
Why budget deficits matter
How exactly do budget deficits affect the economy? In previous decades, some Latin American governments resorted to printing more money to finance their budget shortfalls. This policy option promoted higher inflation and reduced economic stability in those countries. More prudent debt management policies are the norm today. In this environment, the main consideration of budget deficits is that they reduce national savings — the sum of public and private savings (after-tax income that is saved rather than spent).
A decline in national savings has a negative effect on the overall economy because it leads to a drop in investment or net exports or a combination of both. This decline is brought about largely through interest rate channels. Interest rates rise because a decline in national savings results in a decrease in the supply of loans to private borrowers; as savings dwindle, there is simply less money available to make loans. The falloff in the supply of loans raises the cost and thus pushes up the interest rate, causing some private borrowers to curtail their investment plans.
Net exports are also affected by higher interest rates, which attract more investors, both domestic and foreign. Since investors must first purchase a country’s currency in order to purchase assets from that country, demand for the currency increases. Greater demand results in a higher price for the currency, and a stronger currency, in turn, means that domestic goods are more expensive for foreigners and foreign goods are cheaper for domestic consumers. The resulting rise in imports and drop in exports turns the trade account toward deficit.
Concerns for U.S. businesses
If protracted, slumps in exports have a negative impact on a country’s national output. On the investment side, persistent declines reduce growth in a country’s capital stock and thus hamper the country’s ability to produce goods and services. Persistent deficits in net exports also hurt output as more and more income from domestic production flows overseas to service the debt. So persistent budget deficits lead to a reduction in output because either fewer goods are produced or less of the production stays at home.
The higher interest rates associated with weak fiscal positions also make it harder for businesses to borrow money. If the high rates are protracted, productive investment will decline and consumers will be deterred from many purchases; these developments tend to induce a recession or worsen an existing economic downturn. Consumers in Latin America, in turn, tend to buy fewer goods imported from the United States and other countries. U.S. exports to Latin America fell in 1999 as many countries experienced high fiscal deficits and recessions. Factoring out Mexico, which did not suffer the type of problems occurring in most other Latin American countries, U.S. exports to Latin America fell an estimated 13 percent in 1999 compared to the previous year.
This set of conditions can have a greater impact on areas with even closer trade and investment ties. For example, U.S. exports to Brazil fell an estimated 12 percent in 1999. Although the decline in exports was greater to some other countries (U.S. exports to Chile and Colombia fell an estimated 24 percent and 28 percent, respectively), the larger size of the Brazilian economy and the close commercial relationship between Florida and Brazil mean that the impact may be greater on Florida businesses.
What’s more, the growing interdependence of some Latin economies can also cause a chain effect. The recession in Brazil worsened conditions in Argentina, its neighbor and closest trading partner in Latin America. The Argentine economy also experienced a recession in 1999, which in turn helped produce a 17 percent decline in U.S. exports to Argentina.
The increasing interdependence of economies poses challenges to countries with fiscal problems. Markets can effectively transfer risk, or perceived risk, across national boundaries in a matter of minutes. And national finances may be subject to detrimental market oscillations from other countries with unsustainable policies.
The nature of economies in Latin America suggests that the region will continue to experience macroeconomic volatility as well as fluctuating degrees of access to capital markets. This volatility will continue to be reflected in government accounts, especially in revenue and interest payments. These factors highlight the need for policymakers to continue pursuing credible economic policy mixes that will balance public sector accounts and help shield the domestic economy from short-term market contagion. Sustainable fiscal policies will help insulate regional economies from greater volatility and smooth out economic swings.
Amid the challenges Latin American governments face, however, there are signs of optimism. Patterns of best practices are emerging as countries differentiate themselves in the management of public sector accounts, coming up with innovative institutional and legal approaches to curbing future problems.
Editor’s note: This article is excerpted from a paper prepared for a recent Federal Reserve Bank of Atlanta conference on sustainable public sector finance in Latin America. The article was researched and written by analysts in the bank’s Latin America Research Group.