External Conditions and Debt Sustainability in Latin America

This is a cross-post of a piece written by Gustavo Adler and Sebastian Sosa (International Monetary Fund – IMF)

Did Latin America save the windfall?” is the title of one of the sessions that took place at the 18th Annual Meeting of the Latin American and Caribbean Economic Association (LACEA) and the 28th Latin American Meeting of the Econometric Society (LAMES), Mexico City October 31st – November 2nd, 2013. Sponsored by the International Monetary Fund (IMF), the session was dedicated to discuss the following papers: “Four Decades of Terms-of-trade Booms: Saving-Investment Patterns and a New Metric of IncomeWindfall“, by Gustavo Adler and Nicolas E. Magud; “External Conditions and Debt Sustainability in Latin America“, by Gustavo Adler and Sebastian Sosa.

In a context of highly favorable external conditions, especially for commodity exporters, Latin America’s fiscal and external fundamentals improved markedly over the last decade. But, how dependent are these gains on a continuation of such conditions? To address this question, we develop a debt sustainability framework that integrates econometric estimates of the effect of global factors on the main domestic variables that drive debt dynamics, and use it to forecast debt trajectories under less favorable external scenarios.

Over the last decade, and especially during the period 2003-08, Latin America experienced a remarkable improvement in key macroeconomic fundamentals, reducing public and external debt ratios, accumulating foreign assets, strengthening fiscal and external current account balances, and reducing debt structure vulnerabilities. While prudent policies played an important role, a growing view is that much of these gains reflected the effect of a highly favorable external environment, characterized by strong external demand, a commodity price boom, and benign external financing conditions (see Inter-American Development Bank, 2008; Izquierdo and others, 2008; and Osterholm and Zettelmeyer, 2008). Thus, with prospects of a less favorable global environment ahead, the strength of the region’s fundamentals remains an open question. In particular, have countries strengthened their fiscal and external positions enough to guard themselves from a weakening of external conditions? Our recent paper (Adler and Sosa, 2013) sheds light on this issue, by studying how fiscal and external accounts of Latin American countries would be affected by less favorable global conditions.

A decade of falling public debt

Between 2003 and 2008, Latin America experienced a remarkable decline in public debt ratios (Figure 1), averaging 30 percentage points of GDP. And even though this steep trend came to a halt in 2009—as the region felt the effects of the global financial crisis—public debt levels today remain quite low in historical perspective. These improvements were broad-based, but the driving forces varied, and countries can be broadly classified in two groups, based on how they managed their rapidly rising revenues (Figure 2).

LACEA blogIn Brazil, Chile, Colombia, Mexico, Paraguay, Peru, and Uruguay (the ‘LA7’ group) the drop in public debt was mainly driven by robust primary surpluses and rapid real GDP growth. The former reflected prudent fiscal policies, with public expenditure growing at a slower pace than booming revenues—which came primarily from the commodity sector—and slower than potential output. This fiscal restraint was relaxed somewhat after 2008.

The rest of Latin America (Argentina, Bolivia, Ecuador, and Venezuela) also experienced a remarkable drop in public indebtedness, although from much higher starting levels. In their case, the decline was largely driven by strong output growth (above long-term potential, except in Bolivia) and negative real interest rates. While primary surpluses also played an important role in reducing debt ratios, the extent of savings of the booming revenues was more limited, as evidenced by a path of public expenditure that largely outpaced output, and even more so potential output.

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