Opinion
It was short lived, the decoupling. For a few months -from August, 2007, to mid 2008- Latin America thought it might emerge from the global financial crisis relatively unscathed. Even as the subprime cancer spread through the industrialized world, in Latin America things didn't look bad. Currencies strengthened, Central Banks accumulated reserves, direct foreign investment kept flowing in, growth prospects for 2008 were revised upwards, stock markets appeared stable compared to the New York stock exchange, and Peru and Brazil were designated "investment grade."

The decoupling oasis was the result of an accelerated increase in commodity prices (oil, grains, industrial metals), which more than offset the negative forces of the financial turmoil and economic slowdown in rich countries. A surge of inflation, triggered by high and increasing international prices of grains and fuels and exacerbated by economic overheating in several countries was the main problem in the decoupling phase. Equipped with more robust monetary policy frameworks, Latin American central bankers confronted inflation by decidedly and repeatedly increasing interest rates. But just as the inflation fight was underway, it was eclipsed by greater priorities as the decoupling oasis vanished.

By mid 2008, commodity prices plummeted as the financial crisis spread globally and the world economy entered an acute slowdown. These three factors converged to create a "perfect storm" for Latin America, inaugurating the "re-coupling" phase we are now experiencing. The region's stock markets joined the global selloff; currencies depreciated dramatically; households, companies, and governments began feeling the credit crunch; remittances weakened; and a process of downward revisions to 2009 growth prospects was set in motion. All of this is happening amidst great uncertainty about the future of global economic and financial dynamics.          

In reality, during the past decade Latin American governments implemented sound policies that reduced macroeconomic vulnerability to external shocks. The combination of greater exchange flexibility with more developed local currency debt markets helped mitigate currency mismatches in debtors' balance sheets (previously those mismatches raised the likelihood of "sudden stops" in capital flows). This was aided by improved of fiscal management that contributed to a lower ratio of public sector debt to GDP. 

To be sure, not all that glitters is gold as Ernesto Talvi and other economists remind us. Part of this reduced vulnerability arguably reflects the region's good luck--namely, the high commodity prices and abundant liquidity that prevailed in the world in past years. But luck is only part of this story. Key improvements in the quality of the economic policy is the other rather significant part.

But no matter how well it did its homework, Latin America is not immune to a global crisis as big as this one. We live in an interconnected world. When importers in Europe, Russia or the United States face lower demand at home and reduced access to credit, the region's exporting potential will unavoidably suffer. 

The region is better prepared to prevent the inevitable problem of flows (falling fiscal revenue, lower GDP growth, reduced credit) from turning into a devastating run on Latin American assets. Managing the flow problem, however, will be difficult. It will severely test economic policies, particularly monetary and fiscal policy. 

The central challenge for monetary policy will be whether, when, and how much to ease. In principle, exchange rate flexibility coupled with deeper local currency debt markets open space for countercyclical monetary policy, that is, for lowering interest rates to mitigate the extent of economic slowdown. In practice, however, the room for monetary policy maneuvering will not only depend on inflation pressures but also on how much stress the domestic currencies and financial systems are facing. Overall, countries with autonomous central banks and solid fiscal processes are better positioned to face this challenge.

The main challenge for fiscal policy in Latin America will be to manage the inevitable fall in tax collection (related to the economic downturn and fall in commodity prices) so as to protect expenditures (in education, social security, infrastructure) that are necessary to prevent a rise in poverty and lay the foundations for future growth. Fortunately, Latin American governments are not contributing to the crisis and have, as a result, some capacity to provide support to the economy via fiscal interventions. However, maneuvering room for fiscal policy varies considerably among countries and will depend on such factors as the existence of savings accumulated during good times (Chile is an indisputable leader in this regard), the degree of expenditure rigidity, and the scope for prudent borrowing.

Rich countries are the ones to blame for this crisis. Latin America is an innocent bystander that will, nonetheless, suffer adverse consequences. Yet it is precisely during this crisis that the benefits of sound economic management will surface-cushioning the external shocks and facilitating the resumption of growth once the storm is over.

The author is Chief Economist for Latin American and Caribbean, World Bank.
adelatorre@worldbank.org
www.worldbank.org/laceconomist