1 Rethinking Reforms How Latin America and the Caribbean can Escape Suppressed World Economic Growth The team: Eduardo Cavallo Eduardo Fernandez-Arias Andres Fernandez-Martin Luca Flabbi Andrew Powell (Coordinator) Alessandro Rebucci

Contents 1.Global growth likely to be suppressed 2. LAC has little space for counter-cyclical fiscal or monetary policy 3. There is space for reforms and payoffs may be large 2

On the World Economy The US is recovering but policy uncertainty remains European (including UK) growth constrained by fiscal and in Europe’s periphery, competitive issues Japan continues with low growth, potential fiscal issues, rates at zero bound and now a the monetary experiment China may slow gradually and at some pt. rebalance 3

World output suppressed, below potential 4

Adding this up… World growth is likely to be lower than during the Great Moderation for the next few years. If there is a negative shock, Advanced Economies have little fiscal space to respond And there are doubts about the effectiveness of more non-conventional monetary policy The world may even be at the doorstep of a Great Suppression. 5

What does this mean for LAC? Growth may be almost 1% below the Great Moderation 6

Observation 2 LAC is a group of small open economies, the global headwinds will have a negative impact While all projections are subject to uncertainty, growth in LAC is likely to be almost 1% lower than the Great Moderation period While there are differences across countries, most countries in the region will be affected by suppressed world economic growth 7

But LAC growth could exceed that of the ASEAN-5: Through a concerted regional reform effort 8 There are positive spillovers between countries, due to trade and other interactions. If all countries pursue a similar reform effort, regional growth would be boosted by 2.3%. LAC growth would then exceed 6% per annum, somewhat in excess of that of the ASEAN-5* *ASEAN-5: Malaysia, Philippines, Thailand and Vietnam.

If countries pursued a tailor-made reform agenda this could counter a potential Great Suppression 9 A one standard deviation growth shock in: US Europe China Japan Leads to a fall of 0.75% in global growth to 3.4% This results in a fall of 0.8% in LAC growth

Contents 1.Global growth likely to be suppressed 2. LAC has little space for counter-cyclical fiscal or monetary policy 3. There is space for reforms and payoffs may be large 10

Spending has increased and fiscal balances have deteriorated (typical LAC country) 11 Output gaps have essentially closed in LAC, what was seen as a successful counter- cyclical policy to confront the Great Recession may be seen as simply expansionary

12 There is less room for monetary action Other measures of monetary space have also tightened.

Reserves relative to the size of financial systems have started to fall for most countries 13 Reserves as a percentage of GDP have a similar trajectory, while reserves expressed as months of imports have continued to rise.

Real exchange rates have appreciated 14 Appreciation pressures, perhaps due to QE policies in the North and/or inflows spurred by attractive investments in the South, may be accentuated by a suboptimal mix of tight monetary and loose fiscal policy.

Observation 3 15 Most countries have little space for counter-cyclical fiscal policies in case of a new downturn. LAC output gaps have closed, multipliers are then reduced, even in the case of fiscal and monetary space, these may not be the best tools to confront medium term suppressed world growth. Given appreciation pressures, tighter fiscal and looser monetary policy may be warranted. But such a policy mix will not boost growth, nor can it be expected to do so.

Contents 1. Global growth likely to be suppressed 2. LAC has little space for counter-cyclical fiscal or monetary policy 3. There is space for reforms and payoffs may be large 16

LAC’s productivity has declined against the US and even more so vs. Emerging Asia TFP Region/ TFP US LAC relative to the US, For the typical LAC country, two thirds of the LAC-US per capita income gap is due to lagging productivity. Source: “The Age of Productivity”, IDB 2010.

What determines Total Factor Productivity (TFP)? Labor Infrastructure Capital Land TFP Efficiency in allocation Complementarities between inputs Input Quality: Education Skills Training Technology Innovation Incentives: tax and social systems and institutions Inputs

The potential gains from allocating resources more efficiently are very significant 19 If the median country allocated resources as efficiently as the US, there would be a 20% increase in TFP. Translated into growth, the median country would grow by an additional 1% per annum over ten years as a result of reforms that improve resource allocation.

Where should LAC focus reform efforts? 20 Reforms in tax systems and labor markets have lagged behind other areas. Reform index developed by Eduardo Lora

Recent IDB work: on taxation and on education 21

In this report the focus is on: 1. Labor markets 2. Infrastructure 22

LAC labor markets are highly informal 23 Share of labor force in the informal sector

Informality is associated with lower productivity 24 Informal firms tend to be less productive than formal ones Informal firms invest less in labor training, technology adoption and innovation Informality goes hand in hand with lower human capital accumulation, more labor rotation Informal firms evade regulations, restricting access to credit Informal firms tend to be very small and underexploit economies of scale and scope

Infrastructure: perception that in LAC quality is low 25

Infrastructure investment has fallen 26 Investment in infrastructure exceeded 3% of GDP in the 1980’s and 1990’s It has fallen to about 2.5% in the 2000’s To close the infrastructure gap, investment of 5% of GDP may be required Given fiscal constraints, private investment needs to be boosted This requires frameworks to make these investments attractive to investors

Moreover, domestic savings in LAC are low 27 The country with the highest savings in LAC has lower savings than any country in Emerging Asia Median

And LAC has not been able to sustain current account deficits to fill the savings gap 28 Over the last 30 years, only 7 countries in LAC have been able to sustain for more than 5 years the current account deficit needed to finance the estimated infrastructure gap

Conclusions 29 Given world growth LAC is close to its potential, LAC needs to enhance that potential. Countries are in different positions, reform efforts to boost growth should be tailor-made to the needs and context of each country; there is no “one-size-fits-all”. Two areas where the region lags are labor markets and infrastructure. Payoffs to more structural reforms may be large and would be boosted by regional spillovers.

But LAC growth could exceed that of the ASEAN-5: Through a concerted regional reform effort 30 There are positive spillovers between countries, due to trade and other interactions. If all countries pursue a similar reform effort, regional growth would be boosted by 2.3%. LAC growth would then exceed 6% per annum, somewhat in excess of that of the ASEAN-5* *ASEAN-5: Malaysia, Philippines, Thailand and Vietnam.

31 Rethinking Reforms How Latin America and the Caribbean can Escape Suppressed World Economic Growth