COVID | Emerging Markets | Monetary Policy & Inflation
We were delighted to have Alfonso Prat-Gay, Argentina’s former central bank governor (2002-2004) and finance minister (2015-2016) as our podcast guest on Friday. We covered so much interesting ground that we decided to distil his key thoughts into a note in case you don’t have time to listen to the podcast. Although I highly recommend you do!
Four Key Global Trends Pre-COVID
I began by asking Alfonso for his thoughts on the challenges facing the global economy, and for Latin America in particular, prior to the outbreak of coronavirus. He highlighted the unsustainable policy mix in the US, saying, ‘It was quite obvious that under a full employment economy, the fiscal policy was absurdly loose’, adding that monetary policy was also quite loose. On China we discussed the transition from external to more domestic-driven growth and the political and economic challenges of a slower growth. He pointed to this Fed paper looking at the spillovers from a hard landing in China. He also mentioned the structural problems in the Euro area and the tensions due to the design of the monetary union. He expects all of these factors will be reinforced when COVID lockdowns are over.
Decades of Underperformance in Latin America
On Latin America we discussed the end of the commodity super cycle, which benefitted the region between 2000 and 2015, and the regional discontent and social tensions that flared up last year. He said, ‘To me, that was a very clear marker that some of the underperformance of the previous two years was having a significant impact on the social structure of most of our countries and economies and societies.’ COVID could reinforce these trends when the lockdown ends particularly given the exceptionally weak data coming out for the first quarter when lockdowns only started in March.
His prediction for the region this year is an unprecedented contraction in economic output. ‘I think you could safely say that the region is geared towards an 8.5 or 8% drop in economic activity this year. Just to give you a sense, during the 1980s, the lost decade of Latin America, the worst year around that decade was 2.5% for the Latin American region. So, we’re talking COVID is three, even four times as bad as what we had in around the 80s, or around the tequila crisis or even the crisis in Brazil in 1999.’
Highlighting how Latin America has underperformed versus other regions, Alfonso pointed out that over the past 25 years the region has recorded slower growth than Africa – and in the past 5 years even slower than for advanced economies, leaving any catch-up impossible.
Alfonso sees three structural constrains to growth in Latin America. Firstly, poor infrastructure. The institutional infrastructure is weak, capital accumulation is low, and physical infrastructure in terms of roads and other transport/connectivity is lacking. Human capital is also under pressure with education no longer the ‘shining gem’ of the past. Because of these constraints, growth has come through labour rather than productivity. But even this is under pressure given Latin America is ageing faster than Asia or Africa. This is causing problems with pension affordability and wider constraints on the budget.
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We were delighted to have Alfonso Prat-Gay, Argentina’s former central bank governor (2002-2004) and finance minister (2015-2016) as our podcast guest on Friday. We covered so much interesting ground that we decided to distil his key thoughts into a note in case you don’t have time to listen to the podcast. Although I highly recommend you do!
Four Key Global Trends Pre-COVID
I began by asking Alfonso for his thoughts on the challenges facing the global economy, and for Latin America in particular, prior to the outbreak of coronavirus. He highlighted the unsustainable policy mix in the US, saying, ‘It was quite obvious that under a full employment economy, the fiscal policy was absurdly loose’, adding that monetary policy was also quite loose. On China we discussed the transition from external to more domestic-driven growth and the political and economic challenges of a slower growth. He pointed to this Fed paper looking at the spillovers from a hard landing in China. He also mentioned the structural problems in the Euro area and the tensions due to the design of the monetary union. He expects all of these factors will be reinforced when COVID lockdowns are over.
Decades of Underperformance in Latin America
On Latin America we discussed the end of the commodity super cycle, which benefitted the region between 2000 and 2015, and the regional discontent and social tensions that flared up last year. He said, ‘To me, that was a very clear marker that some of the underperformance of the previous two years was having a significant impact on the social structure of most of our countries and economies and societies.’ COVID could reinforce these trends when the lockdown ends particularly given the exceptionally weak data coming out for the first quarter when lockdowns only started in March.
His prediction for the region this year is an unprecedented contraction in economic output. ‘I think you could safely say that the region is geared towards an 8.5 or 8% drop in economic activity this year. Just to give you a sense, during the 1980s, the lost decade of Latin America, the worst year around that decade was 2.5% for the Latin American region. So, we’re talking COVID is three, even four times as bad as what we had in around the 80s, or around the tequila crisis or even the crisis in Brazil in 1999.’
Highlighting how Latin America has underperformed versus other regions, Alfonso pointed out that over the past 25 years the region has recorded slower growth than Africa – and in the past 5 years even slower than for advanced economies, leaving any catch-up impossible.
Alfonso sees three structural constrains to growth in Latin America. Firstly, poor infrastructure. The institutional infrastructure is weak, capital accumulation is low, and physical infrastructure in terms of roads and other transport/connectivity is lacking. Human capital is also under pressure with education no longer the ‘shining gem’ of the past. Because of these constraints, growth has come through labour rather than productivity. But even this is under pressure given Latin America is ageing faster than Asia or Africa. This is causing problems with pension affordability and wider constraints on the budget.
Latin America’s Policy Response to COVID
We also discussed the delayed response of Mexico and Brazil to COVID – they underplayed the dangers from the virus and imposed lockdowns fairly late. By contrast, Argentina has had one of the strictest lockdowns globally and, according to Alfonso, this has been successful, with death rates flattening. Chile’s response has been in the middle of these two extremes, which seems surprising given greater fiscal space than others. Paraguay and Peru have responded with an aggressive fiscal and monetary response. But as Alfonso points out, it’s all down to whether you can afford it.
Mexico could have done a lot more on the policy front. ‘AMLO’s done very, very little on the fiscal side. It’s probably the smallest fiscal package that you can see in the region.’ On monetary policy, Banxico cut rates but not nearly as aggressively as some other central banks in the region have done. Alfonso attributes this to AMLO’s stance on fiscal discipline and austerity seeping into the central bank. Chile and Peru are now hitting the lower bound on rates but the extent of easing in Brazil has also been surprising. ‘You probably wouldn’t have expected Brazil to cut as aggressively as they did.’
Inequality and COVID
Alfonso stressed the importance of the impact on lockdowns on inequality. ‘Lockdowns are tremendously regressive from the point of view of income distribution.’ Informal workers account for 30-50% of the labour force in the region, and, with many surviving on daily budgets, lockdowns are a ‘luxury’. ‘You’re forcing them into picking between risking getting the disease, which they might not be too fussed about in any case, or suffering hunger. It’s a massive trade-off for most of our populations.’
Poverty also complicates the response to COVID. The region’s shantytowns can have large families with three or four generations living in one room. By imposing lockdowns, this could increase the risks, particularly for the elderly.
Inequalities also extend to the ability to work from home and the digital divide, particularly on education. We discussed how these options are much less accessible in Latin America and other EMs, leaving longer-term consequences – particularly on missed education.
Wider fiscal inequalities also exist between advanced and emerging economies. Very sizeable packages can be financed in the US and Europe through deep local markets and access to foreign capital. But this is not always the case in EM, with the result that the fiscal response to COVID has been much more limited. According to Alfonso, Latin America is near the bottom. ‘When you go through the nitty-gritty detail of the fiscal firepower that they’ve been able to put together, it’s not much more than 1% of GDP.’ This compares with double digit fiscal expansion in some advanced economies.
As poverty levels and the income distribution worsen following each crisis, sound macroeconomic policies are a necessary condition to ensure that crises can be avoided. In addition, well-designed social programs can also help fight against widening inequality with universal income, subject to some conditionality. This could help address the entrenched poverty we see in Latin America where ‘today’s poor are the sons and daughters of yesterday’s poor, and there are even the grandchildren of the day before.’ Investment into education and infrastructure in poor areas are also key.
But execution is key in delivering social programs and that needs the right institutions, the judiciary, the level of democracy, transparency, independence of the media and so on.
The Failure of the IMF
As central bank governor during 2002-2004, Alfonso said he had a very clear idea of what needed to be done, but that he ‘had more of a headache with the International Monetary Fund because they never understand. They always think that one size fits all, and they’ve been proven wrong…We finally convinced the fund to let us run things as we saw fit, and we were right. We ended up expanding the monetary base more than 30% in that year, 2003. And yet inflation fell from – listen to this – 40% in 2002 to 3.7% in 2003. And yet we had the exact opposite experience last year with an IMF mission who told the Argentine government back then that the only recipe around is to stop printing money.’ Macri’s government complied and inflation went up, not down.
On the IMF response to the COVID crisis, Alfonso noted that the Fund had been quite active in lending money under traditional programs but that ‘this is not a time for traditional tools.’ We discussed his proposal for the IMF to set up an SPV in an amount equal to sovereign and corporate dollar denominated debt maturities in EM (exc. China) through end 2021, totalling $300bn or around one third of the current $1tn capacity. He suggested to put the amount into an escrow account and leave the authorities to decide whether or not to draw it down. His proposal did not, however, gain sufficient support.
Leadership Drought in Latin America
Brazil’s fragmented political system is causing real problems. They should be the leading voice in the region (Mexico is too close to the US). But an ‘atomized’ political system means parties come and go. ‘You get voted in by one party [and] you switch to another so there’s no political cement to any policy decision that you can take.’ This leaves difficult, very transitory and ultimately unstable policymaking in the region. More generally, leaders in the region have been focused on domestic issues, leaving Latin America with no voice on the international stage.
Middle Income Trap in EM
The COVID crisis creates a ‘beautiful opportunity’ to address the middle-income trap in EM as advanced economies cannot act alone to combat the pandemic. Unfortunately, very little has been seen particularly with Trump turning against multilateralism. The only feasible option for Latin America to catch up is by leapfrogging. ‘One thing about our economies is that there’s a lot of talent, sometimes wasted, but there’s a lot of talent and there is a lot of creativity.’ Some of the best-known unicorns right now come from Latin America and, in fact, quite a few from Argentina. Mercado Libre with a $40bn market cap is one example. Leapfrogging into the economy of communications, knowledge and AI is the probably the region’s best hope. ‘And it’s a very long shot.’
Inflation Environment Post COVID
Alfonso predicts deflation followed by inflation. ‘I think there’s a deep deflation trend that will stay with us for a while after the lockdowns are over.’ Consumers and business will be cautions for perhaps the next 12 months. ‘But I think that once that trend subsides, we’ll move probably quite quickly into an inflation trend. And I think it is very likely that central banks will let that trend go for a while.’ Overshooting on the inflation target can be justified on the basis that inflation had been below target for many years.
But Alfonso also sees an important fiscal element to higher inflation. ‘I think we’re moving into a world of fiscally dominated central banks. The only way you can expect public debt in the developed world to be sustainable in the long run is through inflation.’ He points out that it has happened several times throughout history and that he does not think markets are prepared for it.
Argentina’s Debt Restructuring
Alfonso’s experience in dealing with Argentina’s last default leads him to the opinion that another default ‘would be worse for creditors and bondholders than it would for the sovereign.’ His rationale is that, ‘The best you can hope for is face value plus US rates over the time horizon under which you litigate in the New York courts…So if Argentina is offering you face value plus 3%, I think you should take that offer.’
BoE and Crisis Expertise
Our final discussion was on his candidacy for the Bank of England governorship. Alfonso confirmed he was approached by the UK Treasury when they were considering international candidates in the initial stages of the search. In his view, the Treasury were looking at Brexit as an EM-type of crisis. While Alfonso thinks another foreign governor would have been a difficult sell in the Brexit environment, some crisis expertise would be beneficial to the BoE as they navigate through Brexit. He reminded us that, ‘In times of crisis, it is very important what you do and how you do it, but it’s more important how you communicate it.’
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