The Long Road to Financial Stability

• Author: Claudio M. Loser and Martine Guerguil
• Position: Director of the IMF's Western Hemisphere Department/Senior Economist in the IMF's Western Hemisphere Department

Most countries in Latin America and the Caribbean weathered the economic crises of the late 1990s better than expected, thanks to the policy reforms of the past two decades. Further reform is urgently needed, however, to put the region on a faster growth path and reduce its vulnerability to external shocks.

The past few years have been difficult for Latin America and the Caribbean. The turmoil that swept through international capital markets in 1997 and 1998, combined with the region's deteriorating terms of trade and declining export earnings, produced an economic slowdown that boosted unemployment levels and depressed incomes. The downturn, the second in five years and the largest and broadest since the debt crisis of the 1980s, was a disappointment for a region that had been following a strenuous path of policy adjustment and reform for more than a decade. Per capita output in Latin America and the Caribbean was only 13 percent higher in 1999 than in 1989, and only 7 percent higher than in 1980. Nonetheless, in the face of an extremely adverse external environment, economies in the region displayed unexpected signs of strength, in large part because of the reforms they had undertaken earlier. Private investment proved resilient, and there are signs that output is already beginning to recover after a slowdown of relatively short duration.

Reforms of 1980s and 1990s

After the debt crisis, economic policy in Latin America and the Caribbean underwent a dramatic change. Plagued with severe distortions in the use of resources, most countries abandoned the old model of state-directed, import-substituting industrialization in favor of outward-looking, market-based policies.

In the late 1980s, the fight against inflation-and, more generally, the pursuit of financial stability-became the leading policy objective of many governments around the world, including those in Latin America and the Caribbean, which moved toward stricter fiscal management, reducing government expenditure, reforming bloated civil services, and overhauling tax systems. As a result, the region's average fiscal deficit shrank to about 2 percent of GDP in the mid-1990s, from 4-5 percent in the late 1980s. Countries achieved a more balanced tax burden, with lower trade taxes, greater tax efficiency, and higher ratios of tax revenues to GDP. The ratio of external public debt to GDP fell to less than 20 percent in 1997, from about 50 percent in the late 1980s. The improved fiscal stance made it possible for countries to achieve a more disciplined monetary management and to reduce central bank credit to government. The authorities increased their use of indirect instruments of monetary policy, with a view to enhancing the role of interest rates and improving the efficiency of monetary management. Many also strengthened economic institutions and increased the independence and accountability of their central banks, which were given the explicit mandate of pursuing price stability.

Most countries in the region undertook bold and wide-ranging structural reforms aimed at dismantling price controls and removing existing market distortions, with an emphasis on trade reform, financial liberalization, and the privatization of public enterprises.

* Trade reforms, extensive and widespread, included sharp reductions in tariffs and in their dispersion (average tariffs fell from nearly 45 percent in 1986 to 14 percent in 1998, and maximum rates declined from an average of 80 percent to about 30 percent) and the dismantling of most quantitative and other nontariff trade restrictions. Regional trade agreements surged (see box).

* Financial liberalization was carried out on both the domestic and the external fronts. Direct credit controls were abandoned and interest rates were deregulated and allowed to reach real positive levels. Foreign investment regimes were liberalized, and most controls on foreign exchange and capital transactions were dismantled. After the Mexican crisis of 1994, steps were taken to strengthen banking regulation and supervision and establish more demanding prudential standards.

* Privatization had several aims: eliminating the operational losses that plagued many state-owned enterprises, improving overall efficiency, and increasing private investment. Nearly 800 enterprises were privatized between 1988 and 1997, most of them in the utilities sector, which had traditionally been closed to private sector participation and which was perceived as having the greatest potential for productivity and efficiency gains. A number of publicly controlled financial institutions were also sold to private interests. In most cases, privatization led to a sharp increase in private investment. Privatization did not progress equally rapidly in all countries, however; the process lagged significantly in some countries and was hampered by a lack of transparency in others; in most, the large mining and oil companies remained in the hands of the state.

Economic benefits of reforms

In the early 1980s, when the region found itself engulfed in a string of acute financial crises, it suffered a prolonged shortage of foreign financing and a severe and protracted slump in output (see chart). Although the reforms that took place after these crises could not insulate the region from the global financial crisis that began in Asia in 1997, they limited the damage. Countries were able to control financial panic, preserve macroeconomic stability, and maintain some access to foreign financing.

The...