The Good Old Days
By Alan Stoga*

The good economic news from Latin America is that the whole region — from the Rio Grande to Tierra del Fuego — will grow more than 4% again this year, after recording its fastest growth in 24 years during 2004. The bad news is that this growth surge rests on unsustainable foundations that will, sooner or later, crumble.

That Latin America has been growing faster than it has in decades is partly because of the United States and China, and partly because of local policy changes that have kept inflation under control. The relationship with the United States, of course, is well establish: sixty percent of the region's exports go to the United States; the region's external debt (as well as a significant amount of internal debt) is dollar denominated; and massive remittances from Mexican, Central American, and Caribbean migrants are increasingly moving through legitimate channels.

China is a new factor in the equation: Chinese growth — and the country's strategic desire to diversify sourcing — have driven prices and demand higher for everything from copper and soybeans to steel and oil. In the process, China has become a significant customer, as well as investor, for Latin America. In the short run this has made the difference between modest and surprisingly strong growth. However, even if China has discovered the secret of eternal growth, it is too mercantilist a country for the relationship with Latin America to remain unambiguously positive into the future.

The most remarkable aspect of the current economic renaissance is that inflation has remained subdued almost everywhere in the region. The lingering memories of hyper inflation — which was disastrous in economic as well as political terms — combined with the widespread institutionalization of central bank independence, have kept average inflation around 6% per year. One measure of the pervasiveness of monetary discipline is that last year only 5 countries-Costa Rica, Dominican Republic, Haiti, Jamaica, and Venezuela-recorded double digit inflation. Everywhere else, monetary stability has become good politics.

Unfortunately, this is unlikely to be enough to get Latin America through the inevitable coming downturn in the global economy. The main growth engine — the U.S. economy — is increasingly stretched. Although President Bush promised to reverse the structural deterioration in U.S. public finances that was the hallmark of his first term, the impact of the Iraq war, Hurricane Katrina's devastation, and the slowing of the economy threaten to keep the fiscal deficit at historic levels. The result will be higher interest rates even as the economy softens under the weight of high oil prices and soft investment demand, and vulnerability to the kind of shock that could trigger a real recession.

The real problem is that few countries in the region have taken advantage of higher growth to continue the wave of structural reforms they started almost 20 years ago. Despite refinancing-including not only Argentina's spectacular default, but also repayments and restructuring by Mexico, Brazil and other countries to take advantage of historically low risk spreads-debt levels are still too high for a global environment of rising interest rates. More importantly, concerns over the region-wide drift in policy making towards a less business friendly environment have produced a slowing of the direct foreign investment that countries need to become internationally competitive.

Characteristically, politicians have chosen short run growth over long run adjustment, with the result that local financial markets remain too underdeveloped, poverty levels too excessive, and industrial development too retarded to sustain economic momentum into the future.

The short hand version of the story is live by commodities, die by commodities. The region's growth surge has been built on unusually favorable international conditions — high energy prices, low dollar interest rates, and growing demand for industrial and agricultural commodities. When these change, the consequences for most of Latin America is likely to be severe.

That risk will be exaggerated by the political cycle. In the next 18 months, 19 countries in the region will hold national elections, affecting more than 520 million people. Unfortunately, pre-election periods are rarely characterized by better economic policy making than whatever came earlier. Even more unfortunately, the prevailing winds in many countries — from Mexico to Brazil to Argentina — are from the populist left, whose economic model is generally inconsistent with efforts to renew structural reforms that would make economies more globally competitive and less vulnerable to global shocks.

The bottom line is that, at least in economic terms, these years will soon be considered the good old days.

*Alan Stoga is President of Zemi Communications in New York.