New World Bank report discusses overcoming these challenges

Durrant Pate/Contributor

The World Bank has identified the two main challenges facing Latin America and the Caribbean (LAC) region as disappearing fiscal space and inflation, arguing that if left unchecked they would complicate policy action.

Zooming in on the eroding fiscal space, the World Bank, in its new report, New Approaches to Closing the Fiscal Gap, highlighted that strong counter-cyclical fiscal policies across the region to support vulnerable households and firms during the pandemic have eroded the little fiscal space gained by countries in the region in previous years.

According to the World Bank report, which was released yesterday, “the Caribbean was hit particularly hard. Dominica, St Vincent, St Lucia, and The Bahamas all have relatively large deficits, with deficits in the first two countries still exceeding six per cent. Overall, in the region, progress has been made in reducing primary deficits (as per cent of GDP). They have fallen by 0.96 percentage points, on average, across 2022. However, rising interest payments have led to overall deficits similar to those in 2021″.

Increasing LAC public debt stock

Across 2020 and 2021, continuing fiscal deficits were not offset by net private savings (private savings minus investment), leading to current account deficits in all countries except Argentina and Guatemala. The reported cited ongoing deficits resulting in most countries across the region to substantially increase their stocks of public debt.

As the stock of debt and international rates have grown, the implicit interest rate for financing public debt interest payments has risen, so far, only modestly, on average 10 basis points since 2021 with little impact on debt sustainability to date. However, as countries move to roll over debt at higher rates, the repayment burden is likely to rise.

Further, international market confidence in the region remains generally robust. Although the trend is generally upward, and is significant in Argentina, Colombia, and Mexico, after a spike around the height of the pandemic, the report says: “Emerging Market Bond Index is hovering close to its pre-pandemic levels. Additionally, international credit ratings agencies have been forgiving of the debt accumulation.”

Despite the typical worsening of ratings as the stock of public debt increases, large debt increases such as the ones in Brazil, the Dominican Republic, Paraguay, and Uruguay have not been punished by any decrease in rating, and the downgrades for Bolivia, Chile, Colombia, and Peru have been mild. The moderate increase in sovereign spreads and moderate downgrade of credit ratings after relative increases in the stock of public debt seem to indicate an acknowledgment by international inversions of financial resilience in the region.

As interest rates increase throughout the world, and investors’ appetite for assets in emerging markets decreases, debt roll-overs (and debt burden) are likely to become more expensive in the near future.

Principal and interest payments will become an increasing share of output and government expenditure, adding pressure to the already strained fiscal balances and making fiscal consolidation a priority.

Tackling inflation monster

As in the rest of the world, inflation has grown sharply in LAC, rising from a steady average of about two pe rcent in the years preceding the pandemic, gaining about four percentage points between 2021 and 2022, and now forecast to reach six per cent for 2022.

The World Bank report says “inflation expectations appear to remain anchored. As high inflation persists, economic agents will start to build expectations of future inflation in their behaviour. Workers will preemptively demand nominal wage gains with the goal of preserving their purchasing power”.

Employers, the report contends, will try to preemptively push the new costs to consumers by setting new prices. In the process, expectations become their own driver of inflation, particularly in economies with a high share of indexed wage and pension systems.

The good news is that, for now, inflation expectations seem to be anchored to levels around central bank targets.

While cost-push factors and the increase in international prices, as continued government deficit spending, have had a sizable effect on inflation, they have occurred in an environment that both validated them and fed demand pressures. As of the first quarter of 2022, liquidity remains relatively high. This excess liquidity has prompted central banks in the region to react aggressively to the recent developments in inflation.