LAST weekend, the IDB launched its paper “Global Recovery and Monetary Normalisation — Escaping a Chronicle Foretold” as a side event at the annual meeting of Jamaica’s largest multilateral lender, held in Costa do Sauipe in Bahia, Brazil. The title of the paper cleverly paraphrases the famous novel by the Latin American literary icon Gabriel Garcia Marquez, observing that monetary normalisation (defined as the “tapering” of asset purchases by the US Federal Reserve and the subsequent eventual rise in short-term interest rates) is a “chronicle foretold”, meaning an inevitability. This timely paper analyses a number of the potential impacts, noting that while some exits from low interest rates in the US have been smooth, “others have unleashed severe volatility in asset prices and declines in capital flows to Latin America and the Caribbean”.

The paper targets financial market complacency, namely the view that because monetary normalisation is so widely anticipated, the impact should be “priced in”, and the region should simply benefit from the global recovery that is underway. However, the Fed’s tapering announcement of May 2013, appeared to impact asset prices significantly and represented a turning point in capital flows that may have persistent repercussions on growth. The report analyses the impact of both positive (faster than expected US economic growth) and negative (China slowdown, earlier than expected rise in US interest rates and its impact on US asset prices) shocks, and other associated risks, recognising that the impact may differ for individual countries depending on their unique fundamentals and varying vulnerabilities.

For example, commodity dependent South American countries are particularly vulnerable to a Chinese slowdown. In contrast, Mexico, Central America and the Caribbean (including Jamaica) may benefit from a scenario of higher growth in the US and lower growth in China. The report concludes that “For the region as a whole, the positive risk of higher US growth and the negative risks of lower asset prices and reduced growth in China may cancel each other out”.

In an exclusive interview for the Jamaica Observer, Andrew Powell, the IDB coordinator of the report, argues that Jamaica would be a key beneficiary of faster US growth through its tourism industry, and that “Jamaica is slightly insulated under its IMF agreement” from the impact of interest rates rising more rapidly than anticipated (unlike other countries in the region it has not benefited from large private sector financial flows over the past five years) and the Chinese economy is “less important to Jamaica” than for many Latin American countries. In his view, even if all three shocks happen together, this could be a “net positive for Jamaica due to its IMF agreement”.

Critically, the report notes that although the region’s economies are on a more sound footing than they were during the shocks of the mid 1990’s, most countries are in a weaker position than they were in 2007, prior to the onset of the great recession. It observes that risks have increased in recent years, as public debt levels have risen, and increased fiscal expenditures on programmes will be difficult to “dial back in counter-cyclical ways”. Structural fiscal deficits have deteriorated across the board, the main exception being Jamaica, which according to Powell has been a “star performer”, producing a sharply increased primary surplus as a result of virtually the region’s only reduction in real primary expenditure, meaning expenditure before interest costs adjusted for inflation.

Financial risks have also risen. Private sector debt levels have increased sharply due to a huge rise in external bond issuance by the regions private sector. Although much of the borrowing has been by way of fairly long-term bonds at fixed rates (rather than the high risk short-term, floating rate bank lending that was a key part of past crises in Latin America), nevertheless, Powell notes, everybody, including the IDB, has “incomplete information” on private sector risks. For example, we don’t know the degree to which the non-traded private sector (who do not have the natural hedge of say an exporter earning US dollars) has borrowed externally without hedging their currency risk, creating potentially very significant “currency mismatch” corporate risk exposures.

Moreover, external private sector issuers have deposited much of the proceeds in the local financial system in local currency, often as a local “carry trade” to take advantage of higher domestic interest rates, exposing them to further balance sheet risk from a large depreciation of the domestic currency if US rates rise. Even when the deposits are in US dollars, this poses a risk to the domestic financial system as such corporate deposits would be the first to seek higher interest rates overseas. In addition, this sharp increase in deposits by external issuers (now accounting for 60 per cent of local deposits) has helped finance very fast growth in domestic private sector credit, which has doubled in the past four years, a traditional warning sign of trouble ahead. Once again, Jamaica has not seen any significant net external borrowing by local corporates, as the exposures of the security dealers have shrunk sharply since 2008.

Looking ahead, higher interest rates in the US could mean declining capital inflows, which will hurt growth, and in some cases lead to exchange rate depreciations and higher inflation. Latin America and the Caribbean may also be at increased risk of a more extreme scenario, a so called “sudden stop” in capital flows, the impact of which depends on the country’s fiscal deficit, current account deficit and the level of dollarisation and reserves, among other variables. Powell observes “This report suggests reserve levels, while higher in many countries, are below levels that are optimal given the risks of a sudden stop scenario. We need to take a closer look at reserve levels in this environment of heightened risks and higher fiscal deficits. And we need to monitor private currency mismatches and liquidity risks”. Despite our IMF agreement, balanced budget and a declining current account deficit (expected to fall by 20 per cent this fiscal year), Jamaica’s still elevated current account deficit of 10 per cent of GDP and the only partial recovery in our net international reserves makes us more vulnerable to such an extreme scenario than some of our peers. As Powell suggests, “We cannot be complacent”, and in my view our policymakers now need to watch the global economy much more carefully than we did in 2008.