A New Report Stresses Reforms to Boost Productivity and Seize Markets in an Uncertain World

Latin American and Caribbean institutions moved forcefully to head off dangers in 2023. Central banks swiftly raised interest rates in the face of inflation, and governments imposed well-considered fiscal policies that brought average primary balances to a level superior to that before the COVID-19 pandemic. Along with strong financial regulation and supervision and resilient financial markets, these robust responses led the region's economies to outperform expectations, with GDP growth reaching 2.1% in 2023, a full percentage point above early 2023 predictions.

Challenges now loom in the near and medium term. Global growth is expected to slow in 2024 and market analysts predict growth in the region will ease to 1.6%, returning to the long-term average of 2% in 2025. This is inadequate to meet the rising aspirations of the region's burgeoning population.

The IDB's recently released 2024 Latin American and the Caribbean Macroeconomic Report addresses these challenges. It analyzes reforms needed to cement macroeconomic stability and catalyze the much-needed productivity growth through an in-depth look at the monetary, fiscal, labor market and financial arenas.

The Productivity Challenge

Aggressive steps must be taken to boost productivity. These include more and better education and training, areas where the region, particularly in lower income countries, lags other emerging economies. The region also must embark on reforms to ensure deeper financial markets and more formal and competitive labor markets. And there has to be stronger property rights protection and greater rule of law. Such transformations can help the region attract capital and stoke productivity growth. They can allow it to seize new opportunities in areas of global concern, like food security and the clean energy transition.

Improving the quality of human capital and the allocation of physical capital is critical to increasing productivity. Human capital significantly lags that of fast-growing economies. In the 2022 Program for International Student Assessment (PISA), three-quarters of students in the region registered "low performances" in mathematics, and more than half were unable to read a single text. These results were worse than for some other developing regions, like Central Asia or East Asia and the Pacific, and explain why productivity remains entirely too low in the region. A key concern is that in lower income countries, not only is the number of years of schooling relatively low, but the quality of education is insufficient, making it twice as difficult to address human capital deficiencies.

Capital misallocation also limits overall productivity growth. Several policies, including preferential tax treatments for small firms and other types of distortive subsidies, tend to favor small, less efficient firms over larger more efficient ones. In many countries of the region, allocating capital more effectively could lead to levels of total factor productivity-the output from a given number of inputs-50% higher than their current levels. Closely related is the problem of informality, in which heavy regulation, taxation and the cost of doing business (payroll and firing costs, etc.) in the formal sector encourage firms to remain in the informal sector, a lower-productivity one. Protectionist trade measures and imperfect credit markets also prevent the reallocation of resources to the most productive enterprises.

Macroeconomic Concerns for Latin America and the Caribbean

On the fiscal side, governments have done a commendable job in phasing out most COVID-related expenditure increases. The regional average primary deficit in 2023 was 0.1% of GDP, an improvement over the pre-pandemic level of 1%, and even more so over the 4.8% registered during the pandemic. Nonetheless, the overall fiscal defict stands at 2.8%, a reflection in part of the rise in interest rates in world markets to combat inflation. With low growth, the debt-to-GDP ratio still high at 60%, and substantial fiscal gaps, the region will have to continue its efforts at fiscal consolidation and do so even as growing weather-related shocks, like excessive rainfall and floods, affect public coffers with higher food prices and damage to infrastructure. It will also need to find fiscal space to finance productivity enhancing reforms.

Fiscal consolidation, as well as the need for increased fiscal space, implies a redoubling of efforts at fiscal discipline through measures like the establishment of good-quality fiscal rules and independent fiscal councils, which can substantially increase the likelihood of fiscal sustainability. Tax evasion, estimated to cause average tax revenue losses of 6% of GDP, must also be addressed. And there should be a reduction in public spending inefficiencies through the better targeting of socially oriented transfers and subsidies, the combatting of leakages in public sector purchases, and the alignment of public sector salaries with private sector ones, especially for lower-productivity positions. Preserving public investment through it all is key, as this may not only maintain but increase output over time. This is particularly important now that governments need to adjust: Consolidation that is public-investment friendly is not contractionary and can even be expansionary.

On the monetary side, central banks in Latin America and the Caribbean that adhere to inflation-targeting regimes acted decisively to head off the inflation surge of 2021, maintaining their credibility. Indeed, many central banks in the region were more responsive to the inflation surge than those in the United States and the Eurozone, allowing them to begin easing their policy rates in early 2023. As a result, the median rate stood at 7% as of December 2023, with inflation expectations well anchored. Central banks in the United States and Eurozone are expected to gradually start easing their rates in 2024. The challenge now is preventing significant interest rate differential reductions with respect to the more advanced economies that could trigger capital outflows, exchange rate depreciations, and inflationary pressures. Central banks in the region will have to maintain what has been a commendable level of caution and independence. That is crucial if the region's fiscal authorities advocate for faster policy rate reductions to reduce financing costs.

Financial flows to the region decelerated in 2023 amid higher interest rates in developed countries, with the region also showing lower current account and trade deficits. Financial markets have proven resilient, and Sudden Stops have not materialized so far. But efforts by countries in the region to close fiscal and external gaps are crucial to reducing Sudden Stop risks, as is the accumulation of greater international reserves.

Individual banks have also been building stronger financial buffers with adequate amounts of capital in store. With more than half of the countries in the region adopting some version of Basil III, the strengthened regulatory framework to ensure stronger liquidity and capital buffers, the region's financial sector seems healthy, even if the volume of foreign capital has dropped and domestic credit markets show signs of a slowdown. Such financial stability is key to fostering long-term productivity growth.

Opportunities to Expand Markets

Brexit, US-China trade tensions and the conflict in Ukraine have prompted international companies to adjust their production locations and sourcing patterns, providing new opportunities for Latin America and the Caribbean in food and manufacturing. New infrastructure, semiconductor, electrical vehicle and clean energy initiatives in the United States also offer opportunities for the region, given its proximity to U.S. and Canadian markets, its large supply of essential minerals, its lower wage costs and its broad free trade agreements. These opportunities position the region to significantly boost growth, a reality underscored by the current surge in direct foreign investment. But efforts to sustain macroeconomic stability and boost productivity, as outlined in our report, will be crucial to taking full advantage of new circumstances and pivoting to higher long-term growth rates that can raise the region's standard of living and help reduce its poverty and inequality.

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