Latin America’s Economic Challenges: Lessons for Emerging Economies

Nora Lustig (Tulane Univ) and Jaime Ros (UNAM)

Wrap-up Workshop “How can China avoid the middle-income trap?”

ADB/NSD Peking UniversityBeijing, February 24 and 25, 2011

What is the Latin American “middle-income trap?”

Figure 1 – Latin America’s GDP Per Capita vs. the United States: 1900-2008

Source: “From Global Collapse to Recovery: Economic Adjustment and Growth Prospects in LAC,” Chief Economist Office, Latin America and the Caribbean Region, World Bank, Spring Meetings, Washington, DC, April 21, 2010.

LA Economic Performance

• In the last quarter of the 20th century, Latin America—like many other parts of the developing world—experienced a major shift in its development strategy.

• From the aftermath of the Second World War up until the debt crisis of the 1980s, the region had embraced a strategy of state-led industrialization, largely oriented towards the domestic market: import substitution industrialization.

• Following the 1980s debt crisis (and even earlier in a few countries), state-led industrialization was replaced by a new development model in which markets and integration with the global economy took center stage.

LA Economic Performance• The results of the new outward-oriented market-based

development strategy have been disappointing (Figure 1). • Overall, the recent growth performance of Latin America

has been lackluster even if we leave aside the “lost decade” of the 1980s.

• For the period 1990-2008, the average of Latin America’s per capita GDP growth rate has been 1.8 percent per year, well below the 2.7 percent yearly growth rate of the period 1950-1980 and less than the average growth rate of the world economy.

Diverging Income per Capita

What factors “explain” the middle-income trap?

• Proximate factors:– Inflationary bouts and recurrent economic crises

(balance of payments, debt, banking, currency, financial crises)

– Slowdown in productivity growth; in particular, slowdown in labor productivity growth in the service sector

• Fundamental factors:– Conjectures about the role of high inequality/social

and political exclusion of indigenous population

Table 1.1 Recurring Banking Crises, 1974-2003 Region Average number of

crises per country Countries with recurrent crises (percent)

Latin America (excluding the Caribbean) 1.25 35 Latin America and the Caribbean 0.90 27 High-income OECD countries 0.21 0 High-income non-OECD countries 0.09 0 Eastern Europe and Central Asia 0.89 11 East Asia and the Pacific 0.38 8 South Asia 0.38 0 Middle East and North Africa 0.40 0 Sub-Saharan Africa 0.83 13 Source: Galindo, Izquierdo and Micco. 2004. Figure 1.5, p. 9.

Table 3.1 - Labor productivity growth in six Latin American countries since 1950

1950-19801/ 1980-20052/ 1980-19903/ 1990-2005

Argentina 0.8 0.1 -3.2 2.4

Brazil 4.3 -0.4 -1.9 0.7

Chile 2.2 1.2 -1.6 2.9

Colombia 2.1 0.7 1.5 0.2

Mexico 3.2 -0.2 -2.4 1.1

Peru 2.4 0.0 -5.6 3.4

1/ 1950-1981 for Chile and Mexico; 1960-1981 for Peru

Macroeconomic Volatility and Financial Instability

• Latin America has lived through macroeconomic crises driven either by excesses of the state or the market.

• Fiscal crises affected countries such as Brazil and Mexico in the early 1980s under state-led import substitution.

• But private-led financial crises affected the Southern cone countries (Argentina, Chile and Uruguay) in the early 1980s, Mexico (1994-95), Brazil (1999) and Argentina (2001-02) under market-oriented strategies.

• There are lessons from crises which originated in the private/financial sector but in which the state often ended up with a large debt as a result of the insolvency of the former.

• Financial and capital account liberalization have their pitfalls and Latin America learned about them the hard way.

Macroeconomic Volatility and Financial Instability: Lessons for China?

• Fiscal crises--or fiscal duress--can “sneak in” through the back door:

– Rescue of systemically critical sectors:• Financial sector

– Rescue of subnational governments– Unfunded spending commitments (public pensions)

• Underscores the importance of prudential regulation in financial sector; monitoring and/or controlling volatile capital inflows; monitoring the potential development of “asset bubbles;” assess risks and contingent liabilities in sensitive sectors (social insurance and private pension plans; guarantees for privately held debt)

Inflation Targeting and Exchange Rate Management

• Latin America has experimented with every exchange rate regime on earth: fixed exchange rates, crawling pegs, currency boards, dollarization and flexible exchange rates

• In 1990s and 2000s there has been a shift towards flexible exchange-rate regimes(see Figure 2.1).

• The move went together with the adoption of inflation targeting monetary regimes.

Figure 2.1 – Exchange Rate Regimes in Latin America and the Caribbean

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Hard Pegs Intermediate Flexible Free Fall

Exchange Rate Management: Lessons for China?

• Flexible exchange rates-cum-inflation targeting has been successful in – Keeping inflation under control– Weather external shocks– Deal better with volatility of capital flows

• Caveat: there will be periods of real appreciation that may hurt growth

Figure 2.3 - Average inflation and volatility (logarithmic scales)

Source: García and Marfán (2010).

Notes: (1) Calculated as the simple average of official annual inflation figures for Argentina, Brazil, Chile, Colombia, Mexico, Perú, and Venezuela. (2) Rolling 12 month standard deviation of average annual inflation. (3) Cross sectional (across selected economies) standard deviation of annual inflation

Sources: Authors' calculations using National Statistical Office's and Central Bank's data.

0

1

10

100

1000

10000

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 0

1

10

100

1000

10000

Average Inflation (1) Time series volatility (2) Cross sectional volatility (2)

Figure 2.2 – Real Exchange Rate: Brazil, Chile, Colombia, Mexico and Peru Brazil Chile

0

0.5

1

1.5

2

2.5

Jan-

80

Jul-8

1

Jan-

83

Jul-8

4

Jan-

86

Jul-8

7

Jan-

89

Jul-9

0

Jan-

92

Jul-9

3

Jan-

95

Jul-9

6

Jan-

98

Jul-9

9

Jan-

01

Jul-0

2

Jan-

04

Jul-0

5

Jan-

07

Jul-0

8

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

Jan-

80

Jul-8

1

Jan-

83

Jul-8

4

Jan-

86

Jul-8

7

Jan-

89

Jul-9

0

Jan-

92

Jul-9

3

Jan-

95

Jul-9

6

Jan-

98

Jul-9

9

Jan-

01

Jul-0

2

Jan-

04

Jul-0

5

Jan-

07

Jul-0

8

Colombia Mexico

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

Jan-

80

Jul-8

1

Jan-

83

Jul-8

4

Jan-

86

Jul-8

7

Jan-

89

Jul-9

0

Jan-

92

Jul-9

3

Jan-

95

Jul-9

6

Jan-

98

Jul-9

9

Jan-

01

Jul-0

2

Jan-

04

Jul-0

5

Jan-

07

Jul-0

8

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8Ja

n-80

Jul-8

1

Jan-

83

Jul-8

4

Jan-

86

Jul-8

7

Jan-

89

Jul-9

0

Jan-

92

Jul-9

3

Jan-

95

Jul-9

6

Jan-

98

Jul-9

9

Jan-

01

Jul-0

2

Jan-

04

Jul-0

5

Jan-

07

Jul-0

8

The link between inequality and the middle-income trap in LA

• Latin America is the most unequal region in the world

• Using Gini coefficient,– 19 percent more unequal than Sub-Saharan Africa – 37 percent more unequal than East Asia – 65 percent more unequal than developed

countries

19

Gini Coefficient by Region (in %), 2004

32.233.6

38.9 38.9 39.1

44.7

53.2

20.0

25.0

30.0

35.0

40.0

45.0

50.0

55.0

60.0

High Income Europe andCentral Asia

South Asia North Africaand the

Middle East

East Asia andthe Pacific

Sub-SaharanAfrica

Latin Americaand the

Caribbean

Gin

i coe

ffici

ent

20

Was high inequality a “fundamental” cause of the middle-income trap in LA?

• Political Economy Dynamics: High inequality coupled with high expectations of workers and pent-up demands of secularly disenfranchised groups resulted in:Þmacroeconomic populism

Þ high inflation and state-led balance of payments crises: Argentina in early 1970s; Brazil in early 1980s; Mexico 1976 and 1982; Peru in mid-1980s

Which triggered:Þ military coups and center-right regimes

Þfree-market fundamentalism (liberalization of capital and financial markets) => market-led financial/balance of payments crises: Argentina in late 1970s; Mexico 1994/95; Argentina 2001/02

Was high inequality a “fundamental” cause of the middle-income trap in LA?

High inequality also resulted in democratically elected radical left regimes (Chile in early 1970s; Nicaragua in late 1970s) and Marxist guerrilla movements, which triggered: Þright-wing military coups => free-market

fundamentalism (liberalization of capital and financial markets) => market-led financial/balance of payments crises: Uruguay in late 1970s; Chile in early 1980s

Þ civil conflict and civil wars => growth collapses in Central America in the 1980s and early 1990s

Was high inequality a “fundamental” cause of the middle-income trap in LA?

– Economic crises, particularly the 1980 debt crisis, civil wars and alienation of private sector

=> low levels of capital accumulation => slower productivity growth because sectors with increasing returns, economies of scale and/or externalities failed to expand

– Recurrent crises and inflationary bouts => exchange rate as a price-stabilizer => periodic real

appreciations => lower profitability: domestic firms found it harder to compete with imports and export-oriented firms find it hard to compete in the international markets

=> Ill-conceived market-oriented reforms which, with the exception of Chile, ended up hurting productivity growth

In 1980s and 1990s, inequality was on the rise (Gini coefficient, 2009)

35

40

45

50

55

60

Early 90s Mid. 90s Early 2000s Mid. 2000s

Gin

i coe

ffic

ient

0=

But, in the last ten years…

• Inequality in most Latin American countries (12 out of 17) has declined (roughly at 1% a year).

• Decline is robust to period selected.• Decline has continued despite global financial

crisis.• While inequality declined in most of LA, it rose

in other parts of the world.25

Change in Gini Coefficient: 2000-2007(in %)

Change in Gini Coefficient: Three yr averages at end points

El S

alva

dor

Para

guay

Arg

entin

a

Chi

le

Ecua

dor

Peru

Pana

ma

Bra

zil

Mex

ico

Bol

ivia

Dom

inic

an R

epub

lic

Cos

ta R

ica

Ven

ezue

la

Gua

tem

ala

Uru

guay

Hon

dura

s

Nic

arag

ua

Tota

l 13

Tota

l 17

Chi

na

Indi

a

Sout

h A

fric

a

OEC

D-3

0

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

-1.48

-1.05-1.05-1.02-1.01-0.95-0.94-0.91-0.72

-0.52-0.35-0.33-0.24

0.05

0.460.68

1.02

-0.81-0.49

2.02

1.43

0.30 0.25

Ann

ual P

erce

nt C

hang

e

Change in Gini Coefficient: 2000-2009 (includes info for global recession year when feasible)

Ecua

dor

Para

guay

Peru

El S

alva

dor

Arg

entin

a

Bra

zil

Dom

inic

an R

ep.

Pana

ma

Mex

ico

Chi

le

Bol

ivia

Ven

ezue

la

Hon

dura

s

Gua

tem

ala

Cos

ta R

ica

Uru

guay

Nic

arag

ua

Tota

l 13

Tota

l 17

Chi

na

Indi

a

Sout

h A

fric

a

OEC

D-3

0

-2.00

-1.50

-1.00

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

-1.71-1.49

-1.31-1.29-1.27-1.07-0.99-0.97

-0.77-0.66-0.36

-0.24-0.05

0.05 0.080.28

1.02

-0.94-0.63

2.02

1.43

0.30 0.25

Ann

ual P

erce

nt C

hang

e

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 200984.00

86.00

88.00

90.00

92.00

94.00

96.00

98.00

100.00

102.00

104.00

Brazil Chile Mexico

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 200980.00

85.00

90.00

95.00

100.00

105.00

110.00

115.00

Argentina El Salvador Panama Peru

The decline in inequality has been widespread

The decline took place in:Persistently high inequality countries (Brazil) and

normally low inequality countries (Argentina) Fast growing countries (Chile and Peru), slow

growing countries (Brazil and Mexico) and countries recovering from crisis (Argentina and Venezuela)

Countries with left populist governments (Argentina), left social-democratic governments (e.g., Brazil, Chile) and center-right governments (e.g., Mexico and Peru) 31

Main Questions: Why has inequality declined in Latin America? Are there factors in common?

In-depth analysis in four countries:Argentina (urban; 2/3 of pop)BrazilMexicoPeru

Source: Lopez-Calva and Lustig, eds., Declining Inequality in Latin America: a Decade of Progress?, Brookings Institution Press, 2010

32

Argentina (urban areas)

0.42

0.44

0.46

0.48

0.50

0.52

0.54

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

20

25

30

35

40

45

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

0.582

0.589

0.594

0.588

0.596

0.587

0.599

0.615

0.634

0.612

0.580

0.6020.599

0.600

0.600

0.598 0.592 0.594

0.5870.581

0.5690.566

0.560

0.552

0.544

0.5390.53

0.54

0.55

0.56

0.57

0.58

0.59

0.60

0.61

0.62

0.63

0.64

0.65

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Gin

i coe

ffici

ent

Evolution of the degree of inequality in per capita income: Brazil, 1995-2009

1981-2009

Mexico

Peru

Decline is robust

• Decline in inequality is statistically significant and significant in terms of order of magnitude

• There is Lorenz dominance (unambiguous decline independently of choice of inequality measure)

• Robust to income concept (e.g., monetary vs. total)

37

-5

-3

-1

1

3

5

7

9

11

13

15

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100

Aver

age

annu

al g

row

th ra

te (%

)

Distribution of countries (%)

Distribution of countries according to the average per capita GDP growth rate between 1990 and 2005

Brazilian top 10%

Brazilian bottom 10%

China

Germany

Haiti

Over the last years, the income of the Brazilian poor has been growing as fast as per capita GDP in China while the income of the richest has

been growing as fast as per capita GDP in Germany

Proximate and fundamental determinants of changes in inequality

• Useful framework: to consider the ‘proximate’ factors that affect the distribution of income at the individual and household level:1. Socio-demographic factors 2. Distribution of assets and personal

characteristics3. Return to assets and characteristics4. Transfers (private and public)

39

Decomposition results

• Demographics: Changes in the ratio of adults per household were equalizing, albeit the orders of magnitude were generally small except for Peru.

• Labor force participation: With the exception of Peru, changes in labor force participation (the proportion of working adults) were equalizing. This effect was stronger in Argentina.

40

Decomposition results

• Labor income (Earnings): In Argentina, Brazil, and Mexico between 44% and 65% of the decline in overall inequality is due to a reduction in inequality in earnings per working adult . In Peru, however, changes in earnings inequality were unequalizing at the household level (but not so at the individual workers’ level).

• Non-labor income: Changes in the distribution of non-labor income were equalizing; the contribution of this factor was quite high in Brazil and Peru (45% and 90%, respectively).

41

Why has earnings inequality declined?

• Educational upgrading and a more equal distribution of educational attainment have been equalizing (quantity effect). No “paradox of progress” this time.

• Changes in the steepness of the returns to education curve have been equalizing at the individual workers level (price effect). Except for Peru, they have been equalizing at the household level too.

42

44

Why has the skill premium declined?• Increase in relative demand for skilled labor

petered out: Fading of the unequalizing effect of skill-biased technical change in the 1990s: Argentina, Mexico & Peru.

• Decline in relative supply of low-skilled workers: Expansion of basic education since the 1990s: Brazil, Mexico and Peru .

45

46

Why has non-labor income inequality declined?

• The equalizing contribution of government transfers increased over time (both at the national level as well as for urban and, especially, rural households). By 2006 transfers became the income source with the largest equalizing effect of all the income sources considered.

• Remittances became more equalizing too but with a smaller effect than government transfers.

• Both more than offset the increasingly unequalizing impact of pensions.

47

Why has inequality in non-labor incomes declined?

In the four countries government transfers to the poor rose and public spending became more progressive

▪ In Argentina, the safety net program Jefes y Jefas de Hogar.

▪ In Brazil and Mexico, large-scale conditional cash transfers Bolsa Familia and Oportunidades => can account for between 10 and 20 percent of reduction in overall inequality. An effective redistributive machine because they cost around .5% of GDP.

▪ In Peru, in-kind transfers for food programs and health. Also access to basic infrastructure for the poor rose. 48

Argentina: Distributional impact of Conditional cash transfers

49

50

Conclusions

• In the race between skill-biased technological change and educational upgrading, in the last ten years the latter has taken the lead (Tinbergen’s hypothesis)

• Perhaps as a consequence of democratization and political competition, government (cash and in-kind) transfers have become more generous and targeted to the poor

51

Is Inequality Likely to Continue to Fall?

• Despite the observed progress, inequality continues to be very high and the bulk of government spending is not progressive.

• The decline in inequality resulting from the educational upgrade of the population will eventually hit the ‘access to tertiary education barrier’ which is much more difficult to overcome: inequality in quality and ‘opportunity cost’ are high and costly to address.

• Making public spending more progressive in the future is likely to face more political resistance (entitlements of some powerful groups).

52

Has the link between high inequality and bad political economy dynamics been broken?

• Inequality has been on the decline, but is the decline sufficient to prevent bad policies?

• Too early to declare victory, evidence is mixed: – in 2000s elections were won by “risky” policymakers in

Argentina, Bolivia, Ecuador, Nicaragua and Venezuela; – however, elections were won also by a “new” social

democratic left which succeeded in combining macro stability, redistribution and growth (Brazil, Chile, Paraguay and Uruguay)

Thank you!