Carmen M. Reinhart

Interview

Q/ How do you assess the progress and remaining challenges in terms of macroeconomic stability in the region? What were the key enablers and missing elements in the process?

Latin America encompasses very different countries and challenges. So it is a generalization to talk about the region as a whole. With this in mind, I would say that the area where significant progress has been made is in macroeconomic stability.

When the U.S. inflation rate reached 9 % and the Federal Reserve began to raise interest rates rapidly and sharply, the region withstood the interest rate increases remarkably well, which is a very different situation than in the late 1970s and early 1980s, when the sharp rise in international interest rates led to a general financial crisis. So that points to resilience.

So – again generalizing, because Argentina and Venezuela have their own inflation problems – the region’s ability to use monetary policy effectively and to reduce inflation after the post-COVID-19 spike is also testimony to resilience in improving policymaking by policymakers. So those are all positives.

On the negative side, we remain a region where social and income inequality is extremely high by international standards. We remain a place where the promise of a diversified production base is still far off in the future; we have a deep dependence on single commodity exports. And we continue to face substantive social challenges in terms of poverty, education and social indicators. Thus, there are many positive aspects to macroeconomic management, but structural problems remain.

Q/ What were the key factors behind the advances in the deepening of stability and integration of financial markets and what policies are needed to further advance their development in the region?

Latin American countries such as Peru and Brazil, for example, have seen, among others, significant progress in the deepening of domestic financial markets. However, as the question points out, Latin American financial markets, by many measures, remain small and underdeveloped compared to other emerging markets, in Asia, for example.

It is important to note that part of the lack of financial market development in Latin America is due to a history of inflationary stability and economic crises. Latin American countries, of course, Argentina, Brazil, Bolivia, Peru, all have had hyperinflations, have had years and years of upswings, which eroded confidence in domestic financial markets. People prefer to save abroad. I think that mentality has changed, but it doesn’t change drastically overnight . A very positive development in the region as a whole has been its shift to rely more on the public sector, to rely more on domestic currency, debt and legislation, and to reduce its dependence on foreign debt.

The development of the public sector is a very important step in developing the domestic corporate debt market. However, challenges remain. I will conclude by also saying that on the positive side, for many years the regulation of financial systems, the supervision of the banking industry in particular, started to move and converge to international standards, to the Basel accords. The standards and caliber of banking regulation and supervision made great strides.

However, I believe that COVID-19 has caused some setbacks in that dimension. As part of the response to the pandemic, several Latin American countries introduced refinancing policies that allow households and companies to postpone debt repayments to cope with the crisis. This is very common around the world, both in advanced economies and in emerging markets. Forbearance policies were quite common during the COVID-19 crisis, but they were also accompanied by regulation, and so what is classified as a bad loan is much more nebulous today, in several cases. I again generalize, and after years of striving for uniformity within international standards, we have seen some setbacks since COVID-19 in macroprudential regulation and supervision.

Q/ Improving financial systems can contribute significantly to both economic growth and social inclusion. What policies or institutions are key to improving the impact of deepening financial markets on development and what is the way forward for Latin America and the Caribbean in this area?

I think this relates very much to the earlier comment I made that significant moves toward better regulation and supervision of banks are, of course, a step forward. More government reliance on domestic debt financing also encourages some development of domestic capital markets. But in terms of inclusiveness, a common feature of Latin America, is that access to credit is often heavily skewed towards larger companies. Therefore, small and medium-sized enterprises, and households, have much more limited access to credit.

So if the issue is financial inclusion, then Latin America needs to do a lot of work to expand financial inclusion. What can it do? I think it needs to start with smaller steps. A lot of digitization policies, more sensible but welcome microfinance, and more advanced risk assessment would allow banks to broaden the base of who they lend to.

It’s difficult because if you don’t have a very good assessment of risk, and typically you assess risk better for large corporations, you’re going to be less willing to lend along with the capital markets, and in particular try to broaden the base of companies that can borrow. I think national rating agencies can play a more registered role, even small companies. Helping institutions to assess risk is a first step in broadening inclusion in the lending umbrella. With respect to households, I think progress has been slow, but there has been progress. I referred earlier that a long history of high inflation basically did a lot of damage to long-term finance, such as mortgage markets. In many countries, these markets are small by international standards, but other than that, who wants to lend at a fixed rate for 15 or 30 years if the inflation outlook is very uncertain?

I believe that greater macroeconomic stability, in due course, will also help build the housing finance industry as it relates to households, but it takes time. Consistency and stability are built over time.

Q/ How do you assess the fiscal situation and prospects in Latin America and the Caribbean, and what rules and actions seem to be prioritized to ensure fiscal sustainability in the current and future context of the region?

Latin America, again, is a very hybrid region. That is, Argentina has had draconian fiscal problems. The new government is taking draconian measures as well to address the fact that, for years and years, the public sector continued to grow in terms of spending without interruption. And the consequence was the financing of inflation, given a growing spending base without much complement to tax revenues. My point is that fiscal problems have their own character depending on the country.

As a general group, you can say that fiscal problems have become much more acute since COVID-19 because the collapse of production that we saw globally, the displacement of labor markets, meant collapsing revenues and more government spending to support the economy. And so, there were fiscal deficits and a large increase in debt that is common across the board. So, fiscal issues are much more important today, even than in 2019. However, it is very important that policymakers in the region are very careful not to emulate the disregard for rising debt that we see in the United States and other advanced economies such as Japan. Emerging markets have no tolerance for debt, so even more moderate increases in debt can have very serious consequences.

I think policymakers in the region really need to address the broadening of the revenue base which, in general – despite higher tax rates in many emerging markets – tax collection is not the best. So when I talk about broadening the tax base, I also mean more efforts. I mentioned digitalization earlier as a vehicle to improve collection. Efforts need to be made in that regard. And I think the other element of fiscal prudence that needs to be at the forefront of policymakers’ decision-making process is that, in terms of spending demands, prioritization is important. Demands to spend more on climate transition, both mitigation and adaptation, demands for social needs, demands for an aging population; there are those who say that given the uncertainty of geopolitics, there may be demand. Certainly, this applies more to Europe than to Latin America. There may also be more defense demands. But certainly climate, social and aging are going to remain. None of that is going to go away any time soon. Governments need to give priority to addressing these demands with an eye to having a high impact, because dealing with all of them will drain fiscal resources very quickly. And so, again, those demands are there, but the ambition, I think, has to diminish.

Q/ What institutions and arrangements could be developed to address the pro-cyclical fiscal policy caused by insufficient access to finance and excessive debt?

The issue of procyclicality usually appears on the radar screen when there are bad times, bad shocks, whether it is the COVID-19 crisis or rising interest rates in the United States or falling commodity prices. When things go bad, governments lose access to financing or it becomes very expensive, and they have to tighten their belts, possibly worsening what is already a recessionary environment. And so procyclicality generally gets a lot of attention when it means that governments have to tighten in bad times.

The part of procyclicality that is least talked about, yet lays the seeds of recession, is that in good times, governments tend to overspend. So this is an old problem in the region. If you look at the early literature in Latin America, commodity price booms have been notoriously accompanied by the assumption that our export revenues are large, our government revenues are large, we are accumulating foreign exchange reserves, so let’s spend more. And that «spend more» is based on the assumption that higher commodity prices are going to last forever. But commodity prices go up and down. What I mean is that the seeds of crises and procyclicality in bad times are sown during good times. Is there saving for a rainy day? And the answer is usually no.

I think governments have done better in terms of mitigation; if you look at the older episodes, I think that has generally been the case. There are papers by Jeff Frankel and Carlos Vegh that show that procyclicality, in general, has declined somewhat. But I think vehicles, or the development of things like sovereign wealth funds is an effort, and the well-designed ones, the state-of-the-art ones, can help do just that, save for a rainy day and save some of the proceeds during the boom years to have better access to funding during the bad times. This is one idea, and the other I would like to highlight was presented at the Inter-American Development Bank by a former student of mine, Alejandro Izquierdo, and a colleague and co-author, Ernesto Talvi. They argued that Latin America would benefit enormously from having commodity-adjusted fiscal variables, just as in many, if not all, advanced economies that have cyclically adjusted budgets and are commodity-tight.

So what would revenues look like if commodity prices were more of a long-term average and what would the debt be? What this does is that during boom years, when higher commodity prices are associated with a higher inflow of revenue from reserves, things look fiscally very good, but the cyclically adjusted budget would not look so good. Hopefully that introduces or helps motivate the need for some fiscal prudence to account for the fact that, as I noted earlier, commodity prices go up and down. Taking high commodity prices for granted has been a recurring mistake in the past .

Q/ In the region, there are prominent patterns in tax collection, high tax rates, low revenues and a distinctive composition in relation to developed regions. What should be the principles or characteristics of a tax reform that improves revenues, distributes burdens equitably and does not excessively affect growth?

It is a difficult task that can improve tax revenues, do better in terms of equality, and does not affect growth. It is a difficult task that borders on the miraculous. But let me point out a couple of issues that I think are important. I had pointed out earlier that revenues are low even though tax rates are relatively high. And there are two things that are noteworthy there. One is telling you that the base is small: if the tax rate is high but the yield is low, the tax base is low. And why is the tax base low? Well, there’s also a lot of tax evasion. I also referred earlier to some efforts for better digitization, better tracking to income. This is a difficult task as well, because many of these Latin American countries still have very large informal sectors. But digitalization, the integration of people, whether it’s through a grocery store or through a bank, better tracking allows for better tax collection.

There are some preliminary studies that point in that direction. The World Bank has undertaken some of those efforts as a promising avenue for improving tax collection. With respect to fairness, when you first talk about a sales tax, people immediately think, «Oh, well, sales taxes are progressive, right?» The tax rate is not progressive in the way that income taxes can be. However, I should point out that the alternatives that Latin America has often relied on are even more regressive. What am I talking about? I am talking about the inflationary tax. If the government lacks revenues, its expenditures far exceed those revenues and this happens chronically. Often, it resorts to inflation financing. It has done so in the past, but less so now. However, inflation is, in the words of former IMF deputy director and MIT professor Stanley Fischer, and also William Easterly, the cruelest tax. It erodes wages. Wealthier households are better hedged, better able to protect themselves against inflation. And the rise also induces a large increase in relative prices, so staples tend to rise more.

Who has a higher proportion of needs in their budget? Lower-income households. So inflation, which is a tax, is also a very regressive tax. We have to keep an open mind that other tax rates and other forms of taxes, whether they are sales taxes, excise taxes, whatever, have a regressive element. The alternatives that Latin America has historically used are arguably even more regressive. There are no miracle solutions, but I think that broadening the tax base will involve an adoption of technology, better technology to track and increase collection, and it will also involve thinking about other forms of taxation.

Q/ Many countries in the region have economic structures that are highly concentrated and dependent on the primary sector, specializing in sectors that are highly exposed to price volatility. To what extent does this compromise the microeconomic stability of the region and what institutions or regulations can help address this challenge?

Over-specialization and dependence on raw materials have existed practically since the independence of most Latin American countries in the early 19th century. It is an old issue, and we are still poorly diversified and highly dependent on the commodity cycle. It is no coincidence that Latin America had a very good run in the 2000s, when China was growing at more than 10 % and the demand for global commodities was increasing rapidly. This translated into a big boom for Latin American commodity producers, and the outlook, growth and all the general indicators, despite the global financial crisis in the U.S. and advanced economies in 2008 and 2009, were very good in the region, by historical standards, until 2015.

What happened in 2015? China slowed down. Commodity prices plummeted and so did growth in Latin America. I think the region as a group – not so much Mexico, which has integrated through NAFTA – has had relatively limited successes in developing a sustained set of non-traditional exports. We have seen, for example, a classic commodity super-producer: Chile with copper. We have seen Chile have varying degrees of success in including non-traditional exports. But I think in the end we have to maintain, in addition to greater diversification, more trade openness; Latin America as a region. And if you measure trade openness as exports plus imports as a percentage of GDP, it is much more closed than Asian emerging markets with comparable income levels. So apart from the emphasis on continued diversification, increased openness, I think we have to deal with the fact that these countries are producers of basic manufacturing and therefore have to get better at managing these commodity cycles. Hence my earlier comment on sovereign wealth funds.

If you are a commodity producer, it is difficult to change the structure of what you produce, which the last 200 years have shown quite conclusively. This is because, as I said, the issue of under-diversification of exports is an old story in the region, so you have to try to manage the commodity cycle better because it is a roller coaster. Historically, commodities have always been volatile and that has also opened the region to a lot of instability. And broadening the revenue base would make countries less dependent on the ups and downs of commodity prices. Historically, moreover, government revenues have been closely tied to the commodity cycle. So the bottom line is that we will continue with the goal of making these economies more diversified, but on the road to diversification let’s not forget to put a lot of emphasis on managing the commodity cycle better to reduce those risks and the roller coaster ride that commodities have historically been associated with.

Q/ What role do you expect multilateral organizations to play in assisting Latin American and Caribbean countries in meeting the challenges posed by the major trends in the fiscal situation and exposure to external shocks?

In the case of multilaterals, it is necessary to be more precise, rather than lumping them all together. The Inter-American Development Bank (IDB), for example, supports a lot of lending to the region for a variety of uses and projects. The World Bank obviously lends to Latin America and the Caribbean, but puts a lot of emphasis on low-income countries. Indeed, during the COVID-19 crisis, when I was chief economist at the World Bank, there was a fairly strong common reaction from executive directors representing the region that the institution was not paying enough attention to their needs. But I think that while the regional development bank is regionally focused, the World Bank’s emphasis over the years, if you look at the 1980s and early 1990s, was much more focused on Latin America. Since then, it has increasingly shifted to low-income countries and in particular to Sub-Saharan Africa.

So what about the IMF? Well, the hope is that you don’t need the IMF, right? IMF programs are taken when a country is in crisis or close to crisis. So what you want is that you don’t need the multilaterals, and that the sources of financing come from the private sector and better revenue collection. And this dependence on multilaterals is not going to make or break the region again. Look at the countries that have been active in the IMF in recent years. Argentina and Ecuador have had a default situation, very precarious financially; Suriname, too. Venezuela, of course, has had a default without the IMF because that is a political issue, a geopolitical one, between the U.S. and the Maduro government. So what I can say is that it is better not to need the multilaterals or the IMF. I think the exposure to the IDB is quite high for most of the country.

So countries have already been making use of what is available to them from the regional development bank. And I would say that the expectations of what financing will be available from the World Bank are not what they used to be. So I don’t think the multilaterals are going to be the ones that are going to make or break the region in terms of their lending.

Q/ Geopolitical factors such as recent armed conflicts and the trade war between the United States and China, as well as other global trends such as environmental policies, may influence international trade, capital flows and global value chain configurations. How do you assess the regional situation and what areas of strategic response do you foresee in the new global context?

Let me say that, in a nutshell, geopolitical tensions have reinforced what was already a trend of slowing global trade growth. The Russia-Ukraine war, the tensions between the U.S. and China came after global trade had started to slow down. First it was the global financial crisis, then in the context of Brexit in Europe, then it was the first round in the U.S.-China trade war under Trump. Now, we may even have a second round. We don’t know, this has been happening for some time and it’s both a risk and an opportunity. And that sounds superficial, but it’s a risk because the global trade implosion has been negative. I mean, you have to look at the Depression of the 1930s, and the contraction of world trade was one of the many factors that symptomatically caused the problem. But the opportunity is that with more emphasis on nearshoring by the U.S., with more emphasis on industrial policies that bring things home, you would think that, in terms of geopolitical alignment, Latin America could also be a potential beneficiary. Should the U.S. really be pursuing more than just words, but more of a nearshoring policy than in the past? High geopolitical risk is not good for any advanced or emerging country. Very few countries would benefit from it.

Q/ In response to the COVID-19 pandemic, countries around the world implemented these decisive actions of costly monetary and fiscal policy. As a result, in some of them, debt sustainability has deteriorated. To what extent can high debt levels and the more adverse financing conditions associated with the tightening of global monetary policy compromise the institutional framework achieved in terms of central bank independence?

I think we have actually talked a little bit about this in various ways. I already referred to the fact that one of the big challenges, one of the characteristics common to the region, was that the significant deterioration of fiscal finances during the COVID-19 pandemic left the region with a much higher level of debt than before. I think in terms of what kind of risks it poses, does it mean that it is because there are higher debt levels and borrowing is more costly? I would like to point out one thing that we haven’t talked about and that is that the counterpart to higher debt levels has been a significant deterioration in credit risk. This means that credit rating agencies like Moody’s and Standard & Poor’s Fitch have downgraded significantly on multiple occasions.

As a result, the aggregate credit ratings of Latin American countries have declined significantly since 2015. So we have had almost a decade, even before COVID-19, of a loss of credit quality. What does this mean? Again, my message is one of prudence: countries should be very cautious about sustaining large fiscal deficits and allowing debt levels to continue to grow. I believe in fiscal prudence in an environment where credit ratings have been downgraded and international debt levels and interest rates are also higher, even though the Federal Reserve has loosened, is likely to loosen further and the ECB is likely to loosen as well. Interest rates were exceptionally low between 2008 and 2022, and we have come out of that low interest rate environment.

So, financing the debt is going to be more expensive. So, do I think that because financing is more costly, the government will rely on central banks and undermine their independence as a general rule for most countries? I don’t think we are talking about Latin America, I mean, in Argentina that has been the rule, leaning on the central bank with the inflation results that we have seen. But no, I think I started this conversation by saying that one of the successes of the last few years has been that central banks in the region were able to act forcefully to reduce inflation after the post-COVID-19 peak. And there is always the danger that governments will try to undermine the independence of central banks, but I think the tolerance for high inflation in most countries, both politically and economically, does not exist. So I am less concerned about the loss of central bank independence, but I am concerned about the more precarious fiscal situation, and what is the proverbial straw that breaks the camel’s back when it comes to fiscal sustainability.

Q/ Some trends will mark the future of the region, for example, aging, green energy transition, migration and automation of production processes. What are the main trends and their implications for monetary policy?

I think that’s in the realm of conjecture. I went to Silicon Valley and Stanford for an immersion in AI. The scientific potential and what it can do is amazing, but you have to delve into how this new technology will translate into aggregate productivity. Because there are losers and winners. There are those whose productivity is complemented by AI and those who will be replaced. Where is the balance? What does AI do to add to productivity? What is it going to do to add to GDP? The answer was unanimous: we don’t know.

I think there is also a lot of conjecture about climate. What does climate mean for fiscal policy? It’s not easy to understand or implement. It means more allocation. Again, I talked about prioritizing among various objectives, and climate finance will certainly require governments to prioritize more carefully, but also to pursue elusive long-term financing and adaptation to climate change.

The projects we are talking about are not financed with typical short-term flows. These require dedicated long-term financing, and that’s very hard to come by, so that’s going to be an ongoing challenge for the government. So when you speculate on what climate or AI means for policy, AI is a black hole, and climate, I think you know a lot more about. I think securing long-term funding and prioritizing is vitally important, and the continuing problem has been that climate issues generally get pushed aside, that whatever the emergency du jour is, it gets more attention and resources, and climate issues get pushed to the back burner. The realization that that can continue is going to be important, but these are such broad areas that looking for concise and specific implications is difficult.

I think one of the things that climate policy is going to require is a rethinking of risk assessment. You know that the risk of lending is more dependent on climate outcomes. And I say that because, for example, several small Caribbean islands have already done that or are in the process of looking at contingent contracts. If you are subject to a natural disaster, your debt is contingent and you cannot pay it. So, in finance, there is going to be more contingent status and that will affect risk assessment, for example. But beyond that, I think it’s a lot of speculation.

Q/ What do you see as the main effects of globalization in Latin America and the Caribbean? Would a less integrated world economy alter the incentives to maintain current microeconomic institutions?

As I noted earlier, I think there are few who benefit from geopolitical tensions. And, you know, as a region, Latin America is a relatively closed region. Trade is less important. Most countries in the region have not had the clearly export-oriented strategies of the Asian economies, which means that, to some extent, they may be less affected by slower growth in trade, even, by some setback, than those countries that have relied more on export growth.

Having said that, one dimension that I think is going to be very important for the region, and we haven’t really talked about it explicitly, is China. Let’s say hypothetically there is an escalation of trade wars between the U.S. and China, and now it’s not just them, it’s also China and Europe because China supported the Russians in Ukraine, generating a whole wave of new frictions. So, if China’s growth, which has already dropped severely from 2015, when it experienced the first decline in its growth from over 10 % to around 6 %, is now lower, the implications are very negative for many of the Latin producers and exporters of raw materials. If you look, for example, at the five-year GDP growth rates between China and, in particular, the region’s mineral and oil producers, that correlation has grown significantly over time. It was nothing in the 1990s and early 2000s. And since then, integration with China has meant stronger correlations in economic growth. If geopolitical, trade and similar wars have a greater impact on Chinese growth rates, they have plenty of reasons to slow-I’m not going to get into that, that’s a problem in itself. If geopolitical factors contribute to a major slowdown, that would surely have negative effects on many other countries in the region.