IDB report outlines steps for region to respond to Russian War in Ukraine, COVID

• IDB 2022 Latin America and Caribbean Macroeconomic Report finds war dampens growth prospects in Latin America and Caribbean
• Higher commodity prices provide fiscal relief for some countries, but oil importers face additional fiscal pressures; key policy actions to boost inclusive growth should not be delayed
• Report includes analysis of labor market reforms to create future jobs in formal economy

The Russian invasion of Ukraine together with interest rate hikes is likely to reduce growth in Latin America and the Caribbean in 2022-2024, underscoring the urgency of enacting policies to unlock higher and more inclusive growth, the Inter-American Development Bank’s 2022 Macroeconomic report says.

From Recovery to Renaissance: Turning Crisis into Opportunity analyzes the impacts of the war and provides a policy framework to improve the region’s labor and fiscal architecture to complement other efforts to strengthen the region’s economic and social institutions.

Growth scenarios for individual countries depend on a variety of factors, from trade links to Russia to debt levels. Overall, however, the combined effect of aggregating global growth, commodity, and financial shocks is to reduce growth in Latin America and the Caribbean compared to a pre-war scenario.

The combined shock of higher commodity prices, lower Eurozone and U.S. growth rates and tighter than expected U.S. monetary policy would be to shave 1.5 percent off GDP growth on average each year from 2022 to 2024 from the average baseline growth of 2.2 percent per year. This negative scenario sees advanced economies moving more aggressively to curtail inflation. It would cut the region’s GDP growth from 2.1 percent to 1.2 percent in 2022 and to -0.4 percent in 2023. The region recovers in 2024 to 1.3 percent and thereafter converges back to longer-term growth of around 2.5 percent.

“The region has shown its resiliency by bouncing back from the pandemic in 2021 stronger than initially projected,” said IDB President Mauricio Claver-Carone. “I am confident we can do it again, leaving COVID behind and overcoming the new geopolitical challenges by seizing on the trade opportunities and locking in critical reforms. The political economy of these efforts is challenging, but countries will have in the 21st century IDB a strong partner to provide the resources and the knowledge needed to unleash the region’s resilience and growth potential.”

Trade and fiscal opportunities

Russia is an important market for several exports from Latin America and the Caribbean, including dairy products, meat and fruits. About 20 percent of the region's total imports of fertilizers come from Russia, as do over 5 percent of total imports of iron and steel. The elevated price of oil and grains will benefit exporters, but importers, particularly in Central America and the Caribbean, are facing higher prices. While higher commodity prices are generally associated with lower poverty and inequality in the region, lower growth and higher inflation will likely reduce the real income of poorer households, the report says.

Supply bottlenecks and demand shifts may be temporary but global trade links are persistent. The region may be able to increase its share in global trade as firms seek to make their supply chains more resilient. Latin America and the Caribbean is well-placed to limit the volatility of key commodities and help the world contain global inflationary pressures.

The report recommends strengthening export networks through better infrastructure and logistics, and fortifying institutions that can promote trade and provide useful information to exporters. In addition, policymakers need to ensure that the many trade agreements already signed are consistent with each other, and to finish constructing the web of trade agreements across the region and with the rest of the world where there are missing links.

On the fiscal front, the report sees the war increasing debt ratios from 72 percent of debt-GDP ratio for an average country in 2021 to 74 percent in 2024. In 2024, the debt ratio could increase to 68 percent for commodity exporters and to 87 percent for tourism dependent economies.  Incorporating potential financial shocks due to higher interest rates would increase debt levels to 79 percent of GDP for an average country, with tourism-dependent nations at 89 percent and commodity exporters at 74 percent by 2024

“Many countries will experience a commodity windfall that should not go to waste,” said IDB Chief Economist Eric Parrado. “The Macroeconomic Report details a new fiscal architecture that protects productive public investments and includes smart fiscal rules for deficit and debt targets – in an environment of greater transparency and strengthened fiscal institutions to give reforms credibility.”

The report urges governments to reduce technical inefficiencies in spending, for example by levelling off public and private salaries for comparable occupations, limiting leakages in public transfers through better targeting, and improving public procurement to save as much as 4.4 percent of GDP per year on average. Other elements of the new fiscal architecture include measures to reduce tax evasion though the digitalization of records and transactions, replace costly tax exemptions with refunds of a generalized VAT to the poor, and address new challenges in digital economy and climate change.

Labor market reforms

The report analyzes the labor impacts of the crisis and the policies needed going forward. The COVID-19 crisis led to a contraction of both formal and informal jobs as well as closures of micro and small businesses. Employment and wages fell more sharply among informal workers, with women especially hard hit.

The crisis caused by COVID-19 provides an opportunity to tackle pre-pandemic challenges of high levels of informality, low wages reflecting low productivity, and volatility characterized by high turnover and limited incentives for workers to gain better skills.

Labor informality affects 58 percent of the workforce in Latin America and the Caribbean on average, in all income brackets, though it reaches 80 percent in the poorest quintile, compared with 40 percent of workers in the richest quintile. Although this problem has existed for decades, the pandemic likely will make the issue worse because informal jobs are recovering more rapidly than formal jobs.

The report weighs the costs and benefits of the main policy options. For instance, a one-time digitalization subsidy of 1 percent of GDP would lead to a long-term GDP increase of 0.6 percent, relative to a baseline scenario without the policy change. The policy would also generate long-term increases in labor income (0.2 percent), average firm productivity (0.1 percent), and the share of employment that is formal (0.7 percentage points). One billion dollars invested in water and sanitation, energy and transportation generate 100,000 jobs.

To confront the problem of high informality and low coverage of pension systems, social security reforms could make certain benefits universal and independent of an individual’s labor-market status, as well as financing these benefits with general taxation instead of labor taxes.

To help roll back informality, the report recommends tax authorities strengthen their use of digital technologies, transfers to low-wage workers who work in the formal economy, and rewarding formality, via negative income taxes, similar to the EITC (Earned Income Tax Credits) in the U.S.

The report concludes that the pandemic has posed many serious challenges for the region, compounded by the conflict between Russia and Ukraine given its implications for the global economy. Still, the region’s resilience in the face of adversity creates reasons for optimism as the crisis provides a window of opportunity to work towards new policy architectures in critical areas to improve both equity and efficiency.