Financial Reforms and Falling Inequality in Latin America, 2002-2012
Are They Connected?
29 October 2014
Giovanni Andrea Cornia
For the last quarter of the twentieth century, Latin America suffered from low growth, rising inequality, and frequent financial crises; i.e., currency, sovereign debt, and banking crises. For instance, between the early 1980s and 2002 there were at least 26 major banking crises involving 15 countries. Sovereign debt defaults and currency crises were frequent, as were ‘double’ or ‘triple’ financial crises (as in the case of the ‘Tequila crisis’ of 1994, Ecuadorian crisis of 1999, and Argentinean default of 2001-02). The cost of such crises was massive, as during the three years subsequent to their outbreak the cumulative output losses reached up to 98 per cent of GDP. During this period, the high income inequality that had afflicted Latin America for centuries rose further—from a Gini of 48.9 in early 1980s to 54.1 in 2002 (Figure 1)—including because of the impact of devastating financial crises on growth, employment, relative prices, and public subsidies.
Financial crises were seen as the unavoidable downside risk of the life of globalized economies. It was accepted that while in good times international financial integration generated huge beneficial effects on the most open developing countries, in bad times restrictive monetary policies, credit crunches, market downturns (and generalized risk in the OECD area) reverberated most powerfully in these countries. In addition, the vulnerability of Latin America to the vagaries of international capital markets was perceived to be exacerbated by the region’s thin financial markets, less diversified portfolios, lax supervision and regulation, unclear bankruptcy norms, and greater inclination to adopt unstable macroeconomic policies.
The fall of income inequality of the 2000s: due also to greater financial stability?
Things have changed significantly since 2002. Indeed since the turn of the century, the region enhanced its growth performance, reduced inequality, improved its macroeconomic stability and avoided major financial crises. In late 2009, an indication of the new ability of the region to deal with such global shocks led Arturo Porzekanski to write a paper called ‘Latin America: the Missing Financial Crisis’. Perhaps, the most striking change of the new era was a sizeable drop in income inequality which between 200210 fell––if to a different extent and with different timing—in the region’s 18 main countries, with the exception of Nicaragua and Costa Rica. As a result, the unweighted regional Gini coefficient, which had risen by 5.2 points between the early 1980s and 2002, fell by 5.5 points between 200310, thus allowing the region to return in only eight years to its preliberalization level of inequality (Figure 1). During the same years no other developed or developing region experienced such a widespread and sizeable inequality decline.
Statistical decompositions included in a new UNU-WIDER book published by Oxford University Press, edited by Giovanni Andrea Cornia, do show that the inequality drop appears to be permanent rather than cyclical, as it continued also over 2009-12, years of sluggish world growth, falling terms of trade, capital outflows and mounting uncertainty triggered by the US sub-prime loans and European sovereign debt crises (Figure 2). Had inequality stopped falling or begun rising during these years, one would have been tempted to consider the 2002-08 gains as ‘cyclical’ rather than ‘structural’. But this was not the case, and a simple statistical test for 2008-12 and 11 countries with complete data finds that changes in GDP growth rates and changes in Gini coefficients are independent from each other, thus suggesting that the inequality decline which began in 2002-03 mainly depends on factors other than the business cycle.
Drivers of the recent inequality decline
What explains the recent inequality decline? A statistical decomposition of changes in the distribution of income per capita between the early and late 2000s in Chile, Ecuador, El Salvador, Honduras, Mexico, and Uruguay indicates that inequality fell due to (in order of importance):
- a drop in the skilled-unskilled wage ratio
- an increase in social assistance transfers
- a lower degree of concentration of capital incomes.
In rural economies (such as Honduras) a fall in the urban-rural wage gap, and in countries of emigration (such as El Salvador and Mexico) increasingly better distributed migrant remittances were also relevant factors.
Were these statistical changes in inequality due to the endogenous play of market forces (such as the favourable global economic environment for the region)? To the growth acceleration of 2002-08? Or to new approaches to policy design and implementation? Some observers have argued that inequality declined because of ‘luck’—i.e., improvements in global economic conditions. For sure, the enhancement of the region’s international terms of trade, capital inflows and migrant remittances in Central America and the Andean region produced beneficial effects on growth. Yet, given the high concentration of the ownership of land and mines and access to finance prevailing in the region, the recent improvements in external conditions generated, ceteris paribus, an unequalizing effect on the distribution of market income. However, such favourable shocks relaxed the balance of payments constraint and facilitated an acceleration of growth. Yet, growth per se is no guarantee of falling inequality, as shown by China and India—where a very rapid rise of output was accompanied by an equally rapid rise of inequality. In Latin America, growth’s beneficial effects on inequality would not have materialized without the changes in growth patterns which are discussed below.
A key role was played by the greater emphasis placed on educational policies which started in the 1990s and accelerated in the 2000s. Gradually rising public expenditures on education and its better targeting led to an improvement in the distribution of human capital among workers thanks to a rise in secondary education completion rates, especially among the poor. In turn, a higher supply of better-educated workers led to a drop in the skilled-unskilled wage ratio and to a more equitable distribution of human capital.
In turn, a set of ‘social democratic policies’ improved the redistributive effect of budget operations. Tax policy re-emphasized revenue collection and the role of income tax and progressive taxation. As a result, the regional tax/GDP ratio rose by 3.5 points over 2003–08 and fell by only 0.35 points during the 2009 recession. These measures helped improve after-tax income inequality, while higher revenue generation permitted to finance public spending without increasing inflation and the foreign debt. In addition, the increase in social expenditure focused on highly-equalizing social assistance and education programmes. Finally, labour policies explicitly addressed the problems inherited from the past—i.e., high unemployment, job informalization, and falling unskilled and minimum wages. For instance, after decades of decline, many governments decreed hikes in minimum wages.
Macroeconomic and financial policies While the above measures helped to reduce inequality substantially, the adoption of prudent and yet progressive structural macroeconomic and financial policies was another key factor. In the early 1990s the region experienced a return to democracy, and from the late 1990s a shift in political orientation towards left-of-centre governments which adopted growth and distribution-sensitive policies that helped, inter alia, stabilize the macroeconomy and avoid the unequalizing financial crises of the past by adopting structural reforms that encouraged macroeconomic flexibility, fiscal solvency, financial soundness, investor education, and transparency. Such measures included prudent external macroeconomic policies aimed at reducing the exposure of the countries to external shocks—in particular to sudden stops of capital inflows and contagion effects. To do so, the Latin American regimes:
(i) avoided the large deficits, and foreign debt accumulation experienced in the past, by raising, as noted, tax/GDP ratios, and reducing their dependence on foreign borrowing;
(ii) abandoned, with rare exceptions, the fixed pegs of the past in favour of more flexible exchange rate regimes;
(iii) encouraged central banks to accumulate large international reserves (Figure 3) which grew for the region as a whole from US$150 billion to almost US$550 billion during 2002-09, while the region’s gross foreign debt declined from 40 per cent of the regional GDP in 2002 to 20.4 in 2009.
The distributive effects of such measures were favourable, as they reduced the vulnerability to external shocks, and differed markedly, for instance, from East Europe’s policy of growing external indebtedness (Figure 3); and (iv) in a few cases (such as Colombia, Argentina, Brazil) introduced, when needed, capital controls to moderate the impact of currency bonanzas on the level and stability of the real exchange rate.
In terms of domestic macroeconomic measures most countries avoided the traditional pro-cyclical unequalizing fiscal and monetary biases of the past. Fiscal deficits were typically reduced below one per cent of GDP, in 2006-07 the region recorded a balanced budget (Figure 4). As shown below the primary surpluses were recorded through an increase in taxation (from low levels), rather than through expenditure cuts. In addition, governments learned to better manage their external assets and liabilities by creating 'stabilization funds’ to draw upon in times of revenue shortfalls. Furthermore many Latin American countries attempted to control money supply, reduced interest rates in periods of stagnation, and expanded lending by public banks in periods of crisis. They also adopted a stricter regulation of the financial sector so as to avoid the banking crises of the past. Indeed, the financial deregulation of the 1980s and 1990s allowed the creation of off-balance-sheet and shadow financial institutions, not subject to central bank supervision, increased leverage contributing to a long series of financial crises.
Unlike in the OECD and the European transition economies, the Latin American countries did not experience, even in 2009, any financial, sovereign debt, and banking crises. One reason for this crisis avoidance was the expanded role played by the IMF which, in addition to increasing its lendable resources, was seen as ready to support countries facing financial turmoil. Yet another reason was the banking reforms implemented in the region. In this regard, most Latin American governments have made enormous progress in the past decade. They have enhanced the capitalization, funding, and supervision of their banking systems; encouraged the development of local capital markets; introduced a stricter prudential regulation of financial systems; enhanced risk-assessment mechanisms in large banks; developed appropriate legal, judicial, and accounting frameworks; assigned a broader role to state banks in financing economic activity during crises; reduced currency mismatches; and implemented sounder and more credible monetary and fiscal policies (see above).
These changes showed that it is not necessary to wait for improved international financial regulations (as Basel III, which will be implemented only in 2018) in order for reform-minded and well-managed countries to reap the most benefits from, and minimize the deleterious impact of, financial globalization.
More than financial reforms will be needed, particularly in Central America, to further reduce income inequality over the next ten years. Much can be achieved by intensifying the educational, taxation, public expenditure, labour and macroeconomic reforms described above. In the richer countries of the region, such as Argentina and Brazil, inequality can be reduced by improving the quality and targeting of already high public spending. Besides these measures, it is evident that structural reforms need to be introduced to deal with the deep-seated imbalances and polarization that still affects the region. If left unaddressed, the structural biases of the Latin American economy—a persistent inequality in access to land, credit, and tertiary education; the lack of an industrial policy; commodity dependence and the ‘re-primarization’ of exports and output—may well block future declines in inequality by delaying the shift to a sustainable and equitable long-term growth path. Yet, additional changes are needed also in the field of finance to further strengthen the region’s unprecedented resilience acquired in recent years. This will require raising domestic savings (including by promoting a more egalitarian income distribution) and reducing the dependence on foreign capital, and deepen the gains recently achieved in the regulation of the credit-output nexus.
In a modern market economy, the level of credit is critical in the determination of output and employment. Its effective regulation over the business cycle and the reduction of the pro-cyclicality of lending are thus a central policy task. This can be achieved by explicitly discouraging lending booms and preventing credit crunches by assigning an increased lending role to public banks, and by enforcing stricter countercyclical capital requirements and loan provisioning.
Giovanni Andrea Cornia has taught development economics at the University of Florence since 2000. Prior, he was the Director of UNU-WIDER and Chief Economist of UNICEF. His main areas of interest are macroeconomics, inequality, poverty, political economy, and human development. He is the editor of Falling inequality in Latin America: Policy changes and lessons, and co-editor with Frances Stewart of Towards Human Development: New Approaches to Macroeconomics and Inequality.