How can Latin America overcome its dependence on commodities?

The effects of a precipitous drop in global oil, gas and mineral prices have shone a spotlight on the problems faced by countries across Latin America and the Caribbean that are overdependent on commodities. Some countries are bearing the fiscal and monetary shock better than others, but the pervasive uncertainty and macroeconomic impact of over-reliance threatens the progress of much-needed reforms aimed at strengthening these economies. Price-shock induced changes have profound macroeconomic and socio-economic impacts, but they also present a unique opportunity to break free from the trap of natural abundance and set the economy on a more diverse and productive path.

Take fiscal and budget policy as an example. Brazil, Mexico, Chile, Colombia, Trinidad and Tobago, Peru, Ecuador, Venezuela and Bolivia  – which collectively draw a third of their income from these commodities – all face increasing macroeconomic challenges as a result of a softening of the commodity market. Mexico has slashed its 2015 budget by $8.4billion, and the much-anticipated energy reforms that opened the market to the private sector are expected to attract lower bids. The Colombian government has also cut its budget and passed tax reform to extend duties aimed at propping up revenues. Trinidad and Tobago and Ecuador have followed suit with similar adjustments to national budgets. Brazil is likely to have challenges in maintaining the scale of investments in its pre-salt oil reserves, and the viability of other planned projects across the region will come into question.

Diversification: easier said than done

Diversification is the obvious answer. Other industries cannot just step up when extractive industries falter, because extractive industries tend to attract a disproportionate amount of human and financial resources, crowding out other, perhaps more sustainable, sectors. Policy-makers must get the best assessments available on their country’s competitive advantages (geographic, industrial, human capital, etc.), then identify which sectors present real growth potential, and attract investment to them by developing the right policies and actively courting investors.

But that’s easier said than done in commodity-driven economies. It often requires a level of cross-government and inter-agency coordination that most administrations struggle with. Diversification is also harder in boom times, yet this is exactly when decision-makers should embrace targeted investments to soften the impact during busts, making sure those investments are converted into productive platforms for growth.

Sovereign wealth funds: an underappreciated tool

Sovereign wealth funds (SWFs) have emerged as another important but underutilized tool for commodity-driven economies to stabilize their long-term macroeconomic fundamentals. SWFs have been around for decades, yet only four countries in the region have embraced the concept of commodity-based SWFs. Beyond stabilization, SWFs provide a mechanism for intra-generational wealth transfer by investing assets externally, and in some cases even domestically. The advantages of an SWF are only realized, however, if institutions are built around it to ensure proper oversight and management.  Otherwise, SWFs can actually add complexity and opacity to the management of natural resource revenues.

The fund should be treated the same way countries typically treat central banks, with independent governance protected and enshrined in law. Other best practices include transparency in reporting, removal of opportunities for political interference, and clearly defined rules for contributions and withdrawals to ensure they are used exclusively for investments that elicit a return or encourage measureable growth. Chile’s Economic and Social Stabilization Fund (ESSF), put in place to save large surpluses from high copper prices, and Trinidad and Tobago’s Heritage and Stabilization Fund both receive high transparency ratings. Other countries should take note.

Integrating the informal sector

Effectively managing commodity cyclicality and promoting sustainable growth also means that policy-makers from the region must address tax policies and inefficiencies. Governments in the region currently collect taxes from just over half of the active economy, with an estimated 47% of GDP output coming from the informal sector.

Appeals to civic obligations and attempts at enforcement can only go so far.  Experience shows that workers and businesses must be drawn into the formal sector. And there are real benefits: the ability to make and enforce contracts, legal ownership of operations and assets, membership to trade associations, and tax incentives for business development. To make the formal economy an attractive option, it’s also important to cut the red tape for registering a business, obtaining licenses and remitting taxes. Brazil and Uruguay pushed through reforms that have led to 14% and 15% drops in total informal workers, respectively, over the past 10 years.

Accelerating reforms

Beyond slashing fiscal spending temporarily, and scaling back on non-essential projects, there are other measures that policy-makers should explore now to better position their economies for the future. The IMF found that energy subsidies for the average country in the region cost about 1.8% of annual GDP in 2011-13 (about 1% of GDP for fuel and 0.8% of GDP for electricity).

With falling oil prices, governments now have an opportunity to scale back these subsidies. Policy-makers in commodity-driven countries in the region also need to accelerate public sector reforms that aim to drive efficiency and boost service levels, while realizing savings. Procurement reform, improved spending controls that seek to reduce cost overruns, and partnerships with the private sector to deliver public goods and services more effectively are some of the areas that should be considered.

Abundant natural resources can be a competitive advantage, but they can produce unintended negative economic consequences owing to regular cycles of booms and busts. Policy-makers have a window of opportunity to take corrective measures. They should prioritize economic reforms aimed at breaking the over-reliance on commodity wealth and positioning their economies to withstand other seismic cyclical shifts, which will surely continue into the future. Many countries have in fact started down this path, but more urgency is needed.

The World Economic Forum on Latin America 2015 takes place in Riviera Maya, Mexico, from 6-8 May.

Author: Jack Campbell, Regional Director of Latin America for Marsh & McLennan Companies’ Strategic Solutions Group, based in Mexico City. Avinash Boodoosingh, Director, Strategic Solutions Group, Marsh & McLennan Companies

 Image: A port worker checks a shipment of copper that is to be exported to Asia, in Valparaiso port, northwest of Santiago, January 25, 2015. REUTERS/Rodrigo Garrido