A quarterly magazine of the IMF

June 2006, Volume 43, Number 2

What Happened?
Anthony Elson

Why East Asia surged ahead of Latin America and some lessons for economic policy

In 1950, Latin America was the most developed region outside the industrial countries, with an average real GDP per capita more than two and a half times that of East Asia (excluding China and Japan), and about one-fourth that of the United States. By the beginning of the current century, however, this relative position had been reversed: the real GDP per capita of the East Asian region had more than doubled, relative to the United States, whereas that of Latin America had declined (see Table 1).

What accounted for this big shift in fortunes? Clearly, many factors need to be considered, including the differences in countries' initial conditions, such as the impact of culture, historical traditions, and natural endowments. One way of organizing one's thinking is to consider the so-called deep determinants of economic development, which reflect some of the impact of initial conditions and other fundamental factors in the development process: geography (natural endowments, distance from the equator or from major markets), integration (trade and other policy reform), and institutions.

Geography, it turns out, does not significantly differentiate Latin America and East Asia. Both regions contain resource-rich and resource-poor countries; both regions include a roughly similar portion of territory in the tropics; and both are similarly located in relation to major trade markets.

In relation to integration and institutions, a comparison of the recent development experiences of East Asia and Latin America highlights three factors that can account for much of Latin America's lagging economic performance during the second half of the past century: its problems of macroeconomic instability; its low level of integration with the global economy; and the poor quality of its public institutions.

Too much macroeconomic instability

Most of the growth divergence between the two regions occurred in the last quarter of the 20th century. For Latin America as a whole, economic growth was particularly weak during the 1980s—the "lost decade"—when real GDP per capita fell by nearly 1 percent in the wake of adjustments to a regional debt crisis. Average real income picked up in the 1990s but still grew by only 1.9 percent, while the region's open unemployment rate, according to data from the International Labor Organization, rose to 10 percent by the end of the decade. Real income growth was weaker in the second half of the 1990s than for the decade as a whole, and, during 1998–2003, it was zero, although there has been an encouraging recovery since then. By comparison, growth in real GDP in East Asia was about 6 percent a year, on average, during these same periods. In addition, growth has been significantly more volatile in Latin America than in East Asia since 1980.

A comparison of other indicators of macroeconomic performance also reveals dramatic differences between the two regions: domestic savings and investment, trade openness, and financial deepening show substantially higher values for East Asia (see Table 2). A regional comparison of the incidence of extreme poverty (those living on less than $1 a day) and income inequality also shows marked differences, with Latin America exhibiting little or no change in these measures of development from 1980 to 2000.

Underlying these differences was the lack of consistent and stable economic policies in Latin America. The absence of a stable policy environment, with relatively low inflation, competitive exchange rates, and positive real rates of interest, is clearly detrimental to long-run decisions for investment and growth. This principle was enshrined in the "Washington Consensus" of the early 1990s and generally received wide credence among economic officials in Latin America. It has also long been a bedrock for most of the East Asian economies, which, relatively early in their post–World War II development, established a reputation for fiscal prudence, low public debt, and high domestic savings.

By contrast, the record of Latin America, traditionally plagued by fiscal instability and high inflation, has been far weaker. Recently, under the impetus of macroeconomic reforms to improve domestic tax systems and privatize loss-making public enterprises, Latin America has reduced its chronic inflation and improved fiscal performance, but other elements of macroeconomic instability that discouraged productive investment and growth continue to exist (see F&D, December 2005).

Fiscal policy. Average fiscal deficits in relation to GDP were reduced significantly across Latin America in the 1990s, but fiscal policy in many countries continued to be procyclical (exacerbating booms in the upswing, and recessions in the downturn, of the economic cycle) and to depend heavily on external financing. These characteristics intensified growth volatility, especially in the face of highly variable private capital flows (so-called sudden stops), which contributed to capital account crises. The data presented in Table 2 suggest that the variability of capital flows during the past two decades was not substantially different in the two regions. However, East Asia was better equipped to withstand external shocks from unstable capital flows because of the stronger fiscal positions of its governments, low public external debt, and more robust export sectors. The region even recovered relatively quickly from the financial crisis of 1997–98 and has resumed a robust growth trajectory.

More recently, Latin American governments have been able to maintain a more disciplined approach, maintaining high primary surpluses and bringing down public debt. A particularly noteworthy example is Chile, which has now set a high standard for fiscal policy management for emerging market economies with its structural surplus rule.

Financial system stability. During the past two decades, according to World Bank data, Latin America was subject to more systemic banking crises than any other region in the world, except for sub-Saharan Africa. In many cases, these crises were a consequence of boom-bust cycles induced by fiscal instability and sudden stops in private capital flows, but they also reflected poor bank management, especially of state banks, and weak regulatory systems. These crises, in turn, tended to exacerbate the region's public debt problems, as their resolution required government intervention and financial support exceeding, in some cases, 20 percent of GDP.

Financial system instability has also led, over time, to relatively low rates of financial intermediation, widespread substitution of the U.S. dollar in domestic financial transactions, and high interest rates (with large spreads between domestic lending and deposit rates). At the same time, the flow of bank credit to the private sector in most Latin American countries was less than 30 percent of GDP during the second half of the 1990s.

The contrast with East Asia could not be more striking. Typically, in the East Asian economies, financial intermediation ratios (as measured by broad money in relation to GDP) were above 90 percent in the 1990s, and credit flows to the private sector generally exceeded 80 percent of GDP. While East Asia has also had to deal with banking problems (especially in the crisis period of 1997–98), real interest rates have not exhibited the volatility or high levels sustained in many countries of Latin America and have typically been in the single-digit range. Correspondingly, investment ratios have been much higher in East Asia than in Latin America.

Exchange rates. Another aspect of macroeconomic instability that has differentiated the two regions relates to exchange rate behavior. Key elements of the macroeconomic reforms implemented in Latin America since the late 1980s have been a reduction in trade barriers and a move toward more competitive exchange rates. In both respects, Latin America has traditionally lagged behind East Asia. In addition, during the 1990s, exchange rates, in real effective terms, tended to appreciate significantly in Latin America, reversing the course set in the previous decade. To a significant extent, this tendency resulted from the frequent use of the exchange rate as an anchor for achieving domestic price stabilization, especially in the early 1990s. More recently, Latin American countries have shifted toward more flexible regimes, many using inflation targeting as an effective anchor.

Less integrated with the global economy

While Latin America has lagged behind East Asia in establishing the conditions for the macroeconomic stability needed to sustain growth and development, it also fell behind in its integration with the global economy and the competitiveness of its manufactured exports. In 2000, total exports of Latin America represented only 5½ percent of global exports, unchanged from 1980 (see Table 3). Over the same period, exports of East Asia more than doubled from 8 percent to 20 percent. East Asia has also exhibited higher levels of intra-industry trade, as measured by the ratio of merchandise trade to merchandise value added, which reflect its growing participation and specialization within global production chains.

Most of East Asia's growth in intra-industry trade has been in high-technology exports (such as electronic and communications technology components), which have been the category of most rapid growth in world trade. In Latin America, except for Brazil and Mexico, export growth was heavily weighted toward natural resource commodities and low- and medium-technology exports. As a result, whereas East Asia's share of global manufactured exports rose sharply, that for Latin America remained flat. Excluding Mexico, Latin America's share of global manufactured exports was only 2 percent, a rate below that recorded in 1980. In a global economy in which international production systems for commodities such as automobiles, electronics, and garments have become increasingly fragmented across national boundaries and trade in manufactured goods (mostly in the form of intrafirm trade) has risen to 80 percent of total trade, East Asia has benefited far more than Latin America from the gains of global trade patterns.

A key driver in the trade dynamics described above has been foreign direct investment (FDI) by multinational corporations. Not only has East Asia generally received more FDI flows than Latin America but the flows to East Asia have also mostly been channeled into manufacturing, which has fed exports. In Latin America, during 1996–2000, roughly half of FDI flows were related to mergers and acquisitions in connection with the privatization of state-owned utilities and domestic banks. Much of the rest has been directed, particularly in the Southern Cone and Andean countries, to the exploitation of natural resources (mining, oil, and forestry), where restrictions on private and foreign participation have been lifted under the reform effort. In the Caribbean and Central America, countries like Costa Rica and the Dominican Republic have followed the pattern of the Mexican maquila industry in using FDI to support exports to the U.S. market of electronic components and garments, based mainly on imported inputs and enclave production in export processing zones. However, most economies remain more closed than their Asian counterparts. Mexico is the one Latin America country that comes close to the East Asian model in its export drive.

Differences in FDI have also affected technological capacity and intraregional trade. Latin America has not upgraded its technology as fast as East Asia, leading to weaker performance across a range of indicators, such as transport costs; port efficiency; and depth of road, rail, and airfreight facilities. Similarly, tertiary enrollments in science and engineering education and business expenditures on research and development, on average, are well below the regional average for East Asia. Korea, Singapore, and Taiwan Province of China are among the world leaders in these areas.

The dynamism of investment and exports in East Asia has also been enhanced by regional forces (or positive "neighborhood effects"). Intraregional trade has been growing sharply among East Asian countries and, by the end of the past decade, represented about 37 percent of total regional trade; for Latin America, intraregional trade accounted for only about 18 percent of total trade flows. This phenomenon is likely to increase in East Asia with China's increasing dominance as a major world exporter and destination for FDI flows.

Better public institutions needed

Increasingly, institutions are seen as accounting for divergent growth patterns across countries. Analysts have identified three areas in which government institutions have helped underpin growth in East Asia. One is the strong record of policy consistency of governments: policy credibility and political stability, along with a stable macroeconomic environment, have underpinned the promotion of long-term investment in East Asia. A second element is the strong focus on economic development as a strategic national goal. Such a strategic vision projected by national leaders has been especially characteristic of China, Korea, Malaysia, Singapore, and Taiwan Province of China.

Third, the strength and independence of government bureaucracy has also been important to East Asia's economic development and has too often been lacking in Latin America. Asian governments have tended to foster the development of a professional, merit-based civil service tradition, insulated from political influence, to implement economic policy in close consultation with business groups. To streamline decision making, lead government agencies with strong coordinating authority were created to translate a national strategic vision of economic development into specific actions. Singapore's Economic Development Board is a prominent example of such an institution. Singapore has been one of the top-rated countries in the world for the quality of its public institutions, and seven of the East Asian countries surveyed in the World Economic Forum's 2004 Competitiveness Report were in the top half of countries. Most of the Latin American countries were in the bottom half.

Notwithstanding the strength of East Asia's government institutions, the Asian financial crisis revealed how, in certain cases, close coordination between the public and private sectors gave rise to serious problems in corporate governance and regulatory forbearance. This experience showed that certain institutional arrangements that may have been effective at earlier stages of development needed to be adapted and transformed as market-based arrangements expanded more fully.

Despite these problems, the elements of strategic vision, policy consistency, and bureaucratic autonomy in East Asian societies during their postwar development have compensated for the lack of well-developed market-based institutions and legal frameworks that supported economic development in the advanced countries. By the same token, these elements were not particularly prominent in Latin America, where many governments exemplified capture by special interests or were dominated by patron-client-based political parties focused on the distribution of rents to favored elements of society. In respect of bureaucratic strength, there are clear examples (such as Brazil, Chile, and Mexico) of strong ministries of finance and independent central banks that have developed more recently in the region, but a professional civil service tradition has not generally been fostered. Often, government office holding has been a reward for political support of the ruling political party.

Latin America's recent economic record, unlike that of East Asia, is clearly mixed in terms of reform results and benefits gained from globalization. Four key lessons for economic policy can be drawn from these compared experiences.

First, the requirement of macroeconomic stability for sustained economic growth must be viewed as more than simply an issue of maintaining low inflation and fiscal control. The soundness and stability of the financial system is an essential ingredient of the appropriate macroeconomic framework for development. Stable and competitive values for the real exchange rate and domestic real interest rates are critically important as well.

Second, notwithstanding past debates about the relative importance of the state and the market in the development process, governments have a crucial role to play in supporting economic growth through the establishment of good infrastructure, support for technical training and local technology absorption, and the promotion of exports and FDI.

Third, if governments are to play a positive role in the development process, then the integrity of public institutions needs to be ensured. In many countries, this will require continued public sector reform to streamline bureaucracies and establish independent judiciaries, tax and customs authorities, and regulatory agencies. Strong support should also be given to anticorruption initiatives and the development of civil society organizations to strengthen oversight of government activities.

Fourth, the experience of East Asia has shown that institutions are context-specific and need to be adapted over time. In the absence of well-developed legal frameworks for property rights at the beginning of the post–World War II development phase, other arrangements, including close coordination between government and business, clear policy signals, and good public administration, provided the necessary institutional support for productive investment. At later stages of the development process, however, experience has shown that these arrangements needed to be supplemented by appropriate regulatory and governance structures to support an evolving market-based system.