Smaller economies in Latin America and the Caribbean face a bigger inflation challenge


Smaller economies in Latin America and the Caribbean face a bigger inflation challenge




By Emine Boz, Ilan Goldfajn, Jaime Guajardo and
Metodij Hadzi-Vaskov




September 19, 2022











Less diversified economies, greater import dependence and higher public debt make the fight against inflation more difficult


While inflation continues to be high in Latin America and the Caribbean (LAC), the impact on real incomes and purchasing power remains a major challenge, especially for the most vulnerable. We have examined this challenge from the perspective of small economies in LAC by analyzing recent inflation dynamics for three subgroups of small economies: Central America, Panama and the Dominican Republic (CAPDR); the Caribbean; and the small economies of South America — Bolivia, Ecuador, Paraguay and Uruguay.

Our work shows that high inflation is a bigger challenge in small economies because they are less diversified, more import-dependent and have more limited policy levers. The poorest households have been hardest hit and food insecurity is on the rise. Many of these countries have fixed exchange rates and do not have an independent monetary policy. Thus, they had to rely on temporary tax measures, about half of which targeted the most vulnerable. Countries with larger pre-existing subsidies have tended to introduce smaller measures.

Inflation on the rise

In the first half of 2022, inflation hit multi-decade highs in many of these countries. The latest available inflation data for August reveals that annual headline inflation exceeded 9% in CAPDR and 6% in smaller economies in South America. In the Caribbean, it reached almost 6% in March. Core inflation followed similar trends, remaining at levels below headline inflation as it excludes food and energy prices.

Small economies are generally less diversified and more dependent on imports, which makes them more susceptible to inflationary pressures resulting from rising import prices. In addition, food and fuel, both of which have seen sharp price increases since the start of the war in Ukraine, account for a larger share of the consumption basket in these economies.

Smaller economies also have more limited policy levers. They generally have less flexible exchange rate agreements and therefore are less dependent on exchange rate adjustments. Many smaller countries have high public debt and high sovereign spreads, partly a legacy of the COVID-19 pandemic. Faced with higher levels of public debt, smaller economies have more limited fiscal space and policy options.

The poorest are the hardest hit

The current wave of inflation is hurting the poor more given the rapid rise in food prices. Inflation estimates for all income quintiles in the CAPDR show that in recent months the poorest quintiles have faced significantly higher rates of inflation than the wealthiest quintiles. The main driver of this gap was the increase in food prices. These developments could aggravate food insecurity moreover, which had already increased during the pandemic.

Respond to global shocks despite national constraints

Many countries around the world have implemented measures to mitigate the impact of rising global energy and food prices on the national economy, especially after the start of the war in Ukraine. To assess the magnitude of these measures, we estimate the response of domestic fuel prices to a 1% change in the international fuel price – the to cross from international prices to domestic fuel prices. We find that the pass-through of international prices to domestic fuel prices declined by about 1 before the war (i.e. domestic prices moved almost at the same rate as international prices on average over the period 2015-2021) to about 0.8 after the start of the war. the war. A similar decline was observed in the pass-through of international prices to domestic fuel prices in smaller LAC countries.

Several constraints have shaped policy responses. Many small economies in LAC have a fixed currency and therefore less policy flexibility to deal with the impact of the price shock. Only a few of these economies raised their policy rates to contain second-round effects and keep inflation expectations anchored. To mitigate the impact of rising global energy and food prices, they implemented discretionary fiscal policy measures, most of which were announced as temporary and about half targeted the most vulnerable.

The size of the fiscal measures has varied across economies – they have been larger for economies where food and transportation weigh more heavily in their consumer price index (CPI) basket, weaker social safety nets or lower per capita income.

Examining the new measures and their costs provides a partial picture, as some countries had already implemented significant food and fuel subsidies. When comparing existing energy or food subsidies with the cost of new measures, we see that countries with larger pre-existing subsidies tend to introduce smaller measures.

Preparing for a possibly more persistent inflationary shock

Policymakers need to be prepared for a possible long-lasting inflationary shock. Given the uncertainty surrounding the intensity and duration of the shock, the following general principles can help policymakers weather these turbulent times: (i) domestic prices should adjust to international prices, while providing support targeted and temporary to the most vulnerable; (ii) if targeted measures are not feasible, price smoothing mechanisms with clear exit strategies could help while social safety nets are strengthened; and (iii) consider offsetting revenue or expenditure measures to limit the overall fiscal impact.

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Emine Boz is Deputy Director of the Western Hemisphere Department.
Ilan Goldfajn is director of the Western Hemisphere Department.
Jaime Guajardo is Deputy Division Chief in the Western Hemisphere Department.
Metodij Hadzi-Vaskov is the Regional Resident Representative for Central America, Panama and the Dominican Republic.



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