While the economic challenges facing Latin America and the Caribbean differ across countries, one theme is common: they should rebuild policy space and be watchful for downside risks. Supportive external conditions facing some countries--abundant and cheap external financing, and favorable commodity prices—may persist for a while, but are likely to dissipate over time, the International Monetary Fund’s latest Regional Economic Outlook for the Western Hemisphere states.

“Conditions remain favorable. The double tailwinds of easy external financial and high commodity prices are likely to persist for a while but not forever,” said Nicolás Eyzaguirre, Director of the IMF’s Western Hemisphere Department at the presentation of the report today in Bogotá, Colombia. “Now, the challenge for many countries is to take advantage of this environment to rebuild buffers, to enhance the resilience and flexibility that has served them so well the last few years,” he continued.

Growth in Latin America and the Caribbean (LAC) continues to be firm despite a slowdown in the second half of 2011 due to tightened policies following the post-crisis rebound and the effect of global uncertainties. The Fund projects that the region will grow at 3.7 percent in 2012, and 4.1 percent in 2013, up modestly from forecasts published in January.

The regional outlook report indicates that near-term risks are still tilted to the downside, and revolve most notably around possible renewed tensions in European markets and an oil price shock. But the report also notes different conditions with the region that imply differing policy challenges.

Different Challenges Across the Hemisphere

South America’s financially integrated economies (Brazil, Chile, Colombia, Peru and Uruguay) grew at an average rate of 5.5 percent in 2011, down from over 6½ percent in 2010. With these countries performing near or above potential, but global risks elevated, their central banks face a challenging balancing act. One the one hand, they will need to stand ready to support liquidity conditions if adverse global shocks materialize, while on the other they need to ensure that monetary policy settings continue to anchor inflation expectations. Meanwhile, macro-prudential measures can help avoid financial excesses in the face of robust credit growth and volatile capital flows. In addition, efforts at fiscal consolidation should step up to grant monetary policy the needed flexibility and to rebuild buffers utilized during the 2009 crisis.

Meanwhile, South America’s less integrated commodity exporters (like Argentina and Bolivia), which have for the most part have been operating above potential, the priority should be to shift away from procyclical policies, to avoid further exacerbating overheating pressures and weakening the balance of payments, the report highlights.

Countries in Central America, which are near potential and have debt-to-GDP ratios above pre-crisis levels, should redouble their efforts to consolidate fiscal positions, while strengthening monetary and prudential frameworks.

Finally, Caribbean countries continue to face sluggish growth in tourism-intensive countries and stubborn fiscal imbalances. The near-term focus should thus remain on working off fiscal overhangs and addressing financial fragilities. Looking further ahead, greater efforts are needed to tackle structural weaknesses to boost competitiveness and growth.

Global Financial Shocks, Spillovers from Brazil and Mexico, and Housing Conditions

The report also features short analytical notes on the effects of global financial shocks, spillovers from Brazil and Mexico within the region, and housing and mortgage markets.

On the first topic, the report notes that sustainable external positions and exchange rate flexibility hold the key for emerging markets, particularly those highly financially integrated, to lessen the adverse effects of global financial shocks on economic activity.

Regarding potential knock–on effects from shocks in Brazil and Mexico, the Fund’s analysis finds that spillovers from these big neighbors are significant for Southern Cone partners (especially Argentina, Paraguay and Uruguay), including through indirect effects related to the amplification of global shocks.

On housing markets, rapidly growing mortgage credit does not appear to pose imminent risks to stability. However, this assessment is hampered by a lack of quality data, which points to an urgent need to close information gaps and strengthen oversight of the housing sector.