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Shaking Up Economic Progress: Aggregate Shocks in Latin America and the Caribbean

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World Bank
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Javier E. Báez, Alan Fuchs, Carlos Rodríguez-Castelán

1. Executive Summary

The region has made impressive strides in the struggle against poverty and income inequality The Latin America and Caribbean region has achieved remarkable economic and social progress over the last decade, gradually shifting toward middle-income status.

Economic growth reached an average annual rate of 3.2 percent over 2000–14, noticeably higher than in previous decades. This favorable context contributed to significant poverty reduction and expansion of the middle class. The proportion of the region’s 600 million people living in extreme poverty, defined in the region as life on less than $2.50 a day, was cut in half between 2003 and 2012, to 12.3 percent. Similarly, the share of Latin Americans living in moderate poverty, corresponding to living on less than $4.00 a day, fell from 41.1 percent to 25.3 percent. Since 2011, there have been more Latin Americans in the middle class than in poverty, and the middle class is projected to become the largest group in the region (World Bank 2014a). The gains attained span other areas of human development such as increased access to basic services and lower child and maternal mortality.

But the gains are not assured partly because of substantial exposure and vulnerability to multiple shocks While a significant share of households moved upward in socioeconomic class, the largest group of the population remained vulnerable to poverty. Many Latin Americans escaped poverty buoyed by more than a decade of strong economic growth and inequality reduction. However, most of the new nonpoor did not move directly to the middle class, but continued to be vulnerable, facing economic insecurity and likely to experience spells of poverty in the future.1 Nearly 4 households in 10 in the region belong to this group, making it the largest socioeconomic class. Owing to their substantial vulnerability, many of these households may be one shock away from sliding back into poverty.

The substantial vulnerability is compounded by exposure to a numerous shocks that affect the region, particularly natural hazards. The incidence of these phenomena grew threefold regionally and globally between 1970 and 2014. Extreme rainfall and drought are a near-constant threat across the region. Of every 10 natural events recorded in the region, 7 arise because of storms and floods (Holt 2014). In the Caribbean, at least one country—and often more than one—is hit by a strong hurricane or cyclone every year. The dry corridor, a region of dry tropical forests in Central America spanning parts of Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, and Panama, is regularly affected by recurrent droughts that endanger crops, livestock, and food security. The Andean and Central American countries are within the Ring of Fire, a string of volcanoes and sites of seismic activity in the Pacific Ocean that accounts for roughly 90 percent of the world’s earthquakes and more than 75 percent of the world’s active and dormant volcanoes. Over a quarter of all earthquakes of magnitude 8.0 or higher occur in western South America.

The region must also address major economic and social risks. A more restrictive macroprudential regulatory framework across most countries has made them more resilient to economic downturns. Yet, the region is edging toward a new equilibrium of lower growth, coupled with a rise in current account deficits and greater exposure to other external factors. Crime and violence continue to top the list of challenges in many countries; the incidence of crime is comparable with the rates recorded in war-torn countries. An individual born in Caracas, San Salvador, or Tegucigalpa—the three most violent large cities in the region—has about one chance in eight of being murdered during his lifetime. Parts of the region show a proliferation of violent youth gangs, drug trafficking, money laundering, and domestic violence, whereas other parts have endured civil conflict and unrest. Infectious disease and viruses thrive in warm and humid conditions such as those in the tropics, which span most countries in the region. Major epidemics such as Chikungunya and Zika are a serious risk to public health.

Aggregate shocks often signify income shocks Large natural and man-made shocks undermine economic expansion and household incomes. The first manifestation of a major negative shock at the macro level is typically a drop in output. Gross domestic product (GDP) fell by 6 percent and 11 percent during the crises that hit Mexico (1994–95) and Argentina (2001–02), respectively. At the micro level, household incomes in the region are equally likely to experience hefty declines in the aftermath of major shocks. Hurricanes in Central America cut household incomes by 3 percent for each standard deviation in the intensity of the hurricane windstorm (Ishizawa and Miranda 2016). Similarly, two earthquakes that struck El Salvador in 2001 reduced a third of the preshock median per capita income of households in areas exposed to the strongest ground shaking (Báez and Santos 2009).

Income reductions caused by aggregate shocks may persist Some households recover quickly following aggregate shocks, but recovery may take much longer among many other households, particularly the poor and vulnerable. Access to well-functioning credit and insurance markets, as well as savings, liquid assets, and informal risk-sharing mechanisms such as private transfers and community-based financial systems position households to withstand the negative income effects of major shocks. This is often not the case among the poor and vulnerable, who may be obliged to undertake a shift to a lower equilibrium of welfare and income growth. In Honduras, for example, two and half years after Hurricane Mitch (1998) had ravaged Central America, evidence shows that wealthier households were able to bounce back quickly, but less well off households went on a downward trajectory of sustained asset depletion and low income growth (Carter et al. 2005).

Income reductions translate into consumption shortfalls and greater vulnerability to poverty Income risks help determine consumption, especially among vulnerable, low-income households. Incomplete insurance means vulnerable households manage to protect their consumption only partially from the negative income shocks caused by major hazards.

Plentiful evidence shows that consumption (including basic expenditures) tends to fall in households and communities affected by natural disasters. Median per capita consumption fell by 7.7 percent in households affected by Agatha, a major tropical storm that hit Guatemala in 2010 (Báez et al. 2016). Man-made shocks potentially lead to similar outcomes. Households that were obliged to move from conflict zones in Colombia suffered a 22 percent decline in consumption, affecting their food and calorie intake (Ibáñez and Moya 2006). Moreover, transient impacts on consumption can become chronic. Panel data on rural families in El Salvador show lower consumption growth between 1995 and 2001 among less well off households that had dealt with substantial income shocks (RodríguezMeza and González-Vega 2004).

Because of consumption volatility, vulnerable households may be a disaster away from falling below the poverty line or sliding further back into poverty. If insurance and risk management are lacking or incomplete, income or consumption declines caused by major shocks push some households into poverty or deepen the levels of deprivation among the poor. Poverty rates rose by 5.5 percentage points in areas of Guatemala flooded by Agatha (2010), equivalent to nearly 80,000 more families falling below the poverty line (Báez et al. 2016). In 2003–04, the Dominican Republic experienced a bank collapse, rapid currency depreciation, and inflation, which hastened a domestic crisis that led to economic contraction. The poverty rate soared from 32 percent in 2002 to over 50 percent at the peak of the crisis (World Bank 2014b).

The significant vulnerability is influenced by the enduring negative effects of shocks on current asset stocks and future asset accumulation Major shocks reduce asset ownership. Human capital is particularly sensitive. Natural disasters, civil conflict, and widespread epidemics result in human casualties, leaving negative human capital impacts in their wake. The 2010 earthquake that struck Haiti caused close to 250,000 fatalities. Colombia’s internal conflict, lasting for over 50 years, has claimed a similar number of lives. In addition to human casualties, these events often result in the destruction of the infrastructure required for the acquisition of human capital, such as schools, hospitals, and clinics. Likewise, shocks destroy private property (housing, machinery, crops and livestock), other critical public infrastructure (roads and bridges), and natural capital. Hurricane Mitch (1998) decimated over 80,000 hectares of agricultural land, the large majority of which was used by small farmholders for subsistence agriculture (Ishizawa and Miranda 2016).

Shocks also undermine investments in assets. Major shocks can pose a financial burden on households, often forcing them to cut back on food and health care expenditures, thereby raising the risk of malnutrition and other negative effects on health. For example, Nicaraguan children ages 0–5 in households located in the path of Hurricane Mitch (1998) were 30 percent less likely than children in unaffected parts of the country to be taken for medical consultation after the shock (Báez and Santos 2007). Households may also need to pull their children out of school to benefit from the extra labor, but at the cost of lower human capital. Once Mexican children are withdrawn from school in response to large shocks, they become nearly 30 percent less likely to reenroll relative to children who stay in school (Sadoulet et al. 2004).

Not everyone’s assets are affected equally—the poor and the vulnerable often bear the greater burden Aggregate shocks affect broad economic and social systems, but their impacts on assets, groups, and communities are not evenly distributed. The earthquakes that struck Chile and Haiti in 2010 were of similar magnitude, but were associated with starkly contrasting outcomes: 525 people were killed in the former case compared with over 200,000 in the latter. The variations in impact are determined by the circumstances of the affected population, such as gender equality, geographical location, educational attainment, and type of job. In Mexico, the poor are almost three times more likely than the vulnerable or the middle class to be affected by a natural disaster that results in loss of dwellings, crops, and livestock (de la Fuente, Ortiz-Juárez, and RodríguezCastelán 2017).

Shocks undermine the incentive to use factors of production optimally The supply of labor is sensitive to major shocks, at times increasing and at times declining. Aggregate shocks destroy household wealth and assets, reducing the income opportunities that can be generated from wealth and assets. They change prices and thus relative wages. In an effort to protect private expenditures or prevent expenditures from falling below subsistence needs, affected individuals may respond by supplying extra labor.

Households in northern Colombia, for example, attempted to cope with extreme flooding that struck the country in 2010 by boosting their labor participation (Acevedo 2016). In contrast, unfavorable economic circumstances or major health setbacks can result in less labor supply in the market. Forced migration, a typical risk mitigation strategy, imposes high costs on populations by unsettling their engagement in labor and other markets. Over half the household heads internally displaced by the conflict in Colombia were unemployed three months after settlement at destination sites (Ibáñez and Moya 2006).

Households often rely on the labor of their children to cope with shocks, and this comes at a cost: lower human capital and productivity. Children represent a buffer, particularly among resource-constrained households. In tough times, households are often forced to resort to the labor of their children, who can contribute to income or free up time for adults. However, children’s work entails long-run costs as it often interferes with the human capital accumulation of the children and leads to reduced earnings potential. For instance, Brazilian children, particularly girls, were more likely to abandon school and enter the labor force during several of the economic slowdowns recorded in the 1980s and 1990s. Once out of school, they became 10 percentage points less likely to progress across grades later on, offsetting short-term smoothing gains with long-term losses in human capital (Duryea, Lam, and Levison 2007).

Major shocks disrupt job creation, reducing the demand for labor. Large natural disasters or civil conflicts do more than wipe out homes. They decimate local economies, thereby distressing businesses, supply chains, and markets. Close to 100,000 jobs were lost in Chile after the 2010 earthquake, pushing up the unemployment rate by 1 percentage point. Economic recessions lead to a slowdown in output, a slump in consumer spending, and a reduction in investments in capital and the expansion of credit. As this broad-spectrum aggregate supply slowdown unfolds, firms are likely to freeze hiring and lay off employees, which ultimately results in lower demand for labor, higher unemployment, and diminished job quality. The global financial crisis of 2008–09 raised unemployment rates in Mexico by more than 50 percent (Freije, LópezAcevedo, and Rodríguez-Oreggia 2011).

Uninsured risk pushes households to use productive assets inefficiently and forgo significant returns. Credit- and insurance-constrained, risk-averse households are inclined to mitigate ex ante the effects of shocks by making conservative employment and production choices. Thus, fertilizers or enhanced seeds that boost crop productivity and raise expected profits are typically used less intensively by risk-prone households for fear of incurring investment losses if shocks result in poor harvests. Vulnerable households selfinsure by diversifying toward portfolios with safer, but less profitable activities. Farmers in the Peruvian district of Cuyocuyo, for instance, diversify their crops spatially by working on smaller fields rather than on a more efficient, consolidated plot. However, this diminishes the overall yields by 7 percent (Goland 1993). Likewise, evidence shows that risk-reduction income diversification strategies among vulnerable households often translate into lack of specialization, small scale, informality, and even little income smoothing (the tactic of leveling expenditures across income highs and lows, that is, saving in good times to be able to spend normally in bad times).

Efficiency and equity losses linked to inadequate insurance, protection, and coping justify government intervention Many of the negative impacts and development setbacks that arise from shocks are the result of inadequate risk management. Households follow multiple strategies to manage risk, but these are only partially effective. Inadequate risk management discourages households from taking on the risks that are encountered in pursuing economic gain, undermining income generation. Income- and asset-based strategies to self-insure smooth incomes, but also skew them, clustering households into low-return, low-risk activities. The poor functioning of asset markets constrains the access to alternative economic activities and depresses asset values if these are liquidated during a crisis. Informal risk-sharing mechanisms are prone to collapse if aggregate shocks occur. The welfare losses caused by these inefficiencies are not trivial. In addition, because the shocks tend to affect the poor and vulnerable disproportionally owing to a combination of greater exposure, weaker internal conditions, and unsatisfactory risk management, the resulting equity losses are equally large. The costs of inaction are substantial.

Risk management policy needs to address four objectives to help households effectively prepare for and cope with shocks. World Development Report 2014 argues that preparing for aggregate shocks involves three of the objectives: (1) gaining knowledge to understand the shocks, conditions, and potential outcomes, thereby reducing the uncertainties faced by people, societies, and countries; (2) building protection to reduce the probability and size of losses, while increasing the chances and size of positive outcomes; and (3) acquiring insurance to transfer resources. Successfully coping with aggregate shocks ex post is covered in the fourth objective: (4) applying proven coping mechanisms to recover from the losses inflicted by the shocks.

Strengthening the preparation and coping aspects of risk management requires policy actions on five main fronts, paying special attention to efficiency and equity considerations:

1 Address market failures and the underprovision of public goods. A major factor explaining suboptimal risk management is the lack of critical markets for credit, insurance, and jobs. These markets may exist, but fail to develop completely. Better financial inclusion contributes directly to faster recovery after a disaster, while also supporting asset diversification, which reduces vulnerability. Basic services and public goods that are essential in managing risks such as safe water and sanitation, education, key infrastructure, weather warning systems, economic and political stability, and the rule of law are often missing or substandard.

2 Internalize social and economic externalities. Economic activities adopted by some agents, including risk management strategies, can impose costs on others. Lack of land-use and building regulations can lead to infrastructure development in unsafe places under unsafe construction codes. Free-riding among agents who benefit from risk prevention or mitigation without contributing to the costs likely discourages risk management. Regulatory policies that enable collective action and help internalize relevant externalities need to be adopted.

3 Reform weak government incentives. Intertemporal political incentives are an impediment to adequate risk management. Risk preparation requires investment, often costly, that potentially yields discernible returns only in the medium and long term. Governments prefer to devote resources to policies and programs that produce gains in the short term even if the gains are smaller or to rely on international aid, which translates into a widespread inability to prepare for crises before they occur.
Addressing these failures requires the development ex ante of coordinated plans for postdisaster action and agreements on standby financing.

4 Deal with the lack of resources and information. Investments in risk management infrastructure and technology usually involve large upfront costs. Households and governments on tight budgets may favor current expenditures over investments in risk reduction and mitigation. Lack of information on the relevant risks and on the benefits of risk management constrains the ability of public and private agents to price risks, undermining public and private efforts to insure against shocks and provide compensation at actuarially fair rates. An option is to leverage private resources and official development assistance for large, better investments in resilience. 5 Develop and strengthen rapidly scalable social protection. Households cannot be fully insured against every type of shock. Ex post mechanisms such as social transfers are necessary to ensure a minimally acceptable standard of living, especially among the poor. Adaptive and scalable social protection can provide this type of insurance during a crisis by increasing the amount transferred to beneficiaries, relaxing eligibility rules and conditionalities, extending coverage to new beneficiaries, or creating a new program. Latin America and the Caribbean has succeeded in building safety nets to alleviate poverty. It is now time to use them to enhance the resilience of nonpoor households that face a substantial risk to slide back into poverty if struck by a shock.