Update Country Report Curaçao 29 Dec 2016

2017 should be a better year for Latin America and the Caribbean than 2016, as the region emerges from recession. But political and economic challenges abound. As the region gears up for a busy electoral period in 2018, governments will be under pressure to produce results on the economic front, in the form of faster growth, and on the political front, by tackling the problem of corruption that has dominated the headlines in the past year.

Difficult economic conditions in much of Latin America and the Caribbean have produced serious political and policy challenges in the past year. Progress on poverty reduction, which made rapid strides during the commodity boom, has stalled. Despite recent improvements, income inequality remains higher than in any other region in the world.

Meeting expectations, tackling corruption

In much of the region, weak economic conditions have proved a trigger to a political shift from the left to the right of the political spectrum as voters have moved away from populism as a perceived solution to economic and social ills. Centre-right governments in the region are pressing forward with policy reforms centred on macroeconomic adjustment and improvements to the business environment that should, combined with better external conditions, produce stronger economic growth and bolster private consumption. But these improvements will be slow to emerge in 2017, and governments will be under pressure to produce results next year, ahead of a busy electoral period for the region in 2018.

A key source of frustration and unrest in the region in 2017 will come from the failure of governments to bolster institutions and combat corruption. Institutions remain weak in most countries, leading to continued governmental inefficiency and lax public governance. Engagement with politics and political organisations is low, amid weak confidence in government and the perception that public institutions are corrupt and unaccountable. In this environment, protests related to perceived corruption have erupted in many countries in the region in recent years, including Mexico, Chile, Peru and Guatemala.

But the threat to political stability posed by corruption has perhaps been most evident in Brazil, amid a huge kickback and party-financing corruption scandal at Petróleo Brasileiro (Petrobras, the state-controlled oil company). Dilma Rousseff, who was elected for a second term as president in 2014, was not directly implicated in the Petrobras scandal, but, amid plummeting public support, was impeached on other grounds and removed from office in August 2016. Her successor, Michel Temer, is in a precarious political position, with uncertain congressional backing for economic reforms and low levels of voter support. Meanwhile, investigations into the Petrobras scandal continue, and there is a risk that more cabinet ministers-or the president himself-will be damaged by fallout from ongoing investigations.

Even in countries that remain relatively immune to the risk of significant unrest, political effectiveness will remain weak, given the presence of minority governments and unstable coalitions in many countries in the region. Combined with a lack of political will, this will result in piecemeal and slow progress in the adoption of structural reforms needed to bolster the region's competitiveness.

Trade on the agenda

Latin America's Pacific Rim countries will continue to promote regional integration in 2017 as a means of boosting trade, investment and growth. Following changes of government in Argentina and Brazil, they are being joined in this effort by members of the Mercado Común del Sur (Mercosur, the Southern Cone customs union). The Alianza del Pacífico (Pacific Alliance, an ambitious trade bloc whose founding members include Chile, Colombia, Peru and Mexico) has been holding discussions for a potential medium-term integration agreement with Mercosur, which may eventually contribute to a broadening of free trade throughout Latin America. However, negotiations on such a deal will be lengthy and a deal is not on the cards for 2017. The expansion of the Alianza del Pacífico is likely to happen more quickly. Costa Rica, Panama and Guatemala are likely to become full members in the short term, and many other countries in the region have also expressed an interest in joining the grouping.

Latin America's efforts to increase regional integration lie in stark contrast to a growing protectionist trend evident in the US and Europe, which will complicate the agenda of Latin America's increasingly pro-free-trade governments. Efforts on the part of Mercosur member states to push forward with talks on an EU-Mercosur free-trade agreement are, for example, likely to founder in 2017 as EU governments grapple with a period of deep political change and negotiations over the UK's exit from the EU ("Brexit"). Efforts by Pacific Alliance members to advance trade liberalisation with the rest of the world have also suffered a setback in the aftermath of the US presidential election in November 2016. The president-elect, Donald Trump, quickly confirmed that he would withdraw the US from the Trans-Pacific Partnership (TPP), a free-trade deal bringing together 12 countries in the Asia-Pacific region, including Mexico, Peru and Chile, along with the US and Japan, that jointly account for over one-third of global economic output.

Latin American signatories will certainly be disappointed with the demise of the TPP agreement, but they-and other countries in the region-will move quickly to deepen trade ties with China. Latin America's growing strategic importance to China was evident in the visit of the latter's president, Xi Jinping, to the region in the immediate aftermath of the US election in November-his third visit to Latin America since taking office in 2013. China now appears open to the possibility of expanding its (currently extremely limited) array of free-trade deals in Latin America. For Latin America, deeper trade links will certainly be a priority, but trade and investment diversification will be equally important.

Uncertainty over relations with the US persists

Whereas ties with China look set to continue to deepen, the nature of relations between the region and the US appears to be at a crossroads, with Mr Trump's election in November raising risks of a dismantling of the economic linkages and goodwill that increasingly characterise the US-Latin America relationship. Two of the main themes of Mr Trump's campaign-trade and immigration-are likely to dominate the hemispheric agenda. Mexico-for which the US is the main trading partner-will be hardest hit by Mr Trump's policy direction. Owing largely to the North American Free-Trade Agreement (NAFTA), economic linkages between the two countries are tight, with cross-border supply chains having been built up over many years. The effects on Mexico will depend, however, on the extent to which Mr Trump pursues his protectionist agenda. The US president-elect has threatened to intensify the pace of deportations of illegal immigrants and has also threatened to renegotiate NAFTA-the centrepiece of US-Mexico economic ties. Our baseline forecasts for Mexico are predicated on the expectation that the ramifications of Mr Trump's victory on trade are ultimately limited, but uncertainty over US policy will nevertheless dampen Mexico's growth outlook for 2017 at least.

Besides Mexico, the other Latin American country exposed to a significant policy shift under a Trump presidency is Cuba. During his election campaign, Mr Trump derided the rapprochement with Cuba initiated by the current president, Barack Obama, and said that the US should strike a "better deal". Despite Mr Trump's statements on Cuba, we believe it unlikely that he will completely reverse Mr Obama's policies. Diplomatic relations have been restored and US businesses have already made investment plans for eventual entry into the Cuban market. US air carriers began direct flights to the country this year, and other US firms in the travel and tourism industry have entered the market. US businesses have also lobbied for an end to the embargo, and public sentiment in favour of its lifting is growing. Hence, any rollback would generate little political gain for the new president. Nevertheless, we do not envisage further progress towards normalising relations or a lifting of the embargo in the next few years, and certainly not as long as Raúl Castro remains Cuba's president. Mr Castro is set to step down in 2018.

A turning point for the regional economy

Although the region's terms of trade have stabilised, for many of Latin America's major economies 2016 has been a year of continued macroeconomic policy adjustment to the end of the commodities boom of the past decade. The scope and pace of this adjustment has varied among the region's commodity producers, contributing to a heterogeneous growth outlook within the region. Nonetheless, we expect that for many countries the adjustment process will be coming to or nearing an end in 2017. With some notable exceptions, including Mexico, many countries in the region are shifting to a monetary easing stance as inflation expectations subside. At the same time, a projected pick-up in fiscal revenue, reflecting a moderate recovery in oil prices, will bolster revenue and ease pressure for fiscal tightening (with some notable exceptions, including Brazil, where fiscal adjustment is far from complete). This shift away from procyclical macroeconomic policy tightening will be supportive of growth in 2017.

However, Latin America's long downturn has highlighted enduring structural weaknesses in the region, including persistent commodity dependence and weak productivity. Tackling these problems will require a broad range of structural reforms in areas such as the labour market and regulatory and tax systems. A political shift in many countries in the region over recent years away from populism and towards more orthodox policymaking is likely to put such reforms back on the policy agenda in 2017. However, reflecting institutional deficiencies, weak implementation capacity and political fragmentation, we remain fairly pessimistic about progress in these areas in the next year.

Monetary easing on the cards

We continue to see scope for monetary easing in many of Latin America's larger economies in the next year, although Mr Trump's surprise election victory in the US will present challenges to monetary policymakers in the region, if expectations of firmer US growth lead to higher US rates, a stronger US dollar and increased depreciatory pressure on emerging-market currencies. A number of Latin America's larger economies have shifted to a loosening stance already this year, including Brazil and Argentina. In both of these economies, nominal rates are high, economic activity remains weak and inflation expectations are trending downwards. Argentina has lowered rates steadily, to below 25% in December, after increasing them sharply, to almost 40%, at the start of the year; in Brazil, the target Selic rate was lowered for the first time in four years in October, by 25 basis points, marking the start of an easing cycle that we expect to extend to the end of 2017 and possibly beyond.

In Peru, Colombia and Chile, three of the region's other main economies with inflation-targeting regimes, inflation expectations are again trending down after a period of monetary tightening that began in late 2015, and there is some scope for modest easing next year. Colombia cut rates by 25 basis points in December, to 7.5%, and we expect further cuts in the next year. We also expect monetary easing in Chile, but are less sanguine about the prospect for cuts in Peru, considering that GDP growth remains relatively firm and that the monetary authority will be concerned over the potential for pass-through from any renewed currency depreciation pressures in the event of higher than expected US interest rates. In all of these economies, in fact, the monetary authorities will remain sensitive to supply-side price pressures, reflecting their hard-won reputation for macroeconomic stability, and there are substantial risks to our monetary policy forecast for 2017.

Mexico represents an exception to our monetary policy outlook. We expect the Banco de México (Banxico, the central bank) to remain focused on defending the peso in order to calm nervous markets, which are increasingly taking a negative view of the country's economic prospects in the light of uncertainty over US-Mexico relations during Mr Trump's tenure. In December Banxico raised the policy rate by 50 basis points for the fifth time this year, to 3.25%, in response to growing inflationary pressures and a rise in US interest rates in the same month. We expect further tightening in the medium term (notwithstanding some temporary loosening in 2019, in response to a forecast US slowdown).