A quarterly magazine of the IMF

December 2005, Volume 42, Number 4

Stuck in a Rut
Jaime Saavedra and Omar S. Arias

Avenues for combating persistent poverty and inequality in Latin America

After going through bouts of crisis or economic slowdown in the late 1990s and early 2000s, Latin America now enjoys brighter economic prospects and an ongoing recovery. But poverty and income inequality remain stubbornly high and deep-rooted. While the region overall is on track to meet the Millennium Development Goals (MDGs) relating to human development—being ahead of other regions in terms of child mortality, access to safe water, and gender equity in education—it lags behind on achieving the poverty goal (together with sub-Saharan Africa). Indeed, the World Bank estimates that Latin America is at risk of falling short (by 1 percentage point) of meeting the MDG of halving the 1990 level of poverty by 2015.

Exactly how big is the poverty problem? How come more progress has not been made? And what can be done to turn the situation around? This article explores these questions, suggesting that the key to reducing poverty in Latin America, a region of half a billion people, is to create a level playing field—providing the poor with the opportunities to improve their living standards through access to education, health, infrastructure, and financial services. Improving the access of the poor to assets and services will help them share in, and contribute to, economic growth.

A snapshot of the problem

Poverty measurement is a challenge for analysts and policymakers. International organizations use purchasing power parity (or PPP) figures, as these facilitate international comparisons. Using a level of $1 PPP a day, the World Bank estimates that extreme poverty in the region declined from 11.3 percent in 1990 to 9.5 percent in 2001—although, because of population growth, the number of people living on $1 a day stayed at 50 million during that period (see table). For more recent years, preliminary estimates show a slight increase in the poverty rate. But based on a benchmark of $2 PPP a day, the region has not made much of a dent in poverty. The World Bank estimates that poverty has held at around 25 percent of the population since the mid-1990s. And because of population growth, the number of poor actually increased to around 128 million in the early 2000s.

Yet analysts and regional organizations frequently quote poverty levels in Latin America and the Caribbean that are much higher. That is because countries adopt their own national poverty lines to take account of both domestic economic and social conditions and their own standard of well-being. These national lines are not strictly comparable across countries, but they do enable governments to track progress and determine the number of people who could potentially benefit from poverty alleviation policies according to country-specific living standards.

Using national poverty lines (based on data from the Socio-Economic Database for Latin America and the Caribbean), poverty affects 39 percent of Latin Americans, meaning that more than 200 million lack incomes sufficient to cover basic food and nonfood expenditures. As for extreme poverty—which attempts to measure the inability to pay for a food basket of minimum caloric intake—the rate dropped slightly from 22.5 percent in the early 1990s to 18.6 percent in the early 2000s, with the actual number of people living in extreme poverty now standing at around 96 million.

Moreover, the regional averages hide considerable differences in the levels and trends among countries. For example, according to national poverty data, the poverty rate ranges from above 60 percent in Bolivia and Honduras to below 30 percent in Chile and Uruguay. Moreover, even within countries, these rates vary significantly, especially along ethnic lines (see "Latin America's Indigenous Peoples" on page 23). In Mexico, recent data show that 90 percent of the indigenous population live below the national poverty line compared to 47 percent for the non-indigenous population. In Guatemala, these figures are 74 percent and 38 percent, respectively. And in Brazil, poverty among the Afro-descendants is 41 percent compared to 17 percent among the whites.

Accounting for the high poverty rate

Why has poverty remained so high? First, economic growth has been insufficient. It is well documented that sustained poverty reduction is closely associated with economic growth, but the region achieved a lukewarm 1 percent per capita growth rate over the past 15 years. Moreover, the responsiveness of the incomes of the poor to that growth (known as poverty-growth elasticity) can vary greatly. One factor that feeds into the degree of responsiveness is the level of inequality, and in the case of Latin America, inequality of incomes is extremely high (see Chart 1). As a result, on average, each 1 percent of growth in the region translates into just 1 percentage point fall in poverty—and for the region as a whole over the past 15 years, growth has barely averaged above 1 percent annually.

Second, the growth that has occurred during this period has not generally been pro-poor. As Chart 2 shows, for many countries, such as Paraguay and Argentina, since the mid-1990s per capita income for the poorest 40 percent fell, not rose. In those countries in which per capita incomes for the poorest rose, the increase was less than for the average population as a whole. Only in a handful of cases—Chile, Nicaragua, and Peru—was the increase in the incomes of the poor significantly above the national average growth.

Third, although macroeconomic stability in the region over the past 15 years has generally improved, the succession of economic crises, particularly in the late 1990s and early 2000s, proved devastating for the poor. For example, the poverty rate shot up from 30.8 percent to 58.0 percent in Argentina between 1999 and 2002, and from 26.6 percent to 42.2 percent in the Dominican Republic between 2002 and 2004. Indeed, several studies have shown that economic crises in the region since the mid-1980s have ratcheted up poverty rates even after economic recovery from the crisis has taken hold.

Fourth, the poor lack the minimum level of assets to fully benefit from the growth process. This includes deficiencies in the level and quality of education and health, as well as in access to basic social services and infrastructure, such as paved roads, reliable electricity, clean water, and sewerage. They also face unequal opportunities in access to credit, justice, risk management, and property rights. And the poor often face lower returns to their endowments and productive activities because of their place of residence or plain discrimination.

Finally, we have more evidence now that deep poverty and inequalities of opportunity can also undercut growth, as argued in the World Bank's World Development Report 2006 (see "The Inequality Trap" on page 34 of this issue) and a forthcoming World Bank report on Latin America. Thus inequalities of opportunity not only prevent Latin America's poor from benefiting from growth but can also lower economic prosperity for the region's population as a whole. Inequality of opportunity matters the most for development policy because it is amenable to effective public policy intervention.

Providing opportunities

So what can policymakers do to turn the situation around? A vital component of any poverty reduction plan will include addressing the constraints that the poor face in accessing assets and services, so that they can secure better jobs and boost productivity. A key way to do this is through concerted actions in social policy and the growth and competitiveness agendas of most countries. But additional efforts are needed to ensure that the poor benefit at least as much as the rest of the population from actions on these fronts. This is, however, a multifaceted challenge. In some cases, the poor will benefit the most from targeted programs such as means-tested conditional cash transfers, urban development of slums, or rural infrastructure programs. In other cases, the provision of services need reform to ensure that the poor are well served (assuring similar quality of education, or promoting financial expansion). The good news is that there are a number of promising avenues under way in the region.

Building human capital with smart transfers. Human capital (encompassing the level of education, health, and nutrition of the population) is quintessential for enhancing the productivity of Latin America's poor. Recently several countries have successfully pursued a new generation of cash transfer programs. In previous decades, there was a lot of skepticism about the potential role of cash transfer programs as poverty alleviation mechanisms, because they were seen largely as short-run remedies that were difficult to target effectively and ran the risk of being appropriated for political purposes. The new wave of social assistance makes cash transfers conditional on the beneficiaries sending their children to school and receiving basic maternal and infant health care. As a result of strong positive impacts from rigorous evaluations in Brazil, Colombia, Honduras, Mexico, and Nicaragua conditional cash transfers are now regarded as important components of a long-term poverty reduction strategy. These programs are well targeted, and while their impact on primary enrollment is small where levels are already high, they have had a large impact on delaying dropout and improving transition rates and secondary enrollment (especially for girls). Overall, the average impact on the grade attained at school is up by between 0.6 to 1.4 years (see Chart 3). However, the coverage of these programs remains relatively small, and they are by no means substitutes for well-designed measures to improve overall access and the quality of educational, health care, and child nutrition services.

Access to financial services. In Latin America, many populist financial policies that were launched in the name of the poor have failed. Unfortunate examples are subsidized credit and direct state lending—policies that almost always ended up favoring the better off. Countries have also tried microcredit, but even where it has been successful, it constitutes a very small fraction of credit to the private sector. In fact, informal finance institutions such as rotating savings and credit associations are often less efficient than well-developed credit markets (Besley, Coate, and Loury, 1994). In that sense, expanding financial services to the poor requires broadening the reach of formal financial institutions by improving the banking sector's infrastructure for financial intermediation and developing approaches that encourage banks to offer affordable financial products to poor households.

Access to infrastructure. Another promising initiative—although it awaits rigorous impact evaluation—is the territorial approach to infrastructure provision, where assets and services may be provided exploiting local knowledge, local economies of scale, and complementary development projects. In urban areas, programs like the Favela Bairro in Brazil show that it is possible to turn urban slums around and capitalize the investments made by their inhabitants. A comprehensive program to improve physical infrastructure and public services, education, and commerce, and provide income-generating activities has helped boost both living conditions and the local economy. In rural areas, community driven development efforts facilitated the efficient delivery of basic infrastructure and services, including rural roads, electricity, and potable water, in conjunction with credit and technical assistance. The flagship example is the community-driven development projects in northeast Brazil, where communities prioritize, manage, and monitor investments through participatory municipal councils. A key element of success is having an integrated vision of subnational development based on local knowledge.

Translating opportunities into incomes

How can the equalization of opportunities be turned into higher incomes and eventually a higher quality of life? The key is productive employment. And for that reason, moving out of poverty in a sustainable way will require generating good jobs and enabling the poor to access them. Over the past 15 years, employment in Latin America did rise, but most of the jobs were created in the informal sector. This may be partly the result of the growing number of women participating in the labor force and a shift toward jobs in the service sector. But ultimately, the size of the informal sector reflects decisions taken by firms and workers for whom the rational choice is to operate outside the regulatory framework. Their low productivity leaves them unable to pay taxes or make social security contributions.

To reverse this is an enormous challenge for the region. Part of the solution is an increase in productivity by leveling the playing field for the poor in terms of equality of opportunities. It also requires changes in tax and labor legislation, along with more efficient public services and a better quality and more inclusive social protection system. Ultimately, workers must be able to afford health and old-age risk protection.

How will a more inclusive social policy for the poor be financed? Countries choose how much they want to tax and redistribute. In Latin America, the implicit social contract in the current structure of taxes and transfers has failed to provide equal opportunities to vast segments of the population. With exceptions, taxation is low and distortionary and social transfers go disproportionately to the rich, either through public pensions, nonpreventive health care, or public tertiary education (De Ferranti and others, 2004). In many cases, an equilibrium of low taxes and low public expenditures is maintained because the rich and the middle class opt out. Health services, education, and social protection are paid directly by the rich, who do not have any interest in exerting political pressure to improve the quality of these services when they are provided by the government. The challenge for Latin America is to modify the social contract to make it more inclusive for both taxation and expenditure. This implies ensuring that the pattern of social expenditures in general is not biased against the poor.

Defining an effective strategy

Since poverty is multifaceted, countries will need to adopt policy interventions on multiple fronts, subject to scarce financial and political capital. This means that they will have to find a way of coordinating these various interventions, and the hope has been that this could be done through an integrated poverty reduction strategy (PRS). In recent years, many Latin American countries have tried this route, but the results are quite mixed.

The poorest countries (Bolivia, Guyana, Honduras, and Nicaragua) started implementing PRSs in early 2000 under the Heavily Indebted Poor Countries initiative. The idea was to link sector strategies to poverty reduction in an integrated manner, while monitoring progress to assess the effectiveness of the strategy. However, continuity and policy implementation have been weak, the participatory decision-making process has not always been regular, and poverty monitoring processes still have to be strengthened. As for the middle-income countries, several of them—including Colombia, Guatemala, Mexico, Paraguay, and Peru—have crafted PRSs or national development strategies. In some cases, these have been government-crafted strategy documents; in others, participatory processes were or are being tried. In most cases, the strategies have not been effective in prioritizing how to tackle the key constraints in the economy so that growth is translated more effectively into poverty reduction.

These experiences point to three main lessons in shaping the agenda for poverty reduction:

First, sustained growth is the cornerstone for poverty reduction, but it needs to be accompanied by integrated strategies that encompass economic and social policies to enable the poor to benefit and be part of the growth process. Most governments in poor- and middle–income countries are paying more attention to growth and to policies that facilitate and foster job creation—not relying only on social sector policies aimed at assisting the poor. Countries should recognize and act on poverty reduction being also part of the agenda for growth and competitiveness.

Second, any strategy must prioritize and define the appropriate and realistic set and sequence of policies, taking into account financial, administrative, and political constraints. A strategy must distinguish between "the essential and the merely desirable" (Grindle, 2004). It must establish a roadmap, a sequence, and transitional strategies, particularly when in the short run some segments may lose from needed reforms. So far national plans have, in many cases, been a comprehensive collection of well-intentioned policies and valid objectives, reflecting the fact that poverty reduction implies making progress on a multiplicity of fronts. But prioritization, although scientifically and politically complex, is essential. It implies identifying what set of reforms, and in what sequencing, is most effective at reducing poverty, given budget constraints and what is politically feasible. The challenge for each country is to establish a strategy that takes account of both the fiscal and human resources, as well as the political capital, required to pursue policy change.

Third, progress needs to be monitored and evaluated. Formal poverty reduction strategies in heavily indebted poor countries have included the implementation of monitoring and evaluation systems. At the project level, there is a growing interest in impact evaluation, and several countries (Brazil, Chile, Colombia, Mexico, and Peru) have made progress in implementing various aspects of integrated monitoring and evaluation systems. Such systems allow performance and financial indicators at the program and sector level to be monitored and fed into a centralized system that can be used in the budgetary allocation process. But progress in this area is uneven, and there is a long way to go before these systems and a results-oriented culture are institutionalized. The key point is that for resources to be spent in providing opportunities to the poor, the state has to facilitate accountability and needs to establish the mechanisms for a transparent and efficient monitoring of the use of public resources.

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Thus, while poverty and inequality remain entrenched, it is becoming increasingly clear how progress can be made on improving living standards in Latin America. The huge disparities between the rich and poor should be tackled by providing the poor with a fair social and productive asset base—that is, leveling the playing field. This will allow them to move out of poverty, so long as they are able to access the opportunities in the labor market that will enable them to boost their incomes. And this will in turn improve economic prospects for all Latin Americans. Several avenues are proving to be effective. But in most cases, the biggest challenge will lie in defining and implementing the priorities of poverty reduction strategies, given the financial and political constraints.