Latin American Financial Crises and Recovery

1. Latin American Financial Crises and Recovery Jan Kregel, Senior Scholar, Levy Economics Institute of Bard College and Distinguished Professor, Center for Full Employment and Price Stability, University of Missouri, Kansas City Remarks Prepared for the Conference: A Decade After: Recovery and Adjustment since the East Asian Crisis, Organised by International Development Economics Associates (IDEAs), Good Governance for Social Development and the Environment Institute (GSEI), Action Aid and Focus on the Global South July 12-14, 2007, Bangkok Thailand

2. Asia & LA: Similarities and Differences • Similarility: Capital Reversals caused crisis • Differences in causes of the capital inflows and the capital reversals In Asia • savings and investment rates were extremely high and stable growth at double digit rates, stable prices and exchange rates with contained fiscal and external balances. • countries did not need additional financial resources from capital inflows, • foreign investors were attracted by what appeared to be a successful long-term growth process with stable returns. • In Latin America • savings and investment rates low, chronic fiscal and external deficits, hyperinflation and exchange rate volatility. • Little in performance to attract foreign investors. • Inflows induced by the Brady Plan and the structural adjustment policies that accompanied it. • Expectation of quick profits from the liberalization, privatizing state-owned companies, market-led liberalization and deregulation brought inflows. • Inflows were primarily into financial rather than real assets.

3. Policy Induced Flows Reversed in 1990s • Mexico 1994-5 Tequila crisis • Brazil exchange-rate crisis of 1999 • Argentina Default crisis of 2001 • Confirmation of the failure of the policies to provide sustainable recovery from the 1980’s debt crisis. • Brazil and Mexico • persisted with previous policies • maintained price stability, this has come at the cost of a lower trend growth rate. • Argentina made a break with previous policies • defaulting on its foreign debt, • increase in its trend growth rate and employment, • evidence of emerging inflationary pressures and supply bottlenecks, especially in energy.

4. Lessons from Latin America • The lessons to be drawn from Latin America must be viewed in the context of • the different causes that attracted the inflows and the subsequent reversal, • in particular the failure of post-crisis adjustment policies.

5. Latin America --Policy-Induced Capital Flows • Brady Plan shifted solution of debt problem • from repayment via large current account surpluses • to restoring access to international capital markets in order to refinance their outstanding debt to banks • by shifting it to the private sector institutional lenders in those countries. • Latin American countries were to introduce price stability and investor-friendly policies • Stabilisation of exchange rates and rapid return to full convertibility of currencies at a targeted exchange rate or fluctuation band. • Mexico and Brazil introduced regimes with tight fluctuation bands • Argentina a fixed dollar rate of exchange through the Convertibility Law. • All experienced substantial real exchange rate appreciations

6. Support of Exchange Stability • Policies to introduce market-based resource allocation • reduction in the role of government in the economy • privatization of state-owned enterprises, • creation of (primary) government budget surpluses. • restriction on expansion of the domestic money supply • open domestic markets to foreign competition to reinforce price stabilisation • Financial market deregulation, capital account liberalisation and creation of domestic financial markets to encourage capital inflows to purchase domestic financial assets and provide foreign exchange to repay, and the opportunity to refinance debt. • Privatization of state enterprises through domestic equity markets drew foreign portfolio investors to “emerging markets” as an asset class.

7. Reasons for Inflation Success • After years of failure, success in fighting inflation did not produce a balance of payments crisis as capital inflows more than covered external deficits, increasing reserves reinforce market perceptions of successful recovery. • The Brady Plan and the structural adjustment policies brought the capital inflows that would be produce the reversal and the crisis of the 1990s. • The failure to deliver long-term increases in growth and profitability that produced the eventual reversal. • A number of factors that were crucial to the success in fighting inflation were also important in preventing a return to sustained growth. • real appreciation of exchange rates, • excessively high real interest rates and weak domestic demand • caused deterioration in external accounts and dampened incentives to invest to increase domestic productivity. • Capital inflows had little impact on domestic savings, and were primarily in portfolio assets rather than real assets. • While Latin American countries were praised for their good “macroeconomic fundamentals” they have not been able to harness trade as an engine of stable growth in per capita incomes.

8. Good Macro Policy, Bad Micro Policy? • The good macroeconomic fundamentals – • low inflation, • primary budget surpluses and • control of the money supply, • Overlooked more traditional macro economic fundamentals • high levels of aggregate demand, • low real interest rates • competitive real exchange rates. • As a result they created an overall macroeconomic environment that impeded the required structural changes at the micro level.

9. Bad Micro Policy • Five areas can be identified in which the structural adjustment policies undermined the stability of the macroeconomic fundamentals and the adjustment of the production structure. • overvaluation of the exchange rate, • the high level of real interest rates, • composition of the fiscal budget, • the composition of the external account • the failure of adjustment of the industrial production structure to reduce the dependence of increased investment and increased export capacity on imported inputs.

10. Post-Crisis Recovery Brazil, Mexico and Argentina • Common characteristics of the recovery • the crisis forced countries to abandon their exchange rate policies and the need for the highly restrictive money and fiscal policies necessary to attract the external inflows to keep rates stable or fixed. • The possibility to relax policy provided an opening for recovery and higher growth that was experienced in all countries. • Brazil and Mexico took measures to restore their prior policy stance with nominally flexible exchange rates. • Their expansions were short-lived and soon experienced a return of capital inflows, exchange rate overvaluation, and low trend growth. • Argentina rejected a return to externally financed growth and used low interest rates and a policy of stabilization of the real exchange rate to support growth. • It has experienced higher than trend growth on a sustained basis since 2002.

11. Brazil’s 1999 Exchange rate crisis and recovery • After Recovery -- restrictive policies were quickly reintroduced. • Cardoso re-election run on the premise of maintaining control of inflation • -price stability depended on stability of exchange rate. • Despite deterioration of the external and fiscal balances, tight monetary and fiscal policy maintained to generate the external capital inflows to defend Real in the face of rising unemployment and falling growth. • Real interest rates went from 20 per cent Real Plan over 40 per cent end 1998. • Unemployment rose from under 5 per ce3nt in 1995 to over 8 per cent in 1998, • growth fell from a Real Plan average of over 3 per cent to near zero in1998. • Policy reinforced by an over $35 billion IMF support loan, requiring maintaining current policies. • Nonetheless net capital movements fell from $26 billion in 1997 to less than $16 billion at the end of 1998 • Foreign exchange reserves fell from nearly $75 billion in April of 1998 to around $36 billion in January 1999.

12. Against a CA deficit over $30 billion in 1997 and 1998 and no signs of improvement in fiscal or external balance, after re-election exchange rate abandoned in January of 1999. The Real surpassed 2 Reis to the US dollar and then stabilized. Against conventional expectations inflation pass-though was moderate Arminio Fraga introduced a policy of guiding interest rates downward, while the government persisted in its policy of running primary surpluses. The result was a short-term spurt in growth in 2000 that was quickly reversed by the contractionary policies at the end of the Cardoso administration and the speculation surrounding the incoming Lula administration.

14. The Recovery from the Mexican Crisis of 1994-5 • Mexico followed exchange rate band, and capital inflows more than sufficient to cover its rising external and internal imbalances. • End 1994 NAFTA treaty and political turmoil caused foreign investor loss of confidence • Short-term government liabilities could not be renewed and the peso collapsed. • The IMF + other governments produced largest aid packages ever granted. • Mexico required to implement adjustment package, • Restrictive fiscal and monetary policy and wage controls • The result --a deep decline in output and employment of over 6%, and over 5%, with inflation around 51% in 1995. • The crisis was quickly reversed and the economy started to recover in the third quarter of 1995, and in 1996 GDP grew over 5% and by over 6% in 1997. • The immediate trigger was the fall in private expenditure • Non-oil exports responded quickly and robustly to the large depreciation of the peso, and the domestic receipts from oil exports also rose. • The large improvement of the trade balance from the downward adjustment of imports and the growth of exports supported the level of demand and economic activity. • The decline in government expenditure reversed -- the growth rate from the quarter prior to the crisis until the upper point of the recovery exceeded the rate of growth of GDP. • Private expenditure did not recover from its downswing level, and consumption and fixed investment were lower at the top of recovery than prior to the crisis. • Although employment was restored to its pre-crisis level, average real (manufacturing) wages did not recover. In fact they were 23% lower at the upper point of the recovery than in the quarter prior to the crisis.

15. The government Contribution to Recovery • Demand by government on the domestic market, is equal to government expenditure on goods and services, plus government transfers and wages, plus domestic interest payments. • Deficit refer to government expenditures above those financed with taxes which in Mexico includes government revenues from oil industry. • Thus a rise in the price of oil allows the government to increase domestic expenditure without changing the deficit, but nonetheless creates a net additional demand. • According to estimates made by Julio Lopez Mexico has maintained a positive domestic deficit of around 17% of GDP in the 1980s, and 6% in the 1990s. • Government expenditure and domestic deficit fell until the IIIQ 1995 and from then both recovered to a relatively high level during 1996. • We can conclude that both the domestic deficit and total government expenditure played an important role in recovery sustaining the domestic demand and private profits.

16. Argentina’s Recovery from the 2001 Default • The political stalemate that followed the resignation of the government and the Christmas Eve default of Argentina’s sovereign debt meant that there was little time for a formal change in economic policy. • However, the elimination of external and internal debt service automatically created a less restrictive policy that was reinforced by the market-led devaluation of the exchange rate and the increase in the terms of trade of Argentina’s main agricultural exports • Thus, the initial response was a sharp increase in exports and a collapse in imports due to the deepening recession.

19. Policy Change? • Newly government concentrate don domestic recovery and thus did not seek a rapid conciliation with creditors. • Rapid reconciliation had been Fund objective to allow Argentina to borrow to meet arrears in debt service a la Brady • IMF declined to support the government program, -- O’Neill doctrine that the past history of IMF supported bailouts of debtor countries has created moral hazard amongst creditors • As a result, not only did the IMF withdraw support, it failed to provide support for the Argentine recovery program as had been the case of Brazil and Mexico. • Government argued only return to sustained growth could support debt repayment. • Question --- whether the surplus target would maximize probability of sustained growth or the amounts received by creditors. • In response to Fund insistence on the latter Argentina noted that the Fund was supposed to remove moral hazard but by supporting interests of creditors it was creating moral hazard at the expense of Argentina to forego growth in order to repay debt at 100 per cent of its face value.