New International Capital Flows

1. New International Capital Flows Lino Covarrubias Heather Edelstein Matthew Peabody Kristina Spacone

2. Topics of Discussion • Behavior of Capital Flows • Long Term Investment • Asian Economic Crisis • Mexican Peso Crisis • Chilean Regulation of Capital Flows • Lessons for Capital Mobility

3. Capital Flows to Latin America Supply of Capital • Technology • Pension and Insurance Funds • Baby Boomers • Low Interest Rates in US Structural • Investment Codes • Macroeconomic Policy (exchange rates) • Privatization • Political reform

4. Types of Capital • Foreign Direct Investment • Bond Purchases • Portfolio Equity Flows • Lending Directly to support trade

5. Risk of new Capital Flows • Lack of efficiency • Short-term money • External vulnerability • Exchange rates • Interest Rates

6. Long Term Investment • Focus on local manufacturing • Preferable to short term investment • Concentrated in Mexico & Brazil

7. Pros Technology Efficiency Source of capital Job creation Management skills Cons Culture Human rights abuse Environment Job loss in parent country Linkage w/locals Technology Pros and Cons of FDI

8. Maple Gas – Positive Example • Drill gas in Peruvian jungle • Provide electricity to Peru • New ideas • Environmental challenges • Community • Success – effect on Peru

9. Asia Crisis – Effect on Latin America • Global loss in investor confidence • Increasing interest rates • Brazil’s downfall

10. MEXICAN PESO CRISIS OF 94-95----> • History Prior to the Event: • Healthy recovery from 1982 debt crisis- 1987 PACTO -bus, labor, and govt price control- • Fiscal Stabilization (low and stable inflation- 8% in 94 compared to 20% in late 80’s) • Opening of internal markets • NAFTA talks beginning in 91 and signed in 94 • Hi returns in Mexico--outlook lured Int’l Capital-

11. WHAT WENT WRONG? • Demand by Investors to Invest in Mexico created an ASSET Overvaluation. To ensure not missing out on the opportunity, Investors willingly infused capital without knowing the full extent of the value (sound familiar?) • Capital Inflows artificially overvalued the PESO (up to 30%).

12. What went wrong? • This overvaluation increased the prices of Mexican exports, making them less competitive in World Markets. This caused a decrease in exports= increase in CA (current Account)-GRI • Mexican Gov’t did nothing- sugar coated the problem • Peso not overvalued- reflects growth potential.

13. CA and Peso strength

14. What went wrong? • Presidential election-PRI under attack- could not afford domestic econ problem (I.e. devaluation) • Economic problems: • By 1994: CA is 8% of GDP- deficit must be funded by capital inflows. Although Investors were concerned, this did not cause the capital flight Mexico feared. • If there was a problem Intl Capital flow would not come in.

15. Mexico CA Deficit 1988-1994

16. What went wrong? • 1994 political uncertainty did- Jan: Chiapas uprising; MAR- Pres candidate Colosio assassinated; • INT Capital flew!!! This caused dwindling dollar reserves at Central Bank to pay for public debt • Situation screamed for devaluation- Mexico said no and spent $10Bill from MAR-MAY in reserves to keep from devaluing peso.

17. What went wrong? • To prevent further Capital flight-Int Investors were protected by “TESOBONOS”- dollar dominated treasury bonds.--> MEX internalized currency devalue risk. • After AUG 99 elections- still no devaluation

18. DEC 94-Reserve decreased to dangerous levels- $9bill MEX has no choice but to devalue peso Bad timing- Did it Tuesday before XMAS, with a Finance minister not yet connected Investors felt deceived and didn’t believe MEX would make good on TESOBONOS Major Capital flight THE BIG BLOW

19. MEXICO’S RESCUE • MEXICO did following: • increase in privatization of railroads, ports • wages held down, cut govt spending, • Interest rates increased to 55% to hold investors • domestically, caused a recessionary environment- further decreasing investor confidence. • JAN95: US, IMF, and Bank Intl Settlements- $28 BILL loan - help Mexico stabilize

20. CA deficit below what is sustainable by the economy (normally 3% GDP) is a recipe for disaster, especially if it is being funded by short-term int’l capital. Short-term int’l capital is very susceptible to political volatility. LESSONS LEARNED

21. Chilean case: RegulationAn anecdote…but a cure? • Composition had shifted from loans to FDI, “hot money” as well as portfolio investments and Chilean investment abroad. • Laws attracted FDI into Chile. Most money entered the export sector particularly mining. Similar recipe for disaster confronts Chile with large inflows of international capital.

22. Chile opens doors to investment abroad • 1991-Chile liberalizes laws regulating the outflow of capital. • Pours money into other LA countries. Primarily: • Argentina-electricity business, ceramics, industrial oils. • Bolivia-Railways • Peru-Pension industry, copper wire $

23. Capital Inflows Appreciated CHP Impact of Capital Flows: Vicious Circles • Chilean model driven by exports. Moving on up Exports • Copper • Agricultural Products Inflated ex-rate chokes exports that had originally made the success

24. Downside Risk-Is the Chilean model bullet proof? • Capital Controls are difficult to enforce. • Because Chile is largely dependent on commodities, a drop in global commodity prices could have devastating effects on the balance of payments on current account.

25. Chilean Remedy • Balance external sector growth and internal stability How? • Reserve requirements • Quotas, Fees • Foreign exchange market intervention, and sterilization. Capital enters Chile on “Chilean” terms.

26. Conclusion • Changes in the LA economic environment are perceived to be more permanent. • Improvements, regulatory action, and changes are restoring investor confidence. • Stability, confidence, and predictability are being restored prompting financial investments. • Investors see LA as a “good investment risk” • Inflow of capital has it’s benefits and drawbacks.