Financial crisis in Latin America

1. Financial crisis in Latin America The Argentinean and Chilean experience

2. Pre-crisis developments • Low interest rates in the United States in the early 1990s certainly provided an initial impetus to renewed capital flows.

4. Pre-crisis developments • Low interest rates in the United States in the early 1990s certainly provided an initial impetus to renewed capital flows. • Because the developing world had extensive dollar-denominated debts (original sin in action), there was an immediate and spectacular rise in the interest burden debtor countries had to pay. • Sharp increase in the value of the dollar in the international market.

6. Pre-crisis developments • Low interest rates in the United States in the early 1990s certainly provided an initial impetus to renewed capital flows. • Because the developing world had extensive dollar-denominated debts (original sin in action), there was an immediate and spectacular rise in the interest burden debtor countries had to pay. • Sharp increase in the value of the dollar in the international market. • Finally, primary commodity prices collapsed, depressing the terms of trade of many poor countries.

7. Argentina

8. Convertibility Law (April 1991) • Motivated by previous decade of financial instability and even hyperinflation. • Made Argentina’s currency fully convertible into U.S. dollars at a fixed rate exactly one peso per dollar. • Required that the monetary base be backed entirely by gold or foreign currency, so in one stroke it sharply curtailed the central bank’s ability to finance government deficits through continuing money creation.

9. Intended and unintended consequences • Argentina’s plan had a dramatic effect on inflation, which remained low after dropping from 800 percent in 1990 to well under 5 percent by 1995. • A real appreciation of the Argentinean Peso (30% from 1990 to 1995) led to unemployment and a growing account deficit. • In the mid-1990s the peso’s real appreciation process ended, but unemployment remained high because of rigidities in labor markets.

11. 2001 Argentinean Financial Crisis • As the world economy slipped into recession in 2001, Argentina’s foreign credit dried up. • The country defaulted on its debts in December 2001 and abandoned the peso-dollar peg in January 2002. • The Peso depreciated sharply and inflation soared once again. In a daring move, the government defaulted on Argentina’s external debt. That action was actually followed by strong economic growth.

13. Chile

14. Monetary Developments • Chile instituted a tough regulatory environment for domestic financial institutions and removed an explicit bailout guarantee that had helped to worsen Chile’s earlier debt crisis. • A crawling peg type of exchange rate regime was used to bring inflation down gradually, but the system was operated flexibly to avoid extreme real appreciation. • The Chilean central bank was made independent of the fiscal authorities in 1990. That action further solidified the commitment not to monetize government deficits.

16. Capital Inflows Policy • All capital inflows had to be accompanied by a one-year, non-interest-bearing deposit equal to as much as 30 percent of the transaction. • Penalty felt disproportionally fell on short-term inflows. • One motivation for the implied capital inflow tax was to limit real currency appreciation; the other was to reduce the risk that sudden withdrawal of short-term funds would provoke a financial crisis.