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Latin America: the Missing Financial Crisis

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Latin America: the Missing Financial Crisis Munich Personal RePEc Archive Latin America: The Missing Financial Crisis Porzecanski, Arturo C. American University October 2009 Online at https://mpra.ub.uni-muenchen.de/18780/ MPRA Paper No. 18780, posted 23 Nov 2009 15:25 UTC LATIN AMERICA: THE MISSING FINANCIAL CRISIS by Prof. ARTURO C. PORZECANSKI, Ph.D. American University Washington, DC 20016-8071 [email protected] Final Draft, October 2009 To be published by the United Nations ECLAC Office in Washington, DC, as #6 in their Studies and Perspectives Series www.eclac.cl/cgi- bin/getProd.asp?xml=/washington/agrupadores_xml/ain613.xml&xsl=/washington/ agrupadores_xml/agrupa_listado-i.xsl&base=/tpl-i/top-bottom.xsl Abstract This may well be the first time since Latin America gained its independence in the early 1800s that a major economic contraction and financial calamity in the industrialized world has not caused a wave of currency, sovereign debt or banking crises in the region. What explains Latin America’s unprecedented resilience in contrast with, for example, Eastern Europe’s now-evident financial vulnerability? Here we review the enormous progress made by many governments in Latin America in the past decade to reduce currency mismatches, allow for more flexible exchange-rate regimes, enhance the capitalization, funding and supervision of their banking systems, encourage the development of local capital markets, and implement sounder and more credible monetary and fiscal policies. Evidently, it is not necessary to wait for an improved international financial architecture in order for reform-minded, well-managed countries to reap the most benefits from, and minimize the deleterious impact of market cycles typical of, financial globalization. 1 Introduction In recent decades, the conventional wisdom has come to hold that financial booms and busts are a frequent (and possibly inevitable) feature of capitalism, and that in an increasingly integrated world, so is the transmission of market cycles around the globe. In good times, international financial integration has particularly strong beneficial effects on the most open and thus more rapidly growing developing countries (the so-called emerging markets), but in bad times restrictive monetary policies, credit crunches, market downturns, and generalized risk aversion in the United States, Europe and Japan likewise reverberate most powerfully in those developing countries. The financial vulnerability of Latin America to the vagaries of international capital markets has been on all-too-frequent and public display. This vulnerability first became evident in 1825, when Latin America experienced the fallout of a major financial crisis in Europe soon after many of the countries in the region gained their independence and their new governments began to borrow abroad. The crisis was the consequence of a tightening of liquidity on the part of the Bank of England starting in March 1825, which led to the failure of numerous banks in England and Wales – eventually, about 60 of them shuttered their doors. This wave of bank failures, in turn, generated a financial panic in December of that year that had worldwide repercussions (Bordo, 1998). The ensuing collapse in stocks and bonds, implosion in international trade, and shutdown of the London capital market prompted one after another of the fledgling governments in Latin America to stop servicing their foreign debt obligations. Peru suspended payments in April 1826, and by the middle of 1828, and with the single exception of Brazil, all the Latin American nations that had issued bonds abroad in the early 1820s –a dozen of them in total– had defaulted on their obligations (Marichal, 1989). The repetition of currency, sovereign debt, and/or banking crises in Latin America, and their appearance also in Asia and in just about in every other region in the developing world at some point or another, has spawned a voluminous academic, policy-oriented and even journalistic literature, especially in the last decade (see for example Auernheimer, 2003; Blustein, 2003; Calvo, 2005; Claessens and Forbes, 2001; Dooley and Frankel, 2003; Edwards, 2000 and 2007; Edwards and Frankel, 2002; Edwards and Garcia, 2008; Eichengreen, 2003; Griffith-Jones, Gottschalk and Cailloux, 2003; Ocampo, Kregel and Griffith-Jones, 2007; and Reinhart, Vegh and Velasco, 2008). As a leading economic historian has written in distilling the lessons of the past, “financial crises have always been part of the scene… The effects of crises are and were worse in emerging countries… because they are financially underdeveloped and have thinner markets, less diversified portfolios, less effective supervision and regulation, less well defined property rights and bankruptcy codes, and a greater proclivity to follow unstable macro[economic] policies. All of these features make them more prone to asymmetric information problems, lending booms and busts, and banking crises” (Bordo, 2003, p. 68). In the aftermath of the international financial crises of the mid-1990s, the Office of the Executive Secretary of the Economic Commission for Latin America (at the time headed by José Antonio Ocampo) concluded as follows: “The recent crises have revealed the serious imperfections of the international capital market and the great vulnerability of developing economies to international financial shocks… In boom phases of capital flows, key macroeconomic variables (such as the exchange rate and the prices of assets) tend to move away from their long-term equilibria. The most serious threat is that, if flows reverse abruptly, this may set off banking and financial crises that cause great disruption to the countries directly affected and undermine the vitality of world development” (ECLAC, 1998, p. 41). 2 The phenomenon whereby capital inflows dry up and possibly exit from a country has come to be known as a “sudden stop,” a concept analyzed and popularized by Guillermo Calvo (e.g. Calvo, 1998). Interestingly, however, those who coined the term to help explain several currency crises (e.g., Chile‟s in 1982 and Mexico‟s in 1994) saw it as a phenomenon resulting from a combination of both domestic policy failures and events outside of a government‟s own control (Dornbusch, Goldfajn and Valdés, 1995) – and not merely an exogenous development. A. Transmission channels and policy implications Conceptually, there are several channels whereby a financial crisis in one or more industrialized countries can be transmitted to other industrialized and to emerging and developing countries. First there is the credit channel: a tightening of liquidity conditions in the United States, Europe or Japan, likely accompanied by a wave of risk aversion, will initially reduce the availability and increase the cost of funding for domestic borrowers and investors. In a financially integrated world, however, this credit slowdown will likely spill over across borders and, if sufficiently serious and prolonged, can lead to a “sudden stop” of capital to governments, banks and corporations in other industrialized and developing economies. In contemporary times, the importance of the credit channel was in clearest evidence during the early 1980s, when monetary policies were tightened to an extraordinary degree in the United States and then elsewhere, helping to trigger a major, worldwide credit contraction that helped usher in the debt crises of that decade in Latin America and beyond. Empirical research in the early 1990s confirmed that the most important identifiable factor behind swings in capital flows to Latin America were cycles in U.S. interest rates and in other exogenous macroeconomic, rather than domestic, variables (e.g. Calvo, Leiderman and Reinhart, 1993). More recent empirical research confirms that monetary disturbances in the United States have had large and significant impacts in Latin America, for instance by affecting capital flows and thus having destabilizing effects on exchange rates in the region (Canova, 2005). And by now globalization has proceeded to the point where there is evidence that external financial conditions are capable of affecting even the previously isolated countries in Sub-Saharan Africa (Drummond and Ramirez, 2009). A second main transmission channel for financial crises is through international trade: a credit crunch in one or more of the leading industrialized countries, whether induced by monetary policy or not, will reduce the pace of domestic investment and consumption. In a commercially integrated world, however, this slowdown in domestic demand will likely generate a drop in merchandise import volumes, commodity prices, tourism spending overseas, and workers‟ remittances normally sent abroad. Since many commodities are also financial assets held by investors with access to credit, and not just or mainly by end-consumers and producers, they are quite sensitive to developments in the credit channel, as well. And the credit and trade channels are interrelated in other ways: foreign trade is facilitated by the availability of lines of credit (e.g. import financing and pre-export credit), and credit crunches that disrupt selected productive activities (say, the automobile industry, which is highly integrated across borders) can obviously dislocate worldwide production processes and trade flows (Escaith and Gonguet, 2009). A third transmission mechanism of financial crises is through investor and lender herd behavior and contagion effects: a tightening of liquidity conditions or surprise changes in economic, political or financial
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