ECLAC WASHINGTON OFFICE S E R I studies and perspectives 6 Latin America: the missing financial crisis Arturo C. Porzecanski ECLAC Office in Washington Washington, D.C., October 2009 This document was prepared by Professor Arturo C. Porzecanski, Ph.D., Distinguished Economist-in-Residence at American University, Washington, D.C. The views expressed in this document, which has been reproduced without formal editing, are those of the author and do not necessarily reflect the views of the Organization. United Nations Publications ISSN printed version: 1727-9909 ISSN online version: 1728-5437 ISBN: 978-92-1-121705-6 LC/L.3059-P LC/WAS/L.104 Sales No.: E.09.II.G.57 Copyright © United Nations, October 2009. All rights reserved Printed in United Nations Applications for the right to reproduce this work are welcomed and should be sent to the Secretary of the Publications Board, United Nations Headquarters, New York, N.Y. 10017, U.S.A. Member States and their governmental institutions may reproduce this work without prior authorization, but are requested to mention the source and inform the United Nations of such reproduction. ECLAC – Studies and Perspectives series – Washington – No. 6 Latin America: the missing financial crisis Contents Abstract .................................................................................................... 5 Introduction ............................................................................................ 7 A. Transmission channels and policy implications......................... 8 I. The recession and sudden stop of 2008-09.................................... 11 A. Impact on developing countries ............................................... 12 B. Impact on Latin America.......................................................... 15 II. The missing financial crisis............................................................ 19 A. Reduced currency mismatches ................................................. 20 B. Exchange-rate flexibility .......................................................... 23 C. Resilience of the banking system ............................................. 25 D. Development of local capital markets ...................................... 27 E. Supportive fiscal and monetary policies .................................. 28 F. Conclusion................................................................................ 30 Bibliography .......................................................................................... 33 Studies and Perspectives series, Washington Office Issues published................................................................................ 37 3 ECLAC – Studies and Perspectives series – Washington – No. 6 Latin America: the missing financial crisis Tables TABLE 1 MERCHANDISE EXPORT GROWTH...............................................................................13 TABLE 2 INTERNATIONAL BANK LOANS OUTSTANDING ......................................................13 TABLE 3 NET ISSUANCE OF INTERNATIONAL DEBT SECURITIES ........................................14 TABLE 4 REGIONAL IMPACT OF RECESSIONARY AND SUDDEN-STOP FORCES ...............15 TABLE 5 REGIONAL GDP GROWTH DECELERATION ...............................................................16 TABLE 6 LATIN AMERICA’S GDP GROWTH DECELERATION.................................................17 TABLE 7 NATIONAL CURRENCY MISMATCH.............................................................................23 TABLE 8 NATURE OF EXCHANGE-RATE REGIME......................................................................25 Figures FIGURE 1 FOREIGN CURRENCY INDEBTEDNESS ........................................................................21 FIGURE 2 NET FOREIGN CURRENCY ASSET POSITION..............................................................22 FIGURE 3 DOMESTIC ROLE OF INTERNATIONAL BANKS.........................................................26 FIGURE 4 PUBLIC DEBT IN LATIN AMERICA & THE CARIBBEAN...........................................29 FIGURE 5 EXTERNAL DEBT IN LATIN AMERICA & THE CARIBBEAN....................................29 4 ECLAC – Studies and Perspectives series – Washington – No. 6 Latin America: the missing financial crisis 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. 5 ECLAC – Studies and Perspectives series – Washington – No. 6 Latin America: the missing financial crisis 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). 7 ECLAC – Studies and Perspectives series – Washington – No. 6 Latin America: the missing financial crisis 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). The phenomenon whereby capital