Capital Flows and Recent Financial Crises

Lecture # 16

Week 11

Structure of this class

• “New” Capital flows

• Concerns

• The banking sector

• Financial Crises and “contagion effects”

• The experience of Chile

Capital flows

• Portfolio investments

• Foreign Direct Investments (FDI)

• Official Flows

• Remittances

The 1990s:

Investors’ optimism about growth prospects in Latin America

Why?

“Structural Reforms”: Stabilization, Privatization, & Liberalization

There were reasons for concern, however….

Why?

• Transitory

• The “original sin”

• Dollarization

• Shortermism

• Illiquidity

• Small market size

• Concentration

→ Bandwagon, Procyclical, & Exchange Rates and Interest Rates

The banking sector

• Poor financial intermediation by (weak) domestic banks

→ Capital flight as opposed to CDs

• Weak domestic banks operating under a financial liberalization

• Underdeveloped regulatory frameworks

• Concentration

→ Lack of competition, high spreads, and an lack of credit for SMEs

CrisesMexican Peso Crisis (or “Tequila Crisis”) in 1994

• After a series of reforms in the 1980s

→ Overoptimistic expectations & expanded commercial credit

→ Asset price boom

• However: Trade deficits increased from 1988 – 1994 under a domestic currency fluctuating within a band

• Sustainability?

It all depended on investors’ expectations

C/y = gk*

Other problems

1) Indigenous uprising in “Chiapas”

2) Assassination of Luis Donaldo Colosio

→ Capital Flight

Measures to avert the crisis:

Tesobonos

Adjustment of the band

Emergency loans from the US, Canada, Europe

Investors lost confidence nevertheless

• Huge devaluation and crisis in 1994

→ Affected other countries in the region “Tequila Effect”

Rescue Package:

$27.8 Billion loan from IMF and BIS collateralized with Mexico’s oil reserves

…And Mexico started a new period of recovery

The experience of Chile

• Export-oriented economy

• About 17 million (population)

• Middle income economy ( above Mexico in GDP per capita

but lower than Argentina)

• Small export – oriented: copper,fish products, chemicals, wine..

• As capital inflows increase in the 1990s

Domestic currency tends to appreciate

Negative effect on the export sector

• Chile’s response: - Established reserve requirements, quotas, and fees- Sterilization

Reduction of portfolio inflows and increase domestic savings

The Asian and the Russian Crises

• Both crises had a significant impact

- Capital outflows

- Higher interest rates

Loss of competitiveness

• Country that suffered the most was Brazil

Because of “contagion” effect, Brazil had to abandon the “Real Plan” and experienced a large devaluation

Currency crises first and second generation models

Third: Latin America does not seem vulnerable to the crisis

(a)Proportion of Latin American exports to Asia small

(b)Limited effect of changes of primary commodities

Yet, not the case of Chile (32% exports to Asia, 62% primary commodities)

Fourth, and based on previous research: contagion is possible

Suppose that the probability of a crisis in Chile is 16%

If a crisis in Brazil takes place (first generation models)

→ The probability of a crisis in Chile increases by 26%

Why?

Pure contagion effect (second generation models)

And, indeed, Brazil ultimately experienced a crisis in 1998

Chile more recently

• Although, Chile is now a diversified export-led country, copper is still Chile’s main export product

• Skyrocketing prices for copper in 2004 -2006 have further increased capital inflows

• Appreciation of the peso from 700 to 510 to a dollar

• →threatening the diversification of the Chilean economy (fruit, wine, wood products)

• Government policies (led by Michelle Bachelet). Using windfalls for

a) Increased spending in the social sector

b) Building – up reserves

--- Next class: Corruption and Redefining the Role of the State (Laffont, S-V, and Franko)