Capital flows in Latin America: a new phase

Introduction

The flow of foreign capital into Latin America was interrupted by several periods of severe turbulence during 1994. In some cases, the cause was plainly domestic in origin - the Venezuelan banking crisis is one notable example. In other cases, external factors played an important role, at least in triggering the onset of difficulties. One such external factor was the rise in short-term dollar interest rates in February 1994. This brought a long period of declining rates to an end and contributed to a steep increase in long-term rates. The prices of Latin American bonds were disproportionately hard-hit, and domestic interest rates in many countries had to be increased by much more than US rates.

Mexico - with the area's largest current-account deficit, at some 8% of GDP- was hit by heavy outflows early in 1994, as uncertainties about the domestic political situation worried investors. The Mexican peso came under downward pressure. Interest rates had to be increased; various special measures were adopted to stem outflows and significant foreign official support for the peso was arranged. Although worries about political uncertainties eased during the summer and autumn, short-term interest rates had to be kept high in real terms. Shortly after elections, however, there were renewed outflows of capital: the new government first effectively devalued (20th December) and then floated the exchange rate (22nd December): within ten days, the peso had lost 30% of its value against the US dollar. The Mexican stock market plunged.

The reverberations of the Mexican financial crisis were felt throughout Latin America as foreign investors took a much harder look at their Latin American exposure. Equity markets fell across-the-board. Argentina increased interest rates sharply to contain the initial reaction in financial markets and to maintain its fixed exchange rate against the dollar. The emergence of substantial outflows during 1994 brings into sharper focus some of the issues raised by the recent influx of foreign capital into the region. Two matters are of potential concern. The short-term issue relates to the threat to macroeconomic stability of a sudden reversal of foreign capital flows. How should monetary policy react? Allow the exchange rate to drop (running the risk of triggering an inflation spiral and undermining the credibility of policy) or increase interest rates (depressing the domestic economy, damaging the banking sector and increasing the government's debt burden)? The medium-term question concerns the impact on growth and development prospects of a reduced level of foreign capital inflow, or even an outflow. Two key elements of this question relate to the productivity of real investment and to the rate of domestic saving.

This paper looks at these issues and considers some general policy issues that arise. The emphasis is on general, and not on the specific factors that have often played a part in individual countries. Particular prominence is given to comparisons between Asia and Latin America as these serve to highlight a number of key Latin American policy issues.