CAPITAL FLOWS TO LATIN AMERICA: CHALLENGES AND POLICY RESPONSES. Javier Guzmán Calafell 1

Transcription

1 CAPITAL FLOWS TO LATIN AMERICA: CHALLENGES AND POLICY RESPONSES Javier Guzmán Calafell 1 1. Introduction Capital flows to Latin America and other emerging market regions fell sharply after the collapse of Lehman Brothers in September. During that year, net private capital flows to the region were equivalent to slightly more than fifty percent of the level achieved in. In this context, risk spreads on sovereign debt skyrocketed and interbank credit lines collapsed. Furthermore, bond issues, both sovereign and corporate, basically disappeared, after several years of Latin America s continued access to capital markets at comfortable costs. This situation was reflected in a sharp decline in international reserves and significant depreciations in the exchange rates of many countries in the region. In general, the Latin American economies responded rapidly to the crisis, through the implementation of measures aimed at ensuring the availability of sufficient external liquidity and the soundness of their financial systems. In addition, several countries implemented fiscal and monetary policies to alleviate the impact of the crisis on the real sector. These measures, combined with the reduction of global uncertainty which followed the efforts of the international community to cope with the crisis, allowed a gradual return of access to international capital markets. Thus, risk spreads began to follow a downward trend since early. In addition, by the end of the year sovereign and corporate bond issues had reached levels well above those observed on average in -, and the region s stock of international 1 General Director of the Center for Latin American Monetary Studies. Paper presented at the Conference: International Capital Movements: Old and New Debates ", organized by the Reserve Bank of Peru, the Reinventing Bretton Woods Committee and the Intergovernmental Group of Twenty Four, Cusco, Peru, July 19 and 20,

2 reserves reached record highs. Naturally, these global trends mask important differences from one country to another. Capital flows to Latin America have continued to increase, in a context of high volatility, during the first semester of Both push and pull factors are behind this trend. The former are related to abundant international liquidity, low interest rates in the advanced economies and an increase in the appetite for risk, while the latter are linked mostly to strong economic fundamentals and good prospects for economic growth in general in coming years. The rapid return of Latin American countries to capital markets is indeed a welcome development. Capital inflows provide the means to finance an excess of investment over saving, allow savers and investors to diversify their portfolios, contribute to the development of capital markets, and reduce borrowing costs for both the public and the private sectors, among other benefits. At the same time, however, capital inflows give rise to a number of challenges. First, they are highly volatile and tend to be procyclical. In addition, they can lead to a sharp appreciation of the real exchange rate and unsustainable increases in internal demand and the current account deficit. Moreover, they can endanger financial stability. Not surprisingly, several economic crises observed in Latin America have occurred after periods characterized by favorable external conditions and large capital inflows. The purpose of this paper is to compare the most recent episode of capital flows to Latin America with similar experiences observed in past decades, as well as to analyze to what extent this phenomenon is generalized within the region. The capacity to respond to the challenges arising from the increased inflow of foreign capital is also assessed, and some reflections are made on the measures that have been implemented to address these challenges. 2

3 Characteristics of Capital Inflows and Policy Responses How important is the inflow of capital to Latin America at this stage? To attempt to answer this question, Graph 1 presents the evolution of total net capital flows to the region during the period -2011, with information from the International Monetary Fund (IMF). Capital inflows are defined for these purposes as the sum of the current account balance and the variation of international reserves, expressed as a percentage of GDP. 2 As shown in the graph, the behavior of this variable is not very different when all emerging and developing economies are considered. On the other hand, the trend of total and private net capital flows to Latin America resemble closely. Graph 1. Net Capital Flows to Emerging and Developing Economies and to Latin America % of GDP Total net flows to Latin America Net private financial flows to Latin America Total net flows to emerging and developing economies Source: International Monetary Fund, World Economic Outlook Database. 1 Includes errors and omissions The graph shows that the economies of Latin America have observed three episodes of substantial capital inflows over the past 30 years: 2 The figures include errors and omissions. The information available allows to exclude this item from the series only for the period The behavior of this series is very similar to the one including errors and omissions. 3

4 The first one is related to the aftermath of the oil shocks of the 1970 s. The need to recycle the so called petrodollars gave rise to a boom in international bank lending, especially short term, to developing economies, included those in Latin America. These were used to finance fiscal deficits and the expansion of private consumption, leading to the debt crisis of the s and a lost decade for Latin America. The second episode can be split into two parts. a) The easing of monetary conditions in the advanced countries -with the resulting increase in the supply of low cost external financing- and optimism about the performance of some Latin American economies, among other factors, resulted in a substantial increase in capital flows to the region, which ended with the Mexican crisis of -95. b) A renewed easing of monetary conditions in the US and Europe, combined with substantial declines in risk premia, fostered an expansion of capital flows, especially to Asia and Russia, but also to Latin America. The crisis in Asia and Russia in -98 finally resulted in a collapse of capital flows to all emerging market economies. During the third episode, the ready availability of external financing at low interest rates reflected very easy monetary policies in the advanced economies after the -01 downturn, favorable worldwide economic conditions, financial market innovations that improved liquidity and the distribution of risk, and a change in the pattern of global saving and investment. This was supported on the pull side by relatively strong economic growth in emerging economies including Latin America-, a rising share of the latter in the global economy, and improvements in their macroeconomic performance and more resilient policy frameworks. What are the main differences between the period of capital inflows to Latin America and other emerging market regions that began in early and the previous episodes described above? 4

5 First, it is not totally clear whether the phenomenon we are witnessing today represents the beginning of a new episode of comparable magnitude. In particular, there is a risk that capital flows to emerging economies in general prove to be of a shorter duration this time, as the tightening of monetary policy in the advanced world, and the demand for resources resulting from a cyclical upturn and very high budget deficits in these economies, could crowd out emerging market borrowers. While this possibility cannot be discarded, the predominant view seems to be that interest rates in the main industrial economies will remain low for a relatively long period, and therefore that the main concern among emerging economies for some time to come will be capital inflows and their volatile behavior, rather than outflows. 3 On the other hand, it is important to stress that even under this scenario, current IMF projections point to capital flows to Latin America up to 2011 well below those observed in the previous three episodes (Graph 1). Second, the counterparts to net capital flows are the current account balance and the variation of international reserves. 4 As can be seen in Graph 2, during the capital inflow episodes of both the eighties and nineties, capital flows to Latin America were mostly used to finance large current account deficits. The situation changed dramatically during the first years of the s: in this case, capital inflows were accompanied by surpluses in the current account, thus resulting in a huge accumulation of international reserves. The situation in the period -2011, as projected by the IMF and other analysts, can be termed as an intermediate one, since we observe moderate deficits in the current account and a continued accumulation of international reserves. 3 See for instance Institute of International Finance, Capital Flows to Emerging Market Economies, IIF Research Note, April 15, 2010; and International Monetary Fund, Global Financial Stability Report, April This assumes no errors and omissions. 5

6 Graph 2. Latin America: Current Account and the Variation of International Reserves % of GDP Current account balance Change in reserves Source: International Monetary Fund, World Economic Outlook Database. Third, the composition of capital flows to Latin America has changed substantially over the last thirty years (Graph 3). During the late 70s and early 80s, debt flows represented the largest component of private capital flows. Subsequently, in the 90s, the most relevant feature is the sharp growth of portfolio investment. During the third episode of substantial capital inflows to Latin America, foreign direct investment became the dominant form of financing, and it is expected that this will continue to be the case in coming years, although with a recovery of portfolio flows. Naturally, the composition of capital flows is of great relevance. Since in general the empirical evidence shows that foreign direct investment is the most stable form of flow 5, it can be argued that the changes in the pattern of financing observed in Latin America during the last years have reduced the region s vulnerability to the volatility of foreign capital. 5 See for instance Committee on the Global Financial System, Capital Flows and Emerging Market Economies, CGFS Papers, No. 33, January. 6

7 Graph 3. Latin America: Composition of Private Capital Flows % of GDP Direct investment, net Private portfolio flows, net Other private financial flows, net - Source: International Monetary Fund, World Economic Outlook Database As explained before, these general trends camouflage important differences among individual countries. To assess to what extent the three conclusions above are valid at the country level, a separate analysis was carried out for those countries classified by the IMF as with strong links with international financial markets or EFI (Brazil, Chile, Colombia, Mexico and Peru), which is the subset of economies that are likely to be most affected by changing patterns of international capital movements. 6 Graphs 4 to 8 present information for each of these economies regarding capital inflows, their utilization for either current account financing or reserve accumulation, and the composition of net private capital flows. The graphs show that for some economies (e.g. Brazil and Colombia), capital inflows are sizable and not far below those observed during previous episodes. At the other extreme is Chile, which in registered a net outflow of capital. However, overall the conclusions regarding the use of those inflows and their composition are analogous to those reached at the aggregate level, i.e. foreign capital flows are financing 6 In fact, in capital flows to these countries were higher than the equivalent figure for the whole of Latin America. 7

8 moderate current account deficits and reserve accumulation, and are either dominated by direct foreign investment or FDI represents a substantial share of the total inflow. 8

9 % GDP Graph 4. Brazil Total net capital flows Current Account and Changes in International Reserves Current account Changes in reserves -1 Financial Account Components Direct investment Portfolio investment Other investment -1 Source: International Monetary Fund, International Financial Statistics. 9

10 Graph 5. Chile Total net capital flows Current Account and Changes in International Reserves Current account Changes in reserves -2 Financial Account Components Direct investment Portfolio investment Other investment -2 Source: International Monetary Fund, International Financial Statistics. 10

11 % GDP Graph 6. Colombia Total net capital flows Current Account and Changes in International Reserves Current account Changes in reserves -1 Financial Account Components Direct investment Portfolio investment Other investment Source: International Monetary Fund, International Financial Statistics. 11

12 Graph 7. Mexico Total net capital flows Current Account and Changes in International Reserves Current account Changes in reserves Financial Account Components Direct investment Portfolio investment Other investment Source: International Monetary Fund, International Financial Statistics. 12

13 % GDP Graph 8. Peru Total net capital flows Current Account and Changes in International Reserves Current account Changes in reserves -2 Financial Account Components Direct investment Portfolio investment Other investment - -1 Source: International Monetary Fund, International Financial Statistics. 13

14 Irrespective of whether the size of the inflow of capital to Latin America on this occasion is similar or not to those of previous episodes, it is important to ask: is Latin America better prepared today to cope with the challenges generated by the volatility of external capital flows? The answer to this question seems to be positive. In this respect, it is worth to note the following: The IMF created in March the Flexible Credit Line (FCL). This facility is designed for countries with very strong economic policies and fundamentals, and track records of policy implementation. The criteria for assessing qualification for the FCL include a sustainable external position, a comfortable international reserve position, sound public finances, the absence of bank solvency problems, and effective financial sector supervision, among others. Both Mexico and Colombia have been approved an FCL, and there is a generalized perception that Brazil, Chile and Peru would be granted one, if requested. The sovereign debt of the five Latin American countries considered has received investment grade status from the major rating agencies. In, only one of these economies had achieved that status (see Table 1). There is widespread agreement that flexible exchange rates reduce the probability of crises. These regimes discourage speculative capital inflows, the accumulation of external imbalances and the adverse impact on economic activity of the interest rate increases that usually accompany the defense of a fixed exchange rate as financial conditions worsen. Today, all the countries considered have floating exchange rate regimes. In, only one of them operated under such a regime (see Table 2). 14

15 Table 1. Investment Grade Status Country Outlook Brazil Stable Chile Stable Colombia Positive Mexico - - Stable Peru Stable Total Source: Standard & Poor s 1. Investment grade rating for long-term sovereign debt in foreign currency. Information as of July 15, Table 2. Countries with Floating Exchange Rate Regime Country 2010 Brazil Chile Colombia Mexico - - Peru - - Total Source: International Monetary Fund, Exchange Arrangements & Exchange Restrictions, Annual Reports. Furthermore, according to the IMF, Latin American financial systems overall are much better prepared and more resilient than in the past because earlier weaknesses, such as exposure to currency depreciation or reliance on external financing have been greatly reduced, and important capital buffers have been built. 7 On the basis of an analysis carried out in mid, the Fund concludes that most banking systems in the region have capital adequacy ratios well above international standards (a median of around 15 percent), low nonperforming loan ratios (median level of 2.5 percent), high returns on equities (median of 2 percent a year), balanced or positive 7 See IMF, Regional Economic Outlook, Western Hemisphere, May. 15

16 net foreign asset positions, and adequate liquidity ratios (median of 20 percent of total assets). Against this background, it should not be surprising that no Latin American banking system faced a crisis during the recent episode of global financial turmoil. Being better prepared to tackle capital inflows does not ensure that the proper measures are going to be implemented. The obvious question then is whether the response of the Latin American economies to the recent resumption of capital inflows has been the correct one. It is of course very difficult to provide an accurate answer to this question. Nevertheless, a few observations of a general nature can be made. Most analysts support the idea that there is no one size fits all policy response to large and volatile capital inflows. 8 It is widely accepted that usually efforts will have to include a combination of exchange rate flexibility, the accumulation of international reserves, adjustments in fiscal and monetary policy, and macroprudential measures. In addition, the idea that there may be circumstances in which capital controls could represent one of the components of the policy response has gained acceptance. How these elements are best combined will depend on the particular characteristics of the economy in question (including elements such as the stage of its economic cycle, the degree of over/undervaluation of the exchange rate, the level of international reserves, etc.) and the nature of the inflows of capital, among other factors. The response of the Latin American countries with closer links to international financial markets to the recent surge in capital inflows (or the impact of the current account surplus in the case of Chile) has been based on a combination of measures. 8 See for instance Jonathan D. Ostry et. al., Capital Inflows: The Role of Controls, IMF Staff Position Note, February 19, 2010; and Committee on the Global Financial System, Capital Flows and Emerging Market Economies, CGFS Papers No. 33, BIS, January. 16

17 % Variation billions of USD Graph 9 presents the evolution of the nominal exchange rate and international reserves for these countries, from their low/most depreciated level in to July of this year. As can be seen, all of them have reacted with the combination of an appreciation of the nominal exchange rate and an accumulation of international reserves. Naturally, the policy response in these economies has included a series of measures, such as the tightening of fiscal policy, the implementation of macroprudential measures, and in one case the introduction of controls on capital inflows. Graph 9. International Reserves 1 and Exchanges Rates Brazil Chile Colombia Mexico Peru Exchange rate International reserves Source: National central banks. 1.Variation from the lowest point in to the highest in 2010 (billions of US dollars). 2.Percent variation from the most depreciated level in to the most appreciated in As of July 15. Judged by market expectations on the behavior of the main macroeconomic aggregates, it can be argued that thus far the measures adopted have been successful in meeting the objectives sought. As can be seen in Graph 10, economic growth expectations for 2010 for the countries under consideration have been revised upwards, while inflation expectations have remained relatively stable, with the exception of Brazil. For 2011, analysts project a continued economic expansion, with inflation rates generally lower than expected for this year and with a trend that has remained stable in all cases. 17

18 Graph 10. Economic growth and inflation expectations Economic growth expectations for 2010 Inflation expectations for Jan Feb Mar Apr May Jun Brasil Chile Colombia Mexico Peru Jan Feb Mar Apr May Jun Brasil Chile Colombia Mexico Peru Economic growth expectations for 2011 Inflation expectations for Jan Feb Mar Apr May Jun Brasil Chile Colombia Mexico Peru Jan Feb Mar Apr May Jun Brasil Chile Colombia Mexico Peru Source: Latin American Consensus Forecasts. 18

19 3. FINAL CONSIDERATIONS Although the size of capital flows to Latin America has not reached recently the magnitudes of previous episodes, the most exposed countries of the region are better prepared to face these inflows, and the measures adopted thus far seem to be working well, it would clearly be a mistake to relax the stance: The international economic situation remains very complex and projections are subject to an above normal degree of uncertainty. Also, the responsiveness of capital flows to changing conditions is very high and likely to increase even more. As shown by the recent experiences of Brazil, Mexico and other emerging economies, financial innovation can give rise to operations beyond the authorities control, which have the potential to lead to unpleasant surprises. There is a wide variation of experiences among countries in the region. Furthermore, if Latin America is to face a substantial inflow of capital in coming years, the challenge is not only to face its macroeconomic and financial stability consequences, but to use them productively to increase the region s growth potential. The experience thus far is discouraging. In a recent study by the Interamerican Development Bank on productivity gains and losses relative to the United States for a sample of 76 countries, half of the 20 worst performing are from Latin America and the Caribbean. 9 According to the study, a typical Latin American country could have increased income per capita by 54 percent since 1960 if its productivity had grown like that of the rest of the world during the period. And the document goes on to conclude 9 See Pages-Serra, Carmen, editor, La era de la productividad: Cómo transformar a las economías desde sus cimientos; Banco Interamericano de Desarrollo, junio de

20 that more than additional investments, countries in the region need to make better use of the existing stock of physical and human capital. 20