An earlier version of this paper was presented at seminars at the World Bank and Inter-American Development Bank. The authors wish to thank the participants at these seminars, numerous colleagues and, in particular, M. Bruno, S. Calvo, P. Clark, E. Fernandez-Arias and M. Kiguel for their helpful suggestions.
Mr. Leiderman is on leave from the Department of Economics at Tel Aviv University and was a Visiting Scholar in the Research Department when this paper was written.
Latin America is not the only region that has experienced increased capital inflows in 1991. In fact, similar developments have occurred in Asia and the Middle East. At the same time, there had been a marked rise in capital outflows from the United States and Japan.
For tracing on the evolution over time of individual country ratings see, for instance, LDC Debt Report by Salomon Brothers.
The countries included in our sample are: Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, Uruguay, and Venezuela.
Notice that RA<0 implies accumulation of reserves by the monetary authority.
For the purposes of the present section, Latin America includes the same set of countries included under Western Hemisphere in IMF’s World Economic Outlook and International Financial Statistics.
These figures, which are available from the authors, express investment and consumption as shares of GDP and rely on preliminary national income accounts data for 1991.
On the role of various policy measures to reverse capital flight—such as amnesties, capital account liberalization, and introduction of foreign-currency denominated domestic instruments—see International Monetary Fund (December 1991) and Mathieson and Rojas-Suarez (1992).
Some of this increased borrowing may represent hidden repatriation of flight capital.
The IMF indices of the real effective exchange rate are used, hence an appreciation is represented by an increase in the index.
The price/earnings ratio in Argentina increased from 3.1 in 1990:IV to 38.9 in 1991:IV; in Chile it increased from 8.9 in 1990:IV to 17.4 in 1991:IV; and in Mexico it moved from 13.2 in 1990:IV to 14.6 in 1991:IV. These figures are from Emerging Markets Data Base, International Finance Corporation.
These figures are from Quarterly Review of Emerging Stock Markets. Fourth Quarter 1991, International Finance Corporation.
Some of the factors that make it difficult for foreign investors to invest in several Latin American markets are: the lack of full financial information about various traded companies, the absence of a comprehensive set of insider trading regulations and of strict broker requirements in some cases, and the difficulties in dealing with standard accounting practices under high inflation.
An implication of this discussion is that from the investor’s perspective, the information content of a drop in U.S. interest rates is different from that of an equal rise in the domestic interest rate—while in both these cases the interest rate differential would change by the same amount.
In fact, such comparisons are the subject of a separate research project the authors are preparing.
Notice, however, that the burden of foreign debt was larger at the outset of the present episode than at the start of the earlier episode.
Thus, assuming a 5 percent rate of return Diaz Alejandro (1983) estimates that profits and interests on foreign capital must have accounted for about 20 percent of annual export earnings of the region.
As in subsection 3 above, these are ex post developments that give only a partial indication of the ex ante rates of return, which are the most relevant ones for investors’ decisions.
The countries are: Argentina, Brazil, Colombia, Cuba, and Mexico.
Some examples of this development are as follows: (1) there has been an increase in the amount of investments in foreign securities by mutual funds in the United States. As of May 1992, the assets of stock funds that invest largely outside the United States stood at $41.8 billion, more than twice the level at the end of 1988, and assets of global funds have soared to $28.5 billion from just $3 billion in 1988; (2) in 1991, the sale of foreign shares in public and private deals doubled, to a record $9.78 billion. Bond deals rose 48 percent to $55.33 billion; (3) new foreign investment in U.S. companies and real estate plummeted 66 percent in 1991. See The New York Times (July 5, 1992) and The Washington Post (1992).
As indicated earlier, private capital outflows from Japan also increased sharply, by $36 billion, in 1991.
It is useful to recall how sizable these inflows to the United States were in the mid-1980s (Table 4). From net capital outflows of about $20 billion a year in the late 1970s, the private capital account turned around into surpluses (capital inflow), which peaked at $128 billion in 1985. This inflow, which mainly took the form of increased borrowing from abroad, was mostly used to finance high and increasing current account deficits that were well above $100 billion in the second half of the 1980s.
For an exposition of principal components analysis, see, e.g., Dhrymes (1970). Swoboda (1983), in an application that is close in spirit to ours, used this approach to examine economic interdependence across different exchange rate regimes for six of the G-7 countries.
All the analysis that follows uses the logs of reserves and of the real exchange rate.
The test statistics, which are distributed as a χ2 with 45 degrees of freedom, and the attendant probability values are presented at the bottom of Table 6.
Notice that, as shown in Chart 3, Brazil’s real exchange rate depreciated through most of the sample period and its upturn came fairly late in the sample. Thus, it is not surprising to find that the regional exchange rate index, the first principal component, does poorly in capturing its fluctuations. In effect, their correlation is negative. These details are available upon request.
Morande (1988) noted this pattern of interaction for the case of Chile in the previous capital inflow episode of 1977–82.
Since the sample is small and the collinearity problems common to VAR’s are present, limiting the precision of the estimates, we consider significance levels of 25 percent or below. In any case, the reader may use the marginal significance levels reported in Table 8 in order to check inferences under different levels.
In these cases, it could be argued that the policies and events that led to an appreciation in the real exchange rate are also responsible for attracting capital from abroad.
The contemporaneous relationship between reserves and the real exchange rate, about which Granger causality tests are silent, is explored in the next subsection.
Our procedure is similar to the DYMIMIC models associated with Watson and Engle (1983), and Stock and Watson (1989). One key difference in the approaches is that here we adopt a two—step procedure by first constructing the unobserved factor index (indices) and then incorporating that factor(s) in a dynamic model.
Alternative orderings are explored. One alternative imposes that there be no contemporaneous relationship between reserves and the real exchange rate, while another treats reserves as the most “endogenous” variable in the system. The results do not differ appreciably from those presented here.
Bolivia’s program began in August of 1985; Colombia had programs in 1985-86; while Chile’s stabilization dates to the Tablita.
Argentina has had three stabilization plans during the period considered, while Brazil had four. The Mexican plan began in December 1987 and is continuing. Venezuela floated its exchange rate in January of 1989.
The Peruvian stabilization program began in August 1990, hence it falls beyond the midpoint of our sample, making it difficult to group it with the other countries.
Had we considered the change in reserves (a flow) and the rate of change of the exchange rate instead of levels, the impact of the shock would be expected to die out.
Sometimes following a short-lived appreciation, as in the case of Argentina, Bolivia, Chile Mexico, and Uruguay.
In terms of economic agents in Latin America, it is also possible to interpret these developments as originating in a portfolio shift away from foreign (dollar denominated) and toward domestic financial and physical assets. For a model in which such a portfolio shift leads to a temporary appreciation of the real exchange rate and to accumulation of reserves by the central bank, see Calvo (1983).
For a discussion of these issues from the perspective of Chilean monetary and exchange rate policies, see Zahler (1992).
Actually, unless banks are forced to pay for deposit insurance, free market forces may not generate a privately-based deposit insurance scheme. This is so, because the expectation of free insurance if banks run into financial difficulties may make any privately-based deposit insurance scheme unprofitable.
Point (iv) above, market failure, will not be discussed here. An important example, however, is associated with the export sector which, as shown before, is likely to produce externalities in the rest of the economy.
In addition, to the extent that it reduces the government’s need to issue debt, a tighter fiscal stance is also likely to lower domestic interest rates.
A necessary condition for these outcomes, and for the effectiveness of sterilized intervention, is that domestic and foreign bonds are imperfect substitutes in agents’ portfolios. Casual observation suggests that this seems to be the case in Latin America. Cumby and Obstfeld (1983) produced econometric results for Mexico in the 1970s in support of imperfect substitutability between peso-denominated assets and foreign assets. For industrial countries, Obstfeld (1991) concludes that sterilized intervention is a weak instrument of exchange rate policy, and that monetary and fiscal policies, and not intervention per-se, have been the main policy determinants of exchange rates in recent years.
See also Calvo (1991), which provides an example in which social welfare always declines with sterilization, and in which the effectiveness of sterilization relies on its worsening the credibility of an undergoing stabilization program.
The problem is exacerbated when, like in most Latin American countries, the liabilities of the banking system are heavily biased towards short-term deposits, enhancing the chances of a run against the domestic banking system.