One of the salient features of the recent debt crisis in several Latin American countries has been the coexistence of inverse capital flows. In particular, while public external borrowing was flowing in, private capital was flowing out, as domestic investors made massive switches from domestic financial assets into foreign assets.1 Since domestic public debt was generally quite substantial, a large proportion of these domestic assets were government obligations. Thus, white domestic creditors were reducing their exposure to public debt, foreign creditors were increasing theirs.
One explanation for this portfolio substitution is asymmetrical information available to economic agents: domestic creditors predicted a crisis well before foreign bankers. Although this argument is probably not completely devoid of empirical relevance, it hinges on the existence of substantial long-run irrationality, as this phenomenon occurred over several years and on a scale that should have eventually attracted the attention of the international banking community and fed it to revise its lending operations much earlier.
There exists, however, a fully rational way to justify these seemingly contradictory capital flows. It involves asymmetric risk, rather than asymmetric information. The debt crisis corresponded, in many cases, to a fiscal crisis in which governments were faced with the prospect of not being able to keep servicing their debt, domestic or foreign, as fiscal rigidities prevented a sufficiently rapid adjustment of the budget deficit, following, in particular, the occurrence of large external shocks and fast-rising external debt. In this situation, perceived risks of default on government obligations grew rapidly. However, while a declared default on foreign obligations is a major step which entails large potential costs to the borrowing country,2 a virtual default on domestic debt is much easier to obtain: all it requires is a discrete devaluation which, by raising the price level, erodes the real value of domestic debt. Faced with this asymmetry of exposure between domestic and foreign debt, domestic wealth holders are likely to be the first to pull the trigger on the debt crisis because they perceive themselves as “junior” creditors.3 Furthermore, if domestic assets can be taxed, private capital flight can be encouraged by public foreign borrowing because the government may be perceived as counting on revenue from domestic asset taxation to service its higher foreign debt in the future. Paradoxically, a country committed to servicing its external obligations can thus be more prone to capital flight as domestic creditors suspect that the government may be able to maintain external debt servicing only at the expense of taxing domestic assets.
The notion that investors shift away from domestic assets to avoid inflation taxes brought about by fiscal disequilibrium underlies the whole literature on speculative attacks.4 However, the origins and implications of the weak fiscal stance of the government have seldom been explored, since the analysis has been generally limited to the consideration of an “excessive” rate of credit creation, and money is the only asset explicitly considered. From the existing literature it is particularly difficult to understand why governments do not implement timely corrective measures to prevent a balance of payments crisis. Nor is it clear why the public does not acquire domestic bonds, which could serve as well as foreign bonds as an inflation hedge, and which may be closer substitutes for domestic money. Ex ante, exchange risk is not a satisfactory explanation since the interest premium on domestic bonds could fully adjust to discount expected movements in the exchange rate. Moreover, in some countries, domestic banks have been offering dollar-denominated deposits.
To justify capital flight and the preference for foreign over domestic instruments, it seems more appropriate, then, to generalize the risk factor associated with the overall financial solvency of the public sector to all domestic public debt—not only to money. The government’s weak fiscal stance, which may force it to impose an inflation tax, could also induce it to reduce domestic debt servicing on bonds.
If prices are not perfectly flexible, an explanation can also be found for the exchange rate overshooting that is often the product of balance of payments crises, such as the one experienced by Mexico in 1982. With price inertia, domestic debt servicing cannot be instantaneously reduced through a devaluation-induced jump in the price level. It can, however, be reduced through a fall in the domestic real interest rate, which is possible, even with interest rate parity, if, following an initial depreciation, the real exchange rate gradually appreciates over time, reducing the return of foreign bonds in terms of domestic currency. An expectational equilibrium is thus generated as the public’s fear of lower returns on domestic assets leads to a shift into foreign instruments, provoking an overshooting that enables the authorities to lower domestic interest rates without violating interest rate parity.
In this paper we develop simple models to clarify these issues, using the recent experience of Mexico as an illustration. Section I relates the occurrence of speculative attacks to the solvency of the public sector in an economy with interest-bearing debt, and perfect price flexibility but imperfect asset substitution. Unlike in the usual speculative attacks literature, endogenous tending ceilings are derived, which are fully consistent with the behavior of both domestic and foreign creditors. Section II explores exchange rate dynamics and overshooting phenomena in the opposite case of price inertia and perfect asset substitution. Section III illustrates the results of the analysis using Mexico’s recent experience, and the final section offers concluding comments.
Blanco, Herminio, and Peter Garber, “Recurrent Devaluation and Speculative Attacks on the Mexican Peso,” Journal of Political Economy (Chicago), Vol. 94 (February 1986), pp. 148–66.
Connolly, Michael, and Dean Taylor, “The Exact Timing of the Collapse of an Exchange Rate Regime and Its Impact on the Relative Price of Traded Goods,” Journal of Money, Credit and Banking (Columbus, Ohio), Vol. 16 (May 1984), pp. 194–207.
Diaz Alejandro, Carlos, “Latin American Debt: I Don’t Think We Are in Kansas Anymore,” Brookings Papers on Economic Activity: 2 (1984), The Brookings Institution (Washington), pp. 335–403.
Dooley, Michael, “Country-Specific Risk Premiums, Capital Flight and Net Investment Income Payments in Selected Developing Economies” (unpublished; Washington: International Monetary Fund, 1986).
Dooley, Michael, and Peter Isard, “Tax Avoidance and Exchange Rate Determination” (unpublished; Washington: International Monetary Fund, 1986).
Dornbusch, Rudiger, “Expectations and Exchange Rate Dynamics,” Journal of Political Economy (Chicago), Vol. 84 (December 1976), pp. 1161–76.
Eaton, Jonathan, Mark Gersovitz, and Joseph Stiglitz, “The Pure Theory of Country Risk,” NBER Working Paper 1984 (Cambridge, Massachusetts: National Bureau of Economic Research, April 1986).
Flood, Robert, and Peter Garber, “Collapsing Exchange Rate Regimes: Some Linear Examples,” Journal of International Economics (Amsterdam), Vol. 17 (August 1984), pp. 1–13.
Ize, Alain, “Investment, Capital Flight and Political Risk: The Case of Mexico,” (unpublished; Mexico City: Colegio de México, January 1985).
Ize, Alain, and Guillermo Ortiz, “Political Risk, Asset Substitution and Exchange Rate Dynamics: The Mexican Financial Crisis of 1982,” Documentos de Trabajo No. 5 (Mexico City: Colegio de México, October 1984).
Khan, Mohsin S., and Nadeem Ul Haque, “Foreign Borrowing and Capita! Flight: A Formal Analysis,” Staff Papers, International Monetary Fund (Washington), Vol. 32 (December 1985), pp. 606–28.
Krugman, Paul, “A Model of Balance of Payments Crisis,” Journal of Money, Credit and Banking (Columbus, Ohio), Vol. 11 (August 1979), pp. 311–25.
Lizondo, Saul, “Foreign Exchange Futures Prices Under Fixed Exchange Rates,” Journal of International Economics (Amsterdam), Vol. 14 (February 1983), pp. 69–84.
Obstfeld, Maurice (1984a), “Rational and Self-Fulfilling Balance of Payments Crisis,” NBER Working Paper 1486 (Cambridge, Massachusetts: National Bureau of Economic Research, November).
Obstfeld, Maurice (1984b), “Speculative Attack and the External Constraint in a Maximizing Model of the Balance of Payments,” NBER Working Paper 1437 (Cambridge, Massachusetts: National Bureau of Economic Research, August 1984).
Ortiz, Guillermo, “Currency Substitution in Mexico: The Dollarization Problem,” Journal of Money, Credit and Banking (Columbus, Ohio), Vol. 15 (May 1983), pp. 174–85.
Ortiz, Guillermo, “Economic Expansion, Crisis and Adjustment in Mexico (1977–1983),” The Economics of the Caribbean Basin, ed. by Michael Connolly and John McDermott (New York: Praeger, 1985), pp. 68–98.
Penati, Alessandro, and George Pennachi, “Optimal Portfolio Choice and the Collapse of a Fixed Exchange Rate Regime” (unpublished; Philadelphia: University of Pennsylvania, August 1986).
Sachs, Jeffrey (1984a), “Latin American Debt: I Don’t Think We Are in Kansas Anymore—Comment,” Brookings Papers on Economic Activity: 2 (1984), The Brookings Institution (Washington), pp. 405–7.
Sachs, Jeffrey (1984b), “Theoretical Issues in International Borrowing,” NBER Working Paper 1189 (Cambridge, Massachusetts: National Bureau of Economic Research, August 1983).
Salant, Stephen, and Dale Henderson, “Market Anticipation of Government Policies and the Price of Gold,” Journal of Political Economy (Chicago), Vol. 86 (August 1978), pp. 627–48.
Van Wijnbergen, Sweder, “Fiscal Deficits, Exchange Rate Crises and Inflation” (unpublished; Washington: The World Bank, February 1986).
Mr. Ize, an economist in the Fiscal Affairs Department, is a graduate of Columbia and Stanford Universities. This paper was initiated while he was with the Economics Department of the Colegio de México and an economist at the Bank of México. Mr. Ortiz is an Executive Director of the Fund and a graduate of the Univer-sidad Nacional Autónoma de México and Stanford University.
This phenomenon has puzzled many observers of the Latin American scene. See, in particular, Diaz Alejandro (1984), and Sachs (1984a). Another type of asymmetry in capital flows, private capital flowing out at the same time as private external borrowing was flowing in, is analyzed in Khan and U1 Haque (1985).
Empirical support for that hypothesis can be found in Dooley (1986) who finds, on the basis of a cross-section sample of eight countries, that capital flight is inversely related to the risk premium on external debt and therefore to the differential risk faced by residents and nonresidents.
See the seminal contributions in Salant and Henderson (1978) and in Krugman (1979). More recent contributions include Flood and Garber (1984), Obstfeld (1984a and b), Connolly and Taylor (1984), and, in the case of Mexico, Blanco and Garber (1986). Van Wijnbergen (1986) independently developed a model relatinp fiscal rigidities to asset taxes and capital flows, somewhat similar to ours, while Dooley and Isard (1986) present a general conceptual framework that includes risks of asset taxation into asset demands, and analyzes their macroeconomic impact in a two-country framework.
Conversely, rh could become negative even with no inflation, if domestic bonds were sufficiently imperfect substitutes for foreign bonds. In practice, however, the margin for imposing a pure interest tax on bonds without additional inflation is likely to be limited, first, because nominal rates must be positive and this constraint becomes rapidly binding unless the initial inflation rate is already high, and second, because the degree of substitutability between foreign and domestic bonds may be high. Hence, higher inflation can be expected to be the main vehicle of asset taxation, both because it directly erodes money balances and because it allows for negative real interest rates on bonds.
Real wealth is assumed constant. Although a discrete devaluation does in fact reduce wealth, nothing of substance would change by incorporating changes in wealth into the analysis.
To see this, note that dR = rfdbw+ d(rhbh) = 0 on an iso-interest contour. The slope is horizontal when db = 0, which corresponds to the point where d(rhbh = 0, which maximizes the asset tax.
Although it does not have the same legal implications, a discrete unexpected devaluation can be perceived by the public as a partial default on domestic debt since it amounts to changing unilaterally the terms of an implicit debt contract between the government and private agents.
Similar dynamics would be obtained if the deficit had initially been financed by internal borrowing. In that case, domestic borrowing first rises, and then collapses, as the economy moves back to N following a burst of capital flight.
This can explain the reluctance of countries with already heavy levels of asset taxation to engage in further international borrowing, since the additional foreign debt may be immediately exchanged for domestic debt and converted into deposits abroad.
The default risk on foreign loans that is implied here could be assimilated in the sovereign risk analyzed in the debt repudiation literature (see Sachs (1984b)). The defaulting benefits emphasized here are less inflation and less financial repression, which are not usually considered in the literature.
A more usual adjustment equation would be of the type: ·Ph = ·Ph* + ν(·Ph* − ·Ph). However, when converted into real terms, the inflation rate becomes a determinant of the speed of adjustment. Although this would not alter the analysis in any significant way, a simpler formulation in real terms was chosen.
Overshooting would still work however with a dual exchange system, since in that case the burden of foreign debt servicing does not rise with a devaluation.
Details on the elaboration of this table can be found in the Appendix.
There has been a wide debate on the issue of capital flight measurement. See for example Dooley (1986). While the definition used here has clear shortcomings, it has the advantage of simplicity.
See Ortiz (1985) for an account of the economic events of this period. Apart from the lack of control over the deficit, another costly mistake of the López Portillo administration was maintaining the nominal value of the peso. In the context of our model, devaluing earlier would have been greatly desirable because it would have increased the peso revenues obtained from foreign borrowing and oil earnings. A real 50 percent devaluation implemented at the end of 1980, for example, would have raised oil income in 1981 by 61 (1978) billion pesos and reduced the need for foreign debt by more than two thirds in that year, even considering that the burden of servicing that debt would have risen, as a result of the higher exchange rate. By improving government finance, the reduction in foreign indebtedness would, in turn, have helped stabilize the exchange market, as seen earlier in the model.
Public spending grew, although the Government had announced spending cuts on at least three occasions, in July 1981 and in February and April 1982. Its credibility was understandably damaged by those repeated failed attempts. Besides the downward rigidity of expenditures, two other factors help to explain the increase in the deficit: a fall in non-oil tax income owing to the recession, and exchange losses suffered when the Government converted Mexdollar deposits into pesos at a rate of 70 pesos a dollar. The loss was compounded by the fact that the Government nationalized a banking system that had been forced to convert dollar loans at 50 pesos a dollar.
Although real peso bond balances grew by twice as much as in the previous year, this was essentially the result of the forced conversion of dollar bonds into pesos. Altogether, money and domestic bonds grew by only 45 billion of 1978 pesos, versus 126 billion pesos for 1981.
Foreign borrowing less foreign debt interest.
September and October 1982 are out of line owing to an expectational error motivated by a wrong setting for the controlled exchange rate during those months at an unrealistically low level, given the rates of inflation that had prevailed since January. On the other hand, a small speculative bubble occurred in mid-1984 provoked by a combination of “bad news” concerning the inertia of inflation and the behavior of oil prices and external interest rates.
The concept of fiscal weaknesses or fiscal rigidities could perhaps be endogenized. In Ize and Ortiz (1984) and Ize (1985), spending rigidities are related to the set of political pressures that the government faces.
Average yearly controlled rates were used to convert balance of payments figures since it was at that rate that the state sold its foreign currency surplus to the private sector.