Capital Flows and Recent Financial Crises

1. Capital Flows and Recent Financial Crises Lecture # 16 Week 11

2. Structure of this class • “New” Capital flows • Concerns • The banking sector • Financial Crises and “contagion effects” • The experience of Chile

3. Capital flows • Portfolio investments • Foreign Direct Investments (FDI) • Official Flows • Remittances

5. The 1990s: Investors’ optimism about growth prospects in Latin America Why? “Structural Reforms”: Stabilization, Privatization, & Liberalization There were reasons for concern, however….

6. Why? • Transitory • The “original sin” • Dollarization • Shortermism • Illiquidity • Small market size • Concentration → Bandwagon, Procyclical, & Exchange Rates and Interest Rates

7. 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

8. Crises Mexican 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*

9. Other problems 1) Indigenous uprising in “Chiapas” • Assassination of Luis Donaldo Colosio → Capital Flight Measures to avert the crisis: Tesobonos Adjustment of the band Emergency loans from the US, Canada, Europe

10. 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

11. 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..

12. 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

13. 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

14. Currency crises first and second generation models

18. Third: Latin America does not seem vulnerable to the crisis • Proportion of Latin American exports to Asia small • 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

19. 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 • Increased spending in the social sector • Building – up reserves --- Next class: Corruption and Redefining the Role of the State (Laffont, S-V, and Franko)