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Hemispheric views on international lending and financial stability

It is an honor for me to participate in this 32nd Annual Washington Conference of the Council of the Americas.  <?xml:namespace prefix = "U1" />

In my remarks, I will first focus on the importance of external factors, and in particular external financial factors, in the growth performance of Latin America. Next, I will briefly describe the main features of international lending to Latin America during the last decade. Finally, I will discuss what are, in my view, some necessary steps for a successful reform of the international financial architecture aimed at increasing both the quantity and stability of international lending to the developing world.

During the 1990s, Latin American and Caribbean total GDP grew at an annual rate of 3.3 percent, well below the 5.1 percent averaged by the countries of South East Asia. This modest growth performance was insufficient to significantly reduce poverty in the Region. During the 1990s, the share of Latin Americans who live with less than 2 dollars a day remained almost unchanged.  Besides being low, growth was extremely volatile and this volatility was particularly damaging for the poorest class of society. In fact, during periods of economic crisis poverty and income inequality increased more than they decreased during periods of economic expansion. Therefore, each economic cycle led to a worsening of the social conditions in the most volatile countries.  

Perhaps the most salient characteristic of growth performance in Latin America is the remarkable importance of external factors, especially international lending.   The evolution of international lending is particularly important because growth is closely associated with the magnitude of the net flows of capital to Latin America and the notorious instability of these net flows is associated with the high economic volatility of the region. When access to international capital markets is closed, which happens with distressing frequency in Latin America, the collapse of real activity is dramatic.  The collapse caused by a sudden swing in capital flows (what IDB’s chief economist Guillermo Calvo calls a “sudden stop”) sets in motion a destructive process in the real economy as credit dries up throughout the economy and production is strangled.

The availability of external financing also plays a critical role as an insurance device against adverse economic shocks.  For example, it may allow consumption and investment levels to be maintained in the face of natural disasters and it may allow maintaining equilibrium in the balance of payments at time of negative shocks to export prices. But in order to play such an insurance role, capital flows should be countercyclical, that is, they should increase during periods of economic crisis and drop during periods of economic boom. This was not the case for Latin America during the 1990s when a key characteristic of private external finance was its procyclicality. These procyclical private capital flows, only in part balanced by countercyclical official flows, contributed to the high volatility of Latin American economies.

Before moving on and discussing what policies could be enacted to reduce this procyclicality of external finance, let me briefly review the behavior of international lending to Latin America during the last decade.  The Region saw a strong revival of capital inflows starting in 1990 after a long period of external financing constraints during the debt crisis of the 1980s. With only a brief interruption around the Mexican crisis in 1994-95, this resurgence continued to increase until the Russian crisis in 1998. While this new wave of capital inflows to the region was not unprecedented, it exhibited a different composition.  Its most striking feature was the great importance of portfolio flows, both of debt and equity nature. At the same time, bank borrowing was negligible in contrast with the experience in other emerging markets, including East Asian countries. Foreign direct investments also grew very rapidly over the decade.

Another important characteristic of capital inflows in the 1990s was that funds were largely directed to the private sector. Initially, this was seen as an insurance against balance of payments crises, because it was expected that the corporate sector knew what it was doing.  For this reason, the Mexican crisis of late 1994 came as a surprise to many. The key lesson from this experience was that countries were financially more fragile than previously thought: even if their long-term capacity to pay was sufficient to cover obligations, they could be rendered insolvent if a critical mass of investors exited at once.

Financial contagion was felt throughout Latin America in bond spreads and other financial indicators, and for a period many countries lost access to international lending.  The international official sector reacted quickly by putting together, for the first time, a large rescue package.  Financial contagion disappeared in a few months, Mexico adjusted deeply but recovered quickly, the rescue package was repaid, investors came back, and the episode was brushed aside as an anomaly.   

The second crisis episode was the string of Asian crises of 1997.  These crises hit high-growth, high-savings emerging market countries considered to be low risk at the time.  It then became apparent that liquidity crises were also a possibility in the case of bank lending and that policy ought to focus on the fragility of the financial system. 

The biggest surprise for Latin America was the aftermath of the Russian default in August 1998.  Russia is a country with very little real linkage with Latin America, and it represents less than 1 percent of world output.  And yet, the financial contagion shock wave was enormous, similar to that felt in the aftermath of the Mexican crisis in 1995.

As the financial crises of the 1990s were very harmful for the Region, it is necessary to implement both domestic and global policies aimed at preventing and managing future crises.

On the domestic side, it is necessary to increase national savings and promote the development of a sound and safe domestic financial system. These objectives require good banking regulation and supervision and a stable macroeconomic environment characterized by low inflation and the absence of fiscal imbalances.

Other policies should be directed towards mobilizing external funds by strengthening the ability to export and at increasing commercial integration with the region. This would require appropriate physical infrastructures and domestic policies aimed at avoiding large real exchange rate appreciations, but it would also require an effort by developed countries to reduce protectionist tariffs on agricultural and textile products on which most developing countries have a comparative advantage.

The countries of Latin America and the Caribbean also need to continue their process of regional and hemispheric integration. Under this aspect, the international financial institutions can play an important role by offering technical assistance, channeling and disseminating information (for instance the regional Policy Dialogue of the IDB), and supporting the negotiation process (for instance the three party committee of the FTAA composed by  IDB, OAS, and ECLAC).

The countries in the region can also increase their external financing sources by developing policies aimed at attracting remittances. During 2001, remittances to Latin America amounted to $23 billion and represent large shares of the national incomes of several small countries, like El Salvador and Dominican Republic. One obstacle to this important source of external financing is the high fee charged by some private operators that enjoy a regime of almost monopoly in the transfer of money to isolated and rural areas. For this reason, IDB is working towards the creation of a network of financial institutions that would reduce the cost associated with transferring money to developing countries and hence increase the welfare of both recipients and senders and possibly increase the flow of remittances.  

It should be, however, recognized that national policies like banking supervision, imposition of international standards, and increased trade integration are not sufficient to fully isolate the countries in the region from the systemic risks associated with international financial crises. To fully address this issue, it is necessary to develop a new financial architecture that would include multilateral mechanisms of crisis prevention and management.

The main focus of this new financial architecture should be the reduction of the volatility of external financing. To this extent, the first objective should be the establishment of mechanisms aimed at protecting countries with good fundamentals from speculative attacks. This would involve perfecting facilities similar to the contingent credit line established by the International Monetary Fund that provide automatic financial backing to countries that are facing a liquidity crisis. It is also necessary to create mechanisms to stabilize the demand for emerging market bonds; such mechanisms would play a fundamental role in limiting financial contagion and “globalization hazards.” Finally, it is necessary to develop mechanism of crisis resolution when solvency and not liquidity is the issue.

We should also recognize that global financial problems have a regional component and this component could be addressed with regional cooperation. In particular, regional coordination of monetary and exchange rate policies and the development of a regional system of financial supervision would insure that the adjustment policies adopted by the various countries would take into account their effects on the other countries in the region.

A new international financial architecture is also a necessary condition for the objective of hemispheric economic integration. In fact, exchange rate and financial crises that bring large exchange rate misalignments have been proven to be particularly harmful for the stability of regional integration agreements. The main worry is that if the problems of the international financial architecture are not solved, some countries will establish obstacles to capital mobility, limiting capital inflows during periods of economic boom and capital outflows during periods of economic crisis. This would translate into less capital flows and less growth for the developing world.

Unfortunately, the progress towards the development of this new financial architecture has been limited. The crisis in Argentina, however, made it very clear that addressing these issues is paramount to increasing the growth and stability of the developing world and in the last few weeks there have been several proposals for mechanisms of crisis resolution. While the International Monetary Fund launched an interesting proposal for an international bankruptcy court, the US Treasury seems to favor a more decentralized and market-based mechanism. Although these proposals are still diverging, they are interesting starting points and they both recognize the needs to reform the rules on which international lending is based. It is now fundamental to find a consensus on this important issue. It is our responsibility that the end of the current recession and the recovery of economic activity in the Region will not make us forget that reforming the mechanisms of international lending is key for the economic stability of Latin America and the developing world at large.