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” 2)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 (a)Proportion of Latin American exports to Asia small (b)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 a)Increased spending in the social sector b)Building – up reserves ---  Next class: Corruption and Redefining the Role of the State (Laffont, S-V, and Franko)