Martin Rapetti, Guest Blogger
Since the early 2000s, emerging market economies have attracted growing flows of foreign capital. This trend was briefly interrupted by the eruption of the global financial crisis, but it quickly resumed in mid-2009 with even more impetus. Most Latin American countries have been part of this process. The expansion of liquidity drove risk premia and interest rates down to historical minima in most countries of the region. The EMBI+ index published by JP Morgan is now around 150 basis points in Brazil, Chile, Colombia, Mexico, Peru and Uruguay. Current levels are significantly lower than the 350 basis points that Latin American countries reached in mid-1997 before the South East Asian crises.
The ability to borrow at low cost is certainly beneficial if funds are channeled to productive uses, especially investment in tradable activities and infrastructure. Experience has shown, however, that capital inflows can also end up financing private and public consumption, generating large current account deficits and inflating financial and real estate prices. Latin America has vast experience with boom-and-bust cycles driven by capital inflows that culminated in debt and financial crises with severe economic and social costs. Partly influenced by these experiences, the IMF has recently warned about the potential dangers of capital inflows to Latin America. In its 2011 Regional Economic Outlook , the IMF explicitly pointed to the widening of current account deficits as a source of external fragility that could lead —as it did in the past— to a sudden reversal of capital flows and crises.
It is comforting to see the IMF concerned about the possibility of crises in the region and so focused on their prevention. But, is this the main threat that the current wave of capital inflows pose to Latin American countries? In a recent paper, Roberto Frenkel and I argued that the IMF’s concern might be unfounded. We based our disagreement on three facts. First, while sudden capital flow reversals and crises occurred under some kind of fixed exchange rate arrangements in the past, most countries in the region operate now under managed floating regimes and have accumulated large stocks of foreign exchange reserves.
These elements give monetary authorities greater flexibility to absorb negative external shocks and to avoid sharp exchange rate corrections in the context of capital outflows. Second, foreign debts in Latin America have shrunk substantially during the 2000s and reached historic lows. The emergence of current account deficits in this situation is novel in the region. Since their reincorporation into the international capital markets in the late 1980s, Latin American countries have been dealing with heavy debt burdens inherited from the debt crises in the early 1980s. Under the current configuration, most countries have large margins to accumulate foreign debt before reaching critical levels that precipitate a sudden change of capital flows. For instance, Argentina has reduced the debt-to-exports ratio from above 5 in 2001 to below 2 in 2011. Peru did so from 5 in 1999 to 1 and Brazil from 4 to 1 in the same period. Third, although current account deficits in many countries have widened rapidly in recent years, their composition has changed substantially compared to the pre-crisis episodes. As a result of the reduction of foreign debts during the 2000s, the weight of interest payments in the factor income account of the current account has shrunk significantly. In contrast to the 1980-2000 period, current account deficits are now largely influenced by FDI dividend payments.
The case of Peru is illustrative in this regard. In 1999, about 94% of the factor income account deficit was due to interest payments and just 6% due to FDI dividend payments. In 2011, these figures have switched to 10% and 90%, respectively. This represents an important change. Interest payments have to be paid in foreign currency —typically US dollars— and since they are contractual obligations, they constitute a source of foreign currency outflow that is delinked from the business cycle. On the contrary, FDI dividends are largely obtained in domestic currency —making their value in foreign currency depend on the exchange rate— and are highly correlated with the business cycle. This implies that in the case of a capital inflow deceleration or reversal, the magnitude of FDI dividend payments tends to contract due to both the depreciation of the domestic currency and the deceleration or contraction of domestic economic activity. Furthermore, a significant portion of FDI dividends are normally re-invested in the recipient economy and registered in the balance of payments as a new inflow of capital. This implies that part of factor income account deficit has a relatively automatic source of funding.
Our view that sudden stops and crises in Latin America are unlikely in the near future does not imply that the current wave of capital inflows is unproblematic. Capital inflows have led to a pronounced appreciation of the real exchange rates (RERs) in the region, especially in South America. In Argentina, Brazil, Chile, Colombia, Peru and Uruguay, bilateral RERs against the US have reached or are about to reach the maximum degree of appreciation in the last 20 years, and in many of them, since the early 1980s crises. For the reasons I outlined above and also because of the much higher terms of trade that most countries in the region now face, current RER levels are unlikely to trigger a sudden stop and consequently do not represent a threat in terms of external and financial crises. They do, however, pose a threat in terms of development prospects. Empirical research has found strong evidence that the level of the RER is not neutral for economic growth in developing countries (see here and here) . In particular, it has found that while overvalued RERs tend to hurt growth (e.g., the Dutch disease case), competitive RERs tend to favor it.
Research also suggests that these outcomes result from the impact of the RER on the tradable sector, especially on manufactures and knowledge-intensive tradable services. It is in these activities where increasing returns to scale are more prevalent. Competitive RER levels increase tradable profitability and stimulate a reallocation of resources in favor of these key activities. Structural change and economic development are the outcome of their expansion. More concisely, economic development is tradable-led.
Many economists in Latin America argue that governments should target stable and competitive RERs. Managing the RER, however, is not an easy task. It is more complex than the standard inflation targeting framework because it requires the coordination of exchange rate, capital account, monetary, fiscal and incomes policies. Economists in the region have made specific proposals. They are worth considering.
Martin Rapetti is an Associate Researcher at CEDES and IIEP (FCE-UBA) and an Assistant Professor of Economics at the University of Buenos Aires, Argentina. He is interested in macroeconomics, finance, economic development and Latin American economics. His work can be found at www.martinrapetti.net
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