The Management of Capital Inflows
Paper published in Pensamiento Iberoamericano
© Peterson Institute for International Economics
A number of countries in Asia and Central Europe have recently begun to experience seemingly excessive capital inflows such as have periodically troubled a number of Latin American countries. If those countries are not to repeat the mistakes that have been made in Latin America, their policymakers need to understand the problems that have been created by such inflows in Latin America. This paper is thus intended to help countries in other parts of the world learn from Latin American experience.
The paper is organised as follows. The first section identifies the problems that have been revealed by experience in Latin America, during both the lending by commercial banks in the late 1970s and early 1980s and the more recent influx in the forms of bonds and equity following the resolution of the debt crisis. The second section catalogues the policy options that can be taken in response to seemingly excessive capital inflows. The third section describes the policy options adopted by six principal Latin American countries during the most recent episode, and sketches the outcomes so far. A brief concluding section sketches some policy implications.
The Problems Caused by "Excessive" Capital Inflows
The main danger posed by large capital inflows is that they may destabilize macroeconomic management. This can happen both through the inflows themselves leading to an appreciation of the real exchange rate that causes "Dutch disease"2, and through the inflows cumulating to a stock of debt that the country finds difficulty in continuing to service on the contractually agreed terms.
Consider first the problems that arise through a real appreciation induced by capital inflows. It is traditional to distinguish between the case in which such an appreciation is temporary and that in which it is permanent. A temporary real appreciation that the public expects to be temporary is unlikely to have major effects on investment, which is presumptively governed by long-run expectations; indeed, the principal effect may be to stimulate an attempt to take advantage of the temporarily low price of foreign capital goods in order to accelerate investment. To the extent that domestically made capital goods (e.g. buildings) and foreign-made capital goods (e.g. machinery) are complements, the investment boom will spill over to increase domestic demand as well. Usually a capital inflow will in any event tend to be associated with a domestic boom, when it results from low foreign interest rates, domestic reforms, or a domestic stock market boom (an exception arises if it is caused by high domestic interest rates resulting from tight monetary policy). Consumption can be expected to boom as well except in the last case, for similar reasons (as a result of increasing wealth and complementarity of domestic and imported goods in consumption). And, so long as the public has the rational expectations nowadays posited by many economic theorists, none of this creates a policy problem.
Consider, however, the alternative possibility that the low foreign interest rates or the domestic stock market boom that is responsible for the capital inflow is temporary but that the public does not recognize this. Then the decreased profitability of producing tradables will discourage investment in those industries. Either investment will shift toward nontradable industries, which is perhaps the most likely outcome given that the initiating factor was a decrease in the cost of capital, or the mix of expenditure will shift away from investment and toward consumption. When the capital inflow ceases, as it will by virtue of the hypothesis that it was temporary, the economy will find itself in a worse position to service foreign debt than it would have been in the absence of a capital inflow. It is obvious that in this case a policy of preventing the real appreciation from occurring-of short-circuiting the misleading price signals-would have been beneficial.
Consider now the possibility that the capital inflow is permanent, e.g. because of reforms that make the domestic economy more attractive to foreign investors. There are sharp differences of view among economists about the desirability of resisting a real appreciation that results from a permanent capital inflow. One view is that, just like a resource discovery that induces a real appreciation,3such an inflow is a piece of good fortune that permits a country to enjoy a larger real income, which it can take in that combination of increased consumption and increased investment that it prefers. The other view is that the damage to the tradable goods industries caused by the real appreciation can harm the country's prospects for development, given that those industries tend to be the key to long-term growth. While the theory as to why this should be so has never been very satisfactorily developed, it is a view that is held quite strongly by many economists. Many Latin American economists nowadays argue that a key reason for East Asia's superior economic performance is the attention that has been paid to maintaining a stable and competitive real exchange rate (see, for example, Laraín in Group of Thirty 1994, p. A-78).
In practice, of course, it is often true that neither the public nor the government has a clear view as to whether a capital inflow is going to prove temporary or permanent. A rule of prudence would suggest that positive shocks should be treated as temporary and negative shocks as permanent. A second rule of prudence would suggest that, while no government should ever adopt a policy that is not viable if expectations are rational, it should also avoid policies whose success is dependent upon expectations being rational. The two rules together imply that a prudent government will treat as a problem any capital inflow so large as to induce a real appreciation big enough to threaten the growth of exports.
The other major macroeconomic problem caused by capital inflows is that they may build up a level of debt that the country finds it difficult to service on the contractually agreed terms, as happened throughout Latin America in 1982 (and again in Mexico in the early 1990s). This raises two issues: identifying how much debt a country can prudently take on, and limiting borrowing to a prudent level when the market wants to lend more. The first of these issues is briefly discussed in an appendix to this paper, while the various ways in which the second may be accomplished are discussed in the next section of the paper.
A number of other problems are sometimes also mentioned as possible undesirable consequences of large capital inflows. Inflows may, for example, lead to a speculative bubble in the stock market. One undesirable consequence of such a bubble is typically a decline in the local savings rate, as individuals discover that their asset accumulation objectives are being achieved without the need for anything so tedious as abstaining from consumption. Another undesirable consequence can be a financial crisis, and the danger of a recession, when the bubble bursts.
Capital inflows may also involve the loss of local control over economic decision-making: this is clearest in the case of majority-owned direct investment, although direct investment carries offsetting benefits in terms of access to technology and markets, and the loss of control can in any event often be avoided through joint ventures. Problems may also arise to some degree in the case of portfolio equity investment, if concentrated shareholding is allowed, and even loans, where powerful foreign creditors (notably the IMF when times get difficult) expect to be consulted about the course of economic policy.
On the other hand, there seems no particular reason to be concerned about foreign borrowing leading to dollarization. The latter is caused by economic mismanagement that results in Gresham's Law coming into play to the point where the local currency is undermined. When capital starts to be repatriated, it may seek some form of dollar guarantee, but it seems more natural to blame the resulting dollarization on the preceding mismanagement rather than on the capital reflow. Neither is it right to think of the use of foreign borrowing to finance local expenditure as posing a particular problem. It is even conceivable that, when an economy has idle capacity and is suffering from a foreign exchange constraint, financing local expenditure may be the very best use of foreign borrowing. What matters from the standpoint of preserving creditworthiness is that the new investment should contribute to the production of tradables so as to generate foreign exchange with which to service the debt4, and not what the capital is spent on. It is of course important to be alert to the danger of wasting resources on grandiose projects with a derisory rate of return, but that is true whether they are financed from local savings or from foreign borrowing.
These extra possible problems of foreign borrowing are not addressed in detail in the present paper. They have not been totally absent in Latin America. For example, Chile had a stock market boom in the early 1980s driven by capital inflows, which drastically reduced domestic savings. Many countries were tempted into grandiose projects with poor rates of return by the easy availability of commercial bank finance with no questions asked in the late 1970s, and many of them also paid too little attention to ensuring that sufficient investment was being directed to the tradables industries to be able to service the debt. And worries about foreign control used to be intense. Nonetheless, the rest of the paper is focused on the problems to macroeconomic management posed by large inflows, which have aroused more concern in recent years.
Suppose that a government is faced with large capital inflows. It has to choose among the following possible reactions:
i.to allow a nominal appreciation of the currency
ii.to buy up reserves (e.g. by holding the exchange rate fixed) and allow the money supply to expand in consequence (i.e. to engage in unsterilized intervention)
iii.to liberalize restrictions on imports of goods and services
iv.to buy up reserves but sterilize the intervention by selling an equal value of domestic-currency denominated bonds
v.to increase the reserve ratio applying to bank deposits
vi.to switch government-controlled deposits (e.g. deposits in the postal savings system) from the commercial banks to the central bank
vii.to widen the band of permissible exchange rate fluctuations
viii.to pursue a contractionary fiscal policy
ix.to improve the mobilization of private savings
x.to eliminate any remaining subsidies to inward investment, such as free deposit insurance
xi.to impose or increase controls on capital inflows
xii.to relax controls on capital outflows.
The strategic decision is whether to allow the capital inflow to be translated into a current account deficit so as to finance increased domestic investment and/or consumption. If it is decided to "make the transfer", there are three polar mechanisms by which this can be accomplished. The first is the flexible exchange rate mechanism of currency appreciation, which is listed first on the above list. The second is the fixed exchange rate ("gold standard") mechanism, whereby an expanding money supply increases demand and thus causes inflation and real appreciation once again. The third is to relax import restrictions, which will also lead to an increased current account deficit, although with the important difference that this will come about through higher imports and will avoid the discouragement of exports.
However, it was also argued above that there are circumstances-where the inflow is believed to be temporary, where Dutch disease threatens growth prospects, where the debt is growing so large as to threaten to precipitate a debt crisis, or where the outlook is uncertain-where it is rational to resist current account adjustment that would accomplish the transfer. The natural first resort is in this instance to intervene in the exchange market to hold a "fixed" exchange rate5, and to sterilize the intervention through open market operations (the fourth option). The difficulty with this option is that it is expensive. Especially when domestic interest rates are being held up in order to restrict domestic demand, or because there is a lack of confidence in the domestic currency, the domestic interest rate that the central bank will have to pay on the bonds that it issues6 may be very much higher than the foreign interest rate that it will earn on the reserves that it acquires. Moreover, in order to persuade the public to hold bonds equal to the whole of the reserve increase, it may be necessary to increase the domestic interest rate (although this can be avoided by allowing a monetary expansion equal to a part of the reserve increase). If interest rates are allowed to increase, the capital inflow will rise further; even if they are held constant, there will be no market incentive to reduce the inflow.
Financing such inflows can be expensive. For example, in Argentina in July 1994 the interest rate on 30-day government paper was 10.6% per annum, as against 4.5% on the comparable U.S. government assets that Argentina might have been holding in its reserves. The interest differential of 8.4% consisted of 2.2% exchange risk premium and 3.9% country risk premium. Similarly, Mexico had an interest differential of 7.7% in September 1994, consisting of 3.8% expected depreciation, 1.8% exchange risk premium, and 2.1% country premium.7 In Mexico's case, the loss on sterilized intervention is the interest differential minus planned depreciation, or 3.9%; in Argentina's case it would be a massive 8.4% (although Argentina's currency board system implies that it does not actually undertake sterilized intervention). Other Latin American countries have suffered comparable losses. Larraín in Group of Thirty (1994, p. A-89) reports calculations that the losses on sterilized intervention have been around 0.5% of GDP in both Chile and Colombia.
So far as the central bank is concerned, this cost can be avoided by raising the reserve ratio, thus averting the need to issue additional domestic currency bonds while still avoiding an increase in the money supply despite the increase in the monetary base. However, high reserve ratios impose costs of a different sort, in diminishing the efficiency of the financial system as borrowers are diverted away from those lenders subject to the high resrve requirements toward others that escape that requirement. Another way of achieving de facto sterilization without issuing additional bonds is to require government-controlled financial institutions (like the postal savings system) to switch their deposits from the commercial banks to the central bank. While this has proved effective in a number of Asian countries (Fischer and Reisen 1992), it implies either reducing the return to the savers in those institutions or (if the central bank pays the normal domestic interest rate) it still imposes a financial cost on the central bank.
The seventh possible policy reaction is to widen the band of permissible exchange rate fluctuations. This will allow the capital inflow to push the exchange rate to the top of the band, but is intended to leave the private sector with a presumption that the appreciation is temporary. If that is indeed believed, it will have two helpful effects. The first is that, since foreign investors deduct expected future depreciation from the domestic currency return in order to calculate the expected yield in their own currency, it will reduce the incentive for the capital inflow. The second is that it will minimize the danger that the appreciation will discourage investment in the tradable goods industries, which is presumably influenced mainly by expectations of the long-term real exchange rate.
The eighth policy option is to tighten fiscal policy, either by cutting government expenditure or by raising taxes. This will permit domestic interest rates to be reduced, thus diminishing the incentive for the capital inflow, without losing control of domestic demand and thus risking inflation.
A similar effect could be achieved by institutional measures, as opposed to higher rates of interest, that would increase private savings. The establishment of a postal savings system or of a system for the private provision of pensions are examples of the sorts of measure that might increase savings without requiring higher interest rates. (The latter has induced an important increase in savings in Chile, and other Latin American countries are now following Chile's example.)
Capital inflows might also be discouraged by withdrawing any measures that inadvertently subsidize inward investment. The two most common examples are probably insurance of bank deposits and grants to direct investors. The latter are presumably intended to attract direct investment because of its job-creating or technology-enhancing features, but there is absolutely no reason except accident or inertia why foreigners should get the benefit of free or subsidized deposit insurance.
We are now in the realm of measures intended to repel rather than to finance capital inflows. The classic measures of this type are capital controls. These can take many forms: for example, the prohibition of foreign purchase or holding of domestic assets; requirements to obtain administrative permission for a foreign bond issue; minimum maturity periods for foreign bond issues; a dual exchange rate for capital transactions; taxes on purchases of domestic assets by foreigners or on investment income earned by foreigners; or reserve requirements on deposits held by foreigners. If such controls were easy to enforce, there would be no problem of excessive capital inflows. The dominant question to ask of proposals for such controls is always whether they can be enforced and, if so, at what cost in terms of economic distortions or civil liberties, remembering that additional controls become progressively more likely to produce perverse side-effects as there are a larger number of pre-existing controls with which they may interact in unforeseen ways. As an example of the limits of such controls in a European country with a well-regarded administrative apparatus, Belgium for many years operated a dual exchange rate system, but problems of evasion began to become significant whenever the two rates diverged by more than 3%.
The final entry on my list of possible policy reactions to a capital inflow is to relax controls on capital outflows. There is, however, some evidence that a blanket relaxation of outflow controls can at times have the perverse effect of stimulating a net inflow (Labán and Larraín 1993). The reason is that investors can be so reassured that they will have no difficulty in withdrawing their money should they wish to do so that they actually increase their exposure. It may nonetheless be possible to undertake limited liberalization, e.g. by permitting domestic pension funds to invest abroad, while avoiding the danger of provoking a perverse reaction.
Latin American Policy Responses
Table 1 shows that, for Latin America as a whole, the recent surge of capital inflows was initially used largely to build up reserves. As the inflow was sustained, however, and even more as it began to subside, the inflow has been increasingly fully transferred.
|Year||Balance of goods, services, and transfers, Privatea||Capital balance plus errors and omissions, Neta||Increments in reserves|
|Source: Calvo (1994) on the basis of the data of the World Economic Outlook of the IMF.|
|a The balance of goods and private services and transfers is equal to the current account balance minus official transfers. The latter are treated in this table as external financing and they are included in the capital account.|
Both the extent and the manner of this transfer have differed very significantly between one country and another. It is natural to divide the six8 major countries into three categories: those that have used the exchange rate as a nominal anchor in their stabilization programs, namely Argentina and Mexico; those that have floated, which is only Peru; and those that have managed their exchange rates with a view to maintaining the competitiveness of the export sector, namely Chile and Colombia and, at least until the recent Plano Real, Brazil.
Table 2 provides summary statistics about the recent economic performance of the six countries. It can be seen from the final column that both of the countries that chose to use the exchange rate as a nominal anchor, namely Argentina and Mexico, have experienced a substantial real appreciation as compared to the average for 1982-90 (the years of the debt crisis, which were used as a base period that was sufficiently long to minimize the danger that an erratic number in the base period will lead to misleading conclusions).9
|Annual GDP growth|
|Annual export growth||Current account deficit as percentage of GDP||Capital inflows as percentage of GDP||Changes in investment between 1981-89 and 1990-93 as percentage of GDP||Real exchange rate of exportsa||Average tariff (percentage)|
|1990||Last 12 months||1991-93||1990-92||1990-92||Jan-Sep. 1993||1991-92|
|Source: CEPAL Balance Preliminar de America latina y caribe 1993 y Panorama Economico de America latina y el caribe 1994.|
|a The indices of real exchange rate of exports are calculated with the base years 1982-1990=100. A greater number indicates real appreciation.|
|b World bank, World Debt Tables, 1993-94.|
|c French-Davis and others, 1994|
|d Group of the Thirty, 1994, Table 8.|
|e Edwuards, 1993, Table 5.2.|
Argentina had stagnant exports (although they have recently started to grow, primarily to Brazil under the stimulus of Mercosur) and a significant current account deficit that was overfinanced by capital inflows. Internally it enjoyed spectacular success, with inflation being brought down from 1,344% in 1990 to a mere 4% in the most recent 12-month period for which statistics are given in ECLAC's Economic Panorama of Latin America 1994 (which happen to be the 12 months to August 1994), and strong growth of 6% per year. Investment has been recovering, although it fell to an exceptionally low level at the end of the 1980s.
Mexico had a much larger current account deficit than Argentina, again overfinanced by very large capital inflows. It too achieved a respectable reduction in inflation, though its growth performance was less impressive. (The capital inflow was reversed in Mexico in the course of 1994.) Investment was quite strong in the early 1980s, though more recently savings have been declining.
Peru is the only one of the countries to have adopted a floating exchange rate. It has experienced an even stronger real appreciation, which-despite some bounce-back of exports after the chaos of the Garcia government that left office in 1990-has led to an even bigger current account deficit, which was largely financed by massive capital inflows. Peru again made spectacular progress in bringing hyperinflation under control, although its growth record has been modest until very recently. Growth is currently quite strong.
In contrast, both Chile and Colombia adopted an exchange rate policy that attempted to maintain the gains in competitiveness that they had achieved during the debt crisis, in pursuit of export-led growth. Both of them found this difficult because of the size of the influx of reserves. In the case of Chile, this was because of a massive capital inflow that overwhelmed the modest current account deficit, while in Colombia it was, at least until recently, principally the result of a current account surplus. Both of them maintained strong export growth. Chile also enjoyed strong GDP growth backed by a large rise in investment and combined with an impressive reduction of inflation. Colombian performance was less impressive on all three scores. The discovery of a large oil field, which is currently being developed, has led to big capital inflows that have posed an even more intense challenge to the aim of maintaining a competitive exchange rate.
Until the stabilization program (Plano Real) took effect in July 1994, Brazil also followed a fairly similar exchange rate policy as Chile and Colombia, focused on offsetting domestic inflation so as to maintain the competitiveness of exports. There had in fact already been some slippage by 1993, but Brazil had nonetheless maintained a respectable rate of export growth and kept its current account in balance. However, internal performance was abysmal, with inflation increasing even further and output and investment stagnant. Things changed enormously in the course of 1994: inflation was brought under control, output is buoyant, the current account remains strong so far, capital inflows have surged, and the currency has been allowed to float up from the 1:1 exchange rate against the dollar at which it was introduced. However, intervention again started (reluctantly) after an appreciation of about 17%, and a number of other measures intended to repel capital inflows were adopted, indicating that the authorities maintain their concern with sustaining competitiveness.
It is clear that policies have differed significantly across countries. Argentina and Peru made no attempt to avoid capital inflows being translated into current account deficits: Peru let this happen the quickest way, through currency appreciation, but Argentina's unsterilized intervention produces the same result equally surely (except to the extent that the demand to hold pesos increases). Mexico sterilized much of the intervention and for a time had a large reserve buildup, but its growth has been unimpressive and it now faces a widespread market belief that its currency is overvalued.10 The interesting question is whether these policies are consistent with robust growth. It is certainly true that Argentina, and more recently Peru, have enjoyed quite strong growth, but the critical question is whether this is just bounce-back growth that will be undermined before long by the weakness of exports. If it is true that the only growth that can be sustained in today's world is export-led, the outlook for Peru under its present policy regime is poor, and the question for Argentina and Mexico is whether Mercosur and NAFTA respectively can provide enough export momentum to overcome the hurdle of the strong exchange rate.
Chile is the one country in Latin America where an East Asian rate of growth has become institutionalized, and, since its export performance seems to be a key factor in that achievement, strenuous measures have been taken to avoid overvaluation.11 Particular interest therefore attaches to the measures that Chile has taken to prevent the massive capital inflows with which it has been faced from undermining its policy stance.
The previous section listed 12 possible policy responses to a capital inflow. Chile has applied a wide range of policies:
Item (i). Two small revaluations, of 2% and 5%, were undertaken in 1991 and 1992 respectively (running counter to the regular crawling depreciation that offsets differential inflation).
Items (ii) and (iv). Chile has bought reserves on a massive scale, totalling $6.2 billion from the end of 1989 to November 1993 (some 15% of 1993 GDP). The authorities report having issued large sums of bonds in order to sterilize their purchases of reserves (Ffrench-Davis et al 1994, p. 10). Nonetheless, it is an interesting fact (according to the figures in International Financial Statistics) that during the period when reserves increased by $6.2 billion (from $3.6 billion at the end of 1989 to $9.8 billion in November 1993), the stock of reserve money increased by almost exactly the same amount, namely $6.5 billion (from a dollar value of $7.8 billion to $14.3 billion). Of course, this left Chile no room for domestic credit expansion, but the fact is that over the period as a whole it did not actually sterilize.
Item (iii). The uniform import tariff was reduced from 15% to 11% in June 1991.
Item (v). Leiderman and Reinhart (in Group of Thirty 1994, p. A-17) report that Chile increased marginal reserve requirements.
Item (vi), switching government-controlled deposits to the central bank, could not be applied because there are no such deposits.
Item (vii). The band for exchange-rate fluctuations was widened from +/- 5% to +/- 10% in 1992.12
Item (viii). The budget surplus was increased from 1.8% of GDP in 1989 and 0.8% in 1990 to 2.2% in 1992.
Item (ix). The switch to private provision of pensions in the early 1980s has given Chile a healthy savings rate, but I am not aware of further measures since 1989.
Item (x). The subsidies to inward investment provided by debt-equity swaps were already phased out in the late 1980s.
Item (xi). Chile has retained its minimum term for foreign bond issues. A reserve requirement of 20% was imposed against foreign holdings of bank deposits in 1991, and this was increased to 30% in 1992. A tax of 1.2% was imposed on short-term external credits in 1991. (Ffrench-Davis et al 1994.)
Item (xii). Outward direct investment was liberalized. Pension funds were permitted to place a proportion of their portfolios in foreign assets.
Thus Chile took remarkably broad-ranging actions in its so-far-successful attempt to avoid Dutch disease.
Colombia has also made strong efforts to limit real appreciation (indeed, the successful presidential candidate in the recent election made a pledge to avoid any further real appreciation). Until 1993 the payments surplus originated largely on current account (at least according to the official statistics), but last year the current account surplus was reinforced by a large capital inflow estimated at 4.3% of GDP.
Since early 1993 depreciation has not kept up with the inflation differential, resulting in a real appreciation against the dollar of nearly 20% (though less on an effective basis) by mid-1994. Intervention has nonetheless been massive, and in the case of Colombia it has mostly been sterilized: reserve money increased by only $1.5 billion from the end of 1989 to March 1994, while reserves increased by $4.1 billion. A marginal reserve requirement of 100% was imposed on the deposits of most financial institutions in January 1991 in order to help restrain credit. However, it seems that policy changed after October 1991, with an attempt to reduce domestic interest rates so as to reduce the incentive for capital inflow, implying a greater willingness to allow reserve increases to expand the money supply (Ffrench-Davis et al 1994, p. 13). Perhaps this helps explain the limited success in reducing inflation.
Colombia adopted an extensive trade liberalization program in 1989-90. Quantitative restrictions were almost entirely abolished in 1990, and a 5-year program of tariff reduction was announced. In the event, the whole of the tariff reductions planned for the following four years were brought forward to 1991 (Urrutia 1994). The motivation was explicitly the desire to curb a large reserve buildup without hurting the growth of nontraditional exports.
Another important measure was a de facto widening of the band within which the exchange rate can fluctuate. This was accomplished by replacing cash intervention in the exchange market by the supply of dollar-denominated, noninterest-bearing exchange certificates with a maturity of one year, coupled with an undertaking to keep the discount in a band between 5.5% and 12.5% (Ffrench-Davis et al 1994, p. 13). This in effect gives a 7% band for the exchange rate. It also had the advantage of giving one-off help in sterilizing.
Colombia also pursued an austere fiscal policy during this period, achieving a budget surplus of some 3% of GDP by the end of the Gaviria government.
Colombia still maintains controls on capital inflows, although these have been liberalized in recent years. A further liberalization was undertaken in 1992, when the minimum maturity of external loans was reduced from 5 years to one. In the other direction, a 3% tax on transfers and foreign earnings from personal service abroad was imposed in 1991, and in 1992 the central bank increased the commission for the purchase of foreign exchange from 1.5% to 5% (Ffrench-Davis et al 1994, p. 13).
Finally, Colombia liberalized certain capital outflows in 1992. Exporters were authorized to keep a part of their foreign earnings abroad, and residents were authorized to hold up to $500,000 abroad without prior permission.
Brazil is the third country that has endeavoured to avoid translating capital inflows into current account deficits. It has again applied a wide range of policies to that end. It is in fact the heaviest sterilizer of any of the three: between the end of 1989 and May 1994 reserves increased by no less than $32.4 billion, while (under the pressure of near hyperinflation) the dollar value of the stock of reserve money actually contracted by $1.0 billion. Since stabilization was achieved with the introduction of the real on 1 July 1994, the money supply has been expanding rapidly. Brazil has also experienced a surge of capital inflows since that date, which have been met with a battery of measures.
In the first place, while a floor has been placed under the value of the real by a commitment to sell dollars at a price of 1:1, the exchange rate has been allowed to appreciate. The authorities did not initially indicate any upper limit on how far the rate would be allowed to float, but they began to resist further appreciation when the dollar had reached a price of about 83 centavos. There therefore seems to be a de facto band of a little under 20%, on top of the real appreciation that had already been experienced before the Plano Real started (see Table 2).
Second, imports have been liberalized, under a program that began already back in 1990 and that has seen the abolition of virtually all quantitative restrictions, drastic general tariff reductions, and the negotiation of a free trade area with three neighboring countries (Mercosul). Further tariff reductions have taken place in recent months, especially in sectors where the government regards price increases as abusive. (As the final column of Table 2 shows, at least until recently Brazil had the highest tariffs of the six countries, averaging just over 20% in 1991-92.)
In addition, a reserve requirement of 15% was imposed against new credits in October. And the fiscal deficit has been eliminated, at least for the time being.
Measures have also been taken to discourage capital inflows. A 1% tax was imposed on foreign investment in the stock market in October. The tax on Brazilian companies issuing bonds overseas was inceased from 3% to 7%, and that on foreign capital invested in fixed income funds was raised from 5% to 9%, at the same time. Limits were placed on the ability of exporters to accept prepayment. On the other side of the account, Brazilian pension funds were for the first time allowed to place up to 10% of their portfolio in foreign assets, and all restrictions on foreign spending by tourists were abolished.
An important debate is currently under way in Latin America about the relative merits of the policies pursued in Argentina and Peru on the one hand, versus Chile, Colombia and (tentatively) Brazil on the other. The former group allowed the capital inflows to be translated into current account deficits; the last three have tried to resist losing competitiveness with the danger it poses of undermining export-led growth. Mexico is an intermediate case: it allowed the capital inflow to finance a current account deficit but sought to sterilize the outflow experienced in 1994, leading to a fragile reserve position.
As of now, the most successful countries in each group are clearly Argentina and Chile. Argentina's situation still looks fragile because of its uncompetitive exchange rate and weak balance of payments situation, although there are some positive recent signs even in those areas. Chile has been a spectacular success story in recent years, but it nonetheless also continues to have problems that threaten its ability to sustain the policy course that it has been following, notably the pressure of capital inflows on the exchange rate. The choice between those two strategies depends on fundamental views about whether a macroeconomic policy oriented to the maintenance of a competitive exchange rate is capable of improving on laissez-faire.
What are the lessons of Latin American experience for those who believe that it does indeed make sense for the government to try and maintain a competitive exchange rate? I suggest the following:
*Resisting or neutralizing large capital flows is not easy and can be expensive.
*Nevertheless, there are a wide range of instruments that are relevant. It is simply not true that there is no alternative but to bow to the wisdom of the market, or even that the only things that can help are to tighten fiscal policy or to liberalize imports (though both of those can indeed help).
*The best policy is to employ many instruments and avoid expecting any one to provide a panacea. Sterilized intervention and increased reserve requirements can provide useful short-term relief. The band should be widened, imports should be liberalized, and fiscal policy should be tightened so that domestic interest rates can be reduced. There are a number of ways that capital inflows can be discouraged through controls or taxes, although it is critically important to recognize that all controls leak and will be evaded if the incentive to do so is strong; the most common mistake is to expect too much of capital controls. Certain capital outflows can be liberalized. Together, these measures offer some prospect of enabling a government to keep macroeconomic control without losing the potential of an export boom.
Appendix: Setting a Prudent Limit on Foreign Indebtedness
There is no very satisfying method of estimating the safe level of debt. The best approach still seems to be that based on various ad hoc rules of thumb about the relationship of debt or debt service to variables that influence the ability to service debt, such as exports, GDP or the capital stock. The most famous such rules of thumb state that the debt/export ratio should not exceed 200%, that the debt service ratio (i.e. the ratio of debt service to exports) should not exceed 25%, and that the debt/GDP ratio should not exceed 40%. Such rules of thumb doubtless ought to be combined in some way13, but in the meantime they do at least provide a starting point for analysis.
What do these rules of thumb imply about sustainable (desirable) current account deficits? A little algebra can show. Let D = foreign debt and Y = nominal income (expressed in dollars, like the debt mostly is), and use a hat over a variable to signify its rate of change so that D/D is the proportionate rate of change of debt. Consider a developing country that can expect a long-term growth rate of real income of 5%; then its expected long-term growth of nominal income measured in US dollars (the international currency) will be 8% if one assumes an average 3% dollar inflation. In steady state the rate of growth of debt must be the same as the rate of growth of nominal income. Then the prudent steady-state current account deficit according to the debt/GDP rule of thumb would be D/Y = (D/D).(D/Y) = 0.08 x 0.4 = 0.032, i.e. the steady-state deficit should not exceed 3.2% of GDP. Of course, a country that starts out with a lower debt/GDP ratio than 40% can run a greater deficit for a while, but it is well-advised to prevent the deficit getting too much larger because of the difficulty of adjusting back as the debt limit approaches. (It is appropriate to focus on the debt/GDP ratio for a country with an export/GDP ratio in excess of 20%, and on the debt/export ratio for a country with an export/GDP ratio below 20%, to ensure that both constraints are satisfied.)
Of course, a country's vulnerability to capital outflow depends not just on the level of debt but also on the type of liability that is contracted. Foreign direct investment is the least vulnerable to sudden withdrawal. Portfolio equity investment has an important self-equilibrating property: a loss of confidence will lead to a decline in stock prices that will automatically serve to decrease the incentive for further withdrawals. Long-term bonds have the advantage that the principal can be liquidated only as the bonds mature. Bank loans have the advantage that it is relatively feasible to renegotiate the terms of the contract when the need arises. Nevertheless, both bonds (especially those with a short maturity) and bank loans expose countries to a significant risk of confronting a debt crisis, with consequences that the 1980s showed can be severe.
In view of these differences, is it appropriate to count the stock of non-debt foreign claims on the economy-notably foreign direct investment and foreign holdings of equity claims in domestic companies-on a par with debt itself? They too generate a need for foreign earnings so as to maintain debt service, so it would seem wrong to ignore such claims entirely. Perhaps the most reasonable procedure is to treat a dollar of a foreign non-debt claim as something less than a dollar's worth of debt, e.g. to give it a 50% weight. In any event, such figures can provide no more than a very rough guide as to how much borrowing is more than the economy can safely handle, a figure that will also vary with the proportion of the capital inflow that is being translated into investment in general and investment in tradables in particular.
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2. The term "Dutch disease" was originally used to describe the difficulties encountered by manufacturing in the Netherlands following the development of natural gas on a large enough scale to prompt a major appreciation of the real exchange rate. It has since been used to refer to any situation in which a natural resource boom, or large foreign aid or capital inflows, cause real appreciation that jeopardizes the prospects of manufacturing.
3. Note, however, that it has been argued by Ground and Bianchi (1988) that a resource boom is inherently temporary, because the rents that it generates will ultimately be bid away. This suggests that on some time scale the factors making for Dutch disease should always be considered as temporary. Nevertheless, if the resource boom or the capital inflow is expected to last for 10 or 20 years, it would seem to make sense to adjust the balance of payments to increase absorption rather than to finance the inflow, if such an increase in absorption is indeed in the long run interest of the country in question (see discussion in text).
4. There is no particular need for the individual project financed by foreign borrowing to generate foreign exchange, but it is of fundamental importance that the economy as a whole produce an adequate proportion of tradables to permit debt service to be maintained without throwing the economy into recession or straining the country's ability to borrow.
8. Actually there is a seventh major country, namely Venezuela, but this is excluded from the following comparison because it has not experienced an excessive capital inflow in recent years. (It is still trying to pursue rather old-fashioned policies, including a Bretton Woods style policy of holding a fixed exchange rate until being forced into a reluctant devaluation.)
9. A radically different conclusion would be suggested for Argentina if the WPI rather than the CPI were used as deflator, where the index would be a hyper-competitive 59 rather than 159. (It makes little difference for the other countries.) Anecdotal evidence suggests strongly that it is the CPI figure that should be treated as correct; the reason for the implausible WPI figure is not known.
10. This paper was completed in November 1994. No attempt has been made to update it in the light of the Mexican crisis that broke out the following month, in the belief that those events vindicated most of what is argued here.
11. A part of the explanation of recent Chilean policy would seem to be the recollection of its attempt to stop inflation by using the exchange rate as a nominal anchor in 1979-82. That attempt was fed by a large capital inflow which financed a massive current account deficit reaching some 14% of GDP in 1981 -a policy rationalized at the time by the argument that the fiscal accounts were in surplus and that private foreign borrowing could not create problems (an argument repeated in 1988 in the UK by Nigel Lawson). In the end the currency had to be devalued and GDP fell by about 15% in a savage recession that also cut real wages as much as 35%. Chile adopted a radically different macroeconomic policy stance as it climbed out of that recession.
12. There were also other changes in exchange-rate management, which had previously been based on a dollar peg that had crawled in order to offset the excess of inflation in Chile over that in the United States: these involved the introduction of discretionary intervention within the band, and a switch to a basket peg.