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INSIDE THE GLOBAL ECONOMY--PROGRAM #109 (Rev)
"Exchange Rates, Capital Flight and Hyperinflation"
NARRATOR:
Funding for this program was provided by The Annenberg/CPB Project.
NARRATOR:
When exchange rates gyrate. When investment capital flees the country. When inflation becomes
hyperinflation governments clamp on controls. Exchange Rates, Capital Flight and Hyperinflation:
What's their message? We'll find out when we look Inside the Global Economy.
NARIMAN BEHRAVESH:
In this segment of Inside the Global Economy we're going to be talking about exchange rates,
capital flight and hyperinflation. And we'll also discuss the important interaction between exchange
rates on the one hand and a country's balance of payments on the other hand. We'll also look at
what theories have been developed by economists over the years to explain this important
interaction.
To illustrate some of these points we're going to look at 2 case studies; one in Mexico, the other in
Argentina and we'll also hear from a panel of experts who will focus on some of these key issues.
But first of all let's define some terms. What do we mean by a country's balance of payments?
Well, the balance of payments is the record of a country's interactions, economic interactions and
transactions with the rest of the world. What comes in in terms of money into an economy because
it sells goods abroad or services abroad and what goes out because it buys services and goods from
abroad.
Let's take a look at a hypothetical balance sheet in terms of a balance of payments account. Again,
this is for a hypothetical country. But it helps us to illustrate some of the points here. There are 3
basic sets of transactions that are measured. The first is pretty easy to understand. It's trade;
imports and exports. Exports are goods let's say that the U.S. sells abroad, imports goods that it
buys from abroad. And the difference between those two is the trade balance it is called. It's a trade
deficit if we buy more goods from abroad then we sell abroad. So that's called a deficit. It's a
surplus if we sell more goods abroad than we buy from abroad.
Now traditionally and certainly in the last 10 years, the U.S. has been running a trade deficit. We've
been buying more goods from abroad than we've been selling goods abroad.
The second category here refers to trade in services and this has two different components. One
component might be represented for example by a foreign student coming to the U.S., in a sense
buying a college education. That is money coming in to the U.S. for educational services. It's a
very large transaction as it turns out because there are a lot of foreign students that come to the U.S.
So that's one example of services that we export in effect.
Another is let's say if a U.S. company is earning profits in Germany and brings those monies back
to the headquarters, that's also a service if you will export of, of a kind. It's, it's exports of capital
and earnings on those capital that come back to the U.S. So that too is an important category and it
turns out actually that while the U.S. has run a trade deficit in terms of goods, we've actually run a
surplus in terms of services over the last ten years.
And then finally there's a third category of transactions which look at investments abroad. These
can fall into at least 2 categories. One is direct investment where a U.S. company for example is
buying or building a factory abroad. That's referred to as direct investment. And a second kind are
loans, either short term or long term to a foreign country, either an official loan in the sense if it's a
government loan. Or it could be a private loan.
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So all of these together represent the transactions of let's say the U.S. or a hypothetical country with
the rest of the world and they show the sum total of these in the period that we've got here let's say a
year.
Let's see if we can illustrate this by looking at the U.S. current account deficit in the U... in the
1980's. And what we see is that the current account which if you remember is the combination of
the trade balance and the balance on service exports and imports, this balance deteriorated
dramatically in the 1980's. It went from a slight surplus in 1980 to a deficit of almost 200 billion in
1987 and it reflected the very strong dollar that, that was in place in the, in the early 1980's. The
dollar has strengthened dramatically from about 1980 to 1985 and this showed up as a dramatic
worsening in our trade balance, in our current account balance.
Now let's take a look at this important interaction between the exchange rate and the balance of
payments or the, or the current account balance. And let's look at it in 3 different kind of worlds as
it were. One extreme in a world of fixed exchange rates when exchange rates cannot change then
anything that occurs either in the U.S. economy or in the global economy is going to be reflected in
a couple of ways. One in the balance of payments and secondly let's say if we have a balance of
payments deficit in losses and reserves from the U.S. abroad as the authorities try to keep that
exchange rate fixed. So the point being here is that all the adjustment in a world of fixed exchange
rates is occurring in the trade balance or the current account balance or the balance of payments on,
on the broadest bases.
Now if we look at the second extreme in other words we look at the other side of the spectrum in a
world where we have completely and freely floating exchange rates. In this world it's, it's the
exchange rates that will absorb a lot of the shocks and reflect all the changes that are occurring in
the macroeconomic picture of the U.S. or other countries around the world or other changes in
competitiveness that may be, may be going on. So in this world and it's an extreme case we, the
adjustment is primarily on the exchange rate. Now the reality is that, the, in, in terms of what goes
on day to day we're somewhere between these two extremes. We're in a hybrid world, one in which
both exchange rates on the one hand and the trade balance on the other hand do reflect all the
changes occurring in the U.S. economy and in the global economy.
Let's see if we can illustrate this a little bit further by looking at some flow diagrams that will help
us to hopefully see this a little more clearly. The first 2 sets of flow diagrams will look at how the
economy adjusts to an imbalance in, in our trade accounts under fixed exchange rates. First of all
what if we have a balance of payments deficit. Well, this gets reflected in 2 ways. The first is that
more goods are being bought from abroad so more dollars are going outside then are being sold
abroad, there are more exports being, being sold to other countries. So there's a net deficit on the
trade account. This gets, it shows up in the sense that ex, export jobs are falling and we're losing
jobs abroad if you will but it also means that the supply of money, the reserves of money are being
also lost to, in an attempt to maintain the fixed exchange rates.
So the first effect in terms of loss of jobs is shown in the upper loop here where we see an income
contraction which in turn leads to a reduction in import growth. And that has a correcting effect on
the, on the balance of payments deficit. The, the contraction in the money supply is seen in the
lower loop whereas the money supply or credit shrinks as we try to fix our exchange rate. That
reduces the price level in the U.S. In turn, it means improved competitiveness because our goods
are now cheaper relative let's say to German or Japanese goods. And because they are cheaper they
sell better and so we get an improved export picture and the flip side, a worsening import picture so
both of those again tend to correct the, the deficit on the trade account. So there's a sort of a selfcorrective mechanism going on here.
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Similar but sort of symmetrical situation if we look at a balance of payments surplus we get the
opposite set of effects occurring. First because exports are growing, export jobs are going to grow
more income so that's the top part of the loop here as income grows we import more. That tends to
correct the balance of payments surplus because imports tend to reduce that surplus. On the
bottom part of the loop as, as we incur a balance of payments surplus money comes into the U.S.
reserves, comes into the U.S. again in an attempt to keep that exchange rate fixed so that means an
acceleration of inflation in the U.S. which in turn means a deterioration of competitiveness and that
has 2 effects. It means imports are cheaper now so more imports are bought but exports are more
expensive so fewer exports are sold. Those two tend to correct the surplus.
Now it's important to point out that these adjustments in the real world don't always occur quickly
or completely so often it requires a policy change to accelerate the movement. For example an
increase in taxes or a, a tightening up of, of money, the money supply through tighter credit policies
would certainly help in this situation.
What about a world in which exchange rates can actually float? Well, here the diff... the major
difference and a very important difference is that whenever we run a balance of payments deficit or
surplus it gets reflected in the exchange rate. So in the first instance we have a balance of payments
deficit. This leads to a depreciation in the value of, of the currency, in our case the dollar. And that
has again two effects. First a depreciation improves our competitiveness, it makes our goods
cheaper relative to foreign goods and that tends to reduce imports from abroad and boost our
exports which again corrects the deficit. On the upper part of the loop in this kind of a world, a
currency depreciation tends to lead to potentially not always, potentially led to a rise in inflation and
possibly a rise in interest rates both of which act to slow down the economy, slow down income
growth which in turn slow down import growth which again tend to correct the deficit. Slower
imports means a smaller increase in the, in the deficit and potentially a complete correction in the, in
the deficit.
Again, quickly looking at the, at the reverse case, what if we have a balance of payments surplus?
Here the currency appreciates, becomes stronger. Again, two effects here. An appreciating
currency tends to worsen our competitiveness because now our goods are more expensive
worldwide relative to foreign goods and that leads to increased imports because foreign goods are
cheaper. Reduced exports because our goods are more expensive and this tends to correct the
surplus, turns it more into a deficit as it were. On the upper part of the loop here currency
appreciation tends to lower our inflation rate and interest rates at least there's the potential that it can
do that. It can bring, as a result of that, bring about a boost in GNP growth and income growth, in
other words lower inflation, lower interest rates tend to boost growth. Which in turn boost imports
of foreign goods which again tend to reduce the, the surplus in this, in this case.
Now let's look at what economic theories have been developed over the years to explain exchange
rate movements and their interaction with balance of payments. We're going to look at, at four of
them. This is not an exhaustive list but at least it gives a representation of, of the kind of theories
that have been developed.
The first is the so-called trade or elasticity’s approach where elasticity in this instance refers to the
responsiveness of exports and imports to changes in the exchange rate. And basically what this
theory says is the exchange rate will settle down or equilibrate to use the jargon at the point where
import and exports are in balance. Now the failings if you will or the short comings of this theory
are that number one it doesn't take into account capital flows which are a very important ingredient
of international transactions, certainly in the post war period. But also this particular theory hasn't
been very good at explaining why we've had very large swings in exchange rates in the 1980's or
even before.
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A second theory that explains the movements in, in exchange rates is the purchasing power parity
theory. It's a bit of a mouthful but essentially what it does is it relates changes in the exchange rate
to changes in prices. So to use an example if inflation is growing at 4% in the U.S. and only 2% in
Germany what this theory tells us is that the dollar will depreciated by the difference of those two.
So 4% inflation in the U.S., 2% inflation in Germany would lead us to a deprecation of the dollar or
2% which is the difference between the two inflation rates.
A related theory is the so-called monetary approach to exchange rate movements which takes it back
one step further and relates exchange rate movements to changes in the money supply in the 2
countries. So again let's go back to the German and the U.S. example. If the money supply in the
U.S. is going up by 10% but it's only going up by 5% in Germany then you would expect the
dollar to depreciate by the difference between the two which is 5%. So a 10% money supply
increase in the U.S., 5% percent in Germany leads to a 5% decline in the value of the dollar relative
to the German deutsche mark.
Now these first 3 approaches to explaining foreign exchange movements are better at explaining the
long-term changes that occur in exchange rates then they are about the short-term fluctuations that
occur. So they are useful theories but again they tend to have a very long-term focus and don't
always explain those short term movements and fluctuations that occur month to month or even
year to year.
The last approach has been more promising in trying to round out the picture a little bit in terms of
explaining these large fluctuations. It's called a portfolio balance approach. It not only
encompasses movements in goods and services but more importantly it encompasses capital
movements which have become a very important ingredient in, in the world economy. And it
explains how investors can move and shift their portfolio preferences from country to country as
the interest rates change and as the exchange rate changes. So in that sense it's a more
comprehensive approach to exchange rate movements and really pulls in capital flows as well as
goods and other kinds of factors.
Let's see how we can use these theories to explain some of the events that have happened around the
world over the last decade. And specifically let's turn to our first case study which looks at the
financial crisis in Mexico in late 1994 and early 1995.
THE MEXICAN PESO CRISIS OF 1994
Shot or shots of extreme poverty in Mexico:
NARRATOR: THE 1982 FINANCIAL CRISIS IN MEXICO WAS FOLLOWED BY THE
“LOST DECADE,” WHICH WAS MARKED BY STAGNANT ECONOMIES IN MEXICO
AND THE OTHER LATIN AMERICAN COUNTRIES.
LS Mexico City. Zoom into stock exchange building.
THE EMERGENCE OF ECONOMIC REFORMS AND SIGNING ON TO THE NORTH
AMERICAN FREE TRADE AGREEMENTS IN THE EARLY NINETIES STARTED MEXICO
ON THE ROAD TO RECOVERY. IT WAS SEEN AS A KIND OF POSTER CHILD FOR
DEVELOPMENT, FOR EMERGING MARKET CAPITALISM, FOR THE IDEA THAT
TREMENDOUS PROFITS COULD BE EARNED ON INVESTMENTS IN DEVELOPING
COUNTRIES…
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Int. stock exchange.
FOREIGN INVESTMENT CAPITAL POURED INTO MEXICO.
Int. shopping mall.
TIMES WERE GOOD. NO ONE EXPECTED THE NEXT CRISIS …THE CRISIS OF 1994.
Larry Summers v.o. & on camera:
Mexican financial crisis was a tragedy. It was a tragedy of hubris. It was a tragedy
of overconfidence. It was a tragedy of policy error that didn’t need to happen.
Jonathan Heath on-camera:
Over the past 20 years we’ve had about five major devaluations or five major
periods where just our balance of payments seems to be completely in disequilibrim
and we have to make major corrections in the economy and as a result we go into
these big economic crisis. In Mexico we don’t go into a recession, we go into a
crisis because the whole country seems to fall apart.
Everardo Elizondo on-camera:
In a way the crisis has also of course, as is usually the case not only economic
elements in it but very important political elements that are needed to put into the
picture in order to understand what, what happened.
President Carlos Salinas in crowd.
NARRATOR: PRESIDENT SINCE 1988, WAS CARLOS SALINAS. HE STARTED A
LARGE NUMBER OF STRUCTURAL REFORMS THAT HELPED THE ECONOMY BUT IT
WAS FAR FROM COMPLETE. HIS PARTY, THE PRI, HAD BEEN IN POWER FOR SIXTYFIVE YEARS AND IN THE UPCOMING 1994 ELECTIONS, THEY INTENDED TO STAY IN
POWER.
Larry Summers on-camera:
The Salinas administration basically denied that there was going to be a crisis. The
Salinas administration felt that it was all just a matter of providing confidence and
that if you just were confident enough and you asserted strongly enough that the
exchange rate would hold then it would.
Jonathan Heath on-camera:
We had a lot of capital inflows that were coming into Mexico because everybody
was enthused with a lot of these changes that were occurring. However, a large
amount of these capital inflows were short-term capital flows, more speculative in
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nature that could come in but could easily leave also. So, that meant that while
things did seem to be changing and did seem to be improving a lot of it was more
based on illusion then actual strong elements of recovery. Then 1994 came along
and a lot of things happened almost at the same time that made us keenly aware that
the economy was much more fragile then we expected.
Chiapas rebellion:
NARRATOR: THE FIRST SHOCK TO HIT THE ECONOMY WAS ON NEW YEARS DAY
IN1994. A ZAPATISTA UPRISING IN THE STATE OF CHIAPAS…ONE OF THE
REASONS FOR THE REBELLION WAS THEIR OPPOSITION TO THE SIGNING OF THE
NAFTA AGREEMENT…WHILE THE EVENT DID LITTLE TO STARTLE FINANCIAL
MARKETS, IT DID SHAKE INVESTOR CONFIDENCE…
New York Stock Exchange:
MEANWHILE IN THE UNITED STATES, REPEATED INCREASES IN U.S. INTEREST
RATES LURED MANY INVESTORS OUT OF THE MEXICAN MARKETS INTO THE
MORE ATTRACTIVE U.S. MARKET.
Assassination of Colosio:
AND THEN THE GREATEST SHOCK OF ALL…LUIS DONALDO COLOSIO THE
PRESIDENTIAL CANDIDATE OF THE RULING PRI PARTY WAS ON THE CAMPAIGN
TRAIL…TWO GUNMEN PUT AN END TO HIS CANDIDACY. IT WAS HOPED HE
WOULD BE THE SUCCESSOR TO CARLOS SALINAS. HIS MURDER, TWO OTHER
POLITICAL ASSINATIONS AND A KIDNAPPING HELPED SET THE STAGE FOR WHAT
HAS BECOME KNOWN AS THE “FIRST FINANCIAL CRISIS OF THE 21ST CENTURY.”
Panic on the Mexican stock exchange:
CAPITAL STARTED FLOWING OUT OF MEXICO, RAPIDLY DEPLETING FOREIGN
EXCHANGE RESERVES FROM A LITTLE OVER 28 BILLION DOLLARS TO A LITTLE
OVER 17 BILLION DOLLARS. A NET LOSS OF OVER 10 BILLION DOLLARS IN ONE
MONTH.
Carlos Salinas:
WITH THE ELECTION FAST APPROACHING IT WAS TOO POLITICALLY RISKY TO
DEVALUE THE CURRENCY. THE GOVERNMENT TRIED TO STEM THE FLOW OF
CAPITAL FLIGHT BY ISSUING LARGE AMOUNTS OF DEBT IN THE FORM OF
TESOBONOS.
Everardo Elizondo on-camera:
A Tesobono was nothing but a government debt in pesos, but with a protection
clause against the devaluation of the peso. So when things began to deteriorate in the
Mexican economy and the political system, people began to change from securities
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denominated in pesos to Tesobonos anticipating the possibility of an exchange rate
devaluation.
Jonathan Heath on-camera:
Nobody was quite sure if the Mexican government had enough foreign exchange to
pay the amount of Tesobonos that were outstanding. We owed something like
about 30 billion dollars in, in dollar denominated treasury bills and we had about
maybe 3 billion dollars in foreign reserves. So, obviously everybody rushed to get
in line so that their Tesobonos would be the first ones to be paid and they wouldn’t
lose their money.
Ernesto Zedillo.
NARRATOR: ERNESTO ZEDILLO, THE NEW PRI PARTY CANDIDATE, HAVING WON
THE PRESIDENTIAL ELECTION WAS UNDER STRONG PRESSURE TO CHANGE
ECONOMIC POLICY. IT WAS APPARENT THAT THE PESO NEEDED A SHARP
CORRECTION…A DEVALUATION…
Larry Summers on-camera:
At the Treasury we had been following what happened in Mexico very closely.
When I got the phone call at midnight indicating that they would be devaluing the
next day we were all very alarmed. We were alarmed because we were not sure
there was policy package in place that would provide credibility.
Jonathan Heath on-camera:
But the way that Ernesto Zedillo and his incoming administration handled this
devaluation was very poorly done. For example, he met along with his top economic
advisors and top ministers with a lot of leaders of the private sector to tell them that
they were going to devalue the peso. The leaders of the private sector convinced him
not to devalue but just to have a correction of 15% in the exchange rate instead of
leading to, to having a devaluation. But then by telling them that he was going to
devalue they just turned around and took their money out of the, out of the country
and, and that about 4.5 billion dollars left the country in one single day.
Larry Summers on-camera:
As things turned out they lost nearly half of their remaining reserves in the next
several days and ultimately were forced to create a situation where the peso would
float.
Everardo Elisondo on-camera:
So, we had this total capital mobility, we wanted to have a, a fixed exchange rate and
we didn’t allowed domestic interest rates to jump as high as they should. So, in the
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end this impossible trinity set in on us, as usual the case what gave in was the
exchange rate and the rest is, is history.
People on street, in shopping center, in bank, stock exchange:
NARRATOR: THE SHARP DEVALUATION TOOK THE MEXICAN PEOPLE BY
SURPRISE. WHAT FOLLOWED WAS A PERIOD OF COMPLETE ECONOMIC
CHAOS…INFLATION AND INTEREST RATES ROSE…ORDINARY PEOPLE SAW THEIR
PURCHASING POWER FALL BY A QUARTER OR MORE…MILLIONS OF PEOPLE
WERE UNEMPLOYED…THE VALUE OF MEXICAN ASSETS ON THE STOCK MARKET
FELL BY 50 PERCENT OR MORE…
Jonathan Heath on-camera:
Almost all banks basically were on the brink of bankruptcy because nobody could
pay their payments and it wasn’t one or two people who didn’t want to pay, it was a
collective society in general.
President Clinton in crowd:
NARRATOR: AT THE END OF JANUARY 1995, THE UNITED STATES AND THE
INTERNATIONAL MONETARY FUND PUT TOGETHER A 50 BILLION-DOLLAR
RESCUE PACKAGE.
Larry Summers on-camera:
The United States and the international community moved promptly to focus on the
restoration of confidence through the provision of finance based on strong
conditions on economic policy, that was very different from policy in the 1980’s
that had put the principle focus on debt collection and on seeing how much
resources could be extracted from Mexico.
Larry Summers V.O. & on-camera:
Mexico made serious policy commitments. Mexico contained its budget deficit.
Mexico adjusted its interest rates. Mexico deregulated and opened up its economy
attracting foreign investments into key sectors. Mexico reformed its banking
system. Mexico recognized its need to deepen its engagement with the world.
Jonathan Heath on-camera:
And our external debt levels have systematically reduced year over year so that right
now, I don’t think that Mexico is not even near any type of an external debt problem
or a balance of payments problem like these that have plagued us in the past.
Larry Summers on-camera:
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You know, Mexico faced a critical choice in 1995, it could have taken what happened as a
signal to reverse course and go back to the Mexican economic model of the 50’s and 60’s
or it could have taken what happened as a signal to redouble and recommit itself to reform.
You know, I think the easier political course in those days would have been to have turned
backwards but the right course for Mexico and the one that President Zedillo chose under
the greatest of pressure was the choice of moving forward.
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NARIMAN:
So how can we explain what was going on in Mexico and why investors lost confidence in Mexico?
Some time ago some of my colleagues got together in Melbourne, Australia to discuss this type of
financial crisis. They include Richard Snape of Monash University in Australia, Gerver Torres of
the International Monetary Fund, Magnus Blomstrom of the Stockholm School of Economics and
Rachel McCulloch of Brandeis University. Let's see what they have to say.
BEVERLY:
Rachel, this case study shows an example of capital flight. Are there other examples when capital
moves from one country to another that have less to do with panic?
RACHEL:
Oh, definitely, yes. International capital flows are an important part of today's global economy, and
a force for greater efficiency. From the point of view of investors, capital is always moving in
search of a better, over-all return. Now that better, over-all return can reflect higher productivity of
capital in one place, rather than another and that, of course, is the most healthy kind of capital flow.
It can also reflect circumstances where different markets have different ups and downs and then
having an internationally diversified portfolio allows investors to get the same over-all rate of return
with a lower degree of risk and, of course, that's very attractive as well. In the case of capital flight,
however, we view it as an unhealthy sign...it's not that the capital flight is by itself the bad thing, but
rather it's a sign that the underlying circumstances in the economy experiencing the capital flight are
not so healthy. And that's certainly the case that we see here.
RICHARD:
Well, if you've got to the stage of flight then it is obviously a failure of government policy
somewhere that is causing that flight. On other cases when you have got more normal capital flows,
they’ll be attracted into the country if there's a relatively good rate of return on the flow in. That is,
if the interest rates are such that they can earn a return when you take account of the exchange risk
in the future and so on. It will flow in and typically it will tend to flow from countries which have
got good savers or high savers into countries which are... that is relative to their own investment at
home... to countries which are, in fact, investing a lot relative to their own saving. And so that and
often this will associated with an age, age profile of the country. When a country is aging, it will
tend to be spending more than it is currently producing and it will be dis-saving and it will be
calling on the savings that it’s invested abroad. When a country is relatively productive and
relatively young and building up their assets, they’ll tend to be investing in other countries who
have a flow of capital out of those countries, as Japan has been, in the, in recent decades and you
might expect in a few decades time that there will be a flow back to Japan as the people in Japan are
tending to spend more than they are currently producing.
BEVERLY:
So would there be an argument in some cases to limit capital flow?
RACHEL:
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The experience of most countries is that efforts to limit capital flow, and especially to limit capital
flight, can be extremely difficult to carry out. That could be the intent of countries. But the most
effective way to limit capital outflow is to change the underlying policies and make the country an
attractive place to keep one's money. In the case of Mexico, we can see that happening. When
Mexico changed its policies, a lot of the flight capital came right back to finance new investments.
MAGNUS:
And also, you can also say that the capital flight, in fact, forced Mexico to change policies. It might
have even had a positive effect on these countries.
RICHARD:
And then you almost had a flight back into Mexico.
BEVERLY:
Richard, thank you.
NARIMAN BEHRAVESH:
Let's see if we can summarize what happened in this case study in the discussion. It's important to
point out that both the capital flight and the decline in the value of the currency, the collapse of the
peso, were symptoms of the underlying problems that were really the problems with the domestic
policies in Mexico. It's important also to point out that Mexico was not the only country that
suffered through this. If you look at the loans to developing countries in the 1990's in this graph,
you can see a collapse in lending largely because many countries –Thailand, Indonesia, South
Korea, Russia, Brazil and Argentina - went through the same types of problems that Mexico did. .
Let's see if we can use some of our supply and demand diagrams to explain a little bit of what’s
going on in this example that we just saw.
Here we have the foreign exchange market for Mexican peso. On the vertical axis we've got dollars
per peso, that's the exchange rate. On the horizontal axis we have billions of pesos, that's the
volume in the foreign exchange markets. The supply curve which slopes from the bottom left to the
top right reflects basically the supply of pesos in the world market which comes about because
Mexicans want to export goods, buy securities and so forth so that they pay with pesos or they
exchange their pesos for other currencies. But, nonetheless, they're putting pesos into the
marketplace, they are supplying pesos. So that reflects those kinds of transactions.
The demand for pesos is the line that goes from the top left to the bottom right here. The
downward sloping graph. That illustrates the demand for pesos in the sense that people who want to
buy goods from Mexico and pay the Mexicans in pesos. Obviously they demand pesos for those
payments or companies that want to invest in Mexico will also demand pesos. They need pesos to
pay for those investments.
Now what happened as a result of the capital flight that occurred in 1994 and 1995 in Mexico, the
demand shifted. This is represented by the downward and leftward shift in the demand curve. And
essentially what it means is that investors lost confidence in Mexico, they started to sell off their
assets. They started to dump pesos because they were very worried and so that meant they wanted
fewer pesos and fewer peso denominated assets and so that represents this downward shift in the
demand curve. And the net result of which was a depreciation in the value of the currency. You can
see the value of the currency dropped here in this graph so that the capital flight also resulted in a
depreciation in the value of the peso.
Now what economic theories can help us understand some of what was going on here? And we'll
highlight two of them, there are others that can be used, but let's highlight just two of them. The
first is the monetary approach which essentially signaled that in Mexico the money supply was
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growing very rapidly, inflation had gone up. By 1994 inflation was in the double digits. And this
was largely because of very loose, very expansive monetary policy and the difference between that,
the excessive monetary policy and the relatively stable monetary policy in the U.S. then led to a very
rapid depreciation in the value of the peso. Remember in this view of the world, what matters is the
difference between money supply growth rates in the two countries.
Now we can also appeal to the portfolio balance approach in trying to understand what went on in
Mexico because again what was going on here was portfolio managers, investors, made a bet
against Mexican assets. They decided that Mexican assets were a big risk so they jumped out of
Mexican assets of all kinds. Investments, stocks, bonds all went to the U.S.. And so as a result of
that, their demand for those assets decreased. Their demand for pesos decreased and that had the
effect of depressing the value of the peso.
Let's see how these same theories can explain our second case study in which we had hyperinflation
in Argentina.
VIDEO
AUDIO
Argentina -- May 1989. This once proud,
productive, vital country, was considered
having one of the strongest economies in
the world. But a runaway inflation
process has set its teeth into the hide of
the nation. With its currency in constant
devaluation, its investment capital in flight,
panic and chaos has ensued. The
government was forced to declare a state
of emergency.
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"Hyperinflation in Argentina"
Sixty years earlier, in mid-1929, no one
could have imagined Argentina in such
decline. One of the world’s richest
countries, its economy ranked sixth
largest and was the most successful in
Latin America.
Argentina's rich farms and busy factories
exported large volumes of wheat, meat,
and other agro-industrial goods. Export
earnings were strong, and so was the
national currency, the peso.
Then the Great Depression of the 1930s
began. Bewildered, the nation’s leaders
tried to halt the advancing economic
disaster at their nation's borders. They
hoped to preserve prosperity at home by
adopting a policy of import substitution.
Instead, the economy crashed into ruin.
Year after year, protectionism and the
government's mistaken management of
the economy increased. A large number
of lose-money public enterprises,
continuous salary increases not related to
productivity and a weak tax system made
the government run a permanent and
increasing fiscal deficit which was
combined with a loose monetary policy.
One of the greatest symptoms of the
enduring crisis was inflation. For six
decades Argentina's economic policy
makers were virtually helpless to restrain
rising prices. The unrelenting increases
gained particular momentum and peaked
as hyperinflation hit in 1989. That year
saw staggering inflation rates of as much
as 200% a month, unprecedented even for
Argentina’s bleak economic history.
The man at the helm of Argentina’s
Central Bank was Jose Luis Machinea.
SUPER:
Jose Luis Machinea
Former Head of the Central
Bank
"I would say Argentina was used to high
rate inflation. Between 1980 and 1985 we
had an average inflation rate of 10% a
month. And the country was used to it,
therefore always somewhat exposed to
hyperinflationary explosion."
12
Shopkeeper
"In 40 years it was the worst crisis we
ever lived. really incredible, the less you
sold, the more money you made."
Woman on the street
"Our money's worth less every day and
our living standard too."
Central Bank montage
NARRATOR:
The financial burden on the government
was punishing as well. With the peso
losing value almost hourly, money to be
raised tomorrow through taxes was
certain to have less purchasing power than
government funds spent today. This
chronic inability to catch up with inflation,
deepened the government’s deficit which
in turn gave yet another twist to the screw
of the crisis.
Graphic Animation
The steady devaluation of the peso led
investors to convert their holdings into
stronger currencies, and capital fled
Argentina in massive amounts. Not only
banks and institutional investors, but
ordinary citizens sought to conserve their
purchasing power as well: workers rushed
to buy dollars and other foreign
currencies the moment they received their
pay in pesos.
People unable to exchange their wages or
salary for foreign money hurried to spend
their pesos before it lost all value. With
the annual inflation rate topping 6,000%,
Argentineans bought anything available.
Even perishable food had more staying
power than the peso.
13
Opinions on the street.
"What a disaster."
"It is really crazy."
"It is the fault of the economic system.
Simply that."
As the inflation-wrecked economy neared
complete breakdown, only tangible goods
had lasting value. This explains the
shopkeepers_ reluctance to sell and the
frenzy of the crowds that stormed shops
and supermarkets in 1989. In Buenos
Aires, the capital, as well as in other cities,
bands of despairing people roamed the
streets of poorer districts, plundering what
they could.
In their effort to break inflation’s assault
on the battered peso, the monetary
authorities decided to substantially
increase the interest rates. But it was not
enough.
Roque Fernandez, the current head of the
Central Bank explains, it was the only
strategy they could use.
14
SUPER:
Roque Fernandez
Current Head of the Central
Bank
"It was a strategy designed to cut down
the vicious circle of higher interest rates,
higher debts, bigger deficit being financed
with the emission of money, which is the
actual restructure of that same fiscal debt.
Then the state, in a compulsory way
declares that all deposits in the financial
system, will be exchanged for a ten year
Government Bonus, and together with a
full program to reform the state getting
started with the privatization process,
reducing the expenditure of the public
sector, it finally brought all that monetary
disorder, under control."
NARRATOR:
To salvage Argentina’s economy,
sweeping macroeconomic policy changes
went into effect. The peso exchange rate
was fixed. In this way the government
was obliged to maintain fiscal and
monetary discipline. Otherwise the
national currency would soon become
overvalued. As the exchange was fixed
inflation started to decline to the level of
Argentina's main commercial partners and
so did interest rates.
Prices for goods and services provided by
the state-owned companies are adjusted,
barriers to foreign investment are
dropped, and peso bank accounts are
frozen and converted into U.S. dollars,
with a bonus. A vast program is also
launched to sell off government owned
enterprises.
All these free-market reforms created
confidence both in the international
community and with the national private
entrepreneurs.
As Ricardo Estevez, Director of the
Bunge & Born Group explains.
15
SUPER:
Ricardo Estevez
Director of the Bunge
& Born Group
"For us, us entrepreneurs, as a part of
society, we carry our own huge
responsibility which is maybe even
greater than that of the official sector that
already took its first steps. This means to
answer the great challenge to take on this
big opportunity that unfolds. Our
enterprises simply have to be successful
in the world's context of today. This will
be the ultimate test for the Argentinean
private sector."
NARRATOR:
Hyperinflation was finally vanquished in
1991. From monthly increases in prices
of as much as 200% in 1989, the inflation
rate came down to 0.1% in December
1993.
Today, Argentina continues to consolidate
the gains of the past few years. After
decades of stagnation the Gross Domestic
Product grew 9% in 1991, the same rate
in 1992 and 5% in 1993.
Private investment is robust. And capital
flowing from overseas has strongly
revived the economy.
Government monopolies in
telecommunications, energy, and other
industrial sectors have ended. In June
1993, the privatization of the state oil
company alone brought in three billion
dollars - the single biggest stock issue in
global investment history. It constitutes a
dramatic turning point in the large history
of poorly managed public enterprises.
After decades of grim decline, Argentina
has struggled back to price stability and
reinvigorating growth. If the country’s
current economic success holds,
hyperinflation may some day once again
be as unimaginable as it was 60 years
ago.
NARIMAN:
Let's go back to Melbourne, Australia and see what my colleagues had to say about hyperinflation
in Argentina.
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BEVERLY:
Richard, what, essentially, is the link between inflation and a country's exchange rate?
RICHARD:
Well as usual there can be links both ways in this. And so often in economics there is a linkage
one way and then a linkage back again. If a country is having a rapid inflation then it can be
expected that its exchange rate will be depreciating because as it's inflating, its products will become
less competitive in the world. It will turn to importing more from the rest of the world and that rest
of the world won't be buying the products of the country so the demand for the country's currency
will go down and so the currency will depreciate. In turn, of course, that depreciation of the
currency is going to make its import products more expensive for the consumers and the
consumers may, in fact, have... wage earners may have their wages, real wages eroded by that
increase in the prices of imported goods. They, then, may go along and demand higher wages to
compensate for that. As the wages go up, then, of course, that's more inflation for the country and if
the commodities become less competitive again. And so you can have an inflation/exchange
rate/depreciation/inflation spiral. A very nasty situation, which if it gets out of hand, can lead to
hyperinflation.
BEVERLY:
Where does the interest rate situation come into this, then, in relation to domestic exchange rates?
RACHEL:
Well the interest rates that are paid to savers and charged to borrowers have to reflect people's
expectations of inflation. So that if I'm happy with a three-percent rate of return on my money but I
expect inflation to be ten percent over the next year, then I need ten percent just to stay where I am
and then the extra three-percent. So we'd expect the interest rate to be thirteen percent under those
circumstances. And if the expected inflation rate is a hundred percent, then we would need a
hundred and three percent in order to get a three percent rate of return after adjusting for the effect
of inflation over the period of the year. Now, many countries and especially developing countries,
limit interest rates, they set a ceiling on the interest rate. And that may be a reason for savers to be
unwilling to put their money into banks and to look for alternatives. For example, they may look to
invest their money in real goods, like even food products, as a way of letting their savings keep their
value over time, or they may try to buy foreign exchange assets if they expect those to be more
stable than the domestic currency.
BEVERLY:
This sort of sparks a crisis as it did in Argentina and you really can have a currency crisis and then
hyperinflation... just running away with you.
GERVER:
There's a point when you have to do something very drastically in order to regain confidence from
everybody... from economic agents. In the case of Argentina for example, for example nobody
wanted to have national currency in their hands because that money keep losing it’s value, was
useless everybody want to get rid of it as soon as possible, buying food, by in foreign exchange,
whatever. So the government needed to do something radical, what it do, what it did was to say look
from now on by law the exchange rate is to be fixed, is to be pegged to the dollar, I’m going to
assure you that from now on, one austral will be equivalent to one dollar. Obviously, this is a very
risky gain because if government doesn’t adjust the global economy if it doesn’t pursue a sound
macroeconomic policy then what happens is that very soon it looses all its international reserves.
For example, if the government is running a very important large fiscal deficit if it has a loose
monetary policy, if there is a lot of money running in the economy, all that money is being
converted to the foreign exchange, and if the exchange rate is fixed, then the government or the
country is going to lose all its foreign interest reserves. So in the case of Argentina, as we have
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seen, that measure had to be accompanied, and in fact, was accompanied by very other important
structure reforms and other policy reforms and these have been the ways in which they have been
able to stabilize the economy.
BEVERLY:
Gerver, thank you very much.
NARIMAN BEHRAVESH:
So what is hyperinflation? By one definition it's at least 50% inflation a month. Most of us in the
U.S. haven't experienced it but what it means is that every day prices go up. The value of the
money goes down and it can create serious problems in an economy. Now to be fair Argentina was
not the only country going through this. In fact many of the other Latin American countries were
also suffering hyperinflation; Bolivia, Peru and Brazil. And in fact other countries in the recent
years have also been through a hyperinflation period. Eastern Europe and the former Soviet Union
after the collapse of communism also suffered through periods of hyperinflation.
And going back in history, Germany in the 1920's had a bad bout of hyperinflation and there were
stories of people going to the grocery store with barrels of money. Now this experience has been
deeply etched in the German psyche and since then Germans have been very conservative about
inflation and have been very keen on having a very, very strong currency.
But let's see if we can illustrate what happens in the case of hyperinflation by focusing on Bolivia.
I'm going to show you some graphs which illustrate the kind of extreme experiences that can occur
in hyperinflation. And what we see here is a graph that shows the money supply in Bolivia from
April of 1984 to October of 1985. And look at the scale, this is a logarithmic scale, but it shows
that in fact the money supply during this period rose by 17,000%.
Now what impact did this have on inflation? Well, it was fairly predictable. Inflation also rose
dramatically during this period. It rose by 23,000% in this one-year and a half period. And you
can see that on this graph which is also a logarithmic scale. And finally a fairly predictable impact
on the value of the currency here expressed as the number of pesos per dollar. It declined very
dramatically in this instance the exchange rate fell by 25,000%. And so we can see is a very
extreme set of circumstances where the money supply led to a very high increase in prices, a very
dramatic depreciation of the currency.
Let's see if we can illustrate this graphically during this period. And this is again the supply and
demand but this time it's for Bolivian pesos. The graph here illustrates the supply curve which is
sloping upward here from the bottom left to the top right and the demand curve which slopes from
the top left to the bottom right. On the vertical scale we have the exchange rate, the dollars per peso
and on the horizontal scale, the volume of foreign exchange transactions in terms of trillions of
pesos. And what we see is hyperinflation had a dramatic impact both on the supply side of this
market and the demand side of this market because on the supply side there were so many pesos in
the world market now because of this hyperinflation because of this very high growth in the money
supply. There was a flood of pesos basically. And that's reflected by this dramatic downward and
rightward shift in, in the supply of pesos in the foreign exchange markets.
On the demand side basically investors couldn't wait to get out of peso denominated assets so they
were selling their, their assets as quickly as they could. They were running away from Bolivia as
fast as they could so that is shown by this downward shift and leftward shift in the demand for
pesos during this period. And the net result of which was a very dramatic decline in the value, the
exchange rate of the peso of the Bolivian peso relative to the, to the U.S. dollar which we can see in
this, in this set of graphs here.
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Now what of the various theories that we have talked about in terms of exchange rates help us to
understand what was going on here. Clearly one of the illuminating theories here is the purchasing
power parity theory because that one explains that differences in prices and inflation rates between
the two countries clearly effect the, the value of a currency. And in this instance when inflation was
going up by, by some 23,000% in Bolivia but only by about 5 or 6 in the U.S. you can understand
the, the dramatic impact that that had on the exchange rate.
Similarly the monetary approach leads to the same conclusion. Money supply was going up
17,000% in Bolivia but, but a much, much lower rate in the single digits in the U.S. so again that led
to the conclusion that the currency obviously had to decline by an equivalent difference there.
And finally the portfolio balance approach also shed some light here because what it tells us is that
in this kind of an environment when the value of assets is declining dramatically in a country like
Bolivia, portfolio managers are going to run away from that country as fast as they can and so in
fact again the, the portfolio shift occurred very quickly and dramatically away from Bolivia to other
countries where the price level was more stable.
Now how do we pull this all together? What's the, the bottom line on these theories and their
relationship to this important interaction between exchange rates and balance of payments? Well,
the reality is both from a policy perspective and from an economic theory perspective reconciling
the big swings in, in balance of payments and foreign exchange rates have been difficult to do.
They have been a challenge both theoretically and from a practical, real life perspective.
One thing is certain from the experience we've had so far and that is that the eclectic approach both
to understanding balance of payments movements and exchange rate movements and in terms of
policy responses to both of those is the best approach. And equally important is an approach that at
least understands that the global economy is becoming increasingly integrated.
For Inside the Global Economy, this is Nariman Behravesh.
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NARRATOR:
Funding for this program was provided by The Annenberg/CPB Project.
NARRATOR:
For information on this and other Annenberg/CPB programs call 1-800-LEARNER and visit us at
www.learner.org.
NARRATOR:
This is PBS.
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