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NS4540 Winter Term 2017 Latin America: Financing Current Account Deficits Overview • Balance of payments current account (CS) deficits – difference between imports and exports, goods, services and income flows (dividends, profits) must be financed with capital inflows of the same amount. • Historically Latin American deficits have been common • Until recently import substitution industrialization (ISI) combined with overvalued exchange rates tended to • Create a high demand for imports • Penalize exports • During this period the CA deficits created a great need for financing inflows. Since the end of IS, deficits have remained, and been funded with inward flows of foreign capital. • What were the forms of financing, and what were the consequences? 2 Debt vs. Equity I • When discussing borrowing and capital inflows critical distinction between debt and equity • Debt – borrower must repay all or part of loan plus interest at certain points in time • In international capital markets debt occurs in one of three forms: • First governments (rarely firms in Latin America) can issue bonds to raise capital. Carries a commitment of periodic interest payments with payment of value of bond at date of maturity. 3 Debt vs. Equity II • Second, governments may be able to borrow money from commercial banks in the developed countries • Often referred to as sovereign lending • Sovereign lending may not always work out well for the lender – basically borrower can’t declare bankruptcy and there is no collateral backing up the loan • Third governments may borrow for projects or finance current deficits from multilateral institutions such as the World Bank or the International Monetary Fund (IMF) 4 Debt vs. Equity III • Equity a situation in which the lender is also an owner in the company or project being financed • Common form is FDI – company providing all or part of capital involved in ownership and/or control of a project • Second form is portfolio capital – foreign investor owns part of domestic company through stock ownership but usually does not control the firm • Equity finance different from debt in one important respect • Debt payments have to be made regardless of condition of borrower at time of payment • Payments to owners of equity much more tied to current economic conditions • Owners of equity do not have a right to fixed payments in form of a stream of income 5 Debt vs. Equity IV • Debt versus equity distinction has been critical for Latin America • Historically, capital flowing into the region has been in form of debt • Optimism about the future of the region has led to periodic bursts of loans to governments • Because timing of repayment of debt is fixed if conditions turn out worse than expected and governments often forced into default • Last major waves of defaults – 1980s • Last major default – Argentina 2001 • Likely future defaults – Venezuela, Ecuador, Brazil 2017? • Breaking this pattern of high debt and potential defaults has been a critical issue over the years. 6 FDI I • FDI flows into Latin America have been increasing over the last several decades • FDI as a percentage of GDP for the region was just 0.7% in 1990 – exceptionally low for middle income countries • By 2013 FDI had risen to 3.3% of GDP 7 FDI II • Beginning in 1977 FDI Flows into the region were extremely small – around 1% of GDP • These numbers were typical for the late 1970s through the early 1990s for various reasons • Economic turmoil associated with the oil shocks of the 1970s • Poor economic performance during the “Lost Decade” (1980s) • Lost Decade also coincided with major political changes in Latin America • Authoritarian governments of past were being transformed into new democracies • Such transitions may make foreign firms reluctant to invest in short run until the political situation becomes more certain. 8 FDI III • With stronger economic performance and increased confidence in the political situation, foreign investors returned in the 1990s. • At it’s peak FDI accounted for over 4% of GDP in the region – consistent with healthy middle-income countries. • Abrupt drop in FDI in late 1990s due to Asia crisis of 1997 – not reflection on Latin America policies • Asia Crisis decline has been followed with a rapid recovery – rising FDI tends to be positively correlated with increases in the rate of growth of GDP • Gradual recovery following the 2008-09 financial crisis 9 FDI IV • General propositions • Middle income countries are normally still relatively capital scarce and the rate of return on capital should be high • If middle income country is well managed, capital should be flowing into the country from high income countries in search of a better rate of return • Result is that if a Latin American country is running a CA deficit of 3% of GDP and FDI is 3% of GDP, deficit not a problem • In 1970s and 1980s something clearly wrong in Latin America – little or no FDI • Once growth and political stability had returned to region, foreign investors responded 10 Portfolio Capital I • Portfolio capital inherently more volatile than FDI • International investors and financial markets attempting to maximize returns over a short period of time. • As returns in various countries and region change, flows of portfolio capital change quickly as well 11 Portfolio Capital II • Not infrequently, high returns found in middle income countries that are capital scarce • High returns tend to be correlated with higher risk • As perceptions of potential risk change the flows of portfolio capital will also change • As the economic environment in Latin America has improved, the flows of portfolio capital are positive for development, but only in the long run. • In the short run, capital outflows are possible • Both large inflows and outflows can be destabilizing in terms of the exchange rate and possibly the economy as a whole 12 Portfolio Capital III • Capital controls: • Controls on these flows have the benefit of insuring against such instability, but at a cost of reducing the inflows in the long run • Uncontrolled flows optimize the inflows in the long run, but have the potential to produce exchange rate shocks • The regulation or lack thereof flows of portfolio capital is an economic problem for which there is no clear-cut optimal policy 13 Official Development Assistance (ODA) I • Primary purpose of official development assistance (ODA) is to assist in the long-run economic development of the country • Often ODA goes into infrastructure that is essential for economic development • ODA takes on two general forms – government to government, grant or loan. • Grants are essentially a gift from the donor country to be used for development or national defense. • Loans may be used either for economic development or supporting current account deficits • On occasion loans end up being converted to grants 14 Official Development Assistance (ODA) II • Problem with ODA is the aid is frequently “tied” to the donor country • Donor may specify the recipient country must use the country for a particular project and/or that the money be spent on goods and services produced by the donor country • Donor has provided ODA, but the transfer is not as generous as it appears. • In some cases the developing country may end up purchasing goods and/or services that are not completely appropriate due to restrictions on how money spent 15 Official Development Assistance (ODA) III • For Latin America most of the ODA was a transfer of funds from the U.S. to the region. • In most cases these transfers may have more to do with general foreign policy objectives than with economic development • Capital flowing from multilateral instructions such as the World Bank is more straightforward. • Loan applications are made for specific projects and capital flows as the project is developed • Less recognized is the concomitant outflow – money has to be repaid • The predominately middle income status of the region has disadvantage – many multilateral institutions have focused on loans and grants to low income countries • ODA as a % of GDP has been generally falling in Latin America since the late 1980s 16 ODA to Latin America 17 Official Development Assistance (ODA) IV • ODA Generalizations for Latin America: • ODA has never been a critical factor in terms of the balance of payments in the region • Dependence on ODA as a means of supporting a deficit on goods and services is generally not sound economic policy • ODA has never been a major factor in the long-run economic development of the region • The sums have simply been too small to be a critical part of the development process • However, at times ODA has been critical for particular countries • recovering from the frequent natural disasters, and • needing financing for large infrastructure projects 18 Remittances I • A major source of inflows of money into Latin America in the twenty-first century is remittances • Remittances are flows of money back to the home country from workers who are employed in another country • Remittances have taken place for years • What is new about remittances is the rapid increase in their absolute size • In 1990 remittances in the world economy were approximately $30 billion. By 2014 they were $584 billion • In 1980 they were less than $2 billion for Latin America. By 2014 they were approximately $55 billion 19 Remittances II • For the region as a whole remittances a small share of GDP • However for some of the lower-income countries of Central America remittances are between 10 and 20% of GDP • The countries for which remittances are large tend to be some of the poorest countries • Flows to the region are now far larger than ODA • For many countries in the region remittances represent a significant contribution to overall economic activity • Surges in remittances can lead to an appreciation of the exchange rate – form of Dutch Disease • Overall there is limited evidence that remittances enhance economic growth – but exact extent of these impacts is still under study in many countries. 20 Remittances to Latin America • US $ millions % of GDP 21 Debt I • The dismantling of the Bretton woods system of fixed exchange rates had profound effects on Latin America • The oil shock of 1973 ended any thoughts of returning to fixed exchange rates • For countries that were oil importers, the demand for foreign exchange increased along with the price of oil. • In this situation, countries could either devalue their currencies or borrow a sufficient amount of foreign exchange to continue to finance current account deficits 22 Debt II • Given the structure of the economies of the region, major depreciations of the exchange rate would have occurred • Such an event could have created a painful mix of inflation, slow growth and high unemployment • Major depreciations would also make it much more difficult to sustain ISI industries if imports became more expensive • Decisions made in Latin America not uniform • However region as a whole slow to adopt floating exchange rates • Many countries continued with a system of fixed exchange rates • Others pursued more complicated systems of depreciating their currencies more slowly 23 Debt III • Whatever action taken, result pretty much the same • The current account deficit could not be covered with inflows of ODA, FDI, and portfolio capital • For most countries, accumulated reserves had long been exhausted • By the mid-1970s this meant borrowing from international capital markets. • Funds were available since OPEC countries putting earnings into the financial system and the recession had reduced the demand for investment capital • Many of these recycled “petrodollars” were loaned to countries in Latin America • With the second oil shock in the late 1970s, the burden of debt became unsustainable by the early 1980s • Many countries forced into major depreciations of their exchange rate as capital inflows decrease dramatically s24 Debt IV • From 1970 to late 1980s, long term debt of region increased from a small amount to nearly $400 billion • As a percentage of GDP the figures are more striking • Long term debt rose from only 15% of GDP to nearly 50% • Difference over last 20 years is interesting • Long term debt has continued to rise to $700 billion • However the ratio of debt to GDP has fallen to under 20% • Similar story for short term debt • For the region it rose from a negligible amount in early 1970s to over $80 billion in the early 1980s • As financial conditions became more difficult, short term debt was cut to less than half that amount by the late 1980s 25 Debt V 26 Debt VI • As a percentage of GDP short term debt peaked at 12% of GDP in the early 1980s • As with long term debt the ratio is back to where it began in the 1970s at 3-4% of GDP • Debt not necessarily a bad think if the money borrowed by governments had been invested in productive assets that enhance economic growth • On the other hand if debt is used to intervene in the foreign exchange market to support an overvalued exchange rate that is not good. • In this case a rising debt level was buying faster economic growth in the short run at the risk of a default or lower economic growth in the future caused by a major depreciation 27 Debt VII • Problem with debt – for most countries foreign debt cannot be repaid in domestic currency • Repayment usually required in dollars or other major currencies • In order to make timely payments on foreign debt, two factors become critical • Countries have official reserve assets – these represent a cushion of foreign exchange • However if these are low, country may face the choice of imports versus debt repayments – may not be enough foreign exchange for both • Other critical factor is the debt/export ratio – amount of debt repayment a country must make in relation to its earnings from exports • If ratio high country may experience difficulties in repaying debt 28 Debt IX • Debt service e payments peaked in the early 1980s at 80% of exports • Aside from servicing debt, the region had little money left for necessary imports • At the same peak debt service payments amounted to 8% of GDP • In effect, the region was transferring nearly 10% of GDP to creditors • Sequence • The first oil shock coupled with current account deficits increased the demand for foreign exchange in the region • Increase occurred so quickly that any stocks of official reserve assets soon fell to very low levels 29 Debt X 30 Debt XI • Without major currency depreciations, a substantial amount of debt was acquired to support exchange rates that were not being adjusted fast enough • Result was a large increase in the numerator of the debt/export ratio • Combination of slow growth in world economy, overvalued exchange rates and reliance on commodity exports meant that the rate of growth of exports was slow • Denominator of the debt/export ratio could not keep up with the numerator. • Steady rising debt/export ratio, coupled with low levels of official reserves, makes further borrowing difficult 31 Debt XII • If these numbers become increasingly problematical, then both foreign and domestic investors may conclude a depreciation of the exchange rate is inevitable • This may result in cpital flight, which simply hastens the inevitable depreciation • In the 1970s and early 1980s such situations were common in the region • Countries in this trap found the only recourse was borrowing from the lender of last resort, the IMF 32 Role of the IMF I • Originally IMF was set up to assist countries that had temporary current account deficits and lacked sufficient quantity of official reserves to support a fixed exchange rate • If the country cannot borrow the requisite amount of foreign exchange from other lenders, it could borrow from the IMF • When the IMF was created in 1944 each member country was required to contribute a quota determined b the relative size of the economy in the world economy. • The total contributed created a pool of official reserve assets that could be loaned to countries with current account deficits 33 Role of the IMF II • • • • • • • • Initially countries could borrow up to 125% of their quota The total was divided into five tranches The first tranche carried no conations Borrowing in the higher tranches required country to sign an agreement with the Fund to take policy steps that would correct the current account deficit Purpose of this conditionality was to correct the imbalance by reducing the demand for foreign exchange Changes in doestic policy that decreased the rate of growth of GDP and reduced inflation Commonly required change was the tightening of fiscal policy – lower government spending and higer taxes Also a reduction in growth of money supply and higher interest rates were also part of conditionality 34 Role of the IMF III • These IMF-mandated conditions were usually referred o as an austerity program • Declines in GDP and inflation would reduce the demand for foreign exchange • External balance world be restored • However the price for success was frequently a domestic recession – engineered by the government but designed by a foreign entity. • In a high income country this might be considered a distasteful but temporary loss of sovereignty necessary to maintain a fixed exchange rate in a world where this was the norm 35 Role of the IMF IV • The effects on developing countries such as those in Latin America much more serious • In a low-income country without without social safety nets, an austerity program could cause significant economic hardship • In most of the developing parts of the world, the IMF was not a popular institution • Especially the case in Latin America • During the 1960s and early 1970s there was little private capital flowing into the region • Countries of the region became regular customers of the IMF, the World Bank and the Inter-American Development Bank (IDB) 36 Bank Borrowing I • For many in the region borrowing from the IMF became associated with potential economic hardship • The higher the borrowing tranches, the harsher the austerity. • In the 1970s as the Bretton Woods system of fixed exchange rates collapsed, countries in Latin America and elsewhere increased their borrowing from the IMF • The IMF created a number of new “facilities” that allowed countries to borrow far more than 125% of their quota • Countries leery of borrowing from the Fund. At the same time capital became available from large international banks, particularly in the U.S. 37 Bank Borrowing II • Borrowing from the fund continued during the decade but at a slower pace because of the ability to borrow elsewhere. • By early 1980s became clear that borrowing on a large scale from commercial banks not sustainable • Mexico’s default in 1982 began a chain reaction in the region as lending from financial institutions was withdrawn • At this point the only source of finance was the IMF • The second oil shock was accompanied by slow growth in world economy, low commodity prices, rising payments on previously accumulated debts and IMF austerity programs 38 Bank Borrowing III • Predictable result – little or no growth in many of the countries in the region • Role of the IMF during this period is controversial • Its lending to countries in the region was a necessary condition, but came at the price of painful austerity programs • Its participation in the negotiations with commercial banks and the US government led to charges it was overly concerned with the health of private sector banks in high income countries 39 Brady Plan I • While IMF created to finance temporary current account deficits in a fixed exchange rate system • Began increasingly lending large amounts to countries in the region already heavily indebted. • IMF attempting to get other creditors to reschedule the existing debt to make the situation more manageable for the countries involved • By late 1980s clear the institution could not continually support current account deficits on this scale • At same time also clear region could not support the transfer of real economic resources to fully pay off all accumulated debts 40 Brady Plan II • An initial plan to alleviate the problem involved new lending to countries in the region in exchange for marketoriented reforms • Hope was the reforms would produce enough economic growth to enable repayment of the debt • By late 1980s clear this was not going to lead to a solution • Growth in the region had stagnated and with large burden of accumulated debt unlikely that the total amount could be repaid • Servicing this debt was still taking nearly half of export earnings • Serving was also requiring 5-6% of GDP in a region of middle income countries 41 Brady Plan III • Situation could not continue • Pressing need was to combine the total amount of debt into a more manageable total and increase the maturity • U.S. helped come up with a manageable arrangement • Negotiations with Mexico provided a template for other countries • Banks were offered a menu of choices • Debt could be swapped for 30 year bonds at a discount of 35% of face value or • 30 year bonds with a below market interest rate or • Backs could offer new money for 4 years at up to 25% of their current loans • Banks could change their current exposure from 65 to 12% of the total 42 Brady Plan IV • Banks chose discount bonds, par bonds or new money at 49, 41 and 10% respectively • These bonds became marketable as they were backed by US Treasury Bonds • With the template established, over next several years most of he countries reached similar deals that differed mainly in the percentages of the different options banks chose. • In total approximately $190 billion in debts was rescheduled. • In the end $60 billion in debt was writted off. • The result was a reduction of the total amount of debt to a level consistent with the resumption of economic growth 43 Brady Plan V • Program a major success • Debt of most of the countries in the region was reduced and replaced by 30 year bonds. • Growth resumed in the 1990s and by the end of the decade much of he debt had been paid well in advance. • Government’s of the region borrowed far too much in the late 1970s and early 1980s • The penalty for this fiscal imprudence was a decade of lost economic growth. • The commercial banks providing the loans were insufficiently attentive to the ability of the borrowers to repay their debts 44 Summing UP • Losing a substantial protion of their total loans was the penalty for a deficiency in analyzing sovereign risk. • Given the size of the debt, whether or not IMF austerity program would work was questionable. • The problem was resolved by the US government putting public money at risk to back a solution • The U.S. government took the risk that the transition to democratic rule in the region would brove to be durable. 45