Download ODA to Latin America

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.
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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)
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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
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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
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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
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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
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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
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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
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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
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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
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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
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ODA to Latin America
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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
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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
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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.
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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
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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
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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
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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
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Debt V
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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
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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
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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
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Debt X
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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
•
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•
•
•
•
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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.
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