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4/02/14 (12,001w)+751=12,752 ECONOMIC REFORMS IN CHILE: FROM DICTATORSHIP TO DEMOCRACY, second edition, Palgrave Macmillan, London and New York, 2010. CHAPTER VIII MANAGING CAPITAL INFLOWS IN THE NINETIES AND THE “ENCAJE”* In the nineties, private capital inflows returned to Latin America (see Calvo et al., 1993; FfrenchDavis and Griffith-Jones, 1995). Undoubtedly, the resumption of capital flows, which had been interrupted in the eighties with dramatic recessive effects on economic activity, had positive short-run effects. In fact, it implied relaxing the shortage of foreign currency (binding external constraint, BEC) under which most countries had operated during the debt crisis. However, both the large magnitude of the new capital inflows and their composition (prone to volatility) caused a growing macroeconomic disequilibria in the recipient countries. Chile was one of the first Latin American countries to attract the renewed flows of |foreign capital and one that faced the largest supply in relation to its economic size. One main feature in Latin America was that the huge capital inflows were directed to consumption and to the acquisition of already existing assets; Argentina and Mexico were outstanding examples in 1991-94 of a crowding-out of their national savings. It will be argued that, in the nineties, one reason for the greater degree of Chilean success in channeling foreign capital to investment was the explicit policy set that included, as an outstanding component, counter-cyclical regulations discouraging an “excess” of short-term inflows; associated with this, a high participa varios años después, en 1981tion of greenfield foreign direct investment (FDI) in total capital inflows was recorded. The Chilean experience suggests that, when capital inflows take the form of greenfield FDI, there is a greater likelihood that flows will be more permanent and complement national savings, instead of crowding-out them which is the case when foreign capital takes the forms of liquid or short-term flows or acquisitions of existing capacity. Policies during most of the 1990s represented a significant move toward a pragmatic, counter-cyclical, pro-development approach to capital flows. In a nutshell, the policy response * This chapter is partially based on Agosin and Ffrench-Davis (2001). I appreciate the authorization of Manuel during the 1990s surges in the supply of foreign capital can be described as a successful attempt to discourage short-term inflows while maintaining openness toward long-term flows. Particularly, policies were directed toward increasing the cost of short-term inflows via noninterest-bearing reserve requirements (el encaje); this is a price-based regulatory policy tool intended to modify relative market costs or profits. Its height and coverage were modified in a counter-cyclical way. The authorities also resorted to intra-marginal intervention in order to slow down real exchange rate (RER) appreciation (in the face of inflows that surpassed the barrier of the reserve requirement) and sterilized the monetary effects of reserve accumulation. In parallel, there was a fiscal budget surplus and prudential regulation and supervision of the financial sector was enhanced. This set of policies sought to protect a development strategy whose main elements were (i) the growth and diversification of exports, and (ii) a stimulating and sustainable macroeconomic environment for productive activities and employment. Policies were effective in achieving their targets during most of the 1990s. During this period, productive capacity expanded briskly and economic activity was close to its output capacity up to 1998. This was determinant of a persistently rising investment ratio and increased employment and wages, in a virtuous circle. Crucial variables were macroeconomic prices, such as interest and exchange rates, which stayed well-aligned. For example, the latter had a very moderate appreciation in Chile in comparison with the rest of Latin America. As a consequence, the current account deficit averaged only 2.3% of GDP in 1990-95; in that period, exports grew vigorously and diversified strongly (see chap. VI). Even, in those years the regressive trend in income distribution of the seventies and eighties stopped, and social equity exhibited an improvement (see chap. VII). However, in 1996-97 this policy mix and the intensity with which it was applied remained rather unchanged, in spite of a new vigorous surge in capital flows to most countries in the region; even more, the systematic monitoring made up to 1995 in order to avoid leakages lost force. As a consequence of the lack of stronger comprehensive counter-cyclical action on the capital surge such as a higher reserve requirement or other similarly restrictive policy tools- and despite heavy intervention in foreign exchange markets, the Central Bank allowed a sharp real exchange rate Agosin, Oxford University Press, and UN/WIDER to make use of that material. 2 appreciation and a worrisome rise of the deficit on current account during this biennium. In parallel, broad exit channels of national capital were being opened (principally for the privatized social security funds), without significant outflows as long as there prevailed optimistic expectations and exchange rate appreciation was expected. This way, for both capital inflows and outflows a pro-cyclical macroeconomic vulnerability was being created, which exploded in 199899. This chapter studies the phenomenon of massive supply of capital inflows to Chile in the 1990s, the policy approaches utilized to deal with it, and their effects on the domestic economy. Section 1 describes the size and composition of capital inflows. Section 2 discusses the policy approaches taken to deal with capital surges. Section 3 analyses macroeconomic impacts and the effectiveness of counter-cyclical policies implemented. Section 4 briefly presents the outcomes in investment, savings and economic growth. Finally, section 5 concludes with a discussion on counter-cyclical policy lessons. 1. Capital inflows: magnitudes and composition The return to democratic rule in 1990 coincided with a new capital surge to emerging economies (EEs). By 1986 there had been an initial spurt of private capital toward Chile, which was associated almost exclusively with the debt-equity swap program started by the authorities in 1985. Owing to the large exchange rate subsidy implicit in the swap scheme, the program was successful in attracting significant amounts of foreign investment; it is well known that generally they did not involve an actual currency inflow to Chile, even though in a process of financial engineering they implied a reduction of the debt with foreign banks (Ffrench-Davis, 1990). The swap program was abandoned by foreign investors in 1991, mainly because the rise in the international price of bonds (pagarés) representing Chilean debt, at the same time that the new authorities reduced incentives, made it no longer profitable to invest via debt swaps. However, FDI not associated with swaps did gain strength. In fact, during the 1990s, greenfield FDI became a major share of net capital inflows (see table VIII.1). Acquisitions, following a strong world trend, also rose in Chile, but up to 1998 remained the minority of FDI inflows; the composition would revert sharply in the recessive environment of 1999. 3 (Table VIII.1) The supply of short-term private inflows also figured prominently in the capital surge toward EEs. For interest-arbitraging capital inflows to take place, the domestic interest rate must exceed the international rate by a margin that is more than sufficient to compensate for any expected exchange rate depreciation and the country risk premium. These conditions did prevail in Chile from the late 1980s, supported by a combination of five reasons. First, in 1992 and 1993 international dollar interest rates reached a thirty-year low. Second, notwithstanding the rising investment ratio of Chile in the 1990s, it still had a low stock of productive capital. Obviously, that shortage of physical capital tends to provide a higher trend rate of return. Therefore, the interest rate must tend to be higher than in a developed economy. Thus, monetary policy, in order to be consistent with sustainable macroeconomic balances, must hold real interest rates over the international ones. Third, in addition to the “structural gap” in interest rates, in 1990 a downward adjustment in economic activity took place which relied on a significant rise in domestic interest rates, which provided room for a recovery of economic activity and prices of financial assets. In January 1990, as discussed in chapter IV, before the assumption of President Aylwin in March of that year, the Central Bank had carried out a sharp interest rate hike.1 Two other requirements for interest arbitrage were also favorable to capital inflows. Chile experienced a RER depreciation of 130% in 1982-88, in response to the sharp scarcity of foreign currency; together with improved terms of trade it appeared that Chile was leaving the debt crisis behind. Consequently, expectations regarding the RER turned from depreciation to appreciation. Additionally, there was a dramatic reduction in country risk expected in EEs by international rating agencies and investment funds. Consequently, in the early 1990s expectations of exchange rate appreciation, the capital inflow itself and an improved current account position, made short-term round-tripping in Chile appear very profitable. Short-term private flows were very sizable until 1992, when they began to decrease as a consequence of the new policy measures adopted in 1990 and 1991 to stem them and their intensification in 1992 (see section 2). Novel components of flows were portfolio inflows. They took two forms: investments through mutual funds set up in the major international capital markets and the issue of American 1 In the first months of 1990, the real lending interest rate averaged 16% annually. 4 Depositary Receipts (ADRs) by large Chilean corporations. The ADR is a mechanism by means of which foreign corporations can issue new shares on the U.S. stock markets. The original or primary emission of ADRs is put under rigorous requirements; for example, the issuing company must satisfy established minimums on capital, exceed requirements on risk classification and, still more importantly, the ADR must correspond to an increase of the capital of the issuing firm. The "primary" issue of ADRs implies an expansion in the capital of large firms at relatively low cost, since capital in U.S. markets naturally tend to be less expensive than in Chile. The relatively developed domestic stock market and the low country risk made Chilean stocks a prime candidate for investors seeking new and more exotic financial vehicles. There is also a "secondary" issue of ADRs through the purchase by non-residents, in the Chilean market, of the rest of the stock of the Chilean firms that have issued ADRs in the U.S.. Subsequently, this purchase can be converted into ADRs, after which they become tradable in the U.S. markets (see Ffrench-Davis, Agosin, and Uthoff, 1995). This "secondary" operation does not constitute an enlargement of the capital of the issuing company but only a change in ownership from nationals to foreigners. These shifts in ownership (without expanding risk capital) involve exposing the economy to an additional degree of volatility, since when foreign investors' mood changes they can easily reverse the operation. These flows have played a destabilizing role. They inflated the stock exchanges in 1994 and 1997 and depressed them in 1995 and 1998, in a clear case of pro-cyclical behavior. At the same time that private flows were increasing, public debt was being reduced. This reduction corresponded to amortizations of liabilities contracted during the debt crisis (see table VIII.1); these amortizations, including substantial prepayments, were undertaken to alleviate the large accumulation of international reserves by the Central Bank; to reduce net financial costs; and to relax appreciating pressures on foreign exchange markets and improve the balance of the Bank. Since 1991, several large Chilean corporations were making direct investments abroad (see FDI outflows in table VIII.1). The destinations were mainly neighboring countries. The largest investments, which intensified along the 1990s, were principally directed to electricity generation and distribution (mostly in recently privatized companies, first in Argentina and then in other Latin American countries), and to other sectors such as light manufacturing and retailing (Calderón and Griffith-Jones, 1995). In 1996-97, after a persistent expansion since 1991, the net 5 flow of investment abroad represented 1.7% of GDP.2 In turn, the main institutional investors (national pension funds, AFPs), in spite of the increasing facilities provided by policy to invest abroad, by mid-1997 had only exported 0.5% of their total assets. As is documented in section 3, the measures to discourage speculative short-term inflows were effective in isolating the Chilean economy from the contagious effects of the tequila crisis. Thus, while the economies of Argentina and Mexico contracted dramatically in 1995, the GDP of Chile expanded vigorously (10.6%), with an increasing investment ratio (22.2% of GDP in 1995 versus 17.6% in 1990; for Argentina and Mexico the investment ratio in 1995 was 16.5% and 15%, respectively). Only the stock-market experienced a drop of foreign portfolio investment. However, it did not have recessive macroeconomic effects, due to its small share in total inflows; particularly, the depreciation that took place was within the margins of the exchange rate band. Again, the contrast with Argentina and Mexico is remarkable: between September 1994 and March 1995, the stock price index of those countries deteriorated 32% and 65%, respectively, whereas in Chile an almost negligible drop of 4% took place. Nevertheless, the new capital surge toward the region in 1996-97, especially to "successful" countries like Chile, which had weakened its counter-cyclical strategy, generated new macroeconomic vulnerabilities.3 In 1998, for the third time in sixteen years, a drastic generalized reversal of financial flows to Latin America took place. Then, the Chilean economy suffered the counterpart of the financial inflows received in 1996-97: financial outflows began by late 1997 and accelerated in 1998-99. Unlike what happened in 1982 --when the majority of creditors were banks, and loans were subject to flexible interest rates--, now most resources caught by Chile corresponded to FDI, a more "friendly" component in periods of crisis (see table VIII.1). Furthermore, the “service” of greenfield FDI tends to be counter-cyclical in recessive situations because of the reduction of profits under a domestic recession.4 In fact, their net profits 2 Balance of payments data underestimate the size of these investments because a large share of them is financed with funds raised on international capital markets that never enter the country. A similar situation emerged regarding Korean investments in its neighbors (see Mahani, Shin and Wang, 2006). 3 Surprisingly, capital inflows as a percentage of GDP were only slightly larger in 1990-95 than during the debt crisis (5.9% versus 5.5% in 1982-89). Nevertheless, in 1997 total inflows peaked to 9% of GDP. 4 Even though they have significantly different productive and macroeconomic implications, acquisitions are customarily registered together with greenfield FDI inflows. They have been disaggregated as M&A in table VIII.1. 6 after taxes fell from US$ 1,850 million in 1997 to US$ 1,050 million in 1999.5 The recessive situation that emerged in 1998 and dominated the macroeconomic environment in 1999, was caused by the reversal of financial inflows by foreigners and by a newcomer to crises, that is outflows by domestic institutional investors. 2. The policy counter-cyclical response In the 1990s, Chilean monetary authorities deployed a wide range of macroeconomic policies to regulate capital surges and their effects. On the one hand, the Central Bank attempted to discourage short-term and speculative inflows while maintaining open access for FDI. On the other, it sought to moderate the impact of financial inflows on the domestic economy, by intervening in foreign exchange markets so as to prevent an unduly appreciated real exchange rate and sterilizing the excessive monetary effects of the rapid accumulation of international reserves (see Ffrench-Davis, Agosin, and Uthoff, 1995). Two other policy factors contributed to the success achieved in managing capital inflows. First, fiscal discipline. A higher level of social expenditure was financed through new taxes. Chile ran a significant public sector surplus during 1990-97, amounting to 2% of GDP.6 The responsible stance on fiscal policy, including compliance with the rules of a copper stabilization fund,7 eased the task for the monetary authorities in managing capital inflows and aggregate demand, while a counter-cyclical macroeconomic approach was applied decisively and with consistency. Second, subsequently to the 1982-83 banking crisis, prudential banking regulations were introduced and have been perfected over the years. This, again, prevented capital inflows from unleashing a lending spree by the commercial banks, which, in turn, eased the task of keeping the current account and the exchange rate within sustainable bounds up to 5 Interestingly, the behavior of profits is counter-cyclical, but that of the rate of remittances tends to be pro-cyclical: the share of profits remitted rose from 59% to 75%, between 1997 and 1999. However, the net effect was a drop in total profit remittances; this compensating effect must be taken into account when examining the implications for the domestic economy of terms of trade changes. 6 Only in 1999 was a deficit recorded, determined by a significant drop in fiscal income. This effect, evidently not a cause, was associated with the severe adjustment process that depressed aggregate demand. 7 Given the weight of copper in the balance of payments and fiscal accounts, and the instability of its price, a Buffer Fund was created in the 1980s under a SAL with the World Bank. The fund was active throughout the 1990s, playing a stabilizing role for fiscal income and the foreign exchange market. 7 1996. a) Implementing a new macroeconomics and the reserve requirement: 1990-92 In a context of a massive supply of capital inflows, the two main goals of exchange rate and inflow management policies should be (i) to achieve sustained macroeconomic balances, especially in an economy prone to huge cycles (recall that in 1975 and 1982 Chile had experienced the sharpest recessions in all Latin America) and (ii) to protect the growth model adopted by the authorities, which granted a leading role to the expansion and diversification of exports. For the former, it is crucial to manage aggregate demand at levels consistent with the evolution of potential GDP; for the latter, it is crucial to manage the exchange rate at ranges consistent with a sustainable balance of the current account. For exports to act as an engine of growth for the Chilean economy, the level and stability of the real exchange rate are crucial. Consequently, the Chilean authorities opted to regulate the foreign exchange market in order to prevent large misalignments in the RER relative to its longterm trend. The option chosen to make long-term fundamentals prevail over short-term factors, influencing the exchange rate and the aggregate demand, assumes that there exists an asymmetry of information between the market and the monetary authorities, because the latter have a more comprehensive set of objectives and knowledge of the factors driving the balance of payments and economic activity; and, principally, because they have a longer planning horizon than agents whose training and reward are associated with the results that they get at the short-term end of the market. Here I give an analytical account relating policy changes implemented in the 1990s. The changes taking place in global markets, the increasing international approval of domestic economic policies, the vigorous economic activity, high domestic interest rates in Chile, and a smooth transition to democracy stimulated a growing capital inflow since 1990. These events were quickly reflected in a RER appreciation. By July 1990, the exchange rate was at the floor of the band managed by the Central Bank (in Latin American terms, i.e., the appreciated extreme). Even during the Iraq crisis in September 1990, the market rate stayed at the floor of the band, despite the fact that Chile was then importing 85% of its oil needs; Chile reacted to the shock brought by the oil price by drastically raising the domestic price of fuel, which caused an inflationary shock in September and October. The CPI, whose inertial 8 component implied a rise of about 2% monthly at the time, jumped to 4.9% and 3.8%, respectively, in those months. The speed and close coordination with which the Central Bank and the government reacted to external shocks may explain why pressures in the foreign exchange market continued to encourage appreciation and inflation was quickly reduced. In early 1991, the strict crawling-peg system that had been followed by the monetary authorities was modified, still without intra-marginal intervention. The adjustment was in order to introduce "exchange-rate noise", which would discourage short-term flows, while deeper reforms were being designed. The rate was moderately revalued on three different shots and then, in compensation, devalued gradually. Thus, at the end of each of these moves, the "official" rate returned to its initial real level; the devaluations within each move made it more costly for short-term inflows and thus served as an effective tool for temporarily stemming the excess supply of foreign exchange. However, the measure could not be repeated too often, since the market would then anticipate the revaluation and the policy would lose its effectiveness, which actually happened in the third move. Nevertheless, during almost six months the authorities gained time to design a policy that would act efficiently in a more prolonged transition period: that main policy reform was the imposition of an unremunerated reserve requirement (URR) on financial inflows. Undoubtedly, this policy reform advanced against the fashionable opinion of multilateral institutions and financial agents, which stressed the need for an across-the-board capital account opening. The reform adopted by the new national authorities was based on the expectation that the large supply of financing was not permanent, and short-term factors affecting the current account --such as the high price of copper, the high domestic interest rates, and the transitory depressed level of imports-- would tend to change in the near to medium term. It was recognized, however, that part of the observed improvement in the current account –a considerably improved non-financial services account, a more vigorous non-traditional exports, and a reduction in the external debt burden– was more structural or permanent. In June 1991, in response to this combination of factors, and pari passu with a 2% revaluation and an import tariff reduction from 15 to 11%, a non-interest bearing reserve requirement (URR) of 20% was established on foreign loans (covering the whole range of foreign credits, including those associated with FDI to trade credit). The reserves had to be maintained with the Central Bank for a minimum of ninety days and a maximum of one year, 9 according to the maturity of the operation. At the same time, a stamp tax on domestic credit, at an annual rate of up to 1.2%, was extended to foreign loans. In July, an alternative to the reserve requirement was allowed for medium-term credits, which consisted of making a payment to the Central Bank of an amount equivalent to the financial cost of the reserve requirement. This cost was then calculated by applying the LIBOR rate plus 2.5% (at an annual rate) to the amount of the reserve requirement. The URR, the option of paying its financial cost, and the tax on credits all had a zero marginal cost for lending exceeding one year, and, as discussed below, the first two were particularly onerous for flows with short maturities (see table VIII.3, below). It should be noted that the stages of the business cycle in Chile and in its "financial center" (the United States) coincided during most of 1991. However, in the ensuing months, USA interest rates continued to decline, exerting pressure on the Central Bank. In parallel, the Chilean economy was booming, and its GDP growth rate had risen well into two digits. Consequently, for the sake of macroeconomic equilibrium, the Central Bank wanted to raise rather than lower domestic interest rates. To avoid encouraging arbitrage and under a large supply of financial inflows, the system of reserve requirements was tightened and extended to other international financial transactions. In fact, beginning in January 1992, it was extended to time deposits in foreign currency; in May, the rate of the reserve requirement was raised to 30%, and the period during which the deposit had to be maintained was extended to one year, regardless of the maturity of the inflow. The spread charged over LIBOR in the option of paying the financial cost of the reserve requirement was increased from the original 2.5 to 4%.8 Later, in July 1995 its coverage was extended to purchases of Chilean stocks ("secondary ADRs") by foreigners.9 In order to close a loophole through which the reserve requirements were being evaded (since equity investment was exempt), the authorities decided to screen FDI applications; permission to enter the country as FDI exempted from the reserve requirement was denied when it was determined that the inflow was disguised financial capital. In such a case, foreign investors had to register their funds 8 On diverse occasions, as a counter-cyclical regulation mechanism, the rate of reference and the spread considered in calculating the entrance fee were modified. 9 It is not difficult to impose reserve requirements on foreign portfolio investments. If funds that will be used for the investment are deposited with a Chilean bank, the foreign deposit is liable to reserve requirements. For those funds that do not use a Chilean bank as intermediary, the reserve requirement can be imposed when the asset is registered in the name of an agent with a foreign address. In order to be converted into ADRs, such assets must also be 10 at the Central Bank as financial investments subject to the reserve requirement. With the Asian crisis, and the sudden sharp scarcity of financial inflows, the reserve requirement rate was reduced to 10% and then to zero in 1998. The authorities announced, however, that the policy tool would remain available in case of new capital surges (Massad, 2000), and it was restated that the URR was as a counter-cyclical macroeconomic tool. A summary of policy actions taken to tackle the excess of foreign currency during the period of abundant external financing can be found in Box VIII. 1. (Box VIII.1) Since 1991, an attempt was made to facilitate capital outflows as a way of alleviating downward pressure on the exchange rate. In particular, gradually, pension funds (AFPs) were allowed to invest up to 12% of their total assets abroad. With a similar goal, as well as the objective of enhancing the productive development of Chilean firms, residents seeking to invest abroad were granted access to the formal foreign exchange market. The policy was effective in encouraging significant flows of FDI and purchases of foreign firms by Chilean companies in neighboring countries (the so-called chapter XII of foreign exchange regulations; see Calderón and Griffith-Jones, 1995). However, higher rates of return on financial assets in Chile than abroad and expectations of peso appreciation discouraged financial investments abroad by Chilean pension and mutual funds. These investments had been rising very slowly as the domestic firms became better informed about foreign financial assets. By mid-1997, the AFPs had only US$200 million invested abroad, which represented 0.5% of the pension funds. An immediate effect of liberalizing outflows probably was to encourage additional inflows as a result of a fall in the country risk perceived by international investors. Consequently, as argued by Williamson (1993) and Labán and Larraín (2000), the resulting effect tends to be the opposite of the desired one. The market takes advantage of opportunities to place foreign currency abroad when expectations of appreciation are replaced with expectations of depreciation.10 In the face of such registered with the Central Bank. 10 Nationals of the countries concerned have been observed to behave much in the same way as foreign portfolio investors if they are allowed to do so. Thus, the ultimate cause of exchange rate and asset price volatility is associated with the openness of the capital account and the ease of moving into and out of assets denominated in foreign currency. For an analysis on Chilean institutional investors, see Ffrench-Davis and Tapia (2001); Zahler (2006). 11 a change in expectations in 1998-99, there were massive outflows in the channels opened (see chap. IX). b) Reforms to exchange rate policy since 1992 The large capital inflows of the early 1990s put strong pressure on the real exchange rate. In order to moderate this trend, the authorities operated through exchange rate policy, as noted earlier. However, appreciating pressures continued in the ensuing months. Many observers began to hold the view that a modification of exchange rate policy with a significant revaluation was unavoidable. Consequently, the official rate began to lose its allocative capacity between tradables and non-tradables. In January 1992, the official exchange rate was revalued by 5% and the floating band in the formal market was expanded to 10%.11 The observed rate abruptly appreciated by 9% in the market; that is, nearly the sum of the appreciation of the official rate and the lowering of the floor of the band. There followed an overwhelming wave of expectations of more revaluations, which was fed by capital inflows in the formal and informal markets. These flows were encouraged by the certainty that the Central Bank, under its own rules, could not intervene within the band. In fact, in a market persistently situated near the floor, it intervened only by buying at the bottom price. The market's expectation was that, if something changed, the floor exchange rate would be revalued, as in fact it had been in January 1992. For a long time, in the Central Bank it had circulated the proposal that a "dirty" or regulated float should be initiated within the band; proponents of this view argued that the prevailing rules, with a pure band, an increasingly active informal market, and a more porous formal market, would lead to an observed exchange rate leaning toward either extreme of the band (on the ceiling in 1989-90, on the floor later). The sudden revaluation of the observed rate by nearly 10% between January and February 1992 contributed to the Bank taking the decision to initiate the dirty float in March of that year. The observed rate then fluctuated for several years within a range of one to eight points above the floor (i.e., normally not on the floor itself), with 11 It must be noted that Chile was coming out of a profound debt crisis, which was accompanied by a sharp exchange rate depreciation. Consequently, there was space for some appreciation. However, as Chile was moving from a restricted to an overabundant supply of external savings, the authorities wanted to avoid an over-adjustment of the exchange rate. One specifically troublesome feature is that, as the expectations of foreign agents change from pessimism to optimism, they seek a higher desired stock of investment in the “emerging market” over a short period of time. This implies excessively large inflows for a while. Obviously, these are transitory rather than permanently 12 the Bank continuing to make active purchases but also frequent sales (though with a significant accumulation of reserves). The widening of the band had apparently signaled that the Central Bank had renounced attempts to deter revaluating pressures in defense of the export strategy, allowing the market, dominated by the short-termist segment, to determine the observed rate within a very wide range. To the contrary, the establishment of the dirty float gave back to the Central Bank a greater management capacity, enabling it to strengthen long-term variables in determining the exchange rate for producers of exportable and importable goods and services. Finally, in July of the same year, the dollar peg of the official rate was replaced with a peg to a basket of currencies (of which the dollar represented 50%, the deutsche mark 30%, and the yen 20%) as the new benchmark exchange rate.12 The purpose of these measures was to make the dollar-peso arbitrage of interest rates less profitable by introducing greater short term exchange rate uncertainty, given the daily instability of international prices among these three currencies. The replacement of a peg to the dollar with a basket of currencies also tended to give greater average stability to the peso values of proceeds from exports. Indeed, unlike financial operations, which are largely dollar-denominated, trade is fairly diversified in geographic terms -with the United States representing then only one-fifth of the total-- and it also operates with a more diversified basket of currencies. As a result of the policy mix implemented in 1990-94 (plus some "good luck", the improvement in the terms of trade in 1994-95), Chile was enjoying a solid external sector with sustainable macroeconomic “fundamentals” (a small deficit on the current account, a sustainable exchange rate, and a limited amount of external short-term liabilities) when the Tequila crisis exploded in late 1994 and its contagion effect reached Argentina in 1995. Therefore, the acrossthe-board cutoff in liquid resources for Latin America did not dampen the Chilean economy. As said, the main (but minor) shock was observed in the outflows of foreign capital from the stockmarket. However, due to the financing of the external deficit with long-term funds, this shock did not cause a recessive situation. In fact, 1995 exhibited an excellent performance in terms of higher levels of periodical inflows. 12 The basket of currencies and its matrix of real exchange rates were already operating implicitly through an index of external inflation (see Ffrench-Davis, 1984). This index was used to determine the official exchange rate month to month. The new policy adjustment implied capturing daily those variations in the peso/dollar rate, following the 13 economic growth, productive investment and employment, in acute contrast with the depressed situation of Argentina and Mexico in that year. Toward mid-1995, speculative capital flows began to return to the region and with special intensity to Chile. Given overwhelming expectations of currency appreciation, after Chile had resulted immune to the Tequila shock, the large interest rate differential between the peso and the dollar (together with good prospects for the Chilean economy) gave foreign portfolio and short-term investors what amounted to a very profitable one-way bet; expected profits far exceeded the toll they had to pay with the reserve requirement for entering domestic financial markets. This trend toward appreciation could have been softened by intensifying price restrictions on inflows (i.e. by increasing the rate, term, and/or extent of the reserve requirement; see Le Fort and Lehmann, 2003); the counter-cyclicality of policy lost consistency. The generalized over-optimism that financial crises had been left behind by the world and the risky temptation to speed the reduction of domestic inflation with a significant exchange rate appreciation weakened the previous highly successful macroeconomic policy. In fact, the external deficit increased pari passu with exchange rate appreciation and rapid aggregate demand growth, which were stimulated by the capital inflows of 1996-97. Exchange rate management encouraged speculative inflows after 1995. In spite of its formal adherence to a crawling band, in 1996-97 the Central Bank was in fact maintaining an almost fixed nominal exchange rate. There are two factors contributing to the peso pressures since 1995: (i) the establishment of an annual exchange rate appreciation of 2%, on the basis of the assumption of greater productivity growth in Chile with respect to its main trading partners, and (ii) overestimates of the external inflation used for the adjustments of the exchange rate band. Moreover, in order to lower the floor of the band, in 1997 the authorities tinkered with the weights assigned to each currency in the basket, making less credible the peg to a currency basket rather than to the dollar.13 Consequently, it was a failure not of the policy tools (the band of a basket of currencies with intra-margin interventions and the encaje) but of (i) their contradictory implementation and (ii) the lack of decision to strengthen the URR. evolution of exchange rates between the rest of currencies of the basket and the dollar. 13 In November 1994, the weight of the U.S. dollar was reduced from 50 to 45%, reflecting the falling incidence of that currency in Chilean trade. In January 1997, it was arbitrarily raised to 80%. For a comparative analysis of bands in Chile, Israel, and Mexico, see Helpman, Leiderman and Bufman (1994). For an excellent analysis of intermediate 14 The effects of the Asian crisis, including worsened terms of trade in 1998 (thus, now combined with some "bad luck") and a slower pace of exports expansion, found Chile with an appreciated exchange rate (which had not happened prior to mid-1995) and a deficit on the current account now twice as large as the average for 1990-95 (see figure VIII.1 and table VIII.2).14 (Figure VIII.1 and Table VIII.2) It took quite a long for the Bank to correct the outlier RER after the contagion of the Asian crisis arrived. It argued that in an economy near to the productive frontier and with a high external deficit, to allow a strong devaluation would have substantial inflationary effects. Undoubtedly, the pass-through effect on inflation is normally greater in an economy operating close to its productive frontier. However, as well, this is a powerful argument for countercyclical action during booms by avoiding the exchange rate misalignment quite before the critical situation arises. Increasingly, from the mid-1990s, the anti-inflationary objective had become an overwhelming priority for the Central Bank, at the expense of the RER and, consequently, at the expense of efficient resource allocation and real macroeconomic balances. In the end, it was a policy reversal at the expense of sustainable growth as well as of equity. c) Strengthening banking regulation and supervision As noted, a tough bank regulation and supervision prevented the excess liquidity of banks from fueling a consumption boom and deterioration in the quality of bank assets. This was a legacy of the banking crisis of 1981-86 in the aftermath of the preceding foreign capital surge, which led to a virtual collapse of the entire banking system (see Díaz-Alejandro, 1985). The prudential regulation and supervision adopted since then includes (i) continuous monitoring of the quality of bank assets; (ii) strict limits on lending by banks to related firms; (iii) automatic mechanisms of bank risk capital adjustment when its market value falls below the limits required by the regulators; and (iv) faculties to freeze banking operations, forbid fund transfers outside of troubled banks, and restrict the payment of dividends by institutions that fail to regimes, with references to Chile, see Williamson (2000). 14 An enlarged deficit on current account (even after being adjusted by the trend terms of trade) is a revealed proof of an overly appreciated exchange rate, which was moving faster than net productivity improvements. I contend that in 1990-95 there was a stabilizing appreciation, while in 1996-97 there was an outlier overvaluation that exceeded 15 comply with capital adequacy requirements. Chilean financial markets have also acquired a depth that allowed for the orderly infusion of new funds, and for their withdrawal, without significantly affecting the quality of bank portfolios (Aninat and Larraín, 1996; Held and Jiménez, 2001). Capital adequacy ratios along the lines of the 1988 Basle Accord were introduced into the new banking law approved by Congress in 1997. But banks' capital, in practice, was well above the Basle norm of 8%. In addition, the Central Bank imposed limits on banks' open positions in foreign exchange, although these were still fairly crude in that they did not differentiate between loans made in foreign currency to firms that earn foreign currency and to firms whose earnings are in domestic currency. Neither do these limits differentiate between different currencies. Currency risk is only one aspect of credit risk evaluation, which as a whole is quite good in Chile. Therefore, this compensates for the weaknesses in the norms on open positions in foreign exchange. 3. Effectiveness of macro-stabilizing measures Macroeconomic counter-cyclical, prudential, regulations also have microeconomic effects. Both are associated with the financial costs imposed by the system of reserve requirements and taxes on foreign lending. The implicit total tax consists of the extra interest costs imposed by the reserve requirement and the tax on foreign credits. The calculations can be seen in table VIII.3. As a result of the lengthening (in 1992) of the reserve requirement holding period to a full year, and regardless of the maturity of the financial transaction, the implicit annualized tax rate on foreign borrowing increased dramatically as maturities shortened. Before the term of the reserve requirement was extended, the implicit annualized tax rate was identical on transactions as short as a quarter (the minimum holding period up to May 1992) or as long as a year. These very large estimates of the implicit tax rate on short-term operations suggest that, if the regulations were not evaded, they must have implied strong discouragement of short-term and portfolio flows. (Table VIII.3) by far actual net increases in TFP in Chile, thus destabilizing the external balance. 16 How effective has the reserve requirement (together with interest and exchange rate management) been in deterring short-term flows and preventing excessive external deficit and exchange rate appreciation? How does it affects different kinds of agents and, therefore, which is the impact on equity? How does it alters the macroeconomic environment for investment and productive development? All these questions have been in the theoretical, empirical and political debate. Here, I deal with them. a) Arguments against capital account management A traditional argument is that (i) the regulation does not have effects because in the present economic world (and the one of the nineties) it stimulates evasion, offsetting all incidence from the start or, gradually, soon after. A variant states that (ii) the regulation affects the composition of flows, but this does not have any economic incidence. A third variant (iii) accepts that there are positive effects but, at the same time, it worsens regressively the access of small companies to financing. Some observers have claimed that the efficacy of measures intended to discourage capital inflows is only temporary, since they assume that private operators usually find ways to fully evade them (see Valdés-Prieto and Soto, 2000). In principle, this can be done through several mechanisms. Here I mention five of them. One is the under-invoicing of imports or the over-invoicing of exports. The second is to delay payment for imports or accelerate export receipts. Third, funds can be brought through the informal foreign exchange market. Fourth, short-term funds can be disguised as FDI. Fifth, agents can arrange back-to-back operations in which, for example, an agent pays for imports with a bank deposit in Chile rather than with foreign exchange; at the same time, the exporter is paid in foreign exchange by a bank in his or her country. All of these (and other forms of evasion as well) are possible, but they are not costless, some have a one-shot impact and only delay effects, and some may have undesirable effects on their tax liabilities for the avoiders of regulation. The authorities were conscious of the risks and the dynamics of the market which, by its nature, looks for evasion channels. For that reason, up to 1995 they maintained a permanent monitoring, closing loopholes that were appearing. I mention two. First, the financial flows that banks or investment funds disguised as risk capital or productive investment; when it was becoming an important loophole, the authorities moved to close it by means of the case-by-case 17 analysis of those flows, and by placing under the reserve requirement those that corresponded to financial investments. While some evasion is inevitable, there is no hard evidence that the measures targeted to discourage short-term capital inflows had been massively evaded, as it is verified below. Second, the case of investment funds purchasing secondary ADRs. By 1993, the secondary issue of ADRs started to rise as a source of short-term inflows with particularly volatile characteristics. Thus, the extension of reserve requirements to these inflows in 1995 was an effective attempt to deal with an incipient problem that was already causing difficulties in policy management. However, after a temporary lull in 1995, they again surged in 1996, though now paying the corresponding cost of the reserve requirement. The evidence suggests that the entry fee came to be perceived as cheap in the face of positive fundamentals, optimistic expectations and a strong likelihood of further RER appreciation. I repeat that, evidently, the policy answer then should have been a strengthening of the restrictive power of the reserve requirement, in order to adapt to the increased liquidity of international financial markets. In contrast to several studies that show a significant effect over short-term inflows, a common line of attack against the use of disincentives has been to claim that, with regard to their behavior, it is impossible to distinguish between capital inflows such as FDI or long-term lending, on the one hand, and short-term or liquid flows on the other. In an influential study (videly promoted by the supporters of the "Washington Consensus") Claessens, Dooley, and Warner (1995) claimed that balance of payments categories have nothing to do with the stability of flows themselves, long-term flows being just as likely to be unstable as short-term flows.15 It is interesting to note that after many empirical works that verified the lack of consistency of those critics, more recently another one arose. This one accepts that the regulations had desirable effects on the composition of flows in the case of Chile, but that they were regressive. In that sense, Forbes (2003) finds that the reserve requirement affected ‘small’ 15 Part of the explanation of their finding that FDI is as likely to be volatile as short-term flows may stem from the fact that, for the countries that they selected, FDI flows were a small percentage of total foreign financing, as reported by IMF statistics. Fluctuations in small numbers tend to be greater than fluctuations in large ones. On the other hand, the period covered excludes the Tequila crisis, when portfolio flows played a significant destabilizing role. It is evident that instability must be tested in critical situations rather than during booms. Finally, we repeat the relevance of distinguishing between FDI and Mergers and Acquisitions. FDI is mainly carried out in fixed assets (it is "irreversible" investment), whereas M&A uses to involve “liquid” inflows. 18 firms more intensively by imposing financial constraints on them.16 Gallego and Hernández (2003) conclude that the reserve requirement affected the financial structures of Chilean firms reducing their leverage, increasing their reliance on self-generated funds (retained earnings), and increasing the maturity profile of their debt. Both microeconomic works use as their sample a group of listed companies in stock markets.17 It is evident that any tax imposes some monetary cost to taxpayers and, in doing so, changes relative prices. The crucial point is what the net effect of capital controls is on overall welfare, after a double test: (i) to contrast their eventual microeconomic costs and their macroeconomic benefits, and (ii) to assess the effects throughout the economic cycle; that is, not only during the boom but also during the fall that usually follows. There is strong evidence that a bust has a significant bias against SMEs, as shown by the regressive impact of the recession of 1999 against SMEs and labor of lower qualification. b) Arguments in favor of the regulation of inflows and its empirical test There are two kinds of evidence that one can use to assess the net effect of regulations. The first is qualitative. There is broad consensus that, in the first half of the nineties, Chile faced a larger supply of external finance (relative to its GDP) than other countries in the region, because of its better economic performance and greater political stability. However, during those years the exchange rate appreciation and the current account deficit (as a share of GDP) were smaller than in other countries in the region that were major recipients of foreign capital (see Ffrench-Davis, 2006, chap. VII). In addition, FDI represented a much larger share of inflows in Chile than in other countries;18 in those years of re-establishment of democracy, besides restricting capital inflows, Chile restored labor rights and some taxes on profits: We can assume that the reason why greenfield FDI responded positively were not these variables but other policies, such as the better macroeconomic environment that counter-cyclical policies generated. 16 Meanwhile, the positive macroeconomic effects of the reserve requirement had been acknowledged by academic circles and authorities of institutions such as the BIS, the IMF and the World Bank. 17 Most listed companies in Chilean stock markets are among the biggest in the domestic economy. Therefore, evidently, conclusions from these works cannot apply directly to the overwhelming majority of SMEs which are not listed in the stock market and have limited access to capital markets. 18 It should be noted that the loans associated with FDI were subject to the reserve requirement. Since the average maturity of these loans averaged about seven years, the incidence of the restriction merely for their first year was low. However, this avoided the danger of short-term credit being disguised as long-term credit. 19 These provided a better environment for productive investment, which attracted FDI and, what is about “four times as relevant”, also spurred domestic investment.19 The second is quantitative. Significant econometric evidence shows that policies directed toward the capital account did work rather well for about one full quinquenium. These studies indicate that the combination of disincentives to short-term inflows together with the other reforms in the macroeconomic approach, at least up to 1995, had been able to reduce short-term and liquid inflows and to avoid an unsustainable deficit on current account (Agosin, 1998; Larraín, Labán and Chumacero, 2000). As discussed below, the policy approach of Chile changed markedly in the following years in the face of a new generalized capital surge toward emerging economies, when restrictions on inflows were, paradoxically, left unchanged by the autonomous Central Bank rather than being increased in response to the huge capital surge of 1996-97. Consequently, the destabilizing effects in that biennium cannot be attributed to the counter-cyclical policies of the first half of the nineties. In fact, there is robust evidence that the capital controls applied in Chile modified the maturity structure of inflows, reducing the share of the short term component.20 Indeed, actual short-term and liquid flows were limited and a significant share of them entered paying the reserve requirement. The magnitude of the financial revenue from the toll reached around 1% of GDP during all the years it was in force. Just a positive by-product. In order to check the hypothesis that the composition of the flows does not make a difference, a series of econometric tests were run to determine the degree of persistence of different types of private flows (see Agosin and Ffrench-Davis, 2001). These tests lead to the conclusion that FDI is considerably less volatile than short-term borrowing and portfolio flows, and that it is advisable to target policies of prudential macroeconomic management (such as the reserve requirement) on short-term or liquid inflows. As well, persistent flows tend to be associated with productive investment and not consumption. This is what the Chilean authorities successfully reached, when they took the decision to apply a comprehensive counter-cyclical policy. Undoubtedly, during the first half of the 1990s, short-term and portfolio inflows would have been much larger in the absence of the reserve requirement. Together with sterilized 19 The ratio of investment by nationals to FDI has been around four. See De Gregorio et al. (2000); Edwards (1999); Gallego et al. (2002); Le Fort and Lehmann (2003). See also the comments about the reserve requirement significant effectiveness in Williamson (2003). 20 20 intervention in foreign exchange and monetary markets, the policy approach adopted prevented undue exchange rate appreciation and a consumption boom, thus keeping the current account deficit within reasonable bounds up to the mid-1990s. The policy mix also had financial costs for the authorities during the boom period. The accumulation of large volumes of foreign exchange reserves imposes a financial cost, since the returns on these assets abroad were lower than the interest payments on the Central Bank liabilities issued to sterilize the monetary effects of reserve accumulation; the losses for the Central Bank were estimated at about 0.5% of GDP per annum. That is the cost of "insurance" for economic stability; the initial accumulation implied a movement toward “equilibrium” since in 1990 net liquid international reserves were notably low (actually, negative if measured comprehensively), but probably became unnecessarily large by 1994 (though most welcome during the sudden stop of inflows of 1995). Undoubtedly, a more flexible and restrictive management of the reserve requirement and other prudential macroeconomic policy tools by the authorities would have moderated that cost. From the point of view of investment and growth, the impressive growth performance of the 1990s supports the hypothesis that the positive effect of the whole macroeconomic approach (including the management of capital inflows) was much stronger than any associated microeconomic costs. Actually, the investment ratio of Chile in the 1990s was the highest recorded in its past history. In this sense, “financial constraints” as defined and reported by Forbes (2003) were not an impediment to expanding productive capacity.21 Moreover, the microeconomic switch from debt to retained earnings in the financial structure, as well as the shift toward longer-term liabilities of ‘small’ firms recorded by Gallego and Hernández (2003) can be considered as a positive by-product of Chilean capital controls. Indeed, the main source of private savings are non-distributed profits and depreciation reserves of firms; the improved macroeconomic environment implied a higher rate of use of installed capacity, higher effective productivity, larger profits, better expectations, and higher reinvestment of profits. That is not a negative outcome, but a highly positive one. This is consistent with stressing that there is a severe incompleteness in the Chilean capital markets with respect to long-term financing for Forbes (2003) defines “financially constrained” firms as those that depend on their own sources of financing to invest. In fact, most SMEs do not have access to the formal financial market, and therefore the macroeconomic environment they faced is a key variable determining its liquidity. 21 21 SMEs and non-wealthy entrepreneurs. In the macroeconomic dimension, there is robust evidence that access to financing and spreads of SMEs are more intensively affected than large firms during crises. Avoiding crises by discouraging capital inflows during the boom stage naturally imply for SMEs paying higher interest rates than otherwise during the boom. However, in the bust phase of the cycle, the policy contributes to avoiding both sharp increases in costs during the avoided bust and the corresponding binding financial constraints that they usually face during recessions; these restrictions could be avoided in 1995 and attenuated as in 1999, thanks to the prior prudential regulations on inflows. But, I must point that it is my interested view as a participant in the design and implementation of this set of policies, the overall balance provides a case of very effective and efficient counter-cyclical policies. In summary, (i) there is strong evidence that the capital controls applied in Chile modified the maturity structure of inflows, reducing the share of short-term components. This conclusion emphasizes a very positive characteristic of this policy tool, because the probability and severity of crisis appear to be closely associated with a greater liquidity of external liabilities. Empirical studies also recognize that the URR (ii) allowed a variable gap between domestic and external interest rates to be maintained, thus providing space for an active monetary policy. This was of great importance for the sustained growth process recorded during almost all the decade; in fact, frequent mini-adjustments from the Central Bank allowed the avoidance of maxi-adjustments, thus resulting in an economy working persistently on or near the production frontier. On the other hand, (iii) effects of the URR on both total flows and real exchange rate appreciation has been found (see Le Fort and Lehmann, 2003; Ffrench-Davis and Tapia, 2005). In all, (iv) the reserve requirement contributed to moderate the stock of liabilities and to improve its profile (from both micro and macro perspectives). According to most international evidence these two factors strongly determine both the probability of crises and its associated costs. There is another dimension that is dynamic, linking with the future: (v) an economy with a high rate of use of productive capacity and stable long-term flows, usually exhibits higher rates of productive investment. This generates two positive effects that increase the efficient absorption capacity of external savings: first, gross capital formation is intensive in imported inputs, which is the reason why a given amount of capital inflows cause less exchange rate 22 pressure when it is channeled to investment than when it goes to consumption; second, a high investment ratio generates a larger output in the future, with its respective demand for imports, creating an efficient and sustainable higher absorption capacity, without a misalignment of the exchange rate.22 c) Chile and two LACS in crisis The Mexican and East Asian crises are illustrative of these dangers of financial destabilization. In the case of Mexico, as emphasized by Sachs, Tornell, and Velasco (1996), domestic policy failures, particularly the large increase in credit that resulted from a poorly regulated financial system, were important destabilizing factors. In both crises, domestic credit booms, however, were triggered by large capital inflows, in a similar process to the one that took place in Chile in the seventies. The herding behavior displayed by foreign portfolio investors has been recognized as a critical element in the Mexican crisis (Calvo and Mendoza, 1996); a similar pattern preceded the Asian crisis. Since assets of firms from a particular developing country are normally a very small proportion of international investors' portfolios, it may not pay to go to the trouble of obtaining costly information. Therefore, they tend to follow “signals”. The pro-boom signal by the early 1990s was that Mexico was undertaking decidedly market-oriented reforms (and was entering NAFTA and then the OECD) that would, in the eyes of the international banks, raise returns on Mexican corporate assets. By late 1994, the signal for a reversal of the financial capital inflow was the notion that current account deficits had become “unsustainable” and the exchange rate had appreciated “excessively” in Mexico; but that should have been a surprise to no one because it was an ongoing process at least since 1992 (see Ffrench-Davis, 2006, box VII.1). Of course, (i) the large current account deficits and outlier macroeconomic prices, particularly an appreciating RER, had principally been a consequence of the exogenous (and collective) behavior of foreign investors in the first place. And (ii) it had been going on for several years. Thus, paradoxically, a “successful” country can see its fundamentals –such as the deficit on the current account, exchange rate, savings, and bank portfolio– worsened by a large capital 22 This relevant effect on absorptive capacity, associated with the composition of inflows, is usually omitted from econometric research. 23 surge. From a theoretical point of view, what we have is the possibility of multiple equilibria: an appreciated exchange rate with large capital inflows, and a depreciated exchange rate with capital outflows. Moreover, there are dynamics involved: capital inflows appreciate the RER, and the latter, if it is gradual, encourages additional inflows. This can proceed for several years, as happened in 1976-81 and 1990-94 in several LACs. After a while, when the deficits on current account accumulate due to increasing stocks of external (particularly liquid and short-term) liabilities, the appreciation trend is replaced with expectations of depreciation, which in turn tends to lead to a reversal in the flows direction (see Ffrench-Davis, 2006, chaps. VI and VII). This indicates that there is a need for policies that reduce the more volatile components of capital inflows, and demonstrates that the "fundamentals" are dependent on policies toward financial flows. Moreover, some equilibriums are more “desirable” than others, in terms of their effects on economic growth and equity and their sustainability. 4. Savings, investment and growth in the 1990s The remarkable increase in the productive investment ratio, and the fact that the ratio kept rising up to 1998 is most relevant. During the mayor part of the period 1991-98, there was no recessive gap (gap between actual GDP and potential GDP). It has been shown that the recessive gap is a significant explanatory variable of the investment ratio (see Agosin, 1998; Ffrench-Davis, 2006, ch.III). It also happens that a larger investment ratio, in response to a negligible recessive gap, tends to be associated with stronger SMEs and overall better employment. The gap remained negligible until 1998, encouraging productive investment, even though other macroeconomic disequilibria were being built: a rising external deficit and an appreciated exchange rate. The two latter explain why Chile was hit by the Asian crisis from 1998 and it did not remain immune as it had been in the Mexican crisis of 1994-95. For that matter, it is important to make a sharp distinction between the period in which the counter-cyclical approach was implemented in a coherent way (1990-95), and the period of increasing abandonment of the active counter-cyclical strategy (1996-97). In the first period, the Chilean economy became one of the less vulnerable in a region facing financial and exchange rate crises, escaping from the contagion of the Mexican crisis. In the case of the Asian crisis, the negative effect was rather moderated and, as discussed, was mostly linked to policy failures like allowing the accumulation of 24 macroeconomic imbalances and the careless liberalization of outflows by residents during the boom phase in 1996-97. When the Asian contagion arrived and a significant recessive gap emerged, the investment ratio fell sharply in 1999. Undoubtedly, the 1990s marks a clear-cut improvement in the growth of productive capacity, in comparison with 1974-89. The gross fixed investment to GDP ratio rose steadily: from 13.6% in 1974-89 to 20.2% in 1990-98 (in constant 2003 prices; see chap. IX, table IX.1). This increased ratio allowed Chile to sustain a GDP growth averaging over 7% per annum in that same period. In those nine years, actual and potential GDP grew at similar and sustainable rates, with the economy operating regularly close to the productive frontier. That is one of the main conditions that must be fulfilled by an efficient macroeconomic policy. As already stressed, that positive feature of a macroeconomics-for-development was determinant of the high rate of productive investment recorded in the nineties, and therefore of the increasing potential GDP growth. In fact, this is strongly associated with the correction of the macroeconomic environment, with high rates of use of productive capacity (and well-aligned macro-prices for the sake of sustainability). Naturally, this high investment ratio contributed to generate productive jobs and to the adoption of technological advances imbedded in imported capital goods. The increase in the gross savings ratio was also strong, rising from 12% during the Pinochet regime to 22% in 1990-98 (in current prices). This reveals that, in the nineties, national and foreign savings worked as complements, as opposed to the substitution that took place in Argentina and Mexico before 1995 and in Chile before 1982 (see Uthoff and Titelman, 1998). As shown in section 1, capital inflows averaged 5.8% of GDP in 1990-95, whereas the use of foreign savings was reduced to 2.3%, with the difference being accumulated in the international reserves. This reveals that the sterilization policies of capital inflows, by preventing excessive exchange rate appreciation and avoiding a high external debt, allowed the economy to absorb less foreign capital than the amount offered, regulating it to amounts consistent with an efficient absorption capacity. This was enhanced by the fact that most flows were associated directly with productive investment. The Chilean policies directed toward restraining capital surges and moderating exchange rate appreciation can be credited with a significant share of the success achieved with regard to investment, savings, and economic growth. On the one hand, the management of inflows has had 25 a positive impact on real macroeconomic stability, and has contributed to keeping effective demand close to productive capacity, which is essential for investment expenditure to rise. On the other hand, when capital arrives in surges rather than trends, and takes the form of volatile financial flows rather than FDI or financing of imports of capital goods, it tends to crowd-out national savings. Foreign savings stimulate consumption through their effects on domestic liquidity, the exchange rate, and asset prices. Thus, success in moderating capital surges and modifying its composition contributed to a sharp increase in savings rates (Agosin, 2001; Solimano, 1990). 5. Some policy lessons from this experience The Chilean experience with the prudential macroeconomic management of capital inflows provides several relevant lessons. For developing countries, the swings in capital flows can be of extraordinary magnitude relative to the size of their economies. Totally passive policy stances will inevitably generate external vulnerabilities, resulting in enormous volatility in key domestic macroprices (exchange and interest rates) and economic aggregates (aggregate demand, output gap and external balance). By depressing investment, these fluctuations have adverse effects on long-term growth, productive employment and social equity. Contrary to the neo-liberal view, it is possible to discriminate between flows (i) that are stable, of a long-term nature, and do contribute to the country's growth (such as greenfield FDI that directly create new capacity) and (ii) those that are basically speculative and lead to excessive domestic volatility. In the Chilean case, the market-based discouragement applied to speculative flows had no adverse effects on FDI, which, on the contrary, reached unprecedented levels during the decade. Some evasion is inevitable: any system of discouragement makes it attractive for some operators to attempt to circumvent it. In the Chilean case, it was necessary to close loopholes when it became obvious that agents were creating them. In fact, circumvention can be kept to a minimum with a well-designed and transparent system such as the reserve requirement on capital inflows (encaje), and continued monitoring by authorities. The objective of sustaining economic growth in the face of volatile capital flows (or volatile export prices, as in Chile) requires the use of a battery of counter-cyclical policy 26 instruments. In the Chilean case, the combination of tax-like instruments meant to deter speculative inflows, a crawling band with intra-marginal intervention (which in my view, was utilized too sparingly), and sterilizing the monetary effects of capital inflows worked well for over a quinquenium. It contributed to the creation of a friendly macroeconomic environment for productive investment, job creation and economic growth, keeping under control the external sources of vulnerabilities that caused severe crises in Argentina and Mexico in 1995. In Notwithstanding the policy reversals in 1996-97, as discussed below, the benefits of the active regulation implemented in previous years had left large net international reserves, a rather low stock of foreign liabilities, and a small share of volatile inflows, which allowed a recessive adjustment in 1999 remarkably less traumatic than those in 1975 and 1982. This case is addressed in the next chapter. 27 REFERENCES Agosin, M. R. (1998), “Capital inflows and investment performance: Chile in the 1990s”, in R. Ffrench-Davis and H. Reisen, eds., Capital Flows and Investment Performance: Lessons from Latin America, OECD Development Centre/ECLAC, Paris. Agosin, M.R. and R. Ffrench-Davis (2001), “Managing capital inflows in Chile”, in S. 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Ffrench-Davis (ed.), Seeking Growth Under Financial Volatility, Palgrave Macmillan, New York. 29 Box VIII.1 REGULATIONS ON CAPITAL FLOWS IN CHILE BY MID-1998 Foreign direct investment The only restriction on FDI inflows is the requirement that investments remain in Chile for a one-year period. There are no additional restrictions on outflows, excepting a tax on profit remittances. FDI must be financed with a maximum debt component of 30% (70% equity). This limit was reduced from 50% in October 1997. Portfolio investment inflows through ADRs Minimum amount of ADR issue is US$25 million, reduced from US$50 million in September 1994. Minimum risk rating of BBB required for non-financial firms and BBB+ for banks issuing ADRs. A 30% reserve requirement on secondary ADRs was established in July 1995. Other financial and portfolio inflows Subject to the 30% reserve requirement for a one year period. With the Asian crisis, it was reduced to 10% in June 1998 and to 0% in September. They include trade credits, foreign currency deposits, foreign loans including those associated with FDI, and bond issues. Bond issuers face the same quality-enhancing restrictions as ADR issuers. Since 1992 foreign loans faced a monthly tax of 0.1% with a maximum of 1.2% on credits of one year or more. Investment abroad by the Chilean non-financial private sector Currency purchase in the formal market for investment abroad is authorized. Investors not wishing to have access to the official foreign exchange market need only inform the Central Bank of their investments abroad. Those wishing to have access to the official market need permission from the Central Bank. This is not difficult to obtain. Generally, the formal and free market exchange rates were similar. Foreign investment by Chilean institutional investors Foreign investments by pension funds, mutual funds and life insurance companies are subject to certain limits as to the amounts and types of foreign assets that they can hold. Pension funds were allowed to hold abroad up to 12% of their total assets (raised to 16% in 1999), and investment in stocks was limited to one-half of total foreign holdings. Foreign investment by banks Foreign financial investments by commercial banks are limited to 25% of bank capital and reserves and are restricted to fixed income securities issued or guaranteed by foreign governments or Central Banks. Banks are authorized to use foreign currency deposits to finance trade among countries belonging to the Latin American Integration Association (LAIA). Commercial banks may hold equity in foreign banks provided that they have a capital adequacy index of at least 10%. ______________________________________________________________________________ Source: Central Bank reports. 30 Table VIII.1 (03.05.10) Composition of capital flows, 1980-2008 (2008 US$ as % of GDP) 1980-81 1982-89 1990-95 1996-97 1998-99 a FDI net inflows Greenfield FDI M&A FDI net outflows b Official gross loans c Public amortizations d Private amortizations Portfolio e f Other capital Net Capital Inflows d 2000-03 2004-07 2008 1.4 1.4 0.0 1.1 1.0 0.1 3.5 2.5 1.0 7.8 4.8 3.0 9.0 2.3 6.7 4.9 1.8 3.0 6.8 5.1 1.7 8.9 6.4 2.5 -0.2 0.0 -0.8 -1.7 -2.7 -2.3 -1.7 -4.7 0.4 2.1 0.9 0.2 0.1 -0.1 -0.1 0.0 -5.0 -1.5 -1.5 -2.7 -0.6 -1.1 -1.3 -1.4 -2.9 -1.7 -1.2 -2.4 -3.9 -7.3 -8.0 -6.7 0.2 0.0 0.7 1.8 -3.8 -1.2 -6.0 -5.2 25.6 19.5 5.5 5.4 4.0 5.8 4.3 7.4 2.5 0.6 8.1 0.9 7.1 -3.3 14.3 5.2 Sources: Balanza de Pagos data from the Central Bank; Mergers and Acquisitions (M&A) from UNCTAD. Balance of payments figures in current US dollars were deflated by an index of external prices faced by the Chilean economy, obtained from FfrenchDavis (1984) and Central Bank, scaled to 2008=100. The GDP series in 1996 constant prices was scaled-up to the 2008 price level, and transformed to 2008 US dollars using the average nominal exchange rate of that year. a FDI in Chile, net from repatriation of capital. Includes net loans associated to risk capital of FDI and excludes debt-equity swaps. b Net investment by Chilean firms abroad. cIncludes loans from foreign official and multilateral institutions. d Amortizations, including pre-payments. eNet balance of flows of investment funds, ADRs and bonds. f Short and mid-term credit lines of banks and others. Table VIII.2 (02.05.10) Net capital inflows and deficit on the current account, 1980-2008 (% of GDP, current prices) Net capital inflows Deficit on the current account 1980-84 12,6 13,7 1985-89 4,6 4,1 1990-95 6,3 2,3 1996-97 7,8 4,8 1998-2003 0,8 1,6 2004-07 -3,2 -3,4 2008 5,7 1,6 Sources: Balance of Payments data from the Central Bank for capital inflows and current account, in US dollars. National Accounts from the Central Bank and Marcel and Meller (1986) for GDP, in pesos. a The GDP figures in current prices were normalized with a trend series for the nominal exchange rate estimated with a Hodrick-Prescott filter, in order to avoid the misleading bias introduced by a volatile RER. 31 Table VIII.3 Implicit cost of reserve requirement on foreign borrowing, 1991-98 (annualized rates) Reserve requirement (%) Minimum holding period (months) LIBOR (%) Implicit cost (%) 12 months 6 months 3 months 1991 II 20 3 5.5 1992 I 20 3 4.3 1992 II 30 12 3.6 2.8 2.8 2.8 2.8 3.2 4.0 3.3 5.5 9.7 1996 1997 30 30 12 12 5.6 5.8 4.2 7.2 13.3 1998 I 30 12 5.7 1998 Q3 10 12 5.6 4.3 7.3 13.4 1.8 2.4 3.7 4.1 6.9 12.7 Source: Author's calculations, based on information from the Central Bank. Implicit cost includes the 0.1% monthly tax, with annual ceiling of 1.2%. Figure VIII.1 Evolution of the real exchange rate, 1986-2009 (1986=100) 115 110 105 108* 106 104 6% 100 12% 99 95 19% 90 91 85 91* 80 80 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 75 Source: The real exchange rate is the amount of real pesos per one unit of a real weighted basket of currencies of trade partners. Index based on official figures from the Central Bank. The numbers correspond to annual averages of sub-periods delimited by horizontal lines. The arrows show the appreciation percentages between the respective peaks or sub-periods of annual averages. *The values for 2008 and 2009 correspond to monthly peak and valley values of each year, respectively; both values correspond to December of each year. 32