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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
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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. GriffithJones, M.F. Montes and A. Nasution (eds.), Short-Term Capital Flows and Economic
Crises, Oxford University Press/WIDER, London and New York.
Aninat, E. and Ch. Larraín (1996), "Capital flows: lessons from the Chilean experience", CEPAL
Review 60, December.
Calderón, A. and S. Griffith-Jones (1995), "Los nuevos flujos de capital extranjero en la economía
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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