Sustainable financing is the key to continued Latin American growth

Business America, May 17, 1993 by Carlos de Quesada

The $6 billion trade surplus with Latin America during 1991-92 was one of the few bright spots in U.S. trade statistics. This situation is one result of the economic growth witnessed in many Latin American countries. While Europe and Japan remained mired in recession and the United States delicately recovered, the Latin American region posted an enviable 4.3 percent gross domestic product (GDP) growth, excluding Brazil, in 1992. Chile, the model of many developing countries, is expected to have 6.5 percent GDP growth for 1993. One has to ask what, if any, unique circumstances led to this economic expansion for an area historically dependent on the health of developed economies, and how long can the regional growth last.

To be sure, there are some extraordinary factors supporting growth in Latin America. Highly publicized divestiture of state-owned assets and companies, fiscal and monetary reform, and trade and investment liberalization measures have set the stage for an influx of funds required to finance growth. Academically, when investment exceeds savings, either the government has to maintain a budget surplus (more revenues than expenditures) or the country must run a current account deficit, or both. Therefore, external financing can have a profound effect on the level of economic growth. A dramatic example of insufficient financing is the infamous "debt crisis" that paralyzed many economies. Other than the prudential reforms mentioned above, there are several factors channeling funds to Latin America and helping the financing of current growth.

Yield-hungry investors from industrialized countries are providing a substantial source of funds as interest rates, inflation, and economic activity remain low in Europe, Japan, and the United States. Although more volatile, the Latin American markets are attracting money. According to the International Finance Corporation (IFC), stock markets in Peru, Colombia, and Mexico were among the top 10 emerging markets with U.S. dollar-based returns of 125 percent, 36 percent, and 19 percent respectively in 1992. Volatility was evident in the Venezuelan bolsa's 43 percent drop and Argentina's 28 percent stock market decline. Encouragingly, the IFC recently established a new set of emerging stock market indexes that will facilitate institutional investment by providing information on markets that may accommodate pension fund investments.

Repatriated capital flight has added significantly to the southbound flow of funds. Regional governments have encouraged the return of money scared abroad during more volatile economic and political moments. The active pursuit of flight capital is seen in the "no questions asked" approach by finance authorities, favorable tax treatment of money returning home, and dollar-denominated investment instruments available to nationals.

Similarly, sizable privatization proceeds have enhanced national treasuries but are expected to decline as less state-owned assets remain for sale. Although a positive policy in the long run, privatization cannot be relied upon to finance sustained growth.

It is not difficult to see the fickle nature of some external financing sources. Changes in the global economic picture can have a deleterious impact on Latin American economies. Rapid growth in China and reconstruction efforts in the former Soviet Union present competition for funds.

Ironically, the large influx of dollars, for reasons cited earlier, to Latin American economies has caused several problems. After 10 years of net financial capital outflows, Latin America became a net capital importer in 1991 and 1992. According to one United Nations figure, the Latin America and Caribbean region received a net inflow of $57 billion in 1992. This is a 45 percent increase over the 1991 inflow. Less diversified and smaller economies are more susceptible to disruption and the problem of "imported inflation" resulting from the incoming funds. Economic success and investor confidence can have unintended results.

The relatively massive inflow of hard currencies, primarily dollars, to a country in a transitional phase can cause rapid extraneous inflation regardless of the government's fiscal and monetary policies. Under floating exchange rates, inflation is adjusted through the value of the currency. But several Latin American countries have pegged their currency to the dollar in an attempt to quell domestic inflation, and as part of broader austerity measures. Although prices may be temporarily kept in check, prices increase as dollars flood the monetary system. Furthermore, the fixed parity or controlled exchange rate has hurt some Latin American exporters who have to contend with an overvalued currency that decreases their ability to compete on price. Argentina and Mexico have pegged their currencies to the dollar, and they have seen their current account deficits balloon as imports become less expensive and trade liberalization releases pent-up demand. The maintenance of controlled exchange rates can be difficult (and costly) if the market disagrees with the government's assessment. For example, in November 1992, Argentina spent $302 million of foreign exchange reserves as speculators bid the peso lower. Interest rates were raised to more than 40 percent in order to bolster holding of pesos. Many Latin American central banks have adopted "sterilization" tactics to mitigate the inflationary effects of capital inflow.