Globalization and Pension Reform in Latin America

Latin American Politics and Society, Winter 2007 by Brooks, Sarah M

Market-Based Constraints on Pension Privatization

Indeed, as capital mobility increased in the 1990s, market actors' loss of confidence in an investment decision could evoke swift and massive capital flight from an economy. Confidence in the creditworthiness of a capital-importing government could be lost, for example, if the government debt (as a share of GDP) ratio rose above commonly accepted levels, raising the perceived risk of default; or if the fiscal deficit ballooned, raising the specter of inflation, which would erode the value of an investment in the local currency. In such instances, a government's sovereign risk rating could be lowered, spurring concerns of default or devaluation and therefore a sell-off of assets in the economy. In addition to raising the cost of access to international credit for the government, the loss of investor confidence could potentially destabilize the entire financial sector of developing nations, dampening economic activity and causing deep and prolonged social dislocations. Thus, while financial liberalization in the early 1990s brought the benefits of access to credit and higher growth, it also rendered Latin American countries vulnerable to the punishment of swift and massive capital flight. Coping with financial openness in the 1990s therefore obliged governments in capital-importing nations to pay close attention to the signals of creditworthiness that even the smallest policy change would transmit.

Whether pension privatization is likely to invoke a market punishment in the near term depends on a variety of factors, including the potential cost of the reform, the financial leeway that governments enjoy to finance the transition, and the economy's vulnerability to capital flight. The cost of transition from a public, pay-as-you-go pension system to a fully funded private scheme has been widely acknowledged as a key obstacle to structural reform (Kay 1999; Brooks 2002; Madrid 2003; Müller 1999). The magnitude of this financing gap varies with the inherited pension cost, the "implicit pension debt" (IPD), and the explicit debt and deficit in the old pension system. Transition costs also depend on the extent of privatization that government actors propose. When state pension liabilities are large, the financing gap created by a deep or radical privatization can be enormous. Governments may cover this financial breach in a variety of ways, although most use some combination of spending cuts, tax increases, and borrowing. Because the imposition of a "double payment" burden on working generations is often politically unpopular, however, the most common means of financing the transition to a private pension system are the use of general budget revenue and the issuance of new sovereign debt.

A government's ability to expand its budget deficit or debt burden is not unlimited, however, for these are key indicators of sovereign risk; and a significant rise in debt and deficit ratios may threaten to spark a loss of investor confidence, and with it, capital flight. It is critical to note, however, that the likelihood that privatization would invoke such punishment varies across nations and over time. For one thing, the importance of the signals that a government sends to international market actors varies with the extent to which a government relies on foreign investment to finance its balance of payments (Maxfield 1997). Not only are capital-importing governments vulnerable to the reversal of those flows, but in the particular circumstances of a persistent current account deficit (which is financed through foreign capital inflows), the loss of confidence and attendant reversal of capital inflows may spark a potentially devastating balance of payments crisis.