Editor’s Note: In the book “
Building a Latin American Reserve Fund: 35 years of FLAR
” eminent experts from the region and around the world in the academic, economic and political fields reflect on the accomplishments and challenges in the field of economic integration in Latin America, the evolution in the management of regional and global economic crises, and the role of the FLAR in the regional and international financial architecture. The content of this article is based on the chapter on financial crises and the need for a lender of last resort.
An unprecedented collapse in international capital flows (mainly driven by the recycling petrodollars and intermediated by international banks) took place in 1982, triggering a crisis in Latin America and giving way to a period known as the “lost decade.” The drought in capital inflows to the region extended until 1989, and the main diagnosis at the time was that the crisis had its genesis in an exhausted import-substitution model and strong state intervention in the economy.
Rise of the Washington Consensus
The crisis of the model opened the way to the so-called Washington Consensus, the central pillars of which were macroeconomic discipline, trade and financial openness of the economy, market deregulation, and privatization of state-owned enterprises. In the years following the crisis, the prevailing interventionist and protectionist model of the region was gradually replaced by a more pro-market stance in the vast majority of countries.
The fundamental premise of the Washington Consensus was that macroeconomic discipline, economic openness, and pro-market policies would attract capital and promote growth. Furthermore, it was believed then that the international financial markets, to which the countries in the region were gradually gaining access at the beginning of the 1990s, would serve as auditors by making sure that good policies were sustained. Any deviation would be punished harshly, resulting in countries losing access to international credit and capital. By contrast, countries with sound economic policies and solid foundations would be guaranteed fluid access to international capital markets.
The Washington Consensus reforms began to be adopted by the vast majority of countries in the second half of the 1980s and the number of countries increased in the early 1990s when hyperinflation in Argentina, Brazil, and Peru was finally overcome. As its promoters had predicted, capital inflows to the region grew exponentially, from close to zero at the end of the 1980s up to 5.5 percent of regional GDP and 24 percent of total investment in the region by mid-1998. Between 1991 and 1997, the region grew at an annual rate of 5 percent, a very strong growth rate given the prior lost decade when the region experienced practically no growth.
Everything seemed to roll in accordance with what had been predicted—excluding the Tequila Crisis that led to a momentary reversal of capital flows in the region that primarily affected Mexico and Argentina—until August 1998, when everything changed. Once again, there was an abrupt, widespread and persistent collapse in international capital flows to the region. Yet again, this collapse led capital flows to levels close to zero by 2002, affecting all countries in the region to a greater or lesser extent. In some countries the shock was virulent: Argentina ended up with a financial and exchange rate crisis, a public debt default, and, eventually, an economic collapse. Even Chile—a country with strong economic fundamentals, sound macroeconomic policies, and a sustained process of structural transformations that modernized its economy and led to high growth—was severely damaged. Although Chile did not experience a financial or sovereign debt crisis, it had to undertake a severe macroeconomic adjustment.
Given this new and unexpected reversal in the region, the initial diagnosis pointed once again to the failure of the model that had been promoted by the Washington Consensus. For critics of the consensus, this crisis was the chronicle of a death foretold and a product of liberalization measures, particularly financial liberalization, which would have facilitated the arrival of “hot money” and created the conditions for destabilizing capital flow movements. Once more, this diagnosis placed the emphasis of distress between 1998 and 2002 on the region’s domestic policies.
In spite of the fact that both capital flow reversals from 1982-89 and 1998-2002 were events that simultaneously hit several countries in the region with different economic policies and fundamentals, very few paid any attention to the systemic nature of these events. The failure to focus on the financial dimensions of these systemic phenomena does not cease to surprise. After all, the collapse in capital flows that affected the region after 1982 did not only have an impact on a large number of emerging countries but also took place after a dramatic and sustained increase in U.S. interest rates orchestrated by the then-president of the Federal Reserve, Paul Volcker, as a way to combat an inflation rate that was dangerously close to 20 percent. Moreover, the capital flows reversals that hit the region starting in 1998 also occurred after the partial Russian default on its domestic debt in August 1998, which precipitated a dramatic increase in the risk premiums of many emerging economies: At the peak of the crisis, they reached 1,500 basis points above U.S. Treasury bonds.
Unlike other interpretations of regional crises that put the emphasis on the shortcomings of domestic policies, systemic interpretations place international capital markets at the epicenter of the problem. Instead of being the auditors of good policies, these markets are intrinsically a source of instability as a result of the weaknesses in the international financial architecture. As a result of these deficiencies, countries with solid foundations and repayment capacity in the long term could be threatened by insolvency, if for any reason beyond the control of governments and not related to the domestic policies of the countries, a critical mass of investors or banks are not willing to refinance the due debt. In other words, a liquidity crunch could lead perfectly healthy economies to become insolvent and cause a crisis.
Paradigm Shift I: From Idiosyncratic to Systematic
The shift in emphasis toward the systemic financial elements common to the regional crisis was a key paradigm shift that emerged with great force, most particularly after the crisis that followed Russia’s default in 1998.
An extremely striking effect of the Russian crisis, which defied our understanding, is that a partial default on domestic debt in a country that represented only 1 percent of the world’s GDP and that had no financial ties or significant trade with Latin America could produce a ripple effect of such proportions.
Calvo (1999) argues that the synchronized and widespread collapse of capital flows to emerging countries in general and Latin America, in particular, can be explained by the impact of the Russian crisis on the balance sheets of financial intermediaries that invest in emerging countries. The intermediaries had a high degree of leverage and the losses caused by the Russian default left them with a lack of liquidity and forced the sale of bonds from all the emerging countries in their portfolio at fire-sale prices, as they looked for ways to cope with the collateral’s loss of value. In the absence of an international lender of last resort that could take the bonds of the emerging countries as collateral for the provision of emergency liquidity, there was a general collapse in the price of these bonds, which affected the cost of and access to the financing of emerging countries with solid foundations and perfect repayment capacity. According to Calvo (1999), the international financial intermediaries were the fundamental propagators of the financial contagion that followed the Russian crisis.
This crisis, and the lessons learned as a result thereof, revealed the absence of a key pillar in the international financial architecture: the existence of an international lender of last resort for the enormous international emerging bond market. Although there were several initiatives to reform the international financial architecture—rather aimed at contributing to an orderly resolution of sovereign debt restructurings—such as the introduction of Collective Action Clauses (CAC) in the new bond issues of emerging countries, or the Sovereign Debt Resolution Mechanism (SDRM) recommended by the International Monetary Fund (IMF)— it was not until 2009, after the bankruptcy of Lehman Brothers and the global financial crisis that erupted as a result, that there was significant progress toward the creation of mechanisms similar to those of an international lender of last resort for the emerging countries.
Former Brookings Expert
After the Lehman Brothers bankruptcy in September of 2008, the international community showed a disposition—until then unheard of— to strongly support emerging economies. This time around, emerging countries were not the epicenter of the crisis, but the victims of the financial crisis that originated in the developed world. The U.S. Federal Reserve made emergency liquidity lines of credit available to Brazil, Korea, Mexico, and Singapore—all of them emerging countries considered systemically relevant. The Bank of Japan provided support to Indonesia and India in due course. The most important and critical decisions took place in April 2009 when the G-20 decided to triple IMF resources and launch its Flexible Credit Line (FCL) that allowed emerging countries with sound economic fundamentals to have access to quick, preventive disbursements without any conditionality, and with a big enough size and long enough maturities to have a significant impact. This decisive and daring action of the international community played a key role in preventing the financial costs of emerging countries from soaring and by impeding an abrupt interruption of international financing.
At the critical point of the global financial crisis, the international community placed unparalleled resources and new financial instruments at the disposal of the emerging economies that de facto produced a significant change in the international financial architecture and in the operating procedures of the IMF, as it introduced mechanisms that played the role of an international lender of last resort for emerging economies. This was in marked contrast to what had happened after the Russian crisis, when support of the international community in general and of the IMF in particular, was slow, subject to conditionality, curative rather than preventive, and of insufficient size.
Once the critical moment of the crisis had passed, the mechanisms for the provision of preventive liquidity were institutionalized, refined, and expanded. Today, the IMF has a wide range of facilities that allow countries with strong fundamentals and sound economic policies to access contingent liquidity lines, which are negotiated ex-ante and disbursed at the discretion of the country—without any conditions—involve potentially significant amounts that are not subject to the usual access restrictions, and are decided on a case-by-case basis. Accompanying this trend, the World Bank and the regional development banks—the Inter-American Development Bank (IDB) and the Latin American Development Bank (CAF)—have developed their own mechanisms for liquidity assistance, while at the same time regional mechanisms for the provision of liquidity such as the Latin American Reserve Fund (FLAR) have been strengthened.
Paradigm Shift II: From Macroeconomic Vulnerabilities to Financial Vulnerabilities
The paradigm shift from the idiosyncratic to the systemic and the gradual awareness of the global dimension of traumatic financial events that the region suffered at the beginning of the 1980s and late 1990s also had their corollary in the conception and design of domestic policies. The focus was expanded to include not only macroeconomic vulnerabilities: monetary and exchange rate risks (a speculative attack on the currency that could result in macro devaluation), fiscal vulnerabilities (the risk of non-convergent debt dynamics that could end in a solvency crisis), and external vulnerabilities (the risk of an unsustainable current account deficit that could force severe macroeconomic adjustments). The paradigm shift increasingly turned attention to financial vulnerabilities: international liquidity, short-term debt, the “dollarization” of liabilities, the speed of credit growth and asset price increases, and the hidden risks that are not reflected in the banks’ balance sheets, to give just some examples.
Domestic financial vulnerabilities tend to amplify the adverse impact of severe turbulence episodes in international financial markets. From a financial point of view, an abrupt reduction in capital flows affects countries differently, depending on their domestic vulnerabilities, in the same way that freezing cold affects people differently depending on their strength and physical health. In some cases, it can produce a simple cold while in other cases it can lead to pneumonia. For example, the sharp decline in capital flows that followed the Russian crisis affected the countries of the region in very different ways. Some of them, such as Chile in 1998, had severe macroeconomic adjustments but no financial crisis, while others, such as Argentina in 1998, experienced a financial crisis, the restructuring of the public debt, and an economic collapse. These differential impacts can be traced back to the fact that the abrupt interruption in capital flows forced a severe adjustment of the real exchange rate in both countries. Argentina, unlike Chile, had strong currency mismatches in the balance sheets of families, businesses, and the public sector, and a devaluation was inevitably bound to create devastating effects on the repayment capacity of these agents and, therefore, on the health of the financial system.
Although the region made significant progress on the inflation and fiscal fronts in the 1990s, it was just after the Russian crisis, which brought about a new round of difficulties in some cases and calamities in others, that remarkable progress was made in reducing financial vulnerabilities. At present, countries such as Brazil, Chile, Colombia, Mexico, and Peru have an average international reserve to short-term debt ratio that is two times higher than the one they exhibited in 1998 before the Russian crisis, and it is comfortably nestled above the critical level of 100 percent. While total indebtedness—public and private, domestic and external — currently exhibits average levels that are similar to those of these same countries prior to the Russian crisis (around 100 percent of GDP), the degree of dollarization has been reduced by more than 20 GDP points and dollarized debt represents, on average, 30 percent of the total debt. The de-dollarization of liabilities has reduced the “fear of floating,” increasingly enabling the movements in the exchange rate to contribute to absorb external shocks (without the fear of the collateral damage that these movements can cause in the balance sheets of households, firms, and governments). Banking regulation and supervision has also improved dramatically in the region. Today, countries have better capitalized banks, in so far as the introduction of macro-prudential policies will help to mitigate the systemic financial risks that tend to arise during periods of prosperity.
In commemorating the 35 years of FLAR, many things have changed for the better in Latin America. In the first place, the international financial architecture has evolved in the right direction, and the multilateral and regional financial institutions today have the resources and tools to offer emerging countries in general (and those of the region, in particular) the services of an international lender of last resort. This new international financial architecture provides immediate liquidity (without conditionality) to countries with strong fundamentals and good policies in times of turbulence in international financial markets when access to financing is difficult and expensive. Had there been a similar security net, the economic and human damage caused by the international financial turbulence at the beginning of the 1980s and at the end of the 1990s, in which the countries of the region played no part, could have been avoided.
Second, the region has made very significant progress in reducing the domestic financial vulnerabilities that have long been a mechanism of propagation and amplification of external financial turbulence, often with dramatic results.
While there is still a long way to go, there is no doubt that, as a result of the favorable changes in the international financial architecture and the strengthening of the domestic financial position, the region is much better equipped to deal with global financial turmoil today than it was only a few years ago. We are confident that this progress is sufficient to leave behind the financial and economic cataclysms that hurt us during the 35 years of FLAR. We hope that the region can thus focus its intellectual and political energies to promote economic development and improve the quality of life of its citizens.
Calvo, Guillermo A. (2005), “Emerging Capital Markets in turmoil, Bad Luck or Bad Policy?”, Chapter 12, XIII, 547 pp. The MIT Press, Cambridge, MA, USA.
Calvo, Guillermo A., Carmen Reinhart, and Leonardo Leiderman (1993), “Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External Factors”, IMF Staff Papers, Vol. 40 (1): 108-151.
Calvo, Guillermo A., and Enrique Mendoza (2000), “Rational Contagion and the Globalization of Securities Markets”, Journal of International Economics 51(1): 79-113.
Calvo, Guillermo A., Alejandro Izquierdo, Ernesto Talvi (2003), “Sudden stops, the Real Exchange Rate, and Fiscal Sustainability: Argentina’s Lessons”, National Bureau of Economic Research, NBER Working Paper No. 9828, Cambridge, MA, USA.
Calvo, Guillermo A., and Ernesto Talvi (2005), “Sudden Stops, Financial Factors and Economic Collapse in Latin America: Learning from Argentina and Chile”, National Bureau of Economic Research, NBER Working Paper No. 11153, Cambridge, MA, USA.
Calvo, Guillermo A., Alejandro Izquierdo and Luis F. Mejia (2008), “Systemic Sudden Stops: The Relevance of Balance-Sheet Effects and Financial Integration,” National Bureau of Economic Research, NBER Working Paper Nº 14026, Cambridge, MA, USA.
CLAAF (2002), “Reforms in the Process of Restructuring International Sovereign Debt”, URL: http://www.claaf.org/documents/06_Statement.pdf. Joint Statement of the European, Japanese, Latin American and the U.S. Shadow Financial Regulatory Committees, Washington, D.C.
Izquierdo, Alejandro and Ernesto Talvi (2009), “A Stability Pact à la Maastricht for Emerging Markets”, URL: http://www.voxeu.org/article/future-internationallender-last-resort-facilities. VoxEU.org, December 12th, 2009.
Izquierdo, Alejandro and Ernesto Talvi (2010), “The Aftermath of the Global Crisis: Policy Lessons and Challenges Ahead for Latin America and the Caribbean”, Inter-American Development Bank Report, Washington, D.C.
Kaminsky, Graciela and Carmen Reinhart (2003), “The Center and the Periphery: The Globalization of Financial Shocks”, National Bureau of Economic Research, NBER Working Paper No. 947, Cambridge, MA, USA.
Krueger, Anne O. (2002), “Sovereign Debt Restructuring Mechanism: One Year Later”, URL: https://www.imf.org/external/np/speeches/2002/111202.htm. Banco de Mexico’s Conference on “Macroeconomic Stability, Financial Markets and Economic Development,” Mexico City.
Rodrik, D., and Andres Velasco (1999), “Short-Term Capital Flows”, National Bureau of Economic Research, NBER Working Paper Nº 7364, Cambridge, MA, USA.
Stiglitz, Joseph (2003), “Whither reform? Toward a New Agenda for Latin America”, CEPAL Review No. 80, Santiago, Chile.
 The pioneering study by Calvo, Reinhart and Leiderman (1993) was extremely influential work on the role of external factors in the economic performance of Latin America.
 This shift in paradigm was led by key contributions such as the ones provided by Calvo (1999), Calvo and Mendoza (2000) and Kaminsky and Reinhart (2003) studies, among others.
 See, for example CLAAF (2002) and Krueger (2002).
 See Izquierdo and Talvi (2010), and Izquierdo and Talvi (2011).
 Although typically, these facilities have been underutilized ex-ante, the institutional scaffolding is ready for them to be used ex-post in periods of systemic financial turmoil and loss of access to international capital markets.
 See Calvo, Izquierdo and Talvi (2003), Calvo and Talvi (2005), Calvo, Izquierdo and Mejía (2008).