Latin American CrisesPresentation 2 - EC/EIB 230 International Finance

Mathew Cravens

Venkatesh Ramamoorthy

Jiong Zhou

Agenda● Background of crisis - Economical & Political

● Transmission & Impact of crisis

● Control measures

● Mexico – 1994 crisis

● Argentina – 1998-2018 crises

● Brazil – 2014-16 crisis

Why this crisis is important?

Countries in crisis(Reinhart & Rogoff (2009))

Quick facts on crisis● Mother of all crisis● Timeline – late 1970s and early 1980s

● Still echoing!

● 16 Latin American countries and 11 other less-developed countries

● Major reasons○ Foreign debt > Earning potential

○ Fiscal indiscipline (Socialism)

○ Global imbalances

Global imbalances

Flow of surplus

Current Account deficit from Oil importing

countries

Current Account surplus from Oil

exporting countries

US banks

Developed/Developing countries

Payment for oil

Debt for Latin American countries

Oil shocks in 1970s

Latin American debt proportion

Exacerbating factors

Latin American

crisis

Enhance growth

Favorable loan terms

Non-viable projects

Oil payments

Transmission mechanism

Low interest rates & overall

expansion

Monetary tightening in US/Europe

Banks increased

interest rates

No evergreening

Interest rate situation outside Latin America

Negative loop

Worsening CAD – reduced reserves

Capital flight – HNIs and

corporates

No restructuring

No new lending

Impact of crisis

Impact of crisis

Lack of investment in infrastructure

No new lending

Increased rates for less developed

countries

Drop in GDP

Mitigating measures

Mitigating measures (1/2)

1982-84

• IMF• Austerity measures, abandoned import substitution• Perceived as outside interference

1985-89

• Baker plan• Planned to fund debt from surplus countries like China

alongside reforms• No consensus was reached

Mitigating measures (2/2)

1989

• Brady plan• Convert loans to bonds with haircuts which can be traded – reduces concentration risk• Collateral was by US bonds, Reserves of affected countries• Ended in 1990s but used for Russia, Ecuador• Mexico, Phillippines, Colombia, Venezuela, Brazil have retired the bonds

1996• HIPC

• Joint IMF-World Bank initiative – special relief package for indebted countries• Conditional on social/economics reforms and fiscal targets

Political reasons

Political culture

Polit

ical

cu

ltur

e Corruption

Weak Democracy

Populism

Political instability (Huntington 1976)

Equalization

Economic stagnation

Political instability

Political participation

Dictatorship

Populist leaders

The Oil Boom Crisis

The Peso Crisis

The Sub-Prime Crisis

● Consistent growth from 1954 to 1971● The “Oil Boom”, the following turbulent 1980s and the Peso Crisis● A look back from 2011: 40 years of lag in income

The Mexican stories

Background before the “Oil Boom”Good Time● Consistent growth from 1954 to 1971

○ GDP gr @ 6% and inflation 3%○ “Mexican Economic Miracle” and “Stabilizing Development”○ Consisted in an Import Substitution Industrialization (ISI) model.○ Stable fixed exchange rate of 12.50 Pesos per USD for 22 years (1956 to 1976)

Bad Time● International financial uncertainty caused by rising US trade deficit

○ Mexico’s response: more public investment to sustain growth ○ Fully new printed money financed investment caused inflation○ 1973 oil shock ○ A 58% devaluation of Peso in 1976 ceased panic

The Turnaround： The discovery of Cantarell Field, the “Oil Boom”

A shaky foundation of “Oil Boom”● From 1977 to 1981

○ Average 9% annual growth in the GDP○ Massive job creation calmed the 20% plus inflation

● However, the shaky foundation○ Indebtedness mounted with expansionary fiscal policy financed by higher foreign borrowing

denominated in USD against the future oil revenue ○ Highly overvalued Peso hurting non-oil industries which caused reliance on import○ Raised tariff hampered modernization and competitiveness of Mexican industries

When the dance stopped● The oil demand and price eased causing

○ Rising interest rate○ Rising inflation○ Disappearance of international reserves

When the dance stopped● The oil demand and price eased causing

○ Rising interest rate○ Rising inflation○ Disappearance of international reserves

● The oil demand and price eased causing○ Rising interest rate○ Rising inflation○ Disappearance of international reserves

When the dance stopped

● Rising interest rate● Rising inflation Default & Capital Flight● Disappearance of international reserves

Policy Responses● Devaluation to fulfill international payment● Nationalization of private sectors● Contractionary fiscal policy: cutting public spending and raising tax● Contractionary monetary policy: raise interest rate to stop capital flight● Signing up the commitments of the IMFMarket Responses● Fear of sovereign default● Foreign investment was deterred ● Capital flight deteriorated causing more inflationary pressures● Local competitiveness was hampered by high tax rate“Lost Decade”

1982 crisis and recovery

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Another one: 1994 Mexico Peso Crisis● Sparked by sudden devaluation of Peso against USD● Strikingly characterized with political influence and decisions● Triggered by both structural weakness of Mexican economy and political instability

○ Violent Zapatista uprising in the state of Chiapas○ The assassination of the presidential candidate Luis Donaldo Colosio

● Capital flight

Before the crisis● Incumbent Administration: Carlos Salinas de Gortari (In office from 1988 to 1994)

○ Neoliberalism○ Encouraging private investment through denationalization and deregulation○ NAFTA○ Expansionary fiscal and monetary policy by issuing short-term debt instruments

denominated in domestic currency with a guaranteed payment in USD

● Political instability of 1994 presidential election season○ Violent Zapatista uprising in the state of Chiapas High risk premium on Mexican○ The assassination of the presidential candidate Downward pressure on Peso

● Central Bank Intervention ○ Issuing dollar-denominated public debt to by Pesos○ Purchasing treasury securities using dollar reserves to maintain its money supply

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When the crisis hit● Massive job loss● Value of Peso vapourized● Inflation ● Drop in reserves

When the crisis hit● Massive job loss● Value of Peso vapourized, from peg to float● Inflation● Drop in reserves●

When the crisis hit● Massive job loss● Value of Peso vapourized● Inflation, hyperinflation● Drop in reserves●

When the crisis hit● Massive job loss● Value of Peso vapourized● Inflation● Drop in reserves, again and sharp●

1994 crisis and recovery● Higher risk premium caused by political instability ● Unable to refinance through issuing new debt Capital Flight● Hyperinflation

Policy Responses● Contractionary fiscal policy: cutting public spending and raising tax, again● Contractionary monetary policy: raise interest rate to stop capital flight, again● $50 million bailout by the US, IMF and BISMarket Responses● Fear of default● Local competitiveness was hampered by high tax rate● Mutual funds started liquidating emerging market assets

“Tequila Effect”

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Argentina Pt. 1: Pre-Crisis 1991 - 1998● 1991, President Carlos Menem

○ Fixed exchange rate: Economy Minister Domingo Cavallo introduces 1 peso : 1 USD peg

■ Helped tame extraordinary inflation

Argentina Pt. 1: Pre-Crisis 1991 - 1998

● 1993-1994○ Strong economy: deregulation and

privatization of key industry sectors

● 1995○ Brief recession: contagion from Mexican

peso crisis leads to brief recession in Argentina

● 1996-1998○ Strong economy returns

■ Wall Street financiers begin loaning huge amounts of USD to Argentinian government, thus heavily increasing Argentinian external debt denominated in USD

Argentina Pt. 2: Crisis 1998 - 2002● 1998

○ The IMF warns Argentina that they are susceptible to the same kind of financial crisis ravaging emerging Asian economies

○ Argentina essentially ignores IMF warning given high inflow of foreign investment and continues course unabated

● 1999○ Financial crisis breaks out in Brazil leading to a devaluation of the

Brazilian real

○ Contagion: Brazilian financial crisis spreads to Argentina as state workers strike in demand of back pay

○ Recession sets in

Argentina Pt. 2: Crisis 1998 - 2002● 2000

○ Argentinian recession continues, interest rates are high, external debt reaches 50% of GDP

○ Domestic political turmoil leads to increased interest rates as capital flight occurs

○ IMF steps in with loan package totaling $14B plus $6B from other lenders

● 2001○ Turmoil in Turkey leads to investor lack of confidence for emerging economies in general and

Argentinian economic troubles increase○ To resume economic growth and reduce Argentinian pressure to service debts, a nearly $30B

“mega-swap” program for Argentinian bonds is implemented ○ “Mega-swap” program does not end financial crisis and the Argentinian market continues to

worsen, return to IMF for help■ Argentina receives an additional $8B from the IMF to service debt

○ External pressure on Argentina, particularly from New York bankers, to restructure debt■ Argentina announces a partial debt restructuring program

○ Capital controls: deposit withdrawal restrictions imposed to halt capital flight■ Riots ensue, President Fernando de la Rua and Economy Minister Domingo Cavallo forced to resign

Argentina Pt. 3: “End” of crisis 2002 - 2003● 2002

○ After a series of presidents, President Eduardo Duhalde comes into office

■ 2 January 2002 – 25 May 2003○ End of exchange rate peg of 1 peso : 1 USD

■ Floating exchange rate led to immediate devaluation to 3.06 peso : 1.00 USD

○ Formal default on unserviceable debt

● 2003○ Argentina not back to pre-crisis health, though:

■ Peso appreciated some■ Economy grew some■ Inflation remained similar

Argentina 2003

Unemployment

Argentina Pt. 4: Period of Growth 2003 - 2015

Argentina Pt. 4.a: “Kirchnerism” 2003 - 2007● Named after President Nestor Kirchner● Strong focus on human rights● Politically affiliated with left-wing populism

○ Historical roots in the Argentinian Peronism party persecuted during the Dirty War of the mid-1970s to early 1980s

● Overturned policies of past administrations, particularly the Menem administration, that gave immunity to those accused of human rights violations and/or other crimes during the Dirty War

● Economic focus: industrialist developmentalism○ Opposed to past neoliberal economic policies of previous administrations

in favor of protectionism○ No imports of goods that are and/or can be produced in Argentina○ Opposed free trade agreements, especially those concerning the Americas

■ Favored regional South American and general Latin American cooperation instead

Argentina 2003 - 2007

Unemployment

Argentina Pt. 4.b.: The Continuation of Kirchnerism under Cristina Fernandez de Kirchner, 2007 - 2015

● Continuation of husband’s economic policies○ Controlled exchange rate and Argentinian protectionism○ Social policies

● Innovations○ Capital Controls○ Restriction of access to USD to protect central bank reserves necessary to

prop up the Argentinian peso○ Export taxes on grains ○ Debt swap with some of the remaining 1998-2002 crisis creditors that

initially refused debt restructuring offers● Complications

○ 2014, financial: technical default after U.S. Supreme Court refuses to hear case requiring Argentina to repay $15B USD to creditors

○ 2015, political: investigation into alleged Iran trade deal to cover up Iranian involvement in the bombing of a Jewish community center in 1994

Argentina 2007 - 2015

Unemployment

Argentina Pt. 5: 2015 - Present● President Mauricio Macri● Elected in 2015 in response to perception

of failed “Kirchnerism” policies, economic and otherwise

● Politically conservative● Macri reforms

○ Cut export taxes and restrictions○ Ended currency controls○ Settled dispute with remaining debtors from the 1998 -

2002 crisis○ Argentina returned to international market○ Central bank raised interest rates to 25% to help

combat inflation● Continuation

○ High fiscal expenditures

● Complications○ Previous Kirchner administrations relied heavily on

expansionary monetary policies■ Money creation■ Selling bonds to domestic banks

○ Macri: Return to external financing ○ Fiscal deficit worsened

■ Fiscal expenditures increased○ Current account imbalances increase

Return to Crisis: 2017 - Present● Crisis: Return to 1998

○ Fiscal deficit■ Continuation of excessive fiscal expenditures relative to GDP to maintain political support

○ Foreign debt increase■ Return to external borrowing to finance fiscal expenditures and debt servicing once more made

Argentina vulnerable to external shocks, namely interest rate hikes of the borrowed currency, in this case USD

■ U.S. Federal Reserve increased interest rates in 2017■ Pressures forced a depreciation of the Argentinian peso■ Weakened peso made it more difficult to service debts, especially those denominated in USD■ U.S. Federal Reserve continues to raise interest rates■ Investors moved away from Argentinian bonds

● Reduced investment combined with selling of Argentinian bonds○ Inflation

■ Increasing inflation and increased fears of continual exceptional increases■ Money printing

○ Environmental■ Drought

Crisis 2017 - Present

Unemployment

2018 Crisis Response● Goal: balance fiscal expenditure● Initial increase of interest rates

○ May: 40%● Return to IMF for assistance

○ $50B aid package in exchange for Argentinian fiscal expenditure balance

■ $15B initial payment■ Remainder discretionary

● Second increase of interest rates○ August: 60%

● Request for increase of IMF assistance to $57.1B

Brazilian Economics Crisis in 2014● Coupled with impeachment of president Dilma Rousseff● GDP, fell by 3.9% in 2015● Unemployment average from 6.8% to 8.5%

Brazilian Economics Crisis in 2014● Commodity price cycle● From expansionary to contractionary

Any questions?

Thank you!