Enrique V Iglesias: Economic Trends in Latin America
- The Context of a Globalized Economy
Statement of Mr Enrique V Iglesias, President of the Inter-American Development Bank, at the
meeting of the Bank for International Settlements, in Mexico City, Mexico, on 13 November 2000.
* * *
Dear Governors and friends:
I am honored that BIS invited me to speak to this distinguished audience of Central Bank Governors
from so many countries. That our host, the Bank of Mexico, is celebrating its 75th anniversary makes
this a particularly special occasion.
As you may expect, my topic today is Latin America. I would like to use this opportunity to convey
the views of the Inter-American Development Bank on the state of economic affairs in the region and
also to share with you some of our concerns about the future. I hope that some of these concerns may
be of interest to the BIS as they relate to its important work of strengthening financial systems.
I shall divide my remarks in three parts. FIRST, I shall briefly talk about the deep reforms that our
region undertook in the past decade, which have radically transformed for the better the economic
landscape of Latin America. However, despite the strong policies and institutions that were put in
place, as you know, our economies were overwhelmed by the external shocks suffered in recent years.
SECOND, I shall tell you how our region has experienced recent international financial turmoil and
how it is currently recovering from a growth slowdown. The key question now is whether changes
have been made to prevent the same experience from happening again and, after this painful episode
comes to an end, whether growth and stability will prevail. I certainly hope so, but, FINALLY, I shall
close with some of my concerns about our continuing vulnerability to a sometimes hostile external
environment, which I think are of interest to the BIS and others involved in reforming the international
financial architecture.
1. The reforms undertaken by the region in the last decade
The reforms were deep: In the last decade, Latin America embarked on a broad range of
macroeconomic stabilization efforts and structural reforms that radically changed the economic
environment.
Macroeconomic stabilization has been the result of a very important effort to correct our traditional
fiscal imbalances throughout the region. Fiscal deficits larger than 3% of GDP were common in the
eighties and are now exceptional: The average fiscal deficit in the last ten years has been just 1.4% of
GDP. Fiscal consolidation has been supplemented with sound monetary policies, which has resulted in
much lower levels of inflation in most countries of the region. The typical rate of inflation in our
countries is now 6%.
The progress of structural reform has been equally impressive. In the eighties, the typical Latin
American economy was isolated from the rest of the world, financially repressed, and seriously
distorted by all sorts of government interventions. That has changed. Trade restrictions have been
virtually eliminated and tariffs have been drastically cut to less than 10% at present. Privatization has
been the most visible component of the strategy of modernization and consolidation of the state in
Latin America. In the area of finance, liberalization measures have led to lifting controls on capital and
interest rates, as well as dismantling bankrupt systems of targeted credit.
Improvements in prudential regulation and supervision of banking systems, in large part based on well
learned lessons from past banking crises, merit special mention. Banking crises of the past led to
important lessons. The shift towards accepting and acting on these lessons began in the late 1980s, but
gained its full impetus only after the Mexican financial crisis in 1994-95. The policy lessons extracted
include the need for accounting standards, especially concerning the valuation of loan portfolios,
standards on information disclosure and auditing, the importance of regulating loan concentration and
connected lending, and the weakness of the supporting legal system, especially bankruptcy law. There
is growing recognition in the region that international Basle capital requirements may be insufficient
on average due to the larger shock volatility in Latin America, but in any event, requirements ought to
reflect overall portfolio risk, not only credit but also exchange and interest rate risks. Many of these
areas of regulation, such as most of the standards, are universal and the corresponding international
standards ought to be promptly adopted. Others are dependent on country diversity and international
convergence will be more difficult. Supervision needs to be independent. Bank restructuring needs to
be done promptly, making sure that owners are not unduly saved and face potential losses.
Not everything is fine, unfortunately. For all their promise, a decade of reforms have not made a
visible reduction in poverty or a dent in income inequality, which as you know is a very big social
problem in Latin America. Many economists think that inequality would have actually worsened in the
period in the absence of these reforms, and they may very well be right, but we will not be satisfied
until we see a significant drop in inequality.
Nevertheless, reforms have improved efficiency as expected and led to higher growth and resiliency.
Our research shows that macroeconomic stabilization and structural reforms have led to significant
gains in growth. As a result, 1997 was the year of fastest growth in 25 years. This same process led to
unprecedented resiliency in the face of serious challenges during 1998-99. In fact, with the exception
of Ecuador, fiscal discipline was maintained, inflation was tamed, and there was no uncontrolled
currency crisis, widespread banking crisis, or external payments crisis.
The reforms are solid: they were not rolled back, but withstood the 1998-99 recession. Much has been
said about an alleged reversal of reforms. Such a reversal has not taken place. In spite of the serious
difficulties caused by the international financial crisis of 1998-99, virtually all countries of the region
continued to deepen the structural reforms instituted in earlier years. Of 14 countries evaluated by the
Bank, 10 promoted major fiscal or tax reforms in 1999, 7 were discussing significant reforms in their
social security systems, 4 had made major progress in their privatization programs and 4 were
discussing deep labor reforms. The review noted an additional 25 cases of reforms in financial
systems, in legislation to promote competition and in other areas of economic and social policy in
those countries.
2. Recent experience with financial turmoil
If reforms were so effective and fundamentals so strong, why did Latin America have a serious growth
slowdown and recession during 1998-99? The answer is the combination of negative external shocks,
to which the region remains quite vulnerable. In their absence, the region was poised to maintain a
path of relatively high growth.
International terms of trade and commodity prices deteriorated substantially in 1998, in large part as a
result of the East Asian crisis. Most Latin American countries are still quite vulnerable to changes in
commodity prices. Some countries were severely hit by natural disasters, including El Nino.
These external shocks could have been accommodated with additional external financing, but it was
not available. Worse yet, normal external financing dried up and became the main problem. Not only
were international capital markets not there for Latin America when they were most needed, but they
actually aggravated the problem. Unfortunately, this procyclical pattern with external financing,
drying up when external conditions (such as terms of trade or interest rates) deteriorate, is typical in
Latin America.
Right there you have a core problem in our region: precarious access to external financing that
disappears when it is most needed. That is why our hosts, our Mexican friends, decided to arrange a
special stand-by financial package under the umbrella of the IMF, "blindaje" as we say in Spanish, to
insure against any market surprise during the electoral season despite the strength of their economy.
This is a good example for the entire region.
In this episode, fundamentals were quite strong and access would have been maintained if it were not
for the coup de grace of the Russian crisis. Subsequent financial contagion led to external financial
conditions totally misaligned with the region's strong fundamentals. This collapse in external
financing resulted from the problems faced by our main foreign investors, not problems in our
economies. The problem was not our countries' creditworthiness but that of our foreign investors.
Over time, however, difficulties in accessing external finance do hurt fundamentals and may render
countries truly uncreditworthy. From a Latin American perspective, international financial contagion
and financial panic are new and dangerous sources of external shocks associated with financial
integration.
The combination of negative shocks led to a severe contraction in imports and a greater growth
slowdown than during the Tequila crisis in 1995. The exception is Mexico, which benefits from its
current association with the US economy; but South America experienced negative growth in 1999.
The collapse in private foreign financing was similar in both the Tequila and the current episodes.
However, this time there was a significant deterioration in the terms of trade and less help from
official sources.
Recovery is now well under way (albeit hesitant in Argentina) and this year's growth rate will be
above 4%, despite the fact that commodity prices and risk spreads have not completely returned to
normal. Prospects are excellent, barring new external shocks. However, the volatility of financial
conditions and their overall deterioration in recent months sound a clear warning that recovery is
vulnerable to external shocks. In fact, our concerns for the future, to which I now turn, are
concentrated on the extent to which we have made progress in achieving deeper and safer financial
integration.
3. Is the financial world a better place now? Will growth and stability prevail in the
future?
How is the Region responding to the challenge of strengthening its financial systems?
The IDB is convinced of the importance of strengthening financial systems throughout the region. At
the IDB we have pioneered efforts to warn against the risk associated with credit booms and to derive
its implications for macroeconomic policy, to highlight the importance of standards to make regulation
meaningful, to insist on strong and countercyclical regulatory requirements, and to suggests ways to
improve the independence and quality of the institutions of bank supervision. In particular, we have
highlighted the need to adopt more strenuous capital and liquidity standards on account of the higher
volatility of our economic environment. I have just received an invitation from Andrew Crockett for
the IDB to cooperate with the Financial Stability Forum in raising awareness in our region of the
international standards that have been developed and to promote the discussion of the implementation
issues that would arise. It is a pleasure for me to announce here that I am delighted to accept this
invitation to cooperate in this issue of common interest.
Countries are also very interested in finding ways to further strengthen their financial systems, to the
point that many of them would like to have the opportunity to participate more actively in the
development of new ideas and standards. As you can imagine, more participation in the elaboration
process would greatly facilitate the productive discussion of the implementation issues of the Forum's
international standards that I have just mentioned. This issue of participation is critical in the case of
reform of the credit risk capital rules to ensure that it addresses the needs of all global market
participants. The regulatory capital framework must be drafted with a view to its implementation in
emerging markets as well as advanced markets, which requires more intensive and effective
participation by emerging market regulators in the drafting process. It is my hope that Latin American
banking regulators will be involved in finalizing the regulatory capital rules in the next and final round
of consultation starting, I understand, in January 2001, so that we are not surprised by the final
standards.
As I already mentioned, there has been a solid response on the part of countries concerning the two
underlying factors of financial strength: macroeconomic stability and domestic reforms of prudential
regulation and supervision. You will find a very receptive ear to ideas to further strengthen the
countries' financial systems. But we need to recognize that domestic protection is limited and costly.
For example, countries in Latin America hold huge amounts of international reserves with a
significant carrying cost at current rates and no clear stabilizing effect. In fact, there is the fear that the
very use of the reserves may signal weakness and prompt an attack. Many countries in the region
follow prudent policies such as stringent bank liquidity requirements, or long debt maturities, or
controls on short-term capital inflows, but none has been spared from financial contagion. It is clear
that the systemic problems that threaten growth and stability in Latin American countries require
systemic solutions, so the key question is:
How is the financial community responding to the challenge of countries exposed to contagion
effects?
Let me start by saying that we welcome the efforts of the international /financial community to work
on systemic initiatives. But one concern we have is that the systemic initiatives to reform the
international financial architecture that are currently being implemented may not be of much help to
Latin America. For example, standards on banking regulation and supervision, information, etc. are all
very important and good. However, our region is already advanced in these areas, especially after the
Tequila crisis. The fact is that our high standards do not appear to have protected us much from
instability during recent financial turmoil. Therefore, our region could benefit only marginally from
the application of these initiatives. Furthermore, moral hazard induced by implicit public guarantees of
poorly regulated and supervised financial systems, which some identified as an important factor in the
recent Asian crisis, is not a significant risk factor in Latin American financial systems. Therefore,
initiatives aimed at reducing moral hazard might have little beneficial impact in our region.
In particular, we are concerned that Latin America's main problem of precarious access to external
financing, subject to contagion and panic, is not being specifically addressed. Latin America is now as
vulnerable to contagion and panic from abroad as it was before this last episode. (I will come back to
this key point at the end of my talk).
We are also concerned that current thinking about international financial architecture does not
enthusiastically support official rescue packages of the kind that were so successful in our region, in
1995 in Mexico and Argentina and in 1998 in Brazil. The current debate points to promoting stability
by impeding capital inflows through the increase in the cost of capital to the point that it reflects the
true risk of investments, which would be underestimated by investors because they believe that the
official sector will bail them out. The problem is that, again, this source of moral hazard is not a
significant factor in Latin America. The simple fact is that rescue operations of past years stopped the
countries' downfall, led to fast recovery, and were quickly repaid. Nobody was bailed out from high
risk. Rather, the rescue packages eliminated an unnecessary risk (the liquidity risk), yielding an
enormous benefit to countries and to the whole region. I grant you that there is the risk that such
operations may not always work as anticipated. But, I wonder: how conservative would donor
countries have to be in order not to favor rescue packages in countries with strong economies after
crisis prevention fails?
More generally, it is cause for deep concern that new thinking on international financial architecture
may involuntarily have counterproductive effects on Latin America. Our concern is that we simply end
up with lower capital inflows and growth but no worthwhile gain in stability. Subjecting the private
capital to uncertainty and discretion will have this effect. The curtailment of official financial support
with the purpose of eliminating moral hazard would at the same time fail to prevent liquidity crises. If
the latter is more relevant than the former, as I think it is in Latin America, the result would be not
only less capital but also less stability!
Let me offer some concrete examples of our concerns in connection with the currently proposed
modification of the Basle Capital Accord for bank credit risk. As I already mentioned, IDB has long
had an interest in strengthening the regulatory framework for banks and making it flexible to
accommodate financial stress. To the extent that the new regulatory capital rules provide emerging
market supervisors with stronger tools for assessing the strength of a bank and for encouraging
bankers to improve their risk management systems, I believe that the proposed new rules could
contribute greatly to the development of more mature lending markets. Having said that, it is
important to recognize that in this proposal the cost of capital will increase in most of our countries.
As you know, at present net bank lending has largely disappeared already and this may be a lethal
blow to this class of credit. I am not sure this is a cost worth paying. Apart from that, there are a
number of concerns that I take the liberty to stress:
• We do not think that the use of private rating agencies to determine capital requirements for
sovereign lending is a good idea. First, it puts the agencies in a position to play God with
countries' fortunes, which neither the region nor the agencies want. And second, it is likely
to be destabilizing as agencies try to conform to market perceptions.
In contrast, in Latin America we like to think that internal rating systems are a more sensible
•
basis for a BIS system. I should also mention that a number of countries in the region have
successful public credit bureaus that should also be taken into consideration as a possible
standard to be used in setting requirements.
• The proposal that no private company should receive a rating better than its sovereign's is
not consistent with the evidence of corporate and sovereign market risk spreads and appears
to be an artificial limitation.
• Capital requirements on short-term loans ought to be lower for countries in which domestic
liquidity provisions are more prudent. This is the case of Latin America. Uniformly higher
requirements would implicitly put our region at a disadvantage and discourage its own
prudential policies.
• Finally, I understand that according to private banks the proposed changes to the definition
of short-term credit could adversely affect the trade financing business, and if so, I would be
very concerned too.
I would like to close by sharing some thoughts with you on the kind of reforms that we think would be
needed to address our key problem of precarious and unreliable access to external financing.
• First, liquidity crises appear to have become common in emerging countries. Like bank runs,
these crises can be prevented and solved by the provision of liquidity. An international
mechanism is needed to produce the required funding. Real progress demands addressing
this issue. I recognize the difficulties and risks, and think that easy access to liquidity has to
be restricted to countries prequalified on the basis of their fundamentals. The Contingent
Credit Line (CCL) Facility of the IMF, perhaps made more attractive to countries, is a good
first step in this direction.
• Second, it is imperative to contain the degree of financial volatility to which countries are
subjected during episodes of panic and financial contagion. I think we need to look at
regulations in developed countries and ask ourselves how they can be adjusted to address the
problems created by contagion and panic in emerging countries. It seems to me that
regulations ought to be flexible in order to lean against the wind of financial turbulence and
discourage the propagation of contagion. For example, impose less stringent regulation on
emerging country financing in times of international financial contagion. At the same time,
the IDB and the rest of the official sector need to be ready to offer financial support during
these temporary emergencies.
• And finally, there is the important issue of how to coordinate the efforts of countries, the
private sector, and the official sector, especially in the most severe crises. I think that the
official sector should lead, move first, and propose a consistent plan. However, this
coordination requires some rules of the game, and not be left to improvisation, so that
official intervention is not perceived as arbitrary by countries and private investors.
"Constructive ambiguity" in this case produces "destructive ambiguity". Ex ante rules would
go a long way in solving some of the tensions surrounding private sector involvement. But I
would go further. It seems to me that those rules should contemplate a private sector
contribution only to the extent needed, so that countries can quickly regain access to private
financial markets.
In a recent article in Financial Times, Martin Wolf, commenting on emerging market economies,
ended with these words that deserve our attention:
"Optimists are not wrong: we do know how to make emerging market economies
more seaworthy than they have been. But pessimists are also right: the turbulent
global capital markets remain dangerous for the unprepared. Those managing
emerging market economies should be aware of the risks. They must understand,
too, that they will receive only modest help from outside. The price of safety
remains careful preparation and eternal vigilance."
Thank you very much for your attention.