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# I. INTRODUCTION AND SUMMARY

The past decade began in a festive mood in Latin America, with policymakers welcoming the future that had finally arrived with its rewards: growth, rising asset prices, rising investment-to-GDP ratios, strong capital inflows, and booming domestic credit. The decade ended, however, on a gloomy note: stagnant growth, falling investment ratios, stagnant or falling asset prices, sluggish domestic credit, and several crippled banking systems. How do we account for this transition, and can we explain the interactions among all these variables? In particular, what is the relationship between the credit boom (external and domestic) and the behavior of asset prices? Is the bust related to the boom? Is the behavior of asset prices governed by fundamentals, or do asset prices in Latin America reflect the presence of bubbles, as in other emerging market economies (Sarno and Taylor, 1998)? To address these issues, we divide the present paper into three main chapters after this introduction.

Chapter II describes the evolution of asset prices in Latin America, summarizes the statistical tests for the existence of bubbles, and identifies chronologically the periods of significant asset overvaluation, as well as the crash episodes. This analysis is based mostly on data for stock market prices, and, to a lesser extent (because of limited data availability), on real estate prices. To identify periods of asset overvaluation we used Froot and Obstfeld's (1991) intrinsic bubbles model as a benchmark, given its tractability and parsimony. This chapter concludes with a generalized rejection of the no-bubbles hypothesis and with the identification of significant stock overvaluation episodes that were synchronized across the region only in the early 1990s. Most bubbles were followed by stock market crashes, with the resulting prices being lower than those before the bubble formed. Crash episodes also tended to lead or coincide with currency crises documented in several papers on this related topic (Kaminsky, Lizondo and Reinhart, 1997).

Chapter III identifies empirical regularities that characterize the significant overvaluation periods. We quantify the relative importance of different factors that determine the probability of bubble occurrence, focusing on the contrast between the countryspecific variables and the common external factors. We included in the country-specific variables (a) both the level and the volatility of domestic credit growth, (b) the volatility of asset returns, (c) capital flows to each country, and (d) the terms of trade. As common external variables, we considered (a) the degree of asset overvaluation in the stock market and the real estate market in the U.S., and (b) the term spread of U.S. Treasury securities. To quantitatively assess the relative importance of each factor, we estimated a Logit model for a panel of five Latin American countries from 1985 to 2001. In general, we found that the marginal probabilities of both common and country-specific variables were roughly of the same order of magnitude. This contrasts with previous studies that found that real asset returns in Latin America were dominated by local factors (Harvey, 1995; Hargis and Maloney, 1997). The single most important determinant of bubbles was the U.S. term spread as it predicts future real interest rates and future economic activity in the