Recent market volatility in the US sub-prime mortgage market and the April-May 2006 shakeup brought memories of 1998, when the Russian default sent the risk premium for EM through the roof and the flows of external capital came to a sudden stop, unleashing a protracted period of economic contraction, financial crises and debt restructurings in Latin America. The region went through a similar roller coaster in the early eighties when the sharp rise in US interest rates triggered the debt crisis. In contrast, the recent episodes were short lived, claimed no massive victims and appear to have been just passing storms. In fact, one is tempted to see these episodes as proof that EM are successfully maturing and have developed greater resilience to capital market shocks.
Nowhere else would that conclusion be more justified than in Latin America, a region that has been able to grow at rates exceeding those of the booms in the late seventies and early nineties without displaying large current account deficits. The previous booms were associated with large current account deficits and therefore were heavily dependent on a steady flow of international financing which ultimately collapsed. Actually, collectively the region displays a current account surplus of about 4 percent of GDP. Under these circumstances, why would Latin America suffer from a tightening in international liquidity for EM that brings its economy to a halt for lack of finance? After all, the region is a net lender, and net lenders can finance themselves by simply refusing to lend. The last statement is right but, unfortunately, the general conclusion is wrong!
First, the previous argument confuses stocks and flows. In spite of its strong current account position, the region might find it difficult to roll over existing stocks of debt if there is a significant tightening in global liquidity. In that case, the current account surplus may have to become even larger. A particularly useful example to illustrate our point is Korea prior to the eruption of the Asian crisis. In 1997 Korea exhibited a small and perfectly manageable current account deficit of 1,5 percent of GDP that became a current account surplus of 12 percent of GPD in 1998, in spite of massive financial assistance provided by multilateral institutions.
Second, a current account surplus does not guarantee that every sector in the economy is a net lender. This observation is especially relevant for Latin America who in the last five years has enjoyed a sizable improvement in its commodity export prices and terms of trade (an exception being Brazil where terms of trade have remained largely constant). Thus, for example, when computed at export prices and terms of trade prevailing in the first quarter of 2002, Latin America would display a current account deficit equivalent to about 4 percent of GDP, ominously similar to the region’s current account deficit prior to the ‘Tequila’ 1994/5 crisis (see Figure 1a). This shows that non-commodity sectors are likely to be net borrowers in international financial markets to the tune of 4 percent of GDP if commodity sectors saved a large share of their price improvement.
Heterogeneous sectoral current accounts, with some sectors of the economy displaying large surpluses and others in deep deficit, is consistent with the recent behavior of the capital account in Latin America. As shown in Figure 1b, since 2002 large gross capital inflows have been accompanied by equally large gross outflows, a very different pattern from that observed in the period 1990-2002 where much of the action was determined by swings in gross capital inflows. Heterogeneous sectoral current accounts is thus in line with a situation in which gainers from the large improvement in the terms of trade ship their savings abroad, and the rest of the economy increases its exposition to foreign lending.
What happens if turmoil hits international financial markets for EM and capital stops flowing to net borrowers? Under a heterogeneous current account scenario a current account surplus is unlikely to insulate the region from a tightening in global liquidity conditions. Why? It is very unlikely that private sector commodity producers that have accumulated surpluses abroad will be willing to repatriate international liquidity to bail out the rest of the economy when foreigners are running for the exit.
What about economies in which the government is a major commodity producer? There the picture is potentially different. Let us consider the case of Chile who has largely saved its terms-of-trade bonanza, generated large fiscal surpluses and accumulated the proceeds in a stabilization fund. In principle, Chile is in a position to greatly alleviate the effects of credit crunch by using these resources. But this is only in principle, not necessarily in practice. In the first place, it would be necessary to identify the sectors that are in need of financing, since markets are not reliable resource allocators during a liquidity crunch. The central bank of Brazil did it in August 2002 by increasing credit to the export sector, but it is a hard act to follow. If the liquidity crunch is not quickly reversed (as it happened in Brazil with the help of a large IMF loan), sectors that do not get special treatment will start lobbying to get it, greatly politicizing the situation. Second, offsetting the deleterious effects of liquidity crunch requires speedy action, increasing the probability of erring on the sectors that require financial support, and making these actions more difficult to defend in the political arena.
In short, there is no doubt that Latin America is enjoying extremely favorable international conditions and exhibiting high rates of growth and a strong external position. However, just looking a little bit below the surface reveals the existence of possibly serious vulnerabilities to a global liquidity crunch. Multilateral institutions and policy makers alike would be ill advised to take too much comfort in the region’s current account surplus.