Current Account Surplus in Latin America: Recipe Against Capital Market Crises?

Volatility has sharply declined in Emerging Markets (EM) since the nerve-wracking heights of August 1998, when it reached a staggering 300 basis points (measured by EMBI’s intra-month standard deviation). 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.[1] 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.

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[1] The regional current account surplus is calculated as the simple average of the seven major Latin American economies, namely, Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, which represent 93 percent of regional GDP.

4 Responses to "Current Account Surplus in Latin America: Recipe Against Capital Market Crises?"

  1. Guest   May 18, 2007 at 10:56 am

    Very good and important points that suggest cautiousness in assessing the external vulnerabilities of Latin America. Also, some countries such as Mexico, still have a large current account deficit. But what are the sectors of the economy with negative savings-investment balances, i.e that contribute to a current account deficit of the non-commodity export sectors? Is is the government? is it the non-tradeable corporate sector? is it the household sector?

  2. Guest   May 18, 2007 at 10:58 am

    You are right that external financing needs include both the current account balance and the amount of foreign borrowing that needs to be rolled over (net of stable long term inflows such as FDI). But how wide are such gaps in Latin America today? With large current account surpluses in most countries such external financing needs may be much smaller and manageable today than in the recent more risky past. Correct?

  3. Anonymous   May 18, 2007 at 7:05 pm

    Very valid and important points and warnings on the risks that Latam still faces. I have a few additional questions on the points raised by Calvo and Talvi that i fleshed out on my blog at:  http://www.rgemonitor.com/blog/roubini/195331

  4. Guest   May 18, 2007 at 7:08 pm

    But foreign cash is flooding Latin America as this Bloomberg story claims…so is the region still at risk? and should the region manage and control these flows or not?    Overseas cash is swamping new and emerging markets   2007/5/15 By Simon Kennedy and Bill Faries PARIS/BUENOS AIRES, Bloomberg  Emerging markets from the Baltic states to Latin America, awash in overseas capital, are paying a price for their popularity. Vietnam’s stock market, among the world’s top performers this year, is triggering concerns that shares may be in for a fall. Brazilian and Colombian exporters are struggling to compete as the value of their currencies mounts. Residents of Latvia’s capital, Riga, have seen house prices jump 67 percent in a year.  Overseas investment will flood emerging markets with US$469 billion this year, according to the Institute of International Finance in Washington. That will bring the total since 2005 to almost US$1.5 trillion, twice as much as in the prior three years. While fueling growth, all that cash is bringing side effects that threaten to turn booms into busts.  “This is the cost of success,” says Claudio Loser, a former International Monetary Fund official now at the Inter-American Dialogue in Washington. “It creates problems.”  Latvia and Romania may be in for hard landings, and big current-account deficits pose a threat to the investment outlook for Bulgaria and Estonia, Standard & Poor’s said last month. The IMF warned about Vietnam in March.  “There is somewhat of a bubble element to all of this,” says Desmond Lachman, a resident fellow with the American Enterprise Institute in Washington. “The world is fraught with risks right now.”   Behind the explosion in overseas investment: The strongest global expansion in a generation and the ability to borrow at near record-low interest rates in markets such as Japan and Switzerland. Those forces are drawing money into economies whose low-cost labor and increasingly valuable commodities offer opportunities for higher returns.  To be sure, foreign capital brings benefits by generating growth, tax revenues, employment and infrastructure improvement. In Turkey, record overseas investment triggered growth of 6.1 percent last year and, by boosting the lira, slowed inflation enough to satisfy the terms of a US$10 billion loan agreement with the IMF. Foreign money cushioned the fall in Turkish stocks last month after the army intervened in the presidential election.   “Turkey welcomes and encourages foreign investment,” says Inan Demir, an economist at Istanbul-based lender Finansbank AS. “It helps growth, and a strong lira supports the disinflation program.”   The challenge comes in managing the flow of money. Let it rip, and so do inflation, asset prices and currency values. Choke it off, and the good times may come to a swift end. “You see an overheating in a number of emerging markets,” says William Rhodes, senior vice chairman at Citigroup Inc. in New York. “There’s a lot more sensitivity to taking steps to avoid a meltdown.”  Governments around the world are now trying to strike the right balance as they realize foreign cash can be too much of a good thing.   Thailand last year went too far and had to backtrack when its stock index sank the most in 16 years after curbs were imposed on foreign investments. “Capital controls are very drastic because they can have a very negative impact on investment and the economy,” says Irene Cheung, an economist at ABN Amro Bank NV in Singapore.   “The sheer volume of trade and capital inflows is getting harder to absorb and is causing distortions,” says David Hensley, director of global economic coordination at JPMorgan Chase & Co. in New York.  China, the biggest emerging market, is struggling to curb over investment in factories and real estate projects, while seeking to limit appreciation of the yuan. Central bank Governor Zhou Xiaochuan on May 6 expressed concern that a bubble is building in the nation’s stock market, which has rocketed more than 80 percent so far in 2007.   Concerns extend well beyond China, which will account for roughly a fifth of the private capital flowing into emerging markets this year, according to IIF figures.   In Latin America, the biggest distortions tend to be in currency values, as rising demand for commodities including copper and soybeans attracts more money from abroad. Colombia’s peso has shot up 10 percent this year, the second biggest gain among 71 currencies tracked by Bloomberg, and Brazil’s real has risen almost 6 percent.   That’s causing pain for the region’s exporters, such as Colombian banana and flower growers. Brazilian shoemaker Sao Paulo Alpargatas SA has been forced to cut jobs as it’s been priced out of export markets.   Brazil’s government has tried to limit the real’s rise by changing tactics to make its sales of the currency less predictable. Colombia’s central bank on May 6 announced lending limits on banks to curb what President Alvaro Uribe calls “speculative” capital inflows.   Central banks in eastern Europe are grappling with inflation as foreigners invest in building plants and buying property in countries joining the European Union.   Latvian consumer prices are accelerating by the most since at least 2001, while property prices in Bulgaria have surged 60 percent over the past two years.   “The prospect of increased investment flows brings with it the possibility of economic overheating,” says Ana Mates, a credit analyst at Standard & Poor’s in London.   The challenge may be most difficult in Asia, where central banks are wrestling with both inflation and appreciating currencies at the same time.   That puts them “on the horns of a monetary-policy dilemma,” says David Simmonds, global head of currency research at Royal Bank of Scotland Plc in London. While central banks need to tame price pressures, doing so through higher borrowing costs draws more money from abroad and pushes up exchange rates.   In India, where the rupee is near a nine-year high, the price of yellow peas, a staple, has shot up 35 percent in six months. Inflation has exceeded the central bank’s 5 percent target since September, even after 2 1/2 years of interest-rate increases. Instead of discouraging lending, those rate increases only raise “the possibility of further capital flows,” says Reserve Bank of India Governor Yaga Venugopal Reddy, who has introduced lending curbs.   Elsewhere in the region, the Philippines central bank last week began offering pension funds and some state companies the chance to deposit money in higher-yielding accounts in order to curb the money supply. The flood of overseas investment in Vietnamese stocks prompted the country’s central bank to consider controls on capital flows.   In such a climate, “there are vulnerabilities out there,” says Tim Ash, emerging markets analyst at Bear Stearns & Co. Inc. in London. “There’s no doubt that at some point there will be corrections. You don’t want to be the last out of the door.”