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Analysis of Economic Crisis in Latin America

Latin America has been the centre of several economic and financial crisis over the last four decades. These systematic events reveal that this continent is subject to some degree of instability, making it interesting from the macroeconomic perspective. Adding to the global recession in 2008, there were two main economic crisis in Latin America: the first one in the beginning of the 1980s and the second one in the late 1990s until around 2002.

This article aims at describing and understanding such phenomenona in this region of the globe, particularly because Brazil has been experiencing an economic crisis, since 2014, mainly due to the corruption and political instability which has a direct influence in the economic situation of the country. According to the World Bank, the unemployment rates are increasing, there are high credit costs and the growth perspectives of the country are among the lowest in the continent which make the Brazilian economy “the worst in Latin America”.

One interesting characteristic of the economic crisis is that they are preceded by a boom phase in which the expectations of individuals about the future are optimistic and, consequently there is an increase in capital inflows for the country. Latin American countries are not an exception of this rule and have experienced this phase several times in recent years. However, after the excessive amount of inflows from abroad, a sudden stop might occur. An alternative way of defining sudden stop is to name it a phenomenon in which an abrupt decrease of net flows from abroad to a given country occur.

Sudden stops are more common in Latin America or emerging economies, than in Europe or other developed economy. From this statement arises one important outcome that help us understand the volatile reality of Latin American economies: due to its instability, public and private sector usually agree short-term repayments of debt. Reinhart and Calvo (2000) state the importance of being extremely careful with the current account deficits (a consequence of sudden stop), especially if financed by short-term debt.

As previously referred, the occurrence of a sudden stop is likely to have a negative effect in the current account, impacting in the short-run both employment and production. Despite the impact in current account deficit, the fragility of the economies in this region need to be careful addressed, as sudden stops can increase the financial vulnerability of a specific country if along with the current account deficit, the same country also faces a huge decline in its international reserves. Ultimately, sudden stops will lead to negative outcomes (even recessions) as consumption and investment are likely to decrease and the policies available are restricted by capital controls.

By the time the international capital markets were developed, Latin American countries were among the nations that were part of such community. Starting with Brazil, these nations started to accumulate external debt, first by public authorities and later by private ones. It is widely recognized that the existence of capital markets is important for borrowers and investors: the international capital market allows borrowers to have more supply of funds/money and to lower the cost of capital, while for investors it allows them to have more alternatives to invest, enabling them to build portfolios that allow for a diversification of risks. Being part of the international community benefits Latin American countries by enabling investors to build portfolios with these countries’ risks.

If it’s true that South American countries started receiving large amounts of funds from abroad, it is also true that this region faced a large number of financial crisis. As countries open for international market, the domestic interest rate tends to increase and early investors try to take advantage of any differences between domestic and international rates. As the first movers have benefits, other agents try to exploit such benefits. The increasing amount of capital flowing to the economy decreases then the domestic interest rate, expanding both production and employment. Consequently prices tend to increase and there is a pressure for the exchange rate to appreciate and for the trade balance to become weaker.

The reduction of trade balance value is the downturn of countries’ positive situation, as such decrease leads to an increase in interest and current account deficit. The decrease of trade balance value ultimately alters the credibility of exchange rate, making it doubtful (exchange rate depreciates) and, as agent perceive this phenomenon, the capital inflows will decrease. At such stage the national authorities are forced to increase the interest rate, but at some point this option is no longer attractive and will, ultimately, lead to an abrupt decrease/stop in inflows.

The first sudden stop in Latin America countries occurred in the early 1980s, as previously mentioned. Affected countries tried to deal with this problem by nationalizing some private sector external debts and to negotiate the debt payments with international financial institutions and commercial banks. After these agreements were met, countries were able to grow again at low rate and experienced high and increasing inflation.

After the first sudden stop and through the first half of the 1990s decade, Latin American countries experienced a considerable growth, undermining the possibility of occurrence of another crisis (which would occur from around 1995 to 2002). The second sudden stop occurred after crisis in Asian countries in 1997, but more importantly after Russian crisis in 1998. Several authors, such as Calvo and Talvi (2005), analysed such impact and tried to infer some explanations of Russian influence for Latin America’s sudden stop and further crisis. As both regions were part of the so-called emerging economies, after Russian default, the investors of this type of countries faced great losses and a liquidity crisis and, in order to meet their desired margins, were forced to quickly sell their emerging market bonds. Alternative explanations of these two sides’ relations could be drawn as, for instance, after the IMF refusal to bailout the Russians, investors could become more cautious about the emerging markets, fearing the high risks for such investments.

Suspicions about emerging markets increased and triggered the occurrence of the second sudden stop in Latin America by the end of the Millennium. This second sudden stop would have a stronger impact due to the financial obligations countries were still meeting from the first crisis.

One important conclusion to take after this second sudden stop is that several countries were hit differently, as domestic fragilities associated with the sharp decrease of capital flows, could deepen such external effect. In Chile, despite the sudden stop and economic crisis, the negative outcomes were not as strong as in Brazil (which would face a currency crisis) or Argentina (which would end up defaulting on its debt and devalue its currency).

Important explanations for this domestic differences effects can be related with how open the economy is and the impact currency’s devaluation: the change in exchange rate to accommodate Sudden Stops is larger for closed rather than open economies. For instance, the impact in Chile was not as strong as for Argentina or Brazil, as this country had a more open economy at the time. An interesting point to add in this context is that countries tried to establish stabilizations policies previous to the crisis with the creation of an almost fixed exchange rate. However the outcomes of such measures were not positive, as for Brazil it lead to an exchange rate crisis, and for countries like Argentina and Uruguay it lead to financial and external debt crisis, devaluation of currencies and banking and currency crisis.

As there are some evidence that Brazil can be heading to a not so bright future, than some conclusions are possible to draw from the policy perspective either before or after the sudden stop emergence. It is important to state that in the boom phase monetary policy and comprehensive regulation are upmost priorities if also aligned with macroeconomic cautions, such as exchange rate policy (that reduce speculation) and balance of payment management. Capital controls are not the best solution, but due to the incapacity of emerging economies to deal with floating exchange rates they may be an option for such countries. Lastly, after the crisis both fiscal policies and interest rate policies can be part of the solution, however its use must be very cautious as many possible drawbacks for the population can occur if such instruments are not properly applied.

Miguel Madeira, 3117

References:

Calvo, G; Talvi, E, “Sudden Stop, Financial Factors and Economic Collapse in Latin America: learning from Argentina and Chile”, 2005, NBER

http://www.nber.org/papers/w11153.pdf

Damill, M; Frenkel, R; Rapetti, M, “Financial and currency crises in Latin America”,

http://inctpped.ie.ufrj.br/spiderweb/pdf_2/10_frenkel_et_al_financial_and_currency.pdf

Reinhart, C; Calvo, G, “When Capital Inflows Come to a Sudden Stop: Consequences and Policy Options”, 2000, MRPA

https://mpra.ub.uni-muenchen.de/6982/1/MPRA_paper_6982.pdf

Rapozza, K; “World Bank: Brazil Is The Worst Economy In Latin America”,2017, Forbes

https://www.forbes.com/sites/kenrapoza/2017/06/06/world-bank-brazil-is-the-worst-economy-in-latin-america/#48577fdd29f0

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Author: studentnovasbe

Master student in Nova Sbe

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