Latin America is all too familiar with financial volatility. The policy tools developed by Latin American central bankers and economic policymakers in response to previous crises will therefore serve them well today. But those tools still need to be improved.
The boom-bust tendency of liberalized financial and capital markets has again been evident in recent months. One aspect of these cycles is the “appetite for risk” that characterizes financial booms. The accumulation of risk later leads to financial meltdowns and to a “flight to quality,” in which investments in risky assets leave. A second is the tendency of both booms and busts to spread (“contagion”). A third is the tendency of the cycle to be particularly strong for markets that are considered higher risk by investors, such as developing-country markets.
In sum, financial markets are pro-cyclical, especially in developing countries. This means that, in terms of GDP, exchange rates and stock markets, these countries are much more likely to be victims of financial volatility and contagion.
Since the 1970s, Latin America has known three cycles of this sort. In short order, they have been a boom of external financing in the 1970s, followed by the debt crisis and lost decade of the 1980s; a new boom in 1990–1997, followed by a sharp reduction in net flows after the Asian and Russian crises of 1997–1998, which led to a new recession; and a new boom in financing since 2003 that probably ended in mid-2008.
This history points to two major lessons. First, financial liberalization must be accompanied by more effective regulation and supervision. Second, policies should be put in place to manage the strong pro-cyclicality of capital flows to the developing countries. On both counts, Latin America is better prepared this time, but is it certainly not immune.
Due to better regulation, largely introduced following past financial collapses, our domestic banking systems are in better shape than during previous crises. Also, and ironically, the fact that certain market segments are less well developed in most Latin American countries than in the industrial world has also served as a source of protection.
Nevertheless, in the debate over the current crisis and the regulatory deficiencies that led to it, subsequent reforms must lead to enhanced regulation around the following principles.
Regulation should have a strong counter-cyclical focus. This is essential to address the basic problem of pro-cyclicality that characterizes financial markets. This principle, however, is still neither widely accepted nor applied. Spain provides a good model. In 2000, it introduced a mechanism that forces banks to accumulate more provisions against loan losses (or reserves) during booms. Other analyses suggest that increasing capital requirements during periods of fast credit growth can have the same effect. In any case, a central feature of banking regulatory reform should be to require banks to maintain a set level of reserves both during booms and downturns.
A second principle is that regulation should be comprehensive; meaning that it should be applied to all financial transactions, whoever makes them. The major losses in derivative markets in Brazil and Mexico during the recent crisis underscore the need for strong regulation in this area, so far ignored by regulatory authorities. Regulations on securitization should also be strengthened. More generally, banking and security regulations should be made consistent to avoid security markets from becoming a source of destabilization, as happened in the United States.
A third principle is that currency mismatches should be avoided or at least strongly penalized. Bank lending and debt contracts should only be made in the currencies in which deposits are made (and in which customers earn revenue). In other words, loans to persons who earn pesos should be denominated in pesos. The ultimate goal of such a policy should be the eradication of financial sector dollarization—an area in which countries like Peru, Bolivia and Uruguay have made advances in recent years, and others, like Brazil, Chile and Colombia always avoided.
Managing capital account booms and their boom-and-bust effects is another issue. Central banks in developing countries can address this by accumulating excessive capital inflows as foreign-exchange reserves during booms. The best analogy is for central banks in developing countries to serve as dams that accumulate excessive foreign exchange liquidity during booms and supply foreign exchange during the drought that follows.
Fortunately, most Latin American central banks followed this and it has already proven useful in managing the recent turmoil. Argentina, Brazil, Peru, and, to a lesser extent, Colombia, are cases in point. Chile also accumulated large foreign exchange assets, though mostly in its copper stabilization funds. The large foreign exchange reserves should allow central banks to apply a counter-cyclical monetary policy over the next few months and years to reduce interest rates to manage the growth slowdown or recession.
The accumulation of foreign exchange reserves therefore provides effective room to maneuver, but it is also costly. It forces central banks to sell the government bonds they hold or to issue their own bonds to offset (or sterilize) the accumulation of foreign exchange. The downside is that these bonds generally carry higher interest rates than what central banks earn on the reserves and therefore generate losses for central banks.
Also, from a national government’s perspective, the long-term costs of external financing are higher than the interest earned on reserves. For that reason, it makes sense to regulate capital flows, particularly during boom years.
How could this be done? One way is to prohibit external capital from being invested in certain domestic assets. Purchases by foreign institutional investors of government bonds issued in domestic currency could be restricted or even prohibited. This can be considered a case of “currency mismatch,” an area in which strong regulations should be introduced.
A second method involves putting in place capital controls establishing minimum stay periods for investments. This is normal practice in the private sector. Mutual and many other private funds require that investors pay a penalty for keeping funds less than a minimum period. One way to do this is to establish a uniform reserve requirement on capital inflows as a way to increase the costs of short-term investments. The practice was applied by Chile and Colombia in the 1990s, and by Argentina and Colombia more recently.
Regulation on banking, securities and on cross-border flows should be discussed in an integrated way. Since cross-border flows are the source of strong boom-bust cycles in developing countries, they simply cannot be ignored. Latin America has lost much in the past from financial volatility. It must use its entire armory to shield itself from current and future global financial turmoil.