Financial Crises in “Successful” Emerging Economies Ricardo Ffrench-Davis, Editor UNITED NATIONS BROOKINGS INSTITUTION PRESS Financial Crises in “Successful” Emerging Economies This page intentionally left blank Financial Crises in “Successful” Emerging Economies Ricardo Ffrench-Davis editor UNITED NATIONS Economic Commission for Latin America and the Caribbean BROOKINGS INSTITUTION PRESS Washington, D.C. The Brookings Institution is a private nonprofit organization devoted to research, education, and publication on important issues of domestic and foreign policy. Its principal purpose is to bring knowledge to bear on current and emerging policy problems. The Institution maintains a position of neutrality on issues of public policy. Interpretations or conclusions in Brookings publications should be understood to be solely those of the authors. Copyright © 2001 All rights reserved. No part of this publication may be reproduced or transmitted in any means without written permission from the Brookings Institution Press. Financial Crises in “Successful” Emerging Economies may be ordered from: , 1775 Massachusetts Avenue, N.W., Washington, D.C. 20036. Telephone: 800/275-1447 or 202/797-6258. Fax: 202/797-6004. Internet: www.brookings.edu. Library of Congress Cataloging-in-Publication data Financial crises in “successful” emerging economies / Ricardo Ffrench-Davis, editor. p. cm. Includes bibliographical references and index. ISBN 0-8157-0211-6 (pbk. : alk. paper) 1. Latin America—Economic conditions. 2. Asia—Economic conditions. 3. Financial crises—Latin America. 4. Financial crises—Asia. I. Ffrench—Davis, Ricardo. II. United Nations. Economic Commission for Latin America and the Caribbean. HC123 .F56 2001 2001003366 332’.095—dc21 9 8 7 6 5 4 3 2 1 The paper used in this publication meets minimum requirements of the American National Standard for Information Sciences—Permanence of Paper for Printed Library Materials: ANSI Z39.48-1992. Typeset in Adobe Garamond Composition by Northeastern Graphic Services, Hackensack, New Jersey Printed by R. R. Donnelley and Sons, Harrisonburg, Virginia Preface vii 1 The Globalization of Financial Volatility: Challenges for Emerging Economies 1 - 2 Korea and Taiwan in the Financial Crisis 38 . 3 Three Varieties of Capital Surge Management in Chile 65 - 4 From the Capital Surge to the Financial Crisis and Beyond: The Mexican Economy in the 1990s 107 5 An International Financial Architecture for Crisis Prevention 141 - Contributors 167 Index 169 Contents v This page intentionally left blank T his book is the result of a project developed by the United Nations Economic Commission for Latin America and the Caribbean (ECLAC), with support from the Ford Foun- dation. The text encompasses five articles analyzing emerging economies that were generally rated as successful by international financial institu- tions and the financial press during episodes characterized by a broad sup- ply of external funds. We include the cases of Chile, Korea, and Mexico in the critical years of the 1990s and Chile in the deep crisis of the 1970s. All of these economies were praised for their efficient public policies. They all experienced episodes of an abundant supply of financial capital, and they all suffered macroeconomic disequilibria as a result. We contrast these cases with the positive experiences of Chile during the Tequila crisis and of Taiwan during the Asian crisis. Three of the articles are country studies, undertaken from a compara- tive perspective. The paper by Manuel Agosin, professor at the University of Chile, draws parallels between Korea and Taiwan. These two countries achieved a similar performance from the mid-1960s through the early 1990s, but their paths then diverged. The study analyzes the national poli- cies adopted in each case and the underlying motives. The article by Ricardo Ffrench-Davis and Heriberto Tapia, both econ- omists at ECLAC, compares three positive financial shocks experienced in Chile: the liberalization of the capital account in the 1970s, which exploded in a massive crisis in 1982; a substantial policy shift in 1991–94 in the di- rection of a prudential macroeconomic management of the capital account, Preface vii which kept Chile immune to the tequila crisis in 1995; and the capital surge of 1995–97, which culminated in a rather severe adjustment in 1999. The third study is by Dr. Jaime Ros, Mexican economist and profes- sor at Notre Dame University, who addresses the contrasting experiences of Mexico in 1991–94 and 1996–97. The paper examines the different do- mestic and external variables that explain the marked differences in the two episodes, and it evaluates the depth of the economic and social effects. The fourth article, by Dr. Stephany Griffith-Jones of the University of Sussex, analyzes the current architecture of the international financial sys- tem and its incapacity for preventing crises or moderating the disequilibria that generally lead to crises. The article analyzes several recent proposals, in- cluding those of the author herself. Finally, the paper by José Antonio Ocampo, Executive Secretary of ECLAC, and Ricardo Ffrench-Davis, which opens the book, examines why countries that were considered successful before the explosion of a cri- sis incurred a level of macroeconomic disequilibria that made them vul- nerable to a financial run. We start by considering the nature of supply, focusing on investors who specialize in short-term, highly liquid opera- tions. We then trace the evolution of the prices of financial assets, foreign exchange, and stock markets in the receiving countries, and we identify links with paths that culminate in unsustainable macroeconomic disequi- libria. On the basis of this analysis, we expose five misconceptions that are commonly held among proponents of full liberalization of the capital ac- count. Heriberto Tapia provided highly professional support in preparing the final manuscript, verifying the technical content, and ensuring agreement between the Spanish and English versions. Lenka Arriagada was excep- tionally efficient in assisting with the presentation of the final manuscript. We thank ECLAC for providing a stimulating environment for policy-oriented research and the opportunity for independent analysis on a most relevant issue today. Our deepest thanks also go to the Ford Foun- dation for its support. Naturally, all the opinions presented here are the re- sponsibility of the respective authors. viii Financial Crises in “Successful” Emerging Economies [...]... points of GDP in Korea, 2 points in Indonesia, and 3 points in Thailand), and an increased vulnerability of the balance sheets of domestic financial intermediaries The disequilibrium was recognized by financial markets only in 1997 and resulted in a weighty bill in 1998 The policy failure was an error shared with the rather similar financial reforms conducted in Chile in the 1970s and in Mexico in. .. and asset prices—determines whether growth in aggregate demand can be sustained or whether it will be subject to corrections associated with imbalances accumulated during recovery Overshooting in Emerging Asia and Latin America The increased availability of financing in the 1990s removed the binding external constraint that had been responsible for the decade-long recession in Latin America The bases... estate were extremely depressed in Latin America That allowed for a 300 percent average capital gain in the Latin American stock markets between late 1990 and September 1994, with rapidly rising price-to-earnings ratios (see table 1-2 ).22 Average 19 For instance, see a warning advice on Latin America, as early as in mid-1992, reproduced in Ffrench-Davis (2000, chap 9) 20 McKinnon (1991); Rodrik (1998);... portfolio inflows Domestic interest rates tended to be high at the outset of surge episodes, reflecting the binding external constraint faced by most countries during periods of sharp reductions in capital inflows, the restrictive monetary policies then in place, and the short-term bias of the financial reforms implemented in Latin America.23 Finally, the increased supply of external financing generated... additional instability Given that financial markets are the major source of economic instability for emerging economies, this line of reasoning implies that instability is inevitable but not excessively costly This assumption is inconsistent with the evidence Crises generate medium- and long-term effects on financial markets The most significant case in recent decades was the effect of the Latin American... policies and reform of the international financial architecture Three Financial Capital Surges to Emerging Economies since the 1970s Purely financial factors have been changing in the world at a much faster pace than international trade and the globalization of production During the 1970s and 1980s, many countries began to liberalize their financial sectors and to relax or eliminate foreign exchange regulations.2... dramatic increase of international financial flows was more diversified in the 1990s than in the 1970s The situation is potentially more unstable, however, inasmuch as the trend has shifted from long-term bank credit, which was the predominant source of financing in the 1970s, to portfolio flows; medium- and short-term bank financing; time deposits; and foreign direct investment (FDI; including acquisitions... domestic financial intermediaries, when short-term external funds were used to finance longer-term domestic credits This issue was particularly severe in the dollarized segment of the domestic financial system and in those cases in which external interbank credit lines were used as a major source of domestic financing Consequently, the region moved into a vulnerability zone, with the economy becoming increasingly...This page intentionally left blank - * 1 The Globalization of Financial Volatility: Challenges for Emerging Economies O ne of the outstanding features of modern financial crises is that they occurred in emerging economies that were generally viewed as very successful until the crises exploded Moreover, recent crises have been radically different... financed increased consumption, crowding out domestic savings.11 Recovery from Recession The domestic conjuncture has crucial implications for the link between capital flows and economic activity When there is a binding external constraint, any inflow will contribute to relaxing it, thus facilitating a recovery of economic activity Binding external constraints predominated during several episodes in . Financial Crises in Successful Emerging Economies Ricardo Ffrench-Davis, Editor UNITED NATIONS BROOKINGS INSTITUTION PRESS Financial Crises in Successful Emerging Economies This page intentionally. Washington, D.C. 20036. Telephone: 800/27 5-1 447 or 202/79 7-6 258. Fax: 202/79 7-6 004. Internet: www.brookings.edu. Library of Congress Cataloging -in- Publication data Financial crises in successful . imbalances accu- mulated during recovery. Overshooting in Emerging Asia and Latin America The increased availability of financing in the 1990s removed the bind- ing external constraint that had