The resurgence of capital flows in the 1990s

The resurgence of capital flows in the 1990s

Beginning in about 1990, lending to and investing in developing countries began to increase again.Four forces converged to drive this new lending.Firstly, the size and scope of the Brady Plan led investors to believe that the previous crisis was being resolved.As each debtor country agreed to a Brady deal, it was usually able to receive new private lending almost immediately.Secondly, low US interest rates again led lender to seek out higher returns through foreign investments.Thirdly, the developing countries were becoming more attractive places to lend as governments reformed their policies.Governments were opening up opportunities for financing profitable new investments as they deregulated industries, privatized state-owned firms, and encouraged production for export with outward-oriented trade policies.Fourthly, individual investors, as well as the rapidly growing mutual funds and pension funds, were looking for new forms of portfolio investments that could raise returns and add risk diversification.Developing countries became the emerging markets for this portfolio investment.

The Mexican crisis, 1994-1995

A series of crises had punctured the generally strong flows of international lending to developing countries since 1990.The first of these struck Mexico in late 1994.

Mexico received large capital inflows in the early 1990s, as investors sought high returns and were impressed with Mexico’s economic reforms and its entry into the North American Free Trade Area.But strains also arose.The real exchange rate value of the peso increased, because the government permitted only a slow nominal peso depreciation, while the Mexican inflation rate was higher than that of the United States, its main trading partner.The current account deficit increased to 8 percent of Mexico’s GDP in 1994, although this was readily financed by the capital inflows.Mexico’s banking system was rather weak, with inadequate bank supervision and regulation by the government.With the capital inflows adding funds to the Mexican banking system, bank lending grew rapidly, so did defaults on these loans.The year 1994 was an election year with some turmoil, including an uprising in the Chiapas region and two political assassinations.The peso came under some downward pressure.The government used sterilized intervention to defend its exchange rate value, so its holdings of official international reserves fell.

Mexico’s fiscal policy was reasonable, with a modest government budget deficit.Still, the fiscal authorities made the change that became the center of the crisis, by altering the form of the government debt.Beginning in early 1994, the government replaced peso-denominated government debt with short-term dollar-indexed government debt called tesobonos.By the end of 1994, there had been about $28 billion of tesobonos outstanding, most maturing in the first half of 1995.

The crisis was touched off by a large flight of capital, mostly by Mexican residents who feared a currency devaluation and converted out of pesos.In December 1994 the currency was allowed to depreciate, but Mexican holdings of official reserves had declined to about $6 billion.The financial crisis arose as investors refused to purchase new tesobonos to pay off those coming due, because it appeared that the government did not have the ability to make good on its dollar obligations.Each investor wanted to be paid off in dollars—a rush to the exit—but what was rational for each investor individually was not necessarily rational for all of them collectively.The Mexican government might not be able to repay all of them within a short time period.As investors reassessed their investments in emerging markets, they pulled back on investments not only in Mexico but also in many other developing countries (the “tequila effect”).

The US government became worried about the political and economic effects of financial crisis in Mexico, and it arranged a large rescue package that permitted the Mexican government to borrow up to $50 billion, mostly from the US government and the International Monetary Fund (IMF).The Mexican government did borrow about $25 billion, using the money to pay off the tesobonos as they matured and to replenish its official reserve holdings.The currency depreciation and the financial turmoil caused rapid and painful adjustments in Mexico.The Mexican economy went into a severe recession, and the current account deficit disappeared as imports decreased and exports increased.

As the rescue took hold, the pure contagion that led investors to retreat from nearly all lending to developing countries calmed after the first quarter of 1995.The adverse tequila effect lingered for a smaller number of countries, as investors continued to pull out of Argentina, Brazil, and to lesser extents, Venezuela and the Philippines.Still, much of the Mexican financial crisis of 1994-1995 was resolved quickly.Overall capital flows to developing countries continued to increase in 1995 and 1996.

The Asian crisis, 1997

In the early and mid-1990s, foreign investors looked favorably on the rapidly growing developing countries of Southeast and East Asia.In these countries macroeconomic policies were solid and the governments had fiscal budgets with surpluses or small deficits; steady monetary policies kept inflation low, and trade policies were outward-oriented.Most of the foreign debt was owed by private firms, not by the governments.

A closer look showed a few problems.In Thailand and Republic of Korea, much of the foreign borrowing was by banks and other financial institutions.Government regulation and supervision were weak.The banks look on significant exchange rate risk by borrowing dollars and yen and lending in local currencies.And the lending boom led to loans to riskier local borrowers and rising defaults on loans.In Indonesia, much of the foreign borrowing was by private non-financial firms, which took on the exchange rate risk directly.

The external balance of the countries also showed some problems.The real exchange rate values of these countries’ currencies seemed to be somewhat overvalued, and the growth of exports slowed beginning in 1996.With the exception of Thailand, the current account deficits were not large.Thailand’s current account deficit rose to 8 percent of GDP in 1996.Still, the strong capital inflows provided financing for the deficits.

The crisis struck first in Thailand.Beginning in 1996, the expectation of declining exports led to great declines in Thai stock prices and real estate prices.The exchange rate value of the Thai baht came under downward pressure.By mid-1997, the pressures had became intense.Banks and other local firms that had borrowed dollars and yen without hedging rushed to sell baht to acquire foreign currency assets.The Thai government could not maintain its defense, and the baht was allowed to depreciate beginning in July 1997.

Throughout the rest of 1997 the crisis spread to a number of other Asian countries/ districts especially to Indonesia and Republic of Korea, but also to Malaysia and the Philippines, as foreign investors lost confidence in the local bank borrowers and local stock markets, and as local borrowers scrambled to sell local currency to establish hedges against exchange rate risk.

In response, the IMF organized large rescue packages, with commitments to lend up to $17 billion to Thailand ($13 billion actually borrowed), up to $42 billion to Indonesia ($9 billion borrowed), and up to $58 billion to Republic of Korea ($27 billion borrowed).As in Mexico, these large rescue packages and policy changes did contain the crisis, though not without costs.The currency depreciations and the recessions did lead to improvements in the current account balance, largely through decreases in imports.However, these countries also went into severe multi-year recessions.

The Russian crisis, 1998

Russia weathered the Asian crisis in 1997 very well, but its underlying fundamental position was remarkably weak.It had a large fiscal budget deficit, and government borrowing led to rapid increases in government debt to both domestic and foreign lender.In mid-1998, lenders balked at buying still more Russian government debt.In July 1998, the IMF organized a lending package under which the Russian government could borrow up to $23 billion, and the IMF made the first loan of $5 billion.However, the Russian government failed to enact policy changes including conditions for the loan.The exchange rate value of the ruble came under severe pressure as capital flight by wealthy Russian led to large sales of rubles for foreign currencies.With substantial debt service due on government debt during the second half of 1998, investor confidence declined, with selling pressure driving down Russian stock and bond prices.

In August 1998, the Russian government announced drastic measures.The government unilaterally “restructured” its ruble-denominated debt, effectively wiping out most of the creditors’ value.It placed a 90-day moratorium on payments of many foreign currency obligations of banks and other private firms, a move designed to protest Russian banks.And it allowed the ruble to depreciate by shifting to a floating rate.Russia requested the next installment of its loan from the IMF, but the IMF refused, because the government had not met the conditions for fiscal reforms.

Foreign lenders were in shock.They had expected that Russia was too important to fail and that the IMF rescue package would provide Russia with the funds to repay them.They reassessed the risk of investments in all emerging markets and rapidly sought to reduce their investments.The sell-off caused stock and bond prices to plummet, with a general flight to high-quality investments like US government bonds.The reversal of international bank lending and stock and bond investing in 1998 led to the first decline in net long-term financial flows to developing countries since the mid-1980s.

The Brazilian crisis, 1999

Brazil was among the countries hit hard by the fallout from the Russian crisis.In November 1998, the IMF organized a package that allowed the Brazilian government to borrow up to $41 billion, in an effort to allow Brazil to fight pressures pushing toward a crisis.Brazil had a large current account deficit, and the government was defending its crawling exchange rate with intervention and high domestic interest rates.However, the government failed to enact the fiscal reforms called for in the IMF loan, and capital outflows increased.

In January 1999, the Brazilian government ended its pegged exchange rate, and the real depreciated.However, this situation did not escalate into a full crisis because the problems did not spread to the Brazilian banking system, which was sound and well regulated.By April 1999, Brazil and other developing countries had been able to issue new bonds to foreign investors.More generally, the market prices of emerging market financial assets began to increase, although the net capital flows to developing countries remained lower than they had been in 1997.

The Turkish crisis, 2001

Turkey’s economy and its government policies had been problematic for decades, and it had borrowed from the IMF continually since 1958.In January 2000 Turkey entered into another borrowing program of $8 billion from the IMF and the World Bank, and committed to reduce its inflation rate (which had been close to 100 percent for a number of years), improve its regulation of the banking system and close failing banks, privatize state-owned businesses, end various subsidies, and reduce its fiscal deficit.As part of the inflation fight, Turkey adopted a crawling exchange rate (pegged to a basket of the euro and the US dollar).

The announcement of the new program brought large capital inflows.Turkish banks were able to borrow foreign currencies at low interest rates to invest the funds in high-interest Turkish government bonds.The country grew quickly, and inflation was lowered below 50 percent, but the fiscal deficit remained high, and the current account deficit widened to about 5 percent of GDP.November 2001 brought the first signs of new trouble, and foreign lenders began to pull back.The Turkish government used a large amount of its official reserves to defend the pegged exchange rate.December 2001 brought new pressures as several prominent bankers were arrested.Overnight interest rates rose to an annual rate of nearly 2,000 percent, to stem the capital outflows.A new IMF program promised additional loans of up to $7.5 billion during the next year.

After calming for a while, conditions deteriorated again in February 2001, because of legislative delays and political fighting between the president and prime minister about reforms.Overnight, interest rates again went into quadruple digits, and the government again used up a large amount of its official reserves defending the pegged exchange rate.Then the government gave up, and the lira lost a third of its value in two days.Turkey’s banks incurred large losses.Turkey entered into yet another IMF program in May 2001.

Argentina’s crisis, 2001-2002

For much of the 1990s Argentina was viewed as a major success story.It tamed a hyperinflation, fixed its peso to the US dollar using a currency board, and grew rapidly up to 1998.It also strengthened its banking system and established sound regulation and supervision.

But beginning in 1997 the peso experienced a real appreciation, first because the dollar strengthened against other currencies, and then because Brazil’s currency depreciated by a large amount in 1999.Argentina’s trade prospects dimmed.Its fiscal situation had been one of its weak points all along, and this situation deteriorated further as the economy went through years of recession beginning in 1998.Most of the government debt was denominated in foreign currency and owed to foreign lenders and bondholders.

In late 2000 Argentina reached the agreement for a package of loans of up to $40 billion, with $14 billion coming from the IMF.However, things did not improve, and the Argentinean government did not meet its obligations under the conditions of the IMF program to reduce its fiscal deficit.In September the IMF made an unusually large disbursement of $6 billion, but it was to be the last.In response to depositor runs on banks, the banks were closed in November, and when they reopened withdrawals were severely limited.

In early 2002 the government surrendered the fixed exchange rate, and the peso lost 75 percent of its value in the first six months of the year.The government also defaulted on its debt.In addition, the peso depreciation caused huge losses in the banks because of the mismatch of dollar liabilities and dollar assets, and because of the terms under which the government mandated the conversion of dollar assets and liabilities into pesos.A number of banks closed up.The public lost confidence in banks and the government.In mid-2002 Argentina was in a severe recession.

At first it appeared that Argentina’s collapse would have few effects on other developing countries, as it had been widely expected.But after a few months Argentina’s problems did spread to its neighbors.Uruguay relied on Argentina for tourism and banking business.The tourism dried up, and Argentinean withdrawals from their Uruguayan accounts increased.After its holdings of official reserves plummeted defending Uruguay’s crawling pegged exchange rate, the Uruguay government floated its currency in June; within two weeks, the currency had fallen by half.In August 2002 an emergency loan from the United States allowed Uruguay to reopen its banks, which had been closed for four days to stop a run by nervous depositors.

Brazil was also hit by fallout from Argentina’s crisis.In July 2002 foreign investors pulled out of their Brazilian investment, and the exchange rate value of the real fell by almost 20 percent.In August the IMF announced a new lending program of $30 billion, and the real stabilized.