Lessons for Latin America

Capital flows - the lifeblood of investment in emerging markets - have been the center of heated debate ever since the December 1994 Mexican devaluation and the subsequent peso crisis. But there has been little coherent analysis of such capital flows.

Mexico wasn't the first to have problems with misguided policies that ended in failure. Other countries, such as Chile in 1982, also suffered setbacks. Yet many of these countries have risen from the ashes of policy mistakes and have gone on to stronger and healthier patterns of economic development, benefitting citizens with more jobs and a higher standard of living. Because of such potential benefits to stagnant or declining economies, it's important to review key concepts of global capital flows.

Investment capital has two general avenues for flowing abroad. The first is Foreign Direct Investment (FDI), usually undertaken by large multinational firms building plants, starting subsidiaries, etc. The second is portfolio investment by institutional and individual investors. Both forms of capital flows were welcomed by developing countries prior to the Mexican devaluation. Since then, portfolio capital flows have been considered the ''bad'' form of capital inflows, while FDI inflows are known as the ''good'' form. Is there any economic logic for this characterization?

Twenty years ago many economists decried the evils of FDI. Multinational firms seeking to build manufacturing plants in developing countries were seen as colonizers. The dependencia school of economics declared that FDI activity forced developing countries to become dependent on foreign capital. Economists who espoused this view argued the countries would never develop on their own. Portfolio investment, therefore, was the preferred route because it allowed local entrepreneurs to retain equity ownership in new enterprises.

The quest to tame inflation

So why the current aversion to portfolio capital? Since the late 1980s, many developing countries have embraced fixed exchange rates as a way of reducing inflation. Take Argentina. In 1991, the economic team of Domingo Cavallo fixed the peso to the dollar and eliminated persistent hyperinflation. Exchange-rate stabilization plans produced quick results in reducing inflation without exposing Argentina to the pain of severe belt tightening and deflation.

This policy approach, however, can also produce insidious macroeconomic problems that only surface later - such as large trade and current-account deficits. Developing countries often lack the internal savings to finance such imbalances and are able to do so only through attracting short-term foreign investment. But the countries can become overdependent on such external funds. Furthermore, any type of political or social shock, such as the Chiapas uprising in Mexico, can produce investment capital outflows, leading to a rapid erosion of a nation's foreign-currency reserves and potentially forcing a devaluation - lowering people's standard of living.

The problem facing emerging markets has not been exposure to portfolio investment. The problem has been an excessive reliance on fixed exchange rates as a ''painless'' form of reducing inflation and a corresponding over-dependence on short-term foreign capital.

Financial seesaw in Chile

Mexico wasn't the first country to flirt with the dangers of exchange-rate stabilization plans. During the late 1970s, Chile was suffering from triple-digit inflation. The government decided to implement a ''crawling peg'' (restricted but not fixed) exchange-rate system in February 1978, while liberalizing trade. By June 1979, the new exchange-rate policy helped push annual inflation down to 34 percent. To get inflation down still further, the government decided to fix the exchange rate at 39 pesos per dollar. Inflation began to steadily decline and reached single digits by 1980.

The liberalization of trade allowed a sharp expansion of both exports and imports in 1978. The following year, however, imports continued to expand, while exports began to level off. Lacking domestic savings to finance the higher level of imports, the country was forced to rely on external investment capital. By 1980, Chile was posting ever-growing trade and current account deficits. The finance minister claimed to be unconcerned since the country was operating with balanced government budget accounts; thus all imported capital was flowing to the private sector.

Unfortunately, the system was becoming dangerously overdependent on external financing and vulnerable to unexpected shocks. The oil crisis and the 1982 Mexican debt crisis resulted in a run on Chile's currency and a drop in foreign currency reserves. The government was finally forced to devalue the Chilean peso. Inflation soared to an annualized rate of almost 80 percent, and the economy entered a steep recession.

Yet, from this financial and economic crisis, a new Chile emerged that became more focused on developing internal savings and pursuing a more stable pattern of development and growth.

First lesson: Such crises may have a silver lining. Mexico, like Chile in '82, is looking for ways to improve national savings and rely less on foreign capital. It's pursuing economic policies that will produce less volatile patterns of growth. Second lesson: The problem isn't external capital. It's wayward domestic policies and low rates of national savings.