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222 Cards in this Set

  • Front
  • Back
Shift after WWI from export-led growth to an import substitution industrialization (ISI) strategy
Dependency Theory (In terms of)
The obsticle to Latin American economic development was the unequal relations with foreign powers in terms of exchange.

High tarriffs
Manufacturing sector completely protected

Developed a very inefficient manufacturing high costs and produced low quality products
Dependency Theory (Def)
By 1970's 2 big oil shocks

1st oil shock
Countries are forced to borrow to keep economies afloat
By 1970's 2 big oil shocks

2nd oil shock
Begins an increase in interest rates so countries cannot afford to service debt to take out new loans
By the beginning of the 1980's capital flows to Latin America dries up...
- Debt crisis of the 1980's
- 1980's last decade of Latin America
________ on greater committemnt and implementation of polices that would reduce government and liberalize markets
Conditional Assistance
Conditional Assistance..
(2) stages

Stage 1 - Macroeconomic Adjustment
- Control Deficit
- Decreased spending
- Control inflation
Conditional Assistance..
(2) stages

Stage 2 - Structual Reforms
a) Liberalize Trade
b) Deregulation of labor markets
c) Deregulation of credit markets
d) Privitization
e) Reforming the tax system
Reduce tarrifs and non-tarrif barriers
Liberlize Trade
Elimination of interest rate ceilings subsidies on loans for certain sectors reduction of reserves allowing (FDI) to come in, in the banking sector
Deregulation of credit markets
Reduce taxes on the hiring and dismissal of workers
Deregulation of labor markets
Privitizing state owned enterprises
Privitizations
Reduce distortions in the tax system
Reforming the tax system
First half of the 1990's things look rosy, but Mexico (Tequila) Crisis dries...
priviate capital out of all the region
Late 1990's is marked by biggest recession in decades partly driven by the fact that there is more room to...
adjust and more competion
Coined 1850's by a Columbian and referred to a group of countries with common geography and language
Latin America
Independant countries in the western Hemisphere and South of the Rio Grande
Geography
Countries where primary language derived from Latin, Spanish, Portugese and French.

Institutions and Colonial origins (Roman law, Portugese & spanish colonies)
Language
- Argentina
- Bolivia
- Brazil (Portugese)
- Chile
- Columbia
- Ecuador
- Paraguay
- Peru
- Uruguay
- Venuzuela

- Mexico
Cuba
Dominican Republic
Haiti -French
20 countries;
10 South American Republics
6 Republics of Central America
- Costa Rica
- El Salvador
- Guatamala
- Honduras
- Nicaragua
- Panama
Most countries gained independance in the 1820's

- Haiti gained independance in
1804
Most countries gained independance in the 1820's

- Domominican Republic gained independance from Haiti in
1844
Most countries gained independance in the 1820's

- Cuba gained independance from Spain in
1898
Most countries gained independance in the 1820's

- Panama gained independance from Columbia in
1903
At the time of independance standards of living were low but were relative to the US and Canada...
at the time
Latin Population was about 25 million...
prominentaly rural
Mining and Agriculture integrated the area with the rest of the world
Production of Natural Resources
Climate, geography, geology had effects on what each...
country produced
Integration of Latin American countries in to the world took place through exports of primary...
products
Differences amoung countries in terms of...
Commodity Specialization
Some commodities lend themselves naturally to foward linkages...
Stimulates other sectors in the economy.

- Cattle
- Meat
- Leather
Some other commodites lend themselves to backward linkages...
Needs inputs from other sectors.

* Copper- Mining tools and machinery
- Argentina - Cattle
- Honduras- Bananas
- Peru - Guano (Used for fertilizer)
Argentina; one of the 12th richest countries in the world until 1940.

Honduras and Peru; Did not benefit much
Commodities that easily substitutable are...
Not good specialization
Normal Goods

Luxury Goods
- Worse

- Export to rich countries (Better)
2 World Wars and Great Depression generated disruptions in terms of imports that Latin America received from the rest of the worls

- Turned policy from...
Export- led growth to an (ISI) Import Substitution Industrialization growth strategy
Which Posed that the main obsticle to economic development were unequal realtions with foreign powers
Birth of Dependency Theory
Industrial industry was inefficient, subsidized...

Took over agriculture in terms of GDP
by government
is the process of meeting the basic human needs of the populaiton and enhancing options for the allocation of economic resources both today and tommorrow

(i) Indicator that measures the distribution of well being

(ii) Indicator should not only capture short-run but long-run

(iii) Indicator of access to basic human needs
Economic Development
_____ measurures the net output produced by factors of production, irrespective of whether they are national or foreign GNP adjusts for net factor income paid abroad
GDP or GNP Per Capita
_____ is defined as the minimum income needed to purchases socially determined essentials (i,e) food, shelter, health care, education)
The Poverty Line
_____ ratio estimates the percentage of people falling below the poverty line
The Headcount Ratio
__________ measures the size of the income or shortfall or the amount of money it would take to raise a person out of poverty
The Poverty Gap
________ is a weighted composite of deprivation and focuses on the following dimensions

(i) vulneralbility to death at an early age

(ii) Exclusion from communicaitons (literacy rates)

(iii) A decsent standard of living

a) % of individuals with access to health services

b) % of populaiton with access to safe water

c) % of children under the age of 5 who are malnurished
The HPI (Human Poverty Index)
______ is a weighted composite of deprivation measured by

(i) Life expectancy at birth

(ii) Educational attainment (literacy rate) in adult population and school attendance

(iii) Income (average income)
The HDI (Human Development Index)
_________ Concentrates not only on economic participation but also on political and professional participation by including variables:

1) % of women in professional and managerial jobs

2) % of women sitting in public office
The GEI (Gender Employment Index)
________ measures the differnce between a hypothetical situation and complete inequaltiy and the actual distribution of income in an economy
The Gini Coefficient (GINI= A/A+B)
______ Economic progress measured by per capita income, accompanied by rising inequaltiy but these disparities go away as benefits of development permeate more widely

Evidence:

1) Looking at data across countries does show an inverted U-shap but driven by the Latin American countries are middle income and high inequaltiy (many other factors may be behind high inequality in Latin America

2) When looking at the experience of individual countries through time this inverted U-shaped relationship between Gini and GDP/Capita does NOT HOLD

3) Inequality & Income Growth:
The hyposthesized relation is a negative relation between inequaltiy and growth

a) Lack of collateral
- When ther is more inequality and poverty, a large part of the population cannot afford investments into education and health

b) Political Instablity/Redistribution
- People care about income level but also about relative standing in terms of income-generates feeling of resentment and may drive political instability or calls for redistrbution

- Political Instability: Capital leaves the countries (capital flight) and educated people leave (brain drain). Income growth falls.

- Calls for Redistribution: Ususally re-distribution is done on the basis of wealth increases and not actual wealth (b/c of tax evasion) but this essentially taxes savings and capital accumualtion → Income growth falls.

c) Changes in demand for goods
- Lower level of demand for goods- the poor are able to buy less and lower demand means less production → Income growth falls

Composition of Demand - As there are more poor people there is moore demand for basic necessities, and as there are rich people there is more rich people there is more demand for luxury goods.

Basic necessaities are produced unskilled labor and reduce demand for skilled labor and machinery → economic growth.

Evidence: Solid Evidence across countries and over time showing negative relation between inequaltity and growth.
Kuznets Hypothesis
The hypothesized relation is a negative relation between inequaltiy and growth

a) Lack of collateral
b) Political instablity/redistribution
c) Changes in demand for goods
Inequality and Income Growth
When there is more inequality and poverty, a large part of the population cannot afford investments into education and health.

And cannot borrow against investments in eduacaiton and health because there is nothing to back these loans(i.e., no collateral)
Lack of collateral
People care about income level but also about relative standing in terms of income-generates feeling of resentment and may drive politcial instablity or calls for re-distribution

(i) Political Instablity
(ii) Calls for redistribution
Political Instability and Redistribution
Capital leaves the countries (capital flight) and educated people leave (brain drain)

- Income Growth Falls
Political Instablity
Usually redistribution is done on the basis of wealth increases and not actual wealth (because of tax evasion) but this essentially taxes savings and capital accumualtion → Income growth falls
Calls for Redistribution
Lower level of demand for goods - the poor are able to buy less and lower demand means less production → Income Growth Falls
Changes in Demand
As there are more poor people more demand for basic necessaties, and as there are richer people there is more demand for luxury goods

→ Basi Necessaties are produced unskilled labor and reduce demand for skilled labor and machinery → Economic Growth

Evidence?
→ Solid Evidence across countries and over time showing negative realtion between inequaltity and growth
Composition of Demand
→ Poverty has been shown to have an effect on malnutrition and malnutrition effects the ablity to work (muscle, wastage, increased illness, vulneralblity t infection) and to produce → reduces Income and Income Growth

Evidence?

Evidence that show vicious circle of poverty, low-income-poverty, both for countries and individual households
Poverty and Income Levels/Growth
Most common policies used to target inequality/poverty
1) Schooling/Education
2) Nutrition/Health
→ Private sector and market will generate the levels of schooling.
→ No need for education or schooling policy

→ Market of failures in te market for education and other markets (e.g. the credit markets)

a) Credit Market Imperfections
b) Externalities in Education
c) Informational Problems
Education
→ As discussed lack of collateral means that is not possible to borrow against future education
Credit Market Imperfections
(i) Educated workers tend to make other workers more productive → underinvestment in education

(ii) Educated ( particularly mothers) → better health and lower fertility → underinvestment in education
Externalities in Education
Usually education decisions made by parents, but parents may be misinformed about benefits of education
Informative Problems
An _________ refers to the uncomepensated impact (positive or negative) of one person's action on the well being of a by-stander.

Ex: A negative externality - Smoking

A positive externality - Education
Externality
Why do we need Education polices?
(i) Externalities
(ii)Credit Market Imperfections
(iii) Lack of informaiton between 3% to 7% of GDP gets spent on education
In Latin America bad use of resources spent on education
(i) Spending disproportionate concentrated at the University level rather than going to primary and secondary schooling

(ii) Spending is concentrated in urban rather than rural areas where the market imperfections are likely to be more prevelant

(iii) Public spending goes mainly to infastructure rather than to other important inputs such as teachers salaries
Illiteracy rates have come down from 26% in 1970 to 13% in the late 1990's.

Situation of illiteracy still dismal in Central America (between 20% and 30%)
Adult Literacy Rates
A little under 7 years of education on average in Latin American Countries, but under 5 years in Central America

But big differnce for those at the top/bottom of income distribution
Average years of Education
Of age eligible population

90% of age eligible students enrolled in primary school

67% of age eligible population in secondary schooling
School Enrollments
Captures the extent of deprivation by incorporating measures on enrollemnt, gender, equaltiy, and completion rates

Problems:

1) Demand Side - to little effective demand → opportunity, cost of education to high for many households
Educational Performance Index (EPI)
a) Subsidies to poor families (Progressa/Oportunidades, Families en Acttion)
→ Conditional cash transfers. Conditional in sending kids to school and provides health checks

→ Targetted to poor families, Example: The regional program

b) Flexible and practical Education system

→ Flexible schedule

→ Practical application to the type of work that children do
Reforms/Policies on the Demand Side
a) Provide market incentives to public schools

→ Introducing incentives for schools (P900 Program in Chili)

b) School Vouchers
→ Subsidies provide school attendance or public municipal schools

→ Credit incentives for school to do better as some families turn to private education (voucher systems in Chili and Columbia)
Reforms/Policies on Supply Side
→ Flexible schedule

→ Practical application to the type of work that children do
Flexible and practical Education system
Local governments are better placed to determine what local schools need (answer)
Decentralization
Market imperfections in health insurance
→ Asymetric info for those who need most insurance are the very sick but these patients are the first that insurance decline or turn away

Money is not allocated efficiently
Health
→ No Collateral and healthier individual can provide
Credit Market Imperfections
→ Contagious disease
between 5% and 10% of GDP goes to health
Externalities
Money is not allocated efficently

(i) Too much money spent on curative as opposed to preventive care

(ii) Disporpionate amount of money spent in urban to rural areas (50%-80% of all health expenditures go to hospitals in urban centers)

(iii) Spending disporpotionately concentrated in plant equipment and services, which take away from primary/preventive care
Health
Discounts the HDI for gender inequaltiy in life expectancy, educational and income by assigning a penalty for inequality between men and women
Gender Development Index (GDI)
→ Mixed system of health care

(i) Social security institutes -
Provide health benefits to the formal sector employees
Health Performance Indicators
Lowers those who are uninsured and those who opt out of SSI's

Ministry of health covering the very poor
Private Sector
(1) Increased access to preventive care

→ educating women
mobile units

(ii) Privitization - Chili and Columbia
(iii) Decentralization
Policy Solutions with regard to Health and Private sector
→ Latin American coutries started fallling behind in comparison to the U.S. and Canada

→ 1850 - Argentina and Brazil's GDP exceed that of Canada and that 65% of the GDP in the U.S.

→ 1913 - Canada's GDP reached 75% of that in the U.S. and Brazils' was only 15% and Argentina's 50%
Export Led Stategy
→ Argentina, Chili and Uruguay attraced European immigrants

→ Brazil and Cuba bought slaves from Africa

→ Peru bought Chinese workers

(1) Export growth high in many countries 1850-1890 but by 1900's declines in export-growth for many countries

(2) Export Diversification - Only Argentina and Mexico and Peru have had their top two exports comprising less than 50% of all exports.

Endowements but also policy important in terms of what countries produced and how much they diversified
Export Led Strategy
Only Argentiana and Mexico and Peru had their top two exports comprising less than 50% of all exports
Export Diversification
Policy important in terms of what coutries produced and how much they diversified
Endowments
Why policy important in driving the economy in one direction or other.

Development economist Paul Rosenstein-Rodan advanced the concept of balanced growth.
Complimentaries

Paul Rosenstein-Rodan (1943)

→ Economic under development is the outcome of a problem of coordination where several investments don't occur if investments elsewhere are not forthcoming

→ Failures of coordination are most evident when we consider various sectors linked from one another. (See notes of graph)
Linkages that facilitate the ease of supply of a product other industries → push factor
Foward Linkages
Linkages that increase the demand in other sectors

→ Pull factors
Backward Linkages
Refers t sectors where the higher the scale of operation, the lower cost of production
Increasing returns to scale
1950-ISI, From the time of independance to WWI
Export Led Growth Strategy
Very good for most countries 1890-1912 - Argentina, Chili and Mexico
Export Performance
Argentian and Peru leading export accounts for less than 25% of ll exports
Export Diversification
Peru- Copper
Bolivia - Tin
Chili - Nitrates
Brazil, Peru - Rubber
Argentina, Uruguay - Wool
Mexico - Henequen
Production of other minerals and Agricultural products
Columbia, Costa Rica, all other central Amercian Countries, tropical luxuries
Export Led Growth Strategy

- Export diversification with regard to Columbia
Wheat, linseed, rye, barley, maize, beef, lamb, wool and hides
Argentina
Initially heavily dependant on Guano
→ Diversify after the collapse of Guano boom to the production: sugar, cotton, coffee, silver, copper, rubber

(See Graph)

→ Relying in a single or a few commodities is a viable stratgy as one expericences a commodity boom, however commodoties are subject to cycles. They experience booms and busts so when busts hit the economy can no longer be sustained by a single commodity.

WWI - Decline in Demand
- Disruption of production and shipping.

Exconomies also lacked geographical diversification in terms of exports. More than 70% of all exports went to the U.K., France, Germany and the U.S.
Peru
Decline in Demand - Commodity busts hit most countries.
- Disruption of production, shipping

Economies also lacked gepgraphical diversification in terms of exports (Table 3.6)More than 70% of all exports went to the U.K., France, Germany and the U.S.

- Decline in demand - Commodity busts hit most countries
- Disruptiion of production shipping
WWI
- Decline in demand - Commodity busts hit most countries

- Disruption of production shipping

- The countries that suffered the least were the ones that diversified geographically in terms of commodities:Argentina, Paraguay, Columbia, Uruguay

- But also hurt by the adverse terms of trade - Price of exports, fall more than price of imports so government revenues decline and spending in infastructure also falls.
WWI
1) Some countries continued to produce the same things and export to same locations.

2) A few countries shifted to production of strategic raw materials needed for the war
Reaction from WWI
Continues to effect demand for many of the goods produced in Latin American countries

Coffee fell by 40% between 1929 and 1930

Price of sugar fell by 60% between 1929 and 1930
1929 - The Great Depression
Moving towards non-durable manufacturing products
Moving towards other products after Great Depression and WWII
- Argentina; Textiles automobiles, chemicals

- Brazil; Pig, Iron, Chemicals

- Chili; Textiles, equipment

Mexico; Textiles

Peru; Textiles

Uruguay and to a lesser extent
- Columbia
- Venezuela
Industrial Sectors Developed
Argentina manufacturing sector was 20% of GDP

Chili and Uruguay - 12% and 16%

Brazil, Mexico, and Peru - between 8% and 10%
After WWII sectors to survive but faced a competition from Western Europe and North America
Heavily influenced by advice from Economic Commision for Latin America nad the Carribean (ECLAC)
Turn to policy thinking around 1950's
Advises countries to follow an Import Substitution Industrialization.

Influenced by postulates dependancy theory
Raul Prebisch, Economist
Postulated that center or industrialized countries defined rules of the game and perifery countries that were pawns in the Int'l pursuit profit - Industrialized countries wanted to extract natural resources - exploit labor in the world so richer countries could keep getting richer

Structuralists advocated the move away from primary products to more sophisticated products.

- Local elites performed alliances with international capitalists to gain access to short-term profits
Dependancy Theory
Options?

1) Perifiery countries should overthrow local elites and break ties with core countries

2) Perifiry countries to change focus from primary towards sophisticated products, since it was the nature of the commodities they produced that put them at an advantage.
- Core countries extracted natural resources and exploited labor t make profits and government richer at the expense of making perifiery countries poorer
The United Nations Economic Commission for Latin America and the Carrbean (ECLAC or CEPAL). It was established by the UN Economic and Social Council in 1948. It disseminates economic and social information. It has little decision making power but provides a second opinion for governments' economic and social policy.

Advocated the moderate view, ie. but needed government involvement to overcome market failures associated with the production of sophisticated products:

- Coordination failures associated with pressure

- Increasing returns to scale in production lending sectors
UNECLAC
a) Formulation/establishment of state owned enterprises with focus on lending sectors (e.g) heavy industry and social infastructure

b) Aid private sector by:

1) Reducing taxes
2) Providing subsized credit

c) Selective foreign direct Investment (FDI) - Provided necessary machinery and equpment to produce in industrial sector
Import Substitution Strategy

Industrial Policy
a) Imposing barriers to trade
- Increased tariffs, ie. taxes on imports
- Imposition of quotas

b) Regional integration to enlarge the size of the market
- Customs unions
- Free trade area
Import Substitution Strategy

Trade Policy
→ 6 countries with implemented/adopted inward-looking model.
- Argentina, Brazil, Chili, Columbia, Mexico, Uruguay

→ 3 countries started with ISI but moved away from it
- Bolivia - 1952
Paraguay - 1954
Peru - 1948

→ The rest of the 11 countries stayed with an Export Led Growth Strategy

→ Established state owned enterprises and these proliferated from the 50's to the 70's

→ Focused on lending sectors requiring substantial investments
- Public untilities (gas, water, electric, telephone)
- Heavy industries (oil, petrochemicals, steel, aircraft)

→ Share of manufacturing in GDP by 1960's was large as that in developed countries

→ Also private sector developed with support from government but mainly in non-durable sectors, (textiles, food processing, paper)

→ Hope was to move towards the production of durable intermediate goods

(i) Lacked access to additional finance
(ii) Lacked technology required to mount production of very sophisticated products

But very inefficent industry, from competition and faced a captive market that was forced to produce expensive low quality goods

→ But while industrial sector was meant to replace imports, the industry itself was dependant in imported equipment and machinery

→ Selective FDI - Attracted multinational corporations, (MNC's) in certain reserved sectors, but also requiring the use of local imputs

→ But, for countries to attract MNC's, they needed to offer favorable condition, e.g, Brazil, offered even more favorable conditions to foreign than local firms

→ But MNC's also ended up producing in sectors in which local producers were already present:

- 15-42% in food processing
- 14%-62% in textiles
>90% in tobacco sector

→ For those countries that opted to stick with ELG, this period benefited from commodity booms due to the Korean War

→ Restrictions imposed by developed countries on primary products

→ Price estabilization agreements moderated both price decline as well as price increase
Industrial Policy
a) Barriers to trade

(i) Tariffs
(ii) Quotas

Argentina - 131%
Brazil - 168%
Columbia - 112%
Chili - 138%
Mexico - 61%
Uruguay - 21%

Compared with 13% from western Europe and U.S.
Trade Policy
The bigger the scale of operation, the cheaper it is to produce and learing by doing. (The longer you produce, the cheaper it is to produce)
But benefits from protecting infant induatries in the long run because:

Increasing returns to scale
Protecting sectors with foward and backward linkages
But benefits from protecting infant industries in the long run because:

Complementaries
(ii) Idea behind regional integration was to enlarge the size of the market so that protected. Leading sectors could take advantage of Increasing Returns to Scale

Two options:

a) Free trade Area - Abolition of all trade barriers betwenn countries, but leaving each country free to impose International tariffs and quotas to third countries

- Customs Unions - Abolish all trade barriers between coutries but set commom external tarriffs
Regional Integration
Established in Montevideo in 1960-included 10 countries and Mexico

- The goal was not totally acheived even by 1971
Latin American Free Trade Association (LAFTA)
1969 and Included the Andean countries of Bolivia, Chili, Columbia, and Peru

1973 - Venezuela joins
1976 - Chili withdraws

→ Customs union
Andean PAct
Central American common market (CACM) formed in the late 1960's among central american countries - commons union
Regional Integration
Expansion of intra-regional trade

- 12.5% in 1965
- 18% in 1975

Why did a greater attempt at regional integration work?

(i) All countries producing the same goods for the most part

(ii) all countries being hit by the same shocks
Trade Blocks
→ Government failed to indenify right leading sectors, ie. sectors with lots of backward and foward linkages

→ Very inefficient manufacturing sector-high prices and low quality goods

→ Countries focused on production of non-durable goods

→ Instead durable and capital goods produced by MNC's, they are less likely to generate backward and fooward linkages since more likely to get inputs from abroad and to send goods for processing abroad
Problems with ISI Strategy

Industrial Policy
Is the price at which foreign currency can be exchanged for domestic currency
Exchange Rate
→ Local markets too small to benefit from increasing returns to scale (IRS)

→ But also closing trade to the rest of the world, so market couldn't enlarge

→ Only redeeming feature of trade policy were efforts at regional integration, but regional integration didn;t have the desired effects of increasing size of market, because all coutries were producing same goods

→ Moreover, trade barriers had an additional preverse effect - the trade barriers appreciate the exchange rate.
Problems with ISI Strategy

Barriers to Trade
Focused on an outward orientation by with substantial governement intervention

1) Industrial Policy - Provide subsidies to exports rather than to import substitutes

(i) REduced import duties or quotas for exporters

(ii) Provided preferrrential credit - Banks directed on easier terms for exporters

In the short-run, ad valorum tax generates welfare losses

→ But in the long-run, South-East Asia producers benefitted increasing returns to scale and from learning-by exporting which made producers more efficient, ie, they could produce mkore at a cheaper cost → increased welfare

→ But also generated and appreciation of ht eexchange rate

→ By contrast to LAC, South East Asian Tigers used monetary policy to keep exchange rate in check
Export-Promotion Strategy
a) Public Utilities
b) Mining Industries
c) Oil Sector
d) Intermediate and Capital Goods

(ii) Providing subsidies to private sector-mainly for production in non-durables. But these sectors got unconditional subsidies

(iii) Government expenditures

→ National Security
→ Socal expenditures - rose sharply because socal reforms
LAC started generating big governemnt deficits on spending side.

Finance the expansion of SOE's (State Owned Enterprises)
→ Revenue came mainly from indirect taxes from import and export duties but bacuse of the overvalued exchange rate there were little exports

→ Undertook tax reform and shifted to direct taxes

Ex: In Nicargua 0.2% of populaiton paid taxed at the time
LAC started generating big governemnt deficits on spending side.


On Revenue Side
a) SOE's (State owned enterprises)

b) Private sector subsidies
c) Governement Expenditure

Revenues were very small-export revenues not sufficient enough and little revenues from income taxes due to the tax evasion

Had to borrow heavily

1) Borowing from abroad
2) Generating "Seniorage" (through inflation)

1960's and 1970's- International financial system was desperate to lend to the rest of the world
Budget Deficits Spending
External Debt - Borrowing from abroad increased drastically due to the following reasons:

(i) The spread of branches and representative office in Latin American markets meant that there was more info on local condition and profitable lending opprtunities

(ii) Flow of petrodollars as a result of oil prices increases in 1970's meant that needed to recycle deposits into banks

Negative real interest rates and short term of politicians meant that borrowing has a large incentive to borrow

1974; -22%
1975; -2.9%
1976; -1.2%
1977; -1.4%

By 1982, LA countries had borrowed $30B but by this time real interst rates had gone up again and LA were having problems even paying interst on loans
Debt Crisis - External Debt
1) Debt Trap

→ Excessive borrowing but excessive borrowing on its own is not a problem if one invests on productive activities and this allows one to pay back loans.

→ But governments caught in debt trap

2) Unfavorable External Conditions
Debt Crisis, What generated the debt crisis?
Arise when unproductive investments or investments with very long horizons do not generate returns in time to service loans

a) Corruption
→ Mega projects with little investment value

→ SOE's are filled with names of dead people in the their payrolls

b) Unproductive investments - Investments in projects that were largely unproductive - SOE's subsidies for private sector

c) Long-term Investments - Some productive investments that didn't generate returns in time to pay back loans
Debt Trap
1) Debt crisis precipitated 2nd oil shock, which unravels a world eceonomic crisis and reduces demand for LA products

b) In 1979, Paul Volcker is appointed Chair of the Federal Reserve - Volcker implements contractionary policy to lower inflated and increased real interest rate to 8.1% by 1981

c) Given that loans were dominated in dollars, so given the danger of the peso being devalued may Latin Americans rushed to get their money out of these countries → capital flight reduces tax returns

1982, Mexico announces that it is no longer going to service debt-foreign banks stop lending altogeher to the region.

Inital Reaction: 1982-1985

1) Baker Plan: 1985-1989
2) Brady Plan: 1989 -
Debt Crisis, What generated the debt crisis?

Unfavorable External Conditions
a) Multilateral reaction (involving international organizations as well as U.S. and European governments)

→ Initially saw this as a problem of illiquidity rather than as a problem of insolvency

→ Reduce absorption: - reduce government spending and consumer spending through import suppression

→ Contractionary monetary policy since seniorage was generating inflationary pressures
Initial Reaction: 1982-1985

1) Baker Plan: 1985-1989
2) Brady Plan: 1989 -

INITIAL REACTION: 1982-85
Initially this was seen as a problem of illiquidity rather than solvency.
Inital Reaction from Int'l community (1982-85)
→ Loan conditionality → provide loans as long as countries adopted;

- Fiscal responsibility
- Contractionary Monetary Policy
- Encourage exports by reducing tariffs and quota's
(Inherently contactionary policy)
IMF (International Monetary Fund)
(i) Loans are assets that can be sold to more risk invclined buyers at a discount
Market Reaction (Private Sector); Secondary Market for Debt
Used to convert external debt into ownership of real assets, e.g, SOE's exchanged for debt
Debt for equity swaps (DES)
→ Used to convert external debt into a committment to invest in the environment and education
Debt for Nature Swaps and debt for scholarship schemes
Secretary of the treasury - James Baker announced a plan to jump start these economies → chenged policy from austerity to growth!!

→ Targeted 15 countries and gave $29Billion in new money but too small of an amount compared to the $1Trillion in debt obligations
Baker Plan - 1985-87;
1987 Brazil declared a moratorium
Secretary of the treasury Nicholas Brady introduces a new plan offering 3 options.

1) Decrease face value of debt )preferred option by most countries)

2) Extend period of obligations

3) Infusion of new money

Reduced face falue of debt by swapping old loans for 30 year national bonds with 30-35% discount of face value, backed by U.S. This restored investor confidence
The Brady Plan - 1989
M x V

M) Equity of Money in circulation

V) Velocity of money - number of times per year a unit of currency turns over to purchase goods and services.
Inflation
During ISI it became common to finance large budgets through seignorage
Why do monetary authorities print money?

- Finance Deficits
Excessive borrowing from abroad meant countries were having a hard time servicing their debt. Printing money to purchases foreign exchange and pay back debt.
Why do monetary authorities print money?

- Service Debt
During recessionary period or periods of slack demand quantities produced fall but prices don't fall (e,g, wages) - → monetary authorities end of printing money to have accomodate demand for money
Why do monetary authorities print money?

- Cost-Push Element
- Inertial/Infaltionary expectation
When people export for inflation to keep going up, then the velocity of money increases because pople have an incentive to transform their rapidly worthless money into goods
Why do monetary authorities print money?

Inertial/Inflationary expectation
Cost puch elements and inflationary expectations seen as main causes of inflation
(Different Approahes)
Brazil:
- General Price Feeze
- Partial wage freezes, of consumer price increased then wage increased allowed
- Indexation of wages to inflation.
- Inflationary expectation. New currency introduced - Cruzado

Introduced a set of 1000 cruzeiros and exchanged rate fixed at 13.84 cruzados/dollar

- It worked at first! Inflation down came from 480 a month to 4.5% by, rose by 1% in May.

But given real wage increase and increase in demand, but still slack supply → prices go up again and inflation goes back to 3 digits by December 1986.
(Different Approahes)
Brazil:

(i) Jan 1986 Cuzado Plan
Partial Wage increased → but wages adjusted every three months

- Cruzado devalued through a series a mini devaluations

- Interest rates targeted close inflation

- Control of budget deficit but political pressures made it difficult to reduce deficit

- Novo Cuzado intoroduced
→ but plan doesn't work because of accomodating monetary policy and failure to reduce budget deficits
(Different Approahes)
Brazil:

(ii) Mid 1987 - Bresser Plan
"Kill inflation with one bullet"
- Freeze wages and prices
- New monetary unit - Cuzeiro
- Contractionary monetary policy - money supply down by 80%
-Froze accounts with more than $1000USD
- Reduciton in size of government by privatizing SOE's
- But, Collor de Melo charged with corruption and confidence in government erodes, so infaltioary expectations built again
Different Approahes)
Brazil:

(iii) 1990 - Color de Melo Plan
Wages, prices taxes and exchange rate all denominated in a new accounting unit - URV (Real unit of value)

- Tightened monetary policy
- Emergency fiscal adjustments take place
- New currency- real pegged 1-to-1 with URV
Different Approahes)
Brazil:

(iv) 1993 Real Plan
Budget deficits, tax eroision and debt problems seen as the main problems of inflation
Different Approahes)
Bolivia:
Elements of the Plan

- Devaluation of exchange rate
- Fiscal adjustments- scaling down of SOE's and massive privitization
- Tax reform to increase government revenues
- Rescheduling of debt
- Liberation of trade and capital flows

General strike:
- Find funding from Inter-American Development Bank to finance and Emergency Social Funds (ESC)
(Different Approahes)
Bolivia:

- 1985 New Economic Policy introduced by Victor Paz. Estensorr with advice of Jeffery Sachs
Cost-Push elements and inflationary expectaitons were seen as main causes in 1980's, but in the 1990's changed their focus towards fiscal deficits, tax eroision and the debt.
Different Approahes)
Argentina:
- Wage Plan
- Introduce a new currency
- Fiscal adjustments

Initially it works! Brougt down inflation from 350% to 20% but credibility of plan falls apart when reduced imports generate an overvalued exchange rate
(Different Approahes)
Argentina:

(i) 1985 Austral Plan
(Menum, administration under cavallo)
- Elements of Plan - Locked Argentian peso to the dollar
- Independent currency board up increase meontary supply if USD revenues rises
- Promotion of exports and FDI - to increase stock of $ in Argentina
- Dramatic Fiscal Adjustment - Large scale privitizations (51 SOE's are sold between 1989-92)
- Tax reform to increase governement revenues
- Inflation falls from 3000% to 0.1% in 1991
→ GDP growth increases to 4.6% (Anything above 3% is high)
(Different Approahes)
Argentina:

(ii) 1991 Convertibility Plan
Focus on cost-push elements, inflationary expectations and also in fiscal deficits and debt all seen as causes of inflation.
Different Approahes)
Mexico:
- Fiscal reform - Privitzations of SOE's
- Budget cutting
- Trade liberazation
- Exchange rate fixed
- Explicit price agreements between business labor and government to cooperate in terms of controlling price increases.
Different Approahes)
Mexico:

(i) 1987 - Pact for economic solidarity)
(i) Reductings in non-tariff barriers

(ii) Reductions in average level of tarriffs

(iii) Reductions in dispersion of tarriffs

(iv) Depreciation of exchange rate
5 Areas of structural Reforms

- Trade Reforms
(i) Consumption taxes introduced

(ii) Reduction in the marginal tax rate for income tax

(iii) Reductions in corporate taxes

(iv) Decreased reliance on trade taxes
5 Areas of structural Reforms

- Tax Reforms
- Capital Market repression and little access to credit which implied reliance in foreign capital markets
- High reserve requirments
- Interest rate ceilings imposed
- governments allocated credit arbitrarily
- New financial institution faced substantial barriers to entry
5 Areas of structural Reforms

-Financial Liberalization/Capital market regulation
- Trade Liberation
- Tax reforms
- Privatization
- Financial Liberalization
- Labor Market Reforms
5 Areas of structural Reforms
- Between 1990 and 2000, real reserve ratio requirements reduced in 15 countries by 20 points or more

- Freed up money for banks to lend out

- At the smae time, that reserve requirments were lowered, prudential regulation introduced in accordance with the Basle Accords

Basle Accord demands that reserve requiremnts discount for deliquent loans, exchange rate fluctuations and other factors that affect the level of risk faced by a bank
Financial Liberalization

(i) Lower reserve ratio
(iii) systems of mandatory lending and mandatory investments were eliminated
Financial Liberalization

(iii)
Controls on interest rates were dismantelled in all countries prior to 1995
Financial Liberalization

(ii)
Privateizations of government banks and opening of the sector to foreign investment
Financial Liberalization

(iv)
- Labor reguations (e.g payroll taxes) encouraged the creation and increase in the size of the informal sector.

High dismissal costs reduced the ability of firms to adjust to fluctuations
Financial Liberalization

(v) Labor Reforms
Countries (Argentina, Columbia, Guatemals, Panama, Peru and Venzuels introduced measures to:

- Reduce payroll taxes
- Reduce dismissal costs
Labor Reforms
Main objective was to reduce anti-export bias
- _________ to have the following effects:

a) Lowered price of imported goods and in turn reallocation of production form import-competing sectors towards sectors with a comparitive advantage

b) Reduce anti-export bias and encourage level and diversity of exports
Trade Liberation
(i) Exit of unproductive firms
(ii) Existing firms increase efficiency if they want to survive in the competitive environments
(iii) New entrants are more productive because of tougher competition

Degree of openess is positively associated with productiviity growth
Evidence of trade reforms on productivity
Argentina - 1.91

Bolivia - 0.11

- Chili - 4.96

- Costa Rica - 3.25

- Mexico - 0.32 (Includes agriculture, still heavily protected)

But, productivity growth in Mexican manufacturing does show increased productivity after liberalization:

Period

1940-50 - 0.46
1950-60 - 0.53
1960-70 - 3.00
1985-89 - 3.4
∆ Changes in productivity growth from 1978-82 to 1987-91
(i) Change in the relative price of trade bias to non tradeable goods

(ii0 Reduciton in the cost of imported capital intermediate

(iii) Devalued exchange rate reduced anti-export bias

Volume of exports increases from 2% in 1970's

5.5% in 1980-85
6.7% in 1986 - 1990
The reduction in anti-export bias worked through a number of channels
Free trade areas between Argentian, Brazil, Uruguay, and Praguay in 1991
Move back to regional integration with formation of trade blocks:

(i) Mercosur
REvitalized in 1992
Move back to regional integration with formation of trade blocks:

(ii) Andean Pact
In 1991
Move back to regional integration with formation of trade blocks:

(iii) Cental American Common Market
Free Tade Area between Mexico, U.S. and Canada in 1993
Move back to regional integration with formation of trade blocks:

(iv) NAFTA
a) Reduction in level and volititlty of fiscal deficits

- Shift focus on taxes from trade taxes and seniorage growth towards a more broad based consumption taxes and lower tax rates on income

(i) Increase government revenue. Average public sector deficit in region fell from 6.5% of GDP (1980-1990) to 2% of GDP after 1990

(ii) Reduce volitilty of fiscal deficits as revenues as less dependant in trade taxes

Volititlity of fiscal deficits in the region fell by 15%

b) Reduce distortions on savings and investment and increase growth.

- Evidence that shifting from income to consumption taxes encourages savings
Tax Reforms

Should have had two effects
Should have had the following effects:

a) Reduce deficits, reduce government spending and increase government revenues.
Privatizations
Public Finances:

- Provide liquidity in short term
- (ii) Increase revenues in long term - when in case SOE's unprofitable to begin with and privatized firms become profitable

(ii) Reduce government expenditures permantely.

"Evidence"
- Mexico initial phase 1983-1987 generated close to 3 billion and 2nd phase; 12 billion

- Argentinian privatizations generated close to $18 billion (1989-1992). They rediuced share of public deficits as % of GDP from 6.5% to 0.06%. Also reduced face value of debt by $14 million.

But how much privatizations helped government finances depended on mode of privatizations.

4 MODES:

- Sale of % of shares to private comapny or consortium
(ii) Initial Public Offering
(iii) Employee Layout
(iv) Liquidiation and sale of assets

Evidence:

- Chili, which was a pioneer in area of privatizations relied primarily on (i) by selling to Chilean Conglomerates

- Mexiso allowed employee buyouts and allowed unions to buy a % of firm at a discount

- Argentina stated privatizing unsing strategy (i) but moved to (ii) by holding auctions
Privatizations: Public Finance
b) Increased efficiency of privatized firms and increased welfare for consumers.

- Should expect increased efficiency and reduced prices as a result of privatizations

- Evidence on Productivity:
- Mexico's telephone company in TFP of 15% in 1991.

- Aeromexico and Mexicana - More than doubled labor productivity between 1981 and 1990.

- Mexico deregulation imports in mid 1991 decreased costs by 30% and increased volume of containers handeld by 50%

Chili: Significant but small gains of privatizations frims in Chili

Argentina: In railways, there was a huge increase in labor productivity as total labor force declined 95,000 to 5,000.

Columbia: 3 privatization of an automobile plant, a collection agency and a bank shows large increases in productivity
Privatizations: Efficiency and Welfare
Argentina: Water prices declined and quality of service increased after privatization of water company - in child mortality due to better access to drinking water

Columbia - Reduced prices in automobile and banmking sectors suggest increased welfare of consumers

Argentina and Mexico - Privatization of ports reduced shopping costs by 50%

Mexcio - Prices go up after privatization of telephone company in Mexico.

Some contries introduced regulatory framework along with privatizations to take care of market. Imperfections in some sectors (I.e. utilities, are for most part natural monopolies)
Efficieny and Welfare:

Consumer Welfare
Poverty line set at $720./year or $60./month or $2.00/day.
UN Economic Commision for Latin America and the Carribean (ECLA)
1) Trade Lberations: Productivity ↑, Export ↑.

2) Tax Reforms: Level of volitility of budget deficits ↓. Savings and growth (very little effect).

3) Privatizations: Level of budget deficits ↓. Productivity and consumer welfare ↑

4) Capital Market Deregulation

- Eliminate Interst rate ceilings
↓ reserve requirements
Eliminate mandatory lending and investment.

Effects of Capital Market Deregualtion:
a) Increase in level of investment and in turn on growth - Private investment in Latin America didn't increase after capital market deregulation- Saving in Latin America the lowest i the world and didn't change after the reforms

b) Composition of Investment: Composition and quality of investment changes because better working financial sector in terms of informaiton on promise of financial projects. Avoids making bad loans and having a lot of defaults.

Evidence on changes in composition of investment.
- Chili: Investment in agriculture and manufacturing which resulted in a surge in productivity and growth in exports.

- Mexico: Petrochemical sector grows significantely

- Argentina: Ports and roads duw to investment in infastructure. Country level studies Ecuador, Chili, Mexico, and Columbia → After financial market. Deregulation productivity of small firms.

5) Labor Market Deregulaiton.

Effects of Labor Regulations: Expected effect of lowering dismissal costs is to
(i) increase turnover- both thorugh increased dismissal and hires.

(ii) Increase the size of formal sector and reduce underground activity

Evidence:
(i) Reductions in dismissal costs in Columbia, Peru, Argentian, increase hires and seperations

(ii) Reduciton in distortions increase formal sector employment by about 5% in countries that reduced dismissal costs

Expect effects of reducing payroll taxes- in terms of changes in composition of emplyment

Evidence:
- Some countries find no effect (Chili)
- Increases in formal employment (Columbia)
Structual Reforms
Even before the structural reforms, the period of ISI (1950-1970) was uncharacterized by increasing inequality (Gini Coefficient ↑ 1950-1970's)

The period of the debt crisis, which erupted in 1982, worsened this battered social picture in Latin America
Distribute effects of Structural Reforms
(i) Faster growth is the main determinant of poverty reduction and reduced inequality

a) Faster growth increases employment opportunities
b) Faster growth increases productivity and earnings

(ii) Macro-economic stability affects poverty:

a) Overvaluation of exchange rate hurts labor-intensive export sector.

- More variable inflation if negatively realted to Gini and poverty rate

b) The poor are more vulnerable to inflation tax.

- Over-valuation of exchange rate increases inequaltiy and poverty rate

(iii) Reduction in government spending in social programs increases poverty and inequaltiy

→ Reduction real income throughout the region. By 1991, only Chili and Columbia had a per capita GDP about what they had.

→ % of populaiton living below poverty ↑ in 16/20 countries in region between 1980-1989

→ Inequality kept increasing in 14/20 countries between 1980-1989

→ Likely works through labor market - unemployment alarming high during debt crisis and real wages i 1994 lower than in 1982.
Why did the debt crisis affect poverty and inequality
1) Trade Liberalization - Increased inequality. Why? Because Trade displaced individuals in unskilled intensive sectors

2) Tax reforms - Contributed in Latin America to increase inequaltiy. Why? Replacing progressive for regressive tax

3) Privatizations - Generated massive displacemnts, but of relativley well-off workers
→ Little effect and perhaps a reduction in inequaltiy

4) Capital Market Reforms - Contributed to increase inequaltiy because mandatory lending eliminated

5) Labor Market Reforms - Reduced inequality (more hires and better quality jobs)
Effects of Structural Reforms in terms of poverty and inequality
1)Need to increase the size of the export sector and need to increase diversity
2) Neeed to unertake fiscal reform both in terms of rediucing expenditure and increasing revenue
3) The need to increase availablity of inputs (domestic)
Lessons from 1990's
1) Trade reforms → aiming to prmote exports

2) Tax Reforms → solve problems of fiscal deficit by increasing revenues

3) Privatizations → expenditures
4) Financial Liberalization → access to capital

5) Labor reforms → easy adjustment
Measures taken in 5 main areas
Protectionism from ISI period discouraged export→promotion and created ineffient national industry. It also overvalued local currency reforms:

1) First reforms in 1970's was Chili( 1975-1979)

- Uruguay (1978-1986),
- Bolivia and Mexico (1985-1986)→ with other reformers following in late 1980's and early 1990's.
Trade Reforms
Redirection of non-tarriff barriers - whcih include quotas and prohibition. → reduce coverage of non-tarriff barriers.

(ii) Reduction of average level of import-tarriffs → average levels fell from 48.9% duting pre-reformed years to 10.7% by 1990's.

(iii) Reduce the degree of dispersion of the ratiif structure
→ less uncertainlty and reduce preferrential treatment

→ Chili applied uniform tarrif across sector to avoid any lobby networks

(iv) More control of the exchange rate local currencies were depreciated substantially by 1991 in an effort to promote exports
Trade Reforms; specific Measures
- Problems before social reforms
- Ineffective sytem in terms of collecting revenues
- Distortioanry taxes discouraged savings and investment in the formal sector of economy
→ Reforms tried to improve collectons and simplify adminitration and seek neutrablity measures

(i) Introduciton of value added tax which is a tax on consumers

Advantages:
- Easier to Collect
- Less distortionary
- More regressive tax

(ii) Reduction of all marginal tax rates and personal income

(iii) Corporate taxes were reduced but preferrential treatment in mining, forestry, and tourism

(iv) Reducing reliance on taxes on foregin trade 18% of tax revenues
Tax Reforms
This was made to reduce expenditure because during ISI imports of 80's are steadily growing between 1950's-1980's.

- By 1970's, SOE's had grown beyond and so-called strategic sectors and did not face enough demand and take advantage of increasing returns to scale.

→ By 1990's SOE's imposed a big burden on public deficit - and fueled information.
→ Sale of SOE's was seen as a way to generate short term liquidity and reduce government expenditures on a perminant basis between 1986-99, 396 sales or transfers put sector which representing 30% of privatization in developing world.

→ Bolivia, Peru, Brazil high generated a lof short term insurance. this also led to increase in FDI. In 1990's 36% was FDI.
Privatizations
Reason: Capital market repression and little access ot credit, which implied reliance of foreign capital markets

→ There was high reserve requirement
→ Interest rates were subject to control
→ Government allocated credit arbitratry
→ new financial institutions face substantial barriers to entry

Reforms: Aimed to eliminate then problem

(1) Lowere reserve ratio between 1990 and 2000, real non profit barriers→ whciha re quotas.
Financial Sector reforms/Capital Market Regulations
- Overspending by government
- Restricted monetary policy
- Unsustainable Domestic Policy
* Populism: Promoted growth and income distribution but ignored risks of increasing debt, inflation and external contrains. Corruption ie, Juan and Eva Peron in Argentina

* Overcapacity: Budget Deficits
* Low interest rates discouraged savings
- Budget deficits
- Low interest rates discouraged savings
- Oil Shocks
- External Shocs, central banks engaged in seignorage creating inflation
Explain to the government why they got into the debt crisis
1. Magnitude of capital flows
2. Types of capital flows
3. Benefits/cost of capital flows
Financial crisis
- After structural reforms there was a huge influx of capital into LAC
- By 2000 capital flows [both inflows and outflows] were 25times higher than they had been in 1970
- But while capital in flows very high, capital outflows just as large. Concentrated in some countries, while other countries didn’t receive any capital
- While private financial capital increased foreign gov’t aid decreased

-both demand and supply factors affected this flow

Demand:
1. Uncertainty: demand depends on anticipation of returns in future, expected value of assets
-uncertainty of future performance of asset very high in LAC
- w/structural reforms, uncertainty fell and foreign investors became much more willing to invest in LAC

2. Returns to other Assets- investors make decisions based on the relative returns and returns to other assets fell during this time period (eg. Returns to assets in the US, Europe and Asia)
-low interest rates in the US made investments in the US unattractive
-both supply and demand factors affected this flow

Supply:
1. Technology contributed to reduce transaction costs and increase financial capital flows towards LAC
2. Aging of baby-boomers meant that they were looking for invest opportunities.
Capital Flows
a] bond purchases
b] portfolio equity
c] FDI
Types of Capital
Portfolio Bonds: government bonds, corporate bonds
-involves a promise to pay in the future/ given interest
- purchases of bonds in LAC increased 188times b/w 1990-9
Portfolio Bonds
b] portfolio equity- equity investments in country funds depository receipts and purchase of domestic firms by foreign investors
-purchases of equity increased by 3.5 times during 1990-9 (largely b/c underdeveloped or absence of stock markets in many of countries / (Chile’s stock market similar to France’s and Brazils similar to Spain’s, but the had very small or no stock market)
Portfolio Equity
1) Host-mkt serving- foreign firms are trying to capture the local mkt (Mexico, Brazil, Argentina)

2) Export orientation- foreign firms more to get access to cheap materials and labor and then export to the rest of the world

- Mexico CAC and Caribbean basin- cheap labor and laxer labor/ environmental regulations
- Colombia, Venezuela, chile, and peru- as places where there are cheaper materials

3) Infrastructure building, provide infrastructure for public utility projects
- colombia, venzuela, peru,- FDI came in to build infrastructure for telecommunications, electricity generation and even in oil sector
Reasons behind FDI:
Foreign firms coming to produce in the country - it is perceived as a more permanent that either of the two previously mentioned capital

- FDI increased 10 times b/w 1990-2000

- FDI accounts for 2.2% of GDI
FDI
1) source of financing lor local investments

2) Provision of infastructure

3) FDI spillovers, the backward and foward linkages and transfers of technology
Benefits & Costs of Capital Flows: Benefits
1) Short-term flows generate volititlity an duncertainty which may drive local capital away (capital flight)

2) Large capital inflows appreciate local currencies and make exports less compettitive, generating current account deficits

3) Large inflows of money lower the interest rate, reducing incentives to save and for sources of financing
Benefits & Costs of Capital Flows: Costs
1) Mexcian Peso Crisis (1994)

2) Asian Crisis 1997, Asian Tigers

3) Brazillian Crisis, 1998

4) Argentinan Crisis 2000-2001
2nd half of the 1990's
→ A number of financial crisis
→ Triggered by devaluation of peso in December 20, 1994

→ Huge current account deficit or imbalance (5% of GDP in 1991 and 8% of GDP by 1994)

→ Trade deficit would be ok if using import and capital inflows to financee investments

→ But Mexican using funds to finance consumption and housing
Mexican Peso Crisis
→ Mexican government tried to react to this situation in a gradual manner by:

1) Enticing improvments in productivity in order to increase export competiveness

2) It counted on approval of NAFTA 1992 as a way to attract new FDI, however political events drive investors away

(i) Chiapas revolts
(ii) The assassination of PRI Presidential candidate, Luid Donaldo Colosio and of PRI secretary general, Ruiz Massieu

(iii) Resignaiton of attorney general

(iv) Assasination fo prominent banker

→ Given huge outflows of capital, exchange rate should had devlued but in the 1980's Mexico had established a fixed exchange rate policy (1-to-1 with dollars) as a way to control inflation
Mexican Peso Crisis
1) Raise interst rates but couldn't afford given upcoming election

2) Use stock if international revenues to put dollars into the economy

3) Introduced peso-dominated but dollar-indexed bonds called Tesobonos (bonds fromthe treasury)

Capital inflows declined from 30 billion in 1993 to 10.2 billion in 1994

and International reserves fell from
30 billion in Feb 1994 to 5 billion in December 22, 1994
Options for Mexican government; Mexican Debt Crisis
(i) U.S. Canadian and Eurpoean banks provided $7 billion in guarantees and back short-term tesobonos

(ii) Quickened the pace of privatization

(iii) Banking system opened to FDI

(iv) Interest rates rose by 55%, but this generated a recessionary drag
Emergency measures: Mexican Peso Crisis: 1994
On December 20th 1994, the Mexican govenrment abandons the fixed exchange rate and moves to a floating exchange rate at the risk of ignighting inflation.

→ Geneerates a loss of confidence in foreign investors and portfolio equity fallls drastically while Tesobonos are redeemed as quickly as possible

→ So called "Tequila Effect" means that loss of confidence by investors in Mexican economy spreads to rest of region

→ Bill Clinton in unable to pass an emergency rescue package through Congress, but gets $18 billion from IMF and $10 Billion from banks for International settlements suing oil reserves as collateral
Emergency measures: (continued from (i)-(iv)
→ In summer 1997, Latin America gets hit by a crisis not of its own making

→ New and in expreienced investors who loose confidence in "Asian Tigers" take out their capital out of all emerging markets

→ Currencies in Asian economics devalued sharply so Latin American exports became less competitive and trade deficits build up
Asian Crisis (1997)
→ When the russion ruble collapsed in 1998, uninformed investors pull their capital out of Brazil

- International reserves fall by $500 million in a day!
Brazillian Crisis (1998)
(i) Raise interst rates, inspite of intial reluctance due to Cordoso's upcoming re-election

(ii) Cordoso annouces a fiscal austerity plan which includes $20 Billion in budget cuts

(iii) Keep using interantioanl reserves to defend the real (reeeall- Brazillian currency), but eventually forced to abandon fixed exchange rate (real devalued by 28%)

(iv) Congress passes tax increases and additional expenditure cuts
Responses to the Brazillan Crisis
→ Argentina using capital inflows to finance consumption

→ Government unable to pass fiscal cuts through Congress

→ Argentinian exports not competitive (vis-a-vis Brazillian goods) international investors pull out
Argentine Crisis (2001)
→ Corruption is the extreme institutions.
Weak Institutions
Refers to the concession of public or government goods, services, or resources to certain individuals or favored groups in exchange for private gains or governement official
Corruption (Definintion)
→ Corruption is negatively correlated with negative growth and with investment into physical capital

→ Corruption may also have indirect effects which affect economic performances, eg.g. larger budget deficits
Why do we care about corruption
1) Centalized Corruption

2) Decentalized Corruption
Two types of corruption regimes
A government official organizes all corruption activity in the economy and determines shares of each individual offial in the ill-gotten gains
Centralized corruption: Mexico, Paraguay, Uruguay
(Visios circle - A little better) Take place when each government offical acts like an individual predator with out taking into account the effect of his actions on other predators
Decentalized Corruption
- Avaiblbilty of coca commodity windfalls and foreighn aid

- Restriciotn on trade
- Low civil servant and salaries
- Weak institutions and lack of enformcment
What are the derminants of corruption
Institutions are rules that shape the behavior of individuals in a
society
constitutions, regualaitons, contracts, laws. Informal-values and norms
Formal Institutions
Weak institutions reduces incentives to invest into physical and human capital and reduces entrepeneural activity because more uncertainty and less predectablility
Subjective indicators of institutions
- International country risk guide (ICRG) collect surveys from International and demestic investors on

1) Perceived risk of expropiation

2) Perceived degree of contract enforcablity

3) Existence of mechanisms for peacful

4) Perceive quality of bureaucracies

5) Perceived incidence or corruption
Growth affected by institutions:
Directly
Weak institutions genrate policies in terms of other policies - inflation, budget deficits, trade.
Institutions affect inequaltiy and poverty
→ Institutions provide safety nets tha teh degree and severtiy of the incidence of poverty

→ But, also richer are better off because expected returns from investment and entrepreneurial activity higher
Growth affected by institutions:
Indirectly