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4 Capital Inflows in Latin America Causes, Consequences, and Policy Options

Author(s):
Joaquín Muns, and André Lara Resende
Published Date:
September 1995
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Author(s)
Roberto Steiner

During the past several years, many Latin American countries have faced an abundant foreign exchange supply. In some cases, this was the result of capital inflows in unprecedented amounts, at least since the advent of the debt crisis in 1982. The size, timing, and characteristics of the inflows have varied among countries, as have the initial conditions that these countries faced when the inflows began. Additionally, not all countries have had the same short-term policy objectives; while some were leaning heavily toward reducing inflation, others were engaged in consolidating exports.

This paper compares the experiences of five large Latin American economies1 in regard to the nature and size of foreign exchange inflows, the policy response that was brought about, and the impact on investment and growth. The fact that inflows are said to be, at least partially, the response to sound macroeconomic policies and structural reforms makes it extremely difficult to isolate the effects of the inflows themselves.

Characteristics of the Flows

A correct assessment of the possible causes, and, needless to say, of the amount of the inflows, is necessary to understand the rationale behind the design of macroeconomic policy and to evaluate its impact. Preliminary data suggest that the foreign exchange inflows continue to be an important issue in Latin America (Table 4.1). In fact, in some countries, the assessment made by Calvo, Leiderman, and Reinhart (1994) that the current episode is smaller than the one that preceded the debt crisis may no longer hold true.

Table 4.1.Balance of Payments(In percent of GDP)
Country19801981198219831984198519861987198819891990199119921993
Argentina
Current account−2.3−2.8−2.8−2.3−2.1−1.1−2.7−3.9−1.2−1.73.2−0.3−2.9−2.9
Capital account1.00.82.00.12.12.51.92.02.8−0.81.74.93.9
Net FDI0.40.60.30.20.21.00.50.91.31.31.31.82.5
Portfolio0.10.70.40.60.3−0.7−0.5−0.5−0.6−1.4−1.0−0.3−3.5
Overall balance−1.3−1.9−0.7−2.21.4−0.8−1.91.5−1.72.41.42.01.0
Brazil
Current account−5.4−4.5−5.9−3.5−0.1−2.0−0.41.30.3−0.9−0.41.6−0.1
Capital account3.94.73.43.22.40.10.61.0−0.8−0.11.10.62.52.3
Net FDI0.70.90.90.70.80.60.10.40.80.20.10.4−0.1
Portfolio0.1−0.1−0.1−0.1−0.2−0.1−0.2−0.10.11.02.02.9
Overall balance−1.60.2−2.5−0.32.4−0.1−1.30.60.50.20.30.24.22.1
Chile
Current account−7.1−14.5−9.5−5.7−11.0−8.6−6.7−3.9−0.7−2.5−2.1−1.7−4.6
Capital account11.714.74.72.911.18.05.44.23.74.19.93.67.55.9
Net FDI0.81.21.60.70.30.91.84.54.24.51.91.20.80.9
Portfolio−0.2−0.1−0.10.31.20.71.11.6
Overall balance4.50.2−4.8−2.70.1−0.6−1.30.33.01.67.83.65.81.3
Colombia
Current account−0.6−5.4−7.8−7.8−3.7−5.21.10.9−0.6−0.51.35.72.1−4.6
Capital account3.45.25.73.02.75.62.60.21.01.40.2−1.30.74.9
Net FDI0.20.60.91.31.52.91.80.80.41.41.21.01.71.6
Portfolio0.10.10.50.20.1n.a.
Overall balance2.8−0.2−2.2−4.8−1.00.43.71.10.50.91.64.42.80.3
Mexico
Current account−5.4−6.5−3.43.92.40.4−1.13.0−1.4−2.8−3.1−5.2−7.5−4.5
Capital account5.87.00.6−1.8−1.2−1.91.01.0−2.52.94.08.08.18.5
Net FDI1.11.21.11.50.91.11.60.81.21.41.01.71.31.4
Portfolio0.50.5−0.4−0.4−0.5−0.9−1.00.10.1−1.64.25.87.7
Overall balance0.40.5−2.82.21.2−1.5−0.14.0−3.90.10.92.80.52.0
Source: IMF, International Financial Statistics.
Source: IMF, International Financial Statistics.

Timing and Size

In Argentina, the capital inflows issue began to be relevant in 1991. In 1992 and 1993, their amount was more significant than in the years prior to the debt crisis. Even though this time around a substantial amount of foreign reserves has been accumulated, the current account deficit reached 3 percent of GDP by 1992.2 Foreign direct investment (FDD has increased substantially; it accounted for one-third of the capital account surplus in 1992 and for more than one-half in 1993.

In Brazil, substantial capital inflows appeared in 1992, with portfolio investments playing an important role. The capital account surplus has not financed a current account deficit unlike the situation observed at the beginning of the 1980s, when capital inflows financed significant current account deficits.

Capital inflows to Chile have been important all along, although the amounts involved since 1990 are by no means as large as they were at the beginning of the 1980s, and have financed a significantly smaller current account deficit.3 Foreign investment has been very important, particularly in the late 1980s.

Until 1992, the foreign exchange inflow in Colombia was basically a current account surplus, although a case has been made that private unrequited transfers, which show up in the current account, are actually capital movements. That being the case, capital inflows would have been an important issue since 1991–92. The current account deficit reached 4.6 percent of GDP in 1993. About one-third of the capital account surplus of 1993 can be attributed to FDI.

In the case of Mexico, huge capital inflows that finance significant current account deficits have been important at least since 1990, with portfolio investments playing a dominant role. It is the only country in which the size of the inflow and of the current account deficit now approach the levels that prevailed before the debt crisis.

A straightforward conclusion that can be drawn from this short description is that the typical picture of a significant capital account surplus that finances both a current account deficit and reserve accumulation4 does not necessarily fit all the Latin American countries being reviewed. Though most of them have experienced an abundant supply of foreign exchange during the first years of this decade, the timing and size of the inflows have been quite diverse. A huge capital surplus has characterized the Mexican experience since 1990, a year in which a large and growing current account imbalance emerged. In Argentina, the inflows arrived later, are smaller, and finance a current account deficit that is not very large. In Brazil, the inflows have been even more recent, not very significant, and, at least until 1992, were manifested entirely in a buildup of reserves. In Chile, the capital inflow goes way back; it has not been as large as it was before the debt crisis and it has been accompanied by smaller current account deficits. In Colombia, the episode is more recent and probably less significant.

New forms of access to international financial markets have been developed in recent years, and most Latin American countries have made use of some or all of them. These will not be explored in this discussion. Even though part of the inflow is explained by FDI, in no single case is it the only relevant factor. In fact, with the exception of Chile during the late 1980s, and of Argentina and Colombia in 1993, in no other country is FDI the single most important item in the capital account.

Possible Causes

The events of the early 1990s have prompted an important body of literature in which different characterizations of the inflows have been suggested, although most analysts have emphasized that various elements were playing important roles simultaneously. Some recent case studies are a useful complement to the analysis that emerges from papers that have presented interesting assessments of events in the region as a whole.5

With regard to the causes of the capital inflows, some of the relevant questions that have been raised include the following: Are these inflows mainly the response to “push” factors in the member countries of the Organization for Economic Cooperation and Development (OECD), or are they explained by “pull” factors in Latin America? In the latter case, are those factors related to structural changes in domestic policy or are they more closely related to speculative motives? If “push” factors are the cause, do they mainly affect resources that represent, in essence, the capital flight of the 1980s?

In all interpretations offered, the main concerns have been related to the possibility of an abrupt and sizable currency appreciation and an eventual reversal, on short notice, of the recent inflows.6 Let us look, in slightly more detail, at some of the interpretations that have been offered.

Calvo, Leiderman, and Reinhart (1993, 1994) highlight the role played by a “common external shock” that has affected not only most of the countries in the region, but also several Asian countries.7 This shock is identified with a deterioration in investment opportunities in some OECD countries. Support for this position is provided both by their “principal components analysis” and by many country case studies that have emphasized that external conditions are the only plausible explanation for the shifting of capital to countries in which macroeconomic imbalances were still significant, and market-oriented structural reforms incipient (as in Brazil and Peru until 1991 and as in Ecuador more recently).8 According to this interpretation, an improvement in investment opportunities in industrial countries could eventually produce significant capital outflows.

Speculative factors have been singled out by Rodríguez (1993) as an explanation for capital inflows to economies that faced currency substitution and pursued stabilization programs after hyperinflationary episodes. A good number of studies on the Colombian experience also emphasize the role of speculative forces caused by attempts by the Central Bank to sterilize, with a policy of very high interest rates, a current account surplus that could have originated in a policy of maintaining an undervalued exchange rate.9 Similar problems, though apparently not as significant, also appear to have emerged in Chile.10 According to the interpretation offered by Carneiro and García (1994), the Brazilian experience is one in which speculative factors are the response to a monetary policy of high interest rates aimed at offering a good domestic substitute for the national money to avoid currency substitution.

Sound macroeconomic programs and market-oriented reforms have been identified by, among others, Blejer (1993) as the main cause of the inflows. With the exception of Brazil, a review of case studies indicates that these factors have been recognized as significant, particularly in Argentina, Chile, and Mexico. They include successful stabilization programs, ambitious trade reforms, significant privatization efforts, tax amnesties on previous capital outflows, and successful foreign debt negotiations.11 According to this alternative interpretation, a subsequent outflow should be expected only if the reforms that attracted them turn out to be unsustainable. In this regard, an important question is related to the sustainability of stabilization programs that have relied heavily on the use of the exchange rate as a nominal anchor.

Evidence suggests that capital repatriation played a dominant role (Kuczynski, 1993). In certain aspects of policy design, this might turn out to be a relevant issue. In particular, capital controls might be less effective when it is a resident who is trying to take advantage of the perceived improvement in domestic investment opportunities.

Causality Between Foreign Exchange Inflows and Real Exchange Rate Changes

The causality between current and capital account deficits is another way of looking at the dominance of push and pull factors. Push factors refer to an exogenous inflow that appreciates the real exchange rate, prompting a current account deficit. Pull factors may result from a credible macroeconomic policy that boosts expenditure and temporarily creates a current account deficit that foreigners are willing to finance. The causality could also be the result of a policy of attempting to increase competitiveness through exchange rate policy; the undervalued currency will generate a current account surplus while at the same time prompting expectations of exchange rate appreciation that may in turn induce speculative inflows.

Because detailed balance of payments statistics are rarely available other than on a yearly basis, empirical approximations using higher-frequency data12 have “proxied” capital movements through changes in international reserves. As in Morandé’s (1988) study of Chile, Calvo, Leiderman, and Reinhart (1993, 1994) suggest that causality goes from reserves to the exchange rate, giving supporting evidence to the exogenous nature of the inflows and to the fact that the capital surplus causes the current deficit.

It is clear that if reserve accumulation is the counterpart of a current account surplus, such accumulation may well be the result of the previous exchange rate policy. This accumulation will then probably “cause” an appreciation. In that case, the issue is not one of an exogenous capital inflow prompting an appreciation but, instead, the inability to maintain, for prolonged periods, a significantly undervalued real exchange rate. The undervalued currency argument has been mentioned in explanations of the Colombian experience of the early 1990s. Using monthly data for Colombia from June 1989 to November 1993 (not reported here), we were unable to reject (Granger) causality also going from the real exchange rate to reserves.13

How Sustainable Are the Inflows?

Probably the most relevant question regarding foreign exchange inflows is: How likely is it that they will be reversed? After all, policymakers are unlikely to design macroeconomic policy as if the flows will be permanent; still, they might be tempted to believe that the capital that already came is here to stay.

The dominance of sound domestic policies, and even the lack of good investment opportunities in the OECD, is consistent with increases in FDI and in more medium- to long-term flows. Instead, by definition, the speculative motive emphasizes the possibility of reversibility on short notice. The perceived transitoriness of the inflows plays a significant role in determining macroeconomic policy in general and sterilization and the degree of real exchange rate appreciation that is to be tolerated in particular.14

From an expenditure point of view, one might expect that the higher the FDI component of the flows, the lower the real exchange rate appreciation.15 The authorities in charge of exchange rate policy might hold the opposite view—that the higher the FDI component, the less probable a sudden reversal of flows, in which case the perception is that of a stronger currency. Of course, the opposite is also true: the higher the perceived “speculative” nature, the less likely a substantial real exchange rate appreciation is considered an acceptable policy option unless the capital flow affects a country engaged in an exchange-rate-based stabilization program. In such a case, inflation concerns are so dominant that real exchange appreciation is deemed a cost well worth paying.

From a practical point of view, it is impossible to determine how transitory a capital inflow is. Even if it were possible, changes in macroeconomic conditions could cause a short-run speculative flow to transform itself into a long-term investment, and vice versa. Addressing the issue about how sustainable the inflow might be is equivalent to pronouncing on the sustainability of the factors that attracted it. If the external shock is indeed the dominant factor, then, from a policy viewpoint, one should probably be prudent enough to recognize that a reversal is likely. In contrast, if macroeconomic policies and structural reforms have been an important element in stimulating the inflow, then the flow is likely to endure as long as those policies and reforms are sustainable.

The latter point notwithstanding, one might argue that FDI implies capital flows that are longer lasting than other types of flows. By historical standards, the recent developments in terms of FDI have been impressive only in Chile, and, to a lesser extent, Argentina (Table 4.1).16 The role of privatization and debt-conversion schemes in some of the countries that we are analyzing is shown in Table 4.2. Until 1992, FDI did not play a significant role in Colombia, the only country in which no debt conversion was implemented and in which privatization was nonexistent until 1993.

Table 4.2.Debt Conversion and Privatization
Country19851986198719881989199019911992
Argentina
Foreign direct investment (FDI) (in millions of U.S. dollars)919.0574.0−19.01,147.01,028.02,008.02,439.04,693.0
Through debt conversions (in percent)38.229.615.540.6
Through privatizations (in percent)20.780.939.2
Brazil FDI (in millions of U.S. dollars)1,347.0319.91,225.62,969.31,267.0901.0972.02,000.0
Through debt conversions (in percent)43.164.428.070.374.631.47.04.8
Through privatizations (in percent)
Chile FDI (in millions of U.S. dollars)144.3315.5930.31,026.71,505.6660.6539.1573.5
Through debt conversions (in percent)20.863.075.486.387.866.9−6.8−5.5
Through privatizations (in percent)11.1
Mexico FDI (in millions of U.S. dollars)491.01,523.23,245.62,594.63,036.92 633.24,761.55,366.0
Through debt conversions (in percent)23.844.733.512.83.20.4
Through privatizations (in percent)32.88.4

Even in countries in which the absolute amount of FDI is large, it generally represents only a small percentage of the overall capital surplus. This implies that those countries that implemented the most significant reforms, and therefore attracted the largest portion of FDI, are the same countries that relied more heavily on capital inflows that were probably less stable. This is especially true in the case of Mexico.

Without covering all possibilities regarding the nature of the inflow, a simple matrix will help summarize some of the ideas stated (Chart 4.1). The first column shows the inflows as being the response to pull factors, which can be a temporary event (option 1) if such factors are speculative, or permanent (option 3) if the attracting factors are credible and sustainable domestic policies. The second column characterizes the inflows as being determined by push factors, which can be temporary (option 2) or permanent (option 4). We rule the latter case as implausible.

Option 2, which is the characterization of Calvo, Leiderman, and Reinhart (1993), calls for macroeconomic management that avoids real exchange rate appreciation, current account deficits, and significant increases in the financial intermediation of the inflows. At the opposite extreme, option 3, which is emphasized by Blejer (1993) and most policymakers, should bring about an appreciation that is offset by productivity increases. It could also reasonably finance any excess in domestic aggregate demand and should be intermediated in the process. The biggest policy dilemma has less to do with identifying an event as conforming to option 2 or to option 3 than with recognizing the possibility that something that looked like option 3 is ultimately unsustainable, for example, because of the market’s perception that the exchange rate is substantially overvalued.

A review of case studies suggests that all countries have benefited from an external shock but that, in every case, other factors also played a role. It also seems to be the case that, at least until 1992, Brazil and Colombia conformed to option 1, in which domestic rates of return were much higher than foreign rates, not only because of high interest rates stemming from sterilization attempts, but also, in Colombia, as a result of a severely undervalued real exchange rate, which fostered expectations of a nominal appreciation. Although speculative factors seem to have played an important role in the Chilean experience, most authors suggest that having in place a sound, credible, and sustainable program was the most relevant factor (option 3).

Chart 4.1.Characterization of the Inflows

Characterizing the Argentine and Mexican experiences is more complicated, even though, in both cases, as in the region as a whole, lack of good investment opportunities in the OECD probably played an important role. Both countries have implemented policy reforms across the board that should be credited with attracting a significant amount of foreign capital. However, both countries experienced a significant real exchange rate appreciation.17 The sustainability of most reforms is probably not jeopardized; indeed, many are, for practical purposes, irreversible. However, the same assessment cannot be made of exchange rate policy. If indeed the exchange rate is perceived as being severely overvalued, a capital outflow could eventually occur.

The different elements involved can be integrated in one framework. Latin America has attracted capital because of expectations of high rates of return, which are determined by at least four elements: (1) rates of return increase when the currency is undervalued and an eventual appreciation is a reasonable possibility; (2) they increase when high real domestic interest rates are used in the fight against inflation; (3) they increase when OECD countries experience adverse developments; and (4) they increase when the country risk premium falls.

The idea we would like to stress is that, at some point, the currency can become overvalued. Even if all the other elements that imply an increase in the expected rate of return remain in place, the capital losses that may result from a currency depreciation may be large enough to offset all positive forces. Of course, sound policies can appreciate the equilibrium real exchange rate, making matters much more difficult to assess, because the “observed” real exchange rate—which does not fully correct for all productivity changes—may no longer be a good barometer of macroeconomic consistency.

Another way to view the current episode is as one in which several elements combined so that the relative expected rates of return in the region increased. This increase should presumably subside, diminishing the inflow but not necessarily implying a subsequent outflow. The latter event could come about as a result of expectations of exchange rate depreciation if, notwithstanding the scope of recent reforms, market participants consider the recent real appreciations to be unsustainable.

In some countries, the current account deficit that has emerged is a reflection of a significant fall in private savings. In those cases, the medium-term sustainability of the whole process requires significant amounts of additional capital inflows. It may not be reassuring to recognize that the recent inflows will not be reversed because a continued flow will be necessary, at least while private savings remain at a low level.

Policy Response

The policy response to a foreign exchange inflow depends on whether it is perceived to be permanent, which, as was just mentioned, is a function of the stability of the conditions that were responsible for attracting the inflow. With regard to FDI, it is generally believed that the short-term costs (that is, the exertion of pressure on the exchange rate) are outweighed by long-term benefits (that is, FDI complements domestic savings and is a means of transferring technology). In addition, FDI may be import intensive, thereby implying fewer inflationary pressures to begin with.

Matters are quite different if the capital inflow consists of “hot money.” In that case, as Kuczynski (1993) phrased it, “central banks in Latin America may say they dislike hot money, but they like the increase in international reserves and the anti-inflationary effects of higher exchange rates. So do finance ministries, because the fiscal cost of external debt service declines. Treasurers of large companies certainly like it, because their cost of funding declines and their possibilities of cheap equity financing improve. Then, who dislikes hot money? Presumably, import competing industrialists, exporters, and those making foreign direct investment” (p. 330).

If we disregard differences in “initial conditions” and/or in “policy objectives,” the analysis of the characteristics of the inflows suggests that if one considers only their nature, a real appreciation would probably have been a reasonable response in Chile, where the inflow was responding to a sound macroeconomic policy apparently perceived as permanent. A real appreciation would not have been a reasonable response in Brazil and Colombia, where, presumably, short-term speculative movements were dominant.

On the nature of the inflow, one must superimpose both specific initial conditions and distinct policy objectives. The following characterizations of the five countries when the inflows became important present the information in an orderly fashion. By 1990 Chile had consolidated its structural reforms, its fiscal position was strong, and inflation was moderate. Reducing inflation was an important goal, but the highest priority was assigned to maintaining a competitive real exchange rate. In 1992, Colombia was involved in an ambitious reform program, its fiscal position was good, and inflation was at its usual moderate level. Policy priorities were aimed at consolidating the reforms, which called for the maintenance of a competitive exchange rate. In both Argentina and Mexico, substantial reforms were under way, and further, substantial inflation reduction was a cornerstone of the countries’ macroeconomic policies. Brazil is different; reforms were at an early stage, inflation was very high, and the targeting of the real exchange rate remained an important feature of macroeconomic policy. Inflation and the fiscal balance appear in Tables Table 4.3 and 4.4.

Table 4.3.CPI Annual Inflation(In percent)
Country198519861987198819891990199119921993
Argentina385.481.9174.8387.74,923.31,343.984.017.67.7
Brazil239.158.6394.6993.31,863.61,584.6475.81,149.12,489.1
Chile26.417.421.412.721.427.318.712.712.2
Colombia22.321.024.028.226.132.426.825.222.6
Mexico63.7105.7159.251.719.729.918.911.98.0
Source: United Nations, Economic Commission for Latin America and the Caribbean.
Source: United Nations, Economic Commission for Latin America and the Caribbean.
Table 4.4.Public Sector Balance, Excluding Privatizations(In percent of GDP)
Country1987198819891990199119921993
Argentina
Nonfinancial public sector excluding local governments−4.6−6.0−3.8−3.8−1.60.41.1
Brazil
Nonfinancial public sector−5.7−4.8−6.91.21.4−2.10.3
Chile
Nonfinancial public sector2.63.55.03.12.22.92.0
Colombia
Nonfinancial public sector1.9−2.5−2.4−0.30.1−0.30.2
Mexico
Consolidated public sector−15.5−12.5−5.7−4.0−0.41.60.7
Source: United Nations, Economic Commission for Latin America and the Caribbean.
Source: United Nations, Economic Commission for Latin America and the Caribbean.

We can think of a “loss function” in which one dislikes inflation and likes a competitive real exchange rate and it takes time for domestic inflation to converge to a reduction in the rate of nominal depreciation. In that case, countries must choose, temporarily, between maintaining a competitive real exchange rate with stable and moderate to high inflation or a decreasing rate of inflation with a less competitive exchange rate.18 It is quite clear that Brazil represents the first choice and Argentina and Mexico the second. Chile and Colombia fall between the two scenarios.

The actual evolution of the real exchange rate for the five countries is shown in Table 4.5. A comparison of the level at the end of 1993 with the level in the year prior to the inflows shows that real appreciation has been significant in Argentina and Mexico, and insignificant in Brazil and Chile. In Colombia, the 1993 level was not significantly lower than the average for 1987–89, although a significant appreciation took place from the high, unsustainable levels of 1991.

Table 4.5.Real Exchange Rate(1990= 100)
Country19861987198819891990199119921993
Argentina100122130143100837874
Brazil161157143108100119127III
Chile889610296100999596
Colombia778587891001019083
Mexico130135110103100918479
Note: Weights by destination of exports; CPI is the deflator.Source: United Nations, Economic Commission for Latin America and the Caribbean.
Note: Weights by destination of exports; CPI is the deflator.Source: United Nations, Economic Commission for Latin America and the Caribbean.

Foreign Exchange Intervention and Sterilization

Foreign exchange intervention took place in all of the countries considered, which made no attempt to appreciate the nominal exchange rate openly. In Chile, Colombia, and Mexico, however, episodes of small nominal appreciations occurred when the authorities discretely reduced the central bank’s effective intervention rate and/or widened the band within which the exchange rate was allowed to fluctuate. In most countries, as in Colombia in 1991, a substantial tariff reduction, equivalent to an appreciation of the nominal effective exchange rate for imports, occurred.

Once foreign exchange intervention is established, monetary sterilization becomes crucial. The benefits of sterilization are that it contains inflationary pressures and also reduces the chance of significant credit expansion by the financial system while, at the same time, providing the cushion that limits the country’s vulnerability to a reversal of flows.19 The costs stem from the possibility that high interest rates will further attract inflows, discourage investment, and generate fiscal losses for the central bank.

For analytical purposes, we will follow Frankel (1994) and make use of the simple IS-LM textbook model in the context of an open economy that faces less-than-perfect capital mobility (as reflected in a positively sloped BP curve).20 The horizontal axis represents nominal income. Three cases are distinguished:

(1) A drop in foreign interest rates (Chart 4.2, panel A): initial equlibrium is at s. If the foreign exchange inflow is sterilized, it remains at s, at an interest rate that is above the international rate. If monetization is allowed, the economy will move to the right, reaching point m. If the exchange rate is allowed to appreciate, equilibrium will be somewhere around a. Note that both a and m lie south of s; the increased demand for domestic bonds will imply a drop in interest rates or unchanged interest rates in the extreme case of complete sterilization. The real exchange rate appreciates at m and at a; it is a matter of choice if this is achieved through a nominal appreciation or through higher inflation. If there is insufficient flexibility in the exchange rate system, increased inflation will be a very likely outcome.

Chart 4.2.Domestic Interest Rates and Foreign Reserve Inflows

(2) An increase in net exports (panel B): initial equilibrium is at a. A trade balance improvement, for example, because of an exchange rate depreciation, will shift the IS and BP curves to the right. Sterilization might temporarily imply high interest rates (at s) although increased reserve inflows will eventually move the economy toward m. However, if the exchange rate is allowed to adjust, equilibrium will again be at a, rendering the initial depreciation ineffective.21 Again, the real appreciation can be obtained through a nominal appreciation or through higher inflation.

(3) A successful stabilization program that stimulates capital repatriation while simultaneously increasing money demand (panel C): from an initial equilibrium at m, we move to a point like s, in which interest rates are unnecessarily high. It is better not to attempt sterilization at all but to allow the money supply to adjust to what residents are demanding, with equilibrium at m. Residents’ attempts to convert foreign currency into domestic currency might lead the central bank to allow an exchange rate appreciation; in that case, the BP and IS curves shift leftward, and equilibrium is reached at a, with a reduction in net exports. The higher the weight given to bringing down inflation, the more likely that an exchange rate appreciation will be allowed for.

Because of the common external shock, panel A applies across the board. However, the shock itself does not seem to be the only important factor in any specific case. Elements of panel B are relevant to all countries, either because they have made export promotion the cornerstone of their macroeconomic policy (particularly Brazil, Chile, and Colombia) or because they received significant FDI. Successful exchange-rate-based stabilization programs that significantly increase money demand make panel C relevant in explaining the Argentine and Mexican experiences.22

The framework discussed, although limited in a number of respects, suggests certain guidelines. On the one hand, sterilization is not necessarily called for. On the other, when sterilization is implemented, only under very particular conditions should one observe a (temporary) increase in domestic interest rates.

Countries that implemented, among other reforms, credible exchange-rate-based stabilization programs have faced a substantial increase in money demand (notice the significant decrease in Ml velocity in Argentina and Mexico, Table 4.6). They have not been involved in sterilization efforts. However, when money demand does not increase significantly, one could be tempted to avoid sterilization under the presumption that the money supply increase will reduce interest rates and foster a capital outflow. This approach is always risky; policymakers are afraid that the excess money supply will pass through to prices before having any significant effect on the net foreign asset position of the central bank.23

Table 4.6.Velocity of MI(Annual percent change)
Country199119921993
Argentina5.60−15.90−16.00
Chile−14.805.30−6.60
Colombia−2.00−12.10−0.10
Mexico−43.702.50−4.70
Source: Author’s calculations based on IMF staff estimates.
Source: Author’s calculations based on IMF staff estimates.

In the recent episode, countries that have targeted the real exchange rate did implement sterilization. Indeed, increases in interest rates, which at first glance are an “incorrect” answer to an exogenous capital inflow, were actually part of the policy mix in Brazil, Chile, and Colombia. With the exception of Brazil, the increase was temporary. Both the quasi-fiscal effects and the fact that speculative flows were being further attracted soon rendered sterilization inefficient.

Fiscal Policy

In many countries, fiscal policy is dependent, in part, on the exchange rate. By definition, the fiscal balance depends on that part of the capital inflow that stems from privatization programs, a crucial element in both Argentina and Mexico. Additionally, in most countries, prudent fiscal policy, more than a response to the inflows, was part of the policy mix that attracted foreign capital in the first place. This point is particularly true in the Mexican experience, where, even when one excludes the revenue from privatization, the improvement in the fiscal balance has been spectacular.

All the countries under review have improved their fiscal balance (Table 4.4) and in all countries public expenditure has, at least, not increased (Table 4.7). These developments are significant. It is easy to imagine the gruesome real exchange rate scenario that would have come about if fiscal policy had not been as prudent as it was. As Calvo, Leiderman, and Reinhart (1994) have pointed out, in countries with abundant foreign capital, private sector expenditure is quite independent of tax obligations. In that case, the best fiscal policy is one that reduces government expenditure but does not rely on heavily increasing the tax burden.

Table 4.7.Nonfinancial Public Sector Revenue and Expenditure(In percent of GDP)
Country198719881989199019911992
Argentina
Total revenue13.414.413.516.418.9
Expenditure18.919.217.017.317.918.9
Brazil
Current revenue126.927.333.528.926.5
Expenditure37.943.351.543.331.125.5
Chile
Total revenue34.633.228.329.629.8
Expenditure31.430.727.626.827.926.9
Colombia
Total revenue32.532.732.033.631.7
Expenditure33.834.935.132.333.532.3
Mexico
Total revenue30.529.629.630.030.4
Expenditure45.439.834.531.927.025.9
Source: United Nations, Economic Commission for Latin America and the Caribbean.

In 1991 and 1992, it excludes financial accounts.

Source: United Nations, Economic Commission for Latin America and the Caribbean.

In 1991 and 1992, it excludes financial accounts.

Other Policies

Another important policy option is to impose taxes on capital inflows. Countries that deemed it important to maintain a competitive real exchange rate—such as Chile and Colombia—did in fact establish explicit taxes and/or reserve requirements on foreign capital. Temporary restraints were also implemented in Mexico.

The policy, which seemed to fare rather well in Chile, was considered ineffective in Colombia.24 Policy discussions in the latter case suggest that such an outcome is probably the result of the fact that capital repatriation was an important element, with residents being capable of eluding most restraints that the authorities imposed.

Most countries lifted restrictions on capital outflows as part of a policy package aimed at compensating for the inflationary pressures of the inflows. Again, results do not seem to be favorable; in fact, the lifting of such restrictions may have had the undesirable effect of further stimulating inflows.

Investment and Growth

The poor economic performance of Latin America during the 1980s has been blamed, in part, on the severely restricted access to foreign financing. It is reasonable to expect that bridging the foreign exchange gap would help boost growth, which has certainly picked up during the current episode, albeit for different reasons and to different degrees in the countries considered. Isolating the effects of the foreign exchange inflow is a difficult task, which will not be attempted here. Instead, some possible linkages between inflows and growth that might be relevant will be cited.

There is no clear answer to how foreign exchange inflows affect growth. It is sometimes believed that inflows, by appreciating the real exchange rate, hamper exports while boosting investment because imported capital goods become less expensive.25 Additionally, inflows can relax savings and foreign exchange constraints if they are intermediated by the financial system. Furthermore, the stock market boom that has resulted from the foreign exchange inflows—a common occurrence in all the countries that we are considering—may also provide businesses with additional, inexpensive financing possibilities. Simultaneously, inflows could presumably hamper growth if fiscal and monetary policies designed to accommodate them are sufficiently restrictive, as could have happened in Colombia during the first half of 1992. Finally, capital inflows can substitute for domestic savings, thereby increasing consumption without affecting investment. In this case, inflows can have a positive, but short-lived effect on growth.

Although the rate of exchange rate appreciation has varied among countries, and although some have implemented—at least temporarily—contractionary monetary and fiscal policies, for the most part the results in terms of growth have been good, and in Argentina and Chile, quite remarkable (Table 4.8). Sustainability of growth depends critically on the factors that help explain the recent boost in aggregate demand.

Table 4.8.Growth of GDP(Annual percent change)
Country1987198819891990199119921993
Argentina2.7−2.1−6.2−0.18.98.76.0
Brazil3.6−0.13.2−4.40.2−0.84.1
Chile5.77.09.62.85.79.85.6
Colombia5.64.23.54.01.83.64.9
Mexico1.91.23.34.43.62.80.6
Source: United Nations, Economic Commission for Latin America and the Caribbean.
Source: United Nations, Economic Commission for Latin America and the Caribbean.

Investment has rebounded in Argentina, Chile, and Colombia (Table 4.9), regardlesss of its absolute level and despite the fact that, if anything, public investment has been curtailed in most cases. The impact of FDI on this evolution is probably not important because, through debt conversion schemes, FDI might actually be substituting private domestic investment, while privatization implies the purchase of existing assets.26

Table 4.9.Gross Domestic Investment and Savings(In percent of GDP)
Country19801985199119921993
Argentina
Investment25.317.614.616.718.4
Savings23.823.116.215.116.5
Brazil
Investment23.319.218.917.518.2
Savings21.124.420.920.820.2
Chile
Investment24.617.222.224.126.2
Savings20.519.626.825.823.9
Colombia
Investment19.119.016.817.621.2
Savings19.720.324.320.920.4
Mexico
Investment27.221.221423.321.7
Savings24.926.319.317.715.9

The funding for the increase in investment has, of course, differed considerably between Chile on the one hand and Argentina and Mexico on the other. While in Chile the increase in investment has been coupled with a significant rise in domestic savings, thereby reflecting rather small current account deficits, in Argentina the resurgence of investment has basically been financed with foreign savings (Table 4.9). In Mexico, increased foreign savings have brought about increases in consumption, with no important effect on investment. In the latter case, the drop in domestic savings has been remarkable even though public sector savings have increased (Table 4.9). When analyzing the balance of payments, one might be skeptical about the sustainability of the capital inflow in countries that have experienced a significant real appreciation. A review of the national accounts leads to skepticism because it is unlikely that countries will be able to sustain current account deficits if these imbalances reflect a decrease in savings rather than an increase in investment.

The contraction in the ratio of savings to GDP ratio obviously reflects increases in consumption. With the exception of Brazil, total consumption (both public and private) has been the most dynamic element of aggregate demand (Table 4.10). As is to be expected given the evolution of the real exchange rate, exports have played an important role in boosting aggregate demand in Brazil, Chile, and Colombia, but not in Argentina and Mexico. The trade balance results have been in line with real exchange rate developments. Those countries in which appreciation has been significant have seen their trade balance worsen the most. The dominant factor in the trade balance deterioration has been a marked increase in imports, with purchases of capital goods playing a significant role (Tables 4.11 and 4.12). In most countries, this description has held true since 1991 or 1992; in Colombia it is evident only in 1993.

Table 4.10.Contributions to GDP Growth(Annual averages)
Demand
Consumption
Country/YearGovernmentPrivate1Gross

investment
Domestic

demand
Exports of

goods and

services
Argentina
1981–83−0.2−2.1−16−5.11.0
1984–870.41.00.21.6−0.2
1988–900.7−4.1−2.0−5.41.8
19911.6−7.83.913.3−1.5
19921.66.64.712.80.1
Brazil
1981–830.2−2.5−2.5−4.80.9
1984–670.44.11.45.70.7
1988–900.4−0.7−0.30.3
19910.42.1−0.71.8−0.1
1992−0.1−2.8−0.8−3.72.4
Chile
1981–83−0.3−4.5−2.2−7.30.4
1984–87−0.12.21.73.72.6
1988–900.34.02.16.22.9
19910.33.4−0.23.54.3
19920.47.53.411.34.4
Colombia
1981–830.32.50.63.3−1.4
1984–870.41.50.22.12.9
1988–900.62.70.13.41.2
19910.21.7−1.20.70.7
19921.32.32.25.81.4
Mexico
1981–830.5−1.6−2.6−3.72.5
1984–870.20.40.70.9
1988–900.13.61.45.00.8
19910.43.21.55.21.2
19920.23.62.76.50.1
Source: United Nations, Economic Commission for Latin America and the Caribbean.

Includes changes in stocks.

Source: United Nations, Economic Commission for Latin America and the Caribbean.

Includes changes in stocks.

Table 4.11.Exports of Goods(In billions of U.S. dollars)
YearArgentinaBrazilChileColombiaMexico
19848.127.03.74.324.2
19858.425.63.83.721.7
19866.922.44.25.316.0
19876.426.25.25.720.7
19889.133.87.15.320.6
19899.634.48.16.022.8
199012.431.48.37.126.8
199112.031.68.97.627.1
199212.236.110.07.327.5
199313.138.89.27.430.0
Source: United Nations, Economic Commission for Latin America and the Caribbean.
Source: United Nations, Economic Commission for Latin America and the Caribbean.
Table 4.12.Imports of Goods
ArgentinaBrazilChileColombiaMexico
YearTotal imports1Capital goods2Total imports1Capital goods2Total imports1Capital goods2Total imports1Capital goods2Total imports1Capital goods2
19844.120.613.910.53.319.14.028.011.327.2
19853.523.313.212.12.922.63.721.513.228.5
19864.421.314.015.53.125.53.428.211.439.0
19875.327.515.117.54.027.83.829.012.225.3
19884.925.814.619.34.829.64.527.218.923.5
19893.924.118.317.06.531.84.627.223.422.6
19903.721.420.719.17.033.55.129.431.322.8
19917.623.721.020.07.427.54.527.338.222.2
199213.928.420.530.69.227.56.032.248.224.0
199315.525.532.210.231.49.139.848.9
Source: United Nations, Economic Commission for Latin America and the Caribbean.

In billions of U.S. dollars.

In percent of total.

Source: United Nations, Economic Commission for Latin America and the Caribbean.

In billions of U.S. dollars.

In percent of total.

If one accepts that sound structural policies affect capital inflows, then the link between reforms and growth, regardless of the flows, is obvious. That link has to do with the increases in productivity that should emerge from a more outward-oriented economy, a smaller and more efficient public sector, and spillovers of increased FDI. All of these elements must play an important role in any explanation of changes in long-run growth paths; their short-term effects are probably not as significant and, in any event, are quite difficult to analyze at this stage.

Conclusions

The region as a whole has received significant inflows of foreign exchange, which, in most cases, are the result of a capital account surplus that has financed both current account deficits and foreign reserve accumulation. The inflows come at a time when most countries are engaged in reducing inflation and promoting exports. Because the foreign exchange inflows tend to appreciate the real exchange rate, those countries that have focused on export promotion have worked toward preventing such an appreciation. Success in that effort has, in most cases, implied only modest reductions in inflation.

In countries in which inflation reduction has been considered the premier goal, real appreciation has been marked, trade balance deterioration significant, and achievements in price stabilization remarkable. Even though capital inflows exacerbate pressures on the exchange rate, they are necessary to the sustainability of the exchange rate system.

It seems to be the case that most countries have been successful because either inflation came down, exports increased, or overall growth picked up. In only a few cases is inflation still a major concern; those countries that used the exchange rate as a nominal anchor and that maintained a strong fiscal stance are now experiencing inflation that is rapidly converging to international levels. Generally, exports have increased, although not at the same pace as imports, which have consisted, in an important proportion, of capital goods.

If developments in investment have not been as good as expected, it is in part because overall macroeconomic management has been quite cautious. The data presented suggest that, if anything, the positive assessments of 1992 and 1993 are still valid. Capital has continued to flow into the region, while exchange rate appreciation has subsided markedly. It seems appropriate to conclude that it is a distant possibility that a crisis will occur as a result of the capital that flowed into Latin America in the early 1980s, particularly if the policies that attracted the inflows are not reversed.

Comment

Guillermo A. Calvo

The paper by Steiner is a welcome addition to the literature on one of the most pressing macroeconomic issues for Latin America. While earlier papers have focused on the region as a whole or on specific countries, the present one offers a more balanced view of regionwide and country-specific factors that may be lying behind the remarkable surge of capital inflows in Latin America.

I will start my comments with a clarification that addresses a common misunderstanding about the central message in Calvo, Leiderman, and Reinhart (1993). (I should hasten to say, though, that Steiner’s paper is not guilty of that.) These authors show evidence suggesting that the recent capital inflows in Latin America may be strongly affected by factors lying outside the region—like U.S. interest rates. However, even though our paper’s emphasis is on external factors, the evidence presented there suggests that only 50 percent of the flows may be explained by those factors, the remaining 50 percent probably being due to factors internal to each country. Therefore, there is no contradiction between Steiner’s findings that the timing of the flows is not the same across countries—possibly reflecting policies being undertaken in each country—and those in Calvo, Leiderman, and Reinhart. It should be noted, incidentally, that Steiner’s paper does not utilize statistical methods and, therefore, is unable to provide us with estimates about the explanatory power of country-specific factors. This is a subject that deserves further study.

Capital inflows are in principle a good thing. They relieve the tight financial constraints under which Latin American countries had to operate during the 1980s, helping to replenish badly needed international reserves and to increase capital accumulation from alarmingly low levels. One central concern, however, is that domestic financial institutions may not have the know-how to handle these flows properly, increasing financial vulnerability. The latter may be the result of (1) an inability of the financial system to assess risk—particularly when funds are channeled to new customers or new activities—and/or (2) a pronounced maturity mismatch between deposits and loans—the latter normally being of longer maturity than the former. This type of concern is heightened by the prevalence of explicit or implicit bank insurance given by the central bank, a fact that weakens the incentives of financial institutions to mind loan risk and maturity mismatch.

Under those circumstances, capital inflows may cause serious disruptions even though, otherwise, monetary and fiscal policies follow strict canons. Unfortunately, the “black holes” that may be created by financial vulnerability can be seen only when they happen, which is too late.

Consequently, I believe that we should pay special attention to policies that contribute to lowering financial vulnerability. From that perspective, for example, sterilized intervention (by means of open market operations) is attractive because it lowers the impact of capital flows on the expansion of domestic bank credit to the private sector. Unfortunately, such policy has proven to be fiscally expensive, prompting Colombia to rely much less on it from 1991, and Argentina to abandon it altogether after the start of the Convertibility Plan.

An alternative is sterilized intervention through different procedures, for example, by increasing banks’ (nonremunerated) reserve requirements. To avoid causing serious banking illiquidity, the higher reserve requirements could apply only to deposits in excess of those prevailing in any given base period. This policy is highly effective in the short run and—unlike sterilization through open market operations—brings about no direct fiscal cost. However, in the medium run, high reserve requirements will cause disintermediation, heavier reliance on offshore banking, and the growth of a parallel financial system.

Consequently, in a protracted episode of capital inflows, like the current one, there seem to be two major realistic monetary policy alternatives: (1) floating exchange rates, and (2) strengthening the domestic financial industry through external support.

One major advantage of floating exchange rates is that the central bank recovers some of its powers of “lender of last resort.” However, in heavily dollarized systems like those in Argentina, Peru, and Uruguay, this advantage could be limited. Furthermore, countries are reluctant to allow wide fluctuations of the nominal exchange rate. Under normal circumstances, changes in nominal exchange rates are closely mirrored by changes in the real exchange rate. Therefore, wide fluctuations in the nominal exchange rate also entail wide fluctuations in key relative prices that, as a general rule, are not seen as welcome developments. Consequently, exchange rate flexibility—although, on occasion, useful—is unlikely to provide a full solution to the capital inflows problem.

Now we come to the last realistic monetary policy alternative, namely, international support. Let me first make it very clear that international support is of no use if domestic policies are unsound. For the present discussion, this means, in particular, that domestic regulations must ensure the soundness of the asset side of banks’ balance sheets. Loans must, on the whole, be fully performing. To ensure this, the central bank may have to set high reserve requirements at the beginning of the capital inflows episode given that, as noted above, the banking industry may initially be ill prepared to intermediate the new flows effectively. Again, for reasons mentioned above, this draconian policy may have to be relaxed over time; however, it is to be hoped that such a policy will be accompanied by much-improved banking supervision.

The existence of performing loans does not necessarily prevent a banking crisis. Bank runs could take place and, unless there is a “lender of last resort,” financial institutions may be forced into bankruptcy. Thus, if the central bank did not receive external assistance, it would have to hold very large international reserves—a requirement that may be infeasible in the short or medium run or exceedingly costly.

External assistance can take several forms. It may take the form of a stabilization fund like the one set up by Poland’s donors in 1990, or automatic swap arrangements like those presently available for Mexico from its NAFTA partners. External assistance could also take more subtle forms. For example, the central bank’s role as “lender of last resort” may be less critical if banks get direct financial support from external sources. This may be the case for a branch of a well-known international bank, because the bank may be reluctant to let its subsidiary file for bankruptcy and, therefore, may be more willing to provide the necessary short-run liquid funds to avoid it. Another, more basic reason for greater expeditiousness in obtaining funds from the parent company is that the latter may have better information than the market about the soundness of its subsidiary’s portfolio.

Latin America appears to be marching into an era of progress and stability: the capital inflows phenomenon may well be seen in the future as the harbinger of such an era, and much of this discussion as excessive “wringing of the hands.” This will be a much better mistake, I believe, than the one made at the turn of the 1980s, when the flows were considered a panacea until the region was plunged into its longest, and arguably most painful, twentieth-century recession.

References

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Note: Comments by Alberto Carrasquilla, Patricia Correa, Juan Carlos Jaramillo, and seminar participants were extremely helpful.

Argentina, Brazil, Chile, Colombia, and Mexico. Together they account for about 80 percent of the region’s GDP.

All ratios to GDP are influenced by the choice of the latter in U. S. dollars. The trends in these ratios are highlighted rather than their absolute level.

Of course, the capital inflows of the mid-1980s were insufficient to finance the current account deficit that emerged, especially because of the heavy debt burden.

A pattern that is also found in Spain (Galy, Pastor, and Pujol, 1993) and in some Asian countries (Reisen, 1993).

A detailed explanation of particular events in Argentina, Chile, Colombia, and Mexico appears, respectively, in Fanelli and Damill (1994); Agosin, Fuentes, and Letelier (1994); Cárdenas and Barrera (1994); and Ros (1994). Details of the Brazilian case as well as another description of the Chilean experience are found, respectively, in Carneiro and García (1994) and in Budnevich and Cifuentes (1994).

In what follows, an increase in the real exchange rate index (say, from 100 to 110) represents a depreciation.

On the Asian experience, see also Reisen (1993) and Frankel (1994). A detailed comparative analysis of experiences in various countries, including Chile, Colombia, and Mexico, appears in Schadler and others (1993).

Capital inflows have also affected other economies. On the Bolivian case, see Morales (1994); on the Peruvian experience, Dancourt (1994).

See, for example, Bianchi (1994).

From a different perspective, the hypothesis that the capital inflows to developing countries are the response to economic fundamentals, in the sense that they operate so as to smooth consumption in the event of temporary shocks to national cash flow (defined as output minus investment minus government expenditure), receives empirical support for an important group of countries in Ghosh and Ostry (1993).

As in Edwards (1991) in the case of Colombia.

According to Schadler and others (1993), the “overshooting” of the exchange rate also explains part of the capital inflows to Egypt in 1991–92. For somewhat similar arguments in the cases of Argentina and Mexico, see, respectively, Fanelli and Damill (1994) and Ros (1994).

The policy stance in Chile, shifting as a function of the changing perception of the authorities with regard to the durability of the inflow, is described in Bianchi (1994).

Calvo, Leiderman, and Reinhart (1994) point out that real exchange rate appreciation has been less significant in East Asia than in Latin America because, in the latter, speculative flows have been more important than in the former, and the demand for nontradables increases more with speculative flows than with FDI.

In spite of this, Rodríguez (1993) identifies the inflow to Argentina as being essentially speculative. This assessment is partially challenged by Ghosh and Ostry (1993).

Although, when corrected by productivity gains, the appreciation is obviously smaller and, according to some, probably not very significant.

In the long run, inflation reduction and a competitive real exchange rate are not competing objectives, and, in fact, if the economy is sufficiently open and indexation is not widespread, the convergence of inflation to the rate of nominal depreciation can be quite fast.

In certain countries, particularly in Argentina, the financial intermediation of the inflows has taken the form of significant increases in assets of the financial system that are denominated in foreign currency. In that case, it is very difficult to assess if the central bank’s foreign reserve accumulation constitutes sufficient “backing” for an eventual capital outflow.

Assuming perfect capital mobility will imply no significant changes with regard to the main conclusions. Reactions that take time under less-than-perfect mobility should occur instantaneously when mobility is perfect.

An increase in net exports that produces a current account surplus is also an increase in net wealth; portfolio effects, including an increase in money demand, should take place. A similar pattern will emerge in the case of FDI that effectively increases domestic investment. In many cases, especially in those linked with privatizations, it is not clear if FDI increased overall investment or simply substituted one investing agent for another.

Strictly speaking, money demand should also increase in the scenario described in panel B.

Recent estimates by Budnevich and Cifuentes (1994) for Chile and Cárdenas and Barrera (1994) for Colombia suggest that the “offset coefficient” is low enough to give support to the policymakers’ reluctance to monetize the reserve inflow.

Most, if not all, assessments of the Chilean experience lend support to the belief that capital controls—in the form of differential reserve requirements—have been effective in curtailing the size of the capital inflow. A pessimistic view with respect to the effectiveness of controls, based on the experiences of Ireland, Portugal, and Spain, appears in Fieleke (1994).

Depending on its sectoral destination, FDI can have a positive effect on export performance, notwithstanding the real exchange rate appreciation. A rather pessimistic assessment of this possibility in the cases of Argentina and Chile stems from the analysis of Fanelli and Damill (1994) and Agosin, Fuentes, and Letelier (1994), respectively. On the relationship between investment and the real exchange rate, see Serven and Solimano (1991).

For a somewhat skeptical view of FDI in Chile through debt-conversion mechanisms, see Ffrench-Davis (1990).

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