CarlOS aguIar DE MEDEIrOS

Financial dependency and growth cycles in Latin American countries

Abstract: This paper argues that there was a remarkable similarity in the external cycles in Latin Americas economic history. The desarrollo hacia fuera, the Economic Commission for Latin America and the Caribbean earlier designation for the World Banks outward-oriented model, that prevailed in the last part of the nineteenth century until 1930, was from the beginning a financial-export model where financial integration to the world economy played a central role. An orthodox economic policy based on fiscal contraction, a high rate of interest, and incentives to external debt in order to sustain convertibility and free capital flows was a permanent strategy of this model. After a long period distant from the world financial markets, many Latin American countries received throughout the 1970s and especially during the 1990s, huge volumes of financial capital that brought about once again a similar pattern and strategy of international integration. Key words: economic growth, exchange rate policy, external debt, trade specialization.

The strength of the liberalizing reforms and orthodox economic strategy launched in latin american countries in the 1990s gave momentum to a macroeconomic dynamics and an outward economic model similar to the old pattern that brought these countries into the global economy in the nineteenth century. This occurred not solely because a reinvigorated primary export model was affirmed in many countries as a dominant economic leadership, but also because the evolution of the payments

Carlos aguiar de Medeiros is a professor at Instituto de Economia/universidade Federal do rio de Janeiro. This paper is based on research done at the Faculty of Economics, Cambridge university, with financial support of CaPES (Coordenao de aperfeioamento de Pessoal de Nvel Superior). The author thanks CaPES for the financial support and an anonymous referee for insightful remarks.
Journal of Post Keynesian Economics / Fall 2008, Vol. 31, No. 1 79 2008 M.E. Sharpe, Inc. 01603477 / 2008 $9.50 + 0.00. DOI 10.2753/PKE0160-3477310104

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balance was shaped by financial flows. The old pre-Keynesian doctrine of sound finance and free capital flows was restored as a business and government quasi-consensus. The spectacular crisis of argentina in 2001 followed by a default in external debt and the nationalistic policy adopted in Venezuela in the past few years were a backlash of the radical financial opening that happened in the 1990s. These exceptions came in contrast to the prevailing policies in Brazil, Chile, Colombia, Mexico, and small countries in the region based on a strong reliance in high commodities prices and in policies aimed at attracting foreign funds. Financial dependency and economic growth The historically different patterns of financial and exchange systems between countries and regions brought the exchange rate regime to the core of development economics. For instance, Dooley et al. (2003) referred to asian countries as countries of trade account in contrast to latin american countries described as countries of capital account. The former exchange regime is typical, as argued by Mahon (1996) and also by the Trade and Development Report, 2003 (TDr), of a development strategy that favors trade and industry, whereas the latter favors essentially financial capital. These papers discuss the crucial difference between these two strategies and their predominance in asia and in latin american countries, respectively. However, the institutional and structural conditions that command each adoption are not evident. among structural factors, the composition of exports plays a central role. In latin american countries, commodities have historically had a significant weight in total exports. The different income elasticity between exports and imports and the great volatility of commodities prices in the international market have generated cyclical variations in the import capacity and high instability in exchange rate and demand for capital flows.1

(2003), in an empirical paper covering the previous 20 years, found higher appreciation in the real exchange rate (rEr) associated with capital inflows in latin america than in asian countries. He suggests that the composition of capital inflows where foreign direct investment (FDI) and exports are a large part of capital flows and the evolution of nominal wages explain the relative stability of rEr in asian countries. The dominant role of capital flows directed to exploit the domestic market and the evolution of nominal wages in latin american countries was associated with major price increases and higher appreciation in rEr.

1 athukorala

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Chronic deficits in current account historically present in latin american countries were associated with trade specialization that gave birth to a foreign exchange gap2 as a central feature of developing economies. But in addition to the specialization of commodities, there is another factor that has an autonomous dimension and, due to its persistence, plays a structural role: the historically high level of external indebtedness of latin american countries. In fact, the high levels of indebtedness measured, for example, by the external debt (and assets) stock upon exportspossess an autonomous explanation rather than merely being a consequence of the kind of trade specialization.3 The problem of the foreign exchange gap model is to assume that indebtedness is always economically needed, but as the economic history of latin american countries abundantly shows, external indebtedness can be excessive and not explained by current account problems. To exploit this argument, consider a developing economy that has a deficit in its trade current account. So it is possible to equate [I] FCA = CAD, where FCA stands for net capital account and CAD stands for a current account deficit. as far as CaD grows, there is a necessity of higher capital inflows that respond for a disequilibrium between the potential rate of growth and the availability of currency. Because there is a limit to financing CaD, the economy has to adjust its rate of growth or its export and import elasticities through depreciation in real exchange rate (hereafter rEr) and tariff policies.4 This model assumes that capital flows are a real necessity. Dropping [I], it becomes [II] FCA = CAD + R + NRCO, where R stands for variations

2 The foreign exchange gap emerges as an extension of the HarrodDomar model for open economies of the third world. In addition to the savings gapa common version associated with this modelthis version considers a foreign exchange gap that holds whenever a low import capacity hinders the increase of investment rate until the level allowed by savings availability is reached. This second kind of gap is impossible in the neoclassical approach, which says that proper macroeconomic policies always enable internal resources to become foreign exchange, eliminating the gap. The classical formulation of the two gaps model was developed by Chenery and Bruno (1962). For a broad discussion, see Serrano and Souza (2000). 3 The World Bank and mainstream economics consider latin american countries closed to international trade and inward oriented, in opposition to asian countries, which are described as more open and outside oriented. One of the failures of such an argument is that it does not recognize that latin american countries have always been more open to foreign capital than asian countries. This difference on the role of external finance has deep implications that are the object of reflection of this paper. 4 See Calvo (1998) for analysis of this binding constraint.

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in reserves and NRCO stands for the nonregistered capital outflow that can be considered a proxy of the standard classification of the balanceof-payment errors and omissions. as long as the growth of capital liability over capital asset (net of reserves) exceeds the current account deficit, there is an excess of financial flows over real necessity. and as long as they generate large outflows of nonregistered capital, these flows are financing a demand of residents to put their asset abroad. The point here is the recognition that there is a financial demand for currencya liquidity preference for holding currencythat does not arise by real necessity but by financial fragility. Besides, if this demand is supplied by a large flow of funds, the appreciation of exchange rate can generate an expansion of current account deficit that absorbs the currency surplus. In Capital Exports and growth (1957), Knapp examined the problem of excessive borrowing. The crucial point observed by Knapp is that the reasons to contract a foreign loan are not necessarily entangled by a necessity to finance a supply of services and goods required for economic growth. actually, it derives from differential rate of interests, underdevelopment in financial system in borrowing countries, and the liquidity preferences (for strong currencies) of the wealth owners of these countries. In developing countries, the reasons for an excessive accumulation of claims for foreign currency rely on the combination of two different mechanisms. The first deals with a loan-pushing process; a whole set of pressures from banks and the governments of rich countries that exert in determined moments (when there is a low rate of interest and excess of liquidity in the dominant currency) a strong push in bank loan or finance bonds to peripheral countries (Darity and Horn, 1988; Devlin, 1989). The second mechanism is the excess of borrowing that depends on internal decisions. governments and firms decide to contract excessive loans or issue assets denominated on foreign currency. This aspect has been referred to as original sin (Hausmann and Panizza, 2003) and is associated with many historical and political aspects.5 an overlending of foreign loans (or foreign-denominated liabilities)6 becomes an excess of borrowing when it compromises the external sol5 The idea behind the original sin is that the large ratio of foreign money denominated debt on national debt is imposed by international capital markets. However, this imposition is only part of the story. The other is the fiscal and internal credit self-restriction assumed by peripheral countries in order to fulfill the game rules of an international monetary system in a financially open and integrated economy. 6 For the present discussion, there is no difference if the foreign liability is a foreign bank loan or a bond placed in international market.

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vency and liquidity increasing the fragility of the peripheral financial system. Domar (1950) was right when he considered the solvency ratio as the ratio between the rate of exports and the rate of interest prevailing for the sovereign debt.7 By its turn, the volume of reserves at short notice vis--vis the volume of short-term debt provides a meaningful index of fragility.8 The interaction of these two movementsloan push and overborrowingcan bring about a financial fragility trajectory. This trajectory was examined by Minsky (1982) in a closed economyan evolution from a hedge to a Ponzi financeand was explored by Foley (2003) and lopez et al. (2006) for an open economy. according to this literature, the existence of a net financial inflow allows a rate of investment and a rate of economic growth higher than the profit rate. This generates a growing CaD and speculative regime. It occurs through the rate of interest set by the central bank, which tends to increase as far as the income growth exceeds the rate that equilibrates the balance of payment. The increasing macroeconomic financial fragility (measured by the solvency ratio and liquidity ratio) arouses growing suspicion that the prevailing exchange regime (fixed, peg, or more flexible but stable exchange rate) could not be sustained. In an earlier interpretation on the argentinean cycle, Prebisch (1939) developed a compatible analysis considering that, given the currency board system that characterized the argentinean exchange system during the 1920s (and during the 1990s as well), the increases on export prices and on foreign investmentboth governed by forces outside the countryset in place an increase of internal credit and of imports that adjusted to the new offer of currency. This expansion generated trade deficit. The excess of import and the decline of foreign investment depressed the internal credit and economic growth until a new external cycle began. although these explanations depict correctly a trajectory of increasing financial fragility, it keeps the idea that financial flows is governed mainly by the demand side and that overborrowing (considering the country solvency) has financed a higher rate of economic growth. But, as mentioned above, in a constrained economy, the availability of currency allows higher growth, and there is no necessary link between an overlending and a higher rate of investment and income growth. an
7 although some models such as Moreno-Brid (199899) depicted the limits of growth with external debt in a convergent interpretation, most of them use the ratio between the deficit in current account and product. That can be misleading. 8 See Medeiros and Serrano (2006).

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autonomous process from the creditors banks and from demanders of currency due to wealth motives can generate a speculative trajectory without any correspondence in the real world. The interactions of financial flows and exchange rate in peripheral countries depend on some institutional and structural dimensions. In a currency board regime with nonsterilized intervention, such as considered by Prebisch, a surge in FCa brings about (through credit expansion) a strong expansion on CaD and, depending on the effects on the wage rate, it causes an increase in nontradable goods, generating an appreciation in rEr. In other exchange regimes, the monetary policy can sterilize part of this monetary expansion through a higher rate of interest and expansion of reserves. It is important to consider that in both regimes, the appreciation of rEr has a positive effect on economic growth through the increase of real wages and the reduction of the domestic cost of external debt, stimulating government and firms. Thus, except for exporters, the economic dominant pressures in an indebted country are for an overvalued currency. This is also valid for foreign investors in nontradable goods. But the surge in CaD is associated with this rate of exchange demands and a higher rate of interest and a speculative and Ponzi finance. Once again, this can cause a suspicion that the currency is not sustainable, generating a higher CaD through an increase in profits and interest transferences. This results in a higher demand for FCa to finance a surge in NrCO. The exchange collapse is the likely outcome of this trajectory unless successful exchange depreciation or intense decline in internal absorption equilibrates CaD. Nevertheless, this is improbable due to disruptive capital flight (NrCO). Thus, as Patnaik (2002) affirmed, the intrinsic fragility of third-world currencies as a safe means of holding wealth is always confirmed by the final direction of capital account movements. according to Patnaik, in a financially deregulated world, there is a chronic tendency for capital to move away from these currencies, and therefore, there is a tendency for the domestic currency to depreciate. This tendency cannot consistently be eliminated by monetary policy. In a similar analysis, MacKinnon affirmed that peripheral monies are only provisional because any economic or political disturbance at home provokes the suspicion that . . . foreign debts may not be repayable, and that the domestic currency will depreciated against the dollar (2002, p. 2). given the hierarchy of currencies in a financially open world, the link between these questions and the nature of the tradable sector in latin america is based on three facts: (1) that the financial cycle makes the

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commodities prices cycle deeper, (2) the overvalued exchange rate sustains activity levels, and (3) the import propensity is not compatible to the exporter base.9 Therefore, the financial dependence is simultaneously a cause and consequence of this trade insertion in the world economy. It is important to observe that neither the surge in inflows nor the outflows are primarily determined by domestic forces but are made by the monetary policy of the definitive money. Here it is important to consider some characteristic of a financial cycle as depicted by Perez (2002). She argues that in every technological revolution, there are two moments when the marriage of financial capital and productive capital is broken: soon after the surge of an industrial revolution when a financial frenzy tries to enlarge the higher profit achieved in new activities through speculative bubbles, and during the maturity phase of an industrial revolution when the decline in economies of scale in the old economy triggers a speculative capital outflow and intense competition in order to keep the profitability. These movements are stimulated by financial innovations and a low rate of interest. although Perez centers her arguments on industrial countries, she considers that in these two phaseswhich in some cases can overlap because the industrial cycle does not occur simultaneously in all industrial countries, let alone in the global economythe capital flows to peripheral countries are looking for extraordinary financial opportunities, good export prices, and low wages. When the bubble is over (following an increase in the rate of interest), interrupting the financial frenzy in the beginning of industrial revolution or in the last phase of the maturity of an old paradigm, financial capital tends to concentrate in industrial countries. The rest of this paper argues that the dominance of external events shaping the latin america financial cycles is a long-run feature. as Table 1 shows, all international cycles in latin american economic history were accompanied by financial inflows that shaped the internal cycle and liquidity crisis. Financial cycles in Latin America There are a great number of historical and empirical papers exploring the similarities and differences between the present financial globalization and the nineteenth-century financial globalization.10 In 1870, 1890,
like Kaminsky et al. (2004) related about financial flowswhen it rains, it pours. Nayar (2006), De long et al. (1999), Devlin (1989), Eichengreen et al. (1998; 1999), Kozul-Wright (2006), and TDr (2003) are good examples.
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Table 1 Financial cycles in Latin American economies

Reversion Economic contraction in England and industrial countries. Defaults in Ottoman empire and in Latin American countries. Reversal in terms of trade. Collapse of Barings Bank. Summary Financial cycle led by railway investment and refinancing of old debt.

Upswing cycle

Main trigger factor

186076 maturity phase of railways era

Low British rate of interest and acute competition among European banks for financing railroads in Latin American countries.

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188590 frenzy phase of steel and electricity era

Low British rate of interest and speculative flows to mortgages mainly in Argentina and Uruguay.

Capital inflows propitiated convertibility in currency boards regimes. The Barings crisis generated a strong contagious effect to many Latin American countries, including Brazil. Finance loans to railways and ports. During the war reversal in financial transference and import substitution. High levels of external borrowings for refinancing loans and public works. After 1930, financial transference for the continent remained negative or very low until 1970.

190414 maturity phase of steel and electricity era

Low British rate of interest and strong competition of European banks for Latin American loans for speculative and FDI purposes.

World War I

192129 frenzy phase of oil and automobile era

Dollar diplomacy. Reduction in U.S. rate of interest and strong competition of U.S. banks in Latin American market. Strong valorization of terms of trade after the war.

1929 international crisis. Collapse of terms of trade and defaults on debt throughout the 1930s.

197381 maturity phase of oil and automobile era

Reduction in U.S. rate of interest and extraordinary expansion of international oil-dollars loans. (Between 1974 and 1981, the cumulative net inflows in [2000] dollars amounted $1.155 billion.) Elevation of U.S. rate of interest in 19992000, exhaustion of mass privatization and high external financial fragility.

Strong elevation of U.S. rate of interest in 1979, collapse in terms of trade and Mexican default in 1982.

Overborrowing in 197881 and different growth strategies occurred within countries with different trade and exchange rates regimes. After 1982, strong devaluations in RER caused hyperinflation episodes. A pure financial cycle with deteriorated terms of trade. Radical profinance strategies. Overborrowing and strong valorization of RER. Collapse in RER at the end of decade. After devaluations in RER, booming in export value was achieved by high commodity prices and high volume demanded by international trade growth led by the United States.

19912001 frenzy phase of information and telecommunication era

Reduction in U.S. rate of interest, Bradys Securitization of Foreign Debt and extraordinary expansion of liquidity (between 1992 and 2001, net inflows of $1.243 billion). ?

2002

Reduction in U.S. rate of interest in 2001 and 2002 and high valorization of terms of trade.

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Sources: Technological and financial phases based on Perez (2002); some particular features in latin america based on Marichal (1989); data on TDr (2003).

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1920, 1970, and 1990, the supply of financial flows (loans and bonds) led by financial cycles in developed countries, finance innovations, and changes in the rate of interest in the world financial centers brought about massive loans and capital inflows to latin american countries. These financial inflows created a situation of loan frenzy to public and private sectors in latin american countries, and in many episodes, a current account deficit not checked by exchange rate devaluation. a profinance and procommodity strategy associated with these flows has stimulated an internationalization of private domestic assets. This cycle has been normally reverted by changes in the role of financial capital in industrial countries followed by external shocks transmitted through an increase in the rate of interest of a major financial center and by a fall of commodity prices. The collapse of the exchange rate was followed by the impossibility to meet all of the debt compromises in foreign exchange, generating contraction and defaults. Property transferences, denationalization, and empowerment of mobile international asset holders have been some common political and economic outcomes of this pattern. These cycles resulted in strong variability in the rEr with a tendency to depreciate against the strongest currencies. The finance-export age Prebisch (1949) showed that the inner dynamic of capital flows during the period toward hacia fuera (or export led) in latin american countries was connected to the building of the commodity infrastructure and export capacity for those countries. But, as was recalled by Marichal (1989), the close integration of European merchant/banks and the production of raw material/food in the continent set in motion a new model of economic growth led by exports and financial expansion. In the export age, latin american countries tried to follow the gold patterns rule creating formal or informal convertibility schemes and restrictive Treasury policies. The incompatibility of this endeavor with the volatility of its exports generated a succession of exchange crises when long periods of exchange appreciation sustained by capital inflows brought external crisis and collapse in the rEr. after the independence, a loan spree took place in the 1870s geared by high profit opportunities of commodity exports. The majority of loans were taken by the public sector through bond issuing in london mainly to refinance old debts and to finance railways.11 But not only were these necessities financed by
11

For details and empirical evidence, see De long et al. (1999).

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external capital, many public works were also financed abroad due to the chronic credit constraint imposed by the policymakers; this was in order to follow the game rules associated with the monetary system led by England. So, the contraction of a big loan in sterling or the selling of bonds with gold clauses were the basis for credit and fiscal expansion and to sustain the convertibility of domestic currencies. During the second half of the 1880s, following a financial frenzy associated with a new technological wave led by the united States and germany (Perez, 2002), a second boom of capital flows to latin american countries, mainly in the form of foreign direct investment (FDI) took place. at this time, argentina and uruguay attracted the majority of flows to finance railways and urban infrastructure. This high volume of flows backed a large issue of golden pesos and gold bonds. a speculative issue of mortgage bonds created a huge expansion of wealth assets in pounds and gold for the rich elite of Buenos aires and Montevideo. When, in 1889, the Bank of England raised its discount rate, the financial crisis was settled. The near-collapse of Barings Bankby far the most specialized in argentinean financein 1890 and the argentinean default reached the entire continent. In consequence, the loans flows were stopped, and the next ten years were dedicated to renegotiation of debt with internal policies of deflation asset privatizations and nationalization of debts. In argentina, this financial frenzy changed the property of infrastructure. In Brazil, a highly indebted country, the sharp reduction of capital inflows after the Barings crisis caused a balance-of-payment crisis. This brought a huge devaluation in the exchange rate breaking with the gold standard clausal introduced in 1889. The capital flight that succeeded this large devaluation pressed the rate of exchange additionally with great effects in the inflation rate. The encilhamento crisis that took place in 189091 was a direct consequence of argentinean contagion.12 It is interesting to note that before 1929, there were no central banks in the region. Schemes of currency boards were introduced in many countries in the beginning of the century, but their incompatibility with the sharp fluctuations of commodities prices caused systematic crisis. With the collapse of the international system during the World War I, latin american countries practiced a more pragmatic monetary policy. after World War I, and under the influence of international missions

12 The most common analysis of this crisis attributes the inflation pressures and speculative frenzy to the fiscal imbalances created by excessive money issuing. For a review of this debate and data, see Triner (2001).

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stimulated by growing concerns with capacity of latin american countries to pay their international debts, many central banks were created. They were supposed to control the discretionary power of the Treasury (Furtado, 1970). The basic line was to follow a more efficient orthodox policy based on rules of the game of the gold system and to attract new loans attending the huge financial transfers abroad. The Brazilian economic policy based on the currency board of 192630 was a good example of this endeavor. The experience of argentina deserves further consideration. It was the most developed country of latin america during this period until 1935. When the argentinean Central Bank was created and ruled by raul Prebisch, a currency board system aimed to give convertibility to the national currency. Prebisch, in his early analysis of the argentinean external cycle (Magarinos, 1991), argued that this system only worked during capital inflows and never functioned during gold outflow. But the persistence on keeping this system caused, in many episodes, severe damages in the economy until the burst of a new cycle. This was the main reason for creating a central bankas happened in argentina in 1935with discretionary power on the exchange market and to issue nonconvertible Treasury notes. as argued by Marichal (1989), in all speculative capital inflows, the wealthy land owner, urban property owners, merchants, bankers, and politicians who formed the nucleus of the dominant classes of the primary export model were the main domestic group benefited. after the 1930s, latin america started to face a new realityscarcity of dollars. an autonomous policy was launched in many countries as far as they decided to break with convertibility and to devalue the exchange rate. But this new political economy was confined to the big economies because these structural and institutional changes did not happen in small and passive economies. Venezuela, Cuba, guatemala, Dominican republic, Ecuador, Costa rica, El Salvador, Nicaragua, Panama, Haiti, and Honduras remained attached to a dollar exchange standard with little exchange or financial control.13 The scarcity of dollars ended only in the 1970s, when the financial transferences became positive and excessive, as discussed in the next section.

13 It is important to consider that although during these years, the scarcity of dollars was a prominent factor, latin american countries never interrupted drastically the placement of assets abroad (Mahon, 1996).

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Debt-led growth in the 1970s The surge in capital flows in the 1970s is remarkably different compared to the flows of the 1920s. Shifting from bond finance and from direct investment toward bank finance was the main financial change. This change was built by the enormous dollar liquidity generated by the explosion of oil prices, the maturity of the prevailing technological paradigm, and the deregulation of the financial system. What seems however similar to the 1920s was the overlending and overborrowing process. But in the 1970s, differently than in this financial cycle, there was not a large previous debt to finance. a fundamental financial innovation that pushed the huge volume of surplus funds from the eurodollar market to peripheral countries was the possibility of bank lenders to form large-scale syndication and the inauguration of cross-default clauses in loan contracts. In addition, the Sovereign Immunities act of 1976, on its turn, removed the doctrine of absolute sovereign immunity from u.S. courts (Darity and Horn, 1988). Besides that, the most important innovation was the floating rate loans that passed the risk to the borrower (Devlin, 1989). With these financial innovations, the great differentials in the rate of interest brought about by the reduction of the u.S. prime rate in 1971 opened opportunities for international banksled by u.S. banks in euromarketsto place the excess of funds in developing countries. During the 1970s, exchange regimes in latin american countries were very different, reflecting structural and political aspects. In Brazil and Colombia, a crawling peg system avoided a real appreciation in exchange rate. In Mexico and Venezuela, the huge increases in oil prices were followed by real appreciation of domestic currencies. In argentina and Chile, the excess of liquidity gave birth (at the end of the decade) to a stabilization strategy based on a fixed exchange rate. Different from the previous periods (and the 1990s), the capital account was much more controlled in countries such as Brazil and Colombia. Nevertheless, in argentina, uruguay, and Chile in the last years of the decade, a sharp financial liberalization occurred. Capital controls were never adopted in Mexico and in small countries as in the former countries. Independent of the reasonsin Brazil, capital inflows were used to launch a heavy industry planthe external indebtedness had its own dynamic. as in the nineteenth century, a great part of the new loans was to cover old loans given the short maturity that still prevailed in the majority of this loan spree. So before the export or import substitution proceeds were availablewhere the foreign resources were used to promote

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exports or import substitutionthe borrower country had to cover debt services with new loans, enlarging its external liability (Devlin, 1989). Higher domestic interest rates, lower exchange rates, and high incentives to contract external loans created an overborrowing process that assumed in many places, as in Venezuela, the same millions fever as observed by Furtado (1982). On average, debt services above exports reached 40 percent and the foreign currency reserves expanded in the continent through short-term financial resources. as previously considered, the FCa was in large excess of the necessities put by the variation of CaD, financing positive variations in r and NrCO. although the numbers were not comparable with those that prevailed in the 1980s, in the last years of the 1970s, significant capital flight took place in Mexico, Venezuela, argentina, and even Brazil, the most regulated country (Cumby and levich, 1987). The huge increase in the interest rate in 1979 and the banks decisions to cut lending to latin american countries after Mexicos default in 1982 interrupted this cycle and imposed strong currency devaluations to finance the transfers for the creditors banks. This shift in capital flowsnet capital autonomous inflows became strongly negativeoccurred in all countries except Chile, despite the differences in the use of foreign currency. Capital flight reached large volumes until the end of decade (Schneider, 2003). The external crisis was the base for radical reforms in latin american countries. The objective, in what has been known as the first Washington consensus, was to launch a new pattern of economic growth led by private enterprise through a comprehensive integration to world markets. This marked a radical move from what was christened the ancient regime of imports substitution. But the real expectation was to attract the capital flows from foreigners and repatriate the stock of dollars held by residents. The main solution for the unbearable latin american debt was political, led by u.S. Treasury Secretary Nicholas Brady. It was started as a political and economic problem after the Malvinas (Falklands) War, but only after the Mexican debt rescheduling in 1989 was it implemented in the indebted latin american countries. as shown by the estimated data of capital flight, in argentina in 1988 and in Brazil in 1989, significant capital flows were repatriated (ibid.). The 1990 external cycle and the return of the treasury view The 1980s were characterized by huge capital outflow, high inflation, and stagnation. Except in Chile (which attracted more political support) and Colombia (with lower debt), all stabilization efforts failed. The

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1990s brought to latin american countries enormous inflows of capital attracted by high interest rates and huge privatization opportunities. These flows were preceded by the rise of Bradys bonds, a secondary market in commercial bank loans for latin american countries debts established to relieve u.S. banks of non-performing loans (TDr, 2003, p. 36). In a similar role played by the banks during the 1920s, the new function of underwriting bond issues that spread throughout the decade dissipated the bank risks by selling off participation in latin american loans (Darity and Horn, 1988; Eichengreen and Bordo, 2002). The great financial innovation was the dominant role of the huge american pension and mutual funds on capital markets. This movement gave fund managers and investment banks a great leverage on financial markets and a final say on investor confidence. But at the same timeand different from the nineteenth centuryit gave a more political meaning to the liquidity crisis in that it involved millions of american pensioners, as became clear in the Mexican crisis of 1994. By the same reason, the International Monetary Fund (IMF) had a stronger involvement in latin american countries, providing funds for financial rescues in loans with high policy conditionality. as in all previous cycles, the decline in the u.S. interest rate in the beginning of the 1990s and the financial innovation (securitization) that followed the financial frenzy associated with a new technological wave (telecommunications and information technologies) started a new external cycle. Dismantling capital controls was the dominant aspect to launch a profinance strategy in latin american countries (TDr, 2003). This was considered a huge opportunity not only to stabilize the economy and defeat it from high inflation (hyperinflation in argentina and Brazil), but to establish a new model of economic development centered on trade and financial integration. Trade and capital account liberalization, deregulation, and mass privatization spread to the continent. In this strategy, the technopols, the Central Bank and the Treasury, assumed a high leverage over the economy, reflecting the renewed power of the interests of banks, export-oriented business, and the owners of dollarized assets. But the new role of the Central Bank was created by a strong connection with the IMF. It is important to note that since the 1980s, the IMF acted more as a representative of creditor banks than as a public multilateral finance institution for countries seeking assistance. Its leverage in the region was proportional to the external debt to be restructured and financed. But the novelty throughout the 1990s was the growing submission of the latin american central banks to the IMF stabilization package

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centered on deflation policies. In part, this submission was the result of a growing external instability demanding growing IMF intervention, but, in part, this submission was the result of two other processes. First, the cosmopolitan national groups changed the composition of their assets enlarging financial deposits in foreign banks; in that sense, their interests were more in common with the international creditors and investors. Second, there was a practical consensus between the technopols and academic economists that the best policy to be followed by the Central Bank was the policy prescribed by the IMF. In many countries, as in argentina and Brazil, many deflationary policies deepened the policies and goals above the target established with the IMF. as in the old pattern that prevailed before the 1930s or in the 1970s, there was an overborrowing process and, due to its effects on the rEr enhanced by an adverse terms of trade, the new inflows created their own demand in the form of imports of goods and services. a huge deficit in current accounts was set in motion in the majority of latin american countries by the combination of trade liberalization and appreciation in the rEr, both resulting in liquidity abundance. The financial transferences toward the region became largely positive covering a great deficit in current account and attended to the national residents high domestic demand of dollar-denominated assets. This high level of inflows financed, by its turn, high volumes of capital flight. Throughout the 1990s, the available data (Schneider, 2003) show that capital flight was a permanent feature and after 1994 reached high levels in the region. In order to control the outflow pressures and attract new capital, a high rate of interest was the main policy and the issue of public bonds indexed to the dollar was the main instrument. In consequence, domestic debt boomed, led exclusively by the monetary policy, and squeezed public spending, mainly investment. Different from the 1970s and more similar to the 1920s, the FDI played a major role and was attracted essentially to privatization deals in public utilities, banks, and industry in countries such as argentina, Brazil, and Mexico. after its inception in the early 1990s, this profinance strategy resulted in a very short boombust cycle, alternating phases of huge inflows of capital and appreciation in rEr succeeded by the collapse in exchange regime and capital flight. In all latin american major countries, the combination of external indebtedness with denationalization of wealth (dollar-denominated financial assets and securities held by residents and domestic financial and securities assets held by nonresidents) reached no precedent levels since

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1930.14 Two processes were developed. In countries such as argentina, Bolivia, Peru, uruguay, Ecuador, Nicaragua, and Costa rica, the deposits in dollars and the share of loans denominated in dollars displaced completely the domestic monies from these functions. In other countries, such as Mexico, Chile, Venezuela, or Brazil, although the domestic monies were not replaced, the share of offshore deposits as a share of total deposits increased strongly. From the mid-1990s, capital flight outnumbered by far the amount registered in the 1980s. The provisional nature of latin american currencies was never as evident as in this decade. as in other external cycles, the external and domestic interest rates were of utmost importance. The decline of the u.S. interest rate in the beginning of the decade started this financial cycle; a short increase in the u.S. federal funds rate in 1994 precipitated a capital reversal in Mexico, the last financial crisis of the nineteenth century, as put by Eichengreen et al. (1999), but the decline of this rate after 1994 allowed the financial cycle until the end of the decade. The rate of interest was very high in nondollarized latin american counties (mainly in Brazil) in order to stimulate the capital inflows. Despite that, as was observed in other historic episodes, the 1990s crisis showed that increases in the rate of interest were never enough to stop the capital outflow when the rate of exchange was perceived as strongly overvalued. like in other financial cycles, the reversal in capital flows generated a collapse in the exchange rate followed by a financial and asset crisis (Brazil in 1998, argentina in 20012, and uruguay in 20012). a depreciated rEr achieved in the beginning of the twenty-first century by the majority of the economies could not start alone a new external cycle nor reverted rapidly the trade account that became in a few years largely positive. In fact, it was started by external forces. The terrorist attack in the united States launched a strong military expansionist policy with a decrease in the rate of interest. at the same time, China launched an anticycle policy with big effects on asian countries and on the commodities market. Both events affected trade volume and commodities prices of the main exports of the region. This strongly enlarged the income terms of trade of latin american countries and shifted its negative current account, improving their solvency and liquidity ratios for a higher

14 Here the standard notion of dollarization is considered as the deposits in dollars by national residents. For a detailed analysis of the dollarization process including other concepts and the high index reached in latin america, see reinhart et al. (2003).

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growth despite the negative transference. This new commodities-oriented cycle brought new opportunities for different national strategiesseized after a huge crisis of argentina and Venezuela. However, the majority of latin american countries took the same strategy based on fiscal discipline and openness to financial markets. The appreciation of exchange rate is once more a common feature in many countries and precludes them from seizing this extraordinary opportunity to diversify exports to sectors less dependent on natural resources. Conclusion This paper argued that there was a remarkable similarity in the external cycles in latin american countries economic history. The desarrollo hacia fuera, EClaCs early designation for the World Banks outwardoriented model, that prevailed in the last part of the nineteenth century until 1930, was from the beginning a financial-export model where the financial integration to the world economy played a central role. an orthodox economic policy based on fiscal contraction, a high rate of interest, and incentives to external debt in order to sustain convertibility and free capital flows was a permanent strategy of this model. after a long period distant from the world financial markets that lasted until 1970, many latin american countries in this decade andafter the collapse of the 1980sthe majority of the countries during the 1990s, followed a similar pattern and strategy of international integration. The chronic trade unbalances historically associated with latin american countries in contrast with asian countries cannot explain the high reliance on external finance. In many episodes presented in this paper, the excess of external finance created its own demand through current account deficits. The impact of this financial integration on trade is transmitted through a high variability in rEr that, by its turn, jeopardizes the diversification of exports. The high propensity of the domestic cosmopolitan classes to keep assets in dollars and their political leverage on economic policy comes from this kind of financial integration. The external cycle in the continent showed some common features. Due to external innovations in the money market (bond or loan finance) and the prevalence of low interest rates in developed countries, strong inflows of foreign capital were attracted by profitable opportunities in financially open latin american countries. Higher interest rates in government bonds or higher profit rates in booming sectors triggered by high commodities prices and sales of profitable domestic assets put in motion an external cycle. Despite the huge demand for strong currency for wealth purposes,

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the excess of them in a financially open economy generated, during a certain period of time, a real appreciation in exchange rate. This interrupted the chronic instability and inflation pressures originated from a weak export sector and high demand for currency. Economic growth with overvalued currency generates a high demand for imports and for assets denominated in foreign currency. The reversal in trade and the strong expansion of the services deficits that followed the overvaluation was a perverse consequence of capital inflows; generating their own demand in the form of current account deficit. The strong commitment to balance the budget and attract capital inflow to finance the growing deficit in current account has pressed for a high real interest rate. The combination of a loan push with a domestic credit crunch originated from this economic policyenhanced private external overborrowing. When the boom ended, triggered by a strong reversal in the terms of trade and external flows fed by capital flight, sharp devaluations restored a lower level of rEr. a high variability and a chronic tendency for the rEr of domestic currency to deteriorate was the outcome of these cycles, jeopardizing the diversification of the exports. Thus, the great financial dependency is an autonomous factor to comprehend the unstable performance of the exports in the long term and, consequently, of the development of latin america economies. ReFeRenCes
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