Palgrave Macmillan Journals International Monetary Fund

Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External
Factors
Author(s): Guillermo A. Calvo, Leonardo Leiderman and Carmen M. Reinhart
Source: Staff Papers (International Monetary Fund), Vol. 40, No. 1 (Mar., 1993), pp. 108-151
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IMF StaffPapers
Vol. 40, No. 1 (March 1993)
© 1993 InternationalMonetaryFund
CapitalInflowsand Real Exchange

Rate Appreciationin LatinAmerica
The Role of ExternalFactors
GUILLERMO A. CALVO, LEONARDO LEIDERMAN,

andCARMEN M. REINHART*
Thecharacteristicsof recentcapitalinflowsintoLatinAmericaare dis-

cussed.It is arguedthattheseinflows arepartlyexplainedbyconditions
outsidetheregion,liketherecession intheUnitedStatesandlowerinter-
nationalinterestrates.Theimportance ofexternal
factors thata
suggests
reversal
of those conditionsmaylead toa capitaloutflow,
future increasing
themacroeconomic of LatinAmericaneconomies.Policy
vulnerability
options,itis argued,are limited.[JELG1, F41]
T HE REVIVAL of substantialinternational
capitalinflowsto Latin
Americais perhapsthemostvisibleeconomicchangeintheregion
duringthepasttwoyears.Capitalflowsto LatinAmerica,whichaver-
agedabout$8 billiona yearinthesecondhalfofthe1980s,surgedto$24
billionin 1990and$40billionin 1991.Of thelatteramount,45 percent
wentto Mexico,and mostoftheremainder wentto Argentina, Brazil,
Chile,Colombia,and Venezuela.Interestingly, capitalis returning
to
mostLatinAmericancountries despitewidedifferencesin macroeco-
*An earlierversionofthispaperwaspresented atseminarsattheWorldBank
andInter-American Development Bank.The authors wishto thankthepartici-
pantsattheseseminars,numerous and,inparticular,
colleagues, MichaelBruno,
SaraCalvo,PeterClark,EduardoFernandez-Arias, andMiguelKiguelfortheir
helpfulsuggestions.
Guillermo A. Calvois SeniorAdvisorintheResearchDepartment. Leonardo
Leiderman isa ProfessorintheDepartment ofEconomics atTelAvivUniversity.
Thispaperwaswritten whenhe wasa Visiting ScholarintheResearchDepart-
ment.CarmenM. Reinhart is an Economist in theResearchDepartment. She
holdsa Ph.D. fromColumbiaUniversity.
108

CAPITAL INFLOWS AND REAL EXCHANGE RATES 109
nomicpoliciesand economicperformance acrosstheregion.In most

the
countries, capital inflows have been accompanied byan appreciation
intherealexchangerate,boomingstockandrealestatemarkets, faster
economicgrowth, anaccumulation ofinternationalreserves,and a strong
recovery ofsecondary-market pricesforforeign loans.
Without a doubt,an important partofthisphenomenon is explained
by thefundamental economic and politicalreforms that have recently
takenplaceinthesecountries, including therestructuring oftheirexter-
nal debts.Indeed,itwouldhavebeendifficult to attracttheamountof
foreign capitalmentioned abovewithout thesereforms. Nevertheless,
although domesticreform is a necessary ingredientforreviving capital
flows,it onlypartially explainsLatinAmerica'sforceful reentry into
international capitalmarkets.Domesticreforms alone cannotexplain
whycapitalsometimes flowed tocountries thatdidnotundertake reforms
and conversely whyitsometimes didnotflow,exceptuntilrecently, to
countries wherereforms wereintroduced wellbefore1990.Fordomestic
reforms alone to explainthe co-movement of capitalinflowsacross
countries in theregion,one wouldhaveto posittheexistence ofstrong
reputational externalities (or "contagion"effects): reforms in some
countries give riseto expectations of future reforms in others.1
Thispapermaintains thatsomeoftherenewalofcapitalflowstoLatin
Americaresults fromexternal factors andcanbe considered an external
shockcommonto theregion.We arguethatfalling interestrates,a con-
tinuing recession, and balance ofpayments developments theUnited
in
Stateshaveencouraged investors to shiftresourcesto LatinAmericato
take advantageof renewedinvestment opportunities and the region's
increasedsolvency;2 economicdevelopments outsidetheregionhelpto
explaintheuniversality of theseflows.The presentepisodemaywell
represent an additional case offinancial shocksinthecenteraffecting the
periphery-an idea stressed byDiaz-Alejandro.3
International capitalinflows affect theLatinAmericaneconomiesin
at leastfourways.4First,theyincreasetheavailability ofcapitalin the
Fora theoretical
frameworkthatwouldaccommodate thisexpectationshy-
pothesisand thatfindsbroadempiricalsupportin developing countries,see
Ghoshand Ostry(1992).
2
LatinAmericais nottheonlyregionto experience
increased capitalinflows
in1991.SimilardevelopmentsoccurredinAsiaandtheMiddleEast.Atthesame
time,therewas a markedrisein capitaloutflowsfromtheUnitedStatesand
Japan.
3See Diaz-Alejandro(1983,1984).
4For a recentstudyof the effects
of capitalmovements, see International
Monetary Fund(1991).On theroleofreformsandcapitalaccountliberalization,
see Mathiesonand Rojas-Suarez(1992).

110 CALVO * LEIDERMAN * REINHART
individualeconomiesand allowdomesticagentsto smoothout their

consumption overtimeand investors to reactto expectedchangesin
Second,capitalinflows
profitability. havebeenassociatedwitha marked
appreciation oftherealexchange rateinmostofthecountries. Thelarger
transferfromabroadhas to be accompanied byan increaseindomestic
absorption. Ifpartoftheincreaseinspending fallson nontraded goods,
theirrelativepricewillincrease-thereal exchangerateappreciates.
Third,capitalinflows havean impacton domesticpolicymaking. The
desirebysomecentralbanksto attenuate therealexchangerateappre-
ciationin theshortrunfrequently leadsthemto intervene, purchasing
fromthe privatesectorpartof the inwardflowof foreignexchange.
Moreover,the attemptto avoiddomesticmonetization of thesepur-
chaseshas oftenled themonetary authorities to sterilizesomeof the
inflows,a stepthattendsto perpetuate a highdomestic-foreign interest
ratedifferentialandthatgivesrisetoincreased fiscalburdens.Theextent
to whichtheinflows are sustainable also concernstheauthorities. The
history of Latin America givesreason for such concern: the major
episodesofcapitalinflows, during the1920sand1978-81,werefollowed
bymajoreconomiccrisesandcapitaloutflows, suchas inthe1930sand
in
the debtcrisis the mid-1980s.5 Fourth,capitalinflowscan provide
important-though ambiguous-signals toparticipants inworldfinancial
markets. An increasein capitalinflows can be interpreted as reflecting
morefavorable medium- andlong-term investment opportunities inthe
receiving country. But capitalmayalso pourin forpurelyshort-term
speculativepurposes,whenlackofcredibility ina government's policies
leadstohighnominal returnsondomestic financial assets.Infact,several
suchepisodeshaveoccurred inLatinAmerica,wherelackofcredibility
anda short-term financial
bubblehavebeenassociated withlargeinflows
of"hotmoney"fromabroad.Although itremains tobe seenwhichone
ofthesetwoscenariosbestfitsthepresentpicture, thestrong recovery
in secondary-market pricesof bank claims on most of thesecountries
(Figure1) and variousotherindicators of country riskprovidesome
support for the more
first, favorable, scenario.6
Insum,thispaperhasthreemainobjectives, whicharedevelopedfrom
data forten LatinAmericancountries.7 The firstis to documentthe
current episodeof capitalinflows to LatinAmerica.The secondis to
5Fora comparison of the currentepisodewiththe late 1970s,see Calvo,

Leiderman,and Reinhart (1992).
6Fortheevolutionof individualcountry see LDC Debt Reportby
ratings,
SalomonBrothers.
7Thecountriesincludedin oursampleareArgentina, Bolivia,Brazil,Chile,
Colombia,Ecuador,Mexico,Peru,Uruguay, andVenezuela.

Figure1. Secondary-Market
PricesforLoans,January 1992
1988-June
(In percentoffacevalue)
0.5 0.14
Argentina / Bolivia I
0.4 - 0.13
0.12
0.3
0.11
0.2 0.10
0.1 I.. . . .. .. . . . . j 0.09
Jan.88 Jan.89 Jan.90 Jan.91 Jan.92 Jan.88 Jan.89 Jan.90 Jan.91 Jan.92
0.6 0.9
0.5 Brazil Chile
-
0.8
0.4 0.7
0.3 -
0.6
0.2 -..
0.5
0.36
0.8 Colombia \ \^~ Ecuador
0.28
0.7'
V_ ,,
hrj 0.20
0.6- v
0.12
0.5 . . . .
0.8 0.4
Mexico Peru
0.7 - 0.3
0.6 - 0.2
0.5
0.1
0.4an.- 88 Jan. 89 Jan. 90 Jan. 91 Jan.92I 0
0.76
Uruguay Venezuela 0.7
0.68 -
0.6
0.60 -
0.5
0.52 0.4
0.44 . . . . . . .. . . . . . . . 0.3
LDC DebtReport(variousissues).
Source:SalomonBrothers,

assesstheroleofexternal factorsinaccountingfortheobservedcapital
inflows andtherealexchange rateappreciation.
Thethirdistoelaborate
on theimplicationsofcapitalinflowsforeconomicpolicy.In thispaper,
thefirstsectiondeals withbasicconceptsaboutcapitalflowsand the
relationshipbetweencapitalinflows,theaccumulation ofreserves,and
thegapbetweennationalsavingandinvestment. Thestylized
factsabout
capitalinflowsto theregionare documented in thesecondsection.A
thirdsectionprovidesa quantitativeassessmentoftheroleof external
factorsontheaccumulation ofreserves andon realexchangerateappre-
ciationinthetencountries
considered. Theimplications
ofcapitalinflows
fordomesticeconomicpolicyare discussedin a concluding section.
ofCapitalFlows
I. Accounting
Internationalcapitalflowsare recordedin thenonreserve capitalac-

countofthebalanceofpayments (BOP). Thisaccountincludesall inter-
nationaltransactionsinvolvingassetsotherthanofficial suchas
reserves,
transactionsin money,stocks,government bonds,land,and factories.
Whena nationalagentsellsan assetto someoneabroad,thetransaction
enterstheagent'scountry's balanceofpayments as a creditonthecapital
accountandis regardedas a capitalinflow. Accordingly, netborrowing
abroadbydomestic ora
agents purchase ofdomestic stocksbyforeigners
are consideredcapitalinflows,representing debt and equityfinance
respectively.
The simplerulesof double-entry accounting ensurethat,excluding
statistical the
discrepancies, capital account surplus, ornetcapitalinflow
(denotedbyKA), is relatedto thecurrent account surplus(denotedby
CA) and to theofficial reservesaccount(denotedbyRA) oftheBOP
through theidentity:8
CA + KA + RA 0.
A property ofthecurrentaccountis thatit measuresthechangein an
economy'snetforeign wealth.A country thatrunsa current account
mustfinancethisdeficit
deficit eitherbya privatecapitalinfloworbya
reductioninitsofficial In bothcases,thecountry
reserves. runsdownits
netforeignwealth.Anothercharacteristic
ofthecurrent accountis that
nationalincomeaccountingimpliesthatitssurplus
equalsthedifference
betweennationalsavingsand nationalinvestment (CA S - I). Ac-
8NoticethatRA < 0 impliestheaccumulation

of reserves
bythemonetary
authority.

CAPITALINFLOWSAND REAL EXCHANGERATES 113
cordingly, an increasein thecurrent accountdeficitcan be tracedto

eitheran increasein nationalinvestment, a declinein nationalsavings,
oranycombination ofthesevariablesthatresults inan increased invest-
ment-savings gap.Finally,theofficial reserves accountrecords purchases
and sales ofofficialreserveassetsbycentralbanks.Thus,theaccount
measuresthe extentof officialforeignexchangeintervention by the
authoritiesandis oftenreferred to as theofficial settlements balanceor
theoverallbalanceofpayments.
The foregoing discussionindicatestwopolarcases of howa central
bankmight respondto increasedcapitalinflows. Ifa central bankchooses
nottointervene inresponsetoa capitalinflow, theincreased netexports
of assetsin thecapitalaccountfinancesan increasein netimports of
goods and in
services the current account-capital inflows would notbe
associatedwithchangesinthecentral bank'sholdings ofofficial
reserves.
At theotherextreme, ifthedomestic authorities actively interveneand
the
purchase foreignexchangebrought by in the capitalinflow,the
increasein KA is perfectly matchedbyan increasein official reserves.
In thiscase, thegap betweennationalsavingsand nationalinvestment
does notchange,nordoes thenetforeign wealthoftheeconomy.The
capitalinflow would be perfectlycorrelated withchangesin reserves.
In reality,foreignexchangemarketintervention does notoccuron a
scalethatwouldproducea one-to-one relationship between RA andKA.
Theobserved increaseincapitalinflows toLatinAmericahasbeenpartly
matched byan increaseintheregion'scurrent accountdeficit andpartly
byan increasein thecentralbanks'official reserves.
II. StylizedFacts
somekeyaspectsofthecurrent
In thissection,we quantify episodeof
capitalflowsto LatinAmericaand relatedunderlying macroeconomic
developments.9 To document theregionalaspectsofthisphenomenon,
we aggregateannualdata and focuson LatinAmericaas a whole.10
Monthly dataforindividual areusedtoprovidegreater
countries detail.
We alsoelaborateon theroleofexternaldevelopments, those
especially
in theUnitedStates.
9See also FinancialTimes(1992),Kuczynski (1992),and SalomonBrothers

(1992).
'OForthepurposesofthepresent section,LatinAmericaincludes thesameset
ofcountries includedunderwesternhemisphere in theIMF's WorldEconomic
OutlookandInternational FinancialStatistics.

Table 1. Latin America: Balance of Payments,1973-
Balance on goods, Balance on ca

services,and Balance on account plus
privatetransfersa capital accounta errorsand omi
Billions Percent Billions Percent Billions P
of dollars of GDP of dollars of GDP of dollars o
Year (1) (2) (3) (4) (5)
1973 -4.7 -2.4 - 8.5
1974 -13.5 -5.3 - 13.3
1975 -16.3 -6.1 - - 14.7
1976 -11.8 -3.8 - 16.9
1977 -11.6 -2.7 19.8 4.6 16.4
1978 -19.4 -4.0 30.5 6.2 27.4
1979 -21.7 -3.8 35.0 6.2 32.9
1980 -30.3 -4.3 47.0 6.7 34.0
1981 -43.5 -5.5 59.4 7.4 41.9
1982 -42.2 -5.5 45.1 5.9 23.0
1983 -11.6 -1.7 22.4 3.2 13.6
1984 -3.2 -0.5 15.5 2.3 12.5
1985 -4.4 -0.6 6.7 0.9 5.5
1986 -18.9 -2.6 14.2 1.9 12.3
1987 -12.0 -1.6 14.5 1.9 15.3
1988 -12.4 -1.5 8.2 1.0 4.7
1989 -10.0 -1.1 15.7 1.7 12.1
1990 -8.8 -0.8 24.1 2.3 23.9
1991 -22.3 -2.1 38.1 3.8 39.8
Source: IMF, WorldEconomic Outlook (various issues).
a A minussignindicatesa deficit in thepertinentaccount.Balance on goods, services,and
accountbalance lessofficialtransfers. The latterare treatedin thistable as externalfinancin
bColumn (7) equals the sum of columns(1) and (5). A positiveentryin column (7) indi
reservesby the monetaryauthorities.

CAPITALINFLOWSAND REAL EXCHANGERATES 115
Anatomyof Capital Inflows

Table 1 presentsa breakdownof Latin America'sbalance ofpayments
intothreemain accounts.The capitalinflowsappear as surplusesin the
capital account: about $24 billionin 1990 and about $40 billionin 1991.
A substantialfractionoftheflowshas been channelledto reserves,which
increasedbyabout $33 billionin 1990-91.About 63 percentoftheinflow
in 1990 was matchedby an increasein officialreserves,leavingthe rest
of the inflowto financethe deficitin the currentaccount.Yet, the latter
increased markedlyin 1991, accountingfor 59 percentof the capital
inflow.Consideringthe 1990-91periodas a whole,thenetcapitalinflow
was divided equally between a wideningcurrentaccount deficitand
higherofficialreserves.The formersuggeststhat capital inflowshave
been associatedwithan increasein thegap betweennationalinvestment
and nationalsavings.In countrieslike Chile and Mexico, an important
part of the inflowshas financedincreasesin privateinvestment;yet,in
countrieslike Argentinaand Brazil, there has been a marked rise in
privateconsumption.11 The increasein officialreserves,in turn,indicates
thatthevariousmonetaryauthoritiesmetthecapitalinflowwitha heavy
degree of foreignexchangemarketintervention.
Partoftheincreasedcapitalinflowsrepresentsrepatriation ofprevious
flightcapital, but Latin America is also attractingnew investors.12As
Table 2 reports,an increase in net externalborrowingaccounts for
about 70 percentofthecapitalinflowin 1990-91.The increaseis primar-
ilydue to borrowingby the privatesectorfromforeignprivatebanks.13
Increasedexternalborrowingreflectsthe restorationof access to volun-
tarycapitalmarketfinancingafterthe debt crisis.14 Portfolioinvestment
and foreigndirectinvestmentalso increased. The latteramountedto
about $12 billion,$4 billionof whichresultedfromprivatizations.15
Since therehas been a substantialdegree of centralbank interven-
tion in the face of capital inflows,thereis an importantdegree of co-
" These whichareavailablefromtheauthors,
figures, expressinvestmentand
consumption as sharesofGDP andrelyonpreliminary national
incomeaccounts
datafor1991.
12
On therole of variouspolicymeasuresto reversecapitalflight-suchas
amnesties, capitalaccountliberalization,
andintroduction
offoreign-currency-
denominateddomesticinstruments-seeCollynsand others (1992) and
Mathiesonand Rojas-Suarez(1992).
13 Someofthis increased
borrowing mayrepresenthiddenrepatriation
offlight
capital.
14See,forinstance,
5
El-Erian(1992)andCollynsandothers(1992,chapter
III).
For a comprehensive discussionof thecompositionof theinflows
in the
recentepisodeandhowitcomparesto thatoftheinflows ofthelate1970s,see
Collynsand others(1992).

Table2. LatinAmerica:Itemsin theCapitalAccount,1973-91

(In billionsofU.S. dollars)
Net Non-debt- Asset Errors
external creating transactions and
Year borrowing flows (net)a omissionsa Total
1973 6.0 2.5 - - 8.5
1974 11.1 2.2 - -13.3
1975 11.4 3.3 - - 14.7
1976 14.2 2.7 -- 16.9
1977 19.4 2.8 -2.5 -3.4 16.4
1978 28.0 4.9 -2.5 -3.1 27.4
1979 30.2 7.2 -2.4 -2.1 32.9
1980 43.1 6.8 -3.0 -13.0 34.0
1981 61.0 8.2 -8.9 -17.5 41.9
1982 45.7 7.2 -7.7 -22.1 23.0
1983 18.7 4.6 13.6
-0.9 -8.8
1984 14.1 4.5 12.5
-3.1 -3.0
1985 6.2 6.1 5.5
-5.4 -1.4
1986 11.3 4.3 -1.3
12.3 -1.9
1987 10.0 6.0 -1.2
15.3 0.5
1988 3.8 8.8 -4.3 -3.5 4.7
1989 10.9 6.9 -2.1 -3.6 12.1
1990 28.0 8.6 -12.5 -0.2 23.9
1991 17.3 14.1 6.7 1.7 39.8
Source:Data forwesternhemisphere fromIMF's WorldEconomicOutlook
(variousissues).
aThesetwocategoriesare includedin netexternal andnon-debt-
borrowing
creatingflowsforthe1973-76period.
movementbetweenofficialreservesand capitalinflows.In fact,ifone is

interestedin monthlydevelopments,for which directdata on capital
inflowsare not available, changesin reservesare a reasonableproxyfor
these inflows.Figure2, whichdepictsmonthlydata on officialinterna-
tional reservesfor the countriesin our sample, shows a pronounced
upwardtrendin thestockofofficialreservesstarting fromabout thefirst
half of 1990. In 1991, the year withthe highestcapital inflowsto the
region,theaccumulationofreservesacceleratedas themonetaryauthor-
ities reacted to the inflowsby activelyincreasingtheirpurchases of
foreignassets constituting internationalreserves.16
16
isanexception
Uruguay werenotaccompanied
capitalinflows
tothispattern:
byan increasein reserves.

N
Figure2. TotalReservesMinusGold,January 1992

1988-July
of
(Billions U.S. dollars)
8
Argentina Bolivia 0.26
6-
0.18
4-
2- 0.10
0 i i i n
I . nrL:
I
20 - 10
18 - Brazil Chile
16 - 8
14 -
6
12 -
10 -
8- 4
61 2
1.0
0.8
0.6
0.4
0.2
Jan.90 Jan.91 Jan.92 Jan.88 Jan.89 Jan.90 Jan.91 Jan.92
20 2.8
Mexico -
Peru 2.4
16 -
2.0
12 1.6
1.2
8-
0.8
41 : X 0.4
0.52 - 10
0.44 - 8
6
0.36 - Uruguay 4
0.28 - 2
FinancialStatistics
Source:IMF, International (variousissues).

118 CALVO*LEIDERMAN*REINHART
Real Exchange Rate Appreciation
Figure3 providesevidenceon thebehaviorofrealeffective exchange

rates.17At leasttworegularitiesemergefromthefigure. First,withthe
exception ofBrazil,allcountrieshavebeenexperiencing a realexchange
rateappreciation sinceJanuary 1991.In halfofthecases,theapprecia-
tionbeganbeforeJanuary 1991.Second,evenwithin a smallsampleof
monthly observations,considerableevidencepointstothe behav-
cyclical
ior of real exchangerates.Leadingexamplesof thisphenomenon are
Brazil,Chile,and Uruguay.Althoughsomeofthesecyclescan be at-
tributed to fluctuationsin capitalinflows,theyare also the resultof
othershocks,suchas changesin the termsof tradeand in domestic
monetary, fiscal,and exchangeratepolicies.Combining theevidence
fromFigures2 and 3 indicatesan important degreeof co-movement in
thesevariablesacrosscountries, despitetheirwidedifferencesinpolicies
and institutions.
Rates of ReturnDifferentials
Expectedratesofreturn onavailableassetsplaya keyroleininvestors'

decisionsaboutwhetheror notto movecapitalinternationally. Since
dataforexpectedreturns are notreadilyavailable,anddependon how
onemodelsexpectations, wefirstlookatactualreturns.As showninFig-
ure4, therewasa largeincreaseintheU.S. dollarstockpriceson major
Latin Americanmarketsin 1991.18Argentina's marketexhibitsthe
biggestsingleannual returnof almost 400 percent,whileChile'sand
Mexico'sregisterreturnsof about100percenteach.19The markedin-
creasesinstockmarket priceshaveresulted insimilarrisesintheprices
ofcountryandregionalmarket funds tradedintheUnitedStatesandelse-
where.According totheinvestment bankSalomonBrothers, $850billion
of foreigninvestment enteredBrazil'sstockmarketin the last four
months of1991andabout$600millionenteredtheArgentine market in
1991.20However,as thenumbersindicateand Figure4 confirms, the
17TheIMF indicesoftherealeffective
exchangerateareused;hence,an
is represented
appreciation by anincrease
intheindex.
8The instock 1991wasfollowed
surge prices during bya moderate
declinein
1992.
9Theprice-earnings
ratioinArgentina
increased
from3.1in1990:IVto38.9
in 1991:IV;in Chileitincreased
from8.9 in 1990:IVto 17.4in 1991:IV;andin
Mexico
itmoved
from13.2in1990:IV
to14.6in1991:IV.
Thesefigures
arefrom
Markets
Emerging DataBase,International
Finance
Corporation.
20
See Salomon Brothers(1992).

Figure3. Real Effective

ExchangeRates,January 1992
1988-July
4.4 4.44
Bolivia
4.0- 4.36
3.6 4.28
3.2 - 4.20
Argentina
2.8 I I II 4.12
4.8 - Chile J_ 4.06

4.02
4.6 -
- 3.98
'/v^I
4.4 - - 3.94
Brazil
4.2 - 3.90
4.14 3.94
\ Colombia Ecuador
4.06 - 3.86
3.78
3.98 -
3.70
3.90 - I I 3.62
4.55
Mexico ./ J- 8 S Peru 5.7
4.45 -
4.35 - 5.3
4.25 - /
4.9
4.15 -
4.05 , 4.5
4.3
4.1
3.9
3.7
Source:IMF, Information NoticeSystem(database).

Note: An increasein theindexdenotesrealexchangerateappreciation.

Figure4. StockMarketPerformance, January 1992

1988-August
(Stockpriceindices
in U.S. dollars, 1988
January = 100)
12
10
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
Sources:Standard& Poor's(S&P) Analyst

Handbookand International
Fi-
nanceCorporation, ReviewofEmerging
Quarterly StockMarkets.
Note:The S&P 500indexwasusedfortheUnitedStates.

stockmarketboomsand the attendant highreturns materialized after

capital had begun to flow into the region. It would thus be difficult to
that
argue high differentials on stock market returns were responsible for
attracting thefirst waveofcapital.
Figure5 providesevidenceon thelendingand depositinterest rate
spreads between U.S.-dollar-equivalent domestic interest rates in Latin
American countries andinterest ratesintheUnitedStates.Sinceinsome
countries interest ratesareregulated, andsincecapitalmobility isimper-
fect,spreads across the various countries cannot be comparedin a
straightforward manner. In as 5
addition, Figure highlights, thevariabil-
ity in domestic interest rates differs markedly across countries; as such,
thescales in the figure vary from to with
country country, Argentina and
Peruhaving the broadest ranges and Bolivia and Colombia the narrow-
est.Withthesecaveatsinmind,thedominant impression fromFigure5
isthatofrelatively highinterest ratedifferentials inLatinAmericainthe
1990-91period.It is also evidentfromthefigurethatthepatternof
spreadsvariesconsiderably acrosscountries, an unsurprising resultsince
themonetary authorities in thesecountries havenotreacteduniformly
tothecapitalinflows andsincethetiming ofregulatory changeshasalso
variedconsiderably acrossthesamplecountries. Although therelatively
high differential rate of return on Latin American assets has beenasso-
ciatedwitha markedriseincapitalinflows totheregion,theinflows have
notarbitraged the
away large differentials. In some countries, such as
Argentina, the interest rate differential decreased as
sharply capital
pouredin; in others,suchas Chile,interest ratedifferentials displayed
a lesspronounced responsetotheinflows (see Figure5). As arguedlater
in thispaper,thesedifferent patterns mayreflect cross-country differ-
encesintheauthorities' useofsterilized versusnonsterilized intervention.
In sum,threemainstylized factsemergewithregardto interest rate
differentials. First, there is littleco-movement in domestic interest rates,
and hencein spreads,acrossthecountries in oursample.Second,the
"noise-to-signal ratio"of thedomesticdollarratesvariessubstantially
across countries. As Figure6 illustrates, countries offering thehighest
returns also had the greatest volatilityofreturns.21 Third,despitesizable
the
capitalinflows, positive differentialshave not beenfullyarbitraged
away.The persistence and size of thiswedgebetweendomesticand
foreign ratesalso appearto varymarkedly acrosscountries.
21 An ofthisdiscussion
implication is thatfromtheinvestor's the
perspective
information contentofa dropin U.S. interestratesis different
fromthatofan
equal riseinthedomestic interest
rate-although inbothcasestheinterestrate
wouldchangebythesameamount.
differential

122 CALVO * LEIDERMAN - REINHART
Figure5. InterestRate Spreads,January1988-March1992

(Dollar equivalentof domesticrate less U.S. rate, annual percentagesrates)
Lendingspread ....... Depositspread
800 40
Argentina Bolivia
600 - - 20
400 -
200-
0 ^ [ I\,' - -20
-200 . .. . .40
A breakintheseriesindicatesthespreadwas
inexcessof 1,000percent.
800 150
Brazil Chile
600 - - - 100
400- 50
200 - :- A - \AAAA- C0 »
-100 - , -50
Lendingspreadis definedas thebankrate
less U.S. Treasury
billrate.
40 100
30-
Colombia Ecuador
- - 50
20 -
10- 0- _
-10 -
~~~~~~~~~~~~~~~~~~~0 -s50
-20 -100
1'
U
Lendingspreadis definedas thespreadon
three-month
Treasury bills.
80 -
80 Uruguay
' A - Venezuela 100
100
60 - 50
40 -
20 0
.
~- -50
-20 - '
-40 . ... -100
Sources: IMF, InternationalFinancialStatistics,and variouscentralbank bul-

letins.
Notes: Deposit spreads are based on interestrates on certificates
of deposit;
lendingspreads are based on loan rateschargedby banks less the interestrate
on U.S. commercialpaper.

. _
Figure 6. Risk and Returns
return
Averagemonthly in U.S. dollars
0.040
Argentina
CreditMarkets:LendingRatesof Interest
0.035
0.030
Urluglay
0.025
- Mexico Pe
0.020 Bolivia -
0 Chile
0.015
0 Brazil
0.010
UiiitedStates
0.005 %Colombia
Veniezuela
0
-0.005 Ecuador
-0.010 I I 01 I I I I I I I
0 0.02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 0.18 0.20 0.22
Standarddeviation
in U.S. dollars
return
Averagemonthly
0.05
SelectedStockMarkets 4
Argentina
0
Mexico
0.04 -
Chile
0
0.03 -
Colombia Venezuela Brazil
0
_ _
0.02 -
-_ UiiitedStates
0.01
0 I I I I I I
0.02 0.06 0.10 0.14 0.18 0.22 0.26 0.30
Standarddeviation
FinancialStatistics;variouscentralbank bulletins;
Sources: IMF, International
InternationalFinance Corporation,QuarterlyReviewof EmergingStock Mar-
kets; and Standard& Poor's AnalystHandbook.

Table 3. Latin America: Macroeconomic Indicators,197
Central
Gross govt.
Growthof capital fiscal Commodity Termsof External
ofrealGDP formation Consumptiona balance prices trade debt
(percent (percent (percent Inflation (percent (percent (percent (billions
Year change) ofGDP) of GDP) (percent) of GDP) change) change) of dollars)
1973 8.4 29.3 74.5 32.1 - 47.4 6.5 44.4
1974 6.9 24.4 75.8 37.5 - 20.9 -7.0 58.2
1975 3.1 24.7 77.7 52.0 - -12.5 -7.5 68.6
1976 5.5 23.5 79.6 66.1 - 23.0 12.2 82.0
1977 5.3 25.1 79.0 49.9 -2.2 27.9 8.0 124.6
1978 4.1 24.8 78.6 41.9 -2.0 -12.6 -9.4 154.9
1979 6.1 23.2 79.6 46.5 -0.7 14.0 5.0 187.2
1980 5.3 23.7 79.7 53.7 -0.6 11.8 7.9 229.4
1981 1.0 23.0 79.7 58.2 -3.0 -15.3 -5.2 285.6
1982 -0.9 20.9 80.1 64.6 -4.0 -11.0 -5.0 325.5
1983 -3.2 17.9 81.2 98.6 -3.7 6.8 -2.7 340.2
1984 3.6 17.2 79.0 124.2 -4.1 -0.8 4.2 360.3
1985 3.4 18.4 76.2 128.2 -4.0 -8.3 -5.4 368.2
1986 4.3 18.2 78.9 79.4 -5.2 5.5 -10.2 381.9
1987 2.2 19.9 75.1 117.8 -7.0 -6.8 -5.4 419.1
1988 0.4 20.9 72.7 243.2 -5.8 21.2 -0.6 409.3
1989 1.0 19.6 72.6 434.2 -6.3 -2.3 0.2 408.9
1990 -0.1 19.6 77.0 647.8 -0.3 -7.2 -0.1 422.1
1991 2.9 20.7 - 162.5 -1.0 -5.6 -4.9 440.7
Sources:Data forwesternhemispherefromIMF's WorldEconomic Outlook and Internat
a
This column includesprivateand governmentconsumption.

Other MacroeconomicDevelopments
Selectedmacroeconomic indicators arereported inTable3. Consider

howdevelopments in 1991,theyearwhencapitalinflows grewto about
$40 billion, from
differ those in earlieryears.First, economic growth
revived.Afterthreeyearsofstagnation, realGDP increasedbyalmost
3 percent in1991.However,grosscapitalformation as a percent ofGDP
remainedat about the same level as in the second half of the 1980s,
suggesting a moreefficientutilizationofresources. Atthesametime,the
rateofinflation droppedmarkedly (thoughitnevertheless remainedat
a three-digit levelfortheregion),andcentralgovernment fiscaldeficits
camedownsignificantly.
Thechanging economicconditions inLatinAmericaarealsoreflected
intheregion'sdebtandsolvency indicators.At $441billion,theregion's
externaldebtamountsto 2.6 timesitsexportsof goodsand services.
Although stillhigh,thisratiohasdecreasedmarkedly from the3.5 figure
in1986.SincemostofLatinAmerica's external debttocommercial banks
isstillintermsoffloating rates,thedropinshort-term U.S. interest rates
and the dropin the debt-to-export ratiohavetranslated intoa rapid
declineintheexternal debtserviceratiooverthepasttwoyears.In fact,
thelevelofthedebtserviceratioin1991(32.8percent) is aboutthesame
as thelevelsthatwereobservedbeforethecapitalinflow episodeofthe
late 1970s.
Thesedevelopments represent onlypartofthechanging environment
inLatinAmericaintheearly1990s.In addition, themovetowardpriva-
tizationandderegulation, theintroduction offinancial reforms, andthe
of
restructuringexisting external debt have all contributed to returning
LatinAmericatothelistofviableinvestment locations inworldfinancial
markets.
ExternalFactors
It is difficult
to pointto a singledominant externalfactorthatwould
accountfortherecentcapitalinflows toLatinAmerica,as severalexter-
naldevelopments haveconverged tostimulatesuchflows.First,therehas
beenthesharpdropinU.S. short-term ratesto abouthalftheir
interest
leveltwoyearsago,theirlowestlevelssincetheearly1960s.Byreducing
theexternal debtserviceonfloating-rate thisdeclineinU.S.
obligations,
interest rateshasimproved thesolvency ofLatinAmerican debtors.For
a givenlevelof interestratesin LatinAmerica,thesedevelopments
provideincentives fortherepatriationofcapitalheldintheUnitedStates
and forincreasesin borrowing byLatinAmericanagentsfromcapital

marketsin the United States. Beyond short-term interestrates,returns

fromotherinvestments in theUnitedStateshave decreasedas well,such
as in the real estate market.22
Second, severalexternalfactorsprobablycontributedto the increase
in Latin America'scurrentaccountdeficitand to theneed to financethis
deficitby increasedcapitalinflows.Two such factorsare the continuing
recessionin the United States and in otherindustrializedcountriesand
the continueddeclinein Latin America'stermsof tradethroughout the
past decade-which mainly reflectsa decrease in the of
prices petroleum
and othercommodities.In principle,a decline in a country'stermsof
trade can be expected to resultin a largercurrentaccountdeficit(the
Harberger-Laursen-Metzler effect)and, in the absence of major inter-
ventionby the nationalauthorities,in a largercapital inflowto finance
thisdeficit.However,thechangesin thetermsoftradein 1990-91are too
smallto accountforthesharpincreasein capitalinflows:LatinAmerica's
termsof tradeonlydecreased by 1.2 percentin 1990 and by 5.2 percent
in 1991. This patterncontrastswithearlierepisodes in whichtermsof
tradechangeswere probablythe mainshocksexplainingfluctuations in
the capital account; Diaz Alejandro (1983) documentsthat between
1928/29and 1932/33,therewas an averagedeclineof about 48 percent
in the termsof trade of fiveLatin Americancountries.23 In short,au-
tonomousshocksto international capitalflows seem to playa largerrole
than termsof trade shocks in accountingfor the most recentcapital
inflows.
Third, duringboth of the most recentepisodes of capital inflowsto
Latin America-1978-82 and 1990-91-there were sharpswingsin the
privatecapital accountof the U.S. balance of paymentsin the formof
increasedoutflowsand reducedinflows(Table 4). In fact,theyears1990
and, even more so, 1991 registerthe firstnet capital outflowsfromthe
United States aftereightconsecutiveyears of net inflows!24 That this
Also,therewasa 4 percent decreaseinU.S. corporate whilecorpo-

22
profits,
rateprofitsin otherregions(including LatinAmerica)increased by10 percent
in dollarterms.
23Thecountries are Argentina, Brazil,Colombia,Cuba, andMexico.
24 Some
examples ofthisdevelopment follow.First,therehasbeenanincrease
intheamountofinvestments inforeign bymutualfundsintheUnited
securities
States.As ofMay1992,theassetsofstockfundsthatinvestlargely outsidethe
UnitedStatesstoodat$41.8billion,morethantwicethelevelattheendof1988,
andassetsofglobalfunds havesoaredto$28.5billionfrom just$3billionin1988.
Second,in 1991,thesale offoreign sharesin publicandprivatedealsdoubled,
to a record$9.8billion.Bonddealsrose48 percent to $55.3billion.Third,new
foreign investment in U.S. companies andrealestateplummeted 66 percentin
1991.See TheNewYorkTimes(July5, 1992).
As indicated earlier,
private capitaloutflows
from Japanalsoincreased sharply
in 1991,by$36 billion.

Table4. UnitedStates:BalanceofPayments,
1973-91
Capitalaccount
Current Capital plusneterrors Overall
Year account account andomissions balance
1973 7.07 -9.71 -12.30 -5.23
1974 1.94 -9.25 -10.75 -8.81
1975 18.06 -28.67 -22.71 -4.65
1976 4.18 -25.24 -14.68 -10.50
1977 -14.49 -18.46 -20.55 -35.04
1978 -15.40 -30.63 -18.08 -33.48
1979 0.20 -14.53 9.75 9.95
1980 1:20 -35.91 -10.26 -9.06
1981 7.26 -28.07 -8.50 -1.24
1982 -5.86 28.79 7.89 2.03
1983 -40.18 24.72 36.13 -4.05
1984 -98.99 72.52 99.71 0.75
1985 -122.25 108.18 128.05 5.80
1986 -145.42 95.78 111.64 -33.78
1987 -162.22 98.68 105.36 -56.86
1988 -128.99 101.05 92.72 -36.27
1989 -106.41 104.91 123.34 16.93
1990 -92.16 -4.60 58.90 -33.26
1991 -8.66 -18.20 -21.30 -29.96
Sources:IMF, International
FinancialStatistics
andU.S. Department
ofCom-
merce,Surveyof CurrentBusiness(variousissues).
changeis associatedwithchangesin thecapitalaccountofLatinAmerica

is clear fromTable 5, where it is shown that about 60 percentof the
increasedcapitalinflowsin1991are directlyassociatedwithincreasedpri-
vate capital outflowsfromthe United States to Latin America, as re-
corded in the U.S. BOP accounts.Similarly,the relativelylarge capital
inflowof 1978-81 to Latin America was matchedby increasedprivate
capital outflowsfromthe United States, and the U.S. capital inflow
episode of 1983-89was matchedbyincreasedcapitaloutflowsfromLatin
America.25In otherwords,the data appear to supportthe notionthat
swingsin privatecapital outflowsfromthe United States play a key
25 It is usefulto recallhowsizabletheseinflowsto theUnitedStateswerein

themid-1980s (Table4). Fromnetcapitaloutflowsofabout$20billiona yearin
thelate1970s,theprivate intosurpluses
capitalaccountturned (capitalinflows)
thatpeakedat $128billionin 1985.Theseinflows, whichmainlytooktheform
of increasedborrowing fromabroad,weremostlyused to financehighand
increasing current accountdeficits,whichrosewellabove $100billionin the
secondhalfofthe1980s.

128 CALVO * LEIDERMAN - REINHART
Table5. Changesin CapitalAccounts

Privatecapital
Privatecapital accountof
accountof UnitedStateswith
western hemisphere western
hemisphere
Periodscompared (1) (2)
1978-81against1976-77 17.4 -9.9
1983-89against1978-81 -24.4 30.1
1991against1983-89 30.1 -17.5
Note:Positiveentries
incolumn(1) indicatean increaseinnetprivatecapital
flowingintothewesternhemisphere. A negative incolumn(2) indicates
entry an
increaseinthenetprivatecapitaloutflowfromtheUnitedStatestothewestern
hemisphere.
roleas externalimpulsesaffecting
thesize ofcapitalinflowsintoLatin
America.
A fourthexternal
factorwastheimportant regulatorychangestooccur
in thecapitalmarketsof industrial
countriesin 1990,changesthatre-
ducedthetransactions costsforagentsaccessinginternational capital
markets fromLatinAmericaandotherdeveloping countries.26
Perhaps,
themostsalientchangesweretheapprovalof"Regulation S" and"Rule
144A"intheUnitedStates,whichreducedtransaction andliquidity
costs
facedbydeveloping countriesin approaching markets
capital there.
III. RoleofExternalFactors:Econometric
Analysis
Inthissection,
monthly datafortenLatinAmerican countries
covering
theperiodJanuary 1988to December1991areusedto analyzekeyfea-
turesoftherecentcapitalinflows.
Theanalysis the
beginsbyestablishing
extentofco-movement ofofficial
reserves
andrealexchange ratesamong
thesecountriessincetheyproxyforcapitalflows.We thendevelopand
estimatea modeldesignedto assesstherelativeimportanceofexternal
shocksinthereservesaccumulation andrealexchangerateappreciation.
Co-Movementof Reserves and the Real Exchange Rate
Giventhelackofmonthly data(and,fora number ofcountries

inthe
data)oncapitalinflows,
sample,quarterly weexaminethejointbehavior
ofinternational
reservesand therealexchangerate,twovariablesthat
26 heredrawsheavilyon El-Erian(1992).
Our discussion

havebeencloselyassociated withtherecent inflows. Theprevious section

revealedan important degreeofco-movement in reservesand realex-
changeratesacrosscountries, whichcouldbe interpreted as reflectingthe
effectsofa common external shocktoLatinAmerican countries(Figures
2 and3). Accordingly, a first taskinthissectionis to examinethisissue
quantitativelybyusingprincipal components analysis.Principalcompo-
nentsanalysiscan describetheco-movement in dataseries.27We begin
withtentimeseries,recording reservesforeachcountry, andthencon-
structa smallersetofseries,theprincipal components,explainas much
to
ofthevarianceoftheoriginal seriesas possible.28 The higher thedegree
ofco-movement existing the ten
among original series, the fewer is the
number ofprincipalcomponents needed to explain largeportion the
a of
varianceoftheoriginalseries.If thetenseriesare identical(perfectly
collinear),thefirstprincipal component willexplain100percentofthe
variation oftheoriginal series.Alternatively, ifalltenseriesareperfectly
uncorrelated, it willtake ten principalcomponents to explainall ofthe
varianceintheoriginal series;no advantage would be gainedbylooking
at commonfactors, sincenoneexists.
The procedurebeginsby standardizing the variables,so thateach
serieshasa zeromeananda unitstandard deviation. Thisstandardization
ensures thatallseriesreceiveuniform treatment andthattheconstruction
oftheprincipal components indicesis notinfluenced disproportionately
bytheseriesexhibiting thelargestvariation.
We construct theprincipalcomponents indicesfortheperiodfrom
January 1988toDecember1991.In addition, forcomparative purposes,
twosubperiods are considered:1988-89and thecapitalinflowepisode
of 1990-91.As Figure2 has shownandTable6 confirms, theextentof
co-movement in reserves duringthecapitalinflow of
period 1990-91is
considerable, higher than in the two
preceding years.The first principal
component explains percent thevariation
67 of inreserves, andthesec-
ondprincipal component explainsan additional 13percent ofthevaria-
tion.Accordingly, 80 percent ofthevarianceinthetenreserves seriesis
capturedby two indices,indicating a sizable degree of co-movement.
Moreformally, we testedthenullhypothesis thatthetenreserves series
arelinearly independent and found that this hypothesis could be rejected
at standardsignificance levels.29
27Foran exposition of principal
components analysis,see Dhrymes(1970).
Swoboda(1983),inanapplication thatisclosetooursinspirit,usedthisapproach
toexamineeconomic interdependence acrossdifferent
exchange rateregimes
for
sixoftheGroupofSevencountries.
28Theanalysisthatfollowsuses the logs of reservesand logs of the real
exchangerate.
whicharedistributed
29 The teststatistics, as a X2with45 degreesoffreedom,
and theattendant valuesare presented
probability at thebottomofTable6.

Table6. Establishing
theCo-Movement
inMacroeconomic
Series
1988:1to 1988:1to 1990:1to
1991:12 1989:12 1991:12
rate
Real exchange
CumulativeR2for:
Firstprincipal
component 0.44 0.41 0.58
Secondprincipalcomponent 0.73 0.78 0.79
X2(45 df) ... 302.01 286.31
Probabilityvalue ... (0.00) (0.00)
Reserves
CumulativeR2for:
Firstprincipal
component 0.61 0.48 0.67
Secondprincipalcomponent 0.77 0.69 0.80
X2(45 df) ... 204.97 297.23
Domesticinflation
rate
(12-monthpercentchange)
CumulativeR2for:
Firstprincipal
component 0.37 0.60 0.45
Secondprincipal component 0.57 0.88 0.64
X2 (45 df) ... 475.94 306.40
Note:The cumulativeR2givesthepercentage
ofthevarianceoftheoriginal
seriesexplainedbytheindicated
principal
components.
Applyingthe same procedureto ten data series describingthe real

exchangerateindicatesthatthedegreeofco-movementacrosscountries
in theregionhas also increasedin the recentcapitalinflowepisode. The
fractionof real exchangerate varianceexplainedby the firstprincipal
componentduring1990-91, 58 percent,is substantial,althoughsome-
whatlowerthanforreserves.The firsttwoprincipalcomponentsexplain
a sizable 79 percentof the varianceof the real effectiveexchangerate.
A numberof factors,such as cross-country differences in exchangerate
regimes and in the of
degrees wage and are likelyto ac-
priceflexibility,
countforthelowerdegreeofco-movement observedinthereal exchange
rate when comparedwithreserves.
As fortheincreasedcovariationofreservesand thereal exchangerate
in the recentperiod,it maywell reflectthe effectsof an externalshock
commonto the regionin the past twoyears.Interestingly, whenwe ex-
aminedtheprincipalcomponentsofthedomesticinflation rate,a variable
less obviouslylinkedto externalfactors,we foundthatthe extentof co-

variationamongtheinflationratesofthesetencountrieshaddiminished
ratherthanincreasedin therecentperiod.30
Thecorrelationsbetweenthefirst component
principal ofreservesand
theindividual countryreservesseriestendto confirmthe evidencein
Figure2. The index
regional does quitewellin for
accounting reserve
ineightofthetencountries.
fluctuations Fortherealexchangerate,the
resultsare anticipatedin Figure 3.31
The firstprincipal components (plottedin Figure7) couldbe inter-
as
preted regional exchange rateand reserves indices.Purgedofcountry-
specific idiosyncracies, theycould reflecttheinfluence ofunobservable
external factorscommon totheregionas wellas anycoordinated internal
developments in the region.To explorethe possiblerole of external
factors, Table7 showsthecorrelation betweenthefirst principal compo-
nentsforthereserves seriesandtherealexchangerateseriesand a set
ofvariables fromtheUnitedStates.Thelatterincludes thenominal rates
ofreturn on realestate,stockandbondmarkets, short-term depositand
lendingratesofinterest, and detrended realdisposableincome.
As discussed earlier,itseemsplausibletohypothesize thata fallinU.S.
interest rates,stockmarketreturns, realestatereturns, and economic
activitywould be associatedwith an increase in the flow ofcapitaltoLatin
America,whichwouldat leastbe partlyreflected in an increasein the
regionalindicesforreserves andtherealexchangerate(thelatterindi-
cating a real rate
exchange appreciation). Indeed,mostoftheevidence
on simplepairwisecorrelation coefficientsis inthisdirection (Table7).
Noticethatthecorrelations oftheU.S. variables withtherealexchange
rateindexarelowerthanthoseofthereserves index,although theyare
stillsubstantial.
Havingassessedthedegreeofcross-country co-movement inreserves
and thereal exchangerate,we nextexaminethedynamic interaction
betweenthesetwovariablesin eachcountry. Combining Figures2 and
3 indicatesa patternofco-movement in whichtheincreasein reserves
precedesthe real appreciation in the exchangerate.32 This temporal
patterndiffers fromwhatwouldhaveemergedhad therebeena shock
30Applying a different
methodology, Engleand Issler(1992)findsignificant
co-movement inthepercapitaGDP ofseveralLatinAmerican as these
countries,
countriessharecommontrendsand commoncycles.
31Noticethat,as shownin Figure3, Brazil'srealexchangeratedepreciated
throughmostofthesampleperiodanditsupturn camefairlylate.Thus,itis not
to findthattheregionalexchangerateindex,thefirst
surprising principalcom-
ponent,does poorlyin capturing itsfluctuations.
In effect,
thecorrelation is
Thesedetailsare availableuponrequest.
negative.
32Morande
(1988)notedthispatternofinteraction
forthecaseofChileinthe
previouscapitalinflowepisodeof 1977-82.

132 CALVO *LEIDERMAN * REINHART
Figure 7. FirstPrincipalComponents,January1988-December1991
2.5
2.0
1.5
1.0
0.5
-0.5
-1.0
-1.5
-2.0
Jan.-88 Jul.-88 Jan.-89 Jul.-89 Jan.-90 Jul.-90 Jan.-91 Jul.-91
Notes:An increaseintherealeffective
exchange rateindexdenotesan appre-
ciation.Principal
components indicesare constructed
to havea zeromeanand
unitvariance.
to the externaltermsof trade,or to the real exchangerate,followedby

accommodatingreserveaccumulation.In orderto investigatethisissue
moreformally, we performedGrangercausalitytestsforeach of theten
countriesusingmonthlydata fromJanuary1988to November1991.33On
balance, the resultscharacterizethe recentepisode as one in whichthe
reserveaccumulationpreceded the real exchangerate appreciation.34
33The testsare on thelogarithms

ofthelevelsofthevariables,
and
performed
eachequationincludesa constant
and a timetrend.
34
These resultsare not reportedbut are available upon request.The contem-
poraneousrelationshipbetweenreservesand thereal exchangerate,aboutwhich
Grangercausalitytestsare silent,is exploredin the nextsection.

Table7. Contemporaneous
CorrelationsoftheRegionalVariableswith
SelectedU.S. Indicators,
1988-91
First
principal
First component
principal ofthereal
component exchange
U.S. variables ofreserves rate
Treasurybillrate -0.922 -0.603
ofdeposit
Certificate -0.928 -0.694
Commercial paper -0.926 -0.691
Treasurylongbond -0.696 -0.668
One-month capitalgainin S&P 500 0.001 -0.107
12-month capitalgainin S&P 500 -0.086 0.136
One-month capitalgainin realestatea -0.095 -0.041
12-month capitalgainin realestatea -0.445 -0.707
Deviationsfromtrendin realdisposableincome -0.939 -0.730
Sources:IMF,InternationalFinancial and
Statistics, datafromData Resources
Incorporated.
aMeasuredusingpricesofexisting homes.
the Role of ExternalFactors

Quantifying
In thissection,the analysisproceedsin twostages.First,we construct
indicesof the unobservedexternalfactors(or impulses),whichare then
incorporatedintoa structural vectorautoregression(VAR). Second, we
perform testsof exclusion on theforeignfactorsto determine
restrictions
and we computevariancedecompositionsto
theirstatisticalsignificance,
quantifytheirrelativeimportancein accountingforforecasterrorvari-
ance of reservesand real exchange rates. Impulse response functions
show how reservesand real exchangerates react to an externalshock.
In modelingthe externalimpulses,one could considera whole vector
ofvariablesthatcould affectLatinAmericaneconomies.Here we optfor
an unobservedindex model, wherethe constructedindex is correlated
withthe observed time series for the United States, whichappear in
Table 7. Specifically,we constructand use thefirstand second principal
componentsof these series. Figure 8 illustrateshow closely the first
principalcomponentcapturesthejointmovementof thevariousinterest
rates and economic activityin the United States. The second principal

Figure8. ExternalVariables, 1992

1988-October
January
Jan.-88 Jan.-89 Jan.-90 Jan.-91 Jan.-92 Jan.-88 Jan.-89 Jan.-90 Jan.-91 Jan.-92
11
10
3
Jan.-88 Jan.-89 Jan.-90 Jan.-91 Jan.-92 Jan.-88 Jan.-89 Jan.-90 Jan.-91 Jan.-92
Sources:BoardofGovernorsoftheFederalReserveSystem,U.S. Department
ofCommerce, and theauthors.
Note:Principal
componentsindicesareconstructedto havea zeromeanand
unitvariance.
componentcaptures swingsin returnson the equity and real estate

markets.Having a measureof externalimpulses,we thenembed them
in a structuralVAR. DefiningPCI, and PC2, as the firstand second
principalcomponentsof the U.S. variables and denotingthe logs of
reservesand thereal exchangeratebyRES, and REXt, respectively,
the
reducedformof the systemis givenby

PClt = a1i+ y,t + PliPC1,-i + PiiPC2t-i + uPC,

i=l i=l
n n
PC2, = a2 + Y2t + > B2iPClt-i + PiPC2t-i + uPC2,

i=1 i=l
n n
RESt = t3 + y3t + p3i,PC1t-i + ;BiPC2,t-i

i= 1 i=l
n n
+ E + + RES,
83iRESt-i 83 REXt-
i1 i =l
n n
REXt = c04+ Y4t + P4iPCt_i + 4i PC2t i

i=1 i=1
n n
+ E 84iRESt,i + 8iREXt + REX. (1)
i=1 i=l
As equation (1) illustrates,we allow fordynamicinteractionbetween

the foreignfactorsbut impose temporalexogeneityon themby not in-
cludinglaggedvalues of the endogenousvariables(reservesand the real
exchange rate) in theirrespectiveequations (81i = 82i = i =i 82 = 0).
Hence, we imposestructure on thetemporalrelationships betweenthese
variables.35Each equation in the systemincludesa constantand a time
trend.Since the numberof lags includedin the righthand side of each
equationcould affectthetests,and giventhatwe had no strongpriorson
thisissue,we used theAkaike and Schwarzcriteriato selectamongone-,
three-,six-, nine-, and 12-monthlag profiles.36 These criteria,unless
otherwisenoted, yieldedthreelags as optimal.
The reduced-form residuals,the u,, depend on the structuralerrors,
denotede,, and the contemporaneousrelationshipsamongthe endoge-
nous variables,specificallyu, = e,A. So next,we considerthe structure
of the matrixA, which describes the contemporaneousrelationships
amongthe variables.In the generalcase, a causal orderingamountsto
assumingthatthe endogenousvariablesenterthe systemin a triangular
form,withthe firstequation containingone endogenousvariable, the
second two variables,and so on, givinga specificformto the A matrix.
35 Ourprocedure is similarto theDYMIMIC modelsassociatedwithWatson

and Engle (1983) and Stockand Watson(1989). One keydifference in the
approachesis thatherewe adopta two-step procedurebyfirst
constructing the
unobserved factorindex(indices)and thenincorporating thatfactor(s)in a
dynamic model.
36Forsimulation evidenceon the efficacy see Liitkepohl
of thesecriteria,
(1985).

Instead,we followthemethodology ofBernanke(1986)andBlanchard

(1989): a priori(structural)restrictions
are imposedon theidentifying
matrix.Specifically,sincetheforeign factorsare presumedexogenous,
we do notallowforfeedbackfromtheshocksto thedomestic variables
to thereduced-form errorofthefirst andsecondprincipalcomponents
oftheforeign variables.In addition,we imposetherestrictionthatthe
principalcomponents indicesareorthogonal so that
byconstruction, they
dependon theirownshocks,as in equations(2) and (3),
PC,l = epc, (2)
PC2, = ePC2, (3)
whilereservesare affected
bythestructural
shocksto theforeign
vari-
ablesand bya shockto reservesthemselves,
RES, = a31PCIt + a32PC2, + et , (4)
REX, = a4 PC,l + a42PC2, + a43RES, + e .E (5)
The realexchangerateis allowedto respondto all oftheshocks.37
Afterthesystem is estimated usingmonthly datafromJanuary 1988
to November1991,we testforthesignificance of theforeign factors.
Table8 summarizestheresults ofthetestsforexclusionrestrictions,tests
thatinvolvethetemporal Thenullhypothesis
relationships. beingtested
variablesdo notaffect
is thattheforeign reserves andtherealexchange
rate.The highX2statistics and low probability valuesindicatethatin
eightofthetencountries, one canrejectthenullhypothesis at a 75 per-
centlevelofconfidence orhigher.38Only inhalfof the samplecountries
is thereany evidenceof a significant contemporaneous relationship
betweentheforeign factors and reservesor therealexchangerate.
AlthoughTable8 provides evidenceononlythestatisticalsignificance
of therelationshipsamong variables,it is also usefulto assessthe
the
relative oftheforeign
importance impulses.Forthispurpose, weexamine
variancedecompositions andtheimpulseresponses oftherealexchange
rateand official
reserves.Twoobservations are worthnotingfromthe
resultsof thevariancedecompositions of real exchangerateforecast
errorspresentedin Table 9. First,formostcountries, foreign factors
accountfora sizablefraction 50
(about percent) ofthe monthly forecast
37Alternative
orderingsareexplored. imposesthattherebe no
One alternative
contemporaneous betweenreservesand the real exchangerate,
relationship
whileanothertreatsreservesas themost"endogenous"variableinthesystem.
The resultsdo notdiffer fromthosepresented
appreciably here.
38EvidencesuggestingtheimportanceofU.S. economic developments on the
LatinAmericanbusinesscycleis presentedin Engleand Issler(1992).

Table8. TestsfortheSignificance 1988-91

ofForeignFactors,
Testforexclusion
restrictions
Chi-squared Contemporaneous relationships
Country statistic a31 a32 a41 a42
Argentina 14.981 0.091 -0.451 -0.225 -0.140

(0.242) (0.243) (0.405)
Bolivia 16.167 -0.092 -0.533 -0.011 -0.041
(0.184) (0.170) (0.045) (0.030)
Brazil 23.224 -0.045 0.481 0.043 0.323
(0.026) (0.011) (0.327)
Chile 29.527 -0.031 -0.246 -0.018 0.545
(0.003) (0.041) (0.026) (0.152)
Colombiaa 31.548 -0.014 -0.048 0.009 0.024
(0.002) (0.157) (0.176)
Ecuador 17.285 -0.230 0.668 -0.070 1.359
(0.139) (0.139) (0.082) (0.376)
Mexico 23.203 -0.136 -0.324 -0.056 -0.063
(0.026) (0.216) ... (0.627)
Peru 25.058 0.121 0.150 0.022 0.203
(0.015) (0.061) (0.017) (0.128)
Uruguay 11.275 -0.042 0.197 -0.050 0.076
(0.505) (0.042) (0.012) (0.153)
Venezuela 9.342 -0.045 -0.280 0.003 0.743
(0.673) (0.266) . . . (0.054) ·. .
a
totheAkaikeandSchwarz
According theoptimallaglength
criteria, wassix
months.
error variance in the real exchange rate. Second, a patternappears

among the countriesconsidered. Foreign factorsexplain the greatest
share of the varianceof the real exchangerate in countriesthatexperi-
enced no major changesin domesticpoliciesin theperiodunderconsid-
eration,1988-91: Bolivia, Colombia, Chile, and Ecuador implemented
theirstabilizationprogramswell before our sample started.39Foreign
factorsexplainthe least forArgentina,Brazil, Mexico, and Venezuela,
all countrieswhere significantchanges in domesticpolicy took place
duringthe sample period.4
Foreignfactorsalso accountfora sizable fractionoftheforecasterror
variancein monthlyreservesin mostof the countriesconsidered,as is
clearfromthevariancedecompositionspresentedinTable 10. It turnsout
39 Bolivia's
program beganinAugust1985;Colombiahadprograms in1985-86;
Chile'sstabilizationdatesto theTablitaprogram of 1978.
40Argentina has had threestabilization
plansduringtheperiodconsidered;
Brazilhashadfour.TheMexicanplanbeganinDecember1987andhascontin-
uedthroughout theperiod.Venezuelafloateditsexchange rateinJanuary
1989.

Table 9. Decompositionof Variance:Real ExchangeRate
Real
Standard Foreign exchange
Country Months error factor Reserves rate
Argentina 1 0.706 36.331 3.096 60.573
6 0.917 28.141 12.881 58.978
12 0.949 30.350 12.772 56.878
24 0.974 33.668 12.185 54.146
Bolivia 1 0.059 50.275 0.012 49.713
6 0.128 57.185 2.245 40.570
12 0.134 57.732 2.126 40.142
24 0.139 61.239 1.958 36.803
Brazil 1 0.629 50.796 0.000 49.204
6 1.253 48.370 0.529 51.101
12 1.414 48.600 0.546 50.855
24 1.477 49.166 0.547 50.288
Chile 1 0.292 51.208 0.024 48.768
6 0.461 53.343 0.022 46.635
12 0.468 53.395 0.027 46.578
24 0.468 53.400 0.028 46.572
Colombia 1 0.344 51.697 0.013 48.290
6 0.715 53.234 0.064 46.703
12 0.797 53.250 0.052 46.697
24 0.827 53.495 0.048 46.456
Ecuador 1 0.728 50.747 0.006 49.247
6 1.125 50.861 0.013 49.126
12 1.131 50.952 0.013 49.035
24 1.133 51.093 0.013 48.894
Mexico 1 0.609 47.346 0.142 52.512
6 1.163 46.439 0.231 53.330
12 1.242 46.342 0.249 53.409
24 1.252 46.442 0.250 53.308
Peru 1 0.224 45.589 0.512 53.898
6 0.302 42.408 3.065 54.527
12 0.339 47.796 3.694 48.510
24 0.373 55.599 3.313 41.088
Uruguay 1 0.293 50.547 0.008 49.445
6 0.563 51.202 0.059 48.739
12 0.578 51.074 0.099 48.827
24 0.581 51.229 0.100 48.671
Venezuela 1 0.246 49.910 0.006 50.083
6 0.347 47.950 1.730 50.320
12 0.372 48.748 2.503 48.749
24 0.383 49.985 2.922 47.092

Table 10. Decomposition

of Variance:Official
Reserves
Real
Standard Foreign exchange
Country Months error factor Reserves rate
Argentina 1 0.457 46.939 53.061 0.000
6 0.917 28.141 12.881 58.978
12 0.965 23.908 48.220 27.873
24 1.005 29.242 44.649 26.109
Bolivia 1 0.235 3.583 96.417 0.000
6 0.513 38.860 37.467 23.673
12 0.569 45.647 30.533 23.820
24 0.570 45.794 30.393 23.813
Brazil 1 0.219 50.421 49.579 0.000
6 0.504 51.428 11.183 37.389
12 0.508 51.806 11.053 37.140
24 0.511 52.482 10.893 36.625
Chile 1 0.064 26.316 73.684 0.000
6 0.317 52.475 6.984 40.541
12 0.514 54.327 2.780 42.893
24 0.559 54.621 2.353 43.026
Colombia 1 0.300 49.594 50.406 0.000
6 0.399 48.426 34.939 16.635
12 0.433 51.639 29.657 18.704
24 0.464 56.270 25.818 17.912
Ecuador 1 0.214 21.531 78.469 0.000
6 0.577 53.184 13.929 32.886
12 0.643 54.415 11.242 34.343
24 0.668 57.760 10.413 31.827
Mexico 1 0.416 43.950 56.050 0.000
6 1.753 43.856 4.498 51.646
12 2.176 46.022 3.041 50.936
24 2.264 48.266 2.822 48.912
Peru 1 0.090 15.758 84.242 0.000
6 0.447 43.682 13.199 43.119
12 0.539 49.176 10.681 40.143
24 0.620 58.030 8.645 33.325
Uruguay 1 0.066 24.936 75.064 0.000
6 0.222 51.478 10.499 38.023
12 0.287 52.592 6.304 41.104
24 0.303 54.672 5.688 39.640
Venezuela 1 0.092 21.038 78.962 0.000
6 0.267 31.511 24.542 43.947
12 0.301 29.796 25.532 44.672
24 0.323 30.139 25.209 44.652

thattheexplanatory poweroftheforeign factorsis leastforArgentina

and Venezuela and most forChile,Colombia, Ecuador.
and
Last,we turn impulseresponsefunctions.
to Figures9 and 10 depict
forthetencountries inoursample responseofreserves
the andthereal
exchangerateto a one-standard-deviation shockto thefirstprincipal
component of theforeign variables.As indicatedearlier,and as illus-
tratedbyFigure8, a positiveshockto thefirst principal component of
foreign variablescouldbe interpreted as an increaseinshort-term U.S.
interest rates.Ifthisshockis associatedwitha decreasedcapitaloutflow
fromtheUnitedStates,thenit couldbe associatedwitha permanent
decreasein reservesand a real exchangeratedepreciation in Latin
America.41 For mostcountries, evidencein the figuressupportsthis
hypothesized pattern.Thereare exceptions, however. In particular,re-
servesriseinBrazilandUruguay inresponseto theshock,andEcuador
experiences a sustainedrealappreciation.
Furthermore, theresponsepattern mostcommoninFigure9 (forAr-
gentina, Colombia,Ecuador,Mexico,andPeru)is oneinwhichreserves
declineas capitalflowsout.Whencapitalceasestoleave,reserves stabi-
lizeat a lowerlevel.In Figure10,themostcommonresponseofthereal
exchange ratetoa positive shocktothefirst foreignprincipal component
(forArgentina, Bolivia,Chile,Colombia,Mexico,Uruguay, and Ven-
ezuela) is a real This
permanent depreciation.42 finding confirms that,in
mostof the cases considered,an increasein rates
interest abroad induces
a capitaloutflow from thesecountries.Reversing theexercise tofitrecent
developments, theevidencefromtheimpulseresponses indicates thata
declinein U.S. interest rateswould,all else beingequal, generatean
accumulation ofofficial
reserves andanappreciation oftherealexchange
ratein mostofthecountries, although puzzlingexceptions remain.
IV. PolicyImplications
The foregoingempiricalanalysissuggeststhat externalfactorshave

played a role in recentdevelopmentsin Latin America. These capital
flows,in turn,have contributedto the accumulationof foreignreserves
41 Had weconsidered,insteadoflevels,thechangeinreserves
(a flow)andthe
rateofchangeoftheexchangerate,theimpactoftheshockwouldbe expected
to die out.
42The depreciation
is sometimes followedbya short-lived as in
appreciation,
thecasesofArgentina, Bolivia,Chile,Mexico,andUruguay.

.... .......
Figure9. Responseof Official

Reservesto a One-Standard-Deviation
Shockin
theFirstForeignFactor
O.Cmb
O,
- 0.08
Argentina Bolivia
)4 -
O.C 0.04
0 0
-O.CI4- -0.04
18 .I4 I,
-O.C I I I I I I o I I I I
-0.08
r
0 2 4 6 8 10 12 14 16 1820 2224 0 2 4 6 8 10 12 14 16 1820 22 24
Numberofmonths Numberofmonths
0.0O 0.08
Brazil Chile
0.0,4- 0.04
0 0
-0.04- -0.04
-0.08- I I I I I i i i i
. I i
. i
-0.08
. . . . .
0 2 4 6 8 10 12 14 16 18 20 22 24 0 2 4 6 8 10 12 14 16 1820 2224
- 0.08
Colombia Ecuador
-
- 0.04
U) 0
-0.04- _-I~ ~-
\I~ -0.04
-0.08- . . . . . I I I, I i I I I I I I I I I -0.08
0 2 4 6 8 10 12 14 16 1820 22 24 0 2 4 6 8 10 12 14 16 18 224
0.0.o 0.08
O4 ~- Mexico Peru
0.014-
0.04
0
-0.04 - 0
-0.0)8- -0.04
-0.12 - -0.08
-0.1u . . . _ I I I I I I I I I I I I
0 2 4 6 8 10 12 14 16 18 20 22 24 0 2 4 6 8 10 12 14 16 18 20 22 24
0.08 - 0.08
Uruguay Venezuela
0.04 - 0.04
Iu f -,AI _ (\
,
-0.04 - -0.04
-0.08 -0.08 -
' '
0 2 4 6 8 10 12 14 16 1820 22 24 '0 2 4 6 8 10 1 1161820 22 24

Figure10. Responseof theReal ExchangeRatetoa One-Standard-Deviation

in theFirstForeignFactor
0.0ns-
On
Argentina Bolivia 0.08

0.014- 0.04
0
-0.04 -0.04
-0.0)8- . . . . . .
-0.08
"
0 2 4 6 8 10 12 14 16 18 20 2224 0 2 4 6 8 10 12 14 16 1820 2224

0.018- 0.08
Brazil Chile
0.0 0.04
)4- 0
-0.0)4- -0.04
-0.0)8- -0.08
0 2 4 6 8 10 12 14 16 1820 2224 0 2 4 6 8 10 12 14 16 1820 2224
0.0 Colombia ~~~~~~-~-

Ecuador 0.08
0.014- - 0.04
0 0
-0.04- - -0.04
-0.0'8- - -0.08
0 2 4 6 8 10 12 14 16 1820 2224 0 2 4 6 8 10 12 14 16 1820 2224
0.0}8- Mexico Peru - 0.08

0.04- - 0.04
0 0
-0.04- _ \ Z~~~~- --0.04
-0.08- - -0.08
0 2 4 6 8 10 12 14 16 1820 2224 0 2 4 6 8 10 12 14 16 18 20 22 24
0.08 - Uruguay
-
Venezuela - 0.08
0.04 - - 0.04
0 .,.---
0'
-0.04- - -0.04
-0.08- I I. I I I i I I I I I "i 11012 16' 0--0.08
0 2 4 6 8 10 12 14 16 1820 2224 02 10 1 4 1 22 1820 24

andtheappreciation ofrealexchangerates.43 Usingtheseobservations

as background andtaking intoaccountthepossibility thatexternal factors
could reversetheircourseand resultin capitaloutflows fromLatin
America,we turnto thenextrelevant setofissues,concerning theform
and timing of appropriate to
policyresponses capital flows.
Giventhatthe1980swerea periodofcapitalshortage forLatinAmer-
ica, itfollows that the first questionwhen discussing policyishowshould
policymakers respond to the recent inflows. Several countries in the
are
region concluding successful negotiations with their creditors and
effectively to
coming grips with their fiscal imbalances. Thus, at what
pointdo capitalflows-intocountries likeChileandMexico,whichhave
financed increasesin privateinvestment-become undesirable?
Therearethreetypesofconcerns thatpolicymakers tendtovoiceabout
capitalinflows: (1) sincecapitalinflows aretypically associatedwithreal
exchangerateappreciation andwithincreasedexchangeratevolatility,
theymayadversely affect theexportsector;(2) capitalinflows-particu-
larlywhenmassive-maynotbe properly intermediated andmaythere-
forelead to a misallocation ofresources; and (3) capitalinflows-espe-
ciallythe"hotmoney"variety-may be reversed onshortnotice,possibly
leading to a domestic financialcrisis.These concerns arenotnew.Indeed,
the depthof the debtcrisisin the 1980scertainly contributed to the
magnitude and sudden reversal of international capital flows.The re-
mainderofthissectionexaminesthefoundations oftheseconcerns and
theirpolicyimplications.44
Evidently thedevelopment oftheexport sectorhaslaidthefoundations
fortechnological advancement and economicgrowthin mostLatin
American countries. Moreover, inhighly indebted countries, thebehav-
iorofexports hasbeenan important indicator ofcreditworthiness. Thus,
changesinexports associated withcapitalinflows mayhaveeconomywide
effects,andhysteresis effects,thatarenotfully internalizedbytheprivate
sector-thusproviding a rationaleforpolicyintervention.
In turn,improper intermediation couldbe theresultof speculative
"bubbles,"improperly priced(explicitor implicit)government insur-
ance, lack of policycredibility, marketfailure(suchas externalities,
economiesofscale,andnominalwageorpricerigidity), orsomecombi-
43 In termsofeconomicagentsinLatinAmerica, itis alsopossibletointerpret
thesedevelopments ina portfolio
as originating shift
awayfromforeign (dollar-
denominated) financialandphysicalassetstowarddomestic assets.Fora model
in whichsucha portfolio shiftleads to a temporary appreciation of thereal
exchange rateandtotheaccumulation ofreserves
bythecentral bank,see Calvo
(1983).
44Fora discussionoftheseissuesfrom theperspectiveofChileanmonetary and
exchangeratepolicies,see Zahler(1992).

nationof the above. Althoughthebubbleshypothesisis a highlyappeal-

ingone in policycircles,45 it does not immediatelyfollowthata bubbles
equilibrium(leaving aside its empiricalfoundations)callsforgovernment
intervention. A clear case forintervention could be made ifthe govern-
menthad betterinformation thanprivateagentsand could thusprevent
the creationof a speculativebubble. This propositionis doubtful,how-
ever. Hence, intervention could be ineffective and even counterproduc-
tive. Another case for intervention is when the speculativebubble is
drivenbytheexpectationthatgovernment willbail out speculatorswhen
thebubble bursts.Because thesebubblesare associatedwithimproperly
pricedinsuranceand a lack of policycredibility, theyare notpure bub-
bles. Optimalpolicyto preventthistypeofbubblecould simplymean the
settingup of appropriatemechanismsto preventgovernment frombail-
ing out speculators.It maybe optimalto make a crediblecommitment
thatgovernment willnot intervene if the bubble bursts.
In practice,however,governments maybe unable to make such com-
mitmentscredible,especiallywhen theyinvolvethe possibilityof bank
failures.As recentexperiencein the United States and Latin America
shows,itmaynotbe possibleto statecrediblythatbank depositsare not
fullyguaranteedbythegovernment ifbanksrunintofinancialdifficulties.
As a result,banks mayend up receivingfreedepositinsurance.46 Thus,
a naturalproposal is to requirebanks to join a mandatorydeposit in-
surancescheme.Such a scheme,however,mustbe highlysophisticated-
indeed,muchmoresophisticatedthanthoseprevailingin some industri-
alized countries.For example, such a scheme would have to take into
account the probabilityof a massive withdrawalof fundsif external
conditionsreverted.Consequently,in the short run it may be more
practicalsimplyto precludebanksfromintermediating muchof thenew
capital inflow by increasingrequired reserve ratios. Regulationscould
also make banks less vulnerableto speculativebubblesin othermarkets
(like equityand real estate markets)thatare the by-product of massive
capitalinflows.In particular,bylimiting theinvestments ofbanksinthese
markets,the bankingsystemwould be betterinsulatedwhenthe bubble
bursts.47
opinionis dividedon thisissue(see Stiglitz

45Professional (1990)).
4 Actually,unlessbanksareforcedto payfordepositinsurance, freemarket
forcesmaynotgeneratea privately baseddepositinsurancescheme.Thishap-
pensbecausetheexpectation offreeinsurance ifbanksrunintofinancial
diffi-
cultiesmaymakeanyprivately baseddepositinsurance schemeunprofitable.
47 The above
pointaboutmarket willnotbe discussed
failure here.An impor-
tantexample,however, is associatedwiththeexportsector,which,as shown
in therestoftheeconomy.
before,is likelyto produceexternalities

As pointedout above,a thirdrationaleforpolicymakers' concerns

aboutcapitalinflows isbasedonthefearofa quickreversal oftheinflows.
Sucha reversal mayexacerbate thenegative effectsofimproper interme-
or
diation, actually give riseto improper intermediation. In an environ-
mentcharacterized byasymmetric information, a sudden capitaloutflow
may lead lenders to conclude that the country has suffered a negative
supplyshock, even when no shock has occurred. The sudden capital
inturn,
flight, maybringaboutthediscontinuation ofefficientinvestment
projects.Thus,ifstart-up costsfortheseprojectsaresignificant (because
ofincreasing returnstoscaleormarket failure,usingtwoexamples), their
discontinuation provokesa deadweight loss,which,fromthelenders'
pointofview,maybe observationally equivalent to an exogenousnega-
tivesupplyshock.Consequently, theexpectations thatgaverisetothese
detrimental capitaloutflows maybecomerational. Thus,thisexampleof
a self-fulfilling
prophecy givesanotherreasonforintervention. The ex-
amplealso showsthatpolicyintervention maybe calledforevenwhen
thefundsare channelled to investment projects.
Based on theforegoing discussion, we considerfiveinterventionist
policies:(1) a taxoncapitalimports; (2) tradepolicy;(3) fiscaltightening;
(4) sterilizedand nonsterilizedintervention bythecentralbank;and(5)
a risein themarginal reserverequirements on bankdepositsand more
regulated bank investments in equity and realestatemarkets.
Taxeson short-term borrowing abroad have been usedinsomecoun-
tries-Israelin 1978and Chilein 1991.Although thispolicyis effective
in theshortrun,experience suggests thattheprivatesectoris quickin
finding to
ways dodge these taxes,byover-andunderinvoicing imports
and exportsand byincreasedrelianceon parallelfinancial and foreign
exchangemarkets.
Tradepolicymeasurescanhelptoinsulatetheexportsectorfromreal
exchangerateappreciation. One possibility inthisarea is to payhigher
exportsubsidies.However,thispolicydistorts resourceallocationbe-
tweenexportableand importable goods,and thefiscalcostcouldbe
substantial. Forexample,to offset a 20 percent overvaluation ofthereal
exchangeratethrough exportsubsidieswouldincreasefiscalexpendi-
turesbyabout4 percentofGDP, giventhattheaverageexport-to-GDP
ratioforLatinAmericahoversaround20 percent.Alternatively, the
authorities couldincreasebothexportsubsidiesandimport tariffsinthe
same proportion-toavoidcreatingfurther relativediscrepancies be-
tweeninternaland externaltermsof trade-and announcethatthese
subsidies andtariffs willbephasedoutinthefuture. Indeed,iftheprivate
sectorperceives thesemeasuresas transitory, agentsarelikelyto substi-
tutefutureexpenditure forpresentexpenditure, thuscoolingoffthe

146 CALVO*LEIDERMAN*REINHART
economyandattenuating therealexchange rateappreciation. Thefiscal

costofthispackageneednotbe large,particularly ifthetradedeficit is
small.Furthermore, staticdistortions arenotincreased, sincesuchtrade
policydoes notchangeinitialrelativepricedistortions betweenexports
andimports. However, thispolicycanbe criticized ontwogrounds. First,
itseffectiveness depends on theprivate sector believing that those subsi-
diesandtariffs willbe phasedout;otherwise, individuals willdo littleto
lowerpresent expenditure. Thus, the effectiveness of the policydepends
verystrongly on credibility-both thecredibility ofpolicyandthecred-
of priceforecasts.
ibility Second,thispolicydeviatesfromthepresent
globaltrend toward commercial liberalization andfreetradeagreements.
Anotherpolicyreactionto greatercapitalinflows is to tighten fiscal
policythrough higher taxes or through lower government expenditure.
Thispolicy,althoughnotlikelyto stopthecapitalinflow, maylower
aggregate demand and curb theinflationary impact capitalinflows.48
of
Towardthisend,highertaxesmaybe lesseffective thanlowergovern-
mentexpenditure. Oftenwhencreditis widelyavailable-as whenthe
country is subjectto massivecapitalinflows-individuals' expenditures
canbe largely independent oftheirtaxliability. Thisis especially trueif
higher taxesareexpectedtobe transitory-a somewhat plausibleexpec-
tationsincethe highertaxeswouldbe associatedwiththe transitory
capitalinflows. Bycontrast, lowergovernment expenditure-particularly
whendirectedto thepurchaseofnontraded goodsand services-hasa
directimpacton aggregate demand,whichis unlikely to be offsetbyan
expansionofprivatesectordemand.However,a contraction ofgovern-
mentexpenditure is alwaysa sensitive politicalissue.Overall,itis hard
to finda strong case foradjusting fiscalpolicy-which is usuallyseton
thebasisofmedium- orlong-term considerations-in responseto short-
termfluctuations in international capital flows.However, iftheauthor-
itiesplana tightening ofthefiscalstance,thepresenceofcapitalinflows
maycall forearlieractionin thisrespect.
Sterilized intervention has beenthemostpopularpolicyresponseto
thepresent episode capitalinflow
of inLatinAmerica.Leadingexamples
ofthispolicyare providedbyChilein 1990-91and Colombiain 1991.
Withcapitalinflows, thistypeof intervention amountsto the sale of
government bybonds the central bank in exchange forforeign currencies
andsecurities.49 Thispolicydoesnotnecessarily stopprivate agentsfrom
engaging in international loan transactions, if
but, successful, it does
48In addition,to theextentthatitreducesthegovernment's
need to issue debt,
a tighterfiscalstanceis also likelyto lowerdomestic
interest
rates.
49Fora moredetaileddiscussionof the role of centralbankintervention
or nonsterilized),
(sterilized see Mussa(1988)and Obstfeld(1991).

insulate the stock of domesticmoneyfromvariationsassociated with

capital mobility.If effective,sterilizationtends to increase domestic
nominaland real interestrates,lower aggregatedemand, and mitigate
the appreciationof the real exchangerate.50
There are, however,twomaindifficulties withsterilizedintervention.
First,sterilization leads to an increase in the differentialbetween the
interestrate on domesticgovernmentdebt and internationalreserves,
thuscreatinga fiscal(or quasi-fiscal)deficit.Second, bypreventing a fall
in this differential, sterilizationtends to perpetuatethe capital inflow,
thus exacerbatingany problemscaused by the inflow.The impact of
sterilizationon the interestdifferential can be seen in Figure 11, which
compares cases of sterilizationin Chile and Colombia againsta case of
in
nonsterilization Argentina. It is seen that in therecentcapitalinflows
episode, thedomesticinterestrateexhibitsa muchsmallerdecline(or an
actual increase) in sterilizing versusnonsterilizing countries.The recent
experienceof Chile and Colombia indicatesthatsterilizedintervention
has not reducedcapitalinflows,yettheincreasein thefiscaldeficitmay
be quite substantial.For example,Rodriguez(1991) estimatesthe fiscal
burden of sterilizedinterventionin Colombia during 1991 at about
0.5 percentof GDP. Consequently,serious doubts can be cast on the
desirabilityof sterilizedintervention whencountriesare stillattempting
to solvedomesticdebtdifficulties and whenpublicsectorbudgetsrequire
furthertrimming.51
Alternatively, the centralbank could opt fornonsterilizedinterven-
tion,wherebythe centralbank purchasesthe foreignexchangebrought
inbythecapitalinflowinexchangefordomesticmoney-as undera fixed
exchangerate. This policycan help avoid nominalexchangerate appre-
ciationand is likelyto narrowthedomestic-foreign interestratedifferen-
it is to
tial;however, likely generate an increase in thedomesticmonetary
base beyondthe centralbank's target.The latterdevelopment,in turn,
could fuel inflationary pressuresand contributeto real exchange rate
appreciation. It is at thispointthatcredibility regardinga fixednominal
50A necessaryconditionfortheseoutcomes,and forthe effectiveness of
sterilizedintervention,is thatdomesticandforeign bondsareimperfect substi-
tutesinagents'portfolios. Casualobservation thatthisisthecaseinLatin
suggests
America.CumbyandObstfeld (1983)producedeconometric forMexico
results
in the1970sin support ofimperfect betweenpeso-denominated
substitutability
assetsandforeign assets.Forindustrial
countries,Obstfeld(1991)concludesthat
sterilizedintervention is a weakinstrument of exchangeratepolicyand that
monetary and fiscalpolicies,and notinterventionperse, havebeenthemain
policydeterminants ofexchangeratesin recentyears.
51 See also Calvo (1991),who provides an examplein whichsocialwelfare
alwaysdeclineswithsterilization andin whichtheeffectiveness ofsterilization
relieson itsworsening thecredibilityofa stabilization
program.

Figure 11. DomesticLendingRates in U.S. Dollars

(Quarterlyand monthlyaverages)
Argentina
I :11 IVY :11 March1992
Chile
1 U: 1 I 9U:II
16-
Colombia
12-
1990:11 1991:1 1991:11 March1992
Sources: IMF, InternationalFinancial Statistics,and various central bank

bulletins.
exchangeratecomesintoplay.In thisconnection,floatingexchangerates
have an advantage,because therequiredreal exchangerateappreciation
does not necessarilymean thatinflationmustaccelerate. Furthermore,
floatingratesallow the domesticcentralbank to operate as a "lenderof
last resort."By contrast,underfixedratesand fractional-reserve bank-
ing,preventing financial
liquidity-type crises-particularly,when capital
startsflowingout-may requirethe centralbank to hold a large stock
of internationalreserves,whichis a costlyif not unfeasibleundertak-

ing.52The credibility-related considerations, therefore, givesomesup-

portto a regimeoffloating exchangerateswhentheeconomy is subject
to substantialcapitalflows.53
As discussedearlier,attempting to insulatethebanking system from
short-term capitalinflows is an attractivegoal when most ofthe flows take
theformofincreasedshort-term bankdeposits.In thesecircumstances,
a suddenreversal ofcapitalinflows mayquicklyresultin bankfailures.
Marginal reserve requirements could be sharplyraisedsuchthatthey
becomehigher as thematurity ofdepositsshortens; infact,a 100percent
required reserve ratiocould be imposed depositswiththeshortest
on
maturity. Although thisscheme would imposea burdenon thebanking
system and could resultin some disintermediation ofthecapitalinflows,
ithastheadvantage ofdecreasing banks'exposuretotherisksofcapital
flowreversals. In addition, regulation thatlimitstheexposureofbanks
inequityandrealestatemarkets
to volatility wouldfurther insulatethe
banking system from the bubbles associated with sizablecapitalinflows.
To summarize, to
therearegrounds support a mix ofpolicyinterven-
tionbasedon theimposition ofa taxon short-term capitalimports, on
enhancingthe flexibility of exchangerates,and on raisingmarginal
reserve requirements onshort-term bankdeposits.Giventhelikelyfiscal
costs,itis hardto makea strong case infavorofsterilized intervention,
unlesscountries exhibita strongfiscalstanceand capitalinflowsare
expectedtobe short-lived. In anycase,webelievethatnoneoftheabove
policies willdrastically change thebehaviorof real exchangeratesor
interest rates.The choiceofappropriate policies,however, coulddecid-
edly attenuate the detrimental effects of sudden and substantial future
capitaloutflows.
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Capital Inflows and Real Exchange Rate Appreciation in Latin America: The Role of External

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CapitalInflowsand Real Exchange

GUILLERMO A. CALVO, LEONARDO LEIDERMAN,

Thecharacteristicsof recentcapitalinflowsintoLatinAmericaare dis-

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nomicpoliciesand economicperformance acrosstheregion.In most

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individualeconomiesand allowdomesticagentsto smoothout their

5Fora comparison of the currentepisodewiththe late 1970s,see Calvo,

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Internationalcapitalflowsare recordedin thenonreserve capitalac-

8NoticethatRA < 0 impliestheaccumulation

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cordingly, an increasein thecurrent accountdeficitcan be tracedto

9See also FinancialTimes(1992),Kuczynski (1992),and SalomonBrothers

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Balance on goods, Balance on ca

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Anatomyof Capital Inflows

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Table2. LatinAmerica:Itemsin theCapitalAccount,1973-91

movementbetweenofficialreservesand capitalinflows.In fact,ifone is

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CAPITAL INFLOWS AND REAL EXCHANGE RATES 117

Figure2. TotalReservesMinusGold,January 1992

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Real Exchange Rate Appreciation

Figure3 providesevidenceon thebehaviorofrealeffective exchange

Expectedratesofreturn onavailableassetsplaya keyroleininvestors'

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Figure3. Real Effective

4.8 - Chile J_ 4.06

Source:IMF, Information NoticeSystem(database).

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Figure4. StockMarketPerformance, January 1992

Sources:Standard& Poor's(S&P) Analyst

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stockmarketboomsand the attendant highreturns materialized after

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Figure5. InterestRate Spreads,January1988-March1992

Sources: IMF, InternationalFinancialStatistics,and variouscentralbank bul-

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CAPITAL INFLOWS AND REAL EXCHANGE RATES 123

Figure 6. Risk and Returns

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Selectedmacroeconomic indicators arereported inTable3. Consider

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marketsin the United States. Beyond short-term interestrates,returns

Also,therewasa 4 percent decreaseinU.S. corporate whilecorpo-

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changeis associatedwithchangesin thecapitalaccountofLatinAmerica

25 It is usefulto recallhowsizabletheseinflowsto theUnitedStateswerein

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Table5. Changesin CapitalAccounts

Co-Movementof Reserves and the Real Exchange Rate

Giventhelackofmonthly data(and,fora number ofcountries

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havebeencloselyassociated withtherecent inflows. Theprevious section

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Applyingthe same procedureto ten data series describingthe real