Have We Turned the Corner?

It remains to be seen whether Latin America can break out of its cyclical history of excessive borrowing, default and financial rehabilitation – and achieve rapid, sustained growth.

Latin Americans love to party, but the mornings after are grim. The same principle applies to the

region’s relationship with the international financial system. Nearly 200 years ago, the newly independent states of Latin America borrowed enthusiastically in the City of London, only to go bust shortly after. The Republic of Colombia was the first to borrow in 1822 with a £2 million loan. Mexico was the first to default in 1827, followed soon after by almost every other Latin American government.

The cycle of excessive indebtedness, uncontrolled expenditure and default has continued ever since. Buenos Aires defaulted on its debts in 1890, but seven years later the Financial Times reported how that “enterprising city” had just

received authorization from the Senate to issue “a loan of five million dollars, the object of which, we presume, is to fund the floating debt and leave a balance in hand for more extravagance on the part of the city authorities.” Almost a century later, in 1982, Mexico defaulted on its $80 billion foreign debt. Once again, nearly every other Latin American government also defaulted, ushering in the ‘lost decade’ of the 1980s. But the size, complexity, and depth of that crisis exceeded anything that had gone before.

This magazine was launched in October 1988, just as the end of the lost decade came into sight. Peter Conway,

the first publisher of LatinFinance, felt that the debt crisis would be resolved and that the financial markets would play a critical role in the region’s economic resurgence. Fifteen years ago, the emerging market asset class simply did not exist. The political left viewed market-based reforms as reactionary Reaganomics, and the authoritarian right saw economic liberalization as a threat. Nowadays, such fears seem as outdated as the pictures of investment bankers sporting sideburns and heavy rimmed glasses that appeared in early issues of LatinFinance. There is a consensus, albeit more fragile than a few years ago, that trade liberalization and free markets can deliver growth and stability. Most people agree that two crucial events in Latin America’s recent history occurred in 1989.

That year, Mexico signed up for the first Brady Plan to restructure its foreign debts. Commercial banks offered debt relief in exchange for collateralized, tradable bonds. The Brady Plan was also intended to stimulate growth and prevent future accumulations of debt. Nicholas Brady, today chairman of the investment firm Darby Overseas Investments, says, “Countries received a huge reduction in sovereign debt, which allowed them to function and ultimately return to funding in the international markets. Country reforms to bring down the budget deficits, selling overweight and inefficient government enterprises were also part of the Plan.” Mexico, now Latin America’s biggest economy with an investment grade credit rating, retired the last of its Brady bonds in July 2003.

Chile’s political transition began in 1989, when Patricio Aylwin won the country’s first free elections in over 15 years and took office in 1990. The transition from the politically retrograde, but economically progressive regime of Gen. Augusto Pinochet and Aylwin’s decision to maintain his predecessor’s free market policies proved that reform and democracy could coexist, as Argentina and Brazil were to show. The 1994-2002 center-left government of Fernando Henrique Cardoso in Brazil pushed through more privatizations than any other Latin American government.

Argentina’s Depression

Argentina’s decision in December 2001 to stop payments on $144 billion in debt was the biggest sovereign default in history and the country’s fifth default since 1827. The impact of debt crisis, devaluation and economic depression devastated Argentina, but has not spread far beyond its borders. This is both because most Latin American governments have adopted structural reforms, strengthening their ability to resist crises, and because the international capital markets are now large and deep enough to absorb such shocks. Investors are sophisticated enough to analyze sovereign risk and differentiate among credits. Chile issued bonds at record low yields at the beginning of the Argentine debacle. At times of crisis in Latin America, liquidity may dry up and poorly rated issuers will have trouble raising money, but markets soon recover once the worse is over.

Financial crises will always recur. However, the world’s best financial minds have yet to devise a way to avoid these crises or at least deal with them more effectively when they do occur. One idea, proposed in 2001 by the International Monetary Fund, was to create a new sovereign debt restructuring mechanism (SDRM) modeled on the US bankruptcy code. But Brady says the international financial institutions “have miss-defined the problem. Enormous time has been wasted on an endless, mind-clogging discussion about SDRM.” He says the financial community needs to agree on some basic principles first. “If you define the problem as the advancement of democracy, open markets and free enterprise then you have defined the goal correctly and then you can get on with it and do some constructive thinking.”

Market Force

Robert Rubin, another former US treasury secretary who is now chairman of the executive committee of Citigroup, points out how much is at stake. He said in a speech in Santiago in 1997 that, “markets have produced a vast increase in private sector capital flowing to developing countries around the world, financing investment and growth in amounts that were unimaginable 25 years ago. And I believe that continued openness to global capital flows will be just as important to the emerging economies over the next 25 years. It is worth recalling that per capita income in [South] Korea was on a par with the average income in sub- Sahara Africa in the 1960s.”

Growth in Latin America – with the exception of Chile – has lagged behind Asia since the 1980s. Rubin believes this is due to these countries’ high savings rates, heavy investment in education and a strong work ethic.

Although many Latin American countries, led by Chile, have reformed their domestic capital markets and created private pension systems, Latin America remains heavily dependent on foreign capital, much as it has over the preceding 200 years. When capital flows – foreign direct investment and portfolio investment – decline, so does growth. The Washington- based Institute of International Finance warned in 2003 that “the trajectory of Latin America is still uncertain as several countries are only now just beginning to recover and Venezuela continues to be plagued by economic and political uncertainty. Even Brazil’s situation is not without vulnerabilities despite signs of better conditions and the government’s improving policy credibility. Net direct investment in Latin America is expected to fall to $32 billion [in 2003] from $36 billion last year and over $60 billion in 2001.”

The region’s economies contracted by 0.7% last year, dragged down by Argentina, but are set to grow by about 2% in 2003 and 4% next year. This is a mediocre performance for Latin America, a low-income region that should be growing by 5%-7% a year. In 1997, Brazil’s Planning Ministry forecast that growth in Brazil would continue at 4.5% a year between 1997-2000 and then gradually climb to an average 7% annual growth rate after that. By 2006, it said, Brazil would have a population of 178 million and a GDP of $1.3 trillion. Per capita income would reach $7,300. This sounds absurd now, but if accelerated growth is possible in Chile and Southeast Asia, then it should be in Brazil and elsewhere in Latin America as well.

Add in Reform

In its first issue back in October 1988, LatinFinance stated in a prescient editorial that, “privatization, deregulation and trade liberalization do not in themselves guarantee growth. Nor does debt relief. An economic resurgence will require new sources and methods of financing. Unless market reforms produce a real rise in production, consumption and wages, the consensus for change will disappear.” We would add institutional reform to that list. A free market system cannot function unless there is an effective and honest legal system and a political culture that is largely purged of corruption. The score of most Latin American countries in Transparency International’s Corruption Perception Index has hardly improved over the last five years and some have declined a lot.

Pedro Malan, Brazil’s finance minister from 1994-2002, once commented that, “our vision is one of a country that can combine three things which in my view are essential values for a society in which we would like to live. They are individual liberty, social justice and productive efficiency in the private sector and operational efficiency in the public sector.”

President Luiz Inácio Lula da Silva of Brazil, who began his government in 2003 following the same policies as his predecessor, Fernando Henrique Cardoso, seems to have understood this. Without social justice and an efficient machinery of state, there can be no consensus for reform. And without reform, Latin America cannot deliver the growth it needs to give its people a future – and break out of its 200-year cycle of debt, overspending and default. Maybe by the time LatinFinance celebrates its 20th anniversary we will be celebrating a new period of rapid and sustained growth, rather than glumly contemplating another turn in the boom-bust cycle. LF15th