The authors are grateful to José Juan Ruiz, Andrew Powell and Alessandro Rebucci for their useful comments on an earlier draft of this paper, and to Mathieu Pedemonte for research assistance. The opinions expressed in this publication are those of the authors and do not necessarily reflect the views of the Inter-American Development Bank, its Board of Directors, or the countries they represent.
1Many peripheral eurozone countries are suffering from financial and competitiveness problems reminiscent of previous Latin American challenges. In this essay, we focus on selected areas in which the Latin American experience with crisis and recovery offers useful lessons for today’s European concerns, namely high public debt risk premium, banking system distress, sudden stops of capital flows, low growth and reduced competitiveness.
2We conclude that these lessons are relevant and important but, as the currency union framework imposes a level of complexity that Latin America never faced, they do not fully address the conditions of the European crisis. If it survives, the currency union, as a constraining rigidity, will impede recovery, and, if it fails, will constitute a serious complicating factor threatening stability. At the same time, on a more optimistic note, the European Union (EU) possesses instruments of international cooperation that were never available to Latin American countries. The powerful European Central Bank (ECB), serves only eurozone members, is a case in point. It stands in contrast with the weaker and less reliable International Monetary Fund (IMF), a global multilateral governed by powers external to the region. Our analysis suggests that while current crises in Europe are more complex and potentially more perilous than previous crises in Latin America, Europe’s greater institutional resources provide it with a better chance of successfully navigating the dangers along the way. Nevertheless, the path is uncharted, and success is by no means guaranteed. Our contribution is to highlight the areas in which the Latin American experience may shed light on current European policy challenges.
- 1 For a comprehensive review of the Argentinean crisis, see Cline (2003).
- 2 See Powell (2002).
3Disentangling the underlying factors responsible for a crisis is a difficult task even after the fact, let alone as the problem is on going. The Argentinian crisis of 2001-2002 is perhaps the closest to the current crises in peripheral European states in terms of currency rigidity (through Argentina had a currency board rather than a full-fledged currency union) and overall complexity. The crisis in Argentina has been the object of numerous and diverse retrospective analyses concerning its diagnosis and, a fortiori, applicable treatment.1 Even ten years after the crisis, the primary cause of the collapse remains a matter of dispute, with fiscal unsustainability, currency board rigidity, and several other factors all constituting possible contenders. There is, in fact, an argument to be made for a multiple equilibrium situation, wherein the emergence of a fortuitous bad equilibrium resulted from a combination of the anticipation of the break of the currency board and vacillation on the part of the international official sector regarding the continuation of financial support.2 Just as the primary causes of the Argentinian crisis remain a matter of dispute, diagnosing the underlying factors of the European crises, particularly while events are still unfolding, may be unrealistic. Furthermore, the governing parties’ need to maintain political support in democratic societies may impose critical limitations on feasible policy responses, both in crisis and core countries. While it is difficult to ascertain how the Latin American experience in this regard might be translated for today’s European democracies, it is clear that democratic governance may impede crisis management and create divisions. To ensure the effectiveness of policy responses, it may be prudent to manage risk on all fronts, without disregarding any options a priori, and simply bear in mind the politico-economic limitations on policy decisions. It is in this agnostic spirit that we recommend careful consideration of the Latin American experience analysed below.
4Latin America has an unenviable experience with unsustainable public debt. The Latin American debt crises of the 1980s, ominously known as the Lost Decade, may prove illustrative for contemporary Europe. Though most of the crises were triggered by a change in external borrowing conditions that rendered the states’ mounting public debt, borne of government fiscal excess, suddenly unsustainable, their lessons do not apply exclusively to fiscally profligate economies such as Greece. For starters, the socialization of private debt—a scenario that may eventually apply to countries like Spain—contributed significantly to the accumulation of excessive public debt in Latin America. Chile’s massive public debt, for instance, resulted from a bank bailout. More generally, irrespective of the origins of the unsustainable debt, the resulting fiscal adjustment and debt restructuring contains lessons for all countries with impaired access to credit.
5Having lost access to market financing, Latin-American countries were forced to rely on external official financing and implement corresponding fiscal adjustments for a period of approximately ten years.3 Commercial debt obligations, mostly in the form of foreign bank loans in hard currency, were managed through protracted rescheduling, as since they were issued in foreign currencies, the debt could not be reduced through inflation. This form of debt management was supported first by the United States Federal Reserve and later through a multilateral strategy referred to as the Baker Plan. This strategy was designed to diffuse the threat of an American banking crisis resulting from the inability of major international banks to absorb impaired sovereign loans. The need to contain losses and preserve financial stability created incentives for creditor countries to intervene and facilitate orderly debt rescheduling. It was hoped that, over time, the measures taken to stave off catastrophe would also promote economic growth sufficient to reduce the debt burden and, in concert with fiscal restraint, restore fiscal sustainability in debtor countries. While the primary objective of containing an international banking crisis was achieved as banks cleaned up their portfolios and/or recapitalized, the hoped-for corresponding economic growth did not materialize. The region suffered a period of chronic recession in which income per capita actually declined, on average, by about 10 per cent in the largest economies.
6Three major forces combined to push Latin America into a decade-long contraction. First, fiscal austerity proved inimical to growth. In particular, the collapse of public investment and infrastructure maintenance and reduced economic productivity. At the same time, a general return to private investment and inflationary financing of public deficits led, in many cases, to high inflation, further contributing to distorted investment incentives. Second, the unyielding debt overhang acted as an implicit tax on investment, as the fruits of growth increased countries’ capacity to repay their debts, thus leading to the capital being captured by external creditors. Moreover, and possibly even more importantly, the debt overhang created deep uncertainty as to how the ultimate costs of its elimination would be effectively adjudicated across economic agents. The debt overhang thus acted as dead weight on economic activity until its eradication, paralyzing investment. Finally, balance-of-payments pressures further constrained economic activity. In fact, forced fiscal adjustment and protracted debt overhang also led to the capital outflows of domestic savings to more secure holdings abroad which, coupled with a lack of access to external market financing, resulted in forced external adjustment. A substantial portion of this adjustment took the form of import contraction (in response to large real depreciation) that, due to its reliance on machinery and productive inputs, further depressed investment and production.
7The passive strategy of protracted debt rescheduling, which secured just enough liquidity to keep countries afloat, inevitably led to chronic depression and debt unsustainability. After several years of crisis, a new multilateral strategy, prompted by nascent social unrest, eventually emerged. This new strategy, the Brady Plan, recognized that the debt overhang could only be eliminated through deep debt reduction, conducted in a manner similar to bankruptcy reorganization. To implement the plan, multilateral institutions provided substantial sums, on a long-term basis, to finance discounted debt buybacks or financial enticements (e.g. collateral) of the so-called Brady bonds, which were then to be exchanged for bank loan debt. This lending was done on the condition that a definitive settlement with all creditor banks could be simultaneously. Brady bonds were tailored to creditors’ circumstances, but they all entailed substantially reduced debt obligations over time. The external official sector facilitated bilateral debt restructuring between countries and creditor banks, arguably to the benefit of all involved parties. Nevertheless, the external official sector protected its own interest by providing financing conditioned on seniority, as in bankruptcy arrangements. It also cajoled leading commercial banks into coordinating their negotiations and preventing free riding, so as to preclude them from unduly benefiting from overall debt reduction. In other words, the external official sector wanted to ensure that all banks received a ‘haircut’ (i.e. a reduction in the value of their held sovereign debt).
8At the same time, it was also recognized that debt reduction policies would also facilitate recovery. To effectively leverage the new opportunity for economic recovery offered by eliminating the debt overhang, it was imperative that the policy framework be geared toward encouraging investment, including both the promotion of high-return, domestic investment opportunities and securing the necessary savings from abroad to finance them. Countries became eligible for the Brady Plan only after meeting these investment readiness requirements. Beginning in 1989 and working one country at a time, debt in Latin America was eventually restructured within a few years. Markets were forward-looking, recognizing that the regime emerging from the clean-up offered good business opportunities for both foreign direct investment (FDI) and portfolio flows, which became plentiful shortly afterwards (Fernández-Arias and Montiel, 1996). Despite increased senior multilateral debt, the programme of debt reduction was sufficiently substantial to facilitate additional market financing. Hence, market-friendly restructuring, along with official international support, paved the way for renewed access to external market finance (Figure 1).
source: International Financial Statistics, IMF. Simple average for Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela.
- 4 Reviewed in Sturzenegger and Zettelmeyer (2007).
9More recently, Latin America has experienced another type of debt distress, which calls for a different modality of international cooperation: liquidity or contagion crises (as opposed the previous inability to pay, or ‘insolvency’) (Fernández-Arias, 2011). In contrast to the debt crises of the 1980s, which the muddle-through strategy of the Baker Plan failed to resolve, these crises could be remedied by the provision of external liquidity. In this instance, although high debt was a complicating factor, the problem did not require debt reduction. Some cases were caused by panic or uncertainty concerning conditions a particular country, such as the bunching of short-term obligations in Mexico in 1994, or the 2002 anticipation that Brazil’s first leftist government would be unfriendly to markets and renegotiate debt frivolously. In both cases, liquidity provided by the international community in the form of bridge loans or lines of credit helped minimize the risk of debt crisis. Other cases of liquidity or contagion distress were triggered by international credit shortages, as in the aftermath of the 1998 Russian economic crisis when institutions holding high-risk Latin American bonds suffered funding shortfalls. These temporary financial disruptions led to a spike in sovereign risk spread throughout the region. Unfortunately, at the time, the international liquidity mechanisms that today serve to offset financial stress were poorly developed, and countries suffered various degrees of damage, with some experiencing a debt crisis.4 In contrast to Latin America, the ECB is in a position to avert unnecessary damage caused either by or to any eurozone member suffering a temporary liquidity shortage.
10Finally, Latin America has some experience with cooperative arrangements for sharing sovereign risk, including for example, multilateral development banks, such as the Inter-American Development Bank. While these multilateral arrangements have been extremely successful, they are limited in scale and sustained on the premise of their senior creditor status. This creditor status has been enforced to the point that no shareholder has ever lost money, with the exception of funds diverted through the concessional window available only to the poorest countries. Similarly, the region has experience with cooperative arrangements within states, in the form of fiscal federalism but such initiatives have faced significant enforcement problems. In 2000, Brazil’s federal government successfully put an end to recurrent, ad hoc debt bailouts of Brazilian states by establishing a system wherein said bailouts were granted in exchange for the states’ surrender of their sovereignty with regard to certain matters of fiscal policy to the federal government.
11What are the lessons do these experiences have to offer the European Union? Firstly, the Latin American experience suggests that correct diagnosis of the nature of the financial crisis in the affected country is crucial. Financial distress caused by panic/contagion or other transient market conditions can be remedied by liquidity provision. Otherwise, if the crisis is not counteracted with external liquidity sufficient to cover temporary dislocations in financial markets and prevent deteriorating fundamentals from validating a market run (as in the traditional bank run paradigm), the panic will cause real damage, potentially leading to a full-fledged debt crisis. Yet, at the same time, if the fundamentals themselves are the problem, the provision of liquidity alone will only further debt unsustainability, as demonstrated by Latin America’s experience during the Lost Decade of the 1980s. How are policy makers to know whether external liquidity provision is enough? In the Latin American experience, liquidity stress has typically been associated with identifiable shortcomings in international financial markets, while financial distress stemming from flawed fundamentals has been associated with excessive debt and low-growth prospects in particular domestic economies. Financial distress of the first type is often alleviated by sufficient liquidity support, but is largely unresponsive in the second. It is essential to discern the factors behind the extreme financial distress, and heretofore resistance to liquidity support, in affected European countries. This persistence of financial distress despite liquidity support is sufficient reason to seriously consider the potential impact of debt overhang and debt restructuring as a policy alternative.
12Additionally, when economic fundamentals are the source of financial stress, liquidity provision to affected countries may simply postpone the inevitable, thus increasing the cost to supporting partners whose resources will eventually be needed to address the problem. If fiscal profligacy is the root cause of the crisis, fiscal adjustment may be insufficient to right the economy, and likely actively counterproductive if it is not. The adverse effects of debt overhang, fiscal contraction, and worsening capital accounts tend to compound in depressing economic activity, making it difficult to find a growth-positive solution to the debt problem, even with liquidity support and a commitment to fiscal discipline. While a first attempt to stabilize the economy utilizing liquidity support and fiscal austerity may be given the benefit of the doubt, a vicious cycle of low growth and prohibitive market financing costs should not be allowed to go unchecked, as it did during the Lost Decade.
13Thirdly, a debt overhang is a permanent drag on growth. Elimination of the debt overhang through restructuring should be considered as soon as it becomes reasonably clear that excessive debt cannot be reduced by prudent fiscal adjustment and expected growth. Liquidity provision to avoid disorderly debt default makes is a logical stopgap measure but, if the debt is unsustainable, will only worsen the problem over time. Furthermore, liquidity provision compromises the provider, which is increasingly exposed to credit risk, thus entertaining the possibility of being unable to offer financial support when debt restructuring becomes unavoidable. Experience indicates that recognizing debt restructuring must be part of the solution is a difficult decision, and one that is often excessively delayed (Sturzenegger and Zettelmeyer, 2007). The involved parties involved usually have incentives to postpone the required restructuring for far too long, as creditors benefit from any economic improvement and, perhaps, debtors wish to avoid accepting political responsibility for an unpopular policy.
- 5 The current international financial architecture perilously relies on private markets to arrange ‘ (...)
14Fourth, external multilateral intervention plays a key role in helping to ensure debt restructuring is conducted in an orderly and constructive fashion, to the benefit of creditors (and financial stability in creditor countries) and debtor countries. In this regard, the cooperative institutions of the eurozone such as the ECB compare favourably with the past support provided to Latin American by the IMF and other extra-regional multilateral institutions. As exemplified by the restructuring of the Greek debt, the European institutions have the ability to cajole private participation in debt reduction schemes despite the absence of over-arching global institutions mandated with the task.5 External multilateral intervention provides both a coordinating mechanism and incentives for parties to agree to clean restructuring through the use of sticks (e.g. regulatory pressure with which to cajole creditors) and carrots (e.g. financing to make the obligatory ‘haircuts’ more palatable). The preconditions and conditionality attached to multilateral lending help ensure that growth recovery will result from debt restructuring. It is this overall efficiency gain that makes debt restructuring a winning proposition for all parties. Debt reduction without growth recovery is obviously contentious and, ultimately, futile.
15Fifthly, concerns regarding purported market reluctance to invest following debt restructuring have generally not been borne out by experience. When justified by fundamentals and certified by multilateral institutions following the logic of bankruptcy proceedings, debt restructuring has not had negative consequences for regaining market access. This has occurred, moreover, despite the increase in official senior debt inherent to the restructuring.
16Finally, moral hazard was avoided in Latin America’s financial recovery because states repaid bailouts, internalizing all the costs and benefits of external official assistance, thus precluding opportunistic behaviour. In the case of Latin America, the conditionalities imposed by supranational entities such as IMF to constrain imprudent policy behaviour could perhaps be justified on the basis of domestic governance distortions, but not moral hazard. Nevertheless, the experience of the federal rescue of Brazilian states suggests a risk of moral hazard does exist when bailouts may not be repaid and, as such, mitigation of this risk may require permanent monitoring of the beneficiaries’ fiscal affairs. The risk of moral hazard may be relevant to the European contest in so far as its external financing is more generous and its repayment enforcement more lax than that of multilateral senior lending to Latin America. This is especially relevant in the case of pari passu official lending to European crisis countries. While senior official lending may fail in its objective by discouraging future junior private lending, pari passu official lending may induce moral hazard.
17Latin America has also had its fair share of banking crises, the origins of which can be traced back to both external and domestic shocks. Of these, it is of particular interest to analyse banking crises linked to public debt crises, which often go hand-in-hand, reinforcing each other and underlying the high incidence of twin banking and debt crises in the region.6 When the public sector finds itself temporarily cut off from access to financing, the recourse to bank liquidity by means of financial repression may present itself as a second best option. However, the banks – loaded with sovereign debt, either as a result of financial repression or their own choice – end up inheriting the risk of a debt crisis. Conversely, deeper financial systems may yield a substantial growth dividend, but at the expense of increasing the costs of resolving banking crises when they occur. More specifically, the resolution of banking crises stemming from unsustainable expansions usually draws fresh resources from the public sector, thus creating a substantial jump in public debt. Latin America has had several relevant experiences, both successful and unsuccessful, in dealing with what can be a ‘fatal embrace’.
18An important element of the successful resolution of many banking crises has been the use of mechanisms to contain and isolate the crisis, minimizing its interaction with sovereign risk. If liquidity risks appear to be at play in a situation of bank distress, experience indicates that it is paramount to swiftly provide ample liquidity, in accordance with the traditional Bagehot doctrine, rather than wait to confirm whether the treatment is necessary and will be effective. For example, the potential contagion of the Tequila Crisis of 1995 to the heavily dollarized Argentine banking sector (which did not have a deposit insurance mechanism in place before the crisis) was contained with external liquidity support to the Argentine Central Bank. Due to the connection to sovereign risk, it is better to err on the side of overtreatment than allow preventable bank liquidity problems to ‘infect’ sovereign debt.
19As insolvent banks require additional capital to operate, fundamental bank insolvency problems are more difficult to address. Nevertheless, the principle of minimizing entanglement between banking crisis resolution and sovereign debt still applies. In a situation of fragile public debt, it is better to err on the side of resolution mechanisms that economize public resources. In the case of Argentina in 1995, for instance, many provincial banks were privatized, while insolvent banks were closed—or reorganized to shed their unviable aspects—rather than recapitalized. This helped minimize the burden of resolving the banking crisis borne by the public sector.
20The catastrophic crisis that took place in Argentina in 2002 following the breakdown of the currency board is an example of just how explosive the combination of banking and debt can be. At the outset, increasing sovereign risk contributed to the bank runs of 2001. Subsequent attempts at crisis resolution compounded the attendant risks by penalizing bank assets through the conduct of currency conversion (i.e. pesoification) at arbitrary rates, which, in turn, were compensated utilizing public debt. This arrangement failed to inspire confidence in depositors, who were prevented from further running only through the enactment of highly punitive controls.7 Argentina emerged from the experience with a minuscule and dysfunctional banking sector and, despite a deep debt-restructuring haircut, substantial public debt.
- 8 See Fernández-Arias (2007).
- 9 It should be noted, however, they were not an active part of the solution either, as they failed t (...)
21In contrast, Uruguay, facing a similar but arguably larger shock (resulting, in part, from the Argentine debacle), minimized risk entanglement by allowing financially viable foreign banks deal with their depositors themselves, conducting loan renegotiations with clients on a private, bilateral basis. For those institutions unable to address their problems themselves, all available external resources were pooled to ring-fence and fully secure the payment system, while the maturity dates of time deposits were gradually stretched by legal fiat to help stabilize the system utilizing its existing resources. In parallel, public debt was restructured separately with bondholders at large, a tactic that also followed the minimalist approach of stretching maturities and restoring pre-crisis interest rates. This balkanization strategy was successful in diffusing the financial crisis and promoting subsequent normalization.8 That said, however, it would not have been possible without external support. Foreign banks, as discussed, were not drawn into the problem, thus simplifying resolution of the crisis.9 The IMF and other multilateral institutions, moreover, were generally supportive of debt restructuring and established a line of credit large enough to convincingly bolster the resolution strategy for the banking system.
22These experiences contain important lessons for European countries with fragile public debt situations whose banking systems are under stress. First and foremost, entangling banking crisis risks with sovereign debt crisis risks is a recipe for disaster. There is, however, a high premium on keeping these risks separate. Depending on the circumstances, this general principle may take different forms. If, due to contagion or panic, liquidity conditions are at work, it is essential to swiftly provide ample liquidity rather than wait for greater clarity, regardless of the fact that some resources may be put at risk. The spread of banking risk to sovereign risk may constitute a point of no return. On the other hand, if banking problems are more fundamental (e.g. due to bad real estate loans), liquidity remedies will be ineffective and decisive banking crisis resolution must be implemented, though always with an eye toward minimizing emerging fiscal liabilities. In the Latin American experience, this problem was addressed utilizing some combination of: the privatization of troubled public banks; the avoidance of recapitalizing banks with public money; and the reduction of the size of required support and attendant contingent public liabilities. This last approach involves freeing healthy (generally foreign) banks from interference and concentrating resources on key banking functions, such as the payment system.
23Due to the fact that Central Bank support required committing scarce international reserves or relying on multilateral help to address the crisis, rather than simply printing money to back up local currency bank liabilities, financial dollarization was a critical complicating factor in the Latin American experience. As the ECB can provide unlimited bank support in euros, this complication is obviously absent in eurozone countries. Nevertheless, ECB decisions are mediated by a cooperative arrangement requiring the agreement of all involved parties, in contrast to falling under the sovereign control of a single state. In any event, the protection of the sovereign is, of course, maximized when external financial resources are used to support the banking system. In the European context, their own EU institutions (not just the IMF) may support bank liquidity and provide the credit lines required to implement the much-needed bank support. It is clear that for the purpose of minimizing entanglement, these resources, ideally, should not be sovereign-guaranteed. While this was an unthinkable luxury in the case of Latin America, it may be feasible in the context of supranational EU entities such as the banking union, to the great advantage of peripheral states.
24As mentioned above, following the Lost Decade of the 1980s, capital markets remained closed to Latin America until implementation of the Brady Plan. As financial integration resumed in the 1990s, the region became increasingly exposed to sudden stops in capital flows. Sudden stops occur either a) when foreign investors reduce their holdings of domestic assets (a collapse in gross capital inflows) and/or b) when local investors suddenly accumulate foreign assets (a surge in gross capital outflows). Regardless of how they materialize, sudden stops affect the financing of the overall balance of payments. As a result, affected countries that were previously running current account deficits are forced to close them abruptly. This is usually done through large real exchange rate depreciations.
25In the 1990s, Latin America suffered several episodes of current account reversal caused by contractions in net capital flows (Figure 2). Moreover, sudden stops in the region usually coincided with banking crises and, in the case of countries with fixed exchange rates, currency crises as well (Calvo, Izquierdo and Talvi, 2006). Some of these currency crises were forced by speculative attacks against local currencies pegged to the dollar, wherein a surge in uncertainty led to an increase in the demand for hard currency, depleting the reserves of the Central Bank and creating a currency crash. Fortunately for Europe, eurozone countries in crisis, as they lack a local currency, are not vulnerable to destabilizing speculative attacks.
source: International Financial Statistics (IFS), IMF. Simple averages of current account and net capital flows for Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Systemic Banking Crisis dates in the region from Laeven and Valencia (2008).
26A structural factor contributing to Latin America’s vulnerability to sudden stops is its low domestic saving rates, which leads to increased dependence on external savings to cover investment-financing gaps. The main manifestation of this domestic savings shortfall is the incursion of large current account deficits (as a percentage of GDP). In this respect, the situation in peripheral European countries today is even more troubling than that of Latin America in the mid-1990s (Figure 3). What useful lessons, then, can vulnerable European countries learn from Latin America’s experience with sudden stops?
Figure 3. Latin America and Europe: Saving, Investment and Current AccountZoom Original (png, 27k)source: World Economic Outlook Database, IMF.
- 10 See Cavallo and Frankel (2008).
- 11 See Calvo, Izquierdo, and Mejía (2008).
27In the Latin American case, the disruptive nature of sudden stops was compounded, to a large extent, by liability dollarization and the low ratios of tradable output present in many countries. For a given current account deficit, the smaller the tradable component of an economy’s output, the larger the real exchange rate depreciation needed to close the current account deficit when external financing dries up.10 Large real exchange rate depreciations, in turn, may be disruptive because they increase the cost of servicing foreign currency debts, triggering bankruptcies and large output costs.11
28The European case is, a priori, different, but only to a degree. Any external financing shortfall imposed by the crisis on peripheral economies not offset by liquidity support from external sources must be accommodated; adjustment therefore remains a problem. While the ability of the ECB to provide the balance of payments support needed to control financial stress compares favourably with that of the IMF to help offset sudden stops in Latin American countries, if the underlying economic fundamentals call for adjustment, it cannot resolve the crisis. If adjustment is required, then the Latin American experience with sudden stops may be useful to contemporary Europe. Although European countries are open economies with large tradable sectors, the currency union severely restricts the scope for engineering the adjustment through real exchange rate depreciation and may thus induce a recessionary adjustment to dampen domestic demand. With the crisis still lingering, however, the irreversibility of the euro cannot be taken for granted, as the threat of eurozone exit by one or more countries experiencing ‘sudden stop’ symptoms is being widely discussed. The materialization of the euro exit scenario would entail the reintroduction of local currency(s) and an extreme, Latin American-style ‘liability dollarization’ problem.
29There are cyclical and structural elements to post-sudden stop adjustment. On the cyclical front, the challenge for governments is to transition the adjustment into a tighter external financing constraint while avoiding spillovers into the banking system. In a review of policy responses to sudden stops in Latin America, Cavallo and Izquierdo (2009) document the late-1990s crisis resolution mechanisms of eight Latin American countries. They conclude that successful crisis resolution is more likely when countries are able to use expansionary macroeconomic policies to stimulate the economy during the external credit crunch. Nevertheless, the authors caution that, in the absence of large sums of largely unconditional money provided by the international community to bridge a protracted fiscal gap, successful crisis resolution requires that each country finance its own stimulus by saving during prosperous times. Given that countries in distress are rarely able to fiscally fend for themselves, the lesson of primary relevance from the Latin American experience is that external financial packages are crucial to smoothing the post-sudden stop adjustment. This explains, for example, why Mexico recovered fairly quickly after the Tequila Crisis of 1995, having received a USD 50 billion package partially financed by the U.S. government, whereas Argentina’s economy collapsed when the IMF withdrew its support in November 2001.
30As eurozone countries do not control their monetary policy, and peripheral countries experiencing ‘sudden stop’ symptoms have very limited fiscal cushions, impediments to expansionary macroeconomic policies are particularly relevant in the case of Europe. That said, while individual countries may lack the tools to implement countercyclical policies, such tools do exist at the eurozone level. Of course, using those tools would inevitably entail a reallocation of resources within the European Union, from more creditworthy countries to less creditworthy ones. Such support is reminiscent of a standard external financial package, and would thus carry similar moral hazard risks, to the extent that it is given as a transfer or lent with credit risk.
- 12 Argentina’s vulnerability made it clear that a protracted sudden stop requiring substantial real e (...)
31On the structural front, the Latin American experience suggests that the longer it takes for private capital flows to resume, the more likely it is that solvency will be at risk and consequently require some form of debt restructuring and/or growth-oriented policy reforms. In the late 1990s, when the effects of the Asian and Russian financial crises began to be felt in Latin America, much confusion persisted regarding the nature of the shock and its possible implications. The region had only recently recovered from the contagion effects of the 1995 Tequila banking crisis, and for a time it was believed that the 1998 crisis would be similar – that is, that the credit crunch would be short-lived and contagion would ultimately be contained. Reality, however, proved to be quite different, as three years into the crisis, capital flows had not yet returned to the region at normal levels. Assessing the damage caused by liquidity stress, and the point at which liquidity problems are no longer temporary, is critical to effective policymaking. In the case of Argentina, for example, more than three years into the credit crunch, the authorities were still working under the assumption that liquidity could be restored, resulting in their pursuit of an ill-advised debt swap that pushed obligations forward in time. By the time the government finally switched strategies in late 2001, launching an orderly restructuring program to reduce the debt burden to sustainable levels, the IMF had also changed strategies, withdrawing its financial support due to disagreements with authorities over the macroeconomic framework.12 This unfortunate timing precipitated the events that led to a disorderly sovereign debt default, the end of the convertibility system, and the collapse of the domestic financial system.
32Dealing with sudden stops is difficult because there may be conflicts between solutions suggested by the underlying cyclical and structural challenges. From a cyclical standpoint, expansionary macroeconomic policies may help smooth the adjustment. If, as is often the case, countries are not able to finance the stimulus themselves, external official assistance is needed. In the context of the present discussion in Europe, the implication is that without Troika financial support—including decisive intervention by the European Central Bank to backstop stress in sovereign debt markets—peripheral countries exhibiting ‘sudden stop’ symptoms would likely experience a disorderly adjustment and costly outcomes, potentially including exit from the eurozone.
33To the extent that sudden stops are underpinned by structural factors (such as insolvency due to debt overhang and weak growth prospects), the use of external resources alone is not a solution. In such cases, unconditional external financial assistance would serve only to delay an otherwise unavoidable adjustment in favour of permanently tighter financing constraints. Countercyclical policies financed with external financial assistance may allow time for economies to adjust, but are no substitute for structural reforms aimed at reducing underlying vulnerabilities and restoring long-term growth. Correspondingly, Troika financial support would not be a solution in and of itself. External support ought to be conditional on the country remedying its structural weaknesses.
34Robust growth is an essential part of resolving financial crises, as it reduces high debt burdens and improves bank assets. The resolution of Latin America’s public debt crisis in the 1980s provides a case in point. In this instance, debt reduction was implemented concurrently with structural reforms, giving credibility to fiscal discipline and allowing for the productive use of renewed investment. Immediately after the Brady Plan restructuring of the 1990s, growth-oriented reforms enabled external market financing to include new instruments like portfolio debt and equity. Debt reduction alone was not enough to stem the crisis and spur recovery.
- 13 The main objective of financial sector reforms was to improve the efficiency and reliability of th (...)
35To what extent did structural reforms promote growth in Latin America? Following Lora and Panizza (2002), we focus on five areas of reform: trade liberalization, financial reform, tax reform, privatization, and labour code legislation. The central focus of the reforms, first adopted in the late 1980s, was market liberalization and the removal of controls on the allocation of productive resources. During that period, the structural reform process in Latin America was incomplete and quite uneven, across both countries and areas of reform. The greatest advances occurred in the early 1990s in the areas of trade liberalization and financial market reforms aimed at avoiding financial repression.13 In terms of tax reform and privatization, results have been more uneven across the region. Labour reform is the only area in which progress has been quite limited, both in degree and the comparatively small number of countries pursuing it.
- 14 The estimates imply that in the period of most rapid reform (1991–93), reforms accelerated annual (...)
36In terms of the economic impact of reforms, Lora and Panizza draw two main conclusions. Firstly, the reforms were observed to have significant but transient effects on growth. Growth accelerated, on average, by more than 1 percentage point in the aftermath of the strongest wave of structural reforms, but the growth effect abated as the reform impetus waned.14 The implication of this phenomenon is that to enhance the effectiveness of reforms in accelerating growth, the reform impulse must be sustained over time. Secondly, the growth-enhancing effect of reforms was higher in countries with better institutional environments, generally measured as strong rule-of-law.
- 15 Cavallo and Cavallo (2010) study the conditions under which crises can lead to growth-enhancing re (...)
37What are the implications of Lora and Panizza’s conclusions for Europe today? Interpreting the lessons from the Latin American experience in this area too broadly is unwarranted. In the areas in which Latin America underwent the greatest change in the 1990s, namely trade openness and financial market reform, most European countries, arguably, do not need reform. With respect to labour markets, in contrast, where peripheral European countries have more space for liberalization, Latin America did not pursue deep reforms. The specifics notwithstanding, an important lesson from Latin America is the observation that crisis may present opportunities to implement growth-enhancing reforms. Crises are, in essence, periods in which important, status quo-altering policy decisions are made both within countries and in the international arena. The Latin America experience indicates that in the aftermath of crises, it is more likely that growth-enhancing reforms will be implemented in countries where political institutions foster cooperative behaviour.15 Arguably, these empowering conditions are even more likely to be met in European states, as they generally possess stronger institutional frameworks. Furthermore, the supranational political union of the European Union facilitates cooperative outcomes by harmonizing states’ interests, while in Latin America regional political integration was significantly shallower. To the extent that the political union is substantially preserved amidst the crisis, it seems likely that reform impulses could be stronger and more resilient in Europe.
38An underlying lack of competitiveness may be at the root of low growth in the peripheral eurozone countries affected by the financial crisis. States that have suffered a decline in competitiveness due to protracted real exchange rate appreciations must engineer real depreciations in order to regain external competitiveness. The Latin American experience highlights the contractionary effects of real devaluations upon the cost of imported inputs and balance sheet effects: if a country’s debts are denominated in foreign currency, the indebted banks and corporations’ balance sheets outside the export sector are adversely affected in proportion to the real depreciation.
- 16 For the purposes of this paper, we employ Laeven and Valencia’s (2008) definition of currency cris (...)
39Real depreciations entail either nominal devaluations or lower domestic price inflation – even deflation, in extreme cases. Many economists prefer nominal devaluations, as they ease adjustment costs and provide a quicker boost to exports. In fact, deflationary adjustment is expected to be slow and contractionary. That said, nominal devaluation has the potential to trigger inflation, thus leading to uncontrolled real exchange rate processes punctuated by high volatility and overshooting. The Latin American experience, as illustrated in Figure 4, suggests that simply devaluing local currencies cannot restore growth. A simple event study shows that large nominal devaluations, or currency crises, in Latin America led to output drops of 2 percentage points on average during the crisis years, a decline that persisted at least three years into the aftermath.16 Overall, it should be clear that currency ‘freedom’ is not a panacea but rather a double-edged sword – an instrument with very costly side effects under conditions of financial dollarization. Devaluation has often led to rampant inflation and triggered high inflationary costs.
source: World Bank Data. Crisis Dates: Laeven and Valencia (2008). Counties (crisis year in parenthesis): Argentina (75, 81, 87, 02), Bolivia (73, 81), Brazil (76, 82, 87, 92, 99), Chile (72, 82), Colombia (85), Costa Rica (81, 91), Ecuador (82, 99), El Salvador (86), Guatemala (86), Honduras (90), Mexico (77, 82, 95), Nicaragua (79, 85, 90), Peru (76, 81, 88), Paraguay (84, 89, 02), Uruguay (72, 83, 90, 02), Venezuela (84, 89, 94, 02).
40In the case of eurozone countries, in principle, nominal devaluations would be altogether precluded. If even one country decided to abandon the euro, however, the resulting nominal devaluations of the newly-issued currencies could entail costs far beyond those experienced in Latin America. There is no doubt that flexible exchange rate arrangements may be useful in facilitating the relative price changes necessary in the face of external shocks. In retrospect, the utility of this policy option may be have been insufficiently appreciated by some of the countries now belonging to the eurozone. Once in the eurozone, however, nominal devaluations would require the reintroduction of national currencies, the high and disruptive costs of which could easily outweigh the benefits.
- 17 Argentina had most labour contracts, and a fraction of financial contracts, stipulated in pesos, (t (...)
41In all likelihood, currency reintroduction would mean breaking all pre-existing domestic contracts (including not only financial but also labour contracts) to re-draft them in the local currency, at conversion rates that would likely redistribute wealth on terms unfavourable to those previously entitled to receive euros. This in turn would likely lead to protracted litigation, if not open conflict and social unrest. The local currency would likely be unattractive for storing value, leading to financial ‘euro-ization’ and severe capital flight. Arguably, euro scarcity, in combination with heightened demand, would lead to financial controls aimed at fighting domestic financial ‘euro-ization’ and debt default on foreign debts with inconvertible terms. The Argentinean meltdown of 2002—when the currency board collapsed, leading to the ‘pesoification’ of dollar contracts and controls on financial dollarization—is an object lesson in the great risks inherent to uprooting exchange rate arrangements. In the case of Europe, there are compounding factors that suggest the potential cost of currency reintroduction would be even higher. Some of these factors include the larger scope of the required currency conversions;17 the increased entanglement stemming from the EU’s deeper domestic and international financial integration; and the waste of the comparatively higher levels of investment in institutions. Moreover, courts in Europe – where the rule of law is stronger – would likely hear legitimate complaints by those adversely affected by currency conversions, leading to protracted litigation.
42Can countries operating under an irrevocable pegged exchange rate maintain it while still regaining external competitiveness and avoiding the perils of deflationary adjustment? How? A higher level of euro inflation in core European countries would allow peripheral states to take advantage of the ensuring an inflation gap and regain competitiveness without incurring the macroeconomic costs of deflation. The measure of peripheral inflation spurred by high euro inflation, moreover, may be helpful in diluting nominal wage contracts that threaten to impede the adjustment necessary for full employment and competitiveness in the future. This assumes, of course, that wages in core countries will be renegotiated to incorporate euro inflation. This is a scenario will only materialize if the relevant states cooperate. In the Latin American experience, inflation typically played a key role in resolving financial crises by diluting debts in local currency and allowing a rapid reduction in real wages at full-employment levels. This is particularly important, as nominal wages, being sticky in nominal terms, tend to impede adjustment in both the public and the private sectors.
43In our view, fiscal devaluation constitutes a viable alternative to currency devaluation free of the risks of inflation. Fahri, Gopinath and Itskhoki (2011) define fiscal devaluation as a set of unilateral fiscal policies that implement the same real allocation as a nominal devaluation, but which holds the nominal exchange rate fixed. Two sets of fiscal devaluation policies have been proposed by economists: a) a uniform increase in import tariffs and export subsidies; and b) a uniform increase in Value Added Taxes (VAT) paired with a reduction in payroll taxes. This latter option should make the price of domestic output cheaper relative to that of domestic absorption.
- 18 Fernández-Arias and Talvi (1999) were early proponents of fiscal devaluation in the Latin American (...)
- 19 As the fiscal situation was very fragile in 2001, to minimize the fiscal impacts, the plan was no (...)
- 20 The actual rates fluctuated with the EUR/USD exchange rate. Additionally, in order to lower indust (...)
- 21 See Cavallo and Cottani (2010), de Mooij and Keen (2012) and IMF (2011).
44Latin America has had little experience with successful fiscal devaluations.18 Before the crisis exploded in late 2001, Argentina implemented such policies through a series of sectoral ‘competitiveness plans’ that lowered labour costs in certain economic sectors by allowing firms to expense payroll taxes against the VAT.19 In addition, the government levied a uniform tariff on final goods imports, which was then transferred to exporters.20 As the fiscal situation deteriorated sharply and the country lost access to credit, including that from the IMF, however, these policies were ultimately insufficient to avert the crisis. Due to their more extensive and better-enforced tax systems, as well as possessing the external support required to allow these policies time to work, European countries have a much larger scope for fiscal devaluation. In the case of Europe, the relevant question thus becomes: how much fiscal devaluation would be required to achieve the reduction in labour costs necessary to restore peripheral countries’ competitiveness? This is a key issue that has received some attention in the media and various discussion forums, but has not yet taken centre stage in European policy discussions.21 The effectiveness of fiscal devaluations would be strengthened if the comparatively more EU competitive countries applied opposite measures (i.e. fiscal revaluations) to bolster the competitiveness of peripheral countries within the eurozone.
45Latin America provides a number of useful lessons concerning the imperative to provide swift and abundant external liquidity support to mitigate the financial stress caused by sudden stops of capital flows, spikes in sovereign risk, and banking system instability. Arguably, the limited nature of available external support resulted in the depth of Latin America’s great collapses. At the same time, as demonstrated by Latin America’s failed experiment with the 1980s debt-restructuring Baker plan, if underlying fundamental problems are at the root of financial distress, liquidity alone is not a solution. Under such circumstances, external liquidity support, over time, may even become counterproductive, as it allows the rot to deepen and embroils official liquidity providers in credit risk. The continued failure of liquidity support to cure European countries experiencing financial distress is an indication that fundamental policy reform is probably required, and ought to be conducted alongside such measures. If domestic political economy factors impede undertaking the needed reforms, or repayment enforcement is in doubt, the implementation of structural reforms should be made a condition of continued financial support.
46A public debt overhang is deleterious to growth because it acts as an implicit tax on investment, particularly in the absence of clear rules for its elimination. To the extent that it depresses economic activity, fiscal contraction may easily fail to reduce the debt overhang. The realization that debt reduction is inevitable tends to be delayed, often leading to protracted recession and, occasionally, social unrest and/or political instability. The Latin American experience indicates that, in the right economic environment, orderly debt reduction may spur growth recovery and renewed capital inflows. Where debt restructuring is required, multilateral support, conditional on an appropriate policy framework, appears to be essential to ensuring debt reduction provides a solid base for recovery.
47 The Latin America experience also suggests that entangling banking crisis risks with sovereign debt crisis risks is a recipe for disaster. If bank troubles require a capital injection, banking crisis resolution must be implemented with an eye toward minimizing emerging fiscal liabilities. In Latin American, some of the methods utilized to this end included the privatization of troubled public banks; the liquidation rather than re-capitalization of some banks; and a minimalist approach premised on addressing only problem banks while targeting assistance to preserve key functions of the banking system.
48In all cases, successful crisis resolution requires the restoration of economic growth in order to reduce high debt burdens, improve bank assets and reduce the probability of political backlash. External official support may provide time for economies to adjust, but is no substitute for structural reforms aimed at reducing structural vulnerabilities and restoring long-term growth. The experience in Latin America demonstrates that it is more likely growth-enhancing reforms will be implemented in the aftermath of crises, particularly in supportive institutional environments.
49The Latin American experience—as it relates to fundamental policy choices concerning low growth, fiscal adjustment and financial distress in public debt markets and the banking sector—is relevant to peripheral eurozone countries in crisis. Some of the policies concerning debt restructuring, banking crisis resolution, countercyclical policy and structural reforms for growth, depending on each country’s specific circumstances, are also directly applicable. The policy of enacting real exchange rate depreciation to promptly regain competitiveness, so prevalent in Latin America, however, is unrealistic for Eurozone countries. In our estimation, abandoning the eurozone would be catastrophic for the exiting state attempting to re-introduce its local currency—so costly, in fact, that if at all possible, it should not be considered an option. The absence of this policy instrument makes the European case more complex and, in a sense, more troubling than that of Latin America.
50On the other hand, the existence of the European Union creates possibilities not available to Latin America. At the most general level, the scope for regional cooperation is much larger. Supranational institutions, such as the European Central Bank, are willing and able to play support national policies concerning sovereign debt, the banking system, and general balance-of-payments issues. Furthermore, the core states of the European Union are resourceful and in a position to help. While currency devaluation is not an option, cooperation could enlarge the scope of alternative competitiveness policies, such as complementing fiscal devaluation in less competitive economies with fiscal revaluation in core countries, thus buying time for these policies to work gradually. None of these regional cooperation options were available to Latin American countries, which had recourse only to limited, and not necessarily reliable, multilateral senior loans. The availability of these international cooperation resources ought to make the European problem easier to solve.
51That said, the existence of greater tools to address the complex problems currently facing peripheral eurozone countries does not necessarily guarantee success. The eurozone is navigating uncharted waters, and determining the correct course of action in crisis and core countries alike is a difficult process that will require significant innovation. Democratic governance in European countries, moreover, may limit the policy space of national governments trying to find a cooperative solution. If the available tools are not put to good use, Europe risks squandering the advantage its institutional and policy framework offers in coping with financial crises. The difficulties highlighted in the Latin American experiences reviewed in this essay could then pale in comparison to future European perils.
52In terms of the difficulties associated with currency rigidity, the Argentinian crisis of 2001-2002 is perhaps most closely approximates the current crises in peripheral European countries. Argentina’s experience suggests that the costs of exiting the currency union would be very large for eurozone crisis countries, conceivably larger than those in Argentina. In addition, the probable spillovers of a euro exit would likely threaten the financial stability of core countries. It is thus in the interest of all parties to exhaust all alternatives to a euro exit before even entertaining the idea as a policy option. If, however, the break-up ultimately becomes unavoidable – either because the external adjustment in peripheral countries is unmanageable without more dramatic real exchange rate depreciation than allowed for by the system, or it becomes politically unfeasible to adjust – the Argentine case suggests it would be better for all sides that the exit occur in a context wherein peripheral countries continue to receive financial support, thus facilitating the adjustments necessary to avoid catastrophic outcomes.