nificant risks to economic activity across the globe.
It’s easy to be pessimistic about what this will
mean for Latin America, especially as troubling headlines spread across newswires almost every day. But
smart action by both governments and international financial institutions could reinforce the region’s
already considerable strengths and enable it to emerge
from this crisis with minimal long-term damage.
This hope is anchored in the fact that the region’s
policy framework and economic performance have
strengthened significantly in the past decade. Latin
America entered the global financial crisis after a five-year period of significant and sustained economic
expansion. Unlike the 1990s, when the region embraced
financial globalization during a period of negative or
neutral real shocks, the current decade is marked by
positive, real trends such as an improvement in terms
of trade, low world interest rates, and subsiding risk
spreads (namely, the spread between the interest rate
paid by an emerging market economy’s government on
its debt and that paid by the U.S. Treasury).
Thus, instead of rising external debts and current account deficits, most countries in the region
registered what have been called twin surpluses—
in the current account of the balance of payments
and in the fiscal balance. The benefits accruing from
low inflation, sustained growth and strong financial
sectors translated into an unprecedented accumulation of international reserves. The stock of international reserves in Latin America’s largest economies
exceeds $400 billion, well in excess of the stock of
short-term public debt.
How Did We Get Here?
The current crisis in the advanced economies arose
from the excessive leverage and inflated asset prices
triggered by the creation of innovative and complex
financial instruments in the U.S. mortgage market
(e.g., securitization, “tranching of securities,” special investments vehicles, dubious valuation methods, etc.). Such innovations were largely motivated
Pablo E. Guidotti is dean of the School of
Government, Universidad Torcuato Di Tella .
by the financial institutions’ desire to circumvent
existing prudential regulations, especially those
requiring them to hold enough capital against risky
assets, along with a search for higher yields in a context of historically low interest rates. In the presence
of weak regulatory and supervisory systems, such
conditions combined to accelerate the market meltdown.
3 As the financial crisis erupted, both financial
and capital markets became dysfunctional. As confidence collapsed across financial institutions, interest rates rose and lending froze in the short-term
interbank markets as well as in important segments
of the commercial paper market. As a result, the real
economy started to suffer.
In emerging markets, past financial crises have
displayed two distinct, although interrelated, components. On the one hand, the collapse of confidence
leads to the above-mentioned freezing of financial
and capital markets as counterparty risk (namely, the
risk that the counterparty in a financial transaction
defaults) soars and the search for liquidity becomes
the single most important short-term objective of
market participants, such as banks and other financial and capital-market institutions.
On the other hand, the unwinding of a financial crisis has clear and unavoidable permanent real
effects. It implies a loss of asset value and wealth, and
a sharp deleveraging. As Martin Wolf, associate editor and chief economics commentator at the Financial Times, recently illustrated, the growth of private
debt—particularly in the financial sector—in both the
United States and the United Kingdom had mounted
in recent years to record levels of 300 percent of GDP
and above 450 percent of GDP, respectively.
Most of the unprecedented policy actions taken
so far by governments of the advanced economies
(and particularly their central banks) have been
directed at restoring the functionality of financial
and short-term capital markets. Compared to the resolution of financial crises in emerging market economies, the big difference here is that governments
possess (and have displayed) significant firepower.
And, so far, these measures appear to be working,
as markets are slowly unfreezing. In the U.S. market, spreads for high-yield corporates as well as the
spread between interbank-market rates and the U.S.