1999 Fiscal Conference Comments - Sustainable Public Sector Finance in Latin America: Eisenbeis - International Lending and Capital Flows
Thank you very much. I'd like to take this opportunity to thank you all again for coming and participating in this conference. I think it has been a very interesting meeting and one that has delivered many important insights about what some of the current problems are and what possible solutions are available.
I'd like to take a few minutes to reflect upon a number of the points that both Francisco and Graham made as those insights relate to the development of financial markets and capital flows. I find very little to disagree with in terms of the key ideas that they present, so rather than concentrate on the specifics, I’d like to discuss a number of observations they put forward, to see where this takes us. And, in the time we have left, I’d like to throw out some ideas for discussion.
First, I’d like to build on the point that Graham made with regard to the evolution of financial markets. The international financial system is evolving, and it’s evolving at a very rapid rate. When one can talk about six stages in a matter of just ten years, as Graham did, that tells something about how fast things are evolving and changing. They are evolving and changing in several different ways. First of all, markets are becoming larger. That is pretty clear, and the data have been well documented. Second, they are becoming more informed and more efficient than they’ve ever been before. Third, we are seeing an evolution away from financial institutions, and particularly commercial banks, serving as primary sources of funding to a greater reliance on capital markets. Debt issuance is becoming a major source of funds. That’s something we see here in the United States as well. It’s a logical consequence of the greater efficiency of markets as a whole. And following from this consequence come interesting generalizations.
One generalization is that, for all practical purposes, the era of the free lunch in terms of access to cheap money is essentially gone, or almost gone. What I mean by this is that we had somewhat of a free lunch back in the 1970s when we were recycling the petrodollars and there was an abundance of funds. Lenders were not very informed, and, although they thought they were diversified, they did not realize that any country that is dependent upon oil is also dependent on the price of oil. It doesn’t make any difference where lenders are lending—if repayments are dependent on the price of oil, lenders are not diversified. Another aspect of the free lunch that I think is gone pertains to the world of efficient capital markets: in this environment it’s not possible to sustain any sort of fiscal deficit for a protracted period of time without incurring some kind of cost. This is especially true in Latin America today, and it’s something we have all discussed over the last day and a half.
Talking about financing fiscal deficits is almost a non sequitur in the context of efficient and global capital markets. A country cannot continue to borrow in excess of its revenues on a sustainable basis. Market discipline is going to become a daily fact of life for governments as they try to manage their fiscal situations.
This affects the core of the political, social, and cultural fabric that has been supported in some of the Latin American countries. It goes to the very heart of how many of these countries have been run for years. It is hard, I believe, to run an economy—or society for that matter—without a well-functioning legal system. And the less developed a country’s legal system, the more the market is ultimately going to penalize that inefficiency.
Fiscal disciplines apply not only at the federal level but also at the state and local levels—and I think Brazil is a case in point. It’s not enough to fix the fiscal problems at the federal level alone without also getting things together at the state and local levels. There is going to be a lot of difficulty as people try to deal with the need for reforms. Again, however, problems at the local level are, I think, a logical consequence of the pressure that well-developed financial markets are going to put on countries. It means that government won’t be able to maintain unsustainable monetary policies or fiscal policies over a protracted period of time without suffering certain kinds of difficulties.
In many ways, the current situation in Latin America can be seen as a triage situation. One example is what we heard this morning about Peru, which faced a very difficult set of circumstances and had to try to begin to put policies in place that would remedy the situation quickly. Triage is different from plans developed to respond to the fiscal sustainability question in the longer haul or from evolution forced gradually by markets.
The International Monetary Fund has largely been engaged in triage situations as well. But over the longer haul, are they going to be able to continue to engage in those kinds of activities without engendering the moral hazard problem that Francisco talked about? This is a very real question, and one that is going to have to be dealt with in the longer run. It remains on the table for the international community to come to grips with in one way or another.
Another point I’d like to make deals with the question of coping with so-called capital flight. There were some discussions earlier of how volatile markets have become. I have a somewhat different view as I assess and reflect upon what happened in Asia compared with Latin America. I think in the Asian situation, capital actually responded modestly over a long period of time and on a relatively gradual basis. I guess whether you think it was gradual or not depends upon which side of the Pacific you are on. But the fact of the matter is that all the money did not come out overnight; it came out on a gradual basis over several months. A similar kind of thing happened in Latin America. Initially everybody seemed to be hit with the same risk spread, but investors started to learn, and the markets again continued this evolution process. A balancing of spreads and a differentiation of spreads became apparent, depending upon what the underlying fiscal and financial situation was in individual countries. So, the spreads opened up and lenders started differentiating even more among countries quickly. Thus I think it’s an overexaggeration to say that everybody was painted with the same brush in that crisis. I don’t think the evidence supports that. And this distinction among countries is a trend that is going to continue.
The last point I’d like to make also pertains to the issue of capital flight and has to do with the sorts of policies that can be put into place to try to insulate the domestic economy from what’s going on in the rest of the world. I’d like to submit that it’s going to be difficult to do that. And I’d like to look at Chile for just a second. Everybody has been holding up capital controls as a model of the way to try to deal with the short-term situation. It clearly is a short-term situation and, if you believe in the efficiency and effective functioning of global capital markets, it seems obvious that Chile will not be able to sustain those restrictions on short-term capital flows. Institutions will find ways around those controls, or else funds will leave the country. And in the meantime, the controls will increase the costs of investment in those maturities for which the controls are in place as well as introduce distortions into the functioning of their financial markets.
The bottom line is that market discipline is pervasive: it will continue to work and evolve along the lines that it has thus far. It’s very difficult for countries to operate in this kind of evolving environment because we don’t know how quickly markets and market instruments will change. This uncertainty doubles the problem for those in a policy-making position. But I am optimistic about the impact that market discipline will have. It may signal an end to the horrendous costs of repeated financial crises resulting from the unsustainable policies that have been put in place in the past in many developing countries. Obviously, we will see a greater freedom for individuals as markets work. So I am pretty optimistic. It may be difficult to deal with the transition, but that’s what most of us here are involved with, and plotting the right course is key to a successful policy.