Lessons for Latin America from Overreliance on Foreign Funding to More Stable Economic Development

Article excerpt

Capital flows - the lifeblood of investment in emerging markets - have been the center of heated debate ever since the December 1994 Mexican devaluation and the subsequent peso crisis. But there has been little coherent analysis of such capital flows.

Mexico wasn't the first to have problems with misguided policies that ended in failure. Other countries, such as Chile in 1982, also suffered setbacks. Yet many of these countries have risen from the ashes of policy mistakes and have gone on to stronger and healthier patterns of economic development, benefitting citizens with more jobs and a higher standard of living. Because of such potential benefits to stagnant or declining economies, it's important to review key concepts of global capital flows.

Investment capital has two general avenues for flowing abroad. The first is Foreign Direct Investment (FDI), usually undertaken by large multinational firms building plants, starting subsidiaries, etc. The second is portfolio investment by institutional and individual investors. Both forms of capital flows were welcomed by developing countries prior to the Mexican devaluation. Since then, portfolio capital flows have been considered the "bad" form of capital inflows, while FDI inflows are known as the "good" form. Is there any economic logic for this characterization?

Twenty years ago many economists decried the evils of FDI. Multinational firms seeking to build manufacturing plants in developing countries were seen as colonizers. The dependencia school of economics declared that FDI activity forced developing countries to become dependent on foreign capital. Economists who espoused this view argued the countries would never develop on their own. Portfolio investment, therefore, was the preferred route because it allowed local entrepreneurs to retain equity ownership in new enterprises.

The quest to tame inflation

So why the current aversion to portfolio capital? Since the late 1980s, many developing countries have embraced fixed exchange rates as a way of reducing inflation. Take Argentina. In 1991, the economic team of Domingo Cavallo fixed the peso to the dollar and eliminated persistent hyperinflation. Exchange-rate stabilization plans produced quick results in reducing inflation without exposing Argentina to the pain of severe belt tightening and deflation.

This policy approach, however, can also produce insidious macroeconomic problems that only surface later - such as large trade and current-account deficits. Developing countries often lack the internal savings to finance such imbalances and are able to do so only through attracting short-term foreign investment. But the countries can become overdependent on such external funds. …