World Economic Review
External Fragility or Deindustrialization: What is the Main
Threat to Latin American Countries in the 2010s?1
Roberto Frenkel
Principal Research Associate at CEDES and Professor at University of Buenos Aires,
Argentina
Martín Rapetti
Associate Researcher at CEDES and researcher at IIEP, University of Buenos Aires,
Argentina
Abstract
In this paper we evaluate whether the surge of capital inflows to Latin American countries after the
2007-08 global financial crisis poses a threat for these economies. Recent IMF’s documents have
warned that capital inflows could lead to boom-and-bust cycles ending up in external and financial
crises as in the past. We provide evidence that the external conditions of these economies are far
more robust than in periods prior to crises. The evidence that Latin American countries are not
showing signs of external fragility does not imply, however, that the current flow of capital does not
pose a threat for them. In our view, capital inflows could harm economic development in the region
by weakening the expansion of modern tradable activities. We show that capital inflows have induced
an appreciation of real exchange rates and a deterioration of tradable sector profitability. Signs of
deceleration of growth in manufactures and tradable services have started to emerge.
Key words: Real exchange rate, Latin America, Dutch disease, economic development
1. Introduction
This paper analyzes the challenges posed by persistent capital inflows to Latin America that started
in late 2009. Several countries in the region experienced boom-and-bust cycles in the past, all of
them associated with capital inflows. Based on these experiences, some analysts have recently
begun to warn about the threats related to current flows of capital to the region. Although this is a
valid concern, we believe that the main threat to Latin America lies not so much on the possibility of
crises in some future, but on the effect of capital inflows on the real exchange rate (RER)2. More
concretely, our concern is that capital inflows may lead to excessive RER appreciation, which could
damage the profitability of manufacturing activities, reduce employment and productivity and
ultimately hurt the development prospects of the region.
The paper is organized as follows. After this introduction, we analyze the external context
that most Latin American countries are facing today and argue why it is likely to persist in the
foreseeable future. In section 3, we review the evolution of RERs in Latin America during the last two
decades and suggest that current levels are overvalued. In section 4, we show that the appreciation
1
An earlier version of this paper was prepared for the Economic Development Division of ECLAC (Frenkel and Rapetti 2011).
The authors thank ECLAC for the authorization to translate the article into English and to publish it in this journal. The authors
also want to thank Osvaldo Kacef, Jaime Ros, Jayati Ghosh, John Weeks and, especially, Norbert Häring for their thoughtful
comments, and Eleonora Tubio and Emiliano Libman for their research assistance. The authors declare that they have no
personal or professional link to any industry, company or institution mentioned in this paper and that there is no material conflict
of interest.
2
We follow the definition of nominal exchange rate as the domestic price of a foreign currency. A rise (fall) in the exchange rate
implies a depreciation (appreciation) of domestic currency. Similarly, a higher (lower) RER implies a real depreciation
(appreciation).
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of RERs have resulted in competitiveness loss in manufacture activities. We also show some
evidence suggesting that the loss of competiveness is affecting the performance of manufacture and
services activities. Finally, in section 5, we present a proposal for the conduct of macroeconomic
policy to avoid excessive RER appreciation and its negative effects on employment and productivity
in tradable activities.
2. This is just the beginning
It seems clear that the wave of capital inflows to emerging markets starting circa 2010 is influenced
by the high returns that assets from these countries offer in comparison with those from advanced
countries. Certainly current low GDP growth and interest rates in advanced countries are not
permanent phenomena. Their real and financial yields will both probably rise in some future.
However, we believe that the high rates of growth that emerging markets have been experiencing
since the early 2000s will continue. This seems to us a more persistent phenomenon. Although
growth rates in emerging markets and advanced countries had shown a high correlation since the
1980s, they started to diverge in the 2000s for the first time in the period of financial globalization
(IMF 2010). This trend has persisted during and after the global financial crisis of 2007-08.
Figure 1: Net capital inflows to Latin America and the Caribbean (in billions dollars)
(FDI – foreign direct investment)
Source: World Economic Outlook, April 2011, International Monetary Fund
Besides the yield differentials, current capital inflows are determined by the reduction in the
perceived risks in emerging markets. Regarding this factor, important changes have been observed
in the way these economies participate in international financial markets since the Asian and Russian
crises in 1997-98 (Frenkel and Rapetti 2010a). One key change was the switch from current account
deficits to surpluses in their balance of payments, which also involved a change in the direction of net
capital flows between advanced countries and emerging markets. Other relevant changes that
reduced perceived risks are the substantial accumulation of foreign exchange reserves and the
implementation of more flexible exchange rate regimes. These changes helped reduce the
segmentation of emerging market assets and also the risks of contagion and herd behavior within
this class of assets. As a result, the reduction in the perceived risks also spread to those emerging
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market economies that kept running current account deficits or did not move towards more flexible
exchange rate regimes.
Due to these factors, risk premia in emerging markets followed a falling trend since late
2002. By mid-2005 they went below the minimum levels reached before the Asian crises in 1997-98
and by early 2007 they reached historical minimum levels. This trend was reversed in mid-2007 once
concerns about the US housing and financial markets became apparent. The resulting jump in
emerging market risk premia during the subprime crises was, however, short-lived and since early
2009 they began to fall again. Figure 2 shows that the above description applies to sovereign risk
premia in Latin America. The more accentuated reduction in Latin American countries risk premia
compared to emerging markets average since the early 2000s is attributable to Argentina and
Brazil’s sovereign risk premia, which began the decade from very high levels.
Figure 2: Sovereign risk premia in emerging markets and Latin America,
and US high-yield bonds spread (in basic points)
(EMBI – Emerging Markets Bond Index; EMBI+ – Emerging Markets Bond Index Plus; Bps – basis points;
HY – High Yield; EMBIGLOBAL – Emerging Markets Bond Index Global)
Source: Bloomberg
The global financial crisis was a stress test for emerging markets. With the exception of a few
European countries, none of them suffered external or financial crises and there was no sovereign
debt default. Moreover, the same pattern of international financial integration persisted after the
crisis. The increase in the IMF’s financial resources and the flexibility of its assistance programs also
played an important role in the prevention of crises in emerging markets. Overall, the results of the
stress test and the changes in the IMF reinforced the previous perception about the profitable
opportunities in emerging markets. Thus, we expect that the low risks and capital inflows to emerging
markets will continue in the foreseeable future.
We now turn our analysis to Latin America. Between 2003 and 2007, the region as a whole
ran a current account surplus. In 2008, it turned into a deficit that widened up until 2010, when it
reached a local maximum. In fact, Mexico, Colombia and most of Central American and Caribbean
countries had already been running current account deficits all along the 2000s. Thus, the dynamics
described above resulted from the behavior of most South American countries. Assuming no major
changes in current economic policies, forecasts – including those of the IMF (IMF 2011a) – indicate
that current account deficits in these economies will tend to widen.
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Do increasing current account deficits represent a threat in terms of external and financial crises as
they did in the past? The experiences of capital inflow booms that ended up in crises in Latin
America resulted from sustained current account deficits that led to excessive foreign debt
accumulation. Rapid foreign debt accumulation and rising current account deficits in these
experiences occurred in contexts of fixed exchange rate regimes and appreciated RERs (Frenkel
and Rapetti 2009). The observed rise in sovereign risk premia was precisely associated with the
perception that countries in those contexts would have a hard time meeting debt services. None of
these features are currently observed in Latin American countries.
First, most countries in the region have adopted flexible exchange rate regimes – mostly,
managed floating regimes – and have been accumulating large stocks of foreign exchange reserves.
These elements give monetary authorities greater flexibility to absorb negative external shocks and
to avoid sharp exchange rate corrections in contexts of low liquidity of foreign exchange.
Second, foreign debts in Latin America shrank substantially during the 2000s and reached
historically low levels, as shown in Figures 3 and 4. The emergence of current account deficits in this
situation is novel for the countries in the region. Since their reincorporation to the international capital
markets in the late 1980s, Latin American countries have been dealing with heavy debt burdens
inherited from the debt crises in the early 1980s. The new configuration suggests that most countries
have substantial margins to accumulate foreign debt before reaching high debt-to-GDP ratios.
Figure 3: Foreign debt/total exports, South America
Source: CEPALSTAT, ECLAC3
3
In the case of Argentina, all calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA.
The data on Brazilian exports were obtained from IPEADATA. (See Appendix.)
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Figure 4: Foreign debt/total exports, Mexico and Central America
Source: CEPALSTAT, ECLAC
There is another important element making the threat of crises even less likely. Because of the
reduction of foreign debts during the 2000s, the weight of interest payments in the factor income
account of the balance of payments has reduced significantly. In contrast to the previous 30 years of
financial globalization, current account deficits in most Latin American countries are now largely
influenced by dividend payments of foreign direct investment (FDI). This represents an important
change. Interest payments have to be paid in foreign currency – typically US dollars – and since they
are contractual obligations, they constitute a source of foreign currency outflow that is delinked from
the business cycle. On the contrary, FDI dividends are largely obtained in domestic currency –
making their value in foreign currency depend on the exchange rate – and are highly correlated to
the business cycle. This implies that in the case of a capital inflow deceleration or reversal, the
magnitude of FDI dividend payments tends to contract due to both the depreciation of the domestic
currency and the deceleration or contraction of domestic economic activity. Furthermore, a significant
portion of FDI dividends are normally re-invested in the recipient economy – being registered in the
balance of payments as a new inflow of capital – without even going through the foreign exchange
market. This implies that part of factor income account deficits has a relatively automatic source of
funding. Finally, in cases of severe scarcity of foreign exchange, authorities can impose transitory
restrictions on the remittance of FDI dividends to alleviate the excess demand for foreign exchange.
Table 1 illustrates the change in the composition of current accounts in some Latin American
countries. The current account deficit of Brazil was 49.5% of total exports in 1999. This deficit was
almost equivalent to the gross factor income remittances (41%). 39.7% of these remittances
corresponded to interest payments and the other 60.3% to FDI dividend payments. The current
account deficit represented only 20.3% of total exports in 2010. Once again, gross factor income
remittances were virtually of the same magnitude as the current account deficit (20%). The difference
is that in 2010 virtually all of these remittances (88.6%) corresponded to FDI dividend payments.
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Table 1: Current account of the balance of payments and foreign direct investment
(as a share of total exports)
Source: CEPALSTAT, ECLAC4
In Chile, similar to developments in Brazil, between 1999 and 2010 the proportion of interest
payments went from 40.8% to 7.4%, It went from 82.8% to 26.3% in Colombia and from 93.7% to
15.6% in Peru. The exception has been Mexico, where the proportion only shrank from 75.7% in
1999 to 63.8% in 2010. In all the countries with current account deficits in 2010 (Brazil, Colombia,
Peru and Mexico), the deficits were entirely financed with FDI, a large proportion of which was
re-investment of dividends.
Because of the reasons discussed above, we do not see signs of excessive external fragility
in Latin America and therefore do not think that the current wave of capital inflows represents a threat
in terms of immediate crises. This assessment may look more ‘optimistic’ than a recent evaluation
carried out by the IMF (IMF 2011b), in which the institution warns about the increase in current
account deficits in the region and the potential risks of capital flow reversals. This concern was a
reason behind the recent change in the IMF’s view about the benefits of capital inflows to developing
countries. The institution now promotes a more cautious approach and it even suggests that
countries should consider the possibility of adopting capital controls transitorily (IMF 2011b).
Our assessment that sudden stops and crises are not highly likely in the immediate future
should not be understood as a statement that the current flow of capital is harmless and does not
pose any threats to Latin American countries. Quite on the contrary, we believe that national
authorities should worry about them and adopt measures to discourage them and to mitigate their
effects. Our concern, however, is not so much the possibility of crises but the effects that capital
inflows have on the real economy via their effects on real exchange rates (RER). More concretely,
our concern is that massive capital inflows to Latin America may have pernicious effects via an
excessive appreciation of the RER, which could lead to a contraction in output and employment in
tradable activities with negative effects on long-run growth. Our concern, in other words, is the
possibility of Dutch Disease.
4
Data on balance of payments, external debt, bilateral RER with the US, effective RER, wages and value added in constant
prices are all from CEPALSTAT, ECLAC. The data on Brazilian exports were obtained from IPEADATA. (See Appendix)
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3. The evolution of real exchange rates in Latin America
Between 1990 and 2010, the behavior of RERs in South American has been different from those in
Mexico, Central America and the Caribbean. In the first group, RERs tended to appreciate between
the early 1990s until the eruption of the Asian and Russian crises in 1997-98. To deal with these
shocks, Brazil, Chile and Colombia adopted floating and inflation targeting regimes in 1999. Peru had
been using a managed floating regime since the early 1990s and only formally adopted inflation
targeting in 2002. Argentina and Uruguay maintained fixed exchange rates and overvalued RERs
until the 2001-02 crises and then opted for managed floating arrangements. In all these countries,
RERs reached maximum levels in 2002-03 and then followed a persistent appreciation trend,
transitorily interrupted by the effect of the subprime crisis and its global contagion. Within this group,
Argentina’s RER has been the most volatile and Peru’s the least. Figures 5 the evolution of the
bilateral RERs with the US between 1990 and 2010 for South American countries.
Figure 5: Bilateral real exchange rates with the US, South America (100=2000)
Source: CEPALSTAT, ECLAC5
There are some aspects worth highlighting. First, within each country, 2002-03 is the period in which
RERs reached their highest levels since countries regained access to the international financial
markets in 1990. Second, the rise of the RERs in the early 2000s improved current account balances
before the commodities prices boom started circa 2004-05. Third, because of the high levels at which
they started, during 2002-2008 RERs remained on average relatively high compared to the 1990s,
despite their persistent downward trend. Fourth, the rise of RERs of 2008-09 represented only a mild
and transitory detour from their downward trend.
Figure 6 helps to give a neater view of the fall of the RERs experienced in South America
during the 2000s. With the exception of Argentina’s, RER levels in 2010 were similar to the lowest
levels in the 1990s.
5
In the case of Argentina, all calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA.
(See Appendix.)
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Figure 6: Bilateral real exchange rates with the US, South America.
Minimum levels in the 1990s, 2002-08 average and 2010 (100=2000)
Source: CEPALSTAT, ECLAC6
The behavior of bilateral RERs with the US in Mexico, Central America and the Caribbean has been
different. Figure 7 shows that they were substantially less volatile and that most of them followed a
persistent downward trend all through the two decades.
Figure 7: Bilateral real exchange rates with the US, Mexico, Central America
and the Caribbean (100=2000)
Source: CEPALSTAT, ECLAC
Figures 8 and 9 show the evolution of effective RERs in Latin American countries. In the case of
Mexico, Central America and the Caribbean bilateral and effective RERs are very similar due to the
6
In the case of Argentina, all calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA.
(See Appendix.)
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high weight that the US has on these countries’ international trade. Effective RERs in South
American countries are less volatile than bilateral RERs. This is because trade between these
countries is high and therefore the correlation of bilateral RERs observed in Figure 5 reduces the
volatility of effective RERs. Despite the fact that competitiveness gains and losses against all trade
partners are less pronounced than against the US exclusively, the trajectories followed by effective
RERs have been similar to those of bilateral RERs. The 2010 levels of effective RERs in South
America were also similar to the minimum values of the 1990s as Figure 10 illustrates.
Figure 8: Effective real exchange rates in South America
(100=2000)
Source: CEPALSTAT, ECLAC7
Figure 9: Effective real exchange rates, Mexico, Central America
and the Caribbean (100=2000)
Source: CEPALSTAT, ECLAC
7
In the case of Argentina, all calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA.
(See Appendix.)
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Figure 10: Effective real exchange rates, South America.
Minimum levels in the 1990s, 2002-08 average and 2010 (100=2000)
Source: CEPALSTAT, ECLAC
4. Capital inflows, Dutch disease and economic development
The case in which massive capital inflows appreciate the RER leading to a contraction in output and
employment in the manufacturing sector is commonly indicated as a variant of the Dutch Disease
phenomenon. Some authors conceive Dutch Disease as an equilibrium outcome with no relevant
effect on long-run economic growth.8 Under this view, a positive shock – like the discovery of an oil
field, a permanent increase in the price of an agricultural or mineral commodity or even a sustained
flow of FDI – would represent an increase in national wealth. The consequent rise in the actual and
expected flow of foreign currency income would lead to an equilibrium appreciation of the RER. With
a more appreciated (ie. lower) RER, some other tradable activities – manufactures and services –
would become uncompetitive and would perish against international competition. This outcome
would not be problematic because the labor freed by these activities would be absorbed by the
expanding sectors. This type of de-industrialization would be an equilibrium outcome and a priori
would not affect long-run economic growth. Under this perspective, current capital inflows to Latin
America – unless they represent a transitory phenomenon – should not be a source of concern for
national authorities.
We find this view problematic for several reasons. First, it is not clear that capital inflows
represent an increase of the recipient country’s wealth in foreign currency, as in the standard case of
Dutch Disease. Capital inflows can be a source of finance for a current account deficit – which would
imply an increase in net foreign debt – or an exchange of foreign for domestic assets – without
altering the net international investment position. A green field foreign investment certainly
represents an increase in the capital stock of the recipient country, but it is typically made with the
expectation that the discount value of future dividends will be higher than the original investment.
Second, it is impossible from the viewpoint of a policy-maker to know ex-ante whether a wave of
capital inflows represents a transitory or permanent phenomenon. Third, it is equally uncertain
whether the labor displaced from the industrial and services sectors resulting from the appreciation of
8
This appears to be the view, for instance, of Magud and Sosa (2010) in their assessment of the empirical literature on Dutch
Disease and on the RER-growth relationship.
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the RER will be absorbed by other sectors. There is, on the other hand, a much higher degree of
certainty regarding the effects of a transitory but sustained RER appreciation on industrial
employment and output. Transitory but lasting RER appreciations have typically led to the destruction
of firms and employment, human and organizational capital, vertical and horizontal linkages and
access to foreign markets. These outcomes have been formalized (Krugman 1987 and, Ros and
Skott 1998) and documented empirically (Sachs and Werner 2001). Moreover, there are several
examples in Latin American economic history of sustained RER appreciation leading to deindustrialization. These are, for instance, the experiences of Argentina and Chile between late 1970s
and early 1980s and that of Argentina during the 1990s9.
We also find problematic the view that Dutch Disease and RER appreciations do not have
effects on long-run growth. Economic development is associated with the expansion of modern
tradable activities (ie. manufactures and services intensive in knowledge). The expansion of these
activities generates a variety of positive externalities – learning-by-doing, network externalities and
technological spillovers – that tend to accelerate economic growth. They also increase the net supply
of foreign currency and thus reduce the possibility of stop-and-go dynamics or excessive foreign debt
accumulation and crises that hamper long-run growth. For these reasons, a competitive RER
provides an environment conductive to economic development by stimulating investment in tradable
activities. A recent body of econometric research has found a robust association between growth
acceleration and competitive RERs10. Moreover, this relationship has been observed in several
episodes in the economic history of Latin America: the most successful cases of sustained growth
accelerations have occurred when governments oriented their macroeconomic policy to sustain
competitive and stable RERs that protected industrial activities and promoted non-traditional exports
Frenkel and Rapetti 2012).
Consequently, current capital inflows to Latin America – even if they do not represent a
threat in terms of external vulnerability and crisis – could excessively appreciate the RER, harm the
development of the industrial sector and its employment level and negatively affect long-run growth.
Given current conditions and our expectation about their continuation, we believe that RER levels
that guarantee external sustainability in Latin American countries are more appreciated (ie. lower)
than those required to promote economic development. Macroeconomic policy should care about not
only the RER level that guarantees external sustainability, but also the one that promotes the
expansion of modern tradable activities, employment and economic development11.
It is therefore very important to evaluate whether manufacturing activities in Latin American
countries are experiencing profitability problems that could constrain their long-run development. A
simple way to do this is calculate the unit labor cost in foreign currency (ULC$), which measures
domestic wage rates relative to foreign wage rates in common currency (US dollar), adjusted by
relative productivity12. Changes in ULC$ over time indicate the evolution of the profitability of tradable
activities intensive in labor, as manufactures and modern services. A rise (fall) in ULC$ suggests a
fall (rise) in the profitability of these sectors. For its calculation, we use the simple average of the rate
of variation of GDP per capita of the US, Germany, China and Brazil as a proxy of the rate of
variation of foreign productivity. These countries influence the productivity trends in the dollar and
9
See Ffrench-Davis (2004) for the Chilean experience and Damill (2002) for that of Argentina.
10
See, among others, Aguirre and Calderon (2005), Gala (2007), Rodrik (2008) and Rapetti et al (2012).
11
The notion that the RER level that guarantees external sustainability may be more appreciated than the one required to
stimulate the development of modern tradable activities was originally formulated by Diamand (1972). A recent elaboration of
this argument can be found in Bresser-Pereira (2010).
12
Formally, ULC$ = (W / EW*)(ρ*/ ρ), where W represents the nominal wage rate, E the nominal exchange rate, ρ productivity
and the asterisk (*) indicates foreign country. Due to the lack of homogeneous data, we calculated ULC$ using the CPI and
GDP per capita as proxies of foreign nominal wages and labor productivity, respectively. Consequently, we calculated ULC$ =
(ω/q)(y*/y), where ω is the domestic real wage rate and y GDP per capita and q, the RER. Constructed this way, the indicator
implicitly assumes that foreign real wage remained constant during period of analysis.
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euro areas, Asia and Latin America, respectively and thus represent a reasonable approximation of
the competitive pressures that the countries in the region face.
Figure 11 shows the evolution of unit labor cost in foreign currency (ULC$) for South
American countries between 1990 and 2010. It is apparent that in almost all cases ULC$ have been
rising substantially and sustained since 2002-03 when there is a local minimum. In Colombia, Chile
and Brazil, the 2010 levels are substantially higher than the maximum levels reached during the
1990s: +68%, +38%, and +12%, respectively. These figures suggest that tradable activities intensive
in labor in these countries have been facing increasing challenges in terms of competitiveness and
profitability. The trajectories of Argentina, Uruguay and Peru are similar although less accentuated. In
the former two, the significant increase in ULC$ since 2002-03 has led to levels similar to the
maximum levels reached before the 2001-02 crises. In Argentina, the 2010 level was still 7% lower
than the 2001 level and in Uruguay 7% higher than in 1999. In Peru, ULC$ have been rising at a mild
pace and its last observation (2009) was still 3% lower than the maximum level of 1994. To facilitate
comparisons, Figure 12 shows the 2010 levels, the previous local maximum levels and the 20022008 period averages.
Figure 11: Unit labor costs in US dollars (ULC$), South America (100=2000)
Source: CEPALSTAT, ECLAC13
13
In the case of Argentina, all calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA.
(See Appendix.)
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Figure 12: Unit labor costs in US dollars (ULC$), South America.
Maximum levels of the 1990s, 2002-2008 average and 2010 (100=2000)
Source: CEPALSTAT, ECLAC14
Figure 13 decomposes the rise in ULC$ between 2002 and 2010 in three factors: real wage
increases, RER appreciations and variations of relative productivity. The bars indicate the
percentage variation of ULC$ and its components15. Some aspects are worth noting. First, RER
appreciation was a key element explaining the rise in ULC$ in all cases. There is, however, an
important difference (not shown in the figure) between Argentina and the rest. In Argentina, RER
appreciation resulted from higher domestic inflation relative to foreign inflation whereas in the other
South American countries it mainly resulted from nominal exchange rate appreciation, especially in
Brazil and Colombia. Second, there are significant differences in terms of productivity growth.
Whereas in Brazil, Chile and Colombia productivity grew at a slower pace than in the reference
countries (the US, Germany, Brazil and China), in Argentina, Uruguay and Peru, it grew faster. Third,
in Argentina real wages increased relatively more than the productivity differential; in Peru and
Uruguay, they increased relatively less than the productivity differential. The different behavior of real
wages in these countries is a reason why unit labor cost in foreign currency in Argentina rose more
than in Peru and Uruguay.
14
In the case of Argentina, all calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA.
(See Appendix.)
15
The sum of all factors adds up to the total variation of ULC$ when the calculation is carried out in continuous time. Because
calculations for Figure 13 were done in discrete time, the sum of the parts does not add up to the total. The reported variation of
the factors, however, suggests the relative incidence of each of them on the total variation.
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Figure 13: Decomposition of the increase in unit labor cost ULC$ (2002-2010)
by explanatory factors, South America (in percentage)
Source: CEPALSTAT, ECLAC16
Figure 14 shows the evolution of unit labor cost in foreign currency in Mexico and some Central
American countries between 1990 and 2010. ULC$ have been increasing since the 1990s in all
these cases. In Mexico, the ULC$ level in 2010 was 35% higher than in 1994, a year before the
currency crisis. If that year is taken as a reference of low profitability in Mexican manufacturing, then
current levels suggest that the current situation is even worse. The competitive loss in Mexico and
the Central American countries is largely a result of the low productivity growth relative to foreign
competing countries. This can be observed in Figure 14, which replicates the decomposition of
Figure 13 for Mexico and Central American countries.
Figure 14: Unit labor cost in US dollars (ULC$), Central America and Mexico (100=2000)
Source: CEPALSTAT, ECLAC
16
In the case of Argentina, all calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA.
(See Appendix.)
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Figure 15: Decomposition of the increase in ULC$ (2002-2010) by explanatory
factors, Central America and Mexico (in percentage)
Source: CEPALSTAT, ECLAC17
The evidence gathered so far suggests that – at least in Brazil, Chile, Colombia, Mexico and the
Central American countries examined – the profitability in tradable sectors intensive in labor has
shrunk substantially in the last few years. One would expect that these developments would affect
the performance of these activities and their employment levels. It is, however, difficult to assess the
extent to which RER appreciation hurts tradable profitability because their effects are not immediately
observed. Facing a profitability squeeze, firms first absorb losses, then reduce the workday or force
their workers to anticipate their vacations, then adopt defensive strategies reducing their value added
and simplifying the production lines and finally go bankrupt. As a result, the adaptation to RER
appreciation takes the form of a gradual contraction of value added and employment that takes time
to become apparent. It is documented, for instance, that the effect of RER appreciation on
employment in Latin America has operated with a 2-year lag (Frenkel and Ros 2006).
One would then expect that – if the observed RER appreciation and profit squeeze in Latin
America continue – modern tradable sectors would gradually decelerate their output and employment
growth and that they would eventually start contracting. There are in fact some hints indicating that
tradable profit squeeze is negatively affecting the performance of manufacturing activities in Latin
America. Table 2 reports the elasticity of industrial value added growth with respect to value added
growth in other economic activities, both measures in constant prices for the major South American
countries18. The analysis is made comparing two periods: 2002-05 and 2005-08. In the former period,
countries experienced high GDP growth and had relatively competitive RERs. In the latter period, on
the contrary, countries experienced high GDP growth with substantially more appreciated RERs19.
Although RER levels were even more appreciated in 2010, we did not extend the period until this
year because of the contraction in economic activity in 2009 introduces noises in the time series,
making the interpretation of results less clear.
If the level of the RER affects positively the development of modern tradable activities (eg.
industry) – as argued above – on would expect to observe a worsening in economic performance in
these sectors relative to the rest of the economy. In other words, one should observe a reduction in
the elasticity of modern tradable sector growth (eg. industry) with respect to other sectors’ growth.
Evidence in Table 2 is in line with this prediction: all the countries experienced a relative deceleration
17
GDP per capita data correspond to the World Development Indicators from the World Bank. (See Appendix.)
18
In order to avoid cyclical noises and capture growth trends, we calculated least square growth rates of value added.
Specifically, we estimated the growth rate g by regressing the following model: lnyt = a + gt + et, where y is value added in
constant prices, a is a constant, t represents quarters and e is an error term.
19
Compared to the 2005-2008 period, in 2002-2005 the bilateral RER with the US in Argentina was 25% higher, in Brazil 48%
higher, in Colombia 26% higher, in Chile 21% higher and in Peru 7% higher.
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of industrial sector value added growth. In line with this evidence, there is also a positive correlation
between the contraction in the elasticities and the degree of RER appreciation. For instance, Peru is
the country in this sample with the least degree of RER of appreciation and also the one in which the
fall in the elasticity was the smallest.
Table 2: Elasticity of industrial value added growth with respect to other
sectors’ value added growth (in constant prices)
Source: CEPALSTAT, ECLAC20
Figure 16 shows the evolution of the bilateral RER with the US and two indicators that describe the
relative performance of the industrial sector in Brazil between early 2000 and early 2011. The green
line indicates industrial exports relative to exports of natural resources, both in real terms. The red
line does the same for industrial value added (VAi) relative to the value added of the rest of the
sectors (VAr), also in real terms21. Figure 16 suggests that the performance of the Brazilian industrial
sector appears to be influenced by the level of RER with a 2-year lag22. It is interesting to note how
the relative improvement of industrial exports and value added between mid-2003 and mid-2005 was
preceded by the significant RER depreciation that started in the first semester of 2001. Similarly, the
RER appreciation trend beginning in mid-2004 is followed by a relative worsening in industrial
exports and value added starting in late 2005 and early 2006. This relative performance continues
until the end of the period of analysis in parallel with the RER appreciation trend.
Figure 16: Brazil: Bilateral real exchange rates with the US, industrial exports/naturalresource exports and industrial value added/value added (rest) (1=average 2000-2010)
(RER – real exchange rate; EXPOi – industrial exports; EXPOr – natural resource exports;
VAi – industrial value added; VAr – non- industrial value added)
Source: Banco Central do Brasil
20
In the case of Argentina, all calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA.
GDP per capita data correspond to the World Development Indicators from the World Bank. The data on Brazilian exports were
obtained from IPEADATA. (See Appendix.)
21
To avoid seasonal fluctuations, both indicators were calculated as annualized values.
22
The correlation coefficients between the 2-year lagged RER and the export and value added indicators are 0.73 and 0.84,
respectively.
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The case of the Brazilian manufacturing sector illustrates what in our view is the main threat that
Latin American countries are currently facing with the sustained RER appreciation caused by the
ongoing wave of massive capital inflows.
5. A development-friendly macroeconomic policy framework
Most Latin American countries have made substantial progress in the conduct of their
macroeconomic policies in recent decades. After experiencing high inflation during the 1970s and
1980s, countries in the region managed to stabilize prices during the 1990s. In most cases, price
stability was achieved through stabilization programs that used the exchange rate as a nominal
anchor. An undesired outcome of these programs was excessive RER overvaluations, which led to
external crises23. An important lesson from these experiences was that in order to deal with volatile
capital movements and to avoid external crises, macroeconomic policy not only needs sound
monetary and fiscal management but also an exchange rate policy that avoids RER overvaluation
and combines exchange rate flexibility and foreign exchange reserves accumulation.
Current massive capital inflows pose a threat to Latin American countries. In this article, we
made the case that these economies do not show signs of external vulnerability and that there is no
clear evidence that the external conditions they currently face will dramatically change in the
foreseeable future. Hence, we do not see a scenario of crises very likely.
This assessment is based on our conjectures about the future; and we know the future is, by
its own nature, uncertain. Conjectures about the future – all of them, including ours – necessarily
have to deal with uncertainty. Will the present favorable terms of trade persist? Will current external
financial conditions remain in Latin America? About these things, we cannot certainly know.
Economic authorities should be especially cautious in the face of uncertainty. In this regard, the
design of economic policy should follow two principles. First, it should include all the elements to
assure that the proposed goal is achieved in the foreseeable scenarios. The second principle is to
minimize the potential damage that an economic policy could provoke if the conjectures in which it is
based are finally wrong.
Following these principles, a prudential attitude would suggest implementing measures to
offset or mitigate the effects of capital inflows. These measures should be adopted not only to avoid
the formation of domestic asset bubbles and control inflation but also to avoid external and financial
crises, and consequently a huge damage. Thus, although we have a different perception of the risks
involved, we fully agree with the position that the IMF has taken recently about taking a prudential
approach about capital inflows. We might be wrong in our assessment and thus countries should
take the possibility of crisis seriously. But a prudential economic policy design should broaden the
consideration of potential negative effect of capital inflows and include those associated with Dutch
Disease. These effects should be taken as seriously as those associated to the risks of external and
financial crises because they are largely irreversible. As argued above, it is well documented both
theoretically and empirically that a transitory RER appreciation can have long-lasting effects on the
manufacturing sector in the form of a permanent destruction of physical, organizational and human
capital. Furthermore, a prudent management of the RER is a sound strategy even in the case in
which the favorable terms of trade and international financial conditions were perdurable ex-post
because conjectures about the effects of the Dutch Disease on long-run growth are also uncertain.
For these reasons, we think that macroeconomic policy in Latin American countries should aim to
maintain a stable and competitive RER as an intermediate target for economic development. The
macroeconomic policy framework we have in mind combines the following features.
23
One could refer to this period as the ‘long’ decade of the 1990s, going from the Mexican stabilization program in 1988 to the
Argentine and Uruguayan crises of 2001-02.
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First, given the multiplicity of policy objectives – inflation, employment and a stable and competitive
RER as an intermediate target – the proposed macroeconomic policy framework requires the
coordination of monetary, fiscal, exchange rate and wage policies. Exchange rate policy is oriented
towards signaling a stable RER trend, which in a managed floating regime is compatible with shortrun nominal exchange rate volatility. In context of capital mobility, as in the case of Latin American
countries, active exchange rate policy limits the ability of monetary policy to manage the pace of
aggregate demand expansion. This does not mean that monetary policy is passive, but that it is not
completely independent. Because of this reason, in our proposed framework fiscal policy takes a
relevant role in managing aggregate demand and achieving price stability (Frenkel 2008 and Rapetti
2011). This is a key difference with a standard inflation-targeting regime in which monetary policy
carries virtually the whole burden of managing the expansion of aggregate demand.
Second, in the proposed regime both monetary and exchange rate policies are active. Their
simultaneous conduct requires sterilized interventions and capital controls. Since domestic and
foreign assets are imperfect substitutes, sterilized foreign exchange interventions are effective in
simultaneously managing the nominal exchange rate and the interest rate in cases of excess supply
of foreign currency. These interventions can be thought of as two instruments implemented
sequentially. First, intervention in the foreign exchange markets is used to set the exchange rate to
the desired level. Then, sterilization is used to absorb the excess of liquidity created in the first step
and thus to maintain the interest rate at the desired level. A potential concern is whether these
interventions are sustainable over time because they could create explosive quasi-fiscal cost
dynamics. In a context in which the domestic interest rate is low enough, sterilized buying
interventions are effective and sustainable24. The ability to simultaneously conduct monetary and
exchange rate policies with sterilized interventions depends on the magnitude of capital inflows.
Capital controls can be useful to facilitate the efficacy of these interventions, especially when inflows
are large. Additionally, maintaining a fiscal surplus can help absorb the excess supply of foreign
exchange and thus operate as a complement to capital controls to moderate the impact on domestic
financial markets.
Third, given that each policy by itself is insufficient to neutralize the effects of capital inflows,
it seems desirable to implement them jointly and in a coordinated way. In particular, the coordination
between central banks and economic authorities – largely absent in Latin American countries – is
essential to optimize the efficacy of macroeconomic policy and to neutralize the effects of capital
inflows on the RER.
Some observers appear to be skeptical about the efficacy of buying interventions in the
foreign exchange market. For instance, recent IMF’s documents advice against ‘early interventions’
and suggest to intervene only when the RER has appreciated substantially to dissipate expectations
of further appreciation (IMF 2011a). This view implicitly assumes that agents know the ‘equilibrium’
level of the RER and that market forces ultimately will take the RER to such a level. Intervention is
thus thought as an instrument to avoid excessive but transitory RER misalignments. This is a curious
idea. The same recent IMF documents also warn about the possibility of bubbles in domestic assets
and the domestic currency is one of them. Why should we neglect the possibility that exchange rate
appreciation is the result of a bubble in the foreign exchange market? The observed lack of
effectiveness of recent official interventions in foreign exchange markets may be the result of the
central banks’ inability to change agents’ expectation about the future evolution of the exchange rate.
Bold interventions carried out by central banks making clear their will to manage the trend of the
exchange rate could, on the contrary, influence private sector expectations and thus reduce selling
positions and capital inflows. A key goal of central banks’ interventions in the foreign exchange
market should be to alter market expectations. Interventions should make clear central banks’ power
24
See Frenkel (2007 and 2008) for a formal analysis of the conditions under which sterilized foreign exchange interventions are
sustainable.
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and their desire to orient the medium-run trend of the exchange rate. An example of this type of
intervention is the one carried out by the Swiss central bank that announced in early September 2011
that it would intervene in the foreign exchange market to stop the appreciation of the Swiss franc
generated by capitals running away from the euro area and looking for a safer asset to allocate
wealth. The Swiss central bank managed to stop the appreciation of the franc because in such a
context it has the ability to issue any amount of assets demanded by foreign investors (ie. Swiss
franc). If, for instance, capital is flowing into Colombia’s and Chile’s financial markets looking for
peso-denominated assets, what prevents the Colombian and Chilean central banks to issue those
assets and stop the appreciation of their currency?
Appendix
Data on balance of payments, external debt, bilateral RER with the US, effective RER, wages and
value added in constant prices are all from CEPALSTAT, ECLAC. In the case of Argentina, all
calculations including the CPI were re-calculated using the IPC-7 series elaborated by CENDA. GDP
per capita data correspond to the World Development Indicators from the World Bank. The data on
Brazilian exports were obtained from IPEADATA. The quarterly data series of the Brazilian bilateral
RER with the US used in Figure 16 is from Banco Central do Brasil. Data on risk premia is from
Bloomberg.
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