World Bank Document

Box 4.6 Capital flight in the Southern Cone countries
In the mid-1970s, the Southern Cone countries of Latin of widespread expectations that foreign borrowing
America-Argentina, Chile, and Uruguay-introduced would remain cheap and its supply would be plentiful.
major reforms aimed at breaking out of chronically slow As exchange rates became more overvalued, doubts
growth, fast inflation, and frequent balance of payments grew about the sustainability of the exchange rate policy.
crises. By 1978, all had turned around their external In Argentina and Uruguay, these doubts were reinforced
accounts and slowed inflation. Chile and Uruguay had by mounting fiscal deficits; in Chile by the rapid increase
also speeded up their growth.
in real wages during a period of shrinking profit mar-
Despite these achievements, inflation in all three coun- gins. In all three countries, many companies incurred
tries was still well above its historical average. So in losses, while lax lending practices led to the collapse of
1978-79, the three governments decided to launch a pol- several large banks. Governments sought to allay fears
icy experiment of fixing the exchange rate, with a prede- of devaluation by offering exchange rate guarantees, but
termined path of decreasing small devaluations. They these only enhanced the windfalls to be gained from
hoped that this strategy, coupled with lower import pro- currency speculation. Imports grew at unprecedented
tection and open financial markets, would quickly cut rates, while export earnings lagged far behind.
inflation, improve industrial efficiency, and lower inter- The three countries were able to maintain their
est rates.
exchange rates only by increasing their foreign borrow-
In fact, inflation declined more slowly than antici- ing. When capital inflows slowed in 1981-82 because of
pated, so real exchange rates appreciated substantially. tighter money in the industrial countries and increasing
Uncertainty about policy intentions continued, keeping doubts about the three countries' policies, large outflows
domestic interest rates high. Attracted by the high yields of capital soon forced large devaluations. The principal
available on dollar-denominated assets, large amounts of legacy of the exchange rate experiment was heavy forcapital
flowed into the three countries. These inflows eign debt.
were not regarded initially as a cause for concern because
Borrowing to facilitate adjustment
of spare parts, and improve the competitiveness of
exports, but imports will usually rise before
While many governments have borrowed abroad exports do. Through borrowing, a government can
to postpone adjustment at home, some have done avoid having to deflate the economy to offset these
so to adjust more effectively. Governments have effects. It can therefore hope to secure broad supused
foreign capital to help implement policy port for its reforms, which might otherwise be lost
reforms and to buy particular imports to restruc- if the whole economy had to go through a recesture
the economy.
sion.
The speed of progress toward reform has varied
POLICY REFORM. By the end of the 1970s, many greatly. Some countries have embarked on policy
developing countries needed to change their poli- reforms only to abandon them prematurely; others
cies in two broad areas. First, they had to curb have carried them through. The cases of Kenya
their domestic spending and increase their foreign and Turkey-the first two countries to obtain a
exchange earnings to service their growing foreign structural adjustment loan (SAL) from the World
debt. Second, they needed to improve incentives Bank (see Box 4.8)-illustrate the variety of experifor
efficiency and expansion to strengthen their ence.
long-term growth prospects. Of course, both Kenya introduced a comprehensive program of
reforms are complementary. Measures to encour- reforms in 1975. But the huge increase in coffee
age long-term growth usually founder without bal- prices in 1976 and 1977 produced a boom, making
ance of payments stability; yet stability brings only the program seem less urgent; only a few of the
short-term benefits unless economic efficiency is planned measures were carried out. In 1980, folalso
being improved (see Box 4.7).
lowing the second oil shock, the government again
Foreign capital has a valuable part to play in giv- adopted a reform program, supported by an IMF
ing reforms time to take effect. Some of the mea- standby loan and an SAL. The measures included
sures needed to boost long-term growth may ini- a more market-oriented pricing policy, reduced
tially cause a country's current account to protection for domestic industries, more active use
deteriorate. For example, trade liberalization is of exchange rate policy, more demanding goals for
essential to encourage efficiency, increase supplies state enterprises, improved debt management,
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