Latin American Capital Markets

THE IMPACT OF THE MACROECONOMIC ENVIRONMENT ON CAPITAL MARKETS 95The concepts of risk and uncertainty converge when no probabilities of occurrencecan be assigned to a state of nature. Under macroeconomic instability, thedifference between risk and uncertainty becomes elusive because the instability impingeson the capabilities of economic agents to assign probabilities of occurrence touncertain states of nature. Consequently, the savings rate, a significant input for thegrowth of financial intermediation, is impaired.In many emerging markets, macroeconomic instability arises from excessivegovernment debt financing that crowds out the private sector from both debt andequity markets. Government paper is generally preferred to private paper because allmarket participants know the issuer; the liquidity of government paper is usuallyhigher than that of any other instrument. The government has the power to tax aswell as the ability to print money and only defaults under crisis conditions.Recent experience in Argentina illustrates how poor and inconsistent macroeconomicpolicies can significantly affect domestic capital markets. During the 1990s,and after two decades of macroeconomic instability that ended in hyperinflation,Argentina re-engineered its financial institutions. In 1991, the country implementeda currency board, fixing the peso and the dollar on a one-to-one basis. Within the10-year period during which Argentina kept its currency board, the U.S. dollar appreciatedsubstantially and Argentina's main trading partner, Brazil, devalued its currencyby about 40 percent in real terms. Consequently, Argentina's real exchange rate appreciatedsubstantially, and this disequilibrium required significant productivity gains,coupled with robust fiscal policy, to keep the economy competitive. Instead, towardthe end of the period, the country increased its public sector deficit, which it financedby issuing debt.Given the inflexibility of prices to downward pressure, the adjustment tolower nominal income had to be done through quantities and real income took a dive.The recession led to double-digit unemployment rates.To repair the fiscal gap, the governmentincreased taxes. The recession deepened and fiscal revenues declined. Thegovernment responded to the higher fiscal deficit by reducing expenditures and financingwith higher debt issues.The reduction in expenditures worsened the recession,the country's debt became very risky, and interest rates on its public debt soared.By late 2001, the government defaulted on its external debt, which also affecteddomestic creditors, mainly banks and pension funds. It forced a swap of its highyieldingdebt for new debt that was guaranteed with future fiscal revenues, yieldingonly 7 percent. Banks were paying much higher rates on their funding, so in order tohelp the placement of government debt, the Central Bank put a cap on the interestrate. Under these circumstances, internal savings were pulled out of the formal finan-Copyright © by the Inter-American Development Bank. All rights reserved.For more information visit our website: www.iadb.org/pub