Summary

Introduction
Control of foreign capital and macroeconomic liberalization during the nineties.
Regulations and foreign investment and debt behavior
By way of conclusion
Table 1.- Chilean Foreign Debt

Introduction

Capital flow regulation was not a basic concern for Latin American countries in the last decade, since risk classification was high for most of them, a fact which reduced their chances of obtaining external resources. However, the consequences of the Asian Crisis triggered a debate aimed at reducing the impact of volatile capital inflow. Within this framework, regional consensus has not, as of yet, been achieved at a regional level.

The sustainability problems (Reisen, 1999) of the macroeconomic global project lie in the imperfection of the market and in a certain lack of discipline amongst the fund recipients; in the difficulties of reestablishing balance by way of reducing expenditure in view of the reduction of investment inflows; in the impact provoked by an inflow of non-sterilized funds on interest rates and on value of financial assets (specifically, stock market assets); and especially, in the over-rating of local currency for extended periods of time. All these events are currently of concern in Chile, although their outcome was of lesser importance due to the existence of a fundamental macroeconomic balance.

During the 90´s Chilean economy witnessed its most outstanding performance of the XXth century. Between 1990 and 1999 the gross domestic product grew almost 90%, while annual investment and physical exports and imports volume almost doubled. This may be observed from the unprecedented and persistent rise in productivity. This explains how it was possible that between 1990 and 1998, 900 thousand additional jobs were created, with real salaries which, by the end of the decade would have accumulated a 40% increase. The latter, added to the public social expenditure, allowed the poverty ratio to decrease from 5 million to 3.2 million.

Chilean economic growth during years 1990-98 was originated by a well-balanced and responsible fiscal and monetary policy; by the standardization of the financial system (grossly affected by the 1981-1983 crisis), including supervision and control mechanisms; by an economic policy that strengthened the exporting development by means of trade liberalization based on multilateral and bilateral agreements; by a regulatory policy which increased competition; and by a productive development policy which is increasingly oriented towards the less developed regions of the country. It is also worth noticing that Chile´s democratic transition and adequate institutionalization fostered an extraordinary increase in foreign investment (42% of the GDP for 1999). This permitted that, within the framework of a growing economy, inflation was reduced year after year and also, the public debt.

Taking the above into account, this document shall explore the trends and the regulations on external capital flow within a framework of an increasingly open economy during the nineties.

Control of foreign capital and macroeconomic liberalization during the nineties.

It seems common place to perceive that, when control over foreign capital is in fashion, it is because we are living critical moments; whereas on the contrary, when liberalizing trends abound we are probably experiencing economic prosperity. The truth is that best crisis management occurs when during periods of prosperity we are able to foresee the oncoming threats. In other words, impacts of international financial capital volatility on small economies would be less if controls are established before problems arise.

In fact, the origin of the problems which have triggered the last three critical episodes in Latin America (the well-known debt crisis in 1982; the Mexican „Tequilazo" in 1994; and the Brazilian crisis generated as a result of Asian events occurred in 1999), have focused on financial aspects and, specifically, on capital flows. The first one had a devastating impact on Chile´s economy which at the time was ruled by an orthodox and total liberalism regarding capital flows; whereas the other two, did not impact the Chilean financial system directly, although its effects were felt in other areas.

Three central elements characterized the 1982 crisis: major capital inflows during the previous years (external debt accounting for 48% of the GDP); investment intermediated by financial agencies instead of use of risk capital; and, short term inflows (20% of the total debt, but with reserves inferior to the short term debt), which had a strong effect on bank solvency.

More than as a preconceived idea, regulatory frameworks were set in Chile as a logical response and a decisive element in order to recover credibility in the international financial arena, after repeated and profound failures of orthodox liberalism applied in previous years by the same administration, and which created, successively the deep crisis of the financial system, inability to honour the foreign debt (both public and private), real unemployment reaching over 25% and GDP drops close to 15% per annum.

In fact, in technical circles – both national and international – the idea persisted of the depth of the crisis experienced during the early eighties, when the entire system of capital inflow was liberalized, producing the above-mentioned consequences. This situation triggered the explosive Deficit of the Current Account (DCA), thus reversing the cycle of apparent welfare of the late 70´s.

It was by keeping all this well in mind, that the aims of the new government coalition for the 90´s, were to reduce the inflation rate and to keep the current account deficit of the balance of payment within an acceptable range (Zahler, 1997). These objectives, in charge of the Central Bank, were to be in accordance with other sensitive areas; the intention was: to achieve solidity and solvency of the financial system; to reduce external liability; raise employment rates as well as savings and domestic investment rates; and, to maintain real salaries on a course of growth according to productivity increase.

In order to achieve these aims, traditional instruments were used but with a different orientation framework in regard to the macroeconomic policy, which was focused on: granting the market an increasing role in determining prices (prudent regulation); promoting liberalization in the context of globalization; flexible implementation of policies; contemplating medium to long term horizons; and, driving volatility and liability to a minimum.

Within this context, in the early 90´s, the option was taken of liberalizing the market of outgoing capitals, a market which –just like in the rest of Latin America- had been over-regulated due to the reduction of available resources for the region. Working in this direction, the minimum term for capital repatriation for non residents was reduced from three years to one (1993); local companies were authorized to sell bonds and stock abroad; foreign debt prepayment was liberalized as was the minimum foreign credit percentage linked to external direct investment.

These measures are taken when internal savings barely reaches 20% of the GDP and when greater foreign resources were being looked for. Among the advantages brought about by operating the macroeconomic policy intended to attract foreign capital, we must point out that, since the beginning of the nineties, the country/risk perception established by international risk rating agencies improved; also the reduction of interest rates in industrialized countries and the increase of capital investments in emerging economies, including Chile. The net capital inflow to Latin America went from 2% to 4% of the regional GDP between 1990 and 1993 (Ocampo, 1993).

(See Table 1)

In addition, domestic interest rates were placed above the international level, in order to foster internal savings and/or affluence of foreign capital. At the same time, however, the excessive affluence of short term hard currency between 1992 and 1994 was beginning to work against the essential balance (the current account deficit reached –5,7% in 1993) because the whole process was based neither on exports increase nor on long term investment, but on short term financial investments. It is within this context that during the 90´s a policy of sterilization or discouragement of capital inflow policy is consolidated. This policy consisted mainly in maintaining the prohibition to repatriate hard currency before a year of its permanence in Chile had elapsed. and the application of cash reserves measures for foreign credit.

The Central Bank, was forced to play a very active role in accumulating hard currency, not only to keep adequate international reserves, but also to avoid that inflow of net capital –which between 1992 and 1996 reached an average of 6.1% of the GDP- could provoke an excessive and permanent deficit to the current account.

The above stated notwithstanding, these policies provoke losses for the Central Bank, losses derived from the difference between the interest rates payed by reserves placed in international markets (in foreign currency) and the rates it has to pay for placing the internal debt (in real pesos); all of which is necessary in order to sterilize the monetary impact brought about by that accumulation.

Consequently, although a scheme of liberalization in the capital market was maintained, it was sought to discourage shorter term financial inflows in order to reduce volatility and also to curtail bubble upsurge in the long term stock and fixed revenue markets.

Regulations and foreign investment and debt behavior

In 1989 a new system of currency exchange control was established which grants obligation for currency transactions in the so-called formal exchange market.

That is, exporters and importers (of goods, capitals or services) must act within the framework of this market, only non-commercial operations being exempt. Chapter XIV of the International Exchange Standards regulates investments, contribution of capital or foreign credits and its enforcement and specification is responsibility of the Central Bank of Chile.

Amongst the most important restrictions embodied in the Foreign Investment Statute (round letter 218, 2.4.93) is the one regarding repatriation of capital. Capital may not be repatriated until after one year has gone by from the date of its first settlement (3 years in the previous legislation), although net dividends (after tax) may be repatriated at any time.

An important regulation which puts limits to certain volatilities which emerge at times of nervousness among financial agents, has to do withthe ways in which hard currency is negotiated. In fact, interests and the periods in which payments should be made must be registered at the Central Bank which, by means of an application form, allows the creditor to obtain the hard currency in the formal market.

Another policy designed to discourage the so called „sparrow" capitals (short term and essentially speculative), is the obligatory cash reserve related to credits brought into the country, which has varied from 30 to 0% of total inflows. This cash reserve, in the same currency as the loan, did not produce interests and was deposited in the Central Bank and could only be recovered after no less than a year. Chapter XIV stipulates that „credits, deposits and investments and contributions of capital ... coming from abroad are subject to obligatory cash reserve".

Until April 1997, the Central Bank -before international capital flows into emerging markets was suspended due to the Asian crisis- justifies cash reserve restriction arguing „that international financial flows continue to gain great importance, having increased over the last months its magnitude and volatility" and b) „that the stabilizing task carried out by the Central Bank by means of its monetary and exchange policy, would become extremely complex in an atmosphere of greater permissiveness towards international financial flows into the country; this could have a negative impact on the achievement of its internal and external objectives"

(See Table 2)

The subsequent resolutions regarding cash reserve listed above show that this policy, as well as the one that has to do with restricting repatriation of capital, have played an important preventive role in stabilizing the Chilean economy, essentially because it has been applied in a counter-cycle manner and has operated in the context of flexibility required for these purposes. That is to say, cash reserves have been increased when affluence of short-term capital is greater (1992), and have been reduced or suppressed when credits granted to emerging markets have been reduced (1998).

On the other hand, there is a second implicit objective in the cash reserve policy, because it is equivalent to a tax whose burden is the inverse function of the initial total funding term. This instrument also operates increasing short-term costs, avoiding external arbitration over interest rates differential. Finally, it allows that Central Bank referential interest rates are not seized by international capitals, apart from being an instrument that helps slow down speculation, which is typical for certain short-term capital investments.

All this allowed for a change in the structure or composition of Chile’s foreign debts, increasing both participation of risk capital as compared with external debt obligations and participation of long term capital as compared with short term capital.

By way of conclusion

The Mexican situation (end of 1994) remained unfelt by the Chilean market, because the reduction of short term capital inflows was not such that could create unbalances in the financial market, in so far that the Central Bank held enough reserves to keep the exchange rate under control (flexible band system) and that inflow of long term capital -especially for productive investment - continued growing, the regional financial juncture notwithstanding.

In fact, it may be concluded that the policies adopted to regulate financial inflows will be more efficient if, simultaneously, vulnerability is reduced, which, in this case, can be associated to the indicator showing the range of short term debt, as in regard to currency reserves.

To wit, when that crisis took place, Chilean indicators were not losing the dynamics of the cycle. For example, the GDP grew by 10.6% in 1995; the current account deficit was reduced to –2.1% from GDP; the local currency (peso) was valued in approximately 10% in real terms; that is, the indicators showed a completely different reality than the Mexican, because the vulnerability in face of capital inflow and the consistency of basic economic principles involved a different capacity of response for each country.

In contrast, the impacts of the Asian crisis (1997 – 1998) were felt more strongly by the Chilean economy. They didn’t however, contaminate the financial system as such, but they did the relationship expenditure-product, triggered by the deterioration of terms of exchange (13%), a fact that showed in a drop of exports (12%) and a raise in the current account deficit (-6,3% of GDP) both indicating an unsustainable situation for future macroeconomic coherence. The reduction in Chile of investment inflows was due much more to the well known „herd" effect which dominates international investment agencies, than to a specific appreciation of the Chilean market.

The image of homogeneity of emerging markets perceived by these investors which, in general, does not allow them to differentiate clearly between Russia and Chile or between Brazil and Thailand, is damaging, and it encourages financial panicking. This largely explains short-term investment reduction as observed on Table 1. However, globalization and the concentration of international resources in a few investment agencies forces them to withdraw funds from third countries to deal with losses suffered in some emerging country and thus, in order to be able to honor their commitments towards their clients (mainly, major international insurance companies – health, mutual funds, etc.). That is, the contagious effect responds in certain cases (or additionally) to an entrepreneurial logic, and to an assessment of the afflicted economy.

Within the framework of a risky current account deficit increase in Chile, authorities reacted by significantly increasing the interest rates (from 6% to 14% in a few months) in order to reduce spending, and consequently, moderate the current account deficit. The rate increase did not influence capital flow; but it did have a severe influence on the GDP which in 1999 will drop around –0.5%, while its average growth for the last 10 years was +7%.

This shows that capital does not necessarily react to a single stimulation such as interest rates naturally are; it reacts rather assessing a range of factors related to economic and political stability. In this case, the continued increase of foreign investment was encouraged by asset transfers (purchase opportunities in key areas such as energy and banking) and were not geared towards short-term speculative capitals. Besides, Chile’s net debt –subtracting Chilean investment abroad– is barely one billion dollars and its long term financial market, taking into account only Pension Funds reaches a similar figure to the one of the foreign debt, all this representing yet another reassuring element for foreign investment.

For its part, elimination of the cash reserve restriction has an explanation, because short-term real capital inflows observed at the end of the decade, are not involved in relevant domestic accounts. This elimination, as stated by the Chairman of the Central Bank himself, does not mean the mechanism cannot be reestablished, if proven necessary. In this manner, one has a flexible management of the set of instruments for financial regulation.

The analysis of Chilean economy does not show a direct relationship between regulation instruments and capital flows. In fact, the part of the short-term debt remained constant in spite of cash reserve variations. Cash reserve decrease is not followed by capital flow increase. Moreover, everything indicates that if restrictions had not been implemented the proportion would have been different, as was the case in the crisis of the of the 80´s, generating a high vulnerability trend.

On the other hand the data analyzed permit us to come to the conclusion that it is not obvious that, the fact of bringing about a total and speedy financial liberalization in a country, will permit it to achieve total integration in the capital markets. Because the risk situation of a country and the expectations regarding domestic devaluation also play a role. Here lies the importance of a coherent and comprehensive macroeconomic scheme, where regulatory controls and surveillance are adequately combined with liberalization.

In fact, regulation should not scare off foreign investment since for small economies it is vital to have at their disposal external savings for investment, which, as in the above-mentioned situation, made it possible to absorb transitory shocks suffered by the terms of exchange. This, however, implies the need to maintain a general scheme of financial openness, the risk associated to it being the reduction of internal political autonomy.

For some time now, Chile has been involved in a disjunctive between liberalization and regulation. Moreover, the idea has come up that the country should become a relevant international off shore stock exchange; in order to achieve which, it would be necessary to suppress controls over short and long term capital flows, elaborate policies to attract the establishment in Chile of financial institutions, broaden investment alternatives for institutions and sign various agreements, such as one eliminating double taxation with trade partners. On the other hand, postures emerge showing a tendency to increase controls over the flow of external investment, reducing, for example, the sector range of such investments or assigning quotas according to activities, etc.

In point of fact, at times of crisis ideas arise about capital controls being more expeditious mechanisms for stabilizing currencies, reducing interest rates and controlling stock markets. For Chile it was not necessary to use these instruments because the financial system was not in a liquidity squeeze (lack of hard currency at a given moment), nor did it become insolvent, as was the case of Asian countries due to ill-focused credit systems, wrong selection of investments and an inefficient management (Zang 1999).

In order to define a situation of an ideal combination of liberalization and regulation one has to point out that for small economies such as the Chilean, the risks of becoming contaminated by foreign countries arise from the general volatility of capital flows, a fact closely related to market integration, specially financial markets (globalization effect), and from the simultaneous and coincidental financial international decisions (herd effect). Chile was able to reduce volatility thanks to a low ratio of short-term debt to total debt, and to a high level of international reserves.

Notes:

(1) Traditionally, in foreign debt statistics, those credits which originally set a definite term equal or less than 365 days for complete principal reimbursement of the main figure, have been classified as short term liabilities. However, over the last years, analysis of foreign debt based on commitments related to time has gained importance, and classification according to the residual term is being used more frequently. This criterion implies considering as short term debt, also programmed payments for medium and long term credits for the following twelve months or credits with contracts setting a term of over a year.

Bibliography

Zahler R. La política macroeconómica de Chile en los años noventa: la visión del Banco Central. Cepal, Santiago. LC/R 1771, 1997. (Chile´s macroeconomic policy in the 90´s: the Central Bank´s perspective) Ecla. Santiago. LC/R 1771, 1997.

Ocampo J. La reforma del sistema financiero internacional: Un debate en marcha. FCE-CEPAL. Chile,1999. (The international financial system reform: a continuing debate) FCE-ECLA.Chile 1999.

Zang Hyoungsoo. Proposals for the reform of international financial architecture: Korea’s perspectives. FES in Studies on International Financial Architecture. Germany, 1999.

Rafael Urriola is economist and advisor of the Minister for Public Works in Santiago/Chile.

Table 1.- Chilean Foreign Debt

	1990	1991	1992	1993	1994	1995	1996	1997	1998	1999*
Total Foreign Debt (in millions of US dollars)	17425	16364	18242	19186	21478	21736	22979	26701	31691	34207
Short Term Debt Original (%) (1)	19,4	13,4	19,0	18,2	18,0	15,8	11,5	4,8	5,1	3,9
Short Term Debt Amortization (%)	5,2	6,7	6,5	7,1	7,3	8,0	7,9	8,6	7,4	7,8
TOTAL as a % of total external debt	24,6	20,1	25,5	25,3	25,3	23,8	19,4	13,4	12,5	11,7

Source: Banco Central de Chile

* Preliminary figures to July 31

Form Letters issued by the Central Bank in regard to cash reserves on foreign credit

Letter	Date	Relevant Resolution
129	2.7.91	Establishes the norm for cash reserve and sets the amount of 20%
204	1.7.92	Defines cash reserve reimbursement after a year, notwithstanding the credit term agreed on.
228	19.8.92	Cash reserve increases from 20% to 30%.
440	21.12.95	Resolves that the Central Bank is the only safe deposit for the guaranty. Previously, the cash reserve could be deposited in any formal financial institution.
506	6.12.96	Operations of less than 200.000 US dollars carried out by each agent only once a year are exempt from cash reserves.
599	26.6.98	Cash reserve drops from 30% to 10%.
617	16.9.98	Eliminates cash reserve