Good Bye Financial Repression, Hello Financial Crash - Carlos Diaz-Alejandro

8/2/2019 Good Bye Financial Repression, Hello Financial Crash - Carlos Diaz-Alejandro

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Jour n a l o f D e v e l opm e n t E c onom i c s 19 ( 1985) 1 -24 . N or t h - H ol l a n d

G O O D - B Y E F I N A N C I A L R E P R E S S I O N , H E L L O F I N A N C I A LC R A S H

C a r l o s D I A Z - A L E J A N D R O *Columbia Universi ty , N ew York , N Y 10 027, U SA

Re c e i ve d D e c e m be r 1983 , f ina l ve r s ion r e c e i ve d M a r c h 1984S om e un i n t e nde d c onse que nc e s o f f i nanc i a l li be r a li z a t ion i n L a t i n A m e r i c a a re a na l yz e d i n t h i spa pe r . I n t r i n s i c i mpe r f e c t i ous i n f i na nc i a l ma r ke t s , a nd t he po l i c y d i l e mma s t he y pose , a r ereviewed fi rs t. Th e s ty l ized fac ts of South ern Co ne exp er iments in f inanc ia l l ibe r iza t ion a re thenpr e se n te d . A l t e r na t ive w a ys o f o r ga n l z i ng dom e s t i c c a p it a l ma r ke t s unde r L a t i n A me r i c a ncon di t ion s a re d iscussed, and an ec lec tic, r e form mon ger in g progra m is proposed .

1 . In tro d u ct io nT h i s p a p e r s e e k s t o u n d e r s t a n d w h y f i n a n c i a l r e f o r m s c a r r i e d o u t i ns e v e r a l L a t i n A m e r i c a n c o u n t r i e s d u r i n g t h e 1 9 7 0 s , a i m e d a t e n d i n g ' f i n a n c i a lr e p re s s io n ' , a s d e fi n e d b y R o n a l d M c K i n n o n [ se e, f o r e x a m p l e , M c K i n n o n

( 1 9 8 0 ) ] , a n d g e n e r a l l y s e e k i n g t o f r e e d o m e s t i c c a p i t a l m a r k e t s f r o m u s u r yl aw s a n d o t h e r a l le g e d g o v e r n m e n t - i n d u c e d d i s t o rt i o n s , y ie l d ed b y 1 98 3d o m e s t i c f i n a n c i a l s e c t o r s c h a r a c t e r i z e d b y w i d e s p r e a d b a n k r u p t c i e s , m a s s i v eg o v e r n m e n t i n t e rv e n t i o n s o r n a t i o n a l i z a ti o n s o f p r i v a t e i n s ti t u ti o n s , a n d l o wd o m e s t i c s av i n g s . T h e c l e a re s t e x a m p l e o f th i s p a r a d o x i s C h i l e , w h i c h h a ss h o w n t h e w o r l d y e t a n o t h e r r o a d t o a d e f a c t o s o c i a l i z e d b a n k i n g s y s t e m .A r g e n t i n a a n d U r u g u a y s h o w s i m i l a r t r e n d s , w h i c h c a n b e d e t e c t e d l e s sn e a t l y i n o t h e r d e v e l o p i n g c o u n t r i e s , i n c l u d i n g T u r k e y . I n d e e d , e v e n i n t h eU n i t e d S t a t e s s o m e w o r r i e d o b s e r v e r s h a v e w a r n e d a g a i n s t t h e d a n g e r s o fp e l l- m e l l d e r e g u l a t i o n o f c o m m e r c i a l b a n k s [ se e K a r e k e n ( 1 9 8 1) ].

*A ve r s i on o f t h i s pa p e r w a s f i r st p r e se n t e d a t a c onf e r e nc e he l d i n Bog o t a on N ove m be r 22a n d 2 3, 1 9 8 2 - - s p o n s o r e d b y t h e U n i v e r si d a d d e L o s A n d e s a n d t h e B a n c o d e l a R e p6 b l ic a ., V i s i t s t o C I N V E S , i n M o n t e v i d e o , a n d C I E P L A N , i n S a n t i a g o d e C h i l e , d u r i n g M a r c h 1 9 8 3 ,w e r e ve r y he l p f u l f o r e x t e nd i ng t ha t e a r l y ve r s i on . I a m g r a t e f u l t o a l l t he se i n s t i t u t i ons a nd t onum e r ous i nd i v i dua ls w ho sha r e d w i t h me t he i r v ie w s o f t he e ve n t s na r r a t e d a nd o f t he i ssuesd iscus se d i n t he t e x t. A m on g t hose w ho a r e un l i ke ly t o f i nd e mba r r a s s ing m y a c know l e dge m e n to f t h e i r h e l p , I m a y m e n t i o n J o s 6 P a b l o A r e ll a n o , E d m a r L . B a c h a, G u i l l e rm o C a l v o , J o n a t h a nE a t on , R i c ha r do F f r e nc h- D a v i s , A r m i n i o F r a ga N e t t o , J e f f F r i e de n , E dua r do G a r c i a d ' A c uf i a,Jose A n t on i o O c a mpo , H ugh P a t r i c k , G us t a v Ra n i s , P a t r i c i o Me l l e r , Mi gue l U r r u t i a a ndL a ur e nc e M. We i ss . M y g r a t i tude i s no l e ss f o r t he o f t e n e x t r a o rd i na r i l y ge ne r ous c oope r a t i on o ft hose no t e xp l ic i tl y na me d .


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2 c. Diaz-Alejandro, Con sequences of f inancial l iberal izat ionThe paper wi l l f i r s t rev iew d i lemmas posed by in t r ins ic imperfec t ions o f

any f inanc ia l marke t , and wi l l look a t l ega l p rerequ is i t i es fo r the reasonab lyeff ic ien t ope ra t io n o f thos e m arke t s . Th en i t wi l l exam ine th e s ty l i zed fac t s o fsome Lat in Amer ican exper imen ts in f inanc ia l l ibera l i za t ion , par t i cu la r lyt h o s e ca rd ed o u t i n S o u t h e rn C o n e co u n t r i e s (Arg en t i n a , C h i l e an dUru g u a y ) . F i n a ll y , a l te rn a t iv e wa y s o f o rg an i z in g d o m es t i c cap i ta l m ark e t sunder La t in Amer ican cond i t ions wi l l be d i scussed ; po l ic ies regard ing thel in k s b e t ween d o m es t i c an d i n t e rn a t i o n a l f i nan c ia l m a rk e t s w ill a l s o b econs idered .2. Pecul iari t ies and di lemmas found in domest ic f inancia l markets

Are banks spec ia l , and rea l ly a l l tha t d i f fe ren t f rom bu tcher shops? Nei thertype o f f i rm i s e x a c t l y l ike the t ex tb oo k idea l iza t ion o f the a tom is t i c f irmo p e ra t i n g i n a p e r f ec t ly co m p e t i t iv e m ark e t , wh e re s p o t p r i ce s s u m m ar i ze a lli n fo rm a t i o n r e l ev an t fo r b u y e r s an d s e ll er s o f t h e p ro d u c t . C u s t o m ers a t ab u t ch e r s h o p wi l l n o t o n l y l o o k a t p r i ce , b u t w i l l a l s o a t t em p t t o a s ce r t a i nq u a l i t y ; i n s o m e co u n t r i e s t h ey w i l l b e a i d ed b y g o v e rn m en t -e s t ab l i s h edq u a l i t y ca t eg o r i e s an d ce r t i f i c a t i o n s . B reak d o wn s i n t h e t ru s t co n s u m ers h av ei n t h e ir b u t ch e r s o r i n g o v e rn m en t ce r ti fi c a ti o n , s ay b ecau s e o f ru m o rsreg a rd i n g m ea t t a i n t ed b y p o i s o n o u s s u b s t an ces , co u l d p ro d u ce a k i n d o f' ru n ' o n b u t ch e r s h o p s , an d w i d es p read f a i l u re s am o n g t h em .T h e co m p ar i s o n i s s u re l y, b e i n g fo rced . F ew b u t ch e r s h o p s w i ll d e li v e rm e a t o f s t an d a rd q u a l i t y o u t o f t o w n t o t h i rd p a r t i e s o n i n s t ru c ti o n f ro m acu s t o m er . F ew ex t e rn a l i t i e s co u l d b e ex p ec t ed f ro m a ' r u n ' o n a b u t ch e r s h o pu n d e r s u s p i c io n . F u r t h e rm o re , a b u t ch e r w i ll s e l d o m t u rn d o w n a cu s t o m erwh o wan t s t o b u y wi t h ca s h ev e ry t h i n g i n s i g h t a t t h e p r i ce an n o u n ced b ythe bu tcher (he wi l l ju s t make su re the cash i s no t coun ter fe i t ) ; a banker wi l ls u re l y n o t l en d a l l a cu s t o m er wan t s t o b o r ro w a t t h e g o i n g i n t e re s t r a t e .T h e fo rm er i s a s p o t t r an s ac t io n ; t h e l a t te r i n v o l v es a p ro m i s e t o r e p ay i n t h efu t u re wh i ch m ay o r m ay n o t b e s i n ce re o r wh o l l y c red i b l e . E n fo rc i n g t h eloan con t rac t o r l iqu ida t ing co l la te ra l p roper ty wi l l invo lve cos t s , and evenwi t h s p eed y en fo rcem en t t h e b an k m ay b e u n ab l e t o g e t a ll o f i ts m o n eyb ack . T h e b an k wi l l i n cu r co s t s t o ex p l o re t h e c red i t -wo r t h i n es s o fb o r ro wers ; t h e b u t ch e r w ill n o t ca re m u ch fo r t h e r ep u t a t i o n o f ca s h -ca r ry i n gcu s t o m ers . T h e re i s n o h u m an l y p o s s i b l e w ay o f d ev i si n g a f a i l -p ro o f s y s t emo f f in d in g o u t t h e t ru e i n t en t i o n s o f b o r ro w ers , s o l en d e r s a r e l ik e l y t o e n dup ra t ion ing c red i t, i .e . , pu t t ing a ce il ing on w hat a rm s- leng th cus tom ers canborr ow , regard less o f the i r wi l lingness to p ay h igher in te res t ra tes [ seeStigli tz and W eiss (1981)] . Bank s share wi th o the r f inanc ia l in te rmed iar iesthe p rob lem of seek ing re li ab le borrow ers , bu t hav ing l i ab i li ti es tha t a rep ay ab l e o n d em an d a t p a r p u t s a p rem i u m o n s a fe an d f a i r l y l i q u i d l o an s fo rbanks . Banks supp ly a se rv ice tha t i s a very c lose subs t i tu te to the bu l l s and


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C. Diaz-Alejand ro, Con sequenc es o f financial liberalization 3coins supplied by governments; such pretension imposes special limits onbanks' portfolios.

Financial intermediaries, including banks, rely on borrowed funds; ownersof those institutions typically invest their own capital only in amounts whichare a small fraction of their total lending. A depositor in a bank will havepreoccupations similar to those a lender has when eyeing a borrower: will Ibe able to get not only the promised yield but also my money back ordelivered to a third party as specified in the legal contract? In a totallyunregulated system the rational depositor will attempt to process a great dealof information regarding financial institutions, balancing expected returnsversus risks of not being able to dispose of his funds as promised.One can imagine a world in which all financial intermediation, includingthe payments system, is private and without any direct government regulation.The information imperfections may be partly offset by investments ininformation gathering by lenders and depositors; with the passing of timereputations would be built up. Balance sheets of financial intermediatrieswould be widely available and closely analyzed. It is even conceivable thatpossible economies of scale involved in the processing of information maynot be so large as to impede large numbers of financial agents, assuring somecompetition among them. Unexpected shocks and informational failures inthis economy could of course lead to bankrupticies of some financialintermediaries; an informed public presumably would know the source ofsuch events, so there would be no ripple effects contaminating sounderinstitutions. One would expect to find a rich risk-return menu available tosavers in this world, which would also generate an unregulated stock marketfor those preferring equity arrangements for obtaining or investing funds.Concentration of economic power, in the form of 'economic groups' andconglomerates, would presumably exist only if there are economies of scaleto yield social benefits, with free entry checking monopoly behaviour. In thisworld, the market rate of interest would hover around the natural rate.

Note that even a purely laissez-faire financial system must count withsome indirect government inputs in the form of an efficient and fair judiciaryand police system to punish fraud and to handle the enforcement ofcontracts and the settlement of disputes and bankruptcy cases. And behindthat one must presumably have a polity generating such a judicial and policesystem, and a body of contract, antitrust and bankruptcy laws which areregarded as fair, efficient and enforceable. Financial agents feeling atemptation to cheat on their contracts or give false information must knowthat such behavior will have very high costs; they must also know that evenif they flee their country the long arm of the law is likely to reach themabroad. Governments in this world must be expected neither to change norto corrupt these rules; domestic private citizens must not only believe in thestability of this system, but also believe that other citizens also have that


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4 C. Diaz-Alejandro, Con sequen ces o f financial liberalizationbel ie f. F o r e ign f ina nc ia l a ge n t s , whe n de a l ing w i th tho se o f ou r c o un t r y , m us tn o t e x p e c t t o h a v e t h e s e r u l e s c h a n g e d w h e n t h i n g s g o w r o n g f o r t h e m ;f o r e i g n f i n a n c i a l a g e n t s d e a l i n g w i t h i n o u r e c o n o m y w o u l d p r e s u m a b l y b esub je c t t o the sa m e ru le s o f the ga m e a s ou r f ina nc ia l a ge n t s .

Eve n a m ong those who f ind a p r e dom ina t ly l a i s se z - f a i r e f ina nc ia l sys t e mno t on ly im a g ina b le bu t a l so a de s i r a b le goa l o f po li c y , t he r e a r e d i ff e re nc e so n h o w t o o r g a n i z e t h e u n d e r l y i n g m o n e t a r y s y s te m . S o m e t a k e f o r g r a n t e dt h a t t h e g o v e r n m e n t w ill h a v e a m o n o p o l y in t h e s u p p l y o f c a s h a n d c o in s .A w a r e o f th e m a c r o e c o n o m i c i n s ta b i li ty w h i c h c o u l d b e g e n e r a t e d b y s u d d e nc h a n g e s in t h e p u b l i c p r e fe r en c e s b e t w e e n c a s h a n d t h e d e m a n d d e p o s it ssupp l ie d by ba n ks sub je c t t o f r a c t iona l r ese r ves , a s du r ing the e a r ly 1930s inthe Un i t e d S ta t e s , t he se obse r ve r s wou ld im pose I 00 pe r c e n t r e se r ve s onba nk s supp ly ing those d e pos i ts , wh i l e l e a v ing the r e s t o f the f ina nc ia l sys t e munregula ted , [See Fr iedman (1959) . ] In th is v iew, a s igni f icant d i f fe rencee xis ts be twe e n m on e y ( c a sh p lus de m a nd de pos i ts ) a n d o th e r f ina nc ia l as se ts .O the r obse r ve r s w ou ld c a r r y a l a is se z- fa i re po l ic y e ve n in to c a sh , e l im ina t ingthe gov e r nm e n t m ono po ly , a nd l e a v ing ind iv idua l a ge n t s fr e e to c ho osea m on g a l l po te n t i a l supp l ie r s o f c a sh , i nc lud ing f o r e ign gove r nm e n t s . I n th i sa p p r o a c h t h e r e w o u l d b e n o n e e d t o i m p o s e r e s e rv e r e q u i r e m e n t s o n b a n k s ,w h i c h w o u l d b e t o t al ly f r ee o f g o v e r n m e n t r e g u la t io n s . T h e m o n e y s u p p l ywou ld p r e sum a b ly a d jus t t o r e a l ne e ds , wh i l e p r i c e a nd wa ge f l e x ib i l i t ywo u ld m a in ta in m a c r oe c on om ic ba la nc e [ se e Ha l l ( 1982)].The la issez - fa i re v is ion a lso has (a t leas t ) two var iants regarding how theu n r e g u l a t e d d o m e s t i c e c o n o m y s h o u l d m a n a g e i t s e x c h a n g e r a t e . I f t h ec o u n t r y i s l a r g e e n o u g h , t h o s e g i v i n g t h e g o v e r n m e n t a m o n o p o l y o v e r t h em on e y supp ly a dv oc a te a f r e e ly f luc tua t ing e xc ha nge r a t e , w i th no r e s t r ic t ionon in t e r na t iona l t r a d e o r o n c a p i t a l flows . I f t he c ou n t r y i s sm a l l ( w i th thebor de r l ine be twe e n l a r ge a nd sm a l l l ef t fuzz y) , e ve n m on e y m onop o l i s t s f a vorsom e f o r m o f f ixe d e xc ha nge r a t e sys t e m . F or po l i t i c a l ly tu r bu le n t na t ions , ava r i a n t o f the l ia ssez -- fa ir e v i s ion in a sm a l l c ou n t r y wo u ld d o a w a y w i th thel o ca l c e n tr a l b a n k , i . e . , n o n a t i o n a l c o u l d b e t r u s t e d w i t h t h e m o n e ym o n o p o l y , w h i c h w o u l d b e t u r n e d o v e r t o a p r e s u m a b l y b e n i g n a n dr e sp o n s ib l e fo r e ig n g o v e r n m e n t , a s i n t h e e a s e s o f P a n a m a a n d P u e r t o R i co .No indus t r i a l c oun t r y ha s c om e c lose to the l a i s se z - f a i r e v i s ion , a t l e a s ts in c e t h e 1 93 0s . T h e g o v e r n m e n t m o n o p o l y o v e r c a s h h a s b e e n m a i n t a i n e d ,wh i l e ba nks ha ve be e n r e gu la t e d a nd sub je c te d to f r a c t iona l r e se r ver e qu i r e m e n t s . I n the Un i t e d S ta t e s , a n e xp l i c i t f e de r a l de pos i t i n su r a nc e f o ra c c o u n t s b e lo w a c e r t a in s iz e w a s i n t r o d u c e d d u r i n g t h e 1 9 3 0 s a n dm a in ta ine d s inc e the n , e lim ina t ing o ld - f a sh ione d ' r uns ' o n ba n ks . L ike a nyo the r in su r a nc e sc he m e , de pos i t i n su r a nc e is vu lne r a b le to m or a l h a z a r dc onse que nc e s , i .e ., i t i nduc e s de pos i to r s to th ink tha t ' one b a nk is a s go od a sa n o t h e r ' , a n d l e a d s b a n k m a n a g e r s t o u n d e r t a k e r i s k i e r l o a n s . T o a v o i dsuc h in su r a n c e - induc e d r i sk -t a k ing , supe r v i sion ov e r ba nk por t f o l io s ha s


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C. Diaz-Alejandro, Consequences o f f inancial l iberalization 5a c c o m pa n i e d de pos i t in s u ra nc e . I nde e d , t he F e de ra l R e s e rve ho l ds i mpre ss ived i s c r e t i ona ry po w e r s r e ga rd ing t he l e nd ing po l i c ie s o f c om me rc i a l ba nks , a ndove r t he i r l iqu i da t i on o r me rge r , i f ba n ks a r e found t o be in t r oub l e . Thos ed i s c r e t i ona ry pow e r s , how e ve r , a r e s ub j e c t t o r e v i e w by t he T re a s u ry ,C ongre s s a nd t he c ou r t s . V i g i l a nc e ha s be e n e xe r t e d by t he F e d ra l R e s e rve t ok e e p n o n - b a n k i n g c o m p a n i e s f r o m o w i n g o r c o n t r o l l i n g b a n k s .

W h i l e a t r e n d t o w a r d s b a n k d e r e g u l a t i o n h a s o c c u r e d i n t h e U n i t e d S t a t e sdu r i ng t he 1970s a nd e a r l y 1980s , r e mov i ng s ome a r c ha i c popu l i s t c on t ro l s ,t he v i e w t he ' ba nks a r e s pe c i a l' ha s be e n r e a f fi rme d . Th e r e s c ue o f t heC o n t i ne n t a l I ll ino i s du r i ng 1984 in t he f a c e o f a ne w t ype o f r un byun i ns u re d i n t e rna t i ona l de pos i t o r s , a r e s c ue w h i c h e x t e nde d de - f a c t oi ns u ra nc e t o a l l de pos i t o r s , s how e d t ha t large banks a re qui t e spec ia l . Thi sv i e w i s ba s e d on t he e x t e rna l i t i e s ge ne ra t e d by t he f i qn i d i t y , mob i l i t y a nda c c e p t a b i l i t y o f ba nk - i s s ue d t r a ns a c t i on a c c oun t s , c ha ra c te r i st i cs w h i c h t a kespec ia l s igni fi cance in per io ds o f f inanc ial s t res s [ see Federa l R eserve Ban k ofM i nne a po l i s ( 1982) ] . O n l y ba nks c r e a t e a nd i nc u r l i a b i l i t i e s t ha t a r e pa ya b l eon de ma nd a t pa r a nd t ha t a r e r e a d i l y t r a ns f e r a b l e t o t h i rd pa r t i e s . Y our s a f epa yme n t s s ys t e m i s a l s o my s a f e pa yme n t s s ys t e m; i t i s pa r t l y a pub l i c good ,no t on l y s e rv i ng i nd i v i dua l s , bu t a l s o p rov i d i ng ba c kup l i qu i d i t y on w h i c ht he w h o l e o f t he f i nanc i al s ys t e m r e s ts . The F e de ra l R e s e rve B a nk o fM i nne a po l i s c onc l ude s :

' . . . t he c a s e fo r s e g re ga t i ng essent ia l ba nk i ng func t i ons i n t o a ni de n t if i a b le c l a ss o f i n s t it u t ions i s e ve ry b i t a s p ow e r fu l t o da y a s i t w a sin the 1930s . I f anyth in g , con cerns reg ard ing f inanc ia l conc ent ra t ion ,conf l i c t s of in te res t, an d the f iduc ia ry respon s ib i li t ie s as so c ia ted wi thl e n d i n g d e p o s i t o r s ' m o n e y m a y b e m o r e r e l e v a n t t o d a y t h a n t h e y w e r e50 years ago ' (p . 13) .

O t he r i ndus t r i a l c oun t r i e s , s uc h a s J a pa n a nd t hos e i n W e s t e rn Europe ,a re even fa r the r away f rom the l a i s sez - fa i re v i s ion for the f inanc ia l sys temt ha n t he U n i t e d S t a te s . I n s e ve ra l o f thos e c o un t r i e s i n te r e s t r a te s a r e a l s oc on t ro l l e d o r s upe rv i s e d by mone t a ry a u t ho r i t i e s , a nd i n t e rna t i ona l c a p i t a lf l ow s a r e r e gu l a t e d . N one r e l i e s on j u s t p r i c e a nd w a ge f l e x i b i l i t y t o s e e km a c r o e c o n o m i c b a l a n c e . ( N o t e t h a t t h o s e a d v o c a t i n g a f i x e d - m o n e y - g r o w t hru l e a r e t yp i c a l ly a s s ke p t i c a l o f t he s pe e d y w ork i ng s o f p r i ce a nd w a g ef l e x i b i l i t y t o ma i n t a i n ma c roe c onomi c ba l a nc e a s K e yne s i a n e c onomi s t s . )

F ina l ly , i t i s d i f f i cu l t to f ind smal l and open count r i es which have given upmone t a ry s ove re i gn t y a f t e r t a s t i ng i t . P o l i t i c a l l y s ove re i gn c oun t r i e s u s i ngo t he r c ou n t r i e s ' mo ne ys , o r 'pe rm a ne n t l y ' c om m i t t e d t o a fi xe d e xc ha nge r a t ea nd un re s t r i c t e d c a p i t a l mob i l i t y w i t h a mone t a ry ' b i g b ro t he r ' , u s ua l l y ha vec om e t o t hos e a r r a nge m e n t s a s pa r t o f a t r a ns i ti on f rom a c o l on i a l st a tu s ,a n d i t is m o o t w h e t h e r t h e a r ra n g e m e n t s a r e r e g a rd e d a s re a ll y p e r m a n e n t o r


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6 C. Diaz-Alejandro, Consequences of financial liberalization

on l y a s a s t e p i n mone t a ry l e a rn i ng by do i ng , a s t e p w h i c h ha d t o bea c c e p t e d t o p l a c a t e s pe c i a l i n t e rna l a nd e x t e rna l i n t e r e s t s r a t he r t ha n t a ke na f te r a thoug h t fu l c ons i de ra t i on o f na t i ona l w e l fa r e . D u r i ng O c t o be r 1983t h er e w e re r e p o r t s t h a t I s r ae l w a s a b o u t t o a b a n d o n i ts m o n e t a r ys ove rei gn ty ; t he M i n i s te r r e s po ns i b l e fo r the p ro pos a l r e s i gne d s ho r t l ya f te rwards .

3. Notes on the f inancial h is tory of Lat in American and Southern ConeexperimentsW hi l e the f ina nc ia l h i s t o ry o f La t i n A m e r i c a r e ma i ns t o b e w r i t t e n i t

a ppe a r s t ha t by 1920s m os t c oun t r i e s ha d s uc c e e de d in e s t ab l i s h ingc omm e rc i a l ba nk s o f t he (t he n ) t r a d i ti ona l s o r t; s e ve ra l c oun t r i e s c a r ri e d o u tba nk i ng r e fo rms du r i ng t hos e ye a r s fo l l ow i ng t he a dv i c e o f P ro fe s s o r E . W .K e m m e r e r , o f P r i n c e t o n U n i v e r s it y , a n d o f v i si to r s fr o m t h e B a n k o fE n g l an d . T h e b a n k i n g s y s te m o f S o u t h A m e r ic a n c o u n t r i e s a l re a d y i n c lu d e di ns t i t u t i ons ow ne d by na t i ona l a nd p rov i nc i a l gove rnme n t s ; A rge n t i na , f o re x am p l e , h a d a n i m p o r t a n t g o v e r n m e n t - o w n e d m o r t g a g e b a n k a n d s e v e ra lo t he r pub l i c ba nks . T he l a t e 1920s w e re c ha ra c t e r iz e d i n mo s t L a t i nAmer ican count r i es by f ixed exchange ra tes , conver t ib i l i ty and pr ice s t ab i l i ty ;dom e s t ic in t e r es t r a te s w e re c l o s e l y l i nke d t o t hos e i n N e w Y o rk a ndLon don . A l t h ou gh t he re w a s no ' fi na nc ia l r e p re s si on ' , c ri ti c s po i n t e d t o al a ck o f m e d i um - a nd l ong- t e rm c r e d it , pa r t i c u l a r l y t o f i na nc e indu s t ry a n dnon-e xpor t a g r i c u l t u r e . W i t h i n a g r i c u l t u r e , t hos e w i t hou t r e a l e s t a t ec o l l at e r a l al s o c om pl a i ne d a b ou t non-a va i l a b i l i ty o f c r e d it . D o m e s t i c s t oc ka nd bond ma rke t s w e re s ma l l ; on l y A rge n t i na s e e ms t o ha ve ha d a p romi s i ngf o r m a l d o m e s t ic f in a n ci al m a r k e t , d o m i n a t e d b y m o r t g a g e p a p e r .

T h e 1 93 0s b r o u g h t e x c h a n g e c o n t ro l s a n d t h e e x p a n s io n o f g o v e r n m e n tf inanc ia l ins t i tu t ions , w hich a t the he ight of the c r is i s pro ve d the i r u se fu lnessi n de c re a si ng t he i nc i denc e o f pa n i c s a nd runs ; the m a s s i ve ba n kba nkrup t c i e s w h i c h oc c u re d i n t he U n i t e d S t a t e s du r i ng t he e a r l y 1930s w e reno t w i t ne s s e d i n t he l a rge La t i n A me r i c a n c oun t r i e s , a ppa re n t l y t ha nks t ot he p r e s e nc e o f s t a t e ba nk s p l us a n a c t iv i s t po l i c y o f r e s c u i ng m os t p r i va t eb a n k s i n t ro u b l e. B y t h e 1 94 0s m a n y c o u n t r ie s h a d d e v e l o p m e n t b a n k sg ra n t i ng me d i um- a nd l ong- t e rm c r e d i t s t o non- t r a d i t i ona l a g r i c u l t u r e ,i ndus t ry a nd c ons t ruc t i on . Thos e c r e d i t s , a t l e a s t du r i ng t he 1930s a nd e a r l y1940s , s eem ed to have be en gran ted a t in te res t ra tes sti ll ah ead of do m es t i ci n f l a t i on , o r a t l e a s t no t t oo f a r be h i nd i t , a nd i n mos t c a s e s c on t r i bu t e d t oa n u p s u r g e i n c a p i t a l f o r m a t i o n . P u b l i c d e v e l o p m e n t b a n k s r e m a i n e d , o f t e nthro ug h the 1950s , re la t ive ly smal l a nd e ff ic ien t, a s in the case of theB ra z il ia n B N D E . The d ry i ng -u p o f e x t e rna l s ou rc e s o f f ina nc e du r i ng t he1930s and 1940s encouraged these e f for t s to mobi l i ze loca l savings .


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C. Diaz-Alejandro, Consequences o f f inancial l iberalization 7B y t he 1950s , how e ve r , i t w a s c l e a r t ha t i n S ou t h A me r i c a n c oun t r i e s

e x p e r ie n c in g i n f l a t io n t h e d e v e l o p m e n t b a n k s c r e a te d t o s o lv e o n e f o r m o fpe rc e i ve d ma rke t f a i l u r e ( l a c k o f l ong - t e rm c r e d i t f o r s oc i a l l y p ro f i t a b l e non-t rad i t iona l ac t iv i t i e s ) had l ed to another , i . e . , a segmented domes t i c f inanc ia lm a rke t i n w h i c h s om e ob t a i ne d ( r a t ione d ) c r e d i ts a t ve ry ne ga t i ve re a li n t e r e s t r a t e s , w h i l e non- f a vo re d bo r row e r s ha d t o ob t a i n funds i n e xpe ns i vea nd uns t a b l e i n fo rma l c r e d i t ma rke t s . P ub l i c c on t ro l s ove r t he ba nk i ngsys tem typica l ly l ed to nega t ive rea l in te res t ra tes for depos i tors . 'F inanc ia lr e p re s s i on ' be c a me a n obs t a c l e t o dome s t i c s a v i ngs a nd t he i r e f f i c i e n ta l loca t ion , and f inanc ia l in te rmedia t ion l anguished .

In i n f l a t ion -p ron e c ou n t r i e s, f ina nc ia l r e fo rms w e re i n t roduc e d du r i ng t he1960s in t he fo rm o f i nde x i ng o f s om e l oa ns a nd de pos i ts ; thos e i nvo l v ing t hehous i ng ma rke t w e re a pa r t i c u l a r l y popu l a r f i e l d fo r t he s e ne w po l i c i e s . P os t -1964 Braz il i s the c lea res t ex am ple o f a sus ta in ed e f for t to rev ive thedom e s t i c f ina nc ia l s ys t e m a nd dom e s t i c sa v i ngs u s ing a nu m be r o f i nde x ingde v i ce s , bu t m a i n t a i n i ng c l o s e gove rnm e n t s upe rv i s i on o f f ina nc ia li n s t it u t i ons a n d o f i n t e re s t s r a te s c ha rge d i n fo rma l ma rke t s . T he r e s u l ts o ft he B ra z i l i a n r e fo rms ha ve be e n mi xe d : dome s t i c f i na nc i a l s a v i ngs ha ve be e nenc ou rag ed re la t ive to the pre -1904 s i tua t ion , in sp i te of con t inuing inf la t ion ,a nd t he ne w po l ic i e s s up por t e d i mpre s s ive r a t e s o f c a p i ta l f o rma t i on . B u ta t t empts to encourage a s igni f i cant s tock marke t have fa i l ed , and the f inanc ia lma rke t r e ma i ns he a v i l y domi na t e d by pub l i c s e c u r i t i e s . P r i va t e a ge n t s ha ves how n r e l uc t a nc e t o o f fe r i nde xe d s e cu r it ie s . C re d i t t o s om e s e c to r s , suc h a sagr icu l ture , has b een he avi ly subs id ized for long pe r iods of t ime . Braz i l hasa l s o r e t a i ne d c on t ro l s ove r t he l i nks be t w e e n dome s t i c a nd i n t e rna t i ona lf inanc ia l marke t s , whi le fo l lowing a pass ive c rawl ing peg exchange ra tepo l ic y , w i t h s po ra d i c j um ps a nd o t he r i nnova t i ons .In C e n t r a l A m e r i c a n c oun t r i e s , w i t h a t r a d i t i on o f p r i c e s t a b il i ty a ndc ons e rva t i ve m a c ro e c on om i c ma na ge m e n t (be fo re t he 1970s ), ba nkc o n c e n t r a t i o n a n d a n a s s o c ia t io n o f a f ew p r i v a te b a n k s w i th d o m i n a n te c o n o m i c g ro u p s , h i s to r ic a ll y r a is e d c o n c e r n s a b o u t m o n o p o l y p o w e r . G a l b is(1979, p. 349) noted:

' The e xpe r i enc e o f E l S a l va do r s ugge s t s t ha t i n t e r e st r a t e f r e e domc a n n o t b e e x p e c t e d t o b e a p a n a c e a a n d a u t o m a t i c a l l y p r o d u c e i n t e r e s tr a t e e qu i l i b r i um i n c oun t r i e s t ha t ha ve a r e la t ive l y c onc e n t r a t e d a ndunsophis t i ca ted f inanc ia l sys tem, which i s the typica l case in smal l , l e s sde ve l ope d c oun t r i e s . P os i t i ve po l i c y a c t i ons t o a vo i d ma rke t d i s t o r t i onsmi gh t be r e qu i r e d . '

Th i s t ype o f c onc e rn l e d t o t he na t i ona l i z a t i on o f t he ba nk i ng s ys t e m i nC o s t a R i c a i n t he la t e 1940s a nd i n E l S a l va d or i n 1 979 . G o ve rn m e n tregula t ion , inc luding se lec t ive c redi t a l loca t ions , over such o l igopol i s t i cs t ruc t u r e s ma y m a ke m a t t e r s w or s e , c ons o l i da t i ng a c c e s s by a f e w f a vo re d


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8 C. Diaz-A iejandro, Cons equence s o f financial liberalizationb u s in esse s t o su b s i d ized c r ed it ; p o s t -Seco n d -W o r l d -W ar G reece is sa i d t o b ean ex amp l e o f i n ef fi c ien t an d i n eq u i tab l e r eg u l a t i o n o f co n c en t r a t ed b an k i n gsector.So u t h e rn C o n e co u n t r i e s , co m i n g o u t o f su n d ry p o p u l i s t ex p e r ien cesa ro u n d t h e mi d -1 9 7 0 s , u n d e r t o o k f i n an c i a l r e fo rms g o i n g b ey o n d t h o se o fBrazi l in a la issez-fai re d i rect ion . Post -1973 Ch i le pro vide s the clea restexam ple o f th i s type o f f inanc ia l l ibera t ion [ fo r a care fu l nar ra t ive , seeAre l l ano (1983a ,b )] . Th a t exp er im en t s t a r t ed w i th a fu l ly na t iona l i zedb an k i n g sec t o r ; a f i r s t t a sk w as t o r e t u rn mo s t b an k s t o t h e p r i v a t e sec t o r .T h i s w as d o n e b y au c t i o n i n g t h em o ff , w i t h g e n e ro u s c r ed i t a r ran g em en t s , o rb y r e t u rn i n g t h em t o p r ev i o u s o w n e r s ; ap p a ren t l y l i t t l e e f fo r t w as sp en t o ni n v es t i g a t i n g t h e b an k i u g c r ed en t i a l s o f n ew en t r an t s . A t an ea r l y s t ag ein te res t ra t es were f reed and ' f inanc ie ras ' were a l lowed to opera te wi thp rac t i ca l l y n o r e s t r i c t i o n s o r su p e rv i s i o n ; e a r l y b an k ru p t c i e s i n D ecemb er1 9 7 6 a n d J a n u a r y 1 9 7 7 o f t h e m o r e a d v e n t u r o u s a n d u n r e g u l a te d' f i n an c i e r a s ' l ed t o t h e e s t ab l i sh men t o f mi n i mu m cap i t a l r eq u i r emen t s f o ren t ry . A u t h o r i ti e s r ep ea t ed l y w a rn ed t h e p u b l i c t h a t d ep o s i ts w e re n o tg u a ran t eed , b ey o n d v e ry sma l l d ep o s i t s w i t h b an k s , an d t h a t f i n an c i a lin te rmed iar i es , l ike any o the r p r iva te f irm, cou ld go b ank rup t ; i t wasex p li ci tl y s t a ted t h a t t h e r e w o u l d n o t b e a ' b a il in g o u t ' o f b an k s an d o t h e rf inanc ia l in t e rmed iar i es . S ince 197 4 m ul t i -purpos e ban k in g w as a l lowed , ont h e g ro u n d t h a t t h e Ch i l ean mark e t i s t o o sma l l t o su s t a i n sp ec i a l i z edf inanc ia l ins t i tu t ions o f e f f i c i en t s i ze . Reserve requ i rements were s t ead i lyreduced , reach ing less than t en p ercen t o f deposi t s by 1980 .D u r i n g 1 97 7 i t b e c a m e a p p a r e n t t h a t a n i m p o r t a n t b a n k ( th e B a n c oO s o rn o ) w as i n se r io u s t r o u b le . T h e au t h o r i t ie s , f e a r in g th a t i ts b a n k ru p t cyw o u l d t a rn i sh e x t e rn a l an d i n t e rn a l co n f i d en ce i n C h i l ean f in an c ia lins t i tu t ions , in t e rvened , and rescued a l l deposi to rs and the ins t i tu t ion .A p p a ren t l y , t h e f ea r t h a t ex t e rn a l l o an s w o u l d d ec rea se i f t h e O so rn o h adb een a l l o w ed t o g o b an k ru p t w as t h e c ru c i a l a rg u men t fo r i n t e rv en t i o n .N a t u ra l l y , f r ech w a rn i n g s w e re i s su ed t h a t , f r o m t h en o n , f i n an c i a li n t e rmed i a r i e s w o u l d n o t b e r e scu ed . A t t h a t s t ag e p r ac ti c a l ly n o i n sp ec t io nor superv i s ion o f ban k por t fo l ios ex i s ted ; on ly in 198 1 we re s igmif ican tr e g u l a t o ry p o w e r s g i ve n t o t h e S u p e r i n te n d e n c y o f B a n ks . O n e m a ycon jec tu re tha t a f t e r th i s even t most deposi to rs fe l t , de fac to , fu l ly insu redand fo re ign l enders fe lt t ha t the i r loans to the p r iva te Ch i l ean sec to r were , infac t, gua ran teed by the S ta te . Af te r 1977 , bank s , ra th er th an ' financ ie ras ',b ecame p red o mi n an t i n t h e f i n an c i a l sy s t em.D u r i n g 1 9 7 9 t h e Ch i l ean eco n o m i c au t h o r i t ie s s t a r t ed a p ro cess ex p ec tedt o cu l mi n a t e i n a p seu d o -ex ch an g e - r a t e u n i o n Csee Co rd en (19 72 )] w i t h t h eU n i t ed S t a t e s . T h e n o mi n a l ex h an g e r a t e b e t w een t h e p e so an d t h e U .S .do l l a r w as f ixed in Ju ly 1979 , an d res t r i c t ions ov er conver t ib i l i ty and cap i t a lmo v em en t s w e re r el ax ed ; b y 1 9 8 1 t h o se r e s t r i c ti o n s h ad b een co n s i d e rab l y


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C. Diaz-Aie]andro, Con sequenc es o f financial liberalization 9weak en ed , an d C h i l e w i t n es s ed a m as s i v e cap i t a l i n f l o w . P re s u m ab l y t h eh o p e was t o m ak e l en d i n g t o C h i l e s u b j ec t t o n o m o re cu r ren cy r i s k t h anl en d in g t o P u e r t o R i c o o r P a n a m a ; t h e n o m i n a l e x c ha n g e r at e w a s s u p p o s e dt o l a s t 'f o r m an y y ea r s '. S o m e o f t h e eco n o m i c au t h o r i ti e s d rea m ed o f d o i n gaway wi t h t h e n a t i o n a l cu r r en cy a l t o g e t h e r , b u t f ea red t h a t t h e m i l i t a rym i g h t n o t w i s h t o g o t h a t f ar .Th e theore t ica l unde rp inn ing s o f these po l ic ies inc luded a spec ia l vers ion o ft h e m o n e t a r y a p p r o a c h t o t h e b a l a n c e o f p a y m e n t s, p l us t h e h y p o t h e s is t h a tf inanc ia l marke t s , domes t ic and in te rna t iona l , were no d i f fe ren t f rom them a rk e t fo r ap p l e s an d m ea t . Vo l u n t a ry f i nan c ia l t r an s ac t io n s b e t ween p r iv a t eag en t s we re t h e i r o wn b u s i n es s , an d p re s u m ab l y P a re t o -o p t i m a l . In d eed , t h en a t i o n a l i t y o f t h o s e p r i v a t e ag en t s w as r eg a rd ed m o s t i rr e lev an t. T h e t h enD i r e c t o r o f t h e W e s t e r n H e m i s h e re D i v is io n o f th e I n t e r n a ti o n a l M o n e t a r yF u n d p u t i t t h i s way a t m ee t i n g h e l d i n S an t i ag o d e C h i l e d u r i n g J an u a ry1980 [see Rob ichek (1981 , p. 171)]:

' In the case o f the p r iva te sec to r , I wo u ld a rgue tha t the d i ffe renceb e t ween d o m es t i c an d fo re i g n d eb t i s n o t s i g n i f i can t - - b a r r i n g g o v e rn -me nta l in te r fe rence wi th the t rans fer o f se rv ice pay m ents o r o the r c lear lyinap pro pr ia te pubf ic po l ic ies - - i f i t ex i s ts a t al l. The exch ange r i sksa s s o c i a t ed w i t h fo re i g n b o r ro wi n g a re p re s u m ab l y t ak en i n t o acco u n t a sa re t h e o t h e r r i s k s a s s o c i a t ed w i t h b o r ro wi n g , wh e t h e r i t b e f ro md o m es t i c o r fo re i g n s o u rces . M o re g en e ra l l y , p r i v a t e f i rm s can b eexpec ted to be carefu l in assess ing the ne t re tu rn to be der ived f romb o r ro wi n g fu n d s a s co m p ared w i t h t h e n e t co s t s i n ce t h e i r s u rv i v a l a sen terp r i ses i s a t s t ake . '

T h e s a m e a u t h o r w e n t o n t o a r g u e t h a t o v e r b o r r o w i n g b y t h e p r i v a t esec to r , even wi th o f f ic ia l guaran tees , was very un l ike ly , p rov ided o f f ic ia lg u a ran t ee s we re g i v en o n a s e l ec t i v e b as i s ; o n l y p u b l i c b o r ro wi n g o ni n t e rn a t i o n a l f i n an c i a l m ark e t s was r eg a rd ed a s p o s i n g m o re s e r i o u s d eb tservice r isks [see Robichek (1981, p . 172)] .

C o n v e rg en c e o f d o m es t i c in f l a ti o n an d i n te re s t r a te s t o w ard i n t e rn a t i o n a lo n es p ro v ed t o b e a s l o w p ro ces s , d u r i n g wh i ch t h e f i x ed ' p e rm an en t 'nominal exchange ra te y ie lded g rea t incen t ives fo r p r iva te cap i ta l in f lows in toChile: du r in g 19 81 the cu rre n t a cco un t def ic it reache d an a s ton ish ing 14p e rcen t o f C h i l ean G ro s s N a t i o n a l P ro d u c t , w i t h i n te rn a t i o n a l r e s e rv esh o l d i n g t h e i r o wn , wh i l e d o m es t i c s av i n g s ap p ea red t o co l l ap s e . T h e p ro ces so f f i nan c ia l l i b e ra t i o n h a d a l s o l ed t o a w i d e l y n o t ed (b y o p p o s i t i o neco n o m i s t s ) co n c en t r a t i o n o f p o t en t i a l e co n o m i c p o w er i n th e h an d s o f a f ewco n g l o m era t e s o r eco n o m i c g ro u p s , wh i ch co m b i n ed f i n an c i a l an d n o n -f inanc ia l co rpora t ions . Befo re 1981 , the o f f ic ia l v iew seems to have been tha tt h o s e eco n o m i c g ro u p s m u s t r e f lec t s o m e eco n o m i es o f s ca le , an d co u l d b ereg a rd ed a s o n e s p ec i al t y p e o f b u t ch e r s h o p , d i s c i p li n ed b y f r ee en t ry an d


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10 C. Diaz-Alejandro , Con sequen ces o f financial liberalizationo ther co mp et i t ive p ressu res. The i r a l loca t ion o f c red i t resources , o f ten heav i lyl o ad ed i n fav o r o f co m p an i e s a s s o c i a t ed w i t h th e g ro u p , w as p re s u m e d t o b em o re e ff ic ien t t h an t h a t w h i ch g o v e rn m en t b u reau c ra t s co u l d ach iev e .As l a t e a s March 1 9 8 1 i n t e rn a t i o n a l b u s i n e s s p u b l i ca t i o n s we re wr i t i n gt h a t 'C h i l e ' s f r ee -en t e rp r i s e b an k i n g en v i ro n m en t ' was p ro v i n g t o b e ap o wer fu l m a g n e t fo r fo re ig n b an k s , an d t h a t m o re en t r an t s i n t o t h e t h r i v in gsec to r w ere l in ing up . (See Business Latin America, March 11, 1981, p . 79 . ) ByJ u n e 1 9 8 1 t h e s am e p u b l i ca t i o n s we re n o t i n g w i t h co n ce rn t h e ce s s a t i o n o fp ay m en t s o n l o ca l c r ed i t s b y C R AV, a C h i l ean s u g a r co m p an y , a s we l l a so t h e r b l em i s h es o n t h e eco n o m i c m i rac l e , b u t a rg u ed t h a t ' t h e p ro b l em a rea sp o s e n o i m m ed i a t e t h r ea t t o g ro wt h ' (Business Latin America, June 3 , 1981,p . 1 7 3 ) . F o l l o wi n g t h e C R AV n ews , t h e C en t r a l B an k s u p p o r t ed f i n an c ia li n s ti t u ti o n s t o s t em i n c i pi en t ' ru n s '. B y No v e m b er 1 9 8 1 t h e p o s i t i o n o f t woimpor tan t p r iva te Ch i lean banks and severa l ' f inanc ie ras ' became cr i t i ca l :t h ey we re 'i n t e rv en ed ' b y t h e C en t r a l B an k . F u r t h e r i n t e rv en ti o n s o f f in an c ia li n te rm ed i a r ie s o ccu r r ed d u r i n g t h e f ir s t h a l f o f 1 9 8 2 ; r a t h e r t h an h a r s hb an k ru p t cy p ro ceed i n g s , t h e s e ac t i o n s ap p a ren t l y i n v o l v ed a g en e ro u sex p an s i o n o f c r ed i t t o t h e p r i v a t e s ec to r . B e t ween th e en d o f D ecem b er o f1 98 1 an d t h e en d o f J u n e 1 98 2, d o m es t i c c r ed it i n C h i l ean p e s o s ex p a n d ed b y41 percen t ; o f the ne t increase in dom es t ic c red i t , 92 percen t wen t to thepr iva te sec to r [ see In te rna t iona l Monetary Fund (1983 , pp . 118-119 , l ines 32and 32d)] .Th e m as s i v e u s e o f C en t r a l B a n k c red i t t o ' b a il o u t ' p r i v a t e ag en t r a is e sd o u b t s a b o u t t h e v a l i d i ty o f p r e -1 9 8 2 an a l y s e s o f t h e f is cal p o s i t i o n a n d d eb to f t h e C h i l ean p u b l i c s ec t o r. Th e r eco rd ed p u b l i c s ec t o r b u d g e t d e f ic it wasn o n ex i s t en t o r m i n i s cu le fo r sev e ra l y ea r s t h ro u g h 1 98 1, an d m o d e r a t e d u r i n g1 9 8 2 . [F o r ev i d en ce o n t h e ap p a ren t C h i l ean f i s ca l p e r fo rm an ce , s eeM cK i n n o n (19 82 ).] Th e d ec l in i n g im p o r t an ce o f o s t en s ib l e p u b l i c d eb t in t h en a t i o n a l b a l an ce s h ee t was ce l eb ra t ed b y s o m e o b s e rv e r s ; i n d eed i t wasa rg u ed t h a t p u b l i c s ec t o r a s s e t s , s u ch a s r em a i n i n g p u b l i c co rp o ra t i o n s ,exceed ed it s li ab ili ti es . Ex p os t i t tu rned ou t tha t the pu b l ic sec to r , inc lud ingt h e C en t r a l B an k , h ad b een accu m u l a t i n g an ex p l o s iv e am o u n t o f co n t i n g en tl i ab i l i t i es to bo th fo re ign and domes t ic agen ts , who he ld depos i t s in , o r madeloans to the r i cke ty domes t ic f inanc ia l sec to r . Th is h idden pub l ic deb t cou ldbe tu rned in to cash as the f inanc ia l sys tem th rea tened to co l lapse . Eminen ts tuden ts o f f isca l and f inanc ia l sys tems , wh o w ere invo lye d in the Ch i leanre fo rm s , ap p a ren t l y o v e r l o o k ed t h i s p o t en t i a l d eb t b o m b . (P re s en t a t t h ec rea t i o n an d ea r l y d ev e l o p m en t o f th e n ew C h i l ean f i n anc i al s y s t em weree x p e r ts b r o u g h t t o g e t h e r b y th e O r g a n i z a t io n o f A m e r ic a n S t a t es P r o g r a mfo r t h e Dev e l o p m en t o f C ap i t a l M ark e t s ; t o g e t h e r w i t h th e C h i l ean C en t r a lB an k , t h i s p ro g ram s p o n s o red s em i n a r s o n cap i t a l m a rk e t s i n S an t i ag oduring 1974, 1976 and 1977.)

By la te 1981 an d ear ly 1982 Ch i le w as a l so fee ling the fu l l fo rce o f the


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C. Diaz-Alejand ro, Conse quenc es o f financial liberalization 11international economic crisis and discovering that it was not a 'smallcountry' in international financial markets, in the sense of being able toborrow, in either public or private account, all it wished at a given interestrate, even including a generous spread. Pressures mounted on the alreadyovervalued nominal exchange rate, fixed with respect to the U.S. dollar sinceJuly 1979; in June 1982 the unthinkable devaluation was carded out in haste,initiating a period of experimentation, which has included clean and dirtyfloating, a crawling peg, multiple rates, and a tightening up of exchangecontrols.The official exchange rate rose rapidly from 39 pesos per U.S. dollar to arange of 74-80 pesos by January 1983; the free rate went substantially aboveofficial quotation. Those who had dollar debts were placed under stress;financial difficulties contributed to and were aggravated by a drop in realGross National Product of about 14 percent during 1982. The Central Bankundertook rescue operations of banks and other financial intermediariesduring the second half of 1982, to avoid a breakdown of the financial system.In January 1983 a controversial, massive intervention in five banks, theliquidation of another three, and the direct supervision of another two leftthe government in control of a good share of the Chilean corporate sector, aswell as of its domestic and foreign debts. It has been estimated that non-performing assets of banks rose from 11 percent of their capital and reservesat the end of 1980, to 22 percent at the end of 1981, to 47 percent at the endof 1982, and to 113 percent in May 1983 [Arellano (1983a, p. 192)].

Many of those linked to the intervened banks and associated companies,including ex-Ministers of the Pinochet regime, charged that the January 1983measures by the Central Bank and its now active superintendency of bankswere unnecessary, arbitrary and politically motivated, hinting that rivaleconomic groups stood to profit from the measures. General Pinochethimself took the lead in charging the troubled economic groups with anumber of sins, including betrayal of the General's good faith. During 1983and 1984 some well-known financiers and ex-Ministers were jailed, chargedwith fraud. Specifically, it has been charged that Banco de Chile and threeother private Santiago banks set up a new bank in Panama, which was usedto circumvent limits on how much a bank could loan to members of its owngroup, when those measures were belatedly (during 1981) imposed to control'the conglomerates' rampant self-lending tactics' (The W all Street Journal,March 6, 1984, p. 38)Whatever the merits of these charges, it was clear that the domesticfinancial crisis in Chile had questioned not only the future of many existingbanks and corporations but also the rules of the game as they had beenunderstood during the years of the 'Chilean miracle'. The opaqueness of theintervention procedures, and of the announced processes to settle the tangledweb of inter-company and bank debts even raised questions about the


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12 C. Diaz-Alejand ro, Cons equence s o f financial liberalizationre , toe ' s respec t fo r p roper ty r igh t s o r a t l eas t i t s wi l l ingness to p rov ideeffec tive mech an i sm s fo r the e f f ic i en t exerc i se o f those r igh ts . O n the o the rh an d , o n l y t h e d ep o s i t o r s w i t h t h e t h r ee l i q u i d a t ed b an k s u n d e rw en t an yd i rec t losses (up to 30 perce n t o f the i r depos it s) ; a ll o th er de pos i to rs w ereas s u red t h a t t h ey co u l d g e t t h e i r m o n ey b ack .T h e 1 98 2-83 b rea k d o w n o f ru l es , an d t h e r e l ian ce o n d i s c re t io n b y Ch i l eanoff i c i a l s , ex tended to the hand l ing o f p r iva te ex terna l deb t s . In con t ras t wi tho the r heavy bor row ers , such as Brazil , a l a rge share o f the p re-1982 cap i t a li n fl o w i n t o C h i le w en t d i r ec t ly t o p r i v a t e b an k s an d co rp o ra t i o n s , b o r ro w i n gab ro ad w i t h o u t g o v e rn men t g u a ran t ee s . I n d eed , b o t h p r i v a t e b o r ro w er s an dl en d e r s w ere w arn ed b y g o v e rn men t o f f i c i a l s t h a t t h ey w ere o n t h e i r o w n ,an d t h a t s u ch d eb t co u l d i n n o w ay b e r eg a rd ed a s a Ch i l ean national deb t .In s p it e o f th e s e ex -an t e an n o u n c em en t s , d u r i n g ea r l y 1 9 8 3 ex t e rn a l d eb t s o fp r i v a t e b an k s w ere t ak en o v e r b y t h e g o v e rn m en t , w h i ch an n o u n ced i tsi n t en t io n t o co n t i n u e s e rv ic i ng th em. T h o s e p r i v a t e d eb t s h av e b een i n c l u d edi n d eb t r e s ch ed u l i n g b e i n g n eg o t i a t ed b e t w een t h e Ch i l ean s t a t e an d t h efo re i g n b an k ad v i s o ry co mmi t t ee fo r Ch i l e . A p p a ren t l y t h e Ch i l eang o v e rn m en t cav ed i n u n d e r p r e s s u re f ro m t h e b an k ad v i s o ry co m mi t t ee ,w h i ch a rg u ed t h a t i t w o u l d b e e x t r eme l y di ff icu lt f o r t h e i n t e rn a t io n a lf in an c ia l co m m u n i t y t o fo cu s i ts a t t en t i o n o n t h e p re s s in g n eed s o f Ch i lew h i le an i n c reas in g n u m b e r o f co mp an i e s an d t h e i r a s so c i a ted Ch i l ean b an k sw ere ex p e ri en c in g o r ap p ro a ch i n g a s u s p en s io n o f th e i r p ay m en t s an ds u b s eq u en t b an k ru p t cy . T o mak e t h e i r v i ew p o i n t ab s o l u t e l y c l ea r , f o r e i g nb an k s ap p a re n t l y t ig h t en ed u p t h e i r g r an t i n g o f v e ry s h o r t t e rm c o m merc i a lc r ed i t s t o Ch i l e d u r i n g t h e f i r st q u a r t e r o f 1 98 3, a t e ch n i q u e r ep o r t ed l y u s edwi th some success t en years ear l i e r v i s - / t -v i s the same coun t ry . TheIn t e rn a t i o n a l M o n e t a ry Fu n d , a l so ac t i v e i n t h e d eb t r e s ch ed u l i n g ex e rc is e ,h as n o t p u b l ic l y o b jec t ed to t h is t h r ea t t o t h e R o b i ch ek d o c t r in e .In s u m, t h e ad h o c ac t i o n s u n d e r t ak en d u r i n g 1 9 8 2 -8 3 i n Ch i l e t o h an d l et h e d o mes t i c an d ex t e rn a l f i n an c i a l c r i s i s ca r ry w i t h t h em an en o rmo u spo ten t i a l fo r a rb i t ra ry weal th red i s t r ibu t ion . The l es sons p r iva te agen t s a rel i k e l y t o d r aw f ro m t h es e ev en t s a r e u n l i k e l y t o b e co mp a t i b l e w i t h arecons t ruc t ion o f a domes t i c f inanc ia l sec to r re ly ing on cred ib le th rea t s o fb an k ru p t cy t o d i s c i p l i n e b o r ro w i n g an d l en d i n g . I n s p i t e o f t h e ex -p o s tg o v e rn men t g u a ran t ee s t o p es o d ep o s i t s , p r i v a t e i n d i v i d u a l s d ec reas ed t h e i rd eman d fo r p e s o -d en o mi n a t ed a s s e t s , a s d o mes t i c i n f l a t i o n p i ck ed u p , an dex p ec t a ti o n s g rew t h a t t h e c l ea r i n g u p o f t h e d o me s t i c d eb t t an g l e w o u l di n v ol v e ad d i t i o n a l i n f la t io n , ex ch a n g e - r a t e d ep rec i a t io n an d a rb i t r a ryco n t ro ls . Fa i t h i n o rd e r l y j u d i c ia l p ro ceed i n g s t o c l ea r u p d eb t s an d c l ai mson asset s app ear ed to be qu i t e low; sto r ies abo un de d o f deb to rs f l ee ing theco u n t ry , an d o f p e t t y an d g ran d f i n an c i a l ch i can e ry g o i n g u n p u n i sh ed .A rg en t i n e an d U ru g u a y a n d o m es t i c f i nan c i al ex p e r ien ces o f fe r a n u m b er o fs i mi l a r i t i e s an d s o me co n t r a s t s t o t h e n a r r a t ed Ch i l ean ev en t s [ s ee F ren k e l


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C. Diaz-Alejandro, Con sequences o f f inancial l iberal izat ion 13(1984)] . In those count r i es domes t i c f inanc ia l in te rmedia t ion a l so f lour i sheda nd t he n c o l l a ps e d . M a j o r c ompa ra t i ve po i n t s a r e t he fo l l ow i ng :

(1 ) W he t he r o r no t de pos i t s a r e e xp l i c i t l y i n s u re d , t he pub l i c e xpe c t sgove rnme n t s t o i n t e rve ne t o s a ve mos t de pos i t o r s f rom l os s e s w he n f i na nc i a li n t e rme d i a r i e s run i n t o t r oub l e . W a rn i ngs t ha t i n t e rve n t i on w i l l no t befo r t hc omi ng a ppe a r t o be s i mp l y no t be l i e va b l e . F e rna nde z (1983) ha sb l a me d e xp l i c i t i n s u ra nc e fo r f i na nc i a l de pos i t s by C e n t r a l B a nk a u t ho r i t i e sin expla in ing the Argent ine f inanc ia l c rash of 1980-82. But , a s we have seen ,e xp l i c i t i n s u ra nc e w a s muc h l e s s u s e d i n C h i l e , w he re ne ve r t he l e s s ma nyf i rms a nd hous e ho l ds a ppa re n t l y f e l t t ha t t he i r de pos i t s w e re i mp l i c i t l ygua ra n t e e d by t he C e n t r a l B a nk [ s e e A re l l a no (1983a , b ) ] .

( 2) The C e n t r a l B a nks , e i the r b e c a us e o f a mi s gu i de d be l i e f t ha t ba n ks a r el ike bu t c he r s hops , o r be c a u s e o f l a c k o f t ra i ne d pe r s onne l , ne g le c t e dpru den t ia l regu la t ions ov er f inanc ia l in te rmedia r ies . N ot surpr i s ingly , thea s s e ts he l d by A rge n t i ne a nd C h i l e a n ba n ks a n d ' f i na nci e ra s ' a rou nd 1980-81a ppe a re d t o ha ve s ubs t a n t i a l l y r i s k i e r r e l a t i ve t o t hos e he l d by s i mi l a ri n s t i t u t i ons i n t he U n i t e d S t a t e s o r i n W e s t e rn Europe , a nd r e l a t i ve t oplaus ib le coun te r fac tu a l s of sens ib ly- reg ula ted f inanc ia l in te rmed ia r ies int hos e c oun t r ie s . I t ha s be e n a rgue d t ha t i n U rug ua y t he p r e s e nc e o f U . S .ow ne d b a nks , r e gu l a t e d i nd i r e c t ly by t he F e de ra l R e s e rve, r e duc e d t hem a g n i t u d e o f r i sk - t a k in g b y b a n k s .(3 ) The ne w f i na nc i a l i n s t i t u t i ons i n t he S ou t he rn C one a t t r a c t e d f r e s he n t r ep r e n e u r s a n d s t im u l a t e d t h e c r e a ti o n o f n e w c o n g l o m e r a t e s a n de c onomi c g roups . W hi l e ne w e n t r e p re ne u r i a l b l ood ha s a n a t t r a c t i ve a u ra ,e xpe r i e nc e i nd i c a t e s t ha t s uc h ve n t u re s ome a n i ma l s p i r i t s a r e be t t e rc ha nne l e d t ow a rd non- f i na nc i a l e nde a vor s , w he re t he d i s c i p l i n i ng t h r e a t o fb a n k r u p t c y c o u l d b e m o r e c r e d i b l e .

(4 ) I n e c ono m i e s c ha ra c t e r i z e d by i n t r a c ta b l e m a rke t a nd i n fo rma t i ona li m p e rf e ct io n s , c o n g l o m e r a t e s a n d e c o n o m i c g r o u p s , e v e n a s th e y m a y c o r r e c tgove rnme n t - i nduc e d f i na nc i a l r e p re s s i on i mpe r f e c t i ons , c ou l d e xa c e rba t eo t he r s, pa r t i c u l a r l y v i a t he c r e a t i on o f o li gopo l i st i c pow e r . The c l e s ca s s oc i a t i on o f f ina nc ia l i n t e rme d i a r i e s w i t h no n- f ina nc i a l c o rpo ra t i ons ,f row ne d upon by U n i t e d S t a t e s r e gu l a t i ons , c a n i nde e d l e a d t o d i s t o r t i ons i nt he a l l oc a t i on o f c r e d it , a s s how n by t he A rge n t ine a nd C h i l e a n e xpe r ie nc e s.L i n k a g e s i n b o t h c o u n t r i es b e t w e e n b a n k s a n d f ir m ~ , w h i c h w e r e h a r d l ya rms ' l e ng th , w e re r e s pons i b l e fo r t he h i gh us e o f de b t b y p r i va t e f irms. I nC h i l e by l a te 1982 p r i v a t e f irms w e re mo re i nd e b t e d t ha n s t a te e n t e rp r is e s;w i t h i n t he p r i va t e s e c t o r , e x t r e me i nde b t e dne s s w a s found a mong t hos e t ha tc o n t r o l l e d b a n k s ( a n d t h a t h a d a c q u i r e d f r o m C O R F O t h o s e f i r m sna t ion a l i zed un der the Al lende Pres idency ) . Be tw een 1975 and 1982, Chi lew e n t f rom a f i na nc i a l l y s ha l l ow e c onomy, w he re i n f l a t i on ha d w i pe d ou t r e a lva l ue o f de b t , t o a n e xc e s si ve ly f ina nc i al ly de e p e c on om y w he re c r e d i t o r s


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14 C. Diaz-Alejandro, Consequ ences o f financial liberalizationow ne d a ve ry l a rge s ha re o f r e a l w e a l th , a c l e a r c a s e o f ' t oo m uc h de b t a n dt oo l i tt le e qu i t y ' . I n t e rpe ne t r a t i on o f e c on om i c a nd f i na nc ia l pow e r a pp e a r st o ha v e r e a c he d e x t r a o rd i na ry le ve ls . The t w o l a rge s t bus i ne s s g rou ps i nC h i l e by l a te 1982 c on t ro l l e d t he p r i nc i pa l i n s u ra nc e c o mp a n i e s , m u t u a lf u n d s , b r o k e r a g e h o u s e s , t h e l a r g e s t p r i v a t e c o m p a n y p e n s i o n f u n d s a n d t h et w o l a rge s t p r i va t e c omm e rc i a l ba nks ; a b ou t ha l f o f a ll p r i va t e e x t e rna l de b tw a s c h a n n e ll e d t h r o u g h t h e d o m e s t i c b a n k i n g s y st e m , s o c o n t r o l o f b a n k sa l l ow e d r e a d y a c c e s s bo t h t o do me s t i c a nd fo r e ign c r ed i t. B y la t e 1982 ma n yba n ks ha d l e n t one qu a r t e r o f m ore o f the i r r e s ou rc e s t o a ff ilia te s.

(5) The f r e ei ng o f i n t e r e s t r a te s a nd t he r e l a xa t i on o f c on t ro l s ove rf ina nc ia l i n t e rme d i a t i on w i ll no t ne c e s sa r i ly e nc o ura ge i n t e rm e d i a t i on be yo nds hor t - t e rm ma t u r i t ie s . T he f l ou r is h i ng o f p r i va t e f i na nc ia l i n t e rme d i a r i e s i nt he S ou t he rn C on e , e ve n a t t he he i gh t o f t he boo m , w a s l i mi te d t o de p os i t sa nd l oa ns o f l es s t ha n s ix mon t hs ' du ra t i on . Lo nge r - t e rm i n t e rme d i a t i on v i ab a n k s o r b o n d s , n o t t o m e t i o n v i a a c t i v e s t o c k m a r k e t s , r e m a i n e d v e r y w e a k .Ins o fa r a s t he ne w po l i c i e s de s t roy p r e - e x i s t i ng gove rnme n t - s uppor t e d l ong -t e rm i n t e rme d i a t i on a r r a nge me n t s , a s i n the c a s e o f t he C h i l e a n h ous i ngsys tem, SINAP, f inanc ia l l ibe ra t ion wi l l reduce ava i l ab le long- te rm f inanc ia li n s t rume n t s . S t oc k ma rke t s ma y w i t ne s s s ho r t booms , bu t w i l l mob i l i z e ve ryfe w funds; cha rge s o f ma n i pu l a t i on a nd f r a ud , p l u s la c k o f p ro t e c t i on fo rmi nor i t y s t oc kho l de r s , w i l l r e duc e pub l i c i n t e r e s t i n buy i ng s t oc ks i nun re gu l a t e d o r ba d l y r e gu l a t e d s t oc k ma rke t s . I t ha s be e n c ha rge d i n t heC h i l e a n c a s e t h a t f a l s e s t o c k t r a n s a c t i o n s w e r e a n i m p o r t a n t c o m p o n e n t i nt he g row t h o f f ina nc ia l i n t e rme d i a r ie s du r i ng 1977-81 . I t is a rgue d t ha tm a r k e t p r ic e s o f s h a re s o w n e d b y l a rg e b u s i n e s s g r o u p s w e r e m a n i p u l a t e dupw a rds , v i a ph on y t r a ns a c t ions , t o i nc r e a s e the va l ue o f c o l l a te r a l u s e d t os e c u re l oa ns a nd t o i nduc e f r e s h i n f l ow s i n t o c a p t i ve mu t ua l f unds .(6 ) T h e e n d o f f in a n ci al r e p r e ss i o n u n d o u b t e d l y e n c o u r a g e d m a n y t y p e s o ff i nanc i a l s av i ngs; A re l l a no (1983a , b ) doc u m e n t s t he b oo m i n C h i l e a n f ina nc ia ls a v i ngs a nd i n t e rme d i a t i on e s pe c ia l ly du r i ng 1977-82 . P a ra dox i c a l l y ,how e ve r , t o t a l dome s t i c s a v i ngs d i d n ot i nc r e a s e i n t he S ou t h A me r i c a ne xpe r i me n t s i n f i na nci a l l ibe r a t ion , i n s p i t e o f ha n ds o m e r e t u rns t o s a v i ngs.C h i l e a n G r o s s N a t i o n a l Sav ings f e l l f r o m a n a v e r a g e o f 1 6 . 3 p e r c e n t o f G r o s sN a t i o n a l P r o d u c e d u r i n g t h e d e c a d e o f t h e 1 96 0s, to 1 2 . 4 p e r c e n t d u r i n g1975--81 [Ar e l l ano (1983b, p . 12)] . Are l l ano cog ent ly a rgu es tha t th ee xpa ns i on i n C h i l e a n f i na nc i a l s a v i ngs c a me ma i n l y f rom t he fo r e i gn c a p i t a li n fl ow , t he r e c o rd i ng on bo t h s ide s o f t he l e dge r o f a c c um ul a t e d i n t e re s t a ndof c a p i t a l ga i ns, a nd a r e o r i e n t a t i on o f s a v i ng f low s from t he pub l i c t o t hep r i va t e s e c t o r [ s e e a ls o H a rb e rge r (1982) fo r a d i s c us si on o f t he po orpe r fo rm a nc e o f C h i l e a n s a v i ngs ] . I n 1980-81 r e fo rms t o t he s oc i a l se c u r i t ys ys t e m ga ve a fu r t he r boos t t o funds f l ow i ng i n t o p r i va t e f i na nc i a l i n s t i t u -t io n s , b y c h a n g in g t h e p a y - a s - y o u - g o g o v e r n m e n t - m a n a g e d s y s te m i n to a


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C. Diaz-Alejand ro, Consequen ces o f financ ial liberalization 15c a p i t a l i z a t i on s c he me , i n w h i c h pe ns i on funds w e re t o be ma na ge d by p r i va t ef inancial ins t i tut ions .

(7 ) A gg re ga t e i nve s t me n t pe r fo rm a nc e s how e d no c l e a r si gn o f e i the ri mprov i ng o r be c omi ng more e f f i c i e n t , i n t he S ou t h A me r i c a n c oun t r i e sunde rgo i ng f i na nc i a l l i be r a t i on . I n C h i l e g ros s f i xe d i nve s t me n t du r i ng t he1960s a ve ra g e d 20 . 2 pe rc e n t o f G ros s D om e s t i c P rod uc t ; du r i ng 1974-82 i tr e a c he d on l y 15 .5 pe rc e n t o f G D P [ s e e A re l l a no (1983a, p. 226 )] . A rge n t i nea n d U r u g u a y a n p e r f o r m a n c e w a s b e t t e r o n t h e i n v e s t m e n t f r o n t , p a r t l ybe c a us e pub l i c s e c t o r c a p i t a l f o rma t i on d i d no t s h r i nk a s t he C h i l e a n c a s e .

(8 ) F o re i gn l e nde r s t a ke gove nme n t a nnounc e me n t s t ha t i t w i l l no t r e s c uel oc a l p r i va t e de b t o r s , e s pe c i a l l y ba nks , w i t h non-gua ra n t e e d e x t e rna l ( o rdom es t ic ) l iab i l it i es even l ess se r ious ly than dep os i to rs t ak e the thre a t of al o ss o f t he i r m one y . T he a l le ge d J a pa ne s e a t t i t ude o f no t d i f f er e n ti a ti ngb e t w e e n t h e p u b l i c a n d p r i v a te e x t e r n a l d e b t o f a d e v e l o p i n g c o u n t r y a p p e a r st o h a v e b e e n u p h e l d e x - p o s t a s a s o u n d e r g u i d e t o a c t i o n t h a n t h e R o b i c h e kdoc t r ine . F o re i gn b a nk s l e nd i ng t o bo t h t he pub l i c a nd p r i va t e s e c to r s o f ac o u n t r y h a v e c o n s i d e r a b l e l e v er a g e to c o n v i n c e g o v e r n m e n t s t o t a k e o v e r e x -po s t bad pr iv a te deb t s , e spec ia l ly those o f f inanc ia l in te rmedia r ies . Therea ppe a r t o be no i n t e rna t i ona l r e f e r e e s t o ke e p t he m f rom e xe rc i s i ng s uc hl e ve ra ge . The s ubs t a n t i ve d i f f e r e nc e s be t w e e n t he na t i ona l i z a t i on o f M e x i c a npr i va t e ba nks du r i ng 1982 a n d the i n t e rve n t ion i n C h i l e a n p r i va t e ba nksdur i ng 1983 ma y be l e s s t ha n one w ou l d t h i nk by r e a d i ng t he e d i t o r i a l s o ft he i n t e rna t i ona l f i na nc i a l p r e s s . I n t e rna t i ona l ba nks , know i ng t he y a r er e gu l a t e d a t home , w he re t he y a l s o ha ve c l o s e po l i t i c a l c onne c t i ons w i t h t he i rgove rnme n t s , e xpe c t t he s a me i n bo r row i ng c oun t r i e s .

W hi l e de b t s o f p r i va t e C h i l e a n ba n ks t o fo r e ign ba n ks w e re fu ll y a s s ume db y th e g o v e r n m e n t , o t h e r o p e r a t io n s b y S o u t h e r n C o n e b a n k s c a rr ie d o u ta b r o a d d o n o t s e em t o h a v e r e ce iv e d t h e p r o t e ct iv e m a n t l e o f h o m e -gove rnme n t s uppor t . F o r e xa mpl e , t he A rge n t i ne a u t ho r i t i e s de c l i ne d t oa c c e p t r e s pons i b il i ty fo r c l a ims on t he N e w Y o rk b ra nc h o f t he fa iling B a n c oI n t e r c a m b i o R e g i o n a l , w h i c h w a s t a k e n o v e r b y t h e N e w Y o r k S t a t eB a nk i ng D e pa r t me n t [ J ohns on a nd A bra ms (1983 , p . 23 ) ] . G i ve n t h i se xpe r ie nc e , i t i s un l i ke l y t ha t S ou t he rn C o ne ba nk s w i ll e me rge a s i mp or t a n tc ompe t i t i o r s i n i n t e rna t i ona l ba nk i ng i n t he ne a r fu t u r e .

( 9 ) T h e c o m b i n a t i o n o f p r e - a n n o u n c e d o r f ix e d n o m i n a l e x c h a n g e ra te ,r e l a t i ve l y f r e e c a p i t a l move me n t s , a nd dome s t i c a nd e x t e rna l f i na nc i a ls ys t e ms c ha ra c t e r i z e d by t he mora l ha z a rd a nd o t he r i mpe r f e c t i ons d i s c us s e da bove s e t t he s t a ge no t on l y fo r s i gn i f i c a n t mi c roe c onomi c mi s a l l oc a t i on o fc r e d i t , bu t a l s o fo r ma c roe c onomi c i n s t a b i l i t y , i nc l ud i ng t he e xp l os i ve g row t hof e x t e rna l de b t , mo s t o f w h i c h w a s i nc u r r e d b y p r i va t e C h i l e a n ba nks ,f o ll o w e d b y a b r u p t c e s s a ti o n o f c a p i ta l i n f lo w s . T h a t m a c r o e c o n o m i ci ns t a b i l i t y w ou l d oc c u r e ve n a s s umi ng t r a nqu i l c i r c ums t a nc e s , bu t i t i s o fc ou r s e e xa c e rba t e d by e x t e rna l s hoc k s h i tt ing e c onom i e s m a de pa r t i c u l a r ly


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16 C. Diaz-Alejandro, Consequences o f financial liberalizationbr i t tl e a nd vu l ne ra b l e by t h a t c om bi na t i on o f po l i ci e s a nd i n s ti tu t i ons.C o n t r a ry t o s om e o l d a nd n e w no t i ons , t he e xpe r i enc e s o f A rge n t i na , C h i lea n d U r u g u a y s h o w t h a t w h a t h a p p e n s t o t h e n o m i n a l e x c h a n g e r a t e d o e saffect the real e x c h a n g e r a t e , a t l e a s t i n t h e s h o r t a n d m e d i u m r u n s , a n d t h a tc ha nge s in t he e xc ha nge r a t e c a n b e a n i mp or t a n t a nd e f fi c ie n t m e c ha n i s m o fa d j u s ti n g t h e b a l a n c e o f p a y m e n t s . F a u l t y e x c h a n g e r a t e p o l i c y a p p e a r smuc h more i mpor t a n t i n e xp l a i n i ng f i na nc i a l t u rbu l e nc e a nd t he s e ve r i t y o ft he C h i l e a n 1982-83 de p re s s i on t ha n t he r e duc t i on i n i mpor t ba r r i e r s . Thec re d ib i li ty o f t he l a tt e r w a s r e duc e d by p e s o ove rva l ua t i on , i nduc i ng a ni mpor t b i nge a nd r e duc i ng l oc a l s a v i ngs .( 1 0 ) S hor t - t e rm r e a l i n t e r e s t r a t e s , p l a us i b l y de f i ne d , on t he w ho l er e ma i ne d ve ry h i gh in A rge n t ina , C h i l e a nd U r ug ua y , e ve n du r i ng pe r i ods o fma s s i ve c a p it a l i n fl ow . A nu m be r o f hyp o t he s e s ha v e be e n o f f e r e d t o e xp l a i nt hi s p h e n o m e n o n : m a c r o e c o n o m i c p o li cy ; e x p e c t a ti o n s o f d e v a l u a ti o n a n di n f l a t i on , w h i c h i n t he s ho r t r un d i d no t ma t e r i a l i z e ; a c ha nge i n t he r e a lp rod uc t i v i t y o f c a p i ta l ; a nd e ve n e xc e s si ve s p re a ds o r i g i na t ing i n C e n t r a lB a n k R e s e rve re qu i r e me n t s . A s in t he c a s e o f e xp l a na t i ons fo r t he h igh , bu tl e s s s pe c t a c u l a r , r e a l i n t e r e s t r a t e s r e c o rde d i n t he U n i t e d S t a t e s du r i ng t hee a r l y 1980s , none o f t he hypo t he s e s a r e fu l l y s a t i s f a c t o ry [ s e e L i t t e rma n a ndW e i s s (1984) ]. F r om t he v i e w p o i n t o f t h is pa pe r , t he m os t i n t r igu i nghypo t he s e s fo r e xp l a i n i ng e x t r a va ga n t S ou t he rn C one r e a l i n t e r e s t r a t e s ,w h i c h i n C h i l e re a c he d 32 pe rc e n t pe r a nn um on t he a ve ra ge du r i ng 1976--82a c c o rd i ng t o A re l l a no [A re l l a no (1983b , p . 31 ) ; t h i s i s t he r a t e c ha rge d fo rs ho r t - t e rm l oa ns ] , f oc us on t he na t u r e o f f ina nc ia l de r e gu l a t i on a ndi mpe r f e c t i ons i n t hos e ma rke t s . I t w a s no t e d e a r l i e r t ha t t he h i gh C h i l e a ni n t e r e s t r a t e s w e re r e f l e c t e d ma i n l y i n doub l e - e n t ry bookke e p i ng . I t c a n bea r g u e d t h a t f i r m s a n d h o u s e h o l d s b o r r o w i n g a t e x t r a v a g a n t r a t e s e i t h e re xpe c t e d t he m t o l a s t f o r ve ry b r i e f pe r i ods , o r , if t he y d i d no t , bo r row e r se x p e c t e d t h e g o v e r n m e n t t o b a i l t h e m o u t , k n o w i n g a s t h e y d i d t h a t m a n yo t he r bo r row e r s w e re i n a s i mi la r s i tua t i on . S uc h e xpe c t a t i ons , o f c ou r s e ,f a vo re d ' d i s t r e s s bo r row i ng ' : e i t he r i n t e r e s t r a t e s f e l l , o r gove rnme n t w ou l d' ba il ou t ' e ve ryone . W h a t e ve r t he va l i d it y o f t he s e a rgum e n t s m a y b e , i t i sc l e ar from t he S ou t h e rn C o ne e xpe r i e nc e t ha t t he t ype o f de r e gu l a t i one xpe r i enc e b y t hos e c oun t r i e s g i ve s no a s s u ra nc e o f s t a b le r e a l i n te r e s t r a t e sh o v e r in g a r o u n d r e a s o n a b l e e s t im a t e s o f th e s o c ia ll y o p t im a l s h a d o w r e ali n t e re s t ra t e. S o me obs e rv e r s ha ve a rgue d t ha t t he ma i n func t i on o f h i gh r e a li n t er e s t r a t e s w a s t o t r a nsf e r t he ow ne r s h i p o f re a l e n t e rp r i s e w e a l t h f romd e b t o r s t o c r e d i t o r s , a m e c h a n i s m d o o m e d t o s t o p w h e n n o m o r e s h a r e -holders ' wea l th was l e f t .( I I ) A s e l s e w he re i n La t i n A me r i c a , t he de c l ine i n r e a l G ros s D om e s t i cP ro du c t i n A rge n t i na ( I I pe r c e n t be t w e e n 1980 a nd 1982), i n C h i le (15pe rc e n t be t w e e n 1981 a nd 1983) , a nd i n U rugua y (14 pe rc e n t be t w e e n 1980a nd 1983) m a y be s a i d t o be t he r e u l t o f un fa v ora b l e e x t e rna l c i r c um s t a nc e s


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C. Diaz-A lejandro, Cons equence s o f financ ial liberalization 17dur i ng t he e a r l y 1980s , c ombi ne d w i t h l e s s t ha n op t i ma l dome s t i c po l i c i e s . A sno t e d e a r l i e r , po l i c y - i nduc e d s t i c k i ne s s i n nomi na l e xc ha nge r a t e s de l a ye da d j us t m e n t t o c ha n ge s i n e x t e rna l t e rms o f t r a de a n d c ha n ge s i n c a p i t a lf lo w s . T h e b r i tt le S o u t h e r n C o n e d o m e s t ic s e c to r s m u s t a l so b e a r b l a m e f o rf i r s t e xa gge ra t i ng t he boom, t he n a gg ra va t i ng t he r e c e s s i on a nd f i na l l yde l a y i ng r e c ove ry . The c ons e que n c e s o f t he C h i l e a n f i na nc i a l c r a s h ha v e be e nt he mo s t s pe c t a c u l a r , le a d i ng t o a ma s s i ve r e a r r a ng i ng o f t he na t i ona lba l a nc e s he e t. S uc h a r e a r ra ng i ng , how e ve r , ha s be e n a s l ow a nd opa quep r o c es s , l e av i n g m a n y e c o n o m i c e nt it ie s n o t k n o w i n g w h o o w n s w h a t, o rw h o o w e s w h a t t o w h o m , h a r d l y i d e a l c i r c u m s t a n c e s f o r e n c o u r a g i n g ar e v iva l o f p r i va t e i nv e s t me n t .

(12 ) A s w i t h i n t e rna t i ona l de b t , t he s o r t ing ou t a n d a l l oc a t ion o f l o ss e sa n d b l a m e fo r ' m i s ta k e s ' ( o n l y c le a r e x - p o s t) b y b o r r o w e r s a n d l e nd e r s i n t h ed o m e s t ic fi n an c ia l m a r k e t s p r e s e n t m o n u m e n t a l c o n c e p t u a l a n d le g alp rob l e ms , e s pe c i a l l y w he n ' m i s t a ke s ' a r e w i de s p re a d . S i nc e 1982 A rge n t i naa p p e a r s t o h a v e t a k e n t h e t i m e - h o n o r e d r o u t e o f w a s h i n g o u t o l d f in a n ci almis takes v ia inf l a t ion (which i s not a l lowed to be re f l ec ted in in te res t ra tes ) ;t h i s a pp roa c h f a vo r s bo r row e r s ove r l e nde r s . A s no t e d e a r l i e r , i n t he C h i l e a nc a s e the pa t h ou t o f t he m ora s s r e m a i ns unc l e a r ; in f l a ti on a c c e l e r at e d , bu t' o n ly ' t o a r o u n d 2 5 - 3 0 p e r c e n t d u r i n g 1 9 8 3 . T h e r e a r e f e w p r e c ed e n t s a n dl e s s a c c e p t e d doc t r i ne r e ga rd i ng f i na nc i a l p roc e s s e s a s b i z a r r e a s t hos eexper ienced by Chi le dur ing 1975-83. Bankruptc ies , f inanc ia l d i s t res s andc o n f u s i o n d e l a y r e c o v e r y b e y o n d w h a t w o u l d b e n e c e s s a r y t o a c h i e v e r e a la d j us t m e n t t o t he n e w i n t e rna t i ona l t e rms o f t r a de , c a p i t a l ma rk e t r e a l it ie sa n d e x p e c t a ti o n s a b o u t g r o w t h i n th e in t e r n a ti o n a l e c o n o m y .

4. Options for Latin American domestic financial systemsS ou t he rn C o ne d om e s t i c fi na nci a l s ys te ms o f the l a t e 1970s a nd e a r l y

1980s e nde d up w i t h a pe s s i mum ' mi dd l e w a y ' : de f a c t o pub l i c gua ra n t e e s t ode pos i t o r s , l e nde r s a nd bo r row e r s , a nd no e f fe c ti ve s upe rv i s i on a nd c on t ro l(unt il i t was to o l a te ) of the prac t i ces o f f inanc ia l in te rmedia r ies . Re formc ou l d l og i c a l l y he a d i n t w o oppos i t e d i r e c t i ons : more l a i s s e z - f a i r e w i t hb i nd i ng ( c ons t i t u t i ona l ? ) c ommi t me n t s a ga i ns t f u t u r e ba i l -ou t s , o r t ow a rdm ore pu b l i c c on t ro l s , pos s i b l y c u l mi na t i ng i n na t i ona l i z a ti on o f t he ba nk i ngs ys te m, a s i n C os t a R i c a , E l S a l va dor , I nd i a a nd F ra nc e . O t he r La t i nA m e r ic a n c o u n t r i e s o u t s i d e t h e S o u t h e r n C o n e , s u c h a s B r a zi l an d C o l o m b i a ,ha ve d om e s t i c fi na nc ia l s ys t e ms t ha t, w h i le s how i ng s i gns o f s t re s s du r i ng t hel a st fe w ye a rs , ha ve no t u nde rg one S ou t he rn -C one - t ype o f c ris is ; t he irexper iences ( inc luding the i r pos t -1981 t roubles ) could be use fu l in ske tchingde s i r a b le c ha ra c t e r i s ti c s o f dom e s t i c f i na nci a l a r r a nge m e n t s .

A s no t e d e a r l ie r , the c r e d i b i li t y o f a gov e rnm e n t c o m m i t me n t t o a t r u l yla i s sez - fa i re domes t i c f inanc ia l sys tem i s ve ry low. F i r s t ly , a s i l lus t ra ted in the


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18 C. Diaz-Alejandro , Cons equence s o f financial liberalizationrecent Chi lean exper ience , fore ign f inanc ia l agent s wi l l no t accept asepa ra t ion of pr iva te and pu bl ic de bt s wh en a c r i si s a r r ives ; financ ia l l a is sez -f a i r e i n one pe r i phe ra l c oun t ry doe s no t s e e m v i a b l e . S e c ond l y ' pub l i cop i n i on ' , i nc l ud ing ge ne ra l s a nd t he i r a un t s , s imp l y doe s no t b e l ie ve t ha t t hes t a t e w o u l d ( n o r c o u l d ) a l l o w m o s t d e p o s i t o r s t o b e w i p e d o u t b y t h e f a i l u r eo f ba n ks a nd f ina nc ia l i n te rme d i a r ie s . I t m a y be t ha t p r i va t e f i na nc ia l a ge n t s ,dome s t i c a nd fo r e i gn , l e nde r s , bo r row e r s a nd i n t e rme d i a r i e s , w he t he r o r no tr e l a t e d t o ge ne ra l s , know t ha t t he dome s t i c po l i t i c a l a nd j ud i c i a l s y s t e ms a r eno t c ompa t i b l e w i t h l a i s s e z - f a i r e c ommi t me n t s w h i c h a mi s gu i de d M i n i s t e r o fF i n a n c e o r C e n t r a l B a n k P r e s i d e n t m a y o c c a s i o n a l l y u t t e r i n a m o m e n t o fdogma t i c e xa l t a t i on . W he n a c r i s i s h i t s , a ge n t s w i l l r e a s on , ba nkrupe y c ou r t sw ill b r e a k d o w n ; w h e n m o s t e v e r y o n e (w h o c o u n t s ) is b a n k r u p t , n o b o d y i s!Thus , e ve n i f one be l ie ve d , fi l a H a y e k , t ha t t he e x t e rna l it ie s a nd pub l i c goo dc ha ra c t er i s ti c s o f t he do me s t i c mo ne t a r y a nd f ina nc ia l s ys t e m a re ne g l ig i bl e,one ma y c onc l ude t ha t t he po l i t i c a l , a nd s oc i a l , i n f r a s t ruc t u r e found i n ma nyde ve l op i ng ( a nd de ve l ope d? ) c oun t r i e s c ons p i r e s a ga i ns t t he v i a b i l it y o f s uc ha pu re l a i s s e z - f a i r e f i na nc i a l s ys t e m. The z e a l o t ma y c onc l ude t ha t t he na t i ond o e s n o t m e a s u r e u p t o t h e p u r i ty o f t h e m o d e l .S o s hou l d one m ov e ba c k t o g oo d o l d 1950s s t y le f ina nc ia l r e p re s si on ,e x t e ns ive c on t ro l s a nd pe rha p s full na t i ona l i z a t ion o f t he dom e s t i c f ina nc i als ys t e m? I t c a n be a rgue d t ha t a believable a l t e rna t i ve s ys t e m c ou l d bedes igned, avo id ing m an y of the inef fi ciencies of f inanc ia l repress ion wh i lea v o i d i n g t h o s e o f t h e S o u t h e r n C o n e e x p e ri en c e , a n d b l e n d in g b o t h p u b l i ca nd p r i va t e f i nanc i al a ge n t s . W ha t fo l l ow s s ke tc he s s om e f e a tu r e s o f t ha tec lec ti c sys tem .N e g a t i v e r e a l ra t e s o f i n te r e st b e c a m e c o m m o n i n L a t i n A m e r i c a d u r i n gt h e 1 9 4 0 s a n d 1 9 5 0 s a s i n f l a t i o n g a i n e d m o m e n t u m a n d m a n y m o n e t a r ya u t ho r i t ie s m a i n t a i ne d c e il ings on nom i na l i n t e r e s t ra t e s o f f e re d a nd c ha rge db y t h e b a n k i n g a n d f in a n ci al s y s te m . A t th a t t im e m o s t S o u t h A m e r ic a nc oun t r i e s (bu t no t M e x i c o , V e ne z ue l a , C e n t r a l A m e r i c a a nd t he C a r i bbe a n )a l s o ma i n t a i ne d e x t e ns i ve e xc ha nge c on t ro l s . L i mi t e d i n t e rna t i ona l c a p i t a lmo b i l i ty bu t t r e s s e d t he t a x i ng o f c a s h ba l a nc e s a nd f ina nc ia l r e p re s s ion ; t het h e n p r e v a l e n t K e y n e s i a n o r t h o d o x y a l s o e n c o u r a g e d t h e s e d e v e l o p m e n t s .W hi le pers i s t en t ly nega t ive rea l ra tes o f in te res t in the form al f inanc ia lm a r k e t o c c u r e d o n l y w h e n t h e g o v e r n m e n t i m p o s e d r a t e c e i l i n g s a n de xc ha nge c on t ro l s , it i s no t ob v i ou s t ha t pub l i c r e gu l a t ion a nd pa r t i c i pa t i oni n t he dome s t i c f i na nc i a l ma rke t ne c e s s a r i l y ha d t o l e a d t o ne ga t i ve r a t e s o fin te res t . The M exic an f inanc ia l sys tem of the 1950s and 1960s , pra i se d byde ve l opm e n t s cho l a rs , c on t a i n e d bo t h pub l i c i n s t it u t i ons a nd s ubs t a n t i a lgove rnme n t r e gu l a t i ons . A s a l r e a dy no t e d , t he pos t -1964 B ra z i l i a n i nde x i nga nd o t he r f i na nc i a l r e fo rms c ou l d ha rd l y be de s c r i be d a s i nvo l v i ng a l a i s s e z -f a ir e a pp roa c h . The c e l e b ra t e d S ou t h K ore a n f ina nc ia l r e fo rms o f t he 1960s


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C. Diaz-Ale#andro, Con sequenc es o f financial liberalization 19w e re c a rr i e d ou t w i t h a h i gh de g re e o f pub l i c ow n e r s h i p a nd c on t ro l o f t heformal f inanc ia l s ec tor [ see Gur ley e t a l . (1965, p . 45) ] .

A s s u m i n g t h a t a c o u n t r y i n te n d s t o m a i n t a i n m o n e t a r y s o v e r ei g n ty b u ttha t s igni f i cant , ye t not explos ive , inf l a t ionary expec ta t ions pers i s t , the re i s as t rong c a s e fo r ma k i ng s u re t ha t f i rms a nd hous e ho l ds ha ve a va i l a b l e adomes t ic l iqu id f inanc ia l a s se t y ie ld ing a rea l in te res t ra te which i s not fa rbe l ow , no r muc h a bove , z e ro . The i n f l a t i ona ry t a x bo rne by c u r r e nc yba l a nc e s m a y r e s u l t f rom t he i na b i l i ty o f the f is ca l s ys t e m t o f r e d non-i n f l a ti ona ry s ou rc e s o f r e ve nue s , o r i t ma y be s i mp l y a by -p ro duc t o f a ni n f l a t i ona ry s p i r a l , w hos e i ne r t i a l mome n t um c ou l d on l y be ha l t e d by as e ve re r e a l c on t r a c t i on . P re s u m a b l y t he t r a ns a c t i ons c o nve n i e nc e p rov i de d bydome s t i c c u r r e nc y w i l l be e nough t o ge ne ra t e s ome de ma nd fo r i t , e ve nu n d e r m o d e r a t e i n f l a t i o n , a n a s s u m p t i o n s u p p o r t e d b y S o u t h A m e r i c a ne xpe r ie nc e s. B u t w i t hou t a l i qu i d a nd s af e s t o r e o f va l ue de no m i na t e d i ndome s t i c c u r r e nc y , w h i c h a t l e a s t ma i n t a i n s i t s pu rc ha s i ng pow e r , a na t i ona lmone t a ry a nd f i na nc i a l s ys t e m w i l l ha ve l i t t l e l ong - run c r e d i b i l i t y , s ho r t o fd ra c on i a n c on t ro l s . I t c ou l d a l s o be a rgue d t ha t w i t hou t s uc h a n a s s e t t hes ys t e m w ou l d no t m e e t t he mo s t e l e m e n t r a ry t e s t s o f s oc ia l e qu i ty .

I t s hou l d be e mpha s i z e d t ha t i n t roduc i ng a ' z e ro - r e a l - r a t e a s s e t s ' ne x t t o az e ro -nomi na l - r a t e a s s e t i nvo l ve s a de l i c a t e t r a de -o f f , w h i c h ma y i nc re a s ew e l f ar e on l y i f t he i n f l at i on t a x on m on e y r e ma i ns ' r e a s ona b l e ' . The z e ro -r e a l - r a t e a s s e t w i l l r e duc e t he de ma nd fo r mone y , bu t ma y a l s o r e duc e t hede ma nd fo r a s s e t s de nomi na t e d i n fo r e i gn c u r r e nc i e s . A n i n f l a t i on w h i c ha c c e l e r a t e d s ha rp l y a bove h i s t o r i c a l no rms , i n t roduc i ng ma s s i ve c u r r e nc ysubs t i tu t ion , c ou ld de s t ro y the c redib i l i ty of a l l dom es t i c f inanc ia l a s se ts .

The re a r e ma ny pos s i b l e w a ys t o s upp l y a z e ro - r e a l - r a t e a s s e t . Theba nk i ng s ys t e m, fo r e xa mpl e , c ou l d p rov i de i nde xe d s a v i ngs a c c oun t s ;de pe nd i ng on p ra c t i c a l c ons i de ra t i ons , t he y c ou l d be u s e d pa r t l y a s c he c k i nga c c oun t s . A t l ea s t t ha t s e gm e n t o f t he ba nk i ng s ys t e m w ou l d ha ve e xp li ci ta nd fu l l de pos i t i n s u ra nc e , pe rha ps on l y fo r a c c oun t s be l ow a c e r t a i n(generous ) l imi t ; insurance for l a rger accounts could par t i a l . Na tura l ly , theu s e b y b a n k s o f f u n d s c o m i n g f r o m t h o s e a c c o u n t s w o u l d b e t i g ht lyr e gu l a t e d b y a f l i n ty - e ye d s upe r i n t e nde nc y o f ba nks . I nde e d , p r a c t ic a lc ons i de

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