Chile: A Changed Jungle for the Latin American Tiger (Abridged)

Abstract

In the early 1990s, in the context of massive foreign capital inflows, the Chilean government restricted the flow of capital into the country to achieve a competitive and stable exchange rate and to control inflation. By the late 1990s, with the onset of the financial crises in emerging market economies, investors began to pull their capital out of Chile and other emerging markets indiscriminately. This sudden reversal of capital flows was threatening to ignite a balance-of-payments crisis in Chile. The government must decide what to do. See also two related cases, "Chile: A Jungle for the Latin American Tiger (A)" (UVA-BP-0461) and "Chile: A Jungle for the Latin American Tiger (B)" (UVA-BP-0462).

Excerpt

UVA-BP-0458

CHILE: A CHANGED JUNGLE FOR

THE LATIN AMERICAN TIGER (ABRIDGED)

In June 1998, Carlos Massad, president of Banco Central de Chile (the central bank of Chile), was evaluating the Chilean economic situation. After a decade of spectacular economic performance with average annual growth rates of more than 7% (Exhibit 1), Chile had earned the name “Latin American Tiger” in reference to the fast-growing tiger economies in East Asia (Hong Kong, Singapore, South Korea, and Taiwan).

Chile was facing one of the biggest challenges since the collapse of its financial system in 1982. Somewhat ironically, the 1997 crisis plaguing those same namesake tigers, which resulted in sharp currency devaluations and severe economic contractions in East Asia, had greatly increased the risk premium for investing in other emerging markets. Investors, who once willingly poured billions of dollars into emerging markets, were now avoiding them indiscriminately. They were choosing instead to park their money in safe havens such as the United States. This sudden withdrawal or stopping of foreign investment was now causing severe economic difficulties in other emerging economies that were dependent on foreign investment for economic development and threatened to ignite a new round of financial crises. Perhaps most worrisome, the next round of crises could be much closer to home. (See Exhibit 2 for Chile's balance of payments.)

For many years, Chile could rely on its abundant natural resources, most notably copper, forestry, and fishery, to provide the country with the hard currency needed to import equipment and technology (Exhibits 3 and 4). But the weakened economies in Asia had depressed the world demand for commodities. The price of copper had fallen to its lowest level since 1988 (Exhibit 5). The combination of capital flight and weakened exports had started to slow down production in Chile (Exhibit 6) and to drain the country's foreign exchange reserves (Exhibit 2). Massad had to come up with a strategy to reverse the deterioration in Chile's balance of payments and prevent a major crisis. While the economic institutions and policies implemented since the early 1990s had worked well for Chile, the global economic environment had changed drastically in the last couple of years. Should Chile change course? If so, in what direction?

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Keywords: Exchange rate risk, emerging economies, international trade, monetary policy