FEDERAL RESERVE BANK OF ATLANTA 1 CAPITAL FLOWS TO LATIN AMERICA: NEW ISSUES AND OLD CONCERNS Eduardo Fernández-Arias and Ugo Panizza Inter-American Development Bank 1 he world is entering its first global recession since the early 1970s. Growth prospects were already weak during the first months of 2001, but the events of September 11 destroyed any hope of escaping a global recession. The most recent estimates from the International Monetary Fund predict that during 2001 and 2002, world output will grow at a rate of 2.4 percent. The growth rate of the advanced economies will be below 1 percent, and Latin America will have a growth rate well below 2 percent. The world slowdown will be particularly painful for countries that export commodities and rely on external financing. The outlook is particularly bad for Latin America, which is facing a deterioration of its external financing conditions and weaker demand for its goods and services (especially commodities and tourism). These external factors, coupled with internal problems in some countries, are putting great pressure on the region’s ability to grow, necessitating a severe fiscal adjustment. This climate is particularly worrisome because it may have severe implications for the welfare of the region in both the short run and long run. In the short run, the crisis is likely to increase poverty and severely impact the most vulnerable groups of the population. In the long run, the economic crisis will generate social discontent and may put in jeopardy the process of structural reforms that the region has painstakingly implemented during the last decade. Since mid-1997, Latin America has experienced a succession of severe adverse shocks. Export prices deteriorated significantly in the aftermath of the Asian crisis. Compared with the second quarter of 1997, terms of trade in non-oil exporting countries, such as Chile and Peru, dropped by approximately 20 percent. While until recently, oil-exporting countries were benefiting from the high price of oil, since September 2001 oil prices also started declining. The Russian crisis (and the other crises that followed, e.g., Brazil, Turkey, and Argentina) led to a significant and persistent rise in the cost of capital for emerging markets in general and an even greater increase for Latin America. Interest rates spreads for Latin American countries went from 260 basis points in the quarter preceding the Asian crisis to 800 basis points in the current quarter. The dramatic rise in the cost of capital was associated with a severe drought in capital inflows to the region. Total flows to the seven largest Latin American 1 The views and interpretations in this document are those of the authors and should not be attributed to the Inter- American Development Bank or to any individual acting on its behalf. T