Sterilization of incoming capital flows

Doug Henwood dhenwood at
Sat Oct 24 15:26:16 PDT 1998

Michael Pollak wrote
>On Doug's WBAI program a couple of weeks ago, he interviewed a very
>interesting Brazilian economist (whose name Doug pronounced so
>authentically I couldn't make it out :-)

Hardly. I mangled it, I'm sure. Luiz Gonzaga Belluzzo is his name.

He spoke in passing about the
>"sterilization" of incoming capital flows, and I'd like very much to
>understand how it this works, since it seems to contain the most concise
>and damning indictment of submerging markets I've ever heard. If I
>understood correctly, Brazil's policy was to maintain a stable, and soon
>over-valued, Real through its peg to the dollar largely in order to
>attract large amounts of foreign capital into the country. But, once those
>capital flows arrived (in the 100's of billions of dollars), the
>government was *forced* to borrow in order to "sterilize them" -- because
>if they hadn't issued domestic bonds, the inflow of capital would have
>undercut the very policies that had brought it in.

Belluzzo's analysis was that the inflow of capital would have swollen the domestic money supply, so the government issued bonds to drain it off. Of course, they probably spent the proceeds of the bond issues, which put the money back into circulation, so I don't know how successful the policy was.

For another take on the sterilization question, if I may quote myself from a 1995 LBO piece on the Mexican crisis, which is also at <>L

<quote> Coping with windfalls

The problem of how to cope with a surge in capital inflows - a fate that capital-starved countries can't imagine has any harmful side - has preoccupied officialdom recently. The recently published Per Jacobsson Lecture, an annual talk sponsored by a foundation housed at the IMF, by the Spanish banker and economist Guillermo de la Dehesa, is devoted to that very issue. Mexico, data presented in Dehesa's talk shows, was the largest recipient of private capital flows in the Third World, nosing out China, whose economy is almost twice as large as Mexico's, and dwarfing South Korea, an economy of comparable size, by more than two-to-one. All together, the flood of capital into the Third World totaled $380 billion between 1990 and 1993, with almost half of it accounted for by the top 5 countries (Mexico, China, Argentina, Korea, and Indonesia). It is important, however, to put that flood into perspective. Official estimates of capital flight from the so-called developing world during the 1970s and 1980s are around $300 billion, meaning that the capital flood brought in only a bit more - less, if inflation is taken into account - than was drained from the poorer countries during the decades of heavy borrowing and the resulting debt crisis.

Why would the equivalent of money falling from the sky be a problem? A country that experiences a surge of external investment can find its equilibrium disturbed. An inflow of funds means a sudden demand for assets with no comparable change in supply. This forces up prices in the target country, and can drive up the country's currency as well. This upward pressure on prices can drive up domestic inflation, and the pressure on the currency can price exports out of global markets.

Therefore the monetary and fiscal authorities have to offset the pressures of the inflow by tightening policy. De la Dehesa: "[A]nother efficient response to capital flows shocks is the establishment of factor market flexibility, both for labor and capital. In a situation of equilibrium nominal wages, exchange rate appreciation will result in too high a wage level. Wage flexibility will be needed not only to restore the balance but to avoid any negative impact on employment." This requires translation. Were de la Dehesa's idiom English rather than mumbo-jumbo, these sentences would read: "To respond to capital flows, markets for labor and capital must be minimally regulated, to assure that wages and interest rates adjust quickly to circumstances. If wages are right to begin with (which they probably are, if markets are unregulated), then capital surges can drive them up above desirable levels; therefore, the appropriate response should be policies to drive down wages - to preserve jobs."

Capital outflow? Cut wages to make the country more attractive to investors. Capital inflow? Cut wages to make the country's products more attractive to foreign buyers. A nice symmetry, really. Or, as de la Dehesa concludes, "in a world environment of freedom of capital movements, developing countries will be subject to severe economic discipline by potential investors." </quote.

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