FROM THE OFFICE OF PUBLIC AFFAIRS

It has been said that to know where your going, it helps to know where you've been. As we close out 1999, Latin America can look back with some satisfaction on the past decade. Protectionist and populist policies that were coming under attack at the beginning of the decade have largely been replaced by policies that allow markets to flourish. As a result, Latin America's GDP has grown 3.8 percent per year during the Nineties, well above the annual growth rate of 2.2 percent in the Eighties. Nevertheless, as the new millennium approaches, dealing effectively with global financial flows poses an ongoing challenge to continued growth and stability in Latin America. We all know that the first line of defense is sound macroeconomic policies. In addition, valuable lessons about financial policies can be drawn from both Latin America's own recent experiences and the experiences of other emerging market countries. I hope my remarks will contribute to this process.

The market-friendly policies adopted by Latin American countries over the past decade have deepened U.S. economic ties with the region. From 1991 to 1998, total U.S. trade (exports plus imports) with Latin America has increased 128 percent, substantially more than the 75 percent increase in U.S. trade with the rest of the world. U.S. investment has accompanied the increase in trade flows. The United States accounted for 47 percent of foreign direct investment, on average, in Latin America in 1997 and 1998.

As U.S. economic ties with Latin America have deepened, so has the level of cooperation and consultation among policy makers. Perhaps most reflective of that trend is the Summit of the Americas process, launched here in Miami five years ago by the heads of state of this hemisphere's democratic nations. As President Clinton said at that time, "history has given the people of the Americas a dazzling opportunity to build a community of nations committed to the values of liberty and the promise of prosperity."

To help further that promise of prosperity, Western Hemisphere finance ministry officials, for example, meet regularly under the auspices of the Committee on Hemispheric Financial Issues or CHFI, as it is commonly known. Through CHFI, the region's finance ministers seek to foster the strengthening and integration of capital markets to support the growing economic ties within the region. The next meeting will be in February in Cancun.

Despite deeper economic integration in the Western Hemisphere and generally prudent macroeconomic policies, Latin American economies remain susceptible to external shocks. Global financial turmoil, falling commodity prices, and unusually bad weather over the last two years have combined to take a heavy toll on regional GDP growth.

Following the Asian crisis that began in mid-1997, net private capital flows to Latin America fell from about $120 billion in 1997 to around $80 billion in 1998. Issuance of bonds in external markets also declined significantly from $85 billion in the eighteen months preceding July 1997 to $65 billion over the following eighteen months. Those developments put pressure on exchange rates and foreign exchange reserves.

Many countries responded by raising domestic interest rates. Local short-term interest rates (90-days or less) in major Latin American countries increased from an average of 17.5 percent in July 1997 to 32 percent in October 1998. The average remained above 24 percent through April of this year. As the adverse effects of higher domestic interest rates and reserve losses mounted, several countries, including Brazil, Ecuador, Chile, and Colombia, re-evaluated their exchange rate regimes and chose to float their currencies.

Weak commodity prices exacerbated the effects of reduced capital inflows and higher domestic interest rates. Commodity prices fell 16 percent from December 1997 to December 1998, by one measure (Commodity Research Bureau). The large drop hurt Latin America's terms-of-trade - prices of exports relative to prices of imports - which the IMF calculates fell 24 percent in 1998. More importantly for the region's oil exporters, the price of oil plunged 58 percent in the 24 months to December 1998. Venezuela, where oil exports account for 15 to 20 percent of GDP, was particularly hard hit.

Non-oil commodity exporters have also suffered. The 44 percent decline in copper prices since June 1995 has constrained the growth of Chile's GDP, where copper exports comprise 40 percent of Chile's total exports. Although commodity prices have rebounded on average in 1999, led by a 77 percent jump in the price of oil, agricultural prices continue to languish, declining 12 percent this year, after falling 20 percent in 1998, as measured by the commonly used Goldman Sachs' Index. That weakness has continued to dampen growth for agriculture exporters such as Argentina, Brazil, and Colombia.

Finally, an unusually bad draw in weather, coupled with negative commodity price shocks, has played havoc with several countries' economies and exports, including the Peru, Ecuador, and Central American economies.

Largely as a result of those shocks, the economies of Argentina, Brazil, Chile, Colombia, Ecuador, and Venezuela are in recession. In some countries, such as Ecuador, deep-seated domestic economic and financial problems also played an important role in causing the recession. For the region, Consensus Forecasts expects GDP to contract 0.5 percent in 1999, after growing only 2.1 percent in 1998. That compares to regional growth of 5.1 percent in 1997. One notable exception is Mexico, where GDP is projected to expand 3 percent or more this year, after growing almost 5 percent in 1998. Mexico has benefited from its close economic ties to the United States. However, Mexico's commitment since 1995 to sound macroeconomic policies in a difficult external environment has been essential to its recent relative economic success; its flexible exchange rate regime also has provided an important shock absorber.

For the most part, the policy response of other Latin American governments to negative external shocks has been similar to Mexico's (though with some exceptions). The vast majority of countries responded to external economic and financial pressures with renewed commitments to prudent fiscal and monetary policies, deeper financial sector reforms, and no significant reversals of trade liberalization. Such responses, during a time of economic pressure, underline the robustness of the reform consensus. One encouraging result of prudent macroeconomic policies is that inflation remains subdued in the region. In 1999, the inflation rate for the region is expected to be in the single digits for the third year in a row.

Responsible economic policies and a more stable external environment provide a solid platform for the resumption of growth next year. The average spread on external Latin American sovereign debt, as measured by J.P. Morgan's Latin EMBI, has fallen from its recent high of over 900 basis points in August to under 700 today. Further, as I noted earlier, commodity prices, with the exception of some agriculture prices, have generally rebounded. Short-term interest rates on average in major economies in the region, at less than 17 percent, are now half as high as one year ago. The increased prevalence of flexible exchange rates provides more scope for continued declines in interest rates looking forward. Thus, next year looks more promising for economic growth in Latin America. The Consensus Forecast currently is for 3.2 percent GDP growth in 2000.

The key issue for Latin American and other emerging market economies going forward is financial management in an environment of large potential shocks in global capital flows. Capital will always have ebbs and flows, to some extent independent of policies in individual countries. Each ebb and flow produces its own challenges. The main precaution Latin American countries can take to protect themselves is to keep policies strong.

The importance of sound financial systems in reducing a country's vulnerability to financial shocks is indisputable. Latin American countries were ahead of the curve when they committed at their 1997 CHFI meeting to implement the Basel Core Principles. This commitment was symbolic of the increased attention to such issues in the wake of the Tequila crisis of 1995. The relative strength of banks in Latin America is probably one reason the region survived the financial turmoil of the past two years with less damage than occurred in Asia.

However, Latin American financial systems are small, which impedes growth. To encourage investment in domestic financial institutions, governments must maintain macroeconomic stability and nurture legal environments that protect property rights. At the same time, authorities need to establish robust regulatory and supervisory frameworks to ensure the soundness of financial systems. Changes are not going to occur overnight; they require continued work to implement and sustain. Nevertheless, they are critical to enhance the ability of Latin America to withstand potential financial market volatility.

Other measures to reduce vulnerability are also required. To sustain confidence in the future, Latin America will need exchange rate regimes that can command the trust of domestic citizens and of foreign investors, accommodate regional and global integration, and remain resilient over time. There is a growing consensus that countries involved in the world capital market will need to avoid the "middle ground" of pegged exchange rates combined with discretionary monetary policies. It has become clear that fixed - but not firmly institutionalized - exchange rate regimes hold enormous risks for emerging market economies in a world where fast-flowing capital and insufficiently developed domestic financial systems coincide. At the same time, adoption of floating exchange rate regimes should not be used as a device to avoid implementing prudent macroeconomic policies.

The most extreme institutional monetary arrangement available to a country, of course, is the abandonment of its own currency. In this context, dollarization has been discussed as an alternative to floating and to the middle ground of adjustable pegs. The decision to make another country's currency one's own is hugely consequential for any country, and it is one that has to be considered carefully. On the one hand, dollarization offers the attractive promise of enhancing stability in the dollarizing country by importing the credibility and discipline of another country's policies in support of its own policies, and, thereby, also advancing its integration with the world economy. On the other hand, the country also must be prepared to embrace that discipline and to accept the potentially significant consequences of doing without the capacity independently to adjust its exchange rate or the direction of domestic interest rates.

U.S. authorities are open to dollarization by other countries. However, we have made clear that it would be inappropriate to adjust our own bank supervisory responsibilities to cover institutions in countries that adopt the dollar, to provide expanded access to the Federal Reserve's discount window, or to adjust the procedures or orientation of U.S. monetary policy in light of another country's decision to dollarize its monetary system. Any country contemplating dollarization will have to weigh carefully these considerations as well as many others.

More generally, countries must take care to avoid the trap of pegged exchange rate regimes that may appear to offer stability, but may in reality encourage large risks to be build up unnoticed. It is noteworthy, in this connection, that this year four Latin American countries have adopted flexible exchange rate regimes. But a great deal of the hard work remains to be done both to implement and stick to prudent macroeconomic policies, regardless of a country's exchange rate regime if a country is to capitalize upon the progress that has been made in liberalizing its economy and financial system.

The risks associated with exchange rate fluctuations are only one factor that contributes to an economy's vulnerability to what Secretary Summers has called modern capital account crises. Governments need to think more broadly about their economies' exposure to all types of financial risk, and focus upon the prudent management of their national balance sheets. Sound management of the national balance sheet is a concept that is broader than the sovereign's own balance sheet and extends to assets and liabilities in both domestic and foreign currency. Sound balance sheet management is essential to help limit the risk that temporarily tight conditions in capital markets will trigger a deep contraction in domestic output.

In light of recent experience, it seems clear that weaknesses in the sovereign's own balance sheet need not be the central source of an economy's financial vulnerability. Risk exposures of banks, finance companies and individual firms, in various combinations, can set the stage for a generalized, reinforcing rush for the exit. It is also clear that private sector leverage and risk exposure can augment pressure on sovereign balance sheets both prior to and during a crisis.

Thus, borrowing and lending decisions that are individually prudent may nonetheless aggregate into vulnerabilities for a country. An individual corporate treasurer, for example, may decide that it is smart to borrow unhedged in foreign currency, or to remain exposed to commodity price declines. However, if all firms in the economy make the same bet, the resulting economy-wide unhedged exposure can contribute to the type of destabilizing dynamics we have seen recently in many countries, where a scramble for foreign currency makes a thin market thinner, and very one-sided.

The interesting question is how to reduce the risk that the conditions that can lead this type of dynamic get established in the first place. The policy challenges are a bit more complicated than those required for prudential management of the sovereign's liabilities alone, since the risks lie in the consolidated balance sheet of the nation overall. To reduce those risks, one has to think about how to influence the behavior of a diverse mix of private actors.

In determining the appropriate policy measures, there is room for creative thought; we do not have all the answers. We can say with some confidence that a sensible approach will require an integrated assessment of the refinancing and currency risks contained on the national balance sheet, as well as other significant sources of risk exposures. Many of these risks can currently be hedged in the capital markets, and even more will be as demands to spread more and more categories of risk lead to the creation of new hedging instruments. Other creative approaches can be explored. Commodity- price-based fiscal stabilization funds, such as Chile's CODELCO, for example, are the type of different approach that other commodity-dependent nations could usefully explore.

Reducing the aggregate risk in the national balance sheet also involves enhanced efforts to strengthen financial sectors. Such efforts include limiting the scope of the financial safety net, improving the prudential regulation and supervision of banks, and developing local capital markets in order to provide alternatives to bank finance. It is also important to avoid the distortions favoring what appear to be "cheap" financing terms on short-term foreign currency obligations that all to often contribute to future financial crises.

Finally, we must not forget the importance of managing the sovereign balance sheet itself. The Asian crises did not originate in sovereign balance sheets, but arguably the crises in Mexico five years ago, Russia last summer, and Brazil last fall did, largely due to excessive concentration on short-term borrowing. In the Brazilian case, it was the sovereign's balance sheet in domestic currency that was most relevant, but the point about potential vulnerability remains.

In conclusion, I leave you with three thoughts. First, Latin America on balance has made enormous progress over the Nineties to the benefit of its citizens and the United States. After weathering the storms of the past two years, it is well positioned to continue to move forward. Second, Latin America, along with many other countries, faces the challenges, as well as the opportunities, of global capital markets and potentially volatile financial flows. Third, to deal effectively with global financial markets in the new millennium, countries will have to maintain sound macroeconomic policies, of course, but they will also have to address vulnerabilities arising from financial systems that are not robust, exchange rate regimes that are not appropriate, and national balance sheets that are embedded with excessive systemic risks. To meet those challenges successfully, the public and private sectors throughout the Americas will have to continue to work together.