International Liquidity Management Problems in Modern Latin America: Their Origin and Policy Implications

Despite significant progress in macroeconomic stabilization and structural reform, Latin America still experiences substantial macroeconomic instability due mostly to terms of trade shocks and capital flow “sudden stops.” The paper employs a simple theoretical model and empirical evidence to justify an international liquidity management strategy in the face of both real and financial shocks. Two key ingredients are identified. First, the paper argues that the weak links to international financial markets can trigger excess volatility and sudden withdrawals of international liquidity. Second, underdeveloped financial markets with limited size and liquidity can further aggravate the contractions induced by external financial shocks. The imperfection of domestic financial markets makes the economy too vulnerable to external shocks as investors do not value international liquidity enough, creating less international collateral than is socially optimal. The paper concludes with two sets of policy recommendations. If the private sector is already facing the socially efficient prices in deciding its international liquidity position, the decentralized equilibrium is efficient given structural constraints, and the government should limit its actions to alleviate these constrains. The second set of policies concentrate on the time and then manner in which the government should attempt to “force” the private sector to increase its international liquidity position.