Jan 22, 2003

What triggers a crisis?

The IDB's Research Department has identified key factors that make economies vulnerable to sudden stops in international capital flows. The findings are applied to Latin American countries in an analysis of what triggers economic crisis.

Size of Public Debt
The first risk factor is the size of the public debt. Anything above 50% of gross domestic product (GDP) is considered highly risky for Latin American economies, given their limited capacity to collect taxes and cut expenses. The Maastricht Treaty of European countries considers debt levels below 60% as sustainable because tax collections as a proportion of GDP in these countries are more than double that in Latin American countries.

Prior to their current crises, Argentina, Ecuador and Uruguay had very high levels of public debt. Brazil, Colombia and Peru also measure up poorly in this regard, while Chile has no risk in this area.

Percentage of debt in dollars
The second critical factor is the percentage of public debt that is denominated in dollars and is thus likely to skyrocket if there is a devaluation of the exchange rate.

When this proportion is high relative to the proportion of tradable to non-tradable GDP (tradable goods are those that have export or import potential), then the risk is high. This is because the debt to GDP ratio can change drastically in the face of exchange rate fluctuations, in many cases negatively affecting fiscal sustainability. This was the case in Argentina and Uruguay prior to their crises, and it may be a serious problem in Peru.

If a large proportion of private debt (internal and external) is tied to the dollar, there are also high risks. Argentina and Uruguay were vulnerable in this area and, to a certain extent, so are Chile and Peru. On the other hand, neither Brazil nor Colombia suffers from this risk factor.

Financial system exposure to the public sector
If the financial sector has a large percentage of its resources tied up in government paper, problems can erupt in this sector. Simply put, banks will fold if the government cannot pay its obligations.

Recently, this has been an issue of public debate in Colombia. Comparative indicators show that the country's risk is considerable, but not as alarming as the risk in Argentina and Uruguay before their crises.

These vulnerabilities are exacerbated when the economy has a limited supply of tradable goods (basically exports) as a proportion of its absorption of tradable goods (basically imports). Any interruption in external financial flows to finance the current account deficit would demand a greater devaluation to generate the foreign exchange shortfall. This was the case in Argentina and, to a lesser extent, in Brazil and Colombia.

This is an extract from the article "Countries at risk: Who will be next?" published by the IDB research department in the Latin American Economic Policies Newsletter (pdf). The newsletter reports on recent research on major economic and social problems affecting Latin America and the Caribbean.

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