Minimizing macroeconomic volatility and avoiding crises: what have we learned?

Minimizing macroeconomic Minimizing macroeconomic volatility and avoiding volatility and avoiding

crises: what have crises: what have we learned?we learned?

Andrés VelascoAndrés VelascoHarvard University and Harvard University and

Universidad de ChileUniversidad de ChileMarch 2004March 2004

Fact of life: Latin America is volatileFact of life: Latin America is volatile

Exogenous volatility: terms of trade, world Exogenous volatility: terms of trade, world interest rates, access to world capital interest rates, access to world capital marketsmarkets

Policy volatility: pro-cyclical fiscal and Policy volatility: pro-cyclical fiscal and monetary policiesmonetary policies

Volatile outcomes: output, consumption, Volatile outcomes: output, consumption, investment, relative pricesinvestment, relative prices

Striking fact: real exchange rate is 3 times Striking fact: real exchange rate is 3 times more volatile in LAC than in the OEDCmore volatile in LAC than in the OEDC

Fact of life: recurrent Fact of life: recurrent crises since 1980crises since 1980

Argentina (twice), Bolivia, Brazil Argentina (twice), Bolivia, Brazil (twice), Bulgaria, Chile, Colombia, (twice), Bulgaria, Chile, Colombia, the Czech Republic, Dominican the Czech Republic, Dominican Republic, Ecuador, Hungary, Republic, Ecuador, Hungary, Indonesia, Korea, Malaysia, Mexico Indonesia, Korea, Malaysia, Mexico (twice), Panama, Pakistan, (twice), Panama, Pakistan, Philippines, Peru, Romania, Russia, Philippines, Peru, Romania, Russia, Thailand, Turkey, Ukraine, Uruguay Thailand, Turkey, Ukraine, Uruguay (twice) and Venezuela. (twice) and Venezuela.

What’s new?What’s new?

In the 1950s, 1960s and 1970s, LAC often In the 1950s, 1960s and 1970s, LAC often suffered current account crises: lack of suffered current account crises: lack of financing called for adjustment, cut in financing called for adjustment, cut in expenditureexpenditure

Since 1980: mostly capital account crisesSince 1980: mostly capital account crises Larry Summers: 21Larry Summers: 21stst century crises century crises Great volatility of output and relative Great volatility of output and relative

prices for countries that do not experience prices for countries that do not experience full-blown crisesfull-blown crises

0

20000

40000

60000

80000

100000

1997

-I

1997

-III

1998

-I

1998

-III

1999

-I

1999

-III

2000

-I

2000

-III

2001

-I

2001

-III

2002

-I

2002

-III

2003

-I

2003

-III

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

LAC-7 Total Capital FlowsLAC-7 Total Capital Flows(4 quarters, millions of US dollars and in % of GDP)(4 quarters, millions of US dollars and in % of GDP)

Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela

Russian Crisis

% GDP (LAC-7 average)

Post-Adjustment Period

What’s new about the new crises?What’s new about the new crises?

Not just fall in net new financing that calls for Not just fall in net new financing that calls for adjustmentadjustment

Sudden stops cause capital accounts to reverse Sudden stops cause capital accounts to reverse sign: much greater adjustmentsign: much greater adjustment

Not just exchange rate crises: also debt crises Not just exchange rate crises: also debt crises and financial crises (banks)and financial crises (banks)

Not just public sector crises: also private debts Not just public sector crises: also private debts (Chile, Korea, Indonesia) and private deposits (Chile, Korea, Indonesia) and private deposits (Argentina, Uruguay, others)(Argentina, Uruguay, others)

Scarce liquidity paramount: Asia, MexicoScarce liquidity paramount: Asia, Mexico Crises contagious: post Asia, post RussiaCrises contagious: post Asia, post Russia

What’s not fully understood What’s not fully understood about the new crises?about the new crises?

They blur the traditional distinction They blur the traditional distinction between liquidity and solvency. between liquidity and solvency.

Lack of liquidity causes costs: recession, Lack of liquidity causes costs: recession, devaluation, abandonment of projectsdevaluation, abandonment of projects

These costs then ensures solvency These costs then ensures solvency problems: low tax revenue, low corporate problems: low tax revenue, low corporate profits, large debts (when measured in profits, large debts (when measured in domestic currency)domestic currency)

Expectations can become self-fulfilling and Expectations can become self-fulfilling and occurrence and timing of crises arbitraryoccurrence and timing of crises arbitrary

Moreover… you can suffer even if Moreover… you can suffer even if you do not have a full blown crisisyou do not have a full blown crisis

Classic example: Chile versus Classic example: Chile versus Australia in late 1990sAustralia in late 1990s

Even in best behaved countries: pro-Even in best behaved countries: pro-cyclical capital flows, large current cyclical capital flows, large current account adjustmentsaccount adjustments

Result: pro-cyclical monetary and Result: pro-cyclical monetary and fiscal policiesfiscal policies

Result: precautionary recessions Result: precautionary recessions (Caballero 2003)(Caballero 2003)

Chile: current account reversalChile: current account reversal

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

90 91 92 93 94 95 96 97 98 99 00 01

Current Account Deficit: 1990-2001(% GDP)

Chile: fChile: fiscal iscal sstrengthtrength

Fiscal Surplus: 1990-2001(% GDP)

-2

-1

0

1

2

3

90 91 92 93 94 95 96 97 98 99 00 01

What causes sudden stops, limited What causes sudden stops, limited access to capital and crises?access to capital and crises?

Moral failure against market failureMoral failure against market failure Unwillingness to payUnwillingness to pay

• Sovereign riskSovereign risk• Moral hazard (bailouts, implicit Moral hazard (bailouts, implicit

guarantees)guarantees)

Inability to payInability to pay• Unforeseen real shocksUnforeseen real shocks• Lack of liquidityLack of liquidity• MismatchesMismatches

Implications of the Implications of the moral hazard viewmoral hazard view

Capital flows to emerging markets Capital flows to emerging markets should be large. But… they are smallshould be large. But… they are small

Capital should flow from rich to poor. Capital should flow from rich to poor. But… it is often the other way aroundBut… it is often the other way around

Flows should have increased after Flows should have increased after bailouts of 95-98. But… they fellbailouts of 95-98. But… they fell

Capital should be skewed away from Capital should be skewed away from FDI and toward bonds and loans. FDI and toward bonds and loans. But… it’s been the other way aroundBut… it’s been the other way around

ConclusionConclusion

Moral hazard “would imply that either Moral hazard “would imply that either emerging market policymakers emerging market policymakers deliberately deliberately brought their economies into painful brought their economies into painful maelstrom (in exchange, perhaps, for a brief maelstrom (in exchange, perhaps, for a brief mirage of affluence) or that they exhibited a mirage of affluence) or that they exhibited a fantastic lack of judgment, bordering on the fantastic lack of judgment, bordering on the insane. However, since there is no scientific insane. However, since there is no scientific evidence that those characteristics are the evidence that those characteristics are the monopoly of emerging market policymakers, monopoly of emerging market policymakers, …the moral hazard view must … be classified …the moral hazard view must … be classified as an intellectually appealing but as an intellectually appealing but unsubstantiated conjecture.” (Calvo 2001)unsubstantiated conjecture.” (Calvo 2001)

What is to be done?What is to be done?

What emerging market countries can do for What emerging market countries can do for themselvesthemselves• Strengthening institutions / credibilityStrengthening institutions / credibility• Improving monetary and exchange rate policyImproving monetary and exchange rate policy• Borrow lessBorrow less• Reducing mismatches and improving risk-sharingReducing mismatches and improving risk-sharing

What the world can do for emerging market What the world can do for emerging market countriescountries• Providing liquidityProviding liquidity• Rethinking crisis resolutionRethinking crisis resolution• Reducing volatility of capital flows and EM asset pricesReducing volatility of capital flows and EM asset prices• Help overcome thin markets and externalitiesHelp overcome thin markets and externalities

Strengthening institutionsStrengthening institutions

Common place of the year: improve Common place of the year: improve institutionsinstitutions

Obvious: better Chile and Singapore Obvious: better Chile and Singapore than many othersthan many others

Problem: the Sweden syndromeProblem: the Sweden syndrome Question: how to do it? Question: how to do it? Are their shortcuts?Are their shortcuts? Can macro policies help?Can macro policies help?

Tough rules Tough rules ≠ strong institutions≠ strong institutions

Tough rules can lack credibility: Tough rules can lack credibility: currency boardscurrency boards

Credibility can be decreasing in the Credibility can be decreasing in the degree of toughness (Neut and degree of toughness (Neut and Velasco, 2003)Velasco, 2003)

The dagger in the wheelThe dagger in the wheel With good institutions you do not With good institutions you do not

need tough rulesneed tough rules

Tough rules Tough rules ≠ strong institutions≠ strong institutions

Example: independent central banks Example: independent central banks and inflation targetingand inflation targeting

Example: Chile since the early 1990sExample: Chile since the early 1990s Better example: Brazil since 2002Better example: Brazil since 2002 Constrained discretion (Bernanke Constrained discretion (Bernanke

and Mishkin, 1997)and Mishkin, 1997) Key: make the sausages but do not Key: make the sausages but do not

tell me howtell me how

Chile: inflation targetingChile: inflation targeting

Inflation and Inflation-Target Rates: 1990-2002(% y-o-y)

0

5

10

15

20

25

30

35

90 91 92 93 94 95 96 97 98 99 00 01 02


What emerging market countries can do for What emerging market countries can do for themselvesthemselves• Strengthening institutions / credibilityStrengthening institutions / credibility• Improving monetary and exchange rate policyImproving monetary and exchange rate policy• Borrow less?Borrow less?• Reducing mismatches and improving risk-sharingReducing mismatches and improving risk-sharing


Can floating work?Can floating work?

Fashion is consolidatedFashion is consolidated Problem: fear of large real exchange Problem: fear of large real exchange

rate volatility and mismatchesrate volatility and mismatches Problem: fear of floating, recent Problem: fear of floating, recent

reserve accumulationreserve accumulation But give it time…But give it time…

LAC-7: Exchange Rate & International ReservesLAC-7: Exchange Rate & International Reserves

Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, VenezuelaIncludes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela

90

110

130

150

170

190

210

Jun-

98

Dic

-98

Jun-

99

Dic

-99

Jun-

00

Dic

-00

Jun-

01

Dic

-01

Jun-

02

Dic

-02

Jun-

03

Dic

-03

Nominal & Real Exchange RateNominal & Real Exchange Rate(vis-à-vis US dollar)

Real exchange rate

Nominal exchange rate

125000

135000

145000

155000

165000

175000

185000

195000

Jun

-98

Jun

-99

Jun

-00

Jun

-01

Jun

-02

Jun

-03


Stock of International ReservesStock of International Reserves(millions of US dollars)


+16%

+8%

Chile: fear of floating?Chile: fear of floating?

Nominal Exchange Rate and Flotation Band(pesos/dollar)

250

300

350

400

450

500

550

600

650

700

750

90 91 92 93 94 95 96 97 98 99 00 01 02

Can floating improve institutions?Can floating improve institutions?

It signals nascent fiscal imbalances It signals nascent fiscal imbalances (Tornell and Velasco 1997)(Tornell and Velasco 1997)

It can build support for central bank It can build support for central bank independence (Mishkin and Posen, independence (Mishkin and Posen, 1997)1997)

More generally: institutions operate More generally: institutions operate better with some flexibility (prevent better with some flexibility (prevent steam from building up)steam from building up)




Borrow less?Borrow less?

““Developing-country leaders need to Developing-country leaders need to realize that borrowing is like taking realize that borrowing is like taking steroids: it gives countries a short-steroids: it gives countries a short-term performance boost but leads to term performance boost but leads to insidious long-term problems. Look at insidious long-term problems. Look at the modern history of most Latin the modern history of most Latin American countries.” American countries.” Ken Rogoff, Newsweek International, Ken Rogoff, Newsweek International, February 16, 2004.February 16, 2004.

200

400

600

800

1000

1200

1400

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Jun-

03

35

55

75

95

115

135

155

Interest Rates

Spread

Spreads & Domestic Interest RatesSpreads & Domestic Interest Rates

Russian Crisis

Do

me

stic

len

din

g r

ate

s

EM

BI+

ad

j. fo

r A

rge

ntin

a

(domestic lending rates, June 1998=100)

200

400

600

800

1000

1200

1400

Jun-

97

Jun-

98

Jun-

99

Jun-

00

Jun-

01

Jun-

02

Jun-

03

Emerging Markets Spreads & Domestic Interest RatesEmerging Markets Spreads & Domestic Interest Rates

Includes: Brazil, Chile, Colombia, Mexico, Peru & Venezuela

EM

BI+

ad

j. fo

r A

rge

ntin

a

Russian Crisis

Pre- Russian Crisis Spread

Emerging Markets SpreadsEmerging Markets Spreads(EMBI+ adj. for Argentina, in bp)

ENRON effect

Borrow less?Borrow less?

Sure, some crises have been caused by Sure, some crises have been caused by over-borrowing, but…over-borrowing, but…

Even with strong fiscal position sudden Even with strong fiscal position sudden stops can happenstops can happen

Sharp increases in Debt/GDP ratios often Sharp increases in Debt/GDP ratios often come from real devaluationscome from real devaluations

Why have it if you cannot use it (Rodrik, Why have it if you cannot use it (Rodrik, 1999)1999)

Much of the borrowing done by the private Much of the borrowing done by the private sector. How to stop?sector. How to stop?




Borrow better (1)Borrow better (1)

Key: the tale of raincoats and bathing suitsKey: the tale of raincoats and bathing suits Avoiding crises: prevent mismatchesAvoiding crises: prevent mismatches The Calvo et al measure: (B+eB*)/(Y+eY*)The Calvo et al measure: (B+eB*)/(Y+eY*) First thing: borrow less in dollarsFirst thing: borrow less in dollars Second thing: open up the economySecond thing: open up the economy Openness may also reduce movements in Openness may also reduce movements in

the real exchange rate, but not very muchthe real exchange rate, but not very much

Chile: real exchange rateChile: real exchange rateMultilateral Real Exchange RateMultilateral Real Exchange Rate

1986=100

60.00

70.00

80.00

90.00

100.00

110.00

120.00

Jan-

90

Jun-

90

Nov-90

Apr-9

1

Sep-9

1

Feb-9

2

Jul-9

2

Dec-9

2

May

-93

Oct-93

Mar-

94

Aug-9

4

Jan-

95

Jun-

95

Nov-9

5

Apr-9

6

Sep-9

6

Feb-9

7

Jul-9

7

Dec-9

7

May

-98

Oct-98

Mar-

99

Aug-9

9

Jan-

00

Jun-

00

Nov-0

0

Apr-0

1

Sep-0

1

Feb-0

2

Jul-0

2

Dec-0

2

May

-03

Oct-03

Date

All relevant currencies 5 most relevant currencies

Borrow better (2)Borrow better (2)

Key: better risk-sharingKey: better risk-sharing Can we separate default risk from Can we separate default risk from

commodity or real exchange risk?commodity or real exchange risk? Who should bear commodity or real Who should bear commodity or real

exchange risk? Can it be diversified?exchange risk? Can it be diversified? Peso bonds? Indexed peso bonds? Peso bonds? Indexed peso bonds?

Commodity bonds (Frankel, 2002)?Commodity bonds (Frankel, 2002)? Some progress: Czech Republic, Hungary, Some progress: Czech Republic, Hungary,

Singapore, Taiwan, Chile MexicoSingapore, Taiwan, Chile Mexico



What the world can do for emerging market What the world can do for emerging market countriescountries• Providing liquidityProviding liquidity• Rethinking crisis managementRethinking crisis management• Reducing volatility of capital flows and EM asset pricesReducing volatility of capital flows and EM asset prices• Help overcome thin markets and externalitiesHelp overcome thin markets and externalities

Providing liquidityProviding liquidity

Liquidity crises require a net international Liquidity crises require a net international provider of liquidityprovider of liquidity

The possibility of moral hazard does not The possibility of moral hazard does not invalidate this roleinvalidate this role

Does the IMF do this?Does the IMF do this? Size: total resources are 200 b., total sovereign Size: total resources are 200 b., total sovereign

debt market 290 b., many other kinds of claimsdebt market 290 b., many other kinds of claims Speed: ex ante versus ex post conditionalitySpeed: ex ante versus ex post conditionality After the CCL, what?After the CCL, what? Role of other IFIsRole of other IFIs

Crisis resolutionCrisis resolution

SDRM debate: a wrong turn, mostlySDRM debate: a wrong turn, mostly Sovereign bonds a small part of the Sovereign bonds a small part of the

problemproblem Bonds with CACS will help, but…Bonds with CACS will help, but… Need to think about broader Need to think about broader

concerted actions: coordinated concerted actions: coordinated rollovers, etc.rollovers, etc.

A role for capital controls?A role for capital controls?



What the world can do for emerging market What the world can do for emerging market countriescountries• Providing liquidityProviding liquidity• Rethinking crisis managementRethinking crisis management• Reducing volatility of capital flows and EM asset pricesReducing volatility of capital flows and EM asset prices• Help overcome thin markets and externalitiesHelp overcome thin markets and externalities

Filling in the missing marketsFilling in the missing markets

There is an externality in market There is an externality in market creation: they need not spring up on creation: they need not spring up on their owntheir own

Example: Brady bondsExample: Brady bonds Role for IFIs in thisRole for IFIs in this Lending to countries in their own Lending to countries in their own

currencies?currencies? Lending in a basket EM currency? Lending in a basket EM currency?

(Eichengreen and Hausmann)(Eichengreen and Hausmann)

Improving risk sharing and Improving risk sharing and stabilizing asset pricesstabilizing asset prices

Emerging market bond fund (Calvo, Emerging market bond fund (Calvo, 2003)2003)

Emerging market collateralized debt Emerging market collateralized debt obligations (Caballero, 2003)obligations (Caballero, 2003)

An IFI role here as wellAn IFI role here as well

Do we need a new international Do we need a new international effort to avoid and resolve crises?effort to avoid and resolve crises?

Gandhi: it would be a good ideaGandhi: it would be a good idea

Documents

Minimizing macroeconomic volatility and avoiding crises: what have we learned?