RIDING BUBBLESRIDING BUBBLESQuestions and ChallengesQuestions and Challenges

Guillermo CalvoGuillermo CalvoColumbia UniversityColumbia University

Presented at the conference on Latin American and the Caribbean DevelopmentChallenges and Policies: What Are the Issues?” IDB, Washington, DC, Sept. 10-11, 2009.

Systemic Financial CrisesSystemic Financial Crises

Systemic financial crises are like bank Systemic financial crises are like bank runs without a Lender of Last Resort.runs without a Lender of Last Resort.Russia 1998 crisis and its spread across Russia 1998 crisis and its spread across Emerging Markets is an outstanding Emerging Markets is an outstanding example.example.The Subprime crisis, especially after The Subprime crisis, especially after Lehman September 2008, is another.Lehman September 2008, is another.Besides, these are episodes of Triple Besides, these are episodes of Triple Time-Inconsistency. (See my voxEU.org Time-Inconsistency. (See my voxEU.org note).note).

Impact on EMs and LACImpact on EMs and LAC

Emerging Markets, in general, saw an Emerging Markets, in general, saw an increase in capital inflows until Lehman.increase in capital inflows until Lehman.My conjecture is that the market believed My conjecture is that the market believed the crisis would bottom out quickly the crisis would bottom out quickly because of massive liquidity injection, in because of massive liquidity injection, in contrast with the 1930s.contrast with the 1930s.And investors positioned themselves in And investors positioned themselves in strong EMs (e.g., LAC) and commodities.strong EMs (e.g., LAC) and commodities.This gave rise to the This gave rise to the decoupling decoupling conjecture.conjecture.

Estimated Sudden Stop ProbabilitiesEstimated Sudden Stop Probabilities(Based on Calvo, Izquierdo and Mejia, NBER Working Paper 14026, 2007)

Notes: Simple country averages. LAC7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. CAC5 includes Costa Rica, Guatemala, Honduras, Nicaragua and Dominican Republic. Eastern Europe includes Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Turkey.

44.8%

41.1%

58.4%

3.7%

35.2%

71.3%

0%

10%

20%

30%

40%

50%

60%

70%

80%

LAC7 CAC5 Eastern Europe

1998

2008

EMBI+ Yield & Terms of Trade in LACEMBI+ Yield & Terms of Trade in LAC(quarterly data, Terms of Trade Index 1997-I = 100, EMBI+ Yield)(quarterly data, Terms of Trade Index 1997-I = 100, EMBI+ Yield)

Note: Terms of trade series include Argentina, Brazil, Chile, Colombia, Mexico and Peru. Simple average.Source: IADB and Bloomberg.

Lehman and AfterLehman and After

Lehman debacle sent a strong message Lehman debacle sent a strong message that the Fed was ready to step out before that the Fed was ready to step out before removing all the sources of infection.removing all the sources of infection.It marks the beginning of a global crisis It marks the beginning of a global crisis (no decoupling).(no decoupling).However, the about-face of the Fed (AIG However, the about-face of the Fed (AIG and the rest) seems to be restoring and the rest) seems to be restoring confidence.confidence.And financial conditions in EMs and LAC And financial conditions in EMs and LAC are improving.are improving.

Greenspan’s “conundrum”

testimony

ExternalExternal Financial Conditions for EMsFinancial Conditions for EMs(daily data, EMBI+, bps, last value 07-Sep-09)(daily data, EMBI+, bps, last value 07-Sep-09)

Source: Datastream.

Pre-Asian Crisis Spread

Pre-Asian Crisis Yield

ENRON Effect

Spreads

Yields

Beginning of improvement in international financial conditions

Fears of FED tightening

=-28%

Lehman Brothers files for

bankruptcy

=-0.1%

(daily data, MSCI Stock Indices in USD, 9/3/07=100, last value 04/07/09)Stock Markets

Source: Bloomberg.

Latin America

Emerging Economies

US $700b Rescue Plan is passed by Congress

LessonsLessons

Once again, we learned that external Once again, we learned that external factors play an important role.factors play an important role.

However, this time found LAC in stronger However, this time found LAC in stronger financial health because of:financial health because of:– a history of current account surplusesa history of current account surpluses– de-dollarization.de-dollarization.

Lehman aftermath also shows that Lehman aftermath also shows that financial health does not ensure output financial health does not ensure output stabilitystability. See Chile, Brazil, Peru, Mexico.. See Chile, Brazil, Peru, Mexico.

Fiscal PolicyFiscal Policy

As shown in As shown in All that GlittersAll that Glitters, LAC has little , LAC has little room for fiscal deficits.room for fiscal deficits.

Available fiscal fire power should be spent Available fiscal fire power should be spent on social programs.on social programs.

It may be worth exploring PPPs with It may be worth exploring PPPs with support from MDBs.support from MDBs.

Monetary PolicyMonetary Policy

With few exceptions, EMs have With few exceptions, EMs have substantially devalued their currencies.substantially devalued their currencies.

This caused little impact on inflation This caused little impact on inflation because of world deflation.because of world deflation.

But may not work that way looking But may not work that way looking forward, because recovery may bring forward, because recovery may bring about another steep rise in commodity about another steep rise in commodity prices.prices.

Inflation TargetingInflation TargetingLow inflation should continue to be a Low inflation should continue to be a critical critical long-termlong-term objective. objective.

However, it would be wrong to stick to low However, it would be wrong to stick to low inflation on the face of, e.g., a boom in inflation on the face of, e.g., a boom in commodity prices.commodity prices.

Moreover, In the short run, IT may be Moreover, In the short run, IT may be inconsistent with a Target on International inconsistent with a Target on International Reserves.Reserves.

Reserves help to protect the banking Reserves help to protect the banking sector and exports during Sudden Stop.sector and exports during Sudden Stop.

Financial RegulationFinancial Regulation

It is as important as monetary policy.It is as important as monetary policy.

Reserve and Liquidity Requirements could Reserve and Liquidity Requirements could be employed to squash excessive credit be employed to squash excessive credit expansion, and to provide liquidity in times expansion, and to provide liquidity in times of financial stress.of financial stress.

This must be distinguished from controls This must be distinguished from controls on capital flows that are easy to on capital flows that are easy to circumvent and fall unduly hard on small circumvent and fall unduly hard on small and medium enterprises.and medium enterprises.

Prudential regulation is good but within Prudential regulation is good but within certain bounds.certain bounds.In a voxEU.org note Rudy Loo-Kung and I In a voxEU.org note Rudy Loo-Kung and I show that financial crises in EMs may show that financial crises in EMs may have been preferable to the status quo.have been preferable to the status quo.Moreover, beware of free riders. There is Moreover, beware of free riders. There is some evidence that public sector some evidence that public sector prudence was accompanied by private prudence was accompanied by private sector imprudence.sector imprudence.

RIDING BUBBLESRIDING BUBBLESQuestions and ChallengesQuestions and Challenges

Guillermo CalvoGuillermo CalvoColumbia UniversityColumbia University

Presented at the conference on Latin American and the Caribbean DevelopmentChallenges and Policies: What Are the Issues?” IDB, Washington, DC, Sept. 10-11, 2009.