Euro-Latin Network:The Macroeconomics Agenda

Guillermo A. CalvoOctober 9, 2002

The IssuesMoral vs. Globalization HazardSudden stops in capital flows:

Factors that contribute to vulnerabilityImplications in terms of real exchange rate adjustmentValuation effects on fiscal sustainability and financial

crises?Dollarization:

Additional vulnerability?Convergence or escape from domestic currencies?Can it be reversed?

The Issues (c’td)Banking:

Universal or Narrow Banking?Indexation in banking system and the choice of exchange

rate regime. Public debt management:

Optimal currency composition?Indexation mechanisms?

Inflation targeting:Effectiveness in dollarized economies?Credibility under large real exchange rate realignment

following sudden stops?

MORAL AND GLOBALIZATIONHAZARDS

Where The G7 Stand (?) G7 appear to hold the view that throwing liquidity into

BOP/financial crises is counterproductive Pontius Pilate’s Aproach to Crisis Prevention and

Resolution: Avoid BOP Crises: FLOAT

if applied to the domestic banking sector, this is equivalent to deposits being subject to floating, market-determined, prices.

problem: Fear of Floating (Terror of Floating in Argentina) Design Chapter 11 for Sovereigns

If applied to the domestic banking sector, this is equivalent to appealing to Chapter 11 even if banks are faced with a liquidity crisis.

problem: sovereigns stop repaying well before they become technically insolvent. Thus, this issue is eminently political.

The Moral Hazard View

Large bailouts starting with the Tequila $50 billion package, induced greater risk taking by governments and investors,

which increased the incidence of crises.

Moral Hazard: A Critique

Capital flows to EMs started to fall a year after Tequila

The composition of flows shifted in favor of Foreign Direct Investment

Private Net Capital FlowsEmerging Markets

-30

20

70

120

170

220

270

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Financial globalization starts Tequila

Foreign Direct Investment

-50

0

50

100

150

200

250

300

1971

1973

1975

1977

1979 1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

Private Flows Private FDI

Financial globalization starts Tequila

Globalization Hazard ViewSince 1989 capital flows to EMs increased at a

very rapid rate, and also collapsed very sharply starting in 1996.

Volatility was high, and capital flow reversals reached record-high levels

Current account adjustments are much bigger in EMs than in Advanced Economies.

Crises could reflect institutional and informational features that apply especially to EMs.

KEY FEATURES OF EMs

SUDDEN STOPReversal of CapitalInflows (% of GDP)

Argentina 1982-83 20Ecuador 1995-96 19Mexico, 1981-83 12Korea 1996-97 11Thailand 1996-97 26Turkey 1993-94 10

Country/Episode

Source: Guillermo Calvo and Carmen Reinhart, (2000).

Fear of Floating: Probability of staying within narrow bands

+/-1 %band p/m

+/-2.5 %band p/m

US$/DM (2/73-4/99) 26.8 58.7Japan (2/73-4/99) 33.8 61.2Bolivia (9/85-12/97) 72.8 93.9Mexico (12/94-4/99) 34.6 63.5Peru (8/90-4/99) 45.2 71.4Uganda (1/92-4/99) 52.9 77.9

Source: Guillermo Calvo and Carmen Reinhart, “Fear of Floating,” QJE, (2002).

Exchange Rate

Fear of Floating: Probability of staying within narrow bands

+/-25 bpsband p/m

+/-50 bpsband p/m

US (2/73-4/99) 59.7 80.7Japan (2/73-4/99) 67.9 86.4Bolivia (9/85-12/97) 16.3 25.9Mexico (12/94-4/99) 5.7 9.4Peru (8/90-4/99) 24.8 32.3Uganda (1/92-4/99) 11.6 32.6

Source: Guillermo Calvo and Carmen Reinhart, “Fear of Floating,” QJE, (2002).

Nom. Interest Rate

10,00012,00014,00016,00018,00020,00022,00024,00026,00028,000

Jan-

96

Jul-

96

Jan-

97

Jul-

97Ja

n-98

Jul-

98

Jan-

99

Jul-

99

Jan-

00Ju

l-00

Jan-

01

Jul-

01

Jan-

02

Mill

ion

Peso

s

-1,000

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Million Pesos

Cavallo Presses the Gas Pedal (Central Bank’s Balance Sheet)

Net Domestic Credit

Foreign Reserves

Monetary Liabilities

Cavallo is appointed

Source: Central Bank of Argentina.

CAPITAL FLIGHT IN LATIN AMERICA?

LAC-7 Business Cycle: 1997-2002(s.a. GDP, mean annualized quarterly growth rate)

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

Deceleration Recession Recovery Stalling

-7%

-5%

-3%

-1%

1%

3%

5%

7%

9%19

97.I

1997

.III

1998

.I

1998

.III

1999

.I

1999

.III

2000

.I

2000

.III

2001

. I

2001

.III

2002

.I

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

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

0

20.000

40.000

60.000

80.000

100.000

120.00019

97-I

1997

-III

1998

-I

1998

-III

1999

-I

1999

-III

2000

-I

2000

-III

2001

-I

2001

-III

2002

-I

0%

1%

2%

3%

4%

5%

6%

% of GDP

Millions of US dollars

LAC-7 Business Cycle and Capital Flows (GDP and Non FDI Capital Flows, last four quarters)

-3%-2%-1%0%1%2%3%4%5%6%7%

Mar

-96

Sep-

96

Mar

-97

Sep-

97

Mar

-98

Sep-

98

Mar

-99

Sep-

99

Mar

-00

Sep-

00

Mar

-01

Sep-

01

Mar

-02

GD

P (y

oy %

cha

nge)

-4%

-3%

-2%

-1%

0%

1%

2%

Non

FD

I Cap

ital F

low

s (%

GD

P)

GDP

Non FDI Capital Flows

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

THE IMPACTOF SUDDEN STOPS

Sudden Stop

1998.II 2001.IIIReversalCapital Flows 5.6 1.6 -4.0

Non-FDI Capital Flows 2.0 -0.9 -2.9 FDI 3.6 2.5 -1.1

Note: Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, andVenezuela. Source: Corresponding Central Banks.

Capital Flows, % of GDP

Equilibrium RERp

hs

p*

p**

p0

h

real trade factors

SS

P = PNT/PT

Liability Dollarization

ARG ECU COL BRA CHLB/e B* 0.08 0.02 0.59 1.76 1.30Y/e Y* 8.63 2.94 6.36 12.34 2.85

(B/e B*)/(Y/e Y*) 0.01 0.01 0.09 0.14 0.45

Source: Own estimates. Note: Values are given for 1998.

Public Sector Debt Mismatch Measure

Sudden Stop and Fiscal Adjustment: Argentina 1998 Debt to

GDPratio(%)

Req. Prim.SurplusAdjust.

(a) Baseline 36.5 0.3

(b) Change in Relative Prices to close the CA deficit (RER depreciation of 46,2%)

49.7 0.7

(c): (b) + 200 BPS Increase in Real Interest Rate

49.7 1.7

(d): (c) + 1% Reduction in GDP growth 49.7 2.2

(e): (d) + Contingent Liabilities 58.6 2.7

Source: Calvo, Izquierdo, Talvi (2002)

Note: The observed primary surplus for 1998 was 0.9 percent of GDP. The baseline scenario assumes a long run rate of growth of 3,8% and a 7,1% interest rate

9.3

22.6

32.8

35.6

44.5

NPV of Req. Adjust.

(% of GDP)

Vulnerability to Sudden StopsA small share of tradable goods output

relative to domestic absorption of tradable goods

Liability dollarization, both in government and non-tradable sectors

High initial public debt, denominated in foreign currency

Bank assets concentrated on government bonds and dollar credit to non-tradable sectors.

POLICY ISSUES

BAILOUT PACKAGESJustified under Globalization Hazard viewThe mid-1990s packages were successful

because capital flowed back very quickly (the prime example is Brazil in 1999).

At present, capital appears to be much slower to flow back, possibly due to Russia’s 1998 crisis and recent corporate scandals.

Thus, present packages may shield the financial but not the real sector, and recession could be large and long-lasting.

THE EXCHANGE RATE The current debate is between Fixed Exchange Rate

and Inflation Targeting. Inflation Targeting is equivalent to fixing the

currency to a basket of goods and services. Actually, if the basket contains only foreign

exchange, or the pass-through coefficient is very high, both systems would be equivalent.

Thus, the current debate is about the best basket to fix to. It is about fixing, not about floating.

Neither system ensures the existence of a Lender of Last Resort.

CHOOSING A BASKETNo basket prevents large exchange rate

misalignment. If the latter is a serious concern, one should adopt RER Targeting, which implies no nominal anchor!

The main focus should be on the financial system and, in particular, the prevailing type of indexation in the financial sector.

Thus, a highly dollarized system may call for full dollarization.

While, a UF system like in Chile, may call for UF targeting.

SUDDEN STOPLearn how to prevent it

Management of reserves and public debt Flexible financial system, contingent claims Flexible public prices and wages

And how to be ready if it happens Contingent credit lines Judicious use of reserves and credit lines to

bail out private sector and financial institutions, accompanied by dirty float.

Timely negotiation of debt restructuring.

Research DepartmentInter-American

Development Bank