Volatility and Crisis:Three Lessons for Developing Countries

Norman Loayza

World BankWorld Bank

The Big Scare…The Big Scare…

• Just one year agoJust one year ago,– Developing countries faced collapsing,

• world productionworld production

• world trade

• remittances

• capital inflows

• investor confidence

Collapsing world demandReal GDP Growth in Advanced Countries

QoQ annualized growth (%), 2004 Q1 – 2009 Q1

0

5

-10

-5

-20

-15

20

2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1

Euro Area Japan United States

Collapsing world demand… and recoveryReal GDP Growth in Advanced CountriesReal GDP Growth in Advanced Countries

QoQ annualized growth (%), 2004 Q1 – 2009 Q3

0

5

-10

-5

-20

-15

20

2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1

Euro Area Japan United States

Collapsing developing country exports

50

Growth (%) in nominal exports of developing countries, year-over-year

30

40

0

10

20

-20

-10

0

-40

-30

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Collapsing developing country exports… and recovery

50

Growth (%) in nominal exports of developing countries, year-over-year

30

40

0

10

20

-20

-10

0

-40

-30

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Collapsing investors’ confidence

2000

Corporate EMBI & U.S. High Yield Bond Spreadin basis points

Corporate EMBI & U.S. High Yield Bond SpreadIn basis points

1600

000

1200

800

High Yield ECA

LAC

0

400g

EAP0

Jan-

07M

ar-0

7

May

-07

Jul-0

7

Sep-

07

Nov

-07

Jan-

08M

ar-0

8

May

-08

Jul-0

8

Sep-

08

Nov

-08

Jan-

09M

ar-0

9

May

-09

Jul-0

9

Sep-

09

Nov

-09

Jan-

10M

ar-1

0

Collapsing investors’ confidence… and recovery

2000

Corporate EMBI & U.S. High Yield Bond Spreadin basis points

Corporate EMBI & U.S. High Yield Bond SpreadIn basis points

1600

2000

1200

800

High Yield ECA

LAC

0

400g

EAP0

Jan-

07M

ar-0

7

May

-07

Jul-0

7

Sep-

07

Nov

-07

Jan-

08M

ar-0

8

May

-08

Jul-0

8

Sep-

08

Nov

-08

Jan-

09M

ar-0

9

May

-09

Jul-0

9

Sep-

09

Nov

-09

Jan-

10M

ar-1

0

A remarkable recovery…A remarkable recovery…

• In almost all dimensions of the crisisIn almost all dimensions of the crisis

• Most developing countries showed notable resilienceresilience

What have we learned?What have we learned?

• Contrary to popular claimsContrary to popular claims,– The 2008 world financial crisis was not so unique

that it invalidated our knowledgethat it invalidated our knowledge

– In fact, it confirmed the lessons drawn from years of experience and researchof experience and research

• especially on volatility and vulnerability

1 S lf i fli t d i th t(or, stop blaming globalization…)

1. Self-inflicted crises are the worst(or, stop blaming globalization…)

Openness and vulnerability (I)Openness and vulnerability (I)

• Does openness lead to more vulnerability toDoes openness lead to more vulnerability to external shocks?

→ YES→ YES

E id f h f h f hi i i– Evidence from the aftermath of this crisis:• Lane and Milesi-Ferretti (2010)

• Calderón and Didier (2009)• Calderón and Didier (2009)

Loayza and Raddatz (2007):

THE EFFECT OF A TERMS-OF-TRADE SHOCK

0.025

0 015

0.020

tion

0 005

0.010

0.015

t Dev

iat

0.000

0.005

Out

pu

-0.0050 2 4 6 8 10

YearsHigh Openness Low Openness

Yes, openness leads to vulnerability, bbut…

• Vulnerability to external shocks is the cost of doing business in the modern worlddoing business in the modern world– Victimization research analogy:

Wh t lik l t ff f i ?• Who are most likely to suffer from crime?

The real sources of volatility…The real sources of volatility…

• Raddatz (2007): In low income countriesRaddatz (2007): In low income countries,

Variance of GDP per capita

Exogenous Shocks Endogenous Shocks

- Commodity price changes - Inflation- Commodity price changes- Aid shocks- Climatic disasters- Famines and epidemics

- Inflation- RER overvaluation- High public deficits- Political instability

- Volatility of high-income countries- Interest rate shocks

- Violent conflict

? ?

The real sources of volatility…The real sources of volatility…

• Raddatz (2007): In low income countriesRaddatz (2007): In low income countries,

Variance of GDP per capita

Exogenous Shocks Endogenous Shocks

- Commodity price changes - Inflation- Commodity price changes- Aid shocks- Climatic disasters- Famines and epidemics

- Inflation- RER overvaluation- High public deficits- Political instability

- Volatility of high-income countries- Interest rate shocks

- Violent conflict

11% 89%

So, should we just ignore l h kexternal shocks?

• No!

• If the economy is well-prepared, the harm from negative shocks can be mitigatedg g– Prudent macro policies

» Blanchard, Faruqee, Das (2010)» Calderón and Didier (2009)

– Political stability» Malik and Temple (2009) » Loayza, Rancière, Servén, and Ventura (2007)

• Another victimization research analogy…– For people in the streets, who are most likely to be victims of a crime?

2 Implicit insurance is2. Implicit insurance is seldom sustainable, always distortionary,

d ll hi

(or, don’t promise what you can’t deliver…)

and usually catastrophic

(or, don t promise what you can t deliver…)

Chronicle of a Death Foretold…Chronicle of a Death Foretold…

G t

Large, growing social cost

• Government implements a policy that

ff i li it• Distorted

ti b• Policy breaks

doffers implicit insurance

Unintended

actions by private sector

down

CRISIS!Unintended incentives

CRISIS!

A Death Foretold: Argentina’s currency board 1990 20001990-2000

d

RER overvaluation

Unemployment• Fixed-exchange rate regime • Borrowing in

d ll h l

Unemployment

• Devaluation

Ignore currency

dollars, while income is in pesos Macroeconomic Ignore currency

mismatch CRISIS!

Another Death Foretold: U.S. current financial crisis

Loss of asset value

Large public deficits• A history

of banking bail-outs • Excessive risk

Large public deficits

• Interrupt

Ignore corporate

taking• “Too big to fail”

bail-outs: Lehman!

g presponsibility PANIC, CRISIS!

Stop bailouts!Stop bailouts!

• Easier said than doneEasier said than done…

• But there are good precedents:I fl ti h i fl ti d h th– Inflations, hyperinflations, and how they were ended:

• Central Banks stopped bailing out governments• Central Banks stopped bailing out governments

• Institutional rules that gave central bank autonomy and prevented fiscal dominance

• Ex. Inflation targeting, used now by over 30 countries» Mishkin and Schmidt-Hebbel (2007)

The challenge remains…The challenge remains…

• Develop fiscal institutions and rules p»to avoid implicit, unsustainable insurance»to stop bailouts

We are in an ever-increasing cycle of risk-taking and too-big to fail bailouts The [next] crisis will be biggerbig-to-fail bailouts… The [next] crisis will be bigger.Where will it come from? State and local governmentdefaults? Pension funds? A new Asian Bubble? Default byGreece Italy or Ireland? Who knows?Greece, Italy, or Ireland? Who knows?

John Cochrane, 2010

3. It’s large fluctuations, not regular l tilit hi h h th

(or, better frequent shakes than a big

volatility, which harms the economy (or, better frequent shakes than a big

earthquake…)

The effect of macro volatility on long-hrun economic growth

• Ramey and Ramey (1995):Ramey and Ramey (1995):• Macroeconomic volatility exerts a significant negative

impact on long-run growth

• Hnatkovska and Loayza (2005):• Decompose volatility into “normal” and “crisis” p y

components

• Only the negative effect of “crisis” volatility is t ti ti ll i ifi t d 4 ti l th th ff tstatistically significant and 4 times larger than the effect

of “normal” volatility

Normal and Crisis Volatility

Argentina, 1960-2008

5.4

a G

row

th

"Normal"1.3

-2.8

per c

apita Normal

volatility

GD

P p "Crisis"

volatility

1960

1962

1964

1966

1968

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008 Year

Good volatility?Good volatility?

• Small doses of certain types of volatility can serveSmall doses of certain types of volatility can serve as “vaccine” against large recessions

• When is volatility good?When is volatility good?– When it reflects flexibility in the allocation of

resources and the communication of information • Changes in relative prices

» Decrease real wages to reduce unemployment» Depreciate real e change rate to red ce trade deficit» Depreciate real exchange rate to reduce trade deficit

• Changes in asset values» Decrease in stock market value of failing enterprisesf f g p

The Dot Com Crisis and the Subprime M t C i i Wh diff t ff t ?Mortgage Crisis: Why so different effects? • Dot Com Crisis:Dot Com Crisis:

– Wiped out $5 trillion in market value from March 2000 to October 2002

– But, no financial crisis and only a mild recession

• Subprime Mortgage Crisis:p g g– Subprime mortgage losses around $400 billion

– Yet, enormous financial crisis and large recession, g

• The difference? » No price adjustment and market breakdown!» No price adjustment and market breakdown!

Chile and Russia: Two different reactions to the l i iexternal crisis (Blanchard, Faruqee, Das, 2010)

• Both countries are large commodity producers• Both received a large trade shock• Both are financially integrated with the world• Russia had larger FX reserves relative to short term debt• Russia had larger FX reserves relative to short-term debt

than Chile• So, did Russia fare better with the crisis?

» NO!• Chile did better,

» More effective fiscal stabilization mechanism» More flexible exchange rate regime

• Early exchange rate depreciation prevented speculative outflows

Shock absorbers, Escape Valves, S f t S it hSafety Switches…

• The economy needs these mechanisms to adjust y jcontinuously and grow

• Macroeconomic stabilization policiesC li l fi l li i» Counter-cyclical fiscal policies

» Responsive monetary and exchange rate policies

• Microeconomic flexibility (e.g., Collier and Goderis, 2009)y ( g )» Flexible entry and exit of firms» Flexible labor markets

• The quasi-paradox is that in order to avoid abrupt• The quasi-paradox is that in order to avoid abrupt fluctuations, the economy needs constant movement and adjustment

Bergoeing, Loayza and Repetto (2004):

Severity of Recessions and Regulatory Burden

0.25

0.3

ssio

ns

Correlation = 0.36**

0.15

0.2

y of

Rec

es

0.1

Seve

rity

0

0.05

0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Regulation IndexDevelopingIndustrializedLinear (Developing)

Loayza, Oviedo, and Servén (2010):

TGO

.06 Correlation: 0.35***

Overall Regulation

IDNMWIPNGTHA4

ARGCOG

HTIJOR

KORMARMYS

NERPER

THA

TUR

VENZMB

ZWE

.04

BRABWA

CHLCIV

COG

COLCRI

DOM

ECU

FINHND

IRL

IRN

ISL KEN

MEXNER

NIC

PHLPRT SEN

SWE

SYR

TTO

URY

.02

AUSAUTBEL

BFA

BGD

BOLCAN

CHEDNK

EGY

ESPFRA

GBR

GHA

GMBGRC

GTM

INDIRL ISL

ISRITAJAM

JPN KEN

LKA

MDGNGA

NLDNOR

PAK PANPRYSLV

SWE TUN

USA

ZAF

0

0 .2 .4 .6 .8 1Overall Regulation Index

In summary…In summary…

1. Domestic policies and institutions continue to be the1. Domestic policies and institutions continue to be the main drivers of volatility and crisis

2. Unsustainable implicit insurance and the practice of bailouts are usually behind the worst crises

3. Flexibility to adjust to new conditions is the best antidote against large macroeconomic disruptionsg g p

Volatility and Crisis:Three Lessons for Developing Countries

Norman Loayza

World BankWorld Bank