Transcript Insuring Emerging Markets: Contingent Debt

Insuring Emerging
Markets:
Contingent Debt
Ricardo J. Caballero, MIT
http://web.mit.edu/caball/www
IADB,
Washington, D.C.
April 9, 2003
The Problem

Many structural/macro reforms but Capital Flows
remain volatile

IMF / Treasury proposals:
• Focus on extreme cases. Bankrupt economies.

Problem is far more widespread and it starts
earlier
• Sudden stops, costly precautionary measures and
recessions

Chile vs Australia during 97-99
• Chile’s response: 10 times larger than it should

HOW CAN WE MAKE EMs MORE LIKE AUSTRALIA
(GIVEN THEIR STRUCTURE AND INSTITUTIONS)?
An “Obvious” Answer:
Hedging/Insurance Markets

Hedging what?
• “Exogenous” Financial constraints
• E.g., Chile: fc triggered by Pcu / High yield.
(beyond flows and govt. revenues)

Example: Chile could embed in its
external bonds a long-term put option
yielding 8b if fc-trigger-indicators (e.g.
Pcu) fall by more than two sd for six
months or more.
• “Fair” Price: 1 or 2% of GDP (very cheap
compared to current precautionary
measures)…
Simulation from “Hedging SS and PS:…”
Sudden Stop estimate from “Hedging…”
The Supply Side

Specialists?
• Early on: yes. Medium run: Not ideal. They
are needed during difficult times. Don’t want
their K to shrink at those times.

US Pension funds, insurance companies,
etc.
• Need to decouple contingency from emerging
markets stuff.

This is harder for “endogenous” variables
• And a lot harder for pure-peso-bonds;
(domestic banks).
Asset Class Protection
Contingent EM - CDO
EM
Contingent
Debt
Senior (A+)
Contingent
Mezzanine
Subord. Debt /
Equity
Specialists
IMF?
(conditionality?)
Toxic waste? Less so…
Why hasn’t it happened?

Markets are slow to develop:
• CAT-bonds (act-of-God)

t0 (1997): 9xE[loss]; t0+2: 5xE[loss]
• Externalities

Focus:
• There are plenty of potentially contractible
shocks. Identify -- Liquidity.
• The IFIs have a key role in promoting and
jump-starting these markets.



Forcing bad cases (e.g. Argentina)
Encouraging good cases (e.g. Mexico, Chile)
[CCL]
2003, a window of opportunity?
Not far… (small/income)



Petrobonds: Mexico 1970s.
Giscards (gold): France 1973
Corporates
• Magma Copper (1988)
• Standard Oil of Ohio (1986)
• Sunshine Mining [Silver] (1980)
• Forest Oil [Natural Gas] (1988)
•…
Final Remarks

“IMF”
• Crisis Department


Non-contractible shocks: totally unexpected
events and domestic misbehavior/blunders
Bankruptcy as Insurance / LLR
• (IFIs) Contingent Markets Department


Contractible capital flows volatility
Other policies
• Fiscal/monetary rules


Designed to prevent “un-insurance”
Indexed to contingencies
Current Account Deficit
Australia
%
%
-1
-1
-2
-2
-3
-3
-4
-4
-5
-5
-6
-6
-7
-7
1997
1998
1999
2000
2001
20%
2.0%
15%
1.5%
10%
1.0%
5%
0.5%
0%
0.0%
-5%
-0.5%
-10%
-1.0%
-15%
-1.5%
-20%
1987
-2.0%
1988
1989
1990
1991
1992
1993
1994
growth (dev from mean)
1995
1996
PV effect
1997
1998
1999
PV effect
growth
Chile (an advanced EM
economy)
External Vulnerability
Growth of Industrial Production
Interest Rates
Data period: 1991 – 2002. Frequency: monthly
EMBI+: percentage change in J.P. Morgan Emerging Market Bond Index Plus. Copper: Spot price of copper US$
Interest Rates: Real interest rate (U.F.) Loans (90-365 days), Banco Central de Chile
Industrial Production: Annual percentage change Industrial Production Index, Instituto Nacional de Estadisticas
Annex



Caballero, R.J., “The Future of the IMF.” [Also,
“On the International Financial Architecture:
Insuring Emerging Markets.” ]
_______, “Coping with Chile’s External
Vulnerability: A Financial Problem.”
_______ and S. Panageas, “Hedging Sudden
Stops and Precautionary Recessions: A
Quantitative Framework.”
Available at http://web.mit.edu/caball/www