Transcript SUDDEN STOPS, THE REAL EXCHANGE RATE AND FISCAL

SUDDEN STOPS,
THE REAL EXCHANGE RATE
AND FISCAL SUSTAINABILITY:
ARGENTINA’S LESSONS
Guillermo Calvo,
Alejandro Izquierdo
and Ernesto Talvi
Policy Seminar
June 6, 2002
Research Department
OUTLINE
I.
Life after Russia: A Hemispheric Perspective
II. The Effects of Sudden Stops on the Real
Exchange Rate and Fiscal Sustainability
III. Sudden Stops in Argentina and Chile (1998):
Two Polar Cases
IV. Choice of an Exchange Rate Strategy after a
Sudden Stop
V.
Policy Recommendations and Conclusions
External Financial Conditions
(LEI, Spread over US Treasuries)
1.400
1.200
Current level
1.000
Pre- Argentine Crisis
Pre- Russian
Crisis
800
600
Pre-Asian
Crisis
400
Jan-02
Sep-01
May-01
Jan-01
Sep-00
May-00
Jan-00
Sep-99
May-99
Jan-99
Sep-98
May-98
Sep-97
May-97
Jan-97
200
Jan-98
524 bp
Vodka is Stronger than Tequila in LAC
(Net private capital flows, US$ billions)
75
70
65
60
55
50
45
40
Tequila
Russia
35
T
T+1
T+2
T+3
Sudden Stop in LAC-7
(Capital flows and CA, 4 quarters, % of GDP)
6%
Capital flows
4%
2%
0%
-2%
Current Account
-4%
Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela
2001-III
2001-II
2001-I
2000-IV
2000-III
2000-II
2000-I
1999-V
1999-III
1999-II
1999-I
1998-IV
1998-III
1998-II
1998-I
1997-IV
-6%
Current Account Adjustment
Current Account Balance, US$ billions
ARG
BRA
CHL
COL
1997
-12.2
-30.8
-3.7
-5.9
1998
-14.5
-33.4
-4.1
-5.2
1999
-11.9
-25.4
-0.1
0.2
2000
-8.9
-24.6
-1.0
0.3
2001
-5.6
-23.2
-0.9
-2.1
Source: World Economic Outlook (IMF), April 2002.
ECU
-0.7
-2.2
0.9
0.7
-0.8
Trend Growth in LAC-7
(Annual growth based on quarterly data, 1997.II=100)
100
90
80
70
60
50
40
1997:2
1998:2
2000:2
Includes: Argentina, Brazil, Chile, Colombia, México, Perú, Venezuela
2001:2
OUTLINE
I.
Life after Russia: A Hemispheric Perspective
II. The Effects of Sudden Stops on the Real
Exchange Rate and Fiscal Sustainability
III. Sudden Stops in Argentina and Chile (1998):
Two Polar Cases
IV. Choice of an Exchange Rate Strategy after a
Sudden Stop
V.
Policy Recommendations and Conclusions
The Sudden Stop Effect on Demand
CAD = A* + S* - Y* = current account deficit
A* = tradables absorption; Y* = tradables output
S* = non-factor payments (interest on external debt)
 After Sudden Stop, percentage fall in tradables:
 = CAD/A* = 1 - 
 = (Y* - S*)/A* = un-leveraged absorption ratio
 Under homotheticity,  applies to home goods, too.
Sudden Stop and Equilibrium RER
p
P = PNT/PT
p*
SS
p**
h
hs
Un-Leveraged Absorption RER Adjustment
Un-leveraged Absorption Coefficient ( w)
BRA
ARG
ECU
COL
CHL
0.56
0.66
0.66
0.70
0.81
Required % Change in Equilibrium RER
BRA
ARG
ECU
COL
CHL
52.5
46.2
46.1
43.0
32.4
Source: World Economic Outlook (IMF), and own estimates.
Note: This measure is calculated in 1998 for all countries.
Public Debt: Dollarization and Mismatches
Mismatch Measure
ARG ECU COL
BRA
CHL
B/e B*
Y/e Y*
0.08
0.02
0.59
1.76
1.30
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.
Fiscal Sustainability after a 50% RER Depreciation
ARG BRA CHL
COL
ECU
(a) Base Exercise
Observed Public Debt (% of GDP)
Real Interest Rate
Real GDP Growth
Observed Primary Surplus (% of GDP)
36.5
7.1
3.8
0.9
51.0
5.8
2.0
0.6
17.3
5.9
7.5
0.6
28.4
7.3
3.6
-3.0
81.0
6.3
2.6
-0.2
i. Req. Primary Surplus (% of GDP)
(b) Change in Relative Prices
1.2
1.9
n.a.
1.0
2.9
Imputed Public Debt (% of GDP)
50.8
58.1
18.7
34.9
107.2
ii. Req. Primary Surplus (% of GDP)
1.6
2.2
n.a.
1.2
3.9
NPV of ii - i (% of GDP)
Corresponding Debt Reduction (%)
ii - i (% of Government Expenditures)
14.3
28.2
2.3
7.1
12.2
1.0
n.a.
n.a.
n.a.
6.5
18.7
1.3
26.3
24.5
4.5
Source: Own estimates. Note: Values are given for 1998. n.a.: Not applicable given that the
real interest is smaller than the growth of GDP.
OUTLINE
I.
Life after Russia: A Hemispheric Perspective
II. The Effects of Sudden Stops on the Real
Exchange Rate and Fiscal Sustainability
III. Sudden Stops in Argentina and Chile (1998):
Two Polar Cases
IV. Choice of an Exchange Rate Strategy after a
Sudden Stop
V.
Policy Recommendations and Conclusions
Sudden Stop in Argentina and Chile
(Private Capital flows, % of GDP)
4%
8%
7%
6%
5%
4%
Argentina
1%
3%
0%
Chile
2%
2%
1%
-1%
0%
Chile
2001-II
2001-I
2000-IV
2000-III
2000-II
2000-I
1999-V
1999-III
1999-II
1999-I
1998-IV
1998-III
-1%
1998-II
-2%
1998-I
Argentina
3%
External Adjustment
(Current Account, 4 quarters, %GDP)
Chile
Argentina
93
2001.III
2001.II
95
2001.I
95
2000.IV
70
2000.III
Argentina
2000.II
80
2000.I
99
1999.IV
85
1999.III
101
1999.II
GDP
1999.I
Chile
1998.IV
105
1998.III
107
1998.II
2001.III
2001.II
103
2001. I
2000.IV
2000.III
2000.II
2000.I
1999.IV
1999.III
1999.II
1999.I
1998.IV
1998.III
1998.II
Economic Activity: GDP and Investment
(s.a., 1998.II=100)
Investment
105
100
90
Chile
97
75
Argentina
65
60
Oct-01
Ago-01
Jun-01
Abr-01
Feb-01
Dic-00
Oct-00
Ago-00
Jun-00
Abr-00
Feb-00
Dic-99
Oct-99
Ago-99
Jun-99
Abr-99
Feb-99
Dic-98
Oct-98
Ago-98
Jun-98
Real Exchange Rate
(Vis à vis the US dollar, June 1998=100)
150
140
Chile
130
120
110
“Empalme” factor
100
Argentina
90
The Contribution of Exports to the
Current Account Adjustment
(In %, 2001.III-1998.II)
60
52.6%
50
40
30
16.3%
20
10
0
ARGENTINA
CHILE
Sudden Stop and the Real Exchange Rate
Un-leveraged Absorption
()
Required % change in RER
to eliminate the CAD
60
0.90
55
0.80
50
0.70
45
40
0.60
35
0.50
30
25
0.40
Chile
Argentina
Source: Calvo, Izquierdo, Talvi (2002)
Chile
Argentina
Key Points: Chile
Chile recovered without international financial support
and in spite of a very weak recovery in capital inflows
due to its:
• relative openness
• low levels of CAD leverage
• low levels of public debt
• low degree of financial mismatches in the public and
the financial sector
which allowed for a very rapid increase in exports that
financed one half of the current account adjustment and
prevented the real exchange rate depreciation from
having adverse balance sheet effects.
An Example: Fiscal Sustainability in Argentina
after a Sudden Stop in 1998
Debt to
GDP
ratio
(%)
Req. Prim.
Surplus
Adjust.
NPV of Req.
Adjust.
(% of GDP)
(a) Baseline
36.5
0.3
9.3
(b) Change in Relative Prices to close the CA
deficit (RER depreciation of 46,2%)
49.7
0.7
22.6
(c): (b) + 200 BPS Increase in
Real Interest Rate
49.7
1.7
32.8
(d): (c) + 1% Reduction in GDP growth
49.7
2.2
35.6
(e): (d) + Contingent Liabilities
58.6
2.7
44.5
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
Key Points: Argentina
Argentina’s lack of recovery and eventual collapse, occurred in
spite of large international financial assistance packages and
was due to the fact that:
 Argentina had it all: a closed economy, high levels of external
indebtedness and public debt, high liability dollarization and, as
a result, large financial mismatches both in the public and
private sector.
 Under those conditions, the change in the equilibrium RER
needed to accommodate a permanent sudden stop was large.
 The expectation of a large real depreciation in turn, led to a
large revaluation of public sector debt relative to GDP
(requiring a larger fiscal effort and/or a larger debt reduction to
achieve fiscal sustainability) and to a deterioration of corporate
balance sheets (contingent liabilities?). The proposed fiscal
adjustments were clearly insufficient for a substantially higher
RER.
Key Points: Argentina (ctd.)
 The deterioration of public and private sector balance sheets
deteriorated the quality of bank assets and led to a run on
banks due to the fear that those losses might be partially
financed by confiscating depositors.
 The run against banks was accommodated by credit expansion
of the CB, leading to a collapse in international reserves and an
acceleration of the run on banks.
Argentina: Political Economy
after the Sudden Stop
• Why was adjustment so hard to materialize?
• The fact that Argentina had a fixed exchange rate
and relatively sticky prices concealed the needed
adjustment in relative prices.
• This provided little evidence for politicians about
the need for adjustment.
• Uncertainty about the duration of the standstill in
capital flows and the size of RER adjustment may
be one of the elements that delayed reform.
• Uncertainty about how the losses of RER
realignment would be distributed also contributed
to delays in reform
Argentina: Policies were not Enough
• Fiscal: Fiscal adjustment in 2000, attempted (failed)
additional adjustment in early 2001, zero-deficit law
on second half of 2001, but it was already too late.
• Exchange Rate: Convergence factor, though in the
right direction, introduced uncertainty about
prevailing convertibility rules.
• Debt Management: Debt swap in mid 2001 validated
extremely high interest rates, further worsening
solvency, perhaps under assumption of liquidity
problems.
• Monetary: Expansionary monetary stance and
public bank bailout led to high credit expansion and
loss of reserves.
Central Bank Policy
Cavallo is appointed
28,000
7,000
International Reserves
26,000
Monetary Liabilities
5,000
22,000
4,000
20,000
3,000
18,000
2,000
16,000
14,000
1,000
12,000
0
Source: BCRA.
Ene-02
Jul-01
Ene-01
Jul-00
Ene-00
Jul-99
Ene-99
Jul-98
Ene-98
Jul-97
Ene-97
Net Domestic Credit
Jul-96
Ene-96
10,000
-1,000
Million Pesos
Million Pesos
24,000
6,000
OUTLINE
I.
Life after Russia: A Hemispheric Perspective
II. The Effects of Sudden Stops on the Real
Exchange Rate and Fiscal Sustainability
III. Sudden Stops in Argentina and Chile (1998):
Two Polar Cases
IV. Choice of an Exchange Rate Strategy after a
Sudden Stop
V.
Policy Recommendations and Conclusions
Exchange Rate Defense and Abandonment
 Countries tried initially to hold to their bands, but
were not successful given magnitude of RER
adjustment needed.
 Markets held expectations that the nominal
exchange rate would be used to make the RER
adjustment needed
 This was reflected in very high interest rates and a
substantial loss of reserves.
 Why wait? The public sector was not heavily
dollarized (except Ecuador and Argentina), but the
private sector may have been. Time to hedge?
 Exit Strategy: Flotation with IT in most cases. Why?
Exchange Rate Defense and Abandonment
BRA
Regime Pre
Sudden Stop
Modifications After
Sudden Stop
Target Zone: Width +/4%
CHL
COL
ECU
Crawling Band Rate of
Crawling Band Rate of
Crawling Band Rate of
Crawl: To preserve PPP Crawl: To preserve PPP Crawl: To preserve PPP
Width: +/- 5%
Width: +/- 7%
Width: +/- 5%
Mar 1998: Realignment
Sep 1998: Realignment of
Dec 1998: Width
and width increased to
the Band. Jun 1999:
Jan 1999: Width increased increased to +/-8% with
+/-10%. Sep 1998: Rate
Second Realignment and
to +/-5%
an increasing factor of
of crawl increased to 20%
width increased to +/0.41% per month.
and width increased to
10%
+/-15%
Floatation Date
Jan-99
/a
Change in Reserves $US(Billions)
-33.0
Change in Reserves % /a
-49.1%
Sep-99
-2.1
-12.9%
Sep-99
-2.4
-23.5%
Feb-99
-0.5
-24.4%
a/ Between end of first quarter 1998 and the date of float. Source: IMF "Exchange Arrangements and
Exchange Restrictions”(various issues) and IFS.
Defense: Interest Rates and Reserves
Increase in Deposit Rates (Basis Points)
BRA
601.7
CHL
COL
ECU
1266.3 1069.3 1669.0
Fall in Reserves (Percent)
BRA
CHL
COL
ECU
49.1
12.9
23.5
24.4
Note: First table reports the difference between the peak interest rate
during the period (before floating) and average figure for quarter
previous to sudden stop. Source: IFS (IMF).
Banking Sector: Dollarization and Mismatches
Financial Mismatches, June 1998
ARG BRA CHL COL ECU
Dollar Loans/Total Loans (%) 61.6
-
9.4
Tradable Production/
Total Production (%) 1/
7.5
26.0
Source: Central Banks.
1/ Proxied by exports.
10.4
13.6
60.4
25.4
Valuation Effects and Choice of
an Exchange Rate Regime
 Closed, highly indebted, highly dollarized and
mismatched economies are vulnerable to large
RER swings and substantial valuation effects that
may deem a country insolvent after a sudden stop.
 Fiscal dominance is present: monetary policy is
subordinated to fiscal insolvency.
 Hypothesis: Countries that chose to float with IT
were successful in cases where fiscal dominance
was absent and monetary policy became credible.
Two Polar Flotation Cases:
Chile and Ecuador
Jan-00
Nov-99
Sep-99
Jul-99
May-99
Mar-99
Jan-99
Nov-98
Sep-98
Jul-98
May-98
Jan-98
Oct-01
Jul-01
5
Jan-01
0
Apr-01
15
Jul-00
5
Oct-00
25
Jan-00
10
Apr-00
35
Oct-99
15
Jul-99
45
Jan-99
20
Apr-99
55
Jul-98
25
Oct-98
65
Jan-98
30
Apr-98
Dollarization
Ecuador
Mar-98
Chile
Mar-00
Float
 Chile successfully brings down devaluation
expectations after choice of new regime
 Ecuador struggles: interest rates reach highest
values at time of announcement of flotation, only fall
after announcement of dollarization
Ecuador: Dollarization is Not Enough
(Sovereign Bond Spread)
5,000
4,500
Default 
 Agreement
4,000
3,500
3,000
EMBI+ Ecuador
2,500
2,000
EMBI+
1,500
Dec-01
Sep-01
Jun-01
Mar-01
Dec-00
Sep-00
Jun-00
Dec-99
Sep-99
Jun-99
Mar-99
Dec-98
500
Mar-00
 Dollarization
1,000
 Debt resolution and fiscal adjustment (primary surplus 2001:
5% of GDP)
Two Polar Flotation Cases:
Chile and Ecuador
GDP Growth
1997
1998
1999
2000
2001
Inflation
CHL ECU
7.4
3.4
3.9
0.4
-1.1
-7.3
5.4
2.3
3.3
5.2
1997
1998
1999
2000
2001
CHL
6.1
5.1
3.3
3.8
3.7
Exports Change / Current Account Change, %
CHL
ECU
1999 vs 1998
11.1
8.0
2001 vs 1998
102.3
41.9
Exports Change, %
1999 vs 1998
2001 vs 1998
CHL
2.4
15.3
ECU
5.0
11.3
ECU
30.6
36.1
52.2
96.2
37.0
OUTLINE
I.
Life after Russia: A Hemispheric Perspective
II. The Effects of Sudden Stops on the Real
Exchange Rate and Fiscal Sustainability
III. Sudden Stops in Argentina and Chile (1998):
Two Polar Cases
IV. Choice of an Exchange Rate Strategy after a
Sudden Stop
V.
Policy Recommendations and Conclusions
Policy Lessons:
1. Closed economies (C), with high public debt (D) and large
financial mismatches (M), are vulnerable to changes in
international conditions that require an adjustment in the current
account deficit since they may require large changes in
equilibrium RER.
2. Large changes in the RER, could turn a sustainable fiscal
position into an unsustainable one and lead to major solvency
problems. Solvency problems can lead to fiscal dominance,
making monetary policy not credible. In those cases, flotation is
a difficult task.
3. Countries like Brazil, Chile and Mexico are much less
dollarized than Argentina and, therefore, have more leeway to
use the exchange rate as an instrument. However, there are
limits to exchange rate flexibility because all of them may find it
difficult to issue debt other than in foreign currency or indexed to
a foreign currency.
Policy Lessons (cont.)
4. CDM economies are vulnerable independently of the
exchange rate regime that is adopted.
5.
In CDM economies it is dangerous to have:
a) High levels of public indebtedness. Rules that allow
governments to reach lower debt levels or even a creditor position
should be given serious consideration
b) Banks with weak links to the international capital market.
In particular, State-Owned banks should be subject to Narrow
Banking rules or privatized
6. Exchange rate flexibility could play a useful role if the C, D or
M are dropped. Otherwise, exchange rate flexibility might do more
harm than good.
Policy Lessons (cont.)
7. In the short run, the C is hard to drop, and dropping D or M
could be traumatic (as exemplified by Argentina’s default and
pesification).
8. Solving a solvency crisis involves wealth redistributions across
sectors. The way and the speed at which those redistributions are
made are crucial in determining how fast a crisis gets resolved.
Research Department