dealing with an credit crunch: past lessons, new challenges eduardo a. cavallo inter-american...

Dealing with an Credit Crunch: Dealing with an Credit Crunch: Past Lessons, New ChallengesPast Lessons, New Challenges

Eduardo A. CavalloEduardo A. Cavallo

Inter-American Development Bank (IDB)Inter-American Development Bank (IDB)

Reforming the Bretton Woods Institutions,Reforming the Bretton Woods Institutions,

Copenhagen, 16-17 September 2009Copenhagen, 16-17 September 2009

Outline Outline

Lessons from past financial crisis: the Lessons from past financial crisis: the experience of LAC.experience of LAC.

Applying the past to the present.Applying the past to the present.

Lessons LearnedLessons Learned

IDB (2009) analyses policy responses to IDB (2009) analyses policy responses to sudden stops episodes of the late 1990s for 8 sudden stops episodes of the late 1990s for 8 LAC countries, bringing in also cross-country LAC countries, bringing in also cross-country analysisanalysis..

1)1) Expansionary fiscal and monetary policy that does Expansionary fiscal and monetary policy that does not affect credibility or solvency can reduce output not affect credibility or solvency can reduce output collapse in the aftermath of a sudden stop. collapse in the aftermath of a sudden stop. However However countries need to be able to afford these policiescountries need to be able to afford these policies..

2)2) Initial conditions matter.Initial conditions matter.

3)3) Initial conditions are not destiny.Initial conditions are not destiny.

4)4) The persistence of the shock is key.The persistence of the shock is key.

5)5) External financial packages are essential when initial External financial packages are essential when initial conditions do not help.conditions do not help.

1) Expansionary Policies can Help1) Expansionary Policies can Help

Observed Fiscal Impulse

-3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0%

TUR 93

RUS

ECU

KOR

COL

MEX

BRA 97

POL

IDN

TUR 98

PER

PHL

ARG 94

HRV

MYS

CHL

ARG 98

THA

% PBI

Structural Fiscal Impulse

-5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0%

RUS

ARG 98

IDN

TUR 93

COL

THA

MYS

KOR

MEX

POL

TUR 98

PER

BRA 97

ECU

CHL

HRV

PHL

ARG 94

% PBI

Characterizing expansionary fiscal policyCharacterizing expansionary fiscal policy

Source: Ortiz, Ottonello, Sturzenegger and Talvi (Chapter 2)Source: Ortiz, Ottonello, Sturzenegger and Talvi (Chapter 2)

1) 1) Expansionary Policies can HelpExpansionary Policies can Help

Monetary Policy Dilemmas and Taylor Rules.Monetary Policy Dilemmas and Taylor Rules.

ConjectureConjecture: in Emerging Markets’ prone to : in Emerging Markets’ prone to financial crises, Central Banks care about:financial crises, Central Banks care about: InflationInflation Output GapOutput Gap Nominal Exchange Rate (“original sin” & “fear of Nominal Exchange Rate (“original sin” & “fear of

floating”)floating”)

Anatomy of financial crises in Emerging Anatomy of financial crises in Emerging Markets.Markets.

1) 1) Expansionary Policies can HelpExpansionary Policies can Help

ARG 98

BRA 97

CHLCOLHRV ECU

IDN

KOR

MYS MEX

PER

PHL

POL

RUS

THA

TUR 93

TUR 98

-0.10

-0.08

-0.06

-0.04

-0.02

0.00

0.02

0.04

0.06

0.08

0.10

-0.045 -0.035 -0.025 -0.015 -0.005 0.005 0.015

GD

P V

aria

tion

( Y

)

*tI

ARG 94ARG 98

BRA 97

CHL

COL

HRV

ECU

IDN

KOR

MYSMEX

PER

PHL

POL

RUS

THA

TUR 93TUR 98

-0.08

-0.06

-0.04

-0.02

0.00

0.02

0.04

0.06

0.08

0.10

0.12

-6.00 -4.00 -2.00 0.00 2.00 4.00 6.00 8.00

GD

P V

aria

tion

( Y

)

tYST /,

Fiscal Policy(GDP variation and Structural Fiscal impulse partialling out the effects of monetary policy)

Monetary Policy(GDP variation and Monetary Policy Regime index

partialling out the effects of fiscal policy)

Source: Ortiz, Ottonello, Sturzenegger and Talvi (Chapter 2)Source: Ortiz, Ottonello, Sturzenegger and Talvi (Chapter 2)

2) 2) Initial conditions matterInitial conditions matter

Stringent preconditions need to be met in order Stringent preconditions need to be met in order to afford policy flexibility:to afford policy flexibility: Fiscal PolicyFiscal Policy: fiscal policy rules that guarantee inter-: fiscal policy rules that guarantee inter-

temporal consistency; maintaining low levels of temporal consistency; maintaining low levels of public debt.public debt.

Monetary policyMonetary policy: maintaining low levels of financial : maintaining low levels of financial and debt dollarization; high degree of credibility in the and debt dollarization; high degree of credibility in the policy framework; trade openness in a context of policy framework; trade openness in a context of open capital markets.open capital markets.

Evidence shows that those that were better Evidence shows that those that were better prepared did better during the crisis.prepared did better during the crisis.

3) Initial Conditions are not Destiny3) Initial Conditions are not Destiny

Domestic Liability Dollarization: Selected LAC Countries

Peru’s policy of reserve accumulation and Peru’s policy of reserve accumulation and disbursementdisbursement

Domestic Liability Dollarization Measure

Before the Crisis

0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0%

URY

PER

ARG

MEX

ECU

BRA

CHL

COL

% of GDP

Net Domestic Liability Dollarization Measure Before

the Crisis

-30.0% -20.0% -10.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0%

URY

MEX

ARG

ECU

PER

BRA

COL

CHL

% of GDP

3) Initial Conditions are not Destiny3) Initial Conditions are not Destiny

Brazil: selective use of international reserves to Brazil: selective use of international reserves to finance trade credit.finance trade credit.

Chile: the capacity to switch gears without Chile: the capacity to switch gears without generating a crisis.generating a crisis.

ColombiaColombia: fear of floating: fear of floating

4) 4) Shock Persistence is KeyShock Persistence is Key

Vodka is stronger than TequilaVodka is stronger than Tequila

5) 5) External financial packages are essential External financial packages are essential when initial conditions do not help.when initial conditions do not help.

Mexico 1994Mexico 1994: $51 billion IMF/USA rescue : $51 billion IMF/USA rescue package.package. 2.8 times the total stock of short-term US$ debt by 2.8 times the total stock of short-term US$ debt by

December 2004.December 2004.

Argentina 2001/2002.Argentina 2001/2002. There is reason to believe that with international There is reason to believe that with international

support, the restructuring process could have been support, the restructuring process could have been much more orderly.much more orderly.

The Great Crisis of 2008/2009The Great Crisis of 2008/2009

¿What is different this time around?¿What is different this time around? The epicenter of the crisis: center vs. perifery.The epicenter of the crisis: center vs. perifery. Countries in the LAC region appear to be better Countries in the LAC region appear to be better

prepared. But: will it be enough?prepared. But: will it be enough?

This time around, the initial response of This time around, the initial response of countries in the region has been countries in the region has been strongly countercyclicalstrongly countercyclical, just like in the developed , just like in the developed world.world.

But unlike the developed world, LAC is not a But unlike the developed world, LAC is not a safe haven for global savings that can provide safe haven for global savings that can provide billions of dollars to pump into a stimulus billions of dollars to pump into a stimulus package. package. Precarious market accessPrecarious market access..

Ernesto Talvi, CERESErnesto Talvi, CERESAlejandro Izquierdo, IDBAlejandro Izquierdo, IDB

CoordinatorsCoordinators

Outlook for LAC in the context of the crisisOutlook for LAC in the context of the crisis

It makes all the difference if the world economy It makes all the difference if the world economy reaches its pre-crisis levels of industrial reaches its pre-crisis levels of industrial production in 2010 or in 2013.production in 2010 or in 2013.

This scenario could trigger a liquidity crisis in This scenario could trigger a liquidity crisis in quite a few countries. If a country does not have quite a few countries. If a country does not have sufficient international reserves to cover the sufficient international reserves to cover the debt service, it could generate a stampede by debt service, it could generate a stampede by everyone who believes that the reserves are not everyone who believes that the reserves are not going to be there when needed.going to be there when needed.

The Role of MultilateralsThe Role of Multilaterals

Precarious access to credit markets for many Precarious access to credit markets for many emerging market governments calls for emerging market governments calls for multilaterals to step in and play a key role as a multilaterals to step in and play a key role as a lenders (and borrowers)-of-last resortlenders (and borrowers)-of-last resort, akin to , akin to the role that credible governments, such as the the role that credible governments, such as the US government, play domestically.US government, play domestically.

The question then is not whether multilaterals The question then is not whether multilaterals should play a key role in the current crisis, but should play a key role in the current crisis, but which is the most effective way to channel their which is the most effective way to channel their intervention and at what financial costintervention and at what financial cost . .

Policy PrinciplesPolicy Principles

Strengthen the role of multilateral institutionsStrengthen the role of multilateral institutions. . Multilateral support will be vital under Multilateral support will be vital under precarious access to credit markets.precarious access to credit markets.

Move away from short-term financingMove away from short-term financing. . Multilaterals should avoid short-term emergency Multilaterals should avoid short-term emergency financing and only consider medium to long-financing and only consider medium to long-term financing in order to partially “complete” term financing in order to partially “complete” markets in terms of maturities.markets in terms of maturities.

Policy Principles (cont.)Policy Principles (cont.)

Redefine the emphasis of multilateral supportRedefine the emphasis of multilateral support. . Multilaterals should not only provide medium to Multilaterals should not only provide medium to long-term financing for fiscal stimulus –when long-term financing for fiscal stimulus –when fiscal sustainability is not at stake– but more fiscal sustainability is not at stake– but more importantly, they should provide for long-term importantly, they should provide for long-term refinancing of maturing debt obligations.refinancing of maturing debt obligations.

Ensure that countries work towards sustainable Ensure that countries work towards sustainable fiscal policy while strengthening social fiscal policy while strengthening social protection. Multilateral support should be protection. Multilateral support should be complemented with incentive-compatible complemented with incentive-compatible conditionality, to ensure fiscal sustainability and conditionality, to ensure fiscal sustainability and strengthen social protection. strengthen social protection.

ILR Dynamics Under Alternative Policies(LAC-7, L-Shaped Scenario, ILR(LAC-7, L-Shaped Scenario, ILR22))

Normal International

Financial Conditions

Precarization of Flows and

Stocks

Full Financing of Flows and

Precarization of Stocks

LAC-7 is the simple average of the seven major Latin American countries, namely Argentina, Brazil, Chile, Colombia, Mexico, Peru LAC-7 is the simple average of the seven major Latin American countries, namely Argentina, Brazil, Chile, Colombia, Mexico, Peru

and Venezuela. These countries represent 91% of Latin America’s GDP.and Venezuela. These countries represent 91% of Latin America’s GDP.

ILR 2t = Reservest / (Public Debt Amortizationst+1 + Short Term Private External Debt Amortizations)

75%

80%

85%

90%

95%

100%

105%

110%

115%

120%

125%

2008 2009 2010 2011 2012

Refinancing Public Debt Stocks vs. Refinancing Public Debt Stocks vs. Financing Fiscal DeficitsFinancing Fiscal Deficits

Source: IDB (2009) Policy-trade-off for Unprecedented Times: Confronting the Global Crisis in LAC. A. Izquierdo and E. Talvi, coordinators.

Concluding RemarksConcluding Remarks

A strategy by the IMF and multilaterals that only A strategy by the IMF and multilaterals that only pays attention to financing countercyclical pays attention to financing countercyclical fiscal policies is incomplete and fiscal policies is incomplete and ignoring the ignoring the impact of expansionary policy on liquidity ratios impact of expansionary policy on liquidity ratios can be a costly mistakecan be a costly mistake..

It is necessary that It is necessary that lender (and borrower)-of-lender (and borrower)-of-last-resort functionslast-resort functions, similar to those that , similar to those that governments perform in developed economies, governments perform in developed economies, be recreated for LAC by multilateral institutions, be recreated for LAC by multilateral institutions, so that liquidity concerns are kept at bayso that liquidity concerns are kept at bay. .

Concluding RemarksConcluding Remarks

Recent responses:Recent responses: IMF´s Flexible Credit LineIMF´s Flexible Credit Line IDB´s Growth FacilityIDB´s Growth Facility

Thank YouThank You

2) Initial Conditions Matter2) Initial Conditions Matter

Balance Sheet Effect and Output Drops

ARG

BRA

CHL

COL

ECU

MEX

PER

URY

-0.02

-0.01

0

0.01

0.02

0.03

0.04

0 2 4 6 8 10 12 14 16 18 20

Output Drop (%)

?

Fiscal Position Under Two Hypotheses on the Global Economy: Are Debt Dynamics Sustainable?

Fiscal BalanceFiscal Balance(LAC-7, % of GDP)(LAC-7, % of GDP)

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

2006 2007 2008 2009 2010 2011 2012 2013

V-Shaped V-Shaped ScenarioScenario

L-Shaped L-Shaped ScenarioScenario

1.6%

-2.6%

-5.0%

0.3%

-3.7%

Public DebtPublic Debt(LAC-7, % of GDP)(LAC-7, % of GDP)

23%

28%

33%

38%

43%

48%

53%

2006 2007 2008 2009 2010 2011 2012 2013

V-Shaped V-Shaped ScenarioScenario

L-Shaped L-Shaped ScenarioScenario

34%

27%

49%

LAC-7 is the simple average of the seven major Latin American countries, namely Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela.

These countries represent 91% of Latin America’s GDP.


Latin America: Monetary and Fiscal Policy Response

Monetary Policy

Inte

rest

Ra

te

Interest Rate

Exchange Rate

Exc

ha

ng

e R

ate

8.5%

8.7%

8.9%

9.1%

9.3%

9.5%

9.7%

9.9%

Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09

98

102

106

110

114

118

122

126

(LAC-7*, Interbank interest rate and Nominal Exchange Rate, in % and Sep-15-08=100)

Fiscal Stimulus Announcements in Latin America

(% of GDP)

Source: Credit Suisse

Argentina

Brazil

Chile

Mexico

Peru

5.1

0.3

1.0

0.5

0.0

0.2

0.1

1.1

1.0

1.4

1.1

3.3

0.7

0.0

1.1

6.4

3.6

2.8

1.5

2.5

ON - BUDGET OFF – BUDGET

TOTALRevenue-side Expenditure-side

LAC-7 is the simple average of the seven major Latin American countries, namely Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. These countries represent 91% of Latin America’s GDP.

*Excludes Argentina and Venezuela


LAC-7 is the simple average of the seven major Latin American countries, namely Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. These countries represent 91% of Latin America’s GDP.

*Excludes Argentina and Venezuela

Monetary and Fiscal Policy Response: Russian Crisis vs. Current Crisis

20%

22%

24%

26%

28%

30%

32%

34%

36%

38%

40%

Jul-98 Aug-98 Sep-98

98

100

102

104

106

108

110

112

114

116

118

Interest Rate

Exchange Rate

Inte

rest

Ra

te

Exc

ha

ng

e R

ate

Monetary Policy(LAC-7*, Interbank Interest Rate and Nominal

Exchange Rate, in % and Jul-98=100)

Fiscal Policy(LAC-7, Structural Fiscal Balance, % of GDP)

-3.2%

-1.2%

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

Dec

-96

Ma

r-9

7

Jun-

97

Sep

-97

Dec

-97

Ma

r-9

8

Jun-

98

Sep

-98

Dec

-98

Ma

r-9

9

Jun-

99

Sep

-99

Russian Crisis


0

100

200

300

400

500

600

700

800

900

Jan-

07

Mar

-07

May

-07

Jul-0

7

Sep

-07

Nov

-07

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep

-08

Nov

-08

Jan-

09

Mar

-09

Corporate Bond SpreadsCorporate Bond Spreads

The End of the Panglossian Period: International Financial Conditions

(Latin CEMBI; 01-Jan-07 = 100)

Total

Variation in bps

CEMBI 87

Jan.07-May.08

Jun.08-Mar.09

516 603

Jan-07

221

06-Mar-09

824

Corporate Bonds: IssuanceCorporate Bonds: Issuance(LAC-7, billions of USD)

0

5

10

15

20

25

Ma

r-0

7

Jun-

07

Sep

-07

Dec

-07

Ma

r-0

8

Jun-

08

Sep

-08

Dec

-08

Ma

r-0

9

21.2

2.5


SovereignSovereign Bonds: Maturity Bonds: Maturity(LAC-7, issuances with maturity less than 1 year, % of

total issuance)

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

Mar

-07

Jun-

07

Sep

-07

Dec

-07

Mar

-08

Jun-

08

Sep

-08

Dec

-08

Mar

-09

63.3%

28.6%

LAC-7 is the simple sum of the seven major Latin American countries, namely Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. These countries represent 91% of Latin America’s GDP.

SovereignSovereign Bonds: IssuanceBonds: Issuance(LAC-7, billions of USD)

56.6

97.8

40

50

60

70

80

90

100

Ma

r-0

7

Jun-

07

Sep

-07

Dec

-07

Ma

r-0

8

Jun-

08

Sep

-08

Dec

-08

Ma

r-0

9

External Factors: International Financial Conditions


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