1. Luis Servén The World Bank Barcelona March 2006 Growth and welfare effects of macroeconomic volatility

2. Growth and welfare effects Why do we care about volatility in LDCs ? Two sources of welfare cost: 1 – The direct cost of consumption volatility. 2 – The indirect cost via reduced output growth and future consumption levels Volatility as a source of poverty traps: poor individuals / countries choose low-risk / low- return activities and stay poor (Azariadis).

3. Output volatility and consumption volatility

4. Why are LDCs more volatile ? Three broad ingredients: External shocks – often bigger in LDCs (e.g., terms of trade) Domestic shocks – e.g., fiscal policy volatility (higher in LDCs) [Fatás – Mihov] Weaker “shock absorbers” – especially financial – part of the problem rather than the solution: Shallow domestic financial systems Weak international financial links Both limit risk sharing / smoothing of shocks Pro-cyclical macro policies that amplify fluctuations

6. Source: Montiel and Serven (2005) Fiscal volatility

7. Bigger external shocks + macro policy shocks + lower financial development -- each accounts for about 1/3 of “excess volatility” of LAC over OECD (WB 2001) More recent emphasis on micro-policies for shock absorption: microeconomic regulation (higher in LDCs) may hamper the reallocation of resources following shocks Empirically, evidence that tighter regulation (product, labor) may raise aggregate volatility [Loayza et al] – likely the opposite of what regulation intended ! Why are LDCs more volatile ?

8. Micro regulation and macro volatility Source: Loayza, Oviedo and Serv é n 2005

9. Volatility and crises Some evidence that “crisis volatility” [extreme adverse realizations] has become more important in LDCs: High incidence of extreme events in the 1990s (growth collapses, sudden stops, banking crises…) Both consumption and output growth display higher skewness in the 1990s than before Crisis volatility accounts for a rising portion of overall volatility (which has itself declined)

10. Source: Montiel and Serven (2005) Normal and extreme GDP growth volatility (percent of total volatility, average of 77 LDCs)

11. Source: Montiel and Serven (2005) Exchange rate collapses (% of LDCs undergoing a Frankel-Rose exchange rate crisis)

12. Source: Montiel and Serven (2005)

13. Sudden stops (% of LDCs undergoing a sudden stop)

14. Banking crises (number of LDCs undergoing a systemic crisis)

15. Volatility and crises Empirically, extreme volatility more harmful for growth than “normal” volatility [Hnatkovska / Loayza] “Threshold effects”: volatility hampers growth only when large enough. Aggregate volatility-investment link negative only for high levels of volatility Large adverse shocks more likely to make liquidity constraints binding (and prevent restructuring) Deep recessions more likely to lead to asset destruction

16. Volatility and crises Crises often the result of domestic policies / rigidities magnifying external shocks [e.g., Argentina] Some major crises of the 1990s [Gen 3] unlike those of the 1980s: multiple equilibria under financial fragilities – e.g., currency or time mismatches making banks and firms vulnerable to BoP runs and RER collapses Emphasis on “crisis-proofing”: reducing fragilities and increasing flexibility

17. Managing macro volatility A strategy with several components: Reduce domestic policy-induced macro volatility – e.g., fiscal volatility: fiscal institutions / rules [“Fiscal Responsibility Laws”] Strengthen shock absorbers: Countercyclical policies [e.g., Chile] Reduce financial fragility by limiting mismatches – in banks’ portfolios as well as their borrowers’ Move away from rigid exchange rate regimes Enhance micro-flexibility – along with safety nets – to adjust to shocks

18. Source: Montiel and Serven (2005) Fiscal procyclicality (procyclicality of public consumption, 15-year rolling windows, group medians)

19. Managing macro volatility …but after achieving all this still need to deal with external shocks. Three general options (Ehrlich-Becker): 1. Self-protection: lower exposure to risk (e.g., by limiting specialization, “precautionary recessions”) 2. Self-insurance: transfer resources across time (e.g., commodity stabilization funds, foreign reserve accumulation) 3. Insurance / hedging: transfer resources across states of the world

20. Managing macro volatility Three options for dealing with external shocks: In practice, few instruments to achieve # 3, so countries resort to # 1-2

21. $ billion Developing-country foreign exchange reserves

22. Reserves as months of imports Developing-country foreign exchange reserves

24. Managing macro volatility Holding massive stocks of cash involves a huge cost in terms of growth and consumption. Big payoff to the development of new instruments to hedge aggregate volatility ex- ante – bigger than to developing ex-post crisis resolution mechanisms Even imperfect hedging by trading instruments linked to world financial indicators (high yield spread, commodity prices…) can be a big help (Caballero-Panageas 2005)

25. Sudden stops: Self-insurance vs hedging Source: Caballero and Panageas 2005

26. Managing macro volatility Why so few hedging instruments ? Moral hazard (e.g., in GDP-linked securities) Coordination problems in creating new markets Potential role for IFIs: A basic step: countercyclical lending (and aid stability) More lending in local currency – remove RER risk Room for contingent credit lines ? Lead the creation and trading of new financial instruments for hedging

27. End

28. Domestic vs foreign factors Across LDCs (unlike OECD), gov size not related negatively to volatility – gov is source of shocks (Suescún) Fatas-Mihov: (discretionary) fiscal volatility reduces LR growth [fiscal volatility is driven by political constraints] Pro-cyclicality not driven by political constraints (but seems to matter less than volatility)

29. Source: Loayza, Oviedo and Serv é n 2005 Micro regulation and macro volatility

30. Source: Loayza, Oviedo and Serv é n 2005