Policy Responses to Sudden Stops in Capital Flows: The Case of Chile in 1998 Rodrigo Valdés Central Bank of Chile

2 Motivation: Why Chile 1998? Chile confronted a large “sudden stop”: –Net capital inflows were equivalent to 7% of GDP in the year ending in 98Q1 and dropped to less than 1% of GDP in 99Q1. In comparison to other episodes, with financial sector meltdown and a deep recession, this case could be considered a successful one: mild recession. In many Chileans’ minds, strong doubts remain on the efficiency of the adjustment.

3 The paper: Revisits the 1998 Chilean episode, underpinning the following: 1.The policy framework and initial conditions; 2.Shocks; 3.Immediate policy responses and macro adjustment; 4.Subsequent overhaul of the policy framework; 5.The Chilean case in perspective; 6.Some lessons

1.Policy Framework and Initial Conditions

5 Macro policy framework-key components before the episode: An independent CB in transition to price stability: –Annual inflation targets; –XR target band with PPP adjustments; –Capital account regulations. Orderly managed fiscal policy: –Public debt declined from 38% of GDP in 1989 to 5% in 1997; –Most of external debt was private. Strong financial institutions –Well regulated and supervised banks.

6 Cyclical conditions in 1997: Against a backdrop of very strong GDP growth (7.7% in ), signs of overheating in included: –Current account deficit above 4% of GDP; –Marked FX appreciation, with signs of misalignment, despite heavy intervention; –Increasing core inflation in The economy’s overheating was a public policy issue: –Special commission to design ways to foster savings; –Strong discussion on role of fiscal policy (surplus 2% in 97); –Extra provisions for consumer credit.

2. Shocks

8 In late 1997, ToT dropped suddenly and threatened to increase the CA deficit… Unit Price of Exports in US Dollars in Real Time 1997Q2-1999Q2 (% annual change)

9 …while domestic demand remained strong and fiscal accounts weakened. Current Account Deficit in Real Time (cumulative four quarters, US$ million)

10 External financing was expensive, but gross outflows dominated dynamics. Changes in Gross Assets and Liabilities (Transactions) (cumulative four quarters US$ millions)

3. Immediate policy responses: Restrictions and effects

12 Policy objectives and restrictions: Central objective: cool down the economy: –Diagnosis: It would happen anyway, either through domestic policy or market-induced. –Market induced more costly (fear of “sudden stop”). Restrictions: –Limit nominal depreciation: Short-term inflation target and imperfect credibility; Large perceived XR pass-trough; Fear of balance sheet effects due to perceived mismatches. –Political constraints to implement fiscal policy.

13 Non sterilized FX intervention and tight monetary policy… Monetary Policy and Interbank Overnight Interest Rate in 1998 (% + UF) Fiscal Adjustment Announcements: Jan. 19th Mar. 21st Jun. 25th

14 “Commitment technology” increased rigidities and vulnerability. Exchange Rate Target Band (pesos per US dollar)

15 CA Adjustment: absorption contracted strongly with little demand switching… RER depreciated only in late 1999; Share of tradable goods stable in value added; Stable contribution of exports to GDP growth. Domestic Demand and Exports’ Contributions to GDP Growth (%) Tradable Goods Participation in Value Added (%)

16 Policy effects and adjustment. Financial market calmed down after CB policy actions. Fiscal policy announcements had no evident effect on financial markets. Real- time “opinions” were mixed/negative. Credit followed a very pro-cyclical pattern. Banks’ indicators deteriorated, but remained in OK zone. Capital outflows in early 1999 driven by pension system (made possible by change in foreign investment limits). Large turnaround of macro policies in 1999, particularly fiscal.

4. Subsequent overhaul of the policy framework

18 Results led to deep changes in the macro policy framework in … XR floating regime; Deepening of XR hedging market; Full fledged inflation targeting; Fiscal policy rule based on structural target; Capital account liberalization; Nominalization of monetary policy; … which combined with a different cyclical position implied a very different policy mix after shocks.

5. The Chilean case in perspective

20 Among Sudden Stop episodes, Chile’s intensity is around average... Distribution of Shock Severity as % of Trade (kernel, 55 cases)

21 …but the policy response and outcome stand out in a few dimensions: Fairly good inflation performance; Average growth outcome; Not very intensive in FX reserve intervention; Rather mild RER depreciation; Rather high real interest rates.

6. Some Lessons

23 Among other things, the Chilean case shows the following: Financial system resilience and public finance (ex-ante) seem key to avoid meltdown and give room for aggressive macro management. With hindsight adjustment could have been more efficient (more RER less AD) –Some priors proved unfounded: low pass-through, low currency mismatches. –Other priors yet “untested”: (costly) market induced adjustment Policy framework too rigid: annual inflation target, XR band…

24 Among other things, the Chilean case shows the following: Potentially large costs of interest rate spikes (liquidity crunches). Implementing “macho” credibility can be self-defeating (Europe ’92). Private sector AD responds to fundamentals. Although the counterfactuals are unknown, fiscal policy announcements apparently did not buy much credibility. Outflows were a key element behind the story limiting applicability to other EMEs.

Policy Responses to Sudden Stops in Capital Flows: The Case of Chile in 1998 Rodrigo Valdés Central Bank of Chile

26 …but relatively stronger drop in import- intensive demand components. Contributions to Domestic Demand Growth (%)

27 Major drop in GDP growth was largely unexpected (as was CA adjustment…) Expected and Actual GDP Growth (cumulative four quarters, % annual change)