Dealing with an Credit Crunch: Past Lessons, New Challenges Eduardo A. Cavallo Inter-American Development Bank (IDB) Reforming the Bretton Woods Institutions, Copenhagen, September 2009

Outline  Lessons from past financial crisis: the experience of LAC.  Applying the past to the present.

Lessons Learned  IDB (2009) analyses policy responses to sudden stops episodes of the late 1990s for 8 LAC countries, bringing in also cross-country analysis. 1) Expansionary fiscal and monetary policy that does not affect credibility or solvency can reduce output collapse in the aftermath of a sudden stop. However countries need to be able to afford these policies. 2) Initial conditions matter. 3) Initial conditions are not destiny. 4) The persistence of the shock is key. 5) External financial packages are essential when initial conditions do not help.

1) Expansionary Policies can Help Observed Fiscal Impulse % PBI Structural Fiscal Impulse % PBI  Characterizing expansionary fiscal policy Source: Ortiz, Ottonello, Sturzenegger and Talvi (Chapter 2)

1) Expansionary Policies can Help  Monetary Policy Dilemmas and Taylor Rules.  Conjecture: in Emerging Markets’ prone to financial crises, Central Banks care about:  Inflation  Output Gap  Nominal Exchange Rate (“original sin” & “fear of floating”)  Anatomy of financial crises in Emerging Markets.

1) Expansionary Policies can Help 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)

2) Initial conditions matter  Stringent preconditions need to be met in order to afford policy flexibility:  Fiscal Policy: fiscal policy rules that guarantee inter- temporal consistency; maintaining low levels of public debt.  Monetary policy: maintaining low levels of financial and debt dollarization; high degree of credibility in the policy framework; trade openness in a context of open capital markets.  Evidence shows that those that were better prepared did better during the crisis.

3) Initial Conditions are not Destiny Domestic Liability Dollarization: Selected LAC Countries  Peru’s policy of reserve accumulation and disbursement 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 Destiny  Brazil: selective use of international reserves to finance trade credit.  Chile: the capacity to switch gears without generating a crisis.  Colombia: fear of floating Colombia

4) Shock Persistence is Key  Vodka is stronger than Tequila

5) External financial packages are essential when initial conditions do not help.  Mexico 1994: $51 billion IMF/USA rescue package. Mexico 1994 Mexico 1994  2.8 times the total stock of short-term US$ debt by December  Argentina 2001/2002.  There is reason to believe that with international support, the restructuring process could have been much more orderly.

The Great Crisis of 2008/2009  ¿What is different this time around?  The epicenter of the crisis: center vs. perifery.  Countries in the LAC region appear to be better prepared. But: will it be enough?  This time around, the initial response of countries in the region has been strongly countercyclical, just like in the developed world. strongly countercyclicalstrongly countercyclical  But unlike the developed world, LAC is not a safe haven for global savings that can provide billions of dollars to pump into a stimulus package.  Precarious market access. Precarious market access Precarious market access

Ernesto Talvi, CERES Alejandro Izquierdo, IDB Coordinators

Outlook for LAC in the context of the crisis  It makes all the difference if the world economy reaches its pre-crisis levels of industrial production in 2010 or in  This scenario could trigger a liquidity crisis in quite a few countries. If a country does not have sufficient international reserves to cover the debt service, it could generate a stampede by everyone who believes that the reserves are not going to be there when needed.

The Role of Multilaterals  Precarious access to credit markets for many emerging market governments calls for multilaterals to step in and play a key role as a lenders (and borrowers)-of-last resort, akin to the role that credible governments, such as the US government, play domestically.  The question then is not whether multilaterals should play a key role in the current crisis, but which is the most effective way to channel their intervention and at what financial cost.

Policy Principles  Strengthen the role of multilateral institutions. Multilateral support will be vital under precarious access to credit markets.  Move away from short-term financing. Multilaterals should avoid short-term emergency financing and only consider medium to long-term financing in order to partially “complete” markets in terms of maturities.

Policy Principles (cont.)  Redefine the emphasis of multilateral support. Multilaterals should not only provide medium to long-term financing for fiscal stimulus –when fiscal sustainability is not at stake– but more importantly, they should provide for long-term refinancing of maturing debt obligations.  Ensure that countries work towards sustainable fiscal policy while strengthening social protection. Multilateral support should be complemented with incentive-compatible conditionality, to ensure fiscal sustainability and strengthen social protection.

ILR Dynamics Under Alternative Policies (LAC-7, L-Shaped Scenario, ILR 2 ) 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 and Venezuela. These countries represent 91% of Latin America’s GDP. ILR 2 t = Reserves t / (Public Debt Amortizations t+1 + Short Term Private External Debt Amortizations) 75% 80% 85% 90% 95% 100% 105% 110% 115% 120% 125% Refinancing Public Debt Stocks vs. Financing Fiscal Deficits Source: IDB (2009) Policy-trade-off for Unprecedented Times: Confronting the Global Crisis in LAC. A. Izquierdo and E. Talvi, coordinators.

Concluding Remarks  A strategy by the IMF and multilaterals that only pays attention to financing countercyclical fiscal policies is incomplete and ignoring the impact of expansionary policy on liquidity ratios can be a costly mistake.  It is necessary that lender (and borrower)-of- last-resort functions, similar to those that governments perform in developed economies, be recreated for LAC by multilateral institutions, so that liquidity concerns are kept at bay.

Concluding Remarks  Recent responses:  IMF´s Flexible Credit Line  IDB´s Growth Facility

Thank You

2) Initial Conditions Matter ?

Fiscal Position Under Two Hypotheses on the Global Economy: Are Debt Dynamics Sustainable? Fiscal Balance (LAC-7, % of GDP) -6% -5% -4% -3% -2% -1% 0% 1% 2% V-Shaped Scenario L-Shaped Scenario 1.6% -2.6% -5.0% 0.3% -3.7% Public Debt (LAC-7, % of GDP) 23% 28% 33% 38% 43% 48% 53% V-Shaped Scenario L-Shaped Scenario 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. Source: IDB (2009) Policy-trade-off for Unprecedented Times: Confronting the Global Crisis in LAC. A. Izquierdo and E. Talvi, coordinators.

Latin America: Monetary and Fiscal Policy Response Monetary Policy Interest Rate Exchange Rate 8.5% 8.7% 8.9% 9.1% 9.3% 9.5% 9.7% 9.9% Sep-08Oct-08Nov-08Dec-08Jan-09Feb (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 ON - BUDGET OFF – BUDGET TOTAL Revenue-sideExpenditure-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 Source: IDB (2009) Policy-trade-off for Unprecedented Times: Confronting the Global Crisis in LAC. A. Izquierdo and E. Talvi, coordinators.

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-98Aug-98Sep Interest Rate Exchange Rate Interest RateExchange Rate Monetary Policy (LAC-7*, Interbank Interest Rate and Nominal Exchange Rate, in % and Jul-98=100) Source: IDB (2009) Policy-trade-off for Unprecedented Times: Confronting the Global Crisis in LAC. A. Izquierdo and E. Talvi, coordinators.

Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 Corporate 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 Jan Mar Corporate Bonds: Issuance (LAC-7, billions of USD) Mar-07 Jun-07 Sep-07Dec-07 Mar-08 Jun-08 Sep-08Dec-08 Mar Source: IDB (2009) Policy-trade-off for Unprecedented Times: Confronting the Global Crisis in LAC. A. Izquierdo and E. Talvi, coordinators.

Sovereign 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 % 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. External Factors: International Financial Conditions Source: IDB (2009) Policy-trade-off for Unprecedented Times: Confronting the Global Crisis in LAC. A. Izquierdo and E. Talvi, coordinators.