Eduardo Cavallo & Alejandro Izquierdo IADB

1. POLICY RESPONSES TO SUDDEN STOPS: INITIAL CONDITIONS AND POLICY CHOICES Eduardo Cavallo & Alejandro Izquierdo IADB XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries October 17, 2007

2. Macroeconomic Vulnerability: Twin Deficits Fiscal Balance External Position Int. Reserves Overall Balance* Current Account % of GDP, last 4 quarters % of GDP, last 4 quarters % of GDP, end of quarter 1998.II 1998.II 1998.II Argentina -1.2% -4.7% 7.7% Brazil -6.1%*** -3.6% 8.1% Chile 1.3% -6.5% 19.1% Colombia -3.0% -6.1% 8.7% Ecuador -4.6% 8.0% -3.0%** Mexico 0.7%*** -5.8%*** 6.2%*** Peru -1.2% -6.9% 17.6% Uruguay -0.9% -1.8% 10.4% Average -1.9% -4.8% 10.8% * Fiscal Accounts Definitions.Argentina: National Administration, Public Enterprises and Other Public Entities; Brazil: General Government; Chile: Central Government; Colombia: National Central Government and Non Financial Public Entities; Ecuador: Central Government, Public Entities and Non Financial Public Enterprises Mexico: Federal Government, Public Entities and Public Enterprises; Peru: Central Government; Uruguay: Non Financial Public Sector and Central Bank Venezuela: Central Government; ** 1997.IV Data; *** 1993. IV Data

3. The Sudden Stop Specter:Domestic Liability Dollarization (DLD and Net DLD) • Sudden Stop brings about substantial change in relative prices (Calvo, Izquierdo and Talvi, 2003) • DLD as share of GDP proxies for size of burden

4. The Sudden Stop Specter:Balance-Sheet Effect and Drops in Output • The outliers: Peru and Mexico

5. Without US Mega-Package? • PER The Sudden Stop Specter: Balance-Sheet Effect and Drops in Output • Netting out Reserves

6. The Sudden Stop Specter: Balance-Sheet Effect and Drops in Output Banking Crises • Standstill in payments system and output collapse

7. Restrictions on Monetary Policy:DLD and Fear of Floating • 3and DLD: Reason to believe floating fears were correct?

8. Temporary or Persistent Financial Drought? Vodka was Stronger than Tequila in LAC(Net private capital flows, US$ billion) 75 70 65 60 55 50 45 40 Tequila Russia 35 T T+1 T+2 T+3 • Tequila crisis was short lived. Would it be the same for the Russian crisis?

9. What Policies Went Wrong Beyond Initial Conditions? Colombia Defense of the Exchange Band • Low DLD • Coming from a history of relatively high inflation (23.5% on average for period 1990:1-1998:7) • Sustaining ER regime with high interest rates (as high as 31% in real terms) • Inflationary concerns (relatively high 1 – inflation as low as 8.2% in 1999) • High ex-post real interest rates led to banking crisis (particularly mortgages) 2100 60 50 1900 40 1700 30 20 1500 10 1300 0 M3 1998 M7 1998 M9 1998 M1 1999 M7 1999 M9 1999 M1 1998 M5 1998 M3 1999 M5 1999 M11 1998 M11 1999 Nominal Exchange Rate Inter-bank Rate

10. What Policies Went Wrong Beyond Initial Conditions? Argentina • High DLD and closed economy • Temporary or persistent shock? • High liquidity buffers, but large vulnerability to balance sheet effects under SS (both private and public) • Expected RER depreciation indicated fiscal insolvency (politically feasible flow adjustments would not offset expected stock effect) • Interpretation of a need for liquidity expansion in a context of insolvency (particularly after “mega-exchange”) accelerated collapse • Step devaluation in 2002 was inconsistent with banking crisis resolution, wreaking havoc over monetary aggregates

11. What Policies Went Wrong Beyond Initial Conditions? Uruguay • High DLD and closed economy • Large trade and financial links to Argentina (68% of dollar deposits held by foreigners) • Temporary vs. persistent shock dilemma and liquidity vs. balance-sheet effects • After easening in 1999, fiscal tightening in 2000-01. A loosing battle when solvency effects kick in: interest rate increases offset other savings (deficit of 4.4% of GDP by 2001) Haircuts on External Debt (%) NPV Def. Conventional Argentina 72.9 67 Ecuador 27.4 60 Uruguay 12.9 26.2 Source: Sturzenegger and Zettelmeyer (2005) • After bank run, intervention of domestic banking system, leaving foreign banks untouched (no “pesification”) • Banking crisis resolution supported by external package. Nevertheless, collapse of GDP similar to that of Argentina. • Counterfactual: Collapse would have been bigger if crisis resolution had been different (real effects from Argentina: 8% of GDP) • Excessive debt: No room for fiscal policy

12. Macroeconomic Vulnerabilities: Then and Now Fiscal Balance External Position International Reserves Overall Balance* Current Account % of GDP, last 4 quarters % of GDP, last 4 quarters % of GDP, end of quarter % of M2**, end of quarter 1998.II 2006.IV 1998.II 2007.I 1998.II 2007.I 1998.II 2007.I Argentina -1.2% 1.8% -4.7% 3.5% 7.7% 16.6% 27.6% 54.4% Brazil -6.1%*** -3.1% -3.6% 1.2% 8.1% 9.9% 22.5% 16.0% Chile 1.3% 7.8% -6.5% 4.8% 19.1% 10.3% 43.0% 19.7% Colombia -3.0% -0.5% -6.1% -2.8% 8.7% 13.5% 29.1% 47.0% Ecuador -4.6% 3.3% -3.0%*** 1.9% 8.0% 5.2% 35.2% 21.7% Mexico 0.7%**** 0.1% -5.8%**** -0.6% 6.2%**** 8.2% 21.4%**** 29.7% Peru -1.2% 1.3% -6.9% 2.8% 17.6% 19.0% 62.9% 67.6% Uruguay -0.9% -1.0% -1.8% -1.8% 10.4% 17.3% 26.5% 34.5% Average -1.9% 1.2% -4.8% 1.1% 10.8% 12.5% 33.5% 36.3% * Fiscal Accounts Definitions.Argentina: National Administration, Public Enterprises and Other Public Entities; Brazil: General Government; Chile: Central Government; Colombia: National Central Government and Non Financial Public Entities; Ecuador: Central Government, Public Entities and Non Financial Public Enterprises Mexico: Federal Government, Public Entities and Public Enterprises; Peru: Central Government; Uruguay: Non Financial Public Sector and Central Bank Venezuela: Central Government; ** M2 = Currency outside banks + demand deposits + time, savings and foreign currency deposits of resident sectors *** 1997.IV Data; **** 1993. IV Data

13. Conclusions • Keep dollarization specter away (on net terms) • Use your instruments: Inflation concerns should not dominate during Sudden Stop when instruments are available and DLD is not at play • Be on the lookout for changes in international cycles, not just domestic cycles • Contingent monetary policies? • Public sector should be part of the solution, not part of the problem • Banking crisis resolution consistent with monetary policy is a must

14. POLICY RESPONSES TO SUDDEN STOPS: INITIAL CONDITIONS AND POLICY CHOICES Eduardo Cavallo & Alejandro Izquierdo IADB XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries October 17, 2007