Why are we obsessed with volatility and what have we done about it? Ugo Panizza Research Department Inter-American Development Bank

Volatility is costly It leads to lower growth Negative effect on productivity Low investment in both physical and human capital It increases inequality and poverty It leads to smaller financial systems In the absence of a well-working financial market, it leads to high volatility of consumption

Latin America is volatile

Why is Latin America volatile? Large external shocks Terms of trade Sudden Stops in capital flows Volatile macroeconomic policies Monetary Policy Fiscal Policy Exchange Rate Policy Political shocks

What can we do to reduce volatility? The 1995 Approach DOMESTIC POLICIES CAN DO THE TRICK!!! Policies aimed at reducing terms of trade risk Export diversification Stabilization funds Policies aimed at reducing fiscal volatility Budget institutions Good debt management Policies aimed at reducing excessive exchange rate volatility and misalignments Managed floating

What can we do to reduce volatility? Lessons from the crises The Asian and Russian crises of the late 1990s spread shockwaves throughout the whole emerging world, also affecting countries characterized by good policies It became clear that good policies and institutions are NECESSARY but not SUFFICIENT conditions for isolating EM from external shocks

What can we do to reduce volatility? Lessons from the crises Efforts to understanding the effects of the Asian and Russian crises and developing mechanisms to reduce volatility gave rise to two new complementary areas of research The role of currency denomination of external debt (ORIGINAL SIN) The role of SUDDEN STOPS in capital flows

What can we do to reduce volatility? Lessons from the crises Research showed that these problems are partly due to the way in which the international capital markets work Hence, they cannot be fully addressed with domestic policies This led to proposals aimed at addressing what Calvo (2002) called GLOBALIZATION HAZARDS

What can we do to reduce volatility? Lessons from the crises Emerging Markets Fund aimed at limiting contagion and generalized Sudden Stops in capital flows (Calvo, 2002) Emerging Markets Index and IFI issues in EM currencies aimed at creating new markets and achieving redemption from Original Sin (Eichengreen and Hausmann, 2004)

Why are we obsessed with volatility and what have we done about it? Ugo Panizza Research Department Inter-American Development Bank