SUDDEN STOPS, THE REAL EXCHANGE RATE AND FISCAL SUSTAINABILITY: ARGENTINA’S LESSONS Guillermo Calvo, Alejandro Izquierdo and Ernesto Talvi and Ernesto Talvi Policy Seminar June 6, 2002 Research Department

OUTLINE I. Life after Russia: A Hemispheric Perspective I. Life after Russia: A Hemispheric Perspective IV.Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases

Jan-97 May-97 Sep-97 Jan-98 May-98 Sep-98 Jan-99 May-99 Sep-99 Jan-00 May-00 Sep-00 Jan-01 May-01 Sep-01 Jan-02 Pre-Asian Crisis Pre- Russian Crisis Pre- Argentine Crisis Current level 524 bp External Financial Conditions (LEI, Spread over US Treasuries)

TT+1T+2T+3 TequilaRussia Vodka is Stronger than Tequila in LAC (Net private capital flows, US$ billions)

Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela Sudden Stop in LAC-7 (Capital flows and CA, 4 quarters, % of GDP) Capital flows Current Account

Current Account Adjustment ARGBRACHLCOLECU Source: World Economic Outlook (IMF), April Current Account Balance, US$ billions

:21998:22000:22001:2 Trend Growth in LAC-7 (Annual growth based on quarterly data, 1997.II=100) Includes: Argentina, Brazil, Chile, Colombia, México, Perú, Venezuela

OUTLINE I. Life after Russia: A Hemispheric Perspective I. Life after Russia: A Hemispheric Perspective IV.Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases

CAD = A * + S * - Y * = current account deficit A * = tradables absorption; Y * = tradables output S * = non-factor payments (interest on external debt)  After Sudden Stop, percentage fall in tradables:  = CAD/A * = 1 -   = CAD/A * = 1 -   = (Y * - S * )/A * = un-leveraged absorption ratio  Under homotheticity,  applies to home goods, too. The Sudden Stop Effect on Demand

Sudden Stop and Equilibrium RER p hshs p*p* p ** h SS P = P NT /P T

BRAARGECUCOLCHL Source: World Economic Outlook (IMF), and own estimates. Note: This measure is calculated in 1998 for all countries. Un-leveraged Absorption Coefficient ( w ) BRAARGECUCOLCHL Required % Change in Equilibrium RER Un-Leveraged Absorption RER Adjustment

ARGECUCOLBRACHL B/e B* Y/e Y* (B/e B*)/(Y/e Y*) Source: Own estimates. Note: Values are given for Mismatch Measure Public Debt: Dollarization and Mismatches

Fiscal Sustainability after a 50% RER Depreciation ARGBRACHLCOLECU (a) Base Exercise Observed Public Debt (% of GDP) Real Interest Rate Real GDP Growth Observed Primary Surplus (% of GDP) i. Req. Primary Surplus (% of GDP)1.21.9n.a (b) Change in Relative Prices Imputed Public Debt (% of GDP) ii. Req. Primary Surplus (% of GDP)1.62.2n.a NPV of ii - i (% of GDP) n.a Corresponding Debt Reduction (%) n.a ii - i (% of Government Expenditures)2.31.0n.a Source: Own estimates. Note: Values are given for n.a.: Not applicable given that the real interest is smaller than the growth of GDP.

OUTLINE I. Life after Russia: A Hemispheric Perspective I. Life after Russia: A Hemispheric Perspective IV.Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases

-2% -1% 0% 1% 2% 3% 4% 1998-I 1998-II 1998-III 1998-IV 1999-I 1999-II 1999-III 1999-V 2000-I 2000-II 2000-III 2000-IV 2001-I 2001-II Argentina -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% Chile Argentina Chile Sudden Stop in Argentina and Chile (Private Capital flows, % of GDP)

External Adjustment (Current Account, 4 quarters, %GDP) Argentina Chile

Economic Activity: GDP and Investment (s.a., 1998.II=100) Chile Argentina Chile Argentina GDPInvestment

Real Exchange Rate (Vis à vis the US dollar, June 1998=100) Chile Argentina “Empalme” factor

The Contribution of Exports to the Current Account Adjustment (In %, 2001.III-1998.II) 52.6% 16.3%

Sudden Stop and the Real Exchange Rate Un-leveraged Absorption (  ) Required % change in RER to eliminate the CAD ChileArgentina ChileArgentina Source: Calvo, Izquierdo, Talvi (2002)

Key Points: Chile Chile recovered without international financial support and in spite of a very weak recovery in capital inflows due to its: relative openness relative openness low levels of CAD leverage low levels of CAD leverage low levels of public debt low levels of public debt low degree of financial mismatches in the public and the financial sector low degree of financial mismatches in the public and the financial sector which allowed for a very rapid increase in exports that financed one half of the current account adjustment and prevented the real exchange rate depreciation from having adverse balance sheet effects.

An Example: Fiscal Sustainability in Argentina after a Sudden Stop in 1998 Debt to GDP ratio (%) Req. Prim. Surplus Adjust. (a) Baseline (b) Change in Relative Prices to close the CA deficit (RER depreciation of 46,2%) (c): (b) BPS Increase in Real Interest Rate (d): (c) + 1% Reduction in GDP growth (e): (d) + Contingent Liabilities Source: Calvo, Izquierdo, Talvi (2002) Note: The observed primary surplus for 1998 was 0.9 percent of GDP. The baseline scenario assumes a long run rate of growth of 3,8% and a 7,1% interest rate NPV of Req. Adjust. (% of GDP)

Key Points: Argentina Argentina’s lack of recovery and eventual collapse, occurred in spite of large international financial assistance packages and was due to the fact that:  Argentina had it all: a closed economy, high levels of external indebtedness and public debt, high liability dollarization and, as a result, large financial mismatches both in the public and private sector.  Under those conditions, the change in the equilibrium RER needed to accommodate a permanent sudden stop was large.  The expectation of a large real depreciation in turn, led to a large revaluation of public sector debt relative to GDP (requiring a larger fiscal effort and/or a larger debt reduction to achieve fiscal sustainability) and to a deterioration of corporate balance sheets (contingent liabilities?). The proposed fiscal adjustments were clearly insufficient for a substantially higher RER.

Key Points: Argentina (ctd.)  The deterioration of public and private sector balance sheets deteriorated the quality of bank assets and led to a run on banks due to the fear that those losses might be partially financed by confiscating depositors.  The run against banks was accommodated by credit expansion of the CB, leading to a collapse in international reserves and an acceleration of the run on banks.

Argentina: Political Economy after the Sudden Stop Why was adjustment so hard to materialize? Why was adjustment so hard to materialize? The fact that Argentina had a fixed exchange rate and relatively sticky prices concealed the needed adjustment in relative prices. The fact that Argentina had a fixed exchange rate and relatively sticky prices concealed the needed adjustment in relative prices. This provided little evidence for politicians about the need for adjustment. This provided little evidence for politicians about the need for adjustment. Uncertainty about the duration of the standstill in capital flows and the size of RER adjustment may be one of the elements that delayed reform. Uncertainty about the duration of the standstill in capital flows and the size of RER adjustment may be one of the elements that delayed reform. Uncertainty about how the losses of RER realignment would be distributed also contributed to delays in reform Uncertainty about how the losses of RER realignment would be distributed also contributed to delays in reform

Argentina: Policies were not Enough Fiscal: Fiscal adjustment in 2000, attempted (failed) additional adjustment in early 2001, zero-deficit law on second half of 2001, but it was already too late. Fiscal: Fiscal adjustment in 2000, attempted (failed) additional adjustment in early 2001, zero-deficit law on second half of 2001, but it was already too late. Exchange Rate: Convergence factor, though in the right direction, introduced uncertainty about prevailing convertibility rules. Exchange Rate: Convergence factor, though in the right direction, introduced uncertainty about prevailing convertibility rules. Debt Management: Debt swap in mid 2001 validated extremely high interest rates, further worsening solvency, perhaps under assumption of liquidity problems. Debt Management: Debt swap in mid 2001 validated extremely high interest rates, further worsening solvency, perhaps under assumption of liquidity problems. Monetary: Expansionary monetary stance and public bank bailout led to high credit expansion and loss of reserves. Monetary: Expansionary monetary stance and public bank bailout led to high credit expansion and loss of reserves.

Ene-01 Jul-01 Ene-02 Million Pesos -1, ,000 2,000 3,000 4,000 5,000 6,000 7,000 Million Pesos Central Bank Policy Source: BCRA. Net Domestic Credit International Reserves Monetary Liabilities Cavallo is appointed

OUTLINE I. Life after Russia: A Hemispheric Perspective I. Life after Russia: A Hemispheric Perspective IV.Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases

Exchange Rate Defense and Abandonment  Countries tried initially to hold to their bands, but were not successful given magnitude of RER adjustment needed.  Markets held expectations that the nominal exchange rate would be used to make the RER adjustment needed  This was reflected in very high interest rates and a substantial loss of reserves.  Why wait? The public sector was not heavily dollarized (except Ecuador and Argentina), but the private sector may have been. Time to hedge?  Exit Strategy: Flotation with IT in most cases. Why?

Exchange Rate Defense and Abandonment BRACHLCOLECU Regime Pre Sudden Stop Target Zone: Width +/- 4% Crawling Band Rate of Crawl: To preserve PPP Width: +/- 5% Crawling Band Rate of Crawl: To preserve PPP Width: +/- 7% Crawling Band Rate of Crawl: To preserve PPP Width: +/- 5% Modifications After Sudden Stop Jan 1999: Width increased to +/-5% Dec 1998: Width increased to +/-8% with an increasing factor of 0.41% per month. Sep 1998: Realignment of the Band. Jun 1999: Second Realignment and width increased to +/- 10% Mar 1998: Realignment and width increased to +/-10%. Sep 1998: Rate of crawl increased to 20% and width increased to +/-15% Floatation Date Jan-99Sep-99 Feb-99 Change in Reserves$US(Billions) /a Change in Reserves% /a -49.1%-12.9%-23.5%-24.4% a/ Between end of first quarter 1998 and the date of float. Source: IMF "Exchange Arrangements and Exchange Restrictions”(various issues) and IFS.

BRACHLCOLECU Note: First table reports the difference between the peak interest rate during the period (before floating) and average figure for quarter previous to sudden stop. Source: IFS (IMF). Increase in Deposit Rates (Basis Points) Defense: Interest Rates and Reserves Defense: Interest Rates and Reserves BRACHLCOLECU Fall in Reserves (Percent)

ARGBRACHLCOLECU Dollar Loans/Total Loans (%) Tradable Production/ Total Production (%) 1/ Source: Central Banks. 1/ Proxied by exports. Financial Mismatches, June 1998 Banking Sector: Dollarization and Mismatches

Valuation Effects and Choice of an Exchange Rate Regime  Closed, highly indebted, highly dollarized and mismatched economies are vulnerable to large RER swings and substantial valuation effects that may deem a country insolvent after a sudden stop.  Fiscal dominance is present: monetary policy is subordinated to fiscal insolvency.  Hypothesis: Countries that chose to float with IT were successful in cases where fiscal dominance was absent and monetary policy became credible.

Two Polar Flotation Cases: Chile and Ecuador ChileEcuador Jan-98 Apr-98 Jul-98 Oct-98 Jan-99 Apr-99 Jul-99 Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct Jan-98 Mar-98 May-98 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00  Chile successfully brings down devaluation expectations after choice of new regime  Ecuador struggles: interest rates reach highest values at time of announcement of flotation, only fall after announcement of dollarization Float Dollarization

500 1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 Dec-98 Mar-99 Jun-99 Sep-99 Dec-99 Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 Jun-01 Sep-01 Dec-01 Ecuador: Dollarization is Not Enough (Sovereign Bond Spread) Default   Dollarization  Agreement EMBI+ EMBI+ Ecuador  Debt resolution and fiscal adjustment (primary surplus 2001: 5% of GDP)

ECU GDP Growth CHL Inflation CHL ECU vs vs vs vs 1998 CHL CHL ECU ECU Exports Change / Current Account Change, % Exports Change, % Two Polar Flotation Cases: Chile and Ecuador

OUTLINE I. Life after Russia: A Hemispheric Perspective I. Life after Russia: A Hemispheric Perspective IV.Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases

Policy Lessons: 1. Closed economies (C), with high public debt (D) and large financial mismatches (M), are vulnerable to changes in international conditions that require an adjustment in the current account deficit since they may require large changes in equilibrium RER. 2. Large changes in the RER, could turn a sustainable fiscal position into an unsustainable one and lead to major solvency problems. Solvency problems can lead to fiscal dominance, making monetary policy not credible. In those cases, flotation is a difficult task. 3. Countries like Brazil, Chile and Mexico are much less dollarized than Argentina and, therefore, have more leeway to use the exchange rate as an instrument. However, there are limits to exchange rate flexibility because all of them may find it difficult to issue debt other than in foreign currency or indexed to a foreign currency.

Policy Lessons (cont.) 4.CDM economies are vulnerable independently of the exchange rate regime that is adopted. 5.In CDM economies it is dangerous to have: a) High levels of public indebtedness. Rules that allow governments to reach lower debt levels or even a creditor position should be given serious consideration b) Banks with weak links to the international capital market. In particular, State-Owned banks should be subject to Narrow Banking rules or privatized 6.Exchange rate flexibility could play a useful role if the C, D or M are dropped. Otherwise, exchange rate flexibility might do more harm than good.

Policy Lessons (cont.) 7.In the short run, the C is hard to drop, and dropping D or M could be traumatic (as exemplified by Argentina’s default and pesification). 8. Solving a solvency crisis involves wealth redistributions across sectors. The way and the speed at which those redistributions are made are crucial in determining how fast a crisis gets resolved.

Research Department