1. Euro-Latin Network: The Macroeconomics Agenda Guillermo A. Calvo October 9, 2002

2. The Issues zMoral vs. Globalization Hazard zSudden stops in capital flows: zFactors that contribute to vulnerability zImplications in terms of real exchange rate adjustment zValuation effects on fiscal sustainability and financial crises? zDollarization: z Additional vulnerability? zConvergence or escape from domestic currencies? zCan it be reversed?

3. The Issues (c’td) zBanking: zUniversal or Narrow Banking? zIndexation in banking system and the choice of exchange rate regime. zPublic debt management: zOptimal currency composition? zIndexation mechanisms? zInflation targeting: zEffectiveness in dollarized economies? zCredibility under large real exchange rate realignment following sudden stops?

4. MORAL AND GLOBALIZATION HAZARDS

5. Where The G7 Stand (?) zG7 appear to hold the view that throwing liquidity into BOP/financial crises is counterproductive zPontius Pilate’s Aproach to Crisis Prevention and Resolution: yAvoid BOP Crises: FLOAT xif applied to the domestic banking sector, this is equivalent to deposits being subject to floating, market-determined, prices. xproblem: Fear of Floating (Terror of Floating in Argentina) yDesign Chapter 11 for Sovereigns xIf applied to the domestic banking sector, this is equivalent to appealing to Chapter 11 even if banks are faced with a liquidity crisis. xproblem: sovereigns stop repaying well before they become technically insolvent. Thus, this issue is eminently political.

6. The Moral Hazard View zLarge bailouts starting with the Tequila $50 billion package, induced greater risk taking by governments and investors, zwhich increased the incidence of crises.

7. Moral Hazard: A Critique zCapital flows to EMs started to fall a year after Tequila zThe composition of flows shifted in favor of Foreign Direct Investment

8. Private Net Capital Flows Financial globalization starts  Tequila 

9. Foreign Direct Investment Financial globalization starts  Tequila 

10. Globalization Hazard View zSince 1989 capital flows to EMs increased at a very rapid rate, and also collapsed very sharply starting in 1996. zVolatility was high, and capital flow reversals reached record-high levels zCurrent account adjustments are much bigger in EMs than in Advanced Economies. zCrises could reflect institutional and informational features that apply especially to EMs.

11. KEY FEATURES OF EMs

12. SUDDEN STOP Reversal of Capital Inflows (% of GDP) Argentina 1982-8320 Ecuador 1995-9619 Mexico, 1981-8312 Korea 1996-9711 Thailand 1996-9726 Turkey 1993-9410 Country/Episode Source: Guillermo Calvo and Carmen Reinhart, (2000).

13. Fear of Floating: Probability of staying within narrow bands +/-1 % band p/m +/-2.5 % band p/m US$/DM (2/73-4/99) 26.8 58.7 Japan (2/73-4/99) 33.8 61.2 Bolivia (9/85-12/97) 72.8 93.9 Mexico (12/94-4/99) 34.6 63.5 Peru (8/90-4/99) 45.2 71.4 Uganda (1/92-4/99) 52.9 77.9 Source: Guillermo Calvo and Carmen Reinhart, “Fear of Floating,” QJE, (2002). Exchange Rate

14. Fear of Floating: Probability of staying within narrow bands +/-25 bps band p/m +/-50 bps band p/m US (2/73-4/99) 59.7 80.7 Japan (2/73-4/99) 67.9 86.4 Bolivia (9/85-12/97) 16.3 25.9 Mexico (12/94-4/99) 5.7 9.4 Peru (8/90-4/99) 24.8 32.3 Uganda (1/92-4/99) 11.6 32.6 Source: Guillermo Calvo and Carmen Reinhart, “Fear of Floating,” QJE, (2002). Nom. Interest Rate

15. Jan-01 Jul-01 Jan-02 Million Pesos -1,000 0 1,000 2,000 3,000 4,000 5,000 6,000 7,000 Million Pesos Cavallo Presses the Gas Pedal (Central Bank’s Balance Sheet) Net Domestic Credit Foreign Reserves Monetary Liabilities Cavallo is appointed Source: Central Bank of Argentina.

16. CAPITAL FLIGHT IN LATIN AMERICA?

17. LAC-7 Business Cycle: 1997-2002 (s.a. GDP, mean annualized quarterly growth rate) Includes: Argentina Brazil, Chile, Colombia, Mexico, Peru and Venezuela DecelerationRecessionRecovery Stalling -7% -5% -3% -1% 1% 3% 5% 7% 9% 1997.I 1997.III 1998.I 1998.III 1999.I 1999.III 2000.I 2000.III 2001. I 2001.III 2002.I

18. LAC-7 Capital Flows (4 quarters, millions of US dollars and % of GDP ) Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela 0 20.000 40.000 60.000 80.000 100.000 120.000 1997-I 1997-III 1998-I 1998-III 1999-I 1999-III 2000-I 2000-III 2001-I 2001-III 2002-I 0% 1% 2% 3% 4% 5% 6% % of GDP Millions of US dollars

19. LAC-7 Business Cycle and Capital Flows (GDP and Non FDI Capital Flows, last four quarters) -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% Mar-96Sep-96Mar-97Sep-97Mar-98Sep-98Mar-99Sep-99Mar-00Sep-00Mar-01Sep-01Mar-02 GDP (yoy % change) -4% -3% -2% -1% 0% 1% 2% Non FDI Capital Flows (% GDP) GDP Non FDI Capital Flows Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela

20. THE IMPACT OF SUDDEN STOPS

21. Sudden Stop 1998.II2001.IIIReversal Capital Flows5.61.6-4.0 Non-FDI Capital Flows2.0-0.9-2.9 FDI3.62.5-1.1 Note: Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Source: Corresponding Central Banks. Capital Flows, % of GDP

22. Equilibrium RER p hshs p*p* p ** p0p0 h real trade factors SS P = P NT /P T

23. Liability Dollarization ARGECUCOLBRACHL B/e B*0.080.020.591.761.30 Y/e Y*8.632.946.3612.342.85 (B/e B*)/(Y/e Y*)0.01 0.090.140.45 Source: Own estimates. Note: Values are given for 1998. Public Sector Debt Mismatch Measure

24. Sudden Stop and Fiscal Adjustment: Argentina 1998 Debt to GDP ratio (%) Req. Prim. Surplus Adjust. (a) Baseline36.50.3 (b) Change in Relative Prices to close the CA deficit (RER depreciation of 46,2%) 49.7 0.7 (c): (b) + 200 BPS Increase in Real Interest Rate 49.71.7 (d): (c) + 1% Reduction in GDP growth 49.72.2 (e): (d) + Contingent Liabilities58.62.7 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 9.3 22.6 32.8 35.6 44.5 NPV of Req. Adjust. (% of GDP)

25. Vulnerability to Sudden Stops zA small share of tradable goods output relative to domestic absorption of tradable goods zLiability dollarization, both in government and non-tradable sectors zHigh initial public debt, denominated in foreign currency zBank assets concentrated on government bonds and dollar credit to non-tradable sectors.

26. POLICY ISSUES

27. BAILOUT PACKAGES zJustified under Globalization Hazard view zThe mid-1990s packages were successful because capital flowed back very quickly (the prime example is Brazil in 1999). zAt present, capital appears to be much slower to flow back, possibly due to Russia’s 1998 crisis and recent corporate scandals. zThus, present packages may shield the financial but not the real sector, and recession could be large and long-lasting.

28. THE EXCHANGE RATE zThe current debate is between Fixed Exchange Rate and Inflation Targeting. zInflation Targeting is equivalent to fixing the currency to a basket of goods and services. zActually, if the basket contains only foreign exchange, or the pass-through coefficient is very high, both systems would be equivalent. zThus, the current debate is about the best basket to fix to. It is about fixing, not about floating. zNeither system ensures the existence of a Lender of Last Resort.

29. CHOOSING A BASKET zNo basket prevents large exchange rate misalignment. If the latter is a serious concern, one should adopt RER Targeting, which implies no nominal anchor! zThe main focus should be on the financial system and, in particular, the prevailing type of indexation in the financial sector. zThus, a highly dollarized system may call for full dollarization. zWhile, a UF system like in Chile, may call for UF targeting.

30. SUDDEN STOP zLearn how to prevent it yManagement of reserves and public debt yFlexible financial system, contingent claims yFlexible public prices and wages zAnd how to be ready if it happens yContingent credit lines yJudicious use of reserves and credit lines to bail out private sector and financial institutions, accompanied by dirty float. yTimely negotiation of debt restructuring.

31. Research Department Inter-American Development Bank