SUDDEN STOPS, THE REAL EXCHANGE RATE

AND FISCAL SUSTAINABILITY: ARGENTINA’S LESSONS

Guillermo Calvo,Guillermo Calvo,

Alejandro IzquierdoAlejandro Izquierdo

and Ernesto Talviand Ernesto Talvi

Policy SeminarPolicy Seminar

June 6, 2002June 6, 2002

Research Department

OUTLINE

I. I. Life after Russia: A Hemispheric PerspectiveLife after Russia: A Hemispheric Perspective

IV.IV. Choice of an Exchange Rate Strategy after a Choice of an Exchange Rate Strategy after a Sudden StopSudden Stop

V.V. Policy Recommendations and Conclusions Policy Recommendations and Conclusions

II. II. The Effects of Sudden Stops on the Real The Effects of Sudden Stops on the Real Exchange Rate and Fiscal SustainabilityExchange Rate and Fiscal Sustainability

III. III. Sudden Stops in Argentina and Chile (1998): Sudden Stops in Argentina and Chile (1998): Two Polar CasesTwo Polar Cases

Pre-Asian Crisis

Pre- Russian Crisis

Pre- Argentine Crisis

Current level

524 bp

External Financial Conditions(LEI, Spread over US Treasuries)

T T+1 T+2 T+3

Tequila Russia

Vodka is Stronger than Tequila in LACVodka is Stronger than Tequila in LAC(Net private capital flows, US$ billions)(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

ARG BRA CHL COL ECU

1997 -12.2 -30.8 -3.7 -5.9 -0.7

1998 -14.5 -33.4 -4.1 -5.2 -2.2

1999 -11.9 -25.4 -0.1 0.2 0.92000 -8.9 -24.6 -1.0 0.3 0.72001 -5.6 -23.2 -0.9 -2.1 -0.8

Source: World Economic Outlook (IMF), April 2002.

Current Account Balance, US$ billions

1997:2 1998:2 2000:2 2001:2

Trend Growth in LAC-7 (Annual growth based on quarterly data, 1997.II=100)

Includes: Argentina, Brazil, Chile, Colombia, México, Perú, Venezuela

OUTLINE

CAD = ACAD = A* * + S+ S** - Y - Y* * = current account deficit= current account deficit

AA* * = tradables absorption; Y= tradables absorption; Y** = tradables output = tradables output

SS** = non-factor payments (interest on external debt) = non-factor payments (interest on external debt)

After Sudden Stop, percentage fall in tradables:After Sudden Stop, percentage fall in tradables:

= CAD/A= CAD/A** = 1 - = 1 -

= (Y= (Y** - S - S**)/A)/A* * = un-leveraged absorption ratio= un-leveraged absorption ratio

Under homotheticity, Under homotheticity, applies to home goods, too. applies to home goods, too.

The Sudden Stop Effect on DemandThe Sudden Stop Effect on Demand

Sudden Stop and Equilibrium RERSudden Stop and Equilibrium RER

P = PNT/PT

BRA ARG ECU COL CHL

0.56 0.66 0.66 0.70 0.81

Source: World Economic Outlook (IMF), and own estimates.Note: This measure is calculated in 1998 for all countries.

Un-leveraged Absorption Coefficient (w)

BRA ARG ECU COL CHL

52.5 46.2 46.1 43.0 32.4

Required % Change in Equilibrium RER

Un-Leveraged Absorption RER Adjustment

ARG ECU COL BRA CHL

B/e B* 0.08 0.02 0.59 1.76 1.30

Y/e Y* 8.63 2.94 6.36 12.34 2.85

(B/e B*)/(Y/e Y*) 0.01 0.01 0.09 0.14 0.45

Source: Own estimates. Note: Values are given for 1998.

Mismatch Measure

Public Debt: Dollarization and Mismatches

Fiscal Sustainability after a 50% RER Depreciation

ARG BRA CHL COL ECU(a) Base Exercise

Observed Public Debt (% of GDP) 36.5 51.0 17.3 28.4 81.0 Real Interest Rate 7.1 5.8 5.9 7.3 6.3

Real GDP Growth 3.8 2.0 7.5 3.6 2.6

Observed Primary Surplus (% of GDP) 0.9 0.6 0.6 -3.0 -0.2

i. Req. Primary Surplus (% of GDP) 1.2 1.9 n.a. 1.0 2.9(b) Change in Relative Prices

Imputed Public Debt (% of GDP) 50.8 58.1 18.7 34.9 107.2

ii. Req. Primary Surplus (% of GDP) 1.6 2.2 n.a. 1.2 3.9

NPV of ii - i (% of GDP) 14.3 7.1 n.a. 6.5 26.3 Corresponding Debt Reduction (%) 28.2 12.2 n.a. 18.7 24.5

ii - i (% of Government Expenditures) 2.3 1.0 n.a. 1.3 4.5

Source: Own estimates. Note: Values are given for 1998. n.a.: Not applicable given that thereal interest is smaller than the growth of GDP.

OUTLINE

leArgentina

Sudden Stop in Argentina and Chile(Private Capital flows, % of GDP)

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

Argentina

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

Argentina

GDP Investment

Real Exchange Rate(Vis à vis the US dollar, June 1998=100)

Argentina

“Empalme” factor

ARGENTINA CHILE

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

Sudden Stop and the Real Exchange Rate

Un-leveraged Absorption ()

Required % change in RERto eliminate the CAD

Chile Argentina

Source: Calvo, Izquierdo, Talvi (2002)

Key Points: ChileKey Points: Chile

Chile recovered without international financial support Chile recovered without international financial support and in spite of a very weak recovery in capital inflows and in spite of a very weak recovery in capital inflows due to its:due to its:

• relative openness relative openness

• low levels of CAD leveragelow levels of CAD leverage

• low levels of public debt low levels of public debt

• low degree of financial mismatches in the public and low degree of financial mismatches in the public and the financial sectorthe financial sector

which allowed for a very rapid increase in exports that which allowed for a very rapid increase in exports that financed one half of the current account adjustment and financed one half of the current account adjustment and prevented the real exchange rate depreciation from prevented the real exchange rate depreciation from having adverse balance sheet effects.having adverse balance sheet effects.

An Example: Fiscal Sustainability in Argentina after a Sudden Stop in 1998

Debt toGDPratio(%)

Req. Prim.SurplusAdjust.

(a) Baseline 36.5 0.3

(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

49.7 1.7

(d): (c) + 1% Reduction in GDP growth 49.7 2.2

(e): (d) + Contingent Liabilities 58.6 2.7

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

NPV of Req. Adjust.

(% of GDP)

Key Points: ArgentinaKey Points: Argentina

Argentina’s lack of recovery and eventual collapse, occurred in Argentina’s lack of recovery and eventual collapse, occurred in spite of large international financial assistance packages and spite of large international financial assistance packages and was due to the fact that:was due to the fact that:

Argentina had it all: a closed economy, high levels of external Argentina had it all: a closed economy, high levels of external indebtedness and public debt, high liability dollarization and, as indebtedness and public debt, high liability dollarization and, as a result, large financial mismatches both in the public and a result, large financial mismatches both in the public and private sector.private sector.

Under those conditions, the change in the equilibrium RER Under those conditions, the change in the equilibrium RER needed to accommodate a permanent sudden stop was large.needed to accommodate a permanent sudden stop was large.

The expectation of a large real depreciation in turn, led to a The expectation of a large real depreciation in turn, led to a large revaluation of public sector debt relative to GDP (requiring large revaluation of public sector debt relative to GDP (requiring a larger fiscal effort and/or a larger debt reduction to achieve a larger fiscal effort and/or a larger debt reduction to achieve fiscal sustainability) and to a deterioration of corporate balance fiscal sustainability) and to a deterioration of corporate balance sheets (contingent liabilities?). The proposed fiscal sheets (contingent liabilities?). The proposed fiscal adjustments were clearly insufficient for a substantially higher adjustments were clearly insufficient for a substantially higher RER.RER.

Key Points: Argentina (ctd.)Key Points: Argentina (ctd.)

The deterioration of public and private sector balance sheets The deterioration of public and private sector balance sheets deteriorated the quality of bank assets and led to a run on deteriorated the quality of bank assets and led to a run on banks due to the fear that those losses might be partially banks due to the fear that those losses might be partially financed by confiscating depositors.financed by confiscating depositors.

The run against banks was accommodated by credit expansion The run against banks was accommodated by credit expansion of the CB, leading to a collapse in international reserves and an of the CB, leading to a collapse in international reserves and an acceleration of the run on banks.acceleration of the run on banks.

Argentina: Political EconomyArgentina: Political Economy after the Sudden Stop 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 The fact that Argentina had a fixed exchange rate and relatively sticky prices concealed the needed adjustment relatively sticky prices concealed the needed adjustment in relative prices.in relative prices.

• This provided little evidence for politicians about the This provided little evidence for politicians about the need for adjustment. need for adjustment.

• Uncertainty about the duration of the standstill in capital Uncertainty about the duration of the standstill in capital flows and the size of RER adjustment may be one of the flows and the size of RER adjustment may be one of the elements that delayed reform.elements that delayed reform.

• Uncertainty about how the losses of RER realignment Uncertainty about how the losses of RER realignment would be distributed also contributed to delays in reform would be distributed also contributed to delays in reform

Argentina: Policies were not EnoughArgentina: Policies were not Enough

• FiscalFiscal: Fiscal adjustment in 2000, attempted (failed) : Fiscal adjustment in 2000, attempted (failed) additional adjustment in early 2001, zero-deficit law on additional adjustment in early 2001, zero-deficit law on second half of 2001, but it was already too late.second half of 2001, but it was already too late.

• Exchange RateExchange Rate: Convergence factor, though in the right : Convergence factor, though in the right direction, introduced uncertainty about prevailing direction, introduced uncertainty about prevailing convertibility rules. convertibility rules.

• Debt ManagementDebt Management: Debt swap in mid 2001 validated : Debt swap in mid 2001 validated extremely high interest rates, further worsening solvency, extremely high interest rates, further worsening solvency, perhaps under assumption of liquidity problems.perhaps under assumption of liquidity problems.

• MonetaryMonetary: Expansionary monetary stance and public bank : Expansionary monetary stance and public bank bailout led to high credit expansion and loss of reserves.bailout led to high credit expansion and loss of reserves.

10,000

12,000

14,000

16,000

18,000

20,000

22,000

24,000

26,000

28,000E

-1,000

Millio

sCentral Bank PolicyCentral Bank Policy

Source: BCRA.Source: BCRA.

Net Domestic CreditNet Domestic Credit

International ReservesInternational Reserves

Monetary LiabilitiesMonetary Liabilities

Cavallo is appointedCavallo is appointed

OUTLINE

Exchange Rate Defense and AbandonmentExchange Rate Defense and Abandonment

Countries tried initially to hold to their bands, but Countries tried initially to hold to their bands, but were not successful given magnitude of RER were not successful given magnitude of RER adjustment needed.adjustment needed.

Markets held expectations that the nominal exchange Markets held expectations that the nominal exchange rate would be used to make the RER adjustment rate would be used to make the RER adjustment needed needed

This was reflected in very high interest rates and a This was reflected in very high interest rates and a substantial loss of reserves.substantial loss of reserves.

Why wait? The public sector was not heavily Why wait? The public sector was not heavily dollarized (except Ecuador and Argentina), but the dollarized (except Ecuador and Argentina), but the private sector may have been. Time to hedge? private sector may have been. Time to hedge?

Exit Strategy: Flotation with IT in most cases. Why?Exit Strategy: Flotation with IT in most cases. Why?

Exchange Rate Defense and AbandonmentExchange Rate Defense and Abandonment

BRA CHL COL ECU

Regime PreSudden Stop

Target Zone: Width +/-

Crawling Band Rate of

Crawl: To preserve PPP

Width: +/- 5%

Width: +/- 7%

Width: +/- 5%

Modifications AfterSudden 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 +/-

Mar 1998: Realignment

and width increased to

+/-10%. Sep 1998: Rate

of crawl increased to 20%

and width increased to

+/-15%

Floatation Date Jan-99 Sep-99 Sep-99 Feb-99Change in Reserves $US(Billions) /a -33.0 -2.1 -2.4 -0.5Change 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.

BRA CHL COL ECU

601.7 1266.3 1069.3 1669.0

Note: First table reports the difference between the peak interest rateduring 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 ReservesDefense: Interest Rates and Reserves

BRA CHL COL ECU

49.1 12.9 23.5 24.4

Fall in Reserves (Percent)

ARG BRA CHL COL ECU

Dollar Loans/Total Loans (%) 61.6 - 9.4 - 60.4Tradable Production/

10.4 7.5 26.0 13.6 25.4Total Production (%) 1/

Source: Central Banks.

1/ Proxied by exports.

Financial Mismatches, June 1998

Banking Sector: Dollarization and Mismatches

Valuation Effects and Choice ofValuation Effects and Choice ofan Exchange Rate Regimean Exchange Rate Regime

Closed, highly indebted, highly dollarized and Closed, highly indebted, highly dollarized and mismatched economies are vulnerable to large mismatched economies are vulnerable to large RER swings and substantial valuation effects that RER swings and substantial valuation effects that may deem a country insolvent after a sudden stop.may deem a country insolvent after a sudden stop.

Fiscal dominance is present: monetary policy is Fiscal dominance is present: monetary policy is subordinated to fiscal insolvency.subordinated to fiscal insolvency.

Hypothesis: Countries that chose to float with IT Hypothesis: Countries that chose to float with IT were successful in cases where fiscal dominance were successful in cases where fiscal dominance was absent and monetary policy became credible.was absent and monetary policy became credible.

Two Polar Flotation Cases:Two Polar Flotation Cases:Chile and EcuadorChile and Ecuador

Chile Ecuador

Chile successfully brings down devaluation expectations Chile successfully brings down devaluation expectations after choice of new regimeafter choice of new regime

Ecuador struggles: interest rates reach highest values at Ecuador struggles: interest rates reach highest values at time of announcement of flotation, only fall after time of announcement of flotation, only fall after announcement of dollarizationannouncement of dollarization

Float Dollarization

5,000D

Ecuador: Dollarization is Not Enough(Sovereign Bond Spread)

Default

Dollarization

Agreement

EMBI+ Ecuador

Debt resolution and fiscal adjustment (primary surplus 2001: Debt resolution and fiscal adjustment (primary surplus 2001: 5% of GDP)5% of GDP)

19971998199920002001

ECU3.40.4-7.32.35.2

GDP Growth

CHL7.43.9-1.1

5.43.3

19971998199920002001

Inflation

CHL6.15.13.33.83.7

ECU30.636.152.296.237.0

1999 vs 19982001 vs 1998

CHL11.1

CHL2.415.3

ECU8.041.9

ECU5.011.3

Exports Change / Current Account Change, %

Exports Change, %

Two Polar Flotation Cases:Two Polar Flotation Cases:Chile and EcuadorChile and Ecuador

OUTLINE

Policy Lessons:Policy Lessons:

1. Closed economies 1. Closed economies (C)(C), with high public debt (, with high public debt (D) D) and large and large financial mismatches financial mismatches (M)(M), are vulnerable to changes in international , are vulnerable to changes in international conditions that require an adjustment in the current account deficit conditions that require an adjustment in the current account deficit since they may require large changes in equilibrium RER. since they may require large changes in equilibrium RER.

2. Large changes in the RER, could turn a sustainable fiscal position 2. Large changes in the RER, could turn a sustainable fiscal position into an unsustainable one and lead to major solvency problems. into an unsustainable one and lead to major solvency problems. Solvency problems can lead to fiscal dominance, making monetary Solvency problems can lead to fiscal dominance, making monetary policy not credible. In those cases, flotation is a difficult task.policy not credible. In those cases, flotation is a difficult task.

3. Countries like Brazil, Chile and Mexico are much less dollarized 3. Countries like Brazil, Chile and Mexico are much less dollarized than Argentina and, therefore, have more leeway to use the than Argentina and, therefore, have more leeway to use the exchange rate as an instrument. However, there are limits to exchange rate as an instrument. However, there are limits to exchange rate flexibility because all of them may find it difficult 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 issue debt other than in foreign currency or indexed to a foreign currency.currency.

Policy Lessons (cont.)Policy Lessons (cont.)

4.4. CDMCDM economies are vulnerable independently of the economies are vulnerable independently of the exchange rate regime that is adopted.exchange rate regime that is adopted.

5.5. In In CDM economies it is dangerous to have:CDM economies it is dangerous to have:

a) a) High levels of public indebtedness. Rules that allow High levels of public indebtedness. Rules that allow governments to reach lower debt levels or even a creditor position governments to reach lower debt levels or even a creditor position should be given serious considerationshould be given serious consideration

b) Banks with weak links to the international capital market. b) Banks with weak links to the international capital market. In particular, State-Owned banks should be subject to Narrow In particular, State-Owned banks should be subject to Narrow Banking rules or privatizedBanking rules or privatized

6.6. Exchange rate flexibility could play a useful role if the C, D or Exchange rate flexibility could play a useful role if the C, D or M are dropped. Otherwise, exchange rate flexibility might do more M are dropped. Otherwise, exchange rate flexibility might do more harm than goodharm than good..

Policy Lessons (cont.)Policy Lessons (cont.)

7.7. In the short run, the In the short run, the CC is hard to drop, and dropping is hard to drop, and dropping DD or or MM could be traumatic (as exemplified by Argentina’s default and could be traumatic (as exemplified by Argentina’s default and pesification).pesification).

8.8. Solving a solvency crisis involves wealth redistributions across Solving a solvency crisis involves wealth redistributions across sectors. The way and the speed at which those redistributions are sectors. The way and the speed at which those redistributions are made are crucial in determining how fast a crisis gets resolved.made are crucial in determining how fast a crisis gets resolved.

Research Department

SUDDEN STOPS, THE REAL EXCHANGE RATE

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SUDDEN STOPS, THE REAL EXCHANGE RATE AND FISCAL SUSTAINABILITY: ARGENTINA’S LESSONS