Towards effective social insurance in Latin America:why can’t we afford counter-

cyclical fiscal policy?Comment by

Ricardo Hausmann

Harvard University

The problem

• Latin America is very volatile

• People suffer from this

• Fiscal policy is pro-cyclical

• …aggravating volatility

• …and lowering social protection when it is most needed

Proposed solution

• Increase automatic stabilizers– Pre-commit to spend more in bad times

• Improve savings in good times– Fiscal rules and stabilization funds

• Improve creditworthiness during bad times– GDP-indexed bonds

What causes pro-cyclicality?

• Excessive spending and borrowing in good times limits creditworthiness in bad times– Hausmann, Gavin, Perotti and Talvi (1996),

Talvi and Vegh (2000)

• Solution: behave more prudently in good times so you can still borrow in bad times– Ergo: Fiscal institutions and rules

• Is this correct?

An alternative interpretation

• Debt service is highly anti-cyclical• …because debt is denominated in US$

– In good times, the real exchange rate is strong, making US$ debt cheap

• ..or in short term in pesos– Real interest rates go up in bad times, as the

government attempts to avoid further real depreciation

• Hence, procyclicality is a consequence of original sin

Real GDP growth is more volatile

Industrial Developing LAC Real GDP volatility 2.0% 4.7% 4.5%

But not that much to write home about

…but GDP measured in US$ is 9 times more volatile

Industrial Developing LAC Real GDP volatility 2.0% 4.7% 4.5%US$ GDP volatility 14.0% 27.5% 36.2%

This is the relevant measure if you borrow in US$

…movements of exchange rates are large and persistent

Industrial Developing LAC Real GDP volatility 2.0% 4.7% 4.5%US$ GDP volatility 14.0% 27.5% 36.2%Gap in RER 5-y MA 19.7% 84.5% 91.8%

This is the maximum gap between 5-yearMoving average of the real exchange rate

Dollar GDP tends to collapse at times of crises

Year Growth GrowthCountry US$ GDP Real GDPChile 1973 -69.3% -4.9%Chile 1982 -38.0% -10.3%Costa Rica 1981 -70.3% -2.3%Dominican Republic 1985 -49.7% 1.0%Ecuador 1999 -50.2% -7.3%Guatemala 1986 -44.8% 0.1%Guyana 1987 -35.1% 0.9%Honduras 1990 -56.3% 0.1%Jamaica 1978 -36.1% 0.6%Jamaica 1983 -38.1% 2.3%Jamaica 1991 -46.4% 0.7%Mexico 1976 -40.6% 4.4%Mexico 1982 -54.4% -0.6%Mexico 1994 -35.2% 4.4%Paraguay 1989 -39.5% 5.8%Uruguay 1982 -66.0% -9.8%Venezuela 1986 -47.0% 6.5%Venezuela 1989 -43.8% -8.6%Average -47.8% -0.9%

Declines in US$GDP greater than

-35%

Notice that capacityto pay in US$

collapses more than real GDP

Implications

• The capacity to pay dollar-denominated debt is dependent on the market value of GDP in US$

• But this measure is 9 times more volatile than real GDP

• …and collapses in bad times• This is associated with large and persistent

cyclical movements in the RER • The problem may not be that we borrow too much

in good times, but that we borrow too poorly

Credit ratings are low, considering that debt levels are low

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Canada

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Denmark

Poland

Italy

United K JapanUnited S

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MexicoEl Salva

Slovenia

Pakistan

Brazil

Norway

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Finland

Chile

Panama

Iceland

ArgentinJordan

Belgium

Austria

Turkey

IsraelHungary

Sweden

China

MoroccoIndia

Oman

Tunisia

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…even considering the lower tax base

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Poland

Italy

United K JapanUnited S

Cyprus

Dominica

Spain

Mexico

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Pakistan

Brazil

Norway

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Finland

Panama

Iceland

ArgentinJordan

Belgium

Austria

Turkey

IsraelHungary

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Morocco India

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Would domestic peso debt be safer?

Short term real interest rates are very volatile and rise in bad times

Volatility elasticity t-stat

United States 0.9 -3.3 -4.1Latin America 10.5 -126.3 -10.9

Mexico 23.0 -73.3 -13.2Venezuela 17.6 0.1 0.0Brazil 17.2 -451.6 -3.4Ecuador 12.2 -2.4 -0.5Uruguay 11.8 2.6 0.4Peru 11.2 -151.4 -1.7Colombia 7.8 -16.6 -2.3Chile 5.4 -8.8 -1.0Costa Rica 5.0 -19.7 -5.0Argentina 4.0 -221.9 -10.3Panama 0.6 -0.4 -0.6

Note: excludes periods in which inflation exceeded 40 percent

(monthly data, 1990-1999)

Some consequences

• Domestic currency short-term or floating rate debt may be subject to large increases in nominal interest rates, especially in bad times

• This also makes debt service pro-cyclical• Volatility of the short rate limits the extension of

maturity• Under these conditions, US$ borrowing may be safer

– Hausmann and Chamon (2002) argue that this may generate multiple equilibria in monetary policy and debt denomination

Original sin and the limits to anticylical fiscal policies

• If there is a SIGNIFICANT NET foreign debt (public or private)

• …and it is in foreign currency• Exchange rate movements cause aggregate wealth effects

– Depreciations lower real income

• Makes debt service harder…• …lowering creditworthiness in bad times

– Less access to finance in bad times

• Makes governments forced to tighten fiscal policy, unless it wants to aggravate crowding out

• …and tighten monetary policy to avoid further depreciation

Implication: automatic stabilizers

• If the problem is that debt service increases in bad times, due to debt denomination,

• …then the solution is NOT to pre-commit to increase spending in bad times

• “Increase automatic stabilizers” NOT YET• This will only aggravate the collapse in solvency

in bad times and will force to cut other (presumably good) but a-cyclical social programs such as Education and Health

Implication: debt structure• Work on debt structure first• Ideal is long-term, fixed rate peso-denominated bonds

– They change in value with the real exchange rate, and with inflation

– But they are the hardest to achieve

• The paper recommends GDP-linked bonds– GDP is very hard to credibly measure

• It may be much easier to develop long-term inflation-indexed fixed rate debt– Protects against collapses in RER & US$ GDP– As in Chile (is this part of Chile’s secret?)

OS is the consequence of the currency concentration of the global portfolio

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United States EUROLAND Japan U.K Switzerland Canada Australia

Debt by Country

Debt byCurrency

(0.9857)

(0.8859)

Implication: international agenda

• It needs an international solution• Create liquidity for instruments with EM

currency risk but no credit or country risk– IFIs could play a large role

• This would allow IFIs to lend in local currency

• Develop the swap market to undo the currency mismatch of EMs

Implication: fiscal rules

• If the problem is debt structure, fiscal rules should deal with this

• Currently, rules relate to deficits and spending• Nothing is geared to monitor the risks involved in

the debt structure• Alternative: target a risk-weighted level of debt

– Risk weights should reflect the pro-cyclicality and volatility of debt service

– Allows the political system to internalize the difference between cheap borrowing and safe borrowing

Conclusion

• It would be great if the government could offer social protection against aggregate shocks

• …but before committing to do so, it needs to be able to do so

• At present, many countries are unable to protect in bad times and in fact need to impoverish their populations in bad times to avoid greater damage

• We should develop the ability to protect before we commit to use it