Brookings: Experts - Eduardo Levy-Yeyati

Privatization and Argentina's Economic Crisis

Eduardo Levy-Yeyati — Mon, 30 Apr 2012 13:14:00 -0400

Argentine President Cristina Fernandez has announced that the government will assume control of a Spanish oil company operating in Argentina. The action calls for the state to take a controlling interest in YPF as a means to funnel much needed money back into Argentina’s troubled economy. Nonresident Senior Fellow Eduardo Levy-Yeyati suggests it might be the right move done the wrong way.

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Argentina's Twin Deficit Problem

Latin America Economic Perspectives: Is there a Future for Financial and Commercial Integration in Latin America?

Fri, 20 Apr 2012 09:15:00 -0400

Event Information

April 20, 2012
9:15 AM - 11:30 AM EDT

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

After successfully weathering the global financial crisis, Latin America and the Caribbean have shown remarkable economic resilience despite facing major challenges that could derail growth and development. The region is falling behind its peers in emerging Asian nations, particularly in commercial integration, at a time when regional markets would offer a welcome counterpoint to growing Chinese influence.

On April 20, the Latin America Initiative at Brookings hosted a discussion on its biannual Brookings Latin America Economic Perspectives report (BLEP). The report analyzes the possibility of stronger financial and commercial ties between Latin American countries in order to profit from the region’s positive growth prospects and to shield the region from external economic shocks. Brookings Nonresident Senior Fellow Eduardo Levy-Yeyati presented the report, followed by a panel discussion featuring Jose de Gregorio, distinguished professor from the University of Chile; Santiago Levy, vice president of Sectors and Knowledge at the Inter-American Development Bank; Moisés Naím, senior fellow at the Carnegie Endowment for International Peace; and Alejandro Werner, director of Global business at BBVA Bancomer. Brookings Senior Fellow Daniel Kaufmann provided introductory remarks.

Participants

Panelists

Moderator: Alejandro Werner

Managing Director, Corporate Investment Banking
BBVA Bancomer

José de Gregorio

Distinguished Professor, Department of Economics
University of Chile

Santiago Levy

Nonresident Senior Fellow, The Brookings Institution
Vice President of Sectors and Knowledge, Inter-American Development Bank

Eduardo Levy-Yeyati

Nonresident Senior Fellow, The Brookings Institution
Professor, Universidad Torcuato di Tella

Moisés Naím

Senior Associate, International Economics Program
Carnegie Endowment for International Peace

Latin America Economic Perspectives - All Together Now: The Challenge of Regional Integration

Lucio Castro, Luciano Cohan and Eduardo Levy-Yeyati — Mon, 16 Apr 2012 11:18:00 -0400

INTRODUCTION: MISSING PARTS

It has been a good ride. After the dismal 1990s, which stigmatized Latin American and Caribbean economies as the paradigmatic emerging markets (a high-risk/high-return bet on inherently unstable countries doomed by the original sin of chronic mismanagement), the 2000s were something of a revelation. Dollarized external obligations shrank or were replaced by more manageable domestic debt issued in local currency, increasing tax revenues enhanced the fiscal capacity to reduce inequality and poverty, and policy continuity and consistency denied the stereotype of a region perennially oscillating between political extremes. Populism, all of a sudden, became smart pragmatism.

For many of the region’s countries –particularly those in South America– this progress was to no small degree aided by an exceptional external context of low inflation, declining financing costs, stable global growth and supportive terms of trade. If anything, the region’s governments took advantage of global tailwinds to reduce their long-dated financial vulnerabilities –an achievement that allowed them to implement, for the first time in decades, countercyclical policies that limited the depth and length of the contagion from the 2008– 9 global crisis, feeding the hope that the 2010s might be, for once, the Latin American decade.

Yet first impressions often overshoot reality. Much as the skeptical view prevalent at the start of the century may have exaggerated the irreversible nature of some of Latin America’s earlier flaws, the goldilocks picture of the region’s miracle overlooks a number of drawbacks that were temporarily dwarfed by the long bonanza. Now that the world has become less supportive, these drawbacks are returning to the foreground.

If anything, it appears that this decade, rather than marking the culmination of a virtuous process, poses a challenge. After working out the macrofinancial constraints that thwarted development policies in the past, can these countries address the pending tasks and issues that are critical to consolidate their gains and keep up the momentum?

We have tackled some of these tasks and issues in past editions of the Brookings Latin American Economic Perspectives. The region’s gradual primarization of exports, its inadequate investment in physical infrastructure and modest productivity growth, and its deficits in social development and education, all cast doubt on its growth prospects looking forward.

In this edition, we concentrate on another economic dimension on which the region is falling behind: commercial integration. Our comparative analyses reveal that, in both the depth and quality of regional integration, the Latin American and Caribbean economies are lagging from their emerging peers in Asia. And this is happening at a time when the missing intraindustry trade could provide the economies of scale needed to increase productivity in nonprimary sectors, and when regional markets offer a welcome counterpoint to the growing Chinese influence and to a global context that, even as the worldwide financial crisis subsides, will not be as stable and supportive as in the 2000s. Chapter 3 highlights several reasons why the wave of free trade agreements in the 1990s fell short of achieving true commercial integration, and it argues that a more proactive political agenda is needed to counter short-term economic incentives to diversify away from the region.

The chapter also tackles another topical aspect of regional integration: the pooling of financial resources to cope with the increasingly recurrent bouts of global financial distress. Now that the long debate about global financial safety nets –namely, multilateral liquidity facilities designed to mitigate the impact of financial contagion– seems to have reached its limit, can the discussion move forward at the regional level? It has been correctly pointed out that because the Latin American and Caribbean economies are all hit by global shocks in the same way, they cannot reduce the needed stock of aggregate liquidity by insuring each other. However, as we show in the pages that follow, regional cooperation in a reserve pool has additional advantages beyond the conventional diversification gains. Moreover, a regional pool is the natural vehicle for cooperatively mustering regional and multilateral resources, which is perhaps the missing link in the dysfunctional global safety net.

Trade and liquidity, external demand and financial stability—these are the two fronts on which the region can help itself in the next decade. Two varieties of integration important enough to be at the top of the regional agenda, and at the center of this report.

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Authors

Lucio Castro
Luciano Cohan
Eduardo Levy-Yeyati

Image Source: Enrique de la Osa / Reuters

What Have I Done to Deserve This? Global Winds and Latin American Growth

Luciano Cohan and Eduardo Levy-Yeyati — Fri, 27 Jan 2012 15:02:00 -0500

Four years ago, when what would become the worst crisis in 80 years was just a concern for the important but encapsulated US mortgage market, academics and practitioners were debating whether the emerging world, which showed no signs of weakening as the developed world sunk into recession, had entered a new age of real (business cycle) ‘decoupling’. Twelve months later, the synchronised collapse of the global economy put to rest these aspirations of economic autonomy.

Latin America, despite showing a more robust macroeconomic resilience during current stressful events, has still had its fair share of mood swings. In mid-2008, the challenge was how to contain inflationary pressure of an overheated economy. In 2009, the slowdown was equal or deeper than in other regions in the world. The growing ties with emerging Asia (particularly, China) were not enough to disable the systemic implosion.

Read the full piece on Voxeu.org »

Authors

Luciano Cohan
Eduardo Levy-Yeyati

Publication: Voxeu.org

Two Versions of the European Debt Crisis

Mario Blejer and Eduardo Levy-Yeyati — Wed, 25 Jan 2012 12:16:00 -0500

An increasing number of observers have hastened to declare that the European debt crisis has been practically resolved or at least stemmed for a few years. This view was reinforced by the falling yields at the last Italian government bond auctions of 2011, which suggested a significant reduction in the perceived sovereign default risk. Since Italian bonds are regarded as the bellwether of the European sovereign crisis, many see this development as an indication of the stabilization of the euro sovereign debt market.

The “solution” to the crisis was facilitated by the European Central Bank’s decision to lend to commercial banks for three-year terms in unlimited amounts at a very low rate. However, the ECB’s decision to do this is only part of what a central bank can normally do to fulfill its natural role as lender of last resort. Why then is there all this renewed optimism?

The immediate answer is that with the ECB’s new decision, commercial banks can now borrow cheaply from the ECB and invest in short-term sovereign bonds, pocketing a sizeable sovereign spread—a profitable “sovereign carry trade”. If banks do indeed play along, and despite the inefficiencies and distortions arising from such roundabout way of monetary financing, the European Central Bank might very much provide some lasting room to breathe for sovereign finances.

But the real reason why this otherwise standard policy decision appears to be such an important step forward is that for the first time the European Central Bank is recognizing the need to address a core drawback in the euro architecture, itself.

This crucial shortcoming relates to the currency dimension of the debate on the euro’s fate, which simply does not square with the tired comparisons to the economic crises in the emerging markets in the 1990s.

If we learned one thing from a decade of emerging market crises was that they were first and foremost currency crises— sharp corrections of overvalued currencies that bankrupted dollarized public and private sector debtors.

By contrast, the currency aspect of the European crisis is less straightforward. Is the Italian euro debt denominated in local or foreign currency? Whose currency is the euro? And whose central bank is the European Central Bank? These questions are essential to understanding the European predicament. However, depending on the answer, one could have two versions of the eurozone with very distinct issues and implications.

The first version sees the eurozone as a unity, with a fully functioning monetary union. Taken as whole, the eurozone is externally and fiscally balanced. It is also heavily indebted, but in domestic currency. The second version assumes the eurozone as a group of individual countries within a common currency area. Most of the countries are unbalanced and are indebted in a currency (the euro) that they cannot print on demand. This is equivalent to foreign currency debt.

In the first version (the euro crisis minus the currency problem), the scenario looks closer to the U.S. than to Latin America in the 1990s (with Italy being more like California than Argentina). The second version of the eurozone saga is comparable to the emerging market crises of the 1990s. That is, the eurozone sort of acts as a dysfunctional family, where the “advanced” countries of northern Europe ponder whether or not to bail out the “emerging” economies of southern Europe; the reluctance of northern European countries to use the ECB as a euro lender of last resort is just one expression of this hesitation.

The prognosis for each version is starkly different. In the first one, interest rates converge and default risk is minimal. If the ECB backstops its members’ liabilities (as the Federal Reserve did during the recent U.S. financial crisis), the euro becomes a “local currency” and the probability of a default collapses. After all, how many sovereign restructurings of local currency debt do you remember?

In the second version, there is differential credit risk and ultimately bank runs, de-euroization and default because the common currency is at odds with the needs of its members.

Which of these two alternative characterizations should prevail is an open question for euro-area members to decide. But two things are clear. First, the decision is largely about the standing of the ECB. And second, there is little in between; the halfway position that European policymakers have been treading so far will not eliminate the “currency problem” and the resulting default risk.

This perspective also helps to understand the oddity of a massive International Monetary Fund program to the region. Why would the IMF lend to Europe in a foreign currency (the SDR), thereby creating a currency imbalance— the root of all emerging market crises– unless Europe is already giving up on the euro?
The euro now faces a fork in the road. One path (a currency area without sovereign backstopping) leads to debt defaults, currency crises and the undoing of the eurozone. The other path (a monetary union with a proper central bank, internal transfers and active regionally-oriented monetary policy) leads to a slow but steady recovery and no default. Clearly, the fate of the euro and the main source of credit risk in the eurozone lie not in Athens or Rome but in Frankfurt with the ECB.

Authors

Mario Blejer
Eduardo Levy-Yeyati

Image Source: © Stringer Germany / Reuters

Argentina's Latest Looming Economic Crisis

Eduardo Levy-Yeyati — Wed, 07 Dec 2011 10:22:00 -0500

Argentina tends to elicit extreme views from economic analysts and commentators, ranging from reborn enthusiasts that marvel at the country`s unexpected performance to the point of promoting an “Argentine solution” to European problems, to sceptics that continue to expect a sudden stop to the ongoing bonanza. However, as Paul Krugman (an enthusiast) recently pointed out (Krugman 2011), a “consistently negative tone of reporting on Argentina” seems to be the rule. “Betting on another Argentine default may be going too far. But betting on a hard landing may not be,” concluded a recent piece in the Financial Times.

Schematically, Argentina's latest looming crisis would stem from a currency loop – a narrowing trade surplus (due as much to an import boom in an overheated economy as to two-digit inflation and the resulting real appreciation) leading to capital flight (in anticipation of a faster depreciation), leading to a fall in central bank reserves (the flipside of the government`s reluctance to let the peso float), feeding back into depreciation expectations, capital flight and reserve losses. In short, nothing that a small dose of the hard-earned exchange-rate flexibility cannot solve.

Read the full article at Voxeu.org »

Authors

Eduardo Levy-Yeyati

Publication: Voxeu.org

Image Source: Â© Marcos Brindicci / Reuters

Keep the International Monetary Fund Out of Europe

Mario I. Blejer and Eduardo Levy-Yeyati — Tue, 06 Dec 2011 15:09:00 -0500

A short-lived rumor recently suggested that the International Monetary Fund was putting together a €600 billion ($803 billion) package for Italy to buy its new government about 18 months to implement the necessary adjustment program. Except for the magnitude of the package, this sounds no different from a standard IMF adjustment program – the kind that we are accustomed to seeing (and criticizing) in the developing world. But there is one crucial difference: Italy is part of a select club that does not need outside rescue funds.

So far, programs for the eurozone periphery have been spearheaded and largely financed by European governments, with the IMF contributing financially, but mainly acting as an external consultant – the third party that tells the client the nasty bits while everyone else in the room stares at their shoes.

By contrast, the attempt to crowd multilateral resources into Europe was made explicit by eurozone finance ministers’ call in November for IMF resources to be boosted – preferably through debt-generating bilateral loans,– so that it could “cooperate more closely” with the European Financial Stability Facility. That means that the short-lived story of Italy’s jumbo IMF package, which was to be funded largely by non-European money, can be regarded as a game changer: while Italy may never receive such a package, Europe, it seems, is determined to resolve its problems using other people’s money.

There are at least three reasons why the IMF should resist this pressure, and abstain from increasing its (already extremely high) exposure to Europe.

Read the full piece on Project Syndicate »

Authors

Mario I. Blejer
Eduardo Levy-Yeyati

Publication: Project Syndicate

Argentina's 2001 Default Has Lessons for Greece and Italy

Mario I. Blejer and Eduardo Levy-Yeyati — Mon, 05 Dec 2011 00:00:00 -0500

The inevitable is finally happening. Although new uncertainties tend to replace old ones -- the focus has shifted to Italy’s troubles in the past few weeks -- Greece is going through a default.

It’s likely that this process will be guided by the broad outlines of an agreement reached between the European Union and Greece in October, although the details are probably subject to change.

As part of that accord, Greece and its private creditors have been invited to implement a bond exchange with a nominal discount, or haircut, of 50 percent of face value. Even though acceptance of the invitation is portrayed as voluntary, this agreement is, in all but name, a default, and for practical purposes should be consider as such.

Many comparisons have been made between Greece and Argentina, and now that default will be another common feature, we believe there are two distinct -- often overlooked or misconstrued -- lessons from the Argentine precedent.

Read the full piece on Bloomberg »

Authors

Mario I. Blejer
Eduardo Levy-Yeyati

Publication: Bloomberg

Image Source: Â© Reuters Photographer / Reuters

Latin America Economic Perspectives: Innocent Bystanders in a Brave New World

Thu, 17 Nov 2011 14:00:00 -0500

Event Information

November 17, 2011
2:00 PM - 5:00 PM EST

Falk Auditorium
The Brookings Institution
1775 Massachusetts Ave., NW
Washington, DC

In the midst of a lingering global financial crisis, Latin American countries are feeling the impact of the global slowdown. The prospect of a long period of modest economic growth, coupled with volatile capital markets, has enticed the creation of numerous regional initiatives aimed at making the region less sensitive to seasonal global swings. However, implementation of many of these initiatives has fallen well short of their intentions.

On November 17, the Latin America Initiative at Brookings hosted a discussion of its biannual Brookings Latin America Economic Perspectives report. The report analyzes the economic resilience of Latin American countries while attempting to understand the obstacles which are hindering the development of a regional agenda. Leading international experts discussed the findings of the report, analyzed the region’s economic performance and set forth recommendations for governments and policymakers.

After each panel, participants took audience questions.

Transcript

Transcript (.pdf)

Event Materials

20111117_latin_america_perspectives

Participants

Panelists

José Antonio Ocampo

Professor and Director of Economic and Political Development Concentration, School of International and Public Affairs
Columbia University

Rodrigo Valdés

Senior Advisor, Western Hemisphere Department
The International Monetary Fund

Luis Bonell

Executive Vice President & CEO, Liberty International

Alberto Musalem

Managing Director
Tudor Investment Corporation

Arturo Porzecanski

Distinguished Economist in Residence
American University

Latin America Economic Perspectives: Innocent Bystanders in a Brave New World

Luciano Cohan and Eduardo Levy-Yeyati — Wed, 16 Nov 2011 12:18:00 -0500

CHAPTER 1 — Looking Back: Six Months in Six Snapshots

The global outlook worsened in the second quarter of 2011 as stimulus programs failed to achieve self-sustained growth in the developed world, leading to a downward revision of past economic data and future growth prospects. Output gaps that may be larger than previously thought plus the eventual risk of a disorderly default in Europe kept risks tilted downward. In China, growth is still about 9 percent, but inflation is inducing a monetary tightening that may hinder growth.

After a strong recovery, Latin America is starting to feel the combined effects of financial stress and dwindling global demand. The LAC-7 countries— Argentina, Brazil, Colombia, Chile, Peru, Mexico and Uruguay—are expected to outperform developed countries and other LAC countries, but the growth recoupling typical of systemic crisis periods indicates that the final score may be disappointing if the global outlook continues to deteriorate.

Real exchange rates have pulled back in the third quarter after moderately appreciating in the first six months, to end close to the beginning-of-theyear levels. In turn, inflation peaked by midyear, partially contained by currency appreciation, the stabilization of commodity prices and, more recently, weaker domestic demand. Inflation expectations should be additionally tamed by the anticipated global slowdown.

With inflation risk slightly tilted toward the downward, central banks chose an early end to their tightening cycles and are now moving toward a data-dependent easing stance. Peru, Uruguay and Brazil have pushed their fiscal primary balances to a safer zone, in line with the tightening bias inmonetary policy. By contrast, primary balances in Colombia and Chile have continued to weaken (in the latter, due to natural disasters). In fast-growing Argentina, the political cycle leading to the October 24 elections has dominated fiscal considerations, but a mild adjustment is expected for 2012.

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Authors

Luciano Cohan
Eduardo Levy-Yeyati

A Euro Exit: Lessons from Argentina’s Economic Crisis

Eduardo Levy-Yeyati — Fri, 16 Sep 2011 09:47:00 -0400

Because the European crisis is both financial and real, any solution that focuses solely on debt restructuring (either through a bailout or a default) is likely to be insufficient if it is not complemented with a plan to recover price competitiveness. An “internal devaluation” (a big wage cut) looks politically unfeasible and economically self-defeating. Hence, the growing debate over a euro exit that promises to boost external demand while avoiding painful nominal cuts.

There is an inevitable comparison to Argentina’s experience during its economic crisis of the late 1990s and early 2000s. Many economists point to Argentina’s swift recovery and systematic outperformance— even relative to its South American neighbors that benefitted by historically high terms of trade— and attribute the results to the newly-gained competitiveness from a depreciated exchange rate. But was the devaluation effect really about competitiveness or was it just debt reduction in a different guise? I believe the competitiveness interpretation of the Argentine devaluation has been vastly exaggerated.

It is true that the devaluation of the Argentine peso brought a mild boost import substitution and nontraditional exports and that its pass-through to inflation lowered real wages, favoring labor intensive activities while avoiding unpopular wage cuts. But its real kick came from its contribution to the debt dilution and wealth transfers that are typical of all “successful” currency collapses.

The math is simple. Take an Argentinean company that owed $10 million to the bank at the end of 2001; twelve months later, with domestic liabilities “pesified” (converted to the local currency at the one-to-one parity prevalent in 2001) and the exchange rate at four pesos to the dollar, the same corporate debtor saw its dollar debt reduced to $2.5 million (a 75 percent haircut). External obligations that could not be pesified under Argentine law were restructured under the umbrella of the sovereign default and the imposition of capital controls that restricted debt service abroad.

The resulting debt dilution in a context of depressed wages and subsidized utility prices provided the internal funds needed to fuel investment in a credit-less economy. Private investment was not driven by external demand but rather by extraordinarily high corporate profits.

Moreover, while Argentina's corporations were short dollars at the time of the crisis, their owners were mostly long, owning large and largely underreported stock of foreign assets. It was these dollar savings that provided the ammunition for bargain hunting in the aftermath of the devaluation and help explain the swift rebound of real estate prices and residential construction, one of the drivers of the Argentinean recovery.

If these type of wealth transfers to the corporate sector and the rich (i.e., those with a greater propensity to save and invest) are not unusual in post-crisis recoveries, Argentina's devaluation-pesification combo turbo charged the dilution machine, and its propelljng effect.

What does all this tell us about the current situation in Europe?

If we leave out the Eurobond solution (which rules out a euro exit by definition), most analysts would agree that a “de-euroization” would almost immediately trigger a debt default since the local currency needed to pay euro debts would increase with the devaluation, exceeding the increase in local currency revenue even in the rosiest scenario.

But what about the converse? Would a debt default within the euro, if possible, be enough to sort things out or does it require an exit to a new currency to solve the real half of the predicament?

In this regard, Argentina´s lessons are far from trivial. On the one hand, take away the commodity boom and evidence suggests that the exit from the peg failed to lead to an export-led boom. On the other hand, in the Argentine experience, debt default was not enough. The conversion to a depreciating peso was an essential part of the process to clean the balance sheets of indebted corporations and re-stimulate the economy.

Judging by this single episode, one would conclude that a new currency by itself is unlikely to improve exports or trigger foreign investment to the point of reigniting growth in peripheral Europe. This is particularly the case given the current unfavorable global economic conditions. But the conversion of financial contracts to the new currency at a one-to-one parity — the only way to avoid an outright default — would render corporations and households miraculously free from the euro debt overhang and ready to spend.

Is this a free lunch? Not at all. In principle, euro creditors that are at the other side of the contracts would be deprived of considerable gains. A devaluation without a currency conversion would make a euro depositor unexpectedly rich; a conversion to the new currency takes that away from him. Indeed, the fact that it is a transfer of contingent rents rather than actual wealth that is at play makes the whole process easier to engineer.

Based on the Argentine experience, a euro exit is unlikely to revive growth in debt-laden peripheral Europe. However, if a European fiscal union does not materialize, the conversion of euro debts into a new depreciated national currency appears to be an unorthodox but effective last resort to bring the European periphery back to life.

Authors

Eduardo Levy-Yeyati

Image Source: Â© Reuters Photographer / Reuters

Debt Buybacks and Backdoor Restructurings: Can Greece Pull an Ecuador?

Eduardo Levy-Yeyati — Fri, 29 Jul 2011 16:16:00 -0400

The latest European package includes, as a way to lighten Greece´s heavy debt burden, a debt buyback: the European Financial Stability Facility (EFSF) would lend the money for Greece to buy back its own bonds in the secondary market at a discount, imposing a loss on private creditors while avoiding an outright default.

There are, of course, Latin American precedents to this initiative: many casualty countries from the debt crises in the 80s conducted similar debt buybacks in the late 80s. Bolivia’s 1988 buyback of 46% of its defaulted sovereign debt, an operation funded by international donors, is a well researched example, which spanned a body of academic literature that concluded that, unless they were conditioned ex ante to significant concessions by participating debt holders, buyback would accrue mostly to creditors at the expense of the debtor –or, for that matter, the funding donors.

But the most relevant Latin American episode is more recent and less well known: Ecuador 2008, perhaps the first opportunistic default (that is, one triggered by unwillingness rather than inability to pay) in modern economic history. A widely foretold affair (debt repudiation was part of President Rafael Correa´s 2006 presidential platform), Ecuador used the default threat to depress bond prices in the secondary market, only to buy them back at bargain prices through the back door. The task was outsourced to Banco del Pacifico, which purchased the soon-to-be-defaulted Ecuadorian paper at prices above 20 cents on the dollar. When, after default was declared in December 2008, Ecuador launched an inverse auction for the defaulted papers, with the outstanding debt largely in friendly hands and the remaining bondholders forced to liquidate their positions to meet the massive post-Lehman Brothers withdrawals, the operation was a stunning success.

For the European case, Ecuador offers an obvious lesson: the crucial part played by the imminence of a default. Indeed, almost two years toying with the a potential default (which included a much publicized commission to evaluate the “legality” of the bonds, along the lines of the odious debt arguments) were not enough to induce a deep discount: Correa needed to move all the way to a credit event in December 2008 to purchase the bonds at fire sale prices. Panic (both due to Ecuador´s default and to the global crisis) was key for the success of the buyback.

Only a credible default ensures that the private sector takes a real hit. To see the “default matters” rule in practice, compare the market-friendly Uruguayan exchange in 2003 with the market-unfriendly Argentine restructuring in 2005. The first one reaped no nominal haircuts and only a minor debt relief; the second, nominal haircuts above 50%.

Moreover, markets do not seem to matter. As early as in late 2006, right before the government intervened the Bureau of Statistics and started tampering with the CPI used to index a big chunk of sovereign debt (in what markets interpreted as a implicit default), Argentine spreads were close to those of Brazil. And even opportunistic Ecuador, blessed by the 2009 recovery in oil prices, could have returned to the voluntary markets shortly after the exchange.

The same default rule, incidentally, seems to apply to the voluntary private sector involvement embedded in the latest Greek package (if the commitment by 30 financial institutions listed in a recent IIF document eventually materializes), which would deliver a Brady-style exchange into 15 or 30 low-coupon par bonds (with principal guaranteed by AAA-EFSF paper) or high-coupon 20% discount bonds –offering a meager debt relief that nonetheless would trigger, as in 2001 in Argentina, a selective default rating.

All this begs the question: Can Greece pull an Ecuador, by convincing markets to sell their bonds at a loss for fear of a default? Probably not. Because a credible offer from euro zone partners to fund the buyback of all Greek debt would eliminate the Greek premium (bailing out private investors in full), a buyback can only succeed (in the sense of sharing the losses with private creditors) if Greece can persuade the market that it is the last chance before a unilateral debt restructuring. In other words, from an ex ante perspective, a successful buyback can only be the preamble to default.

The underlying logic is simple. Small purchases at current panic prices are possible but remain a marginal effort that would not bring a substantive debt relief. By contrast, large purchases would drive secondary prices up making the whole operation unreasonably expensive. And the opaque Ecuadorian methods are out of the question, both because they are illegal and because a transaction of this size could be hardly disguised or outsourced.

Could the EFSF, instead, openly emulate Banco del Pacifico by funding the buyback of Greek paper up to a given threshold price? Again, the perspective is not encouraging. If the threshold is set low to get a good discount, then the stock of debt retired would likely be small, as the buyback facility simply limits the downside risk while preserving the upside risk, thereby creating incentives to hold to the bonds (a perverse effect that could be mitigated by opening the facility for a limited time –although a promise of this kind would hardly be credible in the current context). By contrast, if the threshold is set high to bring bond prices to more civilized levels, purchases will be realized at moderate haircuts, getting dangerously closer to a bondholder bailout.

The premise that only a true default can bring true debt relief to a country remains unchallenged. Ultimately, it appears that only a euro zone rescue (through permanent cash transfers or financial risk sharing, as in a true fiscal union) could avoid a Greek default.

Authors

Eduardo Levy-Yeyati

A Bank Run in Greece May Trigger an Unintended Resolution of the Crisis

María Soledad Martínez Pería, Sergio Schmukler and Eduardo Levy-Yeyati — Tue, 12 Jul 2011 13:41:00 -0400

The Greek crisis debate has centered on the implications of a sovereign default and the chances for a “new drachma” to pull the Greek economy out of the recession. Less has been said about the banking sector, a local front that often plays a decisive role in the development of debt and currency crises. What would happen to local banks if, as expected, the combined threat of a default cum euro exit persists? Can the incipient bank run precipitate an involuntary resolution of the crisis before euro zone members agree on a deliberate one?

The analogies between Greece and Argentina and Uruguay in the early 2000s are useful to illustrate how debt, currency, and banking crises often feed into each other. The intuition behind this vicious circle is simple. On the asset side, dollarized banks hold hard currency loans and sovereign debt, both of which tend to collapse in market value as credit and currency risks mount. On the liability side, dollarized savers first convert their claims to hard currency deposits inside the banks but, once the decline of banks’ asset value (and the fact that hard currency deposits are an imperfect substitute for dollar bills) becomes apparent, they convert them into hard currency bills outside the banks (or at least try to), leading to a bank run. As a result, contingent sovereign debt increases with expectations of a bank bailout funded by the government, and exchange rate pressure deepens with the run to hard currencies, further worsening credit and currency risks.

A close up on the 2001-2002 triplet (debt, currency, and bank) crises in Argentina and Uruguay reveals four stylized facts that shed some light on current and future developments in Greece:

Macroeconomic risk matters more than bank fundamentals. In a context of growing systemic risk, contagion across banks is inevitable. As a result, once the run is underway, selective central bank assistance and restrictions on cash withdrawals (such as the ones imposed in Argentina in November 2001) are ineffective.
Hard currency deposits are no remedy for currency risk. Dollar (or euro) deposits can contain depreciation expectations for a while, but ultimately the realization that banks face exchange rate-challenged banks (exposed to currency mismatched dollar debtors with impaired capacity to pay) should highlight the difference between dollars in the bank and dollars in the pocket, triggering a run on dollar deposits as well.
Liquidity spills over borders. For example, the “good contagion” from the flight of Argentine depositors to the “safer” Uruguayan banks quickly turned into “bad contagion” once the “corralito” (a temporary suspension of deposit convertibility) in Argentina in November 2001 forced them to withdraw to their offshore deposits, ultimately leading to a triplet crisis also in Uruguay.
Depositors run faster than bondholders. Trivially, deposits are on average much shorter than the average bond. As a result, while the run may be rooted in a debt sustainability problem, it is the bank run that often accelerates the proceedings. It was the “corralito” that brought people to the streets in Argentina in November 2001 (and brought the government down shortly thereafter). And the bank run preceded –and, to a large extent, triggered– the currency and debt crisis in Uruguay 2002.

Figure 1 and 2 illustrate this two-step run in Argentina 2001 –and how its benign effect on neighboring Uruguay, one of the places of choice for the offshoring of local dollarized savings under threat, reverted right after the gates were dropped at Argentine banks.

Source: Banco Central de la República Argentina (BCRA) and Banco Central del Uruguay (BCU).

Note: The increase observed in Argentina's deposits in Jan 2002 is due to the forced conversion of dollar deposits at an exchange rate of 1.40 pesos. Sources: Banco Central de la República Argentina (BCRA) and Banco Central de Uruguay (BCU).

A look at the Greek bank data suggests that the hard currency argument (the fact that introducing a new drachma is considerably more complicated and costly –hence, less likely– than the floating of the Argentine peso in 2002) is weakening rapidly. The logic is simple: in the absence of a regional bailout, even if the euro is not abandoned, the “internal depreciation” needed to restore the external and fiscal balances could render much of the economy insolvent –and its financial obligations (including bank deposits) worthless. If so, the good contagion to the Cyprus´ banking sectors (Figure 3) can be easily reverted if the Greek run deepens and a deposit freeze in Greece becomes inevitable.

Source: Central Bank of Greece and Central Bank of Cyprus.

Trivially, the current debate about how to deal with the currency-growth-debt trap that crippled Greece and is now threatening other indebted euro members cannot ignore how alternative strategies would affect a banking sector that, if distressed, could amplify an already massive problem. A bank run followed by deposit freeze is not the only possible outcome: while it would be almost inevitable after a default or a euro exit, it could be easily avoided by a regional bailout by euro member states –in a move towards a fiscal union that many see as a precondition for the long-run success of the euro.

However, the time dimension should not be understated. A protracted deliberation in Brussels should continue to stress depositors in Athens. And, as depositors flee in anticipation, a generalized bank run and the inescapable freeze on bank deposits may deepen the recession and fuel civil unrest, derailing current adjustment efforts. Ultimately, a unilateral default may end up being the unintended result of procrastination.

Authors

María Soledad Martínez Pería
Sergio Schmukler
Eduardo Levy-Yeyati

Publication: VoxEU.org

Image Source: Â© John Kolesidis / Reuters

Financial Globalization in Emerging Economies: Much Ado About Nothing?

Tomas Williams and Eduardo Levy-Yeyati — Thu, 02 Jun 2011 15:46:00 -0400

INTRODUCTION

Financial globalization (FG), understood as the deepening of cross border capital flows and asset holdings, has become increasingly relevant for the developing world for a number of reasons, including the consequences of its changing composition on countries' balance sheets, its role in the transmission of global financial shocks, its benefits in terms of financial development, international risk sharing and business cycle smoothing, and the implication of all of the above for macroeconomic and prudential policies. In this paper, we focus on these issues from an empirical perspective, building on, updating, and specializing the existing literature to characterize the evolution and implications of FG in emerging economies.

As conventional wisdom has it, the globalization process has been growing steadily since the mid-1980s, particularly in developing countries (Kose et al, 2010) and has accelerated in the 2000s, with a dramatic increase in cross-border portfolio flows as a fraction of global wealth (Karolyi, 2010). However, this pattern depends on the measure of FG — usually proxied in the literature by the average of cross border assets and liabilities over GDP (FG-to-GDP ratios). As we show in the first part of the paper, a more natural normalization of foreign holdings by host market size (to control for financial market deepening and spurious relative price effects) reveals a more stable FG pattern during the 2000s. In turn, normalizing foreign portfolio asset holdings by total portfolio holdings by residents show that, despite the growing FG ratios, international portfolio diversification in the emerging world are still remarkably low, and have remained stable or declined.

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Tomas Williams
Eduardo Levy-Yeyati

The Greek Debt Crisis in the Latin American Mirror

Eduardo Levy-Yeyati — Thu, 02 Jun 2011 00:00:00 -0400

Last week, at a panel on emerging markets at the Luxembourg Financial Forum, I was asked what lessons for the European debt crisis could be drawn from the rich and diverse experiences of emerging markets. It was not the obvious comparison with the Argentine economic crisis that came to mind, but rather the Latin American debt crisis of the early 1980s.

The Latin American debt crisis originated from excess liquidity caused by a surge in oil prices in the 1970s and abundant savings by oil exporters, which were channeled to developing economies. Seduced by the easy money, the economies of Argentina, Brazil, Mexico and Peru, among others built up important stocks of hard currency debt that proved to be lethal once interest rates normalized, capital flows retreated, and inflated developing country currencies faced depreciation pressures that pushed debt ratios to unsustainable levels.

The first approach to the Latin American debt problem was denial. Supposedly, all that was needed was time to implement a drastic fiscal adjustment, for which the International Monetary Fund, sponsored by the United States, would provide the needed refinancing. In 1985, the Baker Plan elaborated on this approach by introducing private sector involvement through the voluntary rescheduling of bank loans, so as to lengthen the fiscal adjustment period. The result was a massive debt overhang that discouraged investment and triggered frequent spells of capital flight and disappointing growth that was reflected in growing debt ratios. This became known as the lost decade for Latin America.

Only in the 1990s did the players involved in the debt rescheduling recognize that an insolvent country requires some genuine debt relief, in the form of a reduction in the nominal value of its debt, or a “haircut”. This new understanding took the form of the Brady Plan, which exchanged unrecoverable, unmarketable bank loans for discount marketable Brady bonds – bonds that would be the seed of the emerging markets asset class.

What about Europe? It appears that today’s consensus is halfway between denial (restructuring of any kind “is not on the cards”, as stated by European Central Bank President Jean-Claude Trichet) and a Baker-style solution (a unilateral offer by creditor banks to lengthen the repayment time frame – a view shared by French Finance Minister Christine Lagarde and Eurogoup Chairman Jean-Claude Juncker).

It is tempting to see these positions as an ECB versus eurozone governments debate on collective fiscal responsibility. After all, if we accept that there is a limit to how much adjustment could be realistically expected from Greece’s asset sales and belt tightening without stifling growth or undermining local political support, then there are only two other groups to foot the remaining bill: private creditors and euro member states.

This is the key difference between peripheral Europe now and Latin America in the 1980s. It may have taken almost a decade to reach consensus, but it was clear from the beginning that Latin American creditors would not be able to recoup loans in full and therefore they should take a hit. In contrast, Greece has Europe, which many argue should move closer to a fiscal union if it wants the euro to succeed.

This, and not who pays for Greece’s 2012 financing gap, appears to be the dividing question. On one side, Bank of France Governor Christian Noyer argues that “you can’t ask the European taxpayer to pay for Greece’s bailout and then restructure the debt.” So, should Europe explicitly guarantee the sovereign debt of Greece and other member states? According to German Finance Minister Wolfgang Schäuble, “strong member states will not provide an automatic safety net for weak member states.” Schäuble asserts that “if debt sustainability cannot be confirmed,[…] private sector involvement becomes compulsory.”

Once we see the current division in this light, it becomes even more obvious that a Baker-style rescheduling would not do the trick. For starters, it would do nothing to mitigate Greece’s debt overhang, its exclusion from capital markets, or the lingering risk over other heavily indebted European states and Europe in general. Moreover, it would dodge the critical question about the loss sharing scheme – a question that, as the Latin American history illustrates, could takes ages to be addressed.

Would a Brady-style solution work? Yes. It would not solve Greece’s lack of competitiveness or unbalanced fiscal accounts, but it would offer a clean start and a strong political incentive for Greece to adjust. It would also provide a market disciplining mechanism for Europe, as the market digests the revelation that eurozone sovereign risk is not one but many (which would entail the inevitable contagion to other indebted members states and possibly another restructuring) and scrutinize individual countries accordingly.

Would a fiscal union work? Yes. It would require stronger European rules and enforcement at the expense of fiscal sovereignty, as it would move opposite to the Brady solution, eliminating country differences from a market perspective and, if unchecked, opening the door to fiscal policy free-riding.

A re-scheduling may borrow some time to reduce the exposure of the European banking sector and other indebted peripheral European countries to a Greek default. But, by the same token, it conspires against a Brady-style solution as the current European support— both through the European Financial Stability Facility and through the ECB’s collateralized liquidity assistance— gradually bails out the private creditors that are expected to share in the losses in a restructuring scenario.

Ultimately, which of these two solutions is best for the eurozone is for eurozone member states to decide. However, the Latin American experience suggests against a Baker-style rescheduling of an unsustainable debt, which would only perpetuate the agony by pushing forward the day of reckoning. Rescheduling would be an ineffective solution halfway between fiscal autonomy and fiscal union, which is the longstanding and unresolved tradeoff that is perhaps the key pending assignment for European.

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Eduardo Levy-Yeyati

Graduation Season: Moving Toward Advanced Economy Status

Mauricio Cárdenas and Eduardo Levy-Yeyati — Wed, 01 Jun 2011 12:03:00 -0400

There is no single definition of economic development and there is no one recipe for achieving socioeconomic well-being. However, it is possible to analyze an emerging market’s relative progress toward graduating into the developed world or advanced economy status. The Brookings Graduation Scorecard ranks emerging markets based on four core areas: economic growth, financial resilience, policy track record and broad development factors (all equally weighted). Each of these four core areas is explained below.

• Growth performance over 1999-2010: Risk adjusted GDP growth (average growth over standard deviation) and GDP crisis stress test (deviation of 2009 growth from average pre-crisis, 1999-2007, growth).

• Financial resilience: Public external debt-to-GDP, net external debt-to-GDP, net external financing needs over current account receipts, sovereign bond interest rate spread.

• Policy track record: Risk-adjusted inflation (average CPI inflation plus standard deviation over 1999-2010), five-year moving average of the cyclically adjusted primary fiscal balance.

• Development: Gini coefficient, United Nations Human Development Index, World Governance Indicators (WGI). [1]

For each one of these variables we calculate the z-score, using the average and standard deviation across countries, which we then convert to a 0 to 1 scale. The rescaled z-scores are then averaged across each of the four core areas, resulting in the overall score. This approach allows us to rank countries in the Brookings Graduation Scorecard by variable, by core area, and by overall performance.

The objective of the graduation scorecard ranking is twofold: (1) capture gradual advancements or downfalls in paths of emerging economies toward graduation into the developed world; (2) analyze cross-sectional differences in key economic development indicators within the emerging markets group. This allows us to analyze groupings of emerging market economies.

Anachronistic Acronyms

Based on our graduation scorecard (see Figure 1), we believe that the practice of grouping emerging markets into acronyms by economists and financial experts in order to identify the next group of top performers has become outdated and problematic. From the popular BRICs classification to CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa), MAVINS (Mexico, Australia, Vietnam, Indonesia, Nigeria, South Africa) and EAGLES (Emerging and Growth-Leading Economies ─ the BRICs plus Korea, Indonesia, Mexico, Turkey, Egypt and Taiwan) all of these artificial groupings and acronyms have sought to single out a set of countries, which supposedly outperform the rest.

The BRICs are the largest emerging market economies, but the similarities stop there. Whereas China is in a class by itself, India is a fast growing deficit country, Brazil shares Latin America’s limits for noninflationary growth, and Russia is mainly an oil-exporting country. Looking at the graduation scorecard, we see that as a group the BRICs are well positioned in their pursuit of development relative to other emerging markets. However, each BRIC country on its own ranks quite differently in comparison to its BRIC counterparts in the graduation scorecard.

The grouping of EAGLES and CIVETS are also of questionable relevance. The former, launched by the economic research team at BBVA, added Egypt, Indonesia, Mexico, South Korea, Taiwan and Turkey to the BRICs, based on the countries that were expected to contribute most to the global growth. This classification captures large, fast-growing emerging markets, regardless of any other development quality or policy stance. HSBC’s CIVETS – Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa – were grouped together because they all have large young populations, diversified economies, political stability (the recent events in Egypt simply reminding us that perhaps this aspect was overstated), deep financial markets, low inflation, solid trade balances and limited sovereign debt ratios. Judging by Egypt’s political risk, Turkey’s currency imbalance and growing current account deficit, Vietnam’s incipient financial markets and fat fiscal deficit, not to mention South Africa’s commodity dependence or Colombia’s modest growth performance, one wonders how these countries were classified together as up-and-coming star emerging markets.

Development is not one-dimensional and is by definition an evolutionary process. Proposing classifications of emerging markets is problematic because they are outdated very quickly and do not reflect the diversity and differences within the group. It is with this in mind that the Brookings Graduation Scorecard tries to capture, imperfectly, the complexities and nuances of moving from emerging to advanced economy status. Most importantly, the scorecard presents this graduation process as a dynamic one.

Latin America's Mixed Results

There are two salient groups in the case of Latin American countries. The star performing group includes Chile at the top (third in the overall ranking) followed by Brazil and Uruguay (which has visibly improved its standing relative to last year’s assessment, mainly due to modest gains distributed across the four areas). Peru barely makes the cut of the star performing group (Figure 1). This group of star performers is close to graduating to advanced economy status.

These four Latin American countries are also regional leaders in at least one of the four core areas of the graduation scorecard (Figure 2). While these four countries have different strengths and weaknesses, they all have a strong policy track record.

Compared to other emerging markets, Latin American economies have benefited the most from improving their policy track records, which is perhaps a lesson from the recurrent macroeconomic crisis experienced by the region in previous decades. Chile leads the Latin American region in having the most solid policy track record, followed by Brazil and Peru. Chile also leads the region in the development factors’ ranking.

At the other end of the spectrum are Venezuela and Ecuador, which can be classified as stagnating countries. These two countries are held down in the rankings by high inflation, persistently large deficits, unstable growth and non-desirable development factors. Overall, the worst ranked countries in the graduation scorecard are Ukraine, Ecuador and Venezuela, in that order (Figure 1). It will take time and a combination of right macroeconomic and social policies along with strong economic growth for Venezuela and Ecuador to start ascending in the graduation scorecard rankings. Given the idiosyncratic nature of their governments, this is not likely to occur any time soon.

One common aspect about the scorecard for Latin American countries is the relatively weak performance on the growth front, at least when compared with East Asian emerging markets (Figure 2). The other noticeable feature is the heterogeneous results when it comes to the measures of development factors (Gini coefficient, HDI, and WGI), which has a 25 percent weight in the overall score. The large disparity on the development factors scorecard is almost exclusively due to differences in the WGI (Figure 3). In turn, the WGI can be further disaggregated into each one of its six components in order to understand the specific governance dimensions that explain differences across countries in Latin America. It is in the analysis of these six components, on a country by country basis, that a clear and relevant differentiation within Latin America emerges. Ultimately, it is progress in this area what makes Chile, Uruguay and Brazil to be the most likely candidates to achieve development during this decade.

FIGURE 1. GRADUATION SCORECARD

FIGURE 2. REGIONAL SCORES IN GRADUATION CRITERIA

FIGURE 3. DEVELOPMENT FACTORS DISAGGREGATED

Footnote:

[1] An average of six governance measures: voice and accountability, political stability, government effectiveness, regulatory quality, rule of law, and control of corruption (see http://info.worldbank.org/governance/wgi/index.asp).

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Publication: Brookings Institution

Image Source: ï¿½ POOL New / Reuters

Latin America’s Economic Future: Shifting Gears in the Age of Heightened Expectations

Fri, 15 Apr 2011 09:30:00 -0400

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April 15, 2011
9:30 AM - 12:30 PM EDT

Stein Room
The Brookings Institution
1775 Massachusetts Avenue, N.W.
Washington, DC 20036

In the wake of the most severe financial crisis in recent times, Latin America is witnessing unprecedented economic challenges and opportunities that are shaping the region’s growth and development prospects.

On April 15, the Latin America Initiative at Brookings hosted the launch of its biannual Latin America Economic Perspectives report. This year’s report, "Shifting Gears in the Age of Heightened Expectations," examines the scope and effectiveness of the policies and strategies that different Latin American countries are implementing—or should implement—to address the challenges of today’s global economy. Leading international experts discussed the findings of the report, analyzing the region’s economic performance and setting forth recommendations for governments and policymakers.

After each panel, participants took audience questions.

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20110415_latin_america

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Panelists

Alexandre Tombini

Governor, Central Bank of Brazil

José Luis Escrivá

Head of Global Public Finance, BBVA

Piero Ghezzi

Managing Director and Head of Economics and Emerging Markets Research, Barclays Capital

Juan Carlos Echeverry

Minister of Finance, Colombia

José de Gregorio

Governor, Central Bank of Chile

Curbing Success in Latin America

Mauricio Cárdenas and Eduardo Levy-Yeyati — Thu, 14 Apr 2011 14:57:00 -0400

There are two Latin Americas and one is thriving. While Central America and the Caribbean are still struggling with the effects of the 2008 economic crisis and may grow below 2 percent this year, the stellar seven (Argentina, Brazil, Chile, Colombia, Mexico, Peru and Uruguay) passed with flying colors the test of the global slowdown. These seven countries are expected to grow at an average rate of 5 percent in the near future, fueled by apt domestic policies, favorable terms of trade and considerable amounts of foreign capital inflows.

However, success has come at a price. These seven countries are facing overvaluations in their currencies. Many worry that the region is catching a mild case of Dutch disease — a term coined by The Economist in 1973 to refer to the decline of the manufacturing sector in the Netherlands after the discovery of a large natural gas field in 1959. Dutch disease is an illness that kills jobs and competitiveness (sometimes permanently) in industrial sectors that are adversely affected by the appreciation of the currency.

Traditional Dutch disease has been linked primarily to the effects of high commodity export prices or volumes in one sector at the expense of other sectors. The symptoms are already apparent in commodity exporting countries like Argentina, Brazil, Chile and Colombia, where the volumes of non-primary net exports have been falling rapidly and industrial output and employment are starting to dwindle despite solid GDP growth figures.

But the Latin American seven (with the notable exception of Argentina) are also suffering from a new strain of the disease, the so-called “financial-Dutch disease”, which is driven by capital flows that exacerbate exchange rate appreciation pressures, making many of these countries too expensive for their own good. Initially dominated by foreign direct investment, capital flows are increasingly supplemented by portfolio flows.

In other words, if the traditional Dutch disease is linked to China, this new variety has its source in U.S. monetary policy.

Brazil deserves a special note in this regard. Its diversified manufacturing exports account for the country’s trade surplus. Thus, it is hard to argue that the country’s competitiveness is at stake due to a traditional case of Dutch disease triggered by booming metals and soybean prices. On the contrary, Brazil appears to epitomize financial Dutch disease, losing competitiveness at the hands of enthusiastic global speculators.

Understanding the nature of the disease is critical in order to prescribe a medicine that can cure the ailment. Traditional-Dutch disease from commodity booms calls for sector–specific interventions, such as a mix of taxes and subsidies designed to mitigate its impact on the relative competitiveness of the industry or sector stabilization funds to save the dollars from the external surplus abroad to limit its effect on the exchange rate.

But these measures are ineffective when it comes to a financial-Dutch disease, which requires a macroeconomic dam to keep away the dollar flood; for example, through sterilized exchange rate interventions or capital controls.

Sterilized interventions have become a permanent guest of the macroeconomic policy framework in the seven Latin jaguars (with the exception of Mexico). Capital controls that put sand-in-the-wheels of international finance are less pervasive. But Tobin taxes or unremunerated reserve requirements on selected foreign inflows, although admittedly more controversial, are also becoming part of the standard toolkit.

Micro-prudential measures, such as limits to banks´ foreign exchange positions and lifting of capital restrictions on outflows, are in the same category. An innovative addition to the policies under the macro-prudential umbrella is the use of standard commercial bank reserve requirements (as is the case in Turkey) or taxes on short-term lending (as is the case in Brazil) to widen the wedge between the deposit interest rate that determines the currency carry and the lending rate that governs the transmission of monetary policy.

These seven economies are increasingly attracted to these policy options, but two caveats are in order. First, as we argue in a recent Brookings report, both sterilized interventions and sand-in-the-wheel capital controls are effective, but only marginally and possibly decreasingly so over time.

Precisely because of this, neither the standard inflation-targeting framework nor its extended and expanded version (inflation targeting 2.0, which keep an eye on the potential deleterious influence of the global financial cycle) will be capable alone of delivering macroeconomic stability. In addition, these seven economies have been slow to unwind the fiscal stimulus implemented during the recent economic crisis, for reasons that have to do with elections in Argentina and Peru, natural disasters in Chile and Colombia, or more broadly the political cost of adjustment in an age of heightened expectations in Brazil.

At any rate, it is clear that these policies are not substitutes. A clever combination of exchange rate, monetary and fiscal policies is needed to prevent overvaluation and overheating, and to avoid a hard landing once the global financial cycle makes the inevitable turn.

Authors

Latin America Economic Perspectives: Shifting Gears in an Age of Heightened Expectations

Mauricio Cárdenas, Karim Foda, Camila Henao and Eduardo Levy-Yeyati — Fri, 08 Apr 2011 16:09:00 -0400

INTRODUCTION AND SUMMARY

Overheating and inflationary pressures in Latin America are rising, and many financial regulators wonder whether domestic credit is already growing excessively. On the fiscal front, the region is now facing the well-known fact that tightening during an upturn is harder than loosening during a recession. On the monetary side, the simplistic inflation targeting is being replaced by a combination of targets and ad hoc instruments. Financial stability, or bubble prevention, is the most recent addition to new set of targets. In terms of the toolkit, prudential macroeconomic rules have gained status as an instrument to deliver financial stability.

Bringing macroeconomic stability back by relying exclusively on monetary policy will be too costly. The necessary increase in interest rates will only create more upward pressures on exchange rates, fostering a never-ending destabilizing spiral. If only for this reason, fiscal unwinding is indispensable for economies to return to normalcy.

While intervention and controls have often been framed in a negative light, they are increasingly seen as a useful complement to countercyclical macroeconomic policy toolkit. Sterilized interventions have gradually become the rule, and recent years have seen a comeback of reserve requirements, not only selectively as a tax on inflows but also uniformly as a monetary policy tool to raise lending interest rates without enhancing the appeal of carry trades.

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Mauricio Cárdenas
Karim Foda
Camila Henao
Eduardo Levy-Yeyati

Are Capital Controls Effective?

Eduardo Levy-Yeyati — Thu, 20 Jan 2011 15:34:00 -0500

The global crisis has reignited debate on the desirability of capital controls. This column examines evidence from Argentina and Chile and argues that capital controls can be effective, but that their effectiveness and efficiency varies. It adds that controls need to be considered as part of a macro-prudential toolkit to prevent asset inflation and overvaluation that is costly to revert in the down cycle.

“Not only are they ineffective but, in addition, they raise domestic interest rates.” This type of internally inconsistent commentary is not unusual when discussing capital controls – a subject marked with strong beliefs and weak data. Now that the G20 has sanctioned capital controls in Seoul under the umbrella of macro-prudential policies, it is a good time to revisit the subject of controls in a dispassionate way. [1]

The capital control debate can be broken into two basic questions:

How effective are they? and,
Are they efficient instruments (and if so, when)?

This column addresses the first of these two questions. The debate about the effectiveness of capital controls – namely, whether or not they influence cross-border flows– has received considerable attention in the economic literature. One area of focus has been the controls on inflows imposed by the Chilean government in the mid 1990s, which has generated a series of empirical works, sometimes with contrasting results (see for example, Edwards 1999, De Gregorio et al. 2000. Edwards and Valdes 2000, and Gallego and Hermández 2003).

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Footnote:

[1] In the G20´s own terms:“…in circumstances where countries are facing undue burden of adjustment, policy responses in emerging market economies with adequate reserves and increasingly overvalued flexible exchange rates may also include carefully designed macro-prudential measures.” (G20 2010).

Authors

Eduardo Levy-Yeyati

Publication: VoxEU.org

Brookings: Experts - Eduardo Levy-Yeyati

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Latin America’s Economic Future: Shifting Gears in the Age of Heightened Expectations

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Curbing Success in Latin America

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Latin America Economic Perspectives: Shifting Gears in an Age of Heightened Expectations

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Are Capital Controls Effective?

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