Daniel Titelman Chief Development Studies Unit ECLAC

1. External Shocks: How can regional financial institutions help to reduce the volatility of Latin American economies? Daniel Titelman Chief Development Studies UnitECLAC

2. OUTLINE • The macroeconomic context • Regional Financial Integration • Conclusions

3. GROWTH RATES HAVE BEEN LOW AND VOLATILE

4. VOLATILITY OF GROWTH RATES(Coefficients of variation, 10-year moving averages)

5. External shocks play an important role in growth dynamics: Mainly capital flows and recently terms of trade

6. WORLD GROWTH AND CHINA’S EXPANSION ARE HAVING A POSITIVE IMPACT ON THE TERMS OF TRADE, BUT THIS IMPACT VARIES ACROSS SUBREGIONS VARIATION IN TERMS OF TRADE BETWEEN THE 1990s AND 2005

7. World growth and China’s have a positive effect on terms of trade

8. LATIN AMERICAN ECONOMIES ARE STILL VULNERABLE TO SUDDEN STOPS IN CAPITAL INFLOWS. • Without downplaying the importance of domestic factors, inefficiencies in international financial markets often exacerbate financial volatility, which, in turn, amplifies or generates domestic disequilibria.

9. VULNERABILITY INDICATORS Short-term external debt / international reserves Total external debt/ exports

10. VULNERABILITY INDICATORS Public debt / GDP Public debt in domestic currency / total public debt

11. VULNERABILITYINDICATORS Fixed-rate public debt / total Dollarization of deposits (2005)

12. UNTENABLE LEVELS MAY BE REACHED IN CRISIS SITUATIONS SPREADS: EMBI+ AND LATIN AMERICAN COMPONENT (December 1996 to June 2006)

13. CREDITTO THE PRIVATE SECTOR AND ECONOMIC ACTIVITY(Average for 7 LAC countries)

14. This happens in different countries in the region… Argentina Chile Colombia Venezuela

15. After more than a decade of reforms, financial systems in the region are usually characterised by: • Shallow and underdeveloped markets • The sector is mainly concentrated in banks, and in short term deposits • Credit is rationed, especially for lower and middle firms, and R&D. • High financial costs and high levels of segmentation • Reduced set of instruments for long term finance.

16. Financial depth

17. Main obstacles to entrepreneurial development:

18. Chile: interest rate according to loan amount (local currency, more than 90 days) Nota: A los valores de junio 2006: 0-200 UF = hasta US$ 6.000 aprox. 200-5000 UF = hasta US$ 120.000 aprox.

19. REGIONALFINANCIAL VULNERABILITY IS HEIGHTENED BY • The lack of suitable mechanisms to provide emergency financing to countries facing sudden balance-of-payments difficulties as a consequence of external shocks. • The absence of financial markets to hedge and insure against external shocks • This has led to a policy of self-insurance based mainly on the accumulation of international reserves, which is not always a very efficient option.

20. TRENDS IN INTERNATIONAL RESERVE STOCKS(Millions of US$)

21. RESERVE RATIOS Reserves / Short-Term Debt LAC(18) average Reserves / M3 LAC(18) average Reserves / Imports of Goods and Services (Months)

22. TWO AREAS FOR REGIONAL FINANCIAL COOPERATION • Reserve pooling • Financial Development: promote markets for state-contingency securities

23. SUBREGIONALFINANCIAL INSTITUTIONS Andean Countries BOLIVIA COLOMBIA ECUADOR PERU VENEZUELA Central AmericanCommon Market CAF - ANDEAN DEVELOPMENT BANKCREATED 1968 COSTA RICA EL SALVADOR GUATEMALA HONDURAS NICARGUA CABEI - CENTRAL AMERICAN BANK FOR ECONOMIC INTEGRATIONCREATED 1961 CARICOM - Caribbean Common Market CARIBBEAN DEVELOPMENT BANKCREATED 1969 BARBADOS, BELICE, GUYANA, JAMAICA, SURINAME, T.y TOBAGO, Ay B, DOMINICA, GRENADA, MONTESERRAT, ST.KITTS, ST.LUCIA, ST.VICENT BOLIVIA COLOMBIA COSTA RICA ECUADOR PERU VENEZUELA LATIN AMERICAN RESERVE FUNDCREATED 1978COSTA RICA JOINT 1991

24. FLAREXPERIENCE • Even though it covers only a few countries, the Latin American Reserve Fund has been quite successful in providing short-term financing. Since its creation, FLAR has contributed average resources equivalent to 60% of IMF exceptional financing to the Andean Community countries. • An important feature of FLAR’s financing is its speed and timeliness

25. ANDEANCOMMUNITY: LOANS BY FLAR AND GDP GROWTH

26. RESERVE POOLING • Access to increased reserve holdings. • A possible reduction in reserve volatility. • The ability of a Reserve fund to address externals shocks depends on the probability of negative events being correlated

27. EXPANDING FLAR GEOGRAPHICAL COVERAGE: SIMPLE CORRELATION COEFFICIENTS (1990-2005) • Correlation coefficients of international reserves are significant (at a 5% level) in 32 out of 45 cases and tend to be quite high. • These coefficients may be magnified by the upward trend in reserve accumulation that the countries experienced during the period considered. * Significant at the 5% level

28. EXPANDING FLAR GEOGRAPHICAL COVERAGE: SIMPLE CORRELATION COEFFICIENTS (1990-2005) • Correlation coefficients of the detrended series dropped significantly for most countries, and some coefficients lost significance (only 17 out of 45 were significant at the 5% level). * Significant at the 5% level

29. SIMPLE CORRELATION COEFFICIENTS (1990-2005) • Correlation coefficients of the annual changes in international reserves tend to be low and non-significant. * Significant at the 5% level

30. SIMPLE CORRELATION COEFFICIENTS (1990-2005) • For the terms of trade, correlation coefficients do not show a clear pattern. There is a mixture of negative and positive coefficients of smaller and bigger magnitude, with only 15 of the 45 coefficients being positive and significant. * Significant at the 5% level

31. SIMPLE CORRELATION COEFFICIENTS (1990-2005) • For private capital inflows, there are also no clear patterns emerging. Positive correlations are generally not close to unity. A regional fund could help to curb mechanisms of crisis transmission between countries * Significant at the 5% level

32. Coverage Ratio • Where ρ is the degree of pooling 0< ρ<1 • Ri is the total reserves of country i. • Rj is country j’s reserves. • VAR is the added variance of country i and j • That is, with partial pooling, country i’s total access to reserves equals all its own reserves plus the partially pooled reserves of all other members of the pool. • when ρ=0 no pooling

33. RESERVE VARIABILITY, (1990-2005) Note: The measure of volatility used was the variation coefficient (the ratio of the standard deviation to the mean).

34. COVERAGE RATIOS, 1990-2005 • Don’t improve: • Chile • Colombia • Improve • Bolivia • Costa Rica • Ecuador • Perú • Venezuela • Argentina • Brazil • Mexico Incentive compatibility issues

35. Financial Development • Development of deep and liquid markets for state-contingency securities has been very slow and difficult • coordination problems. • national policies lack of credibility. • problems of transparency and surveillance. • There is a role for International Financial Organizations

36. AT THE REGIONAL LEVEL • IDB and World Bank • FLAR and the use of International Reserves • Subregional Development Banks

37. IDB ISSUES IN LATIN AMERICAN CURRENCIES Source: Eloy Garcia, Presentation at the Seminar on the Role of Regional Funds in Macroeconomic Stabilization, held in Lima, Peru, 17-18 July.

38. FLAR and Subregional Development Banks • Better Investment grade than country members • Could issue medium-term notes denominated in local currency and indexed to domestic inflation, or to GDP, as a way of helping to build a customer base for local-currency bonds. • Regional financial cooperation would facilitate and be facilitated by policy coordination between countries. At the same time, deepening financial integration creates needs and incentives for higher degrees of macroeconomic coordination: Transparency and information exchange • In order to have the effect of helping to introduce a benchmark (risk-free) asset, such borrowing could not, however, exceed levels consistent with the maintenance of current investment grade rating.

39. Risk rating (Moody’s long term debt in foreign currency) FLAR Aa2

40. Summing up • Latin American economies are still vulnerable to external shocks, particularly sudden stops in capital inflows. • Regional financial integration could help to reduce financial volatility at the regional level • Reserve Pooling (more efficient than self- insurance) • Financial development • Correlation analysis suggests that expanding FLAR coverage is feasible. But there might be incentive compatibility issues

41. Summing up • There is a role for regional, sub regional development banks and FLAR to promote state contingency bonds. • Regional financial agreements are complements rather than substitutes for global arrangements. The principle of additionality must prevail. • Deepening financial integration creates needs and incentives for higher degrees of macroeconomic coordination. The progress made in this area in Latin America has so far been rather limited

42. External Shocks: How can regional financial institutions help to reduce the volatility of Latin American economies? Daniel Titelman Chief Development Studies UnitECLAC