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Banking Crises and Sudden Stops in Latin America

Banking Crises and Sudden Stops in Latin America. Alejandro Izquierdo, IADB IADB-Atlanta Fed Conference, September 30, 2005. Credit Volatility. Credit in LAC is highly volatile. Credit Volatility. ...credit volatility is related to an underdeveloped financial sector.

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Banking Crises and Sudden Stops in Latin America

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  1. Banking Crises and Sudden Stops in Latin America Alejandro Izquierdo, IADB IADB-Atlanta Fed Conference, September 30, 2005

  2. Credit Volatility Credit in LAC is highly volatile...

  3. Credit Volatility ...credit volatility is related to an underdeveloped financial sector.

  4. Recurring Banking Crises • LAC is the region of the world with the highest banking crisis recurrence • To what extent are these crises linked to external financial conditions?

  5. 150000 100000 50000 0 -50000 -100000 -150000 Jan-91 External Financial Conditions (EMBI sovereign spread & Current Account Balance in EMs, millions of USD, last four quarters) Tequila Crisis Asian Crisis Russian Crisis 2500 2000 1500 EMBI spread (basis points) 1000 500 0 Jul-96 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-97 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 • A largely unexpected shock forced closure of current account deficits

  6. 7 6 Emerging Markets Developed Economies 5 4 3 2 1 0 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Sudden Stops: Bunching • Triggering Factor, or incipient Sudden Stop, is most likely • external

  7. Crisis and Volatility: Twin Crises • This is highly relevant for the banking sector considering that sudden stops and banking crises are another set of twins (75% in dollarized countries)

  8. In % of total Emerging Developed Markets Economies Depreciations associated with Sudden Stop 63 17 Of which: First Sudden Stop, then depreciation 42 9 First depreciation, then Sudden Stop 21 9 Depreciations not associated with Sudden Stop 37 83 Note: The total number of large devaluations is 19 in emerging markets and 23 in developed economies. Sudden Stops and Large Depreciation • A key element behind this twin relationship is the fact that, for EMS, real currency depreciation is associated about two thirds of the time with Sudden Stops

  9. Sudden Stop and Size of Depreciation • Bringing the current account deficit to balance implies a forced adjustment in demand of tradable goods • When the supply of tradable goods is small (relative to absorption of tradables), relative prices must do most of the work (so that tradables are sufficiently expensive to reach the new equilibrium). • CAD/A=(Y*-S)/A=w

  10. Crisis and Volatility: Sudden Stops • Even if the trigger is external, the probability of a full fledged sudden stop depends on the interaction between: w (capturing potential changes in RER), and the degree of banking dollarization (as a share of GDP)

  11. Crisis and Volatility • This is particularly relevant for LAC because dollarization levels are relatively high...

  12. Crisis and Volatility:Currency Mismatches • mismatches are high...

  13. Crisis and Volatility • ... and public sector debt holdings are high, particularly in larger countries • Public debt is highly dollarized: Governments are part of the problem and cannot secure bailouts with fiscal solvency

  14. Bank Runs and Crisis Resolution • In fear that a Sudden Stop is imminent, depositors will have incentives to run when bank portfolios consist of unhedged dollar loans and public bonds. • In contrast to developed countries, inadequate resolution of crises in LAC (where depositors pay for the crises) may have increased the volatility of deposits.

  15. Summary • Large RER fluctuations and SS are mainly an EM phenomenon. • SS seem to come in bunches. • SS and banking crises are a set of twins. • Openness (un-leveraged absorption of tradables) and liability dollarization heavily influence the probability of a SS. • High levels of current account leverage and financial dollarization could become a dangerous cocktail. • Both are the result of a stream of past domestic policies, very difficult to reverse in the short run.

  16. Policy Agenda: Bank Level • Dealing with domestic liability dollarization to reduce the likelihood of twin crises: • Regulation in the banking system for appropriate treatment of credit risk of dollar loans and government debt: • Price to market • Provisions • Capital adequacy ratios • Hedging • Creation of hedging markets.

  17. Policy Agenda: Macro Level • Reducing liability dollarization: • increasing central bank independence (low inflation volatility and the reduction of fiscal pressures) • introducing sound alternatives to dollar assets, such as CPI-indexed instruments • Facing sudden stops with a pre-announced monetary policy that increases credibility of monetary policy (Caballero) • Crisis resolution processes must ensure that the parties that took higher risk bear the brunt of the costs

  18. Policy Agenda: Global Level • Trade integration to enhance export price elasticity in case of financial stress (reducing RER effects). • Global Lender of Last Resort. For example, Emerging Market Fund, EMF, to stabilize EMBI (Calvo).

  19. Banking Crises and Sudden Stops in Latin America Alejandro Izquierdo, IADB IADB-Atlanta Fed Conference, September 30, 2005

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