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

1. SUDDEN STOPS, THE REAL EXCHANGE RATE AND FISCAL SUSTAINABILITY: ARGENTINA’S LESSONS Guillermo Calvo, Alejandro Izquierdo and Ernesto Talvi Policy Seminar June 6, 2002 Research Department

2. OUTLINE I. Life after Russia: A Hemispheric Perspective II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases IV. Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions

3. External Financial Conditions (LEI, Spread over US Treasuries) 1.400 1.200 Current level 1.000 Pre- Argentine Crisis Pre- Russian Crisis 800 600 Pre-Asian Crisis 400 524 bp 200 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 May-97 May-98 May-99 May-00 May-01

4. Vodka is Stronger than Tequila in LAC(Net private capital flows, US$ billions) 75 70 65 60 55 50 45 40 Tequila Russia 35 T T+1 T+2 T+3

5. Sudden Stop in LAC-7 (Capital flows and CA, 4 quarters, % of GDP) Capital flows Current Account Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela

6. Current Account Adjustment Current Account Balance, US$ billions 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 0.9 2000 -8.9 -24.6 -1.0 0.3 0.7 2001 -5.6 -23.2 -0.9 -2.1 -0.8 Source: World Economic Outlook (IMF), April 2002.

7. Trend Growth in LAC-7 (Annual growth based on quarterly data, 1997.II=100) 100 90 80 70 60 50 40 1997:2 1998:2 2000:2 2001:2 Includes: Argentina, Brazil, Chile, Colombia, México, Perú, Venezuela

8. OUTLINE I. Life after Russia: A Hemispheric Perspective II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases IV. Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions

9. The Sudden Stop Effect on Demand CAD = A* + S* - Y* = current account deficit A* = tradables absorption; Y* = tradables output S* = non-factor payments (interest on external debt) • After Sudden Stop, percentage fall in tradables:  = CAD/A* = 1 -   = (Y* - S*)/A* = un-leveraged absorption ratio • Under homotheticity,  applies to home goods, too.

10. Sudden Stop and Equilibrium RER p P = PNT/PT p* SS p** h hs

11. Un-Leveraged Absorption RER Adjustment w Un-leveraged Absorption Coefficient ( ) BRA ARG ECU COL CHL 0.56 0.66 0.66 0.70 0.81 Required % Change in Equilibrium RER BRA ARG ECU COL CHL 52.5 46.2 46.1 43.0 32.4 Source: World Economic Outlook (IMF), and own estimates. Note: This measure is calculated in 1998 for all countries.

12. Public Debt: Dollarization and Mismatches Mismatch Measure 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.

13. 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 the real interest is smaller than the growth of GDP.

14. OUTLINE I. Life after Russia: A Hemispheric Perspective II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases IV. Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions

15. Sudden Stop in Argentina and Chile (Private Capital flows, % of GDP) 4% 8% 7% 3% 6% 2% 5% Argentina 4% Argentina Chile 1% 3% 0% 2% 1% -1% Chile 0% -2% -1% 1998-I 1999-I 2000-I 2001-I 1998-II 1999-II 2000-II 2001-II 1998-III 1999-III 2000-III 1999-V 1998-IV 2000-IV

16. External Adjustment (Current Account, 4 quarters, %GDP) Chile Argentina

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

18. Real Exchange Rate (Vis à vis the US dollar, June 1998=100) Chile “Empalme” factor Argentina

19. The Contribution of Exports to the Current Account Adjustment (In %, 2001.III-1998.II) 52.6% 16.3%

20. Sudden Stop and the Real Exchange Rate Required % change in RER to eliminate the CAD Un-leveraged Absorption () 60 0.90 55 0.80 50 0.70 45 40 0.60 35 0.50 30 25 0.40 Chile Argentina Chile Argentina Source: Calvo, Izquierdo, Talvi (2002)

21. Key Points: Chile Chile recovered without international financial support and in spite of a very weak recovery in capital inflows due to its: • relative openness • low levels of CAD leverage • low levels of public debt • low degree of financial mismatches in the public and the financial sector which allowed for a very rapid increase in exports that financed one half of the current account adjustment and prevented the real exchange rate depreciation from having adverse balance sheet effects.

22. An Example: Fiscal Sustainability in Argentina after a Sudden Stop in 1998 Debt to GDP ratio (%) Req. Prim. Surplus Adjust. NPV of Req. Adjust. (% of GDP) (a) Baseline 36.5 0.3 9.3 (b) Change in Relative Prices to close the CA deficit (RER depreciation of 46,2%) 0.7 22.6 49.7 (c): (b) + 200 BPS Increase in Real Interest Rate 49.7 1.7 32.8 (d): (c) + 1% Reduction in GDP growth 49.7 2.2 35.6 (e): (d) + Contingent Liabilities 58.6 2.7 44.5 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

23. Key Points: Argentina Argentina’s lack of recovery and eventual collapse, occurred in spite of large international financial assistance packages and was due to the fact that: • Argentina had it all: a closed economy, high levels of external indebtedness and public debt, high liability dollarization and, as a result, large financial mismatches both in the public and private sector. • Under those conditions, the change in the equilibrium RER needed to accommodate a permanent sudden stop was large. • The expectation of a large real depreciation in turn, led to a large revaluation of public sector debt relative to GDP (requiring a larger fiscal effort and/or a larger debt reduction to achieve fiscal sustainability) and to a deterioration of corporate balance sheets (contingent liabilities?). The proposed fiscal adjustments were clearly insufficient for a substantially higher RER.

24. Key Points: Argentina (ctd.) • The deterioration of public and private sector balance sheets deteriorated the quality of bank assets and led to a run on banks due to the fear that those losses might be partially financed by confiscating depositors. • The run against banks was accommodated by credit expansion of the CB, leading to a collapse in international reserves and an acceleration of the run on banks.

25. Argentina: Political Economy after the Sudden Stop • Why was adjustment so hard to materialize? • The fact that Argentina had a fixed exchange rate and relatively sticky prices concealed the needed adjustment in relative prices. • This provided little evidence for politicians about the need for adjustment. • Uncertainty about the duration of the standstill in capital flows and the size of RER adjustment may be one of the elements that delayed reform. • Uncertainty about how the losses of RER realignment would be distributed also contributed to delays in reform

26. Argentina: Policies were not Enough • Fiscal: Fiscal adjustment in 2000, attempted (failed) additional adjustment in early 2001, zero-deficit law on second half of 2001, but it was already too late. • Exchange Rate: Convergence factor, though in the right direction, introduced uncertainty about prevailing convertibility rules. • Debt Management: Debt swap in mid 2001 validated extremely high interest rates, further worsening solvency, perhaps under assumption of liquidity problems. • Monetary: Expansionary monetary stance and public bank bailout led to high credit expansion and loss of reserves.

27. 28,000 26,000 24,000 22,000 20,000 18,000 16,000 14,000 12,000 10,000 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Ene-96 Ene-97 Ene-98 Ene-99 Ene-00 Central Bank Policy Cavallo is appointed 7,000 International Reserves 6,000 Monetary Liabilities 5,000 4,000 Million Pesos 3,000 Million Pesos 2,000 1,000 0 Net Domestic Credit -1,000 Jul-01 Ene-01 Ene-02 Source: BCRA.

28. OUTLINE I. Life after Russia: A Hemispheric Perspective II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases IV. Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions

29. Exchange Rate Defense and Abandonment • Countries tried initially to hold to their bands, but were not successful given magnitude of RER adjustment needed. • Markets held expectations that the nominal exchange rate would be used to make the RER adjustment needed • This was reflected in very high interest rates and a substantial loss of reserves. • Why wait? The public sector was not heavily dollarized (except Ecuador and Argentina), but the private sector may have been. Time to hedge? • Exit Strategy: Flotation with IT in most cases. Why?

30. Exchange Rate Defense and Abandonment BRA CHL COL ECU Crawling Band Rate of Crawling Band Rate of Crawling Band Rate of Target Zone: Width +/- Regime Pre Sudden Stop Crawl: To preserve PPP Crawl: To preserve PPP Crawl: To preserve PPP 4% Width: +/- 5% Width: +/- 7% Width: +/- 5% Mar 1998: Realignment Sep 1998: Realignment of Dec 1998: Width and width increased to the Band. Jun 1999: Jan 1999: Width increased increased to +/-8% with +/-10%. Sep 1998: Rate Modifications After Sudden Stop Second Realignment and to +/-5% an increasing factor of of crawl increased to 20% width increased to +/- 0.41% per month. and width increased to 10% +/-15% Jan-99 Sep-99 Sep-99 Feb-99 Floatation Date /a Change in Reserves $US(Billions) -33.0 -2.1 -2.4 -0.5 /a Change in Reserves % -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.

31. Defense: Interest Rates and Reserves Increase in Deposit Rates (Basis Points) BRA CHL COL ECU 601.7 1266.3 1069.3 1669.0 Fall in Reserves (Percent) BRA CHL COL ECU 49.1 12.9 23.5 24.4 Note: First table reports the difference between the peak interest rate during the period (before floating) and average figure for quarter previous to sudden stop. Source: IFS (IMF).

32. Banking Sector: Dollarization and Mismatches Financial Mismatches, June 1998 ARG BRA CHL COL ECU Dollar Loans/Total Loans (%) 61.6 - 9.4 - 60.4 Tradable Production/ 10.4 7.5 26.0 13.6 25.4 Total Production (%) 1/ Source: Central Banks. 1/ Proxied by exports.

33. Valuation Effects and Choice ofan Exchange Rate Regime • Closed, highly indebted, highly dollarized and mismatched economies are vulnerable to large RER swings and substantial valuation effects that may deem a country insolvent after a sudden stop. • Fiscal dominance is present: monetary policy is subordinated to fiscal insolvency. • Hypothesis: Countries that chose to float with IT were successful in cases where fiscal dominance was absent and monetary policy became credible.

34. Two Polar Flotation Cases:Chile and Ecuador Float Dollarization Chile Ecuador • Chile successfully brings down devaluation expectations after choice of new regime • Ecuador struggles: interest rates reach highest values at time of announcement of flotation, only fall after announcement of dollarization 65 30 55 25 45 20 35 15 25 10 15 5 5 0 Jul-98 Jul-99 Jan-98 Jan-99 Jan-00 Sep-98 Sep-99 Jul-01 Jul-98 Jul-99 Jul-00 Mar-98 Mar-99 Mar-00 Nov-98 Nov-99 Jan-01 May-98 May-99 Jan-98 Jan-99 Jan-00 Oct-01 Apr-01 Apr-98 Apr-99 Apr-00 Oct-98 Oct-99 Oct-00

35. Ecuador: Dollarization is Not Enough (Sovereign Bond Spread) 5,000 Default   Agreement 4,500 • Debt resolution and fiscal adjustment (primary surplus 2001: 5% of GDP) 4,000 3,500 3,000 EMBI+ Ecuador 2,500 2,000 EMBI+ 1,500  Dollarization 1,000 500 Jun-01 Sep-01 Jun-99 Jun-00 Dec-01 Sep-99 Sep-00 Dec-98 Dec-99 Dec-00 Mar-01 Mar-99 Mar-00

36. Two Polar Flotation Cases:Chile and Ecuador GDP Growth Inflation CHL ECU CHL ECU 1997 1997 6.1 30.6 7.4 3.4 1998 1998 5.1 36.1 3.9 0.4 1999 1999 -1.1 -7.3 3.3 52.2 2000 2000 5.4 2.3 3.8 96.2 2001 2001 3.7 37.0 3.3 5.2 Exports Change / Current Account Change, % CHL ECU 1999 vs 1998 11.1 8.0 2001 vs 1998 102.3 41.9 Exports Change, % CHL ECU 1999 vs 1998 2.4 5.0 2001 vs 1998 15.3 11.3

37. OUTLINE I. Life after Russia: A Hemispheric Perspective II. The Effects of Sudden Stops on the Real Exchange Rate and Fiscal Sustainability III. Sudden Stops in Argentina and Chile (1998): Two Polar Cases IV. Choice of an Exchange Rate Strategy after a Sudden Stop V. Policy Recommendations and Conclusions

38. Policy Lessons: 1. Closed economies (C), with high public debt (D) and large financial mismatches (M), are vulnerable to changes in international conditions that require an adjustment in the current account deficit since they may require large changes in equilibrium RER. 2. Large changes in the RER, could turn a sustainable fiscal position into an unsustainable one and lead to major solvency problems. Solvency problems can lead to fiscal dominance, making monetary policy not credible. In those cases, flotation is a difficult task. 3. Countries like Brazil, Chile and Mexico are much less dollarized than Argentina and, therefore, have more leeway to use the exchange rate as an instrument. However, there are limits 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 currency.

39. Policy Lessons (cont.) 4. CDM economies are vulnerable independently of the exchange rate regime that is adopted. 5. In CDM economies it is dangerous to have: a) High levels of public indebtedness. Rules that allow governments to reach lower debt levels or even a creditor position should be given serious consideration b) Banks with weak links to the international capital market. In particular, State-Owned banks should be subject to Narrow Banking rules or privatized 6. Exchange rate flexibility could play a useful role if the C, D or M are dropped. Otherwise, exchange rate flexibility might do more harm than good.

40. Policy Lessons (cont.) 7. In the short run, the C is hard to drop, and dropping D or M could be traumatic (as exemplified by Argentina’s default and pesification). 8. Solving a solvency crisis involves wealth redistributions across sectors. The way and the speed at which those redistributions are made are crucial in determining how fast a crisis gets resolved.

41. Research Department