Comment by Ricardo Hausmann Harvard University

1. Towards effective social insurance in Latin America:why can’t we afford counter-cyclical fiscal policy? Comment by Ricardo Hausmann Harvard University

2. The problem • Latin America is very volatile • People suffer from this • Fiscal policy is pro-cyclical • …aggravating volatility • …and lowering social protection when it is most needed

3. Proposed solution • Increase automatic stabilizers • Pre-commit to spend more in bad times • Improve savings in good times • Fiscal rules and stabilization funds • Improve creditworthiness during bad times • GDP-indexed bonds

4. What causes pro-cyclicality? • Excessive spending and borrowing in good times limits creditworthiness in bad times • Hausmann, Gavin, Perotti and Talvi (1996), Talvi and Vegh (2000) • Solution: behave more prudently in good times so you can still borrow in bad times • Ergo: Fiscal institutions and rules • Is this correct?

5. An alternative interpretation • Debt service is highly anti-cyclical • …because debt is denominated in US$ • In good times, the real exchange rate is strong, making US$ debt cheap • ..or in short term in pesos • Real interest rates go up in bad times, as the government attempts to avoid further real depreciation • Hence, procyclicality is a consequence of original sin

6. Real GDP growth is more volatile But not that much to write home about

7. …but GDP measured in US$ is 9 times more volatile This is the relevant measure if you borrow in US$

8. …movements of exchange rates are large and persistent This is the maximum gap between 5-year Moving average of the real exchange rate

9. Dollar GDP tends to collapse at times of crises Declines in US$ GDP greater than -35% Notice that capacity to pay in US$ collapses more than real GDP

10. Implications • The capacity to pay dollar-denominated debt is dependent on the market value of GDP in US$ • But this measure is 9 times more volatile than real GDP • …and collapses in bad times • This is associated with large and persistent cyclical movements in the RER • The problem may not be that we borrow too much in good times, but that we borrow too poorly

11. Credit ratings are low, considering that debt levels are low Austria Norway United K United S Germany 19 Japan Finland Sweden Denmark Australi Spain Canada Belgium Italy Iceland Slovenia Cyprus Greece Israel Czech Re Chile Hungary Estonia Poland rating for long-term foreign cur Latvia China Tunisia Oman Slovak R Mexico El Salva Panama Costa Ri India Morocco Argentin Brazil Jordan Turkey Dominica Paraguay Pakistan 4 -.430356 1.04646 de_gdp2

12. …even considering the lower tax base United S Norway United K Austria Germany Japan 19 Finland Sweden Denmark Australi Spain Canada Belgium Italy Iceland Slovenia Cyprus Greece Israel Czech Re Hungary Estonia rating for long-term foreign cur Poland Latvia China Tunisia Mexico Panama Costa Ri India Morocco Argentin Brazil Jordan Turkey Dominica Paraguay Pakistan 4 -.772123 5.49817 de_re2

13. Would domestic peso debt be safer?

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

15. Some consequences • Domestic currency short-term or floating rate debt may be subject to large increases in nominal interest rates, especially in bad times • This also makes debt service pro-cyclical • Volatility of the short rate limits the extension of maturity • Under these conditions, US$ borrowing may be safer • Hausmann and Chamon (2002) argue that this may generate multiple equilibria in monetary policy and debt denomination

16. Original sin and the limits to anticylical fiscal policies • If there is a SIGNIFICANT NET foreign debt (public or private) • …and it is in foreign currency • Exchange rate movements cause aggregate wealth effects • Depreciations lower real income • Makes debt service harder… • …lowering creditworthiness in bad times • Less access to finance in bad times • Makes governments forced to tighten fiscal policy, unless it wants to aggravate crowding out • …and tighten monetary policy to avoid further depreciation

17. Implication: automatic stabilizers • If the problem is that debt service increases in bad times, due to debt denomination, • …then the solution is NOT to pre-commit to increase spending in bad times • “Increase automatic stabilizers” NOT YET • This will only aggravate the collapse in solvency in bad times and will force to cut other (presumably good) but a-cyclical social programs such as Education and Health

18. Implication: debt structure • Work on debt structure first • Ideal is long-term, fixed rate peso-denominated bonds • They change in value with the real exchange rate, and with inflation • But they are the hardest to achieve • The paper recommends GDP-linked bonds • GDP is very hard to credibly measure • It may be much easier to develop long-term inflation-indexed fixed rate debt • Protects against collapses in RER & US$ GDP • As in Chile (is this part of Chile’s secret?)

19. OS is the consequence of the currency concentration of the global portfolio (0.9857) 1 Debt by 0.9 Currency (0.8859) 0.8 Debt by Country 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 United States EUROLAND Japan U . K Switzerland Canada Australia

20. Implication: international agenda • It needs an international solution • Create liquidity for instruments with EM currency risk but no credit or country risk • IFIs could play a large role • This would allow IFIs to lend in local currency • Develop the swap market to undo the currency mismatch of EMs

21. Implication: fiscal rules • If the problem is debt structure, fiscal rules should deal with this • Currently, rules relate to deficits and spending • Nothing is geared to monitor the risks involved in the debt structure • Alternative: target a risk-weighted level of debt • Risk weights should reflect the pro-cyclicality and volatility of debt service • Allows the political system to internalize the difference between cheap borrowing and safe borrowing

22. Conclusion • It would be great if the government could offer social protection against aggregate shocks • …but before committing to do so, it needs to be able to do so • At present, many countries are unable to protect in bad times and in fact need to impoverish their populations in bad times to avoid greater damage • We should develop the ability to protect before we commit to use it