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RIDING BUBBLES Questions and Challenges

RIDING BUBBLES Questions and Challenges. Guillermo Calvo Columbia University. Presented at the conference on Latin American and the Caribbean Development Challenges and Policies: What Are the Issues?” IDB, Washington, DC, Sept. 10-11, 2009. Systemic Financial Crises.

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RIDING BUBBLES Questions and Challenges

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  1. RIDING BUBBLESQuestions and Challenges Guillermo Calvo Columbia University Presented at the conference on Latin American and the Caribbean Development Challenges and Policies: What Are the Issues?” IDB, Washington, DC, Sept. 10-11, 2009.

  2. Systemic Financial Crises • Systemic financial crises are like bank runs without a Lender of Last Resort. • Russia 1998 crisis and its spread across Emerging Markets is an outstanding example. • The Subprime crisis, especially after Lehman September 2008, is another. • Besides, these are episodes of Triple Time-Inconsistency. (See my voxEU.org note).

  3. Impact on EMs and LAC • Emerging Markets, in general, saw an increase in capital inflows until Lehman. • My conjecture is that the market believed the crisis would bottom out quickly because of massive liquidity injection, in contrast with the 1930s. • And investors positioned themselves in strong EMs (e.g., LAC) and commodities. • This gave rise to the decoupling conjecture.

  4. EstimatedSudden Stop Probabilities (Based on Calvo, Izquierdo and Mejia, NBER Working Paper 14026, 2007) Notes: Simple country averages. LAC7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. CAC5 includes Costa Rica, Guatemala, Honduras, Nicaragua and Dominican Republic. Eastern Europe includes Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Turkey.

  5. EMBI+ Yield & Terms of Trade in LAC(quarterly data, Terms of Trade Index 1997-I = 100, EMBI+ Yield) Note: Terms of trade series include Argentina, Brazil, Chile, Colombia, Mexico and Peru. Simple average. Source: IADB and Bloomberg.

  6. Lehman and After • Lehman debacle sent a strong message that the Fed was ready to step out before removing all the sources of infection. • It marks the beginning of a global crisis (no decoupling). • However, the about-face of the Fed (AIG and the rest) seems to be restoring confidence. • And financial conditions in EMs and LAC are improving.

  7. ExternalFinancial Conditions for EMs(daily data, EMBI+, bps, last value 07-Sep-09) ENRON Effect Greenspan’s “conundrum” testimony Lehman Brothers files for bankruptcy Fears of FED tightening Basis points Yields Pre-Asian Crisis Yield =-28% Spreads Pre-Asian Crisis Spread =-0.1% Beginning of improvement in international financial conditions Source: Datastream.

  8. Stock Markets (daily data, MSCI Stock Indices in USD, 9/3/07=100, last value 04/07/09) US $700b Rescue Plan is passed by Congress Latin America Emerging Economies Source: Bloomberg.

  9. Lessons • Once again, we learned that external factors play an important role. • However, this time found LAC in stronger financial health because of: • a history of current account surpluses • de-dollarization. • Lehman aftermath also shows that financial health does not ensure output stability. See Chile, Brazil, Peru, Mexico.

  10. Fiscal Policy • As shown in All that Glitters, LAC has little room for fiscal deficits. • Available fiscal fire power should be spent on social programs. • It may be worth exploring PPPs with support from MDBs.

  11. Monetary Policy • With few exceptions, EMs have substantially devalued their currencies. • This caused little impact on inflation because of world deflation. • But may not work that way looking forward, because recovery may bring about another steep rise in commodity prices.

  12. Inflation Targeting • Low inflation should continue to be a critical long-term objective. • However, it would be wrong to stick to low inflation on the face of, e.g., a boom in commodity prices. • Moreover, In the short run, IT may be inconsistent with a Target on International Reserves. • Reserves help to protect the banking sector and exports during Sudden Stop.

  13. Financial Regulation • It is as important as monetary policy. • Reserve and Liquidity Requirements could be employed to squash excessive credit expansion, and to provide liquidity in times of financial stress. • This must be distinguished from controls on capital flows that are easy to circumvent and fall unduly hard on small and medium enterprises.

  14. Prudential regulation is good but within certain bounds. • In a voxEU.org note Rudy Loo-Kung and I show that financial crises in EMs may have been preferable to the status quo. • Moreover, beware of free riders. There is some evidence that public sector prudence was accompanied by private sector imprudence.

  15. RIDING BUBBLESQuestions and Challenges Guillermo Calvo Columbia University Presented at the conference on Latin American and the Caribbean Development Challenges and Policies: What Are the Issues?” IDB, Washington, DC, Sept. 10-11, 2009.

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