1 / 43

Global Financial Turmoil: Is Latin America Sheltered?

Global Financial Turmoil: Is Latin America Sheltered?. Ernesto Talvi. CERES. October 16 th , 2007. Prepared for Presentation at the XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries, IADB, Washington DC. MAIN POINTS OF THE PRESENTATION.

tadeo
Download Presentation

Global Financial Turmoil: Is Latin America Sheltered?

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Global Financial Turmoil: Is Latin America Sheltered? Ernesto Talvi CERES October 16th, 2007 Prepared for Presentation at the XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries, IADB, Washington DC

  2. MAIN POINTS OF THE PRESENTATION • In every major episode of global financial turmoil Latin America suffered a severe blow.

  3. Asian Crisis Tequila Crisis Debt Crisis LTCM / Russian Crisis* 10y Mov.Avg. + 2s 10y Mov.Avg. + 1s Subprime Crisis Global Financial Turmoil Episodes in Perspective* (Moody’s US Baa Spread over US Treasuries) 400 350 300 250 200 150 100 50 0 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 *A global financial turmoil episode is defined as an aggregate-spread window containing a spike in the US Baa spread exceeding two standard deviations from its mean (which starts when the aggregate US Baa spread exceeds one standard deviation, and ends when it is smaller than one standard deviation). If between the end of an episode and the beginning of the next there is less that one year, both are considered part of the same episode.

  4. Debt Crisis LTCM / Russian Crisis 400 350 300 250 200 150 100 50 0 126.5 129.5 140 120 100 -116.6 -146.9 80 60 40 20 0 -20 -40 1978 1984 1986 1994 1996 1998 2000 2002 2004 1980 1982 1988 1990 1992 2006 Global Financial Turmoil Episodes and Sudden Stops in LAC-7* (Moody’s US Baa Spread over US Treasuries and Gross Capital Flows to LAC-7 in billions of 2006 US dollars) 10y Mov.Avg. + 2s 10y Mov.Avg. + 1s Spread on Risky Assets Gross Capital Flows to LAC-7 *LAC-7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, which represent 93% of Latin America GDP

  5. 1980s: Debt Crisis 1990s: LTCM / Russian Crisis LTCM/ Russian Crisis Debt Crisis 105 105 102 100 99 Avg. growth 1998-2002: 0.8% Avg. growth 1991-1997:4.6% 96 Avg. growth 1974-1980: 4.5% 95 93 Avg. growth 1981-1985:0.5% 90 90 87 85 Output Contraction Output Contraction 84 Duration of Recession Phase Recovery to pre-crisis peak levels Recovery to pre-crisis peak levels Duration of Recession Phase Peak to Trough Peak to Trough 81 80 -1.3% 1 yr -5.4% 2 yrs 4 yrs 2 yrs 78 75 75 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Global Financial Turmoil Episodes and Output Performance* (LAC-7GDP, real index) *Talvi, E. (forthcoming), “Sudden Stops in the 80s and the 90s: a Fresh Look at Latin America’s Debt Crisis”

  6. 1980s: Debt Crisis 1990s: LTCM / Russian Crisis 105 105 Debt Crisis LTCM/ Russian Crisis 100 100 Avg. growth 1991-1997:8.5% Avg. growth 1974-1980: 6.8% 95 95 Avg. growth 1981-1985: -4.3% 90 90 85 85 Avg. growth 1998-2002: -4.0% 80 80 75 Output Contraction Output Contraction 75 70 Duration of Recession Phase Recovery to pre-crisis peak levels Duration of Recession Phase Recovery to pre-crisis peak levels Peak to Trough Peak to Trough 70 65 -27.6% 2 yrs 11 yrs -13.9% 1 yr 7 yrs 65 60 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1991 1995 1998 1999 2001 1992 1993 1994 1996 1997 2000 2002 Global Financial Turmoil Episodes and Investment Performance* (LAC-7, Gross fixed capital formation, real indices) *Talvi, E. (forthcoming), “Sudden Stops in the 80s and the 90s: a Fresh Look at Latin America’s Debt Crisis”

  7. Uruguay 90s: LTCM / Russian Crisis Argentina 90s: LTCM / Russian Crisis 35 54% 55 Recovery to pre-crisis trough levels Recovery to pre-crisis trough levels Trough to peak Trough to peak 32% 30% 9 yrs 16% 7+ yrs 30 50 45 25 25% 40 LTCM / Russian Crisis LTCM / Russian Crisis 20 35 30 15 17% 24% 25 10 23% 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 20 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Global Financial Turmoil Episodes and Social Impact: An Ilustration from Argentina and Uruguay* (% of people under the poverty line) *Talvi, E. (forthcoming), “Sudden Stops in the 80s and the 90s: a Fresh Look at Latin America’s Debt Crisis”

  8. MAIN POINTS OF THE PRESENTATION • In every major episode of global financial turmoil Latin America suffered a severe blow. • If recent episodes of capital market turbulence are any indication, the unfolding of a full blown global financial turmoil episode, would be a ‘lethal combo’. Given past experience, it will send once again Latin America diving.

  9. 1100 1000 900 800 700 600 Greenspan’s Conundrum Testimony 500 US Inflation Scare Subprime Crisis 400 Expectations of Fed Tightening 300 China’s Stock Market Sell Off 200 100 1994 1995 1998 1999 2001 2002 2003 2006 2007 1996 1997 2000 2004 2005 Recent Episodes of Global Financial Turbulence (US High Yield Spread, basis points) LTCM / Russian Crisis

  10. Bond Prices (bond price equivalent*, peak to trough variation) Latin America -3.5% US High Yield -3.3% EMBI -3.1% EM Europe -2.7% EM Asia -2.6% BBB Corporate -1.2% AAA Corporate -0.5% US T-Bonds 0.4% Flight to Quality Europe T-Bonds 0.6% Japan T-Bonds 1.0% -4% -3% -2% -1% 0% 1% 2% Credit Spreads Commodity Prices (basis points, peak to trough variation) (peak to trough variation) 72 Latin America -10.5% Industrial Metals US High Yield 66 EMBI 64 Gold -8.1% EM Europe 56 EM Asia 50 Goldman Sachs -4.2% Commodity Index BBB Corporate 23 10 AAA Corporate Agricultural -3.1% Products US T-Bonds -5 Flight to Quality Europe T-Bonds -9 -1.0% Oil -10 Japan T-Bonds -12% -10% -8% -6% -4% -2% 0% -20 0 20 40 60 80 * Own calculations assuming an 11% coupon and 10-year maturity X-Ray of Recent Episodes of Global Financial Turbulence Data Sources: JPMorgan, Bloomberg and MSCI

  11. + 480 bps Simulation of a Global Financial Turmoil Episode (US High Yield Spread over US Treasuries) Asian Crisis Tequila Crisis LTCM / Russian Crisis 1100 1000 10y Mov.Avg. + 2s 900 800 10y Mov.Avg. + 1s 700 600 500 400 300 200 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10

  12. Shock to the US High Yield Spread(bps, High Yield Spread over US Treasuries) 10Y Treasury Yield Dynamics (10Y T-Bond Yield) 6.5% 1050 6.0% 950 +480 bps 850 5.5% 750 5.0% 650 4.5% 550 -35 bps 450 4.0% 350 3.5% 250 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Terms of Trade Dynamics (LAC-7, 91.I = 100) G-7 Industrial Production Dynamics (1991.I = 100) 140 140 -1.5% 138 135 136 130 134 125 132 120 130 115 128 -18% 110 126 105 124 122 100 120 95 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-10 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 “Combo Shock”: Simulation of Collateral Damage of a Global Financial Turmoil Episode

  13. D = + ab + GD + + G D + e y c ' y y ... y - - - - + t t 1 t 1 p 1 t p 1 t Booms and Busts in Latin America: The Role of External Factors* Estimation Strategy: Vector Error Correction Model (VECM) where yt = ( gdp_latt ip_xt tot_latt financ_xt riskt )’ gdp_lat: (log of) Simple average of GDP indices of LAC-7 countries ip_x: (log of) G-7 industrial production index tot_lat: Principal component weighted average of (the log of ) terms of trade indices of LAC-7 countries financ_x: Return on 10 year US T-bonds risk: US High-Yield Bonds Spread *A. Izquierdo, R. Romero and E.Talvi (2007), “Booms and Busts in Latin America: The Role of External Factors”.

  14. External Factors World Growth Actual Fitted Commodity Prices International Financial Conditions US T-Bond Interest Rate Spread on US HY Bonds Booms and Busts in Latin America: The Role of External Factors* (GDP LAC-7, annualized quarter on quarter growth rate) A Vector Error Correction Model 15% Asian Crisis LTCM / Russian Crisis Tequila Crisis 10% 5% 0% -5% -10% Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 *A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.

  15. Output Contraction Recovery to pre-crisis peak levels Duration of Recession Phase Peak to Trough -4.5% 1.5 yrs 3.3 yrs “Combo Shock” LTCM / Russian Crisis -1.3% 1 yr 2 yrs Debt Crisis -5.4% 2 yrs 4 yrs GDP Dynamics w. “Combo Shock” Output Performance: Simulation of the Overall Impact of a Global Financial Turmoil Episode Output Response to “Combo Shock”* 140 135 130 125 120 115 Steady State GDP Dynamics 110 105 100 95 90 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 *Impulse response simulations based on the model by A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.

  16. In every major episode of global financial turmoil Latin America suffered a severe blow. • If recent episodes of capital market turbulence are any indication, the unfolding of a full blown global financial turmoil episode, would be a ‘lethal combo’. Given past experience, it will send once again Latin America diving. MAIN POINTS OF THE PRESENTATION • The analysis based on past experience is faulty, since the external environment is less risky and Latin America’s fundamentals are much stronger today. Thus, the region is less vulnerable to global financial turmoil episodes than in previous expansions.

  17. The ‘This Time is Different’ Hypothesis • The World is a safer place (“Great Moderation” period)

  18. 5.0% 4.0% Economic Growth 3.0% 2.1% 2.1% 2.0% 1.6% 2.0% 1.4% 1.0% 0.0% 7% 6% 5% 3.9% 3.7% 4% Inflation 3% 1.5% 1.5% 2% 0.6% 1% US UK FRANCE GERMANY ITALY CANADA JAPAN 0% 5,0 Real Interest Rates (“perfect foresight” real ex-ante rates for long term instruments) 4,0 3.0 3,0 2.4 2,0 1.6 1.3 Excluding Japan 1.2 0.9 1,0 0,0 60s 70s 80s 90s 00s Growth, Inflation and Interest Rates Volatility in G-7 Countries (standard deviation)

  19. The ‘This Time is Different’ Hypothesis • The World is a safer place ( “Great Moderation” period) • Latin America is more resilient than in previous expansions

  20. Growth Performance (LAC-7, real annual growth rate) Inflation (LAC-7, CPI annual variation) 90s Boom LTCM / Russian Crisis Current Boom 7% 40% LTCM / Russian Crisis 6,2 6,1 6,0 03-06 Average: 5,4% 6% 35% 91-97 Average: 4,6% 5% 30% 4% 74-06 Average: 3,2% 25% 3% Average 91.I-98.II: 20.3% 2% 20% 1% 15% 0% Average 98.II-02.IV: 6.2% 10% -1% 5% -2% 4.1% -3% 0% Mar-91 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 *Median Source: WEO Latin America: Growth and Inflation

  21. External Balance (LAC-7, current account, in millions of USD and % of GDP) International Reserves (LAC-7, billions of US dollars) 5% 55,000 Aug.07/Jun.98 LTCM / Russian Crisis LTCM / Russian Crisis 375 Mexico 2.4 2.3 Peru 345 35,000 3% Brazil 2.3 Dec.02-Aug.07 Variation: 147% 315 Colombia 2.2 % of GDP Millions of USD LAC-7 2.1 285 15,000 Argentina 1.9 1% 255 1.8 Venezuela Chile 1.0 -5,000 225 Jun.98-Dec.02 Variation: -15% Millions of USD % of GDP -1% 195 -25,000 165 Jan.91-Jun.98 Variation: 271% -3% 135 -45,000 105 -5% -65,000 75 45 -7% -85,000 15 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Latin America: External Balance and International Reserves 3.5% 363 173 º -4.9%

  22. Latin America: Fiscal Stance and Debt Management Dollarization of Publc Debt (LAC-7, foreign currency debt, % of total debt) Fiscal Balance (LAC-7, % of GDP) Public Debt Level* (LAC-7, % of GDP) 1,5% 65% 60% LTCM / Russian Crisis 1.0% 61% 1,0% 60% 55% 0,5% 55% 50% 0,0% 50% -0,5% 45% 45% -1,0% 40% 39% 40% 40% -1,5% 34% 35% 35% -2,0% 30% 30% -2,5% -2.7% 25% 25% -3,0% LTCM / Russian Crisis 20% -3,5% 20% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 *Adjusted by Argentina’s debt exchange Source: Cowan, Levy, Panizza, Sturzenegger (2006) and own calculations based on official data.

  23. BB+ Investment Grade Chile Colombia Mexico Investment Grade Chile Mexico B+ Latin America: Credit Ratings (LAC-9** excluding Ecuador, Standard & Poor´s Credit Ratings) Numerical Transformation of Credit Ratings* 11,0 AAA 21 AA+ 20 AA 19 AA- 18 A+ 17 A 16 A- 15 BBB+ 14 BBB 13 BBB- 12 BB+ 11 BB 10 BB- 9 B+ 8 B 7 B- 6 CCC+ 5 CCC 4 CCC- 3 CC 2 SD 1 10,5 Investment Grade 10,0 9,5 9,0 8,5 8,0 7,5 Oct-03 Oct-04 Oct-05 Oct-06 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Feb-04 Feb-05 Feb-06 Feb-07 *A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” (forthcoming) ** LAC-9 includes the Latin American countries currently covered by JPMorgan EMBI

  24. In every major episode of global financial turmoil Latin America suffered a severe blow. • If recent episodes of capital market turbulence are any indication, the unfolding of a full blown global financial turmoil episode, would be a ‘lethal combo’. Given past experience, it will send once again Latin America diving. • The analysis based on past experience is faulty, since the external environment is less risky and Latin America’s fundamentals are much stronger today. Thus, the region is less vulnerable to global financial turmoil episodes than in previous expansions. MAIN POINTS OF THE PRESENTATION • At closer look, the world is still a risky place and Latin America’s underlying vulnerabilities to a global financial turmoil episode are still large, but the current bonanza is disguising a host of fundamental fragilities.

  25. ‘Plus Ça Change, Plus Ça Reste La Même Chose’ (The more things change, the more they remain the same) • The World is still a risky place

  26. Debt Crisis LTCM / Russian Crisis 375 379 1978-2007 Avg. 165 169 116 66 48 1978-2007 Avg. 15 20 24 11 10 0 Great Moderation? The Calm Before the Storm… 450 400 350 Moody’s Baa Corporate Spread 300 250 (basis points) 200 150 100 50 0 80 70 60 Moody’s Baa Corporate Spread Volatility 50 40 (3 year moving standard deviation, in basis points) 30 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

  27. Mean+2s The Global Financial Turmoil Histogram (Moody’s Baa Spread Histogram, 1978 – 2007) 12.6% Global Financial Turmoil Probability: 4.5% 11.2% 9.8% 8.4% 7.0% Mean+1s 5.6% 4.2% 2.8% 1.4% 0% 90 370 390 190 210 230 250 270 290 310 110 130 150 170 330 350

  28. ‘Plus Ça Change, Plus Ça Reste La Même Chose’ (The more things change, the more they remain the same) • The World is still a risky place • Latin America’s fundamentals are weaker than meets the eye

  29. Forecast for GDP: 1998 – 2001 (LAC-7, Values in logs) 90% confidence interval 90% confidence interval 4.72 4.70 4.68 Steady State GDP Predicted GDP w. Observed External Factors 4.66 4.64 Predicted GDP w. Observed External Factors 4.62 4.60 Steady State GDP Observed GDP 4.58 4.56 Observed GDP 4.54 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Nov-97 Nov-98 Nov-99 Nov-00 Nov-01 Assessing Performance in Latin America: A Counterfactual Exercise* Forecast for GDP: 2003 – 2006 (LAC-7, Values in logs) 4.83 4.78 4.73 4.68 4.63 4.58 Jul-03 Jul-04 Jul-05 Jul-06 Jul-02 Mar-03 Mar-05 Mar-06 Mar-02 Mar-04 Nov-02 Nov-03 Nov-04 Nov-05 *Simulations based on the model by A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.

  30. Terms of Trade Adjusted at I.2002 prices Latin America External Balance: A Different Perspective*(LAC-7, current account, in millions of USD and % of GDP) 55,000 5% LTCM / Russian Crisis 35,000 3% % of GDP Millions of USD 15,000 1% -5,000 % of GDP Millions of USD -1% -25,000 -3% -45,000 -5% -4.5% -65,000 -4.9% -85,000 -7% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 * G. Calvo and Talvi, E. (2007): “Current Account Surplus in Latin America: Recipe Against Capital Market Crises?”; www.rgemonitor.com (forthcoming)

  31. Reserves / M2 Average 2002.IV – 2006.III: 48.3% Average 1991.I-1998.II: 45.6% Average 1998.II-2002.IV: 40.3% Latin America: International Reserves (billions of US dollars and % of M2) 260 60% LTCM / Russian Crisis Reserves 240 220 55% 200 180 50% 160 % of M2 Billions of US dollars 140 45% 120 100 40% 80 60 35% 40 20 30% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 M2 = Currency outside banks + demand deposits + time, savings and foreign currency deposits of resident sectors Source: IFS and own calculations

  32. Chile (% of GDP) LAC-7 (% of GDP) LTCM / Russian Crisis Beginning of Current Boom 9,0% 2.0% LTCM/ Russian Crisis Beginning of Current Boom 1.0% Observed Balance 1.0% 7,0% Observed Balance 0.0% 5,0% Structural Balance** -1.0% 3,0% Structural Balance -2.0% -3.1% 1,0% -2.4% -2.7% -3.0% -1,0% Structural Balance -4.0% -3,0% -4.5% -5.0% -5,0% Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dic-05 Dic-91 Dic-92 Dic-93 Dic-94 Dic-95 Dic-96 Dic-97 Dic-98 Dic-99 Dic-00 Dic-01 Dic-02 Dic-03 Dic-04 Dic-06 **Excluding Venezuela Latin America: Structural Fiscal Balance* *A. Izquierdo, Ottonello, P., Talvi, E. (forthcoming), “ If Latin America Were Chile: A Comment on Structural Fiscal Balances and Public Debt” .

  33. Chile (Mar-91 = 100) LAC-7 (Mar-91 = 100) LTCM / Russian Crisis Beginning of Current Boom LTCM/ Russian Crisis Beginning of Current Boom 280 Fiscal Revenues 260 280 240 Fiscal Revenues 220 230 200 Fiscal Expenditures Adjusted Revenues 180 180 160 Fiscal Expenditures 140 130 120 Adjusted Revenues 100 80 80 Mar-91 Mar-93 Mar-95 Mar-97 Mar-99 Mar-01 Mar-03 Mar-05 Mar-91 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Latin America: Fiscal Revenues and Expenditures* *A. Izquierdo, Ottonello, P., Talvi, E. (forthcoming), “ If Latin America Were Chile: A Comment on Structural Fiscal Balances and Public Debt” .

  34. Increase in Public Expenditures per Country (in % of increase in fiscal revenues, 2002-2006) Increase in Total Revenues 92% Venezuela 87% Brasil 85% Mexico Interest Payments 2% Argentina 76% Primary Expenditures Colombia 73% 68% Peru 57% Chile 25% 0% 20% 40% 60% 80% 100% Prociclicality in Public Expenditures Increase in Public Expenditures for LAC-7 (in % of increase in fiscal revenues, 2002-2006) 100% 80% 60% 40% 20% 0%

  35. 48% Structural Debt 42% Latin America: Structural Debt (LAC-7, in % of GDP) 90s Boom Current Boom LTCM / Russian Crisis 55% 52% 50% 49% Observed Debt 45% 40% 39% 35% 32% 30% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 *A. Izquierdo, Ottonello, P., Talvi, E. (forthcoming), “ If Latin America Were Chile: A Comment on Structural Fiscal Balances and Public Debt” .

  36. Brazil Mexico (Federal Domestic Securities, exchange rate linked + Selic linked, % of total debt) (Federal Government Domestic Securities, exchange rate linked Tesobonos, % of total debt) Pre-Asian Crisis Pre-Tequila Crisis Pre-Devaluation Pre-Devaluation 100% 80% 88.1% 66.9% 90% 70% 80% 60% 70% 50% 60% 50% 40% 40% 30% 28.3% 30% 20% 20% 10% 10% 4.9% 0% 0% November 1998 November 1994 August 1997 December 1993 Debt Mutation: Two Compelling Examples* * E. Cavallo, Izquierdo, A., and Talvi, E. (in progress), “External Financial Conditions and Debt Composition: the Mutation Factor”.

  37. In every major episode of global financial turmoil Latin America suffered a severe blow. • If recent episodes of capital market turbulence are any indication, the unfolding of a full blown global financial turmoil episode, would be a ‘lethal combo’. Given past experience, it will send once again Latin America diving. • The analysis based on past experience is faulty, since the external environment is less risky and Latin America’s fundamentals are much stronger today. Thus, the region is less vulnerable to global financial turmoil episodes than in previous expansions. • At closer look, the world is still a risky place and Latin America’s underlying vulnerabilities to a global financial turmoil episode are still large, but the current bonanza is disguising a host of fundamental fragilities. MAIN POINTS OF THE PRESENTATION • The evidence from credit ratings and the behavior of asset prices is consistent with the view that Latin America is still vulnerable to global turmoil, but financial shocks so far have been “too small to hurt”.

  38. Numerical Transformation of Credit Ratings* Russian Crisis AAA 21 AA+ 20 AA 19 AA- 18 A+ 17 A 16 A- 15 BBB+ 14 BBB 13 BBB- 12 BB+ 11 BB 10 BB- 9 B+ 8 B 7 B- 6 CCC+ 5 CCC 4 CCC- 3 CC 2 SD 1 Investment Grade Investment Grade Chile Chile Colombia Colombia Mexico Uruguay Investment Grade Chile Mexico Credit Ratings Agencies Verdict (LAC-9 excluding Ecuador, Standard & Poor´s Credit Ratings) 11,0 BB+ BB+ 10,5 10,0 9,5 9,0 8,5 Investment Grade 8,0 BB 7,5 Dic-96 Dic-97 Dic-98 Dic-99 Dic-00 Dic-01 Dic-02 Dic-03 Dic-04 Dic-05 Dic-06 *A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” (forthcoming)

  39. (1) (2) (3) (4) Relatively Tranquil Recent Period Naïve Beta ΔLA EMBI Spread ΔUS HY Spread Dating (3) / (2) 3-Aug to 19-Oct-98 444 1.5 299 1600 12-Sep to 15-Dec-00 109 0.8 139 7-Feb to 9-Apr-01 Latin EMBI 96 1.0 97 21-May to 4-Oct-01 430 2.0 218 1200 10-May to 14-Oct-02 539 1.3 409 1.3 Systemic Turmoil Period Average 800 19-Apr to 17-May-04 77 1.4 55 10-Mar to 18-May-05 80 0.5 158 10-May to 27-Jun-06 47 1.1 43 400 26-Feb to 7-Mar-07 US High Yield 20 0.7 30 23-Jul to 16-Aug-07 49 0.5 90 0 0.8 Recent Period Average 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Let Prices Talk: EMBI Spreads Reaction to Spikes in US High Yield Spreads Systemic Turmoil Period (US High Yield and Latin EMBI spreads, basis points)

  40. Beta Coefficient where is the correlation coefficient between x and y, and and are the variance of x and y, respectively r s r s b x = s y x s y Variance Adjustment Coefficient where is the variance of x during a period of market turmoil and is the variance of x during a period of relative market stability h s h x x s l s d = - 1 xx x x t s l xx Correlation Adjustment u r where is the actual correlation coefficient and is the unadjusted correlation coefficient u r r t r = t t t u ] + d - r [ 1 1 ( ) 2 t t Measuring Contagion: The Forbes-Rigobon Adjustment* *K. Forbes and Rigobon E. (1999), “No Contagion, Only Interdependence: Measuring Stock Market Co-Movements”

  41. Beta Coefficient (average beta per period, US high yield vs. Latin EMBI) 1600 1.4 1.27 Latin EMBI 1.2 1200 1.0 0.86 0.76* 0.8 800 0.6 400 0.4 US High Yield 0.2 0 Systemic Turmoil Period Relatively Tranquil Recent Period 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Let Prices Talk: EMBI Spreads Reaction to Spikes in US High Yield Spreads Systemic Turmoil Period Relatively Tranquil Recent Period (US High Yield and Latin EMBI spreads, basis points) *Adjusted using Forbes, Rigobon (1999) methodology

  42. IN SUMMARY • When scratching the surface, Latin America is still highly vulnerable to a global financial turmoil episode • Although we should enjoy the good times, policy makers in the region should be on guard and fire departments (i.e. multilaterals) in full alert mode • This analysis should not be construed as a gloomy forecast, but rather as a warning against “irrational exuberance”.

  43. Global Financial Turmoil: Is Latin America Sheltered? Ernesto Talvi CERES October 16th, 2007 Prepared for Presentation at the XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries, IADB, Washington DC

More Related