Dealing with terms-of-trade
volatility
Ricardo Hausmann
Kennedy School of Government
Harvard University
La región andina enfrenta términos de
intercambio muy volátiles
Volatilidad Términos de Intercambio
Venezuela
Ecuador
Bolivia
El Salvador
Rep. Dominicana
Colombia
Perú
Nicaragua
Guatemala
Chile
Brasil
Uruguay
México
Costa Rica
Paraguay
Honduras
Argentina
Panamá
0
10
20
30
40
50
60
...en una región ya de por si
volátil
Standard Deviation of
Latin America
Industrialized
Countries
East Asian
Miracles
4.2
5.6
13.4
463.5
2.2
2.1
4.8
3.9
3.1
4.1
6.2
6.2
4.7
211.1
2.4
5.6
2.4
13.6
15.1
2.8
8.9
1.7
8.0
1.5
Macroeconomic Outcomes
Real GDP growth
Consumption Growth
Change in RER
Inflation Rate
Policy
Fiscal Deficit (%GDP)
Monetary Growth
External Shocks
Terms of Trade Change
Int’l Capital Flows (%GDP)
Volatility in a neo-classical world
• There are shocks
– Terms of trade, natural phenomena, technology
• People smooth consumption
– Borrow in bad times, pay back in good times
– Anti-cyclical finance
• Governments smooth tax rates, spending
– Anti-cyclical fiscal policy, deficits
• Country smoothes domestic demand
– Borrow in bad times, pay back in good times
– Anti-cyclical international finance
Volatility in the developing
world
• Domestic finance is pro-cyclical
• Fiscal policy is pro-cyclical
• Foreign finance is pro-cyclical
Excess volatility
• Inability to borrow in bad times
• …because you may go broke?
– Solvency, inability to pay
• …because you tend to overspend in good
times
• …because you may be unable to commit
– Illiquidity, unwillingness to pay
• The role of collateral
Collateral: domestic and foreign
• Foreign financiers take one type of collateral from
domestic banks
• Domestic banks take another form of collateral
from distressed firms
• If collateral is enough r = r*
• If tradeable collateral is insufficient, you get
firesale prices
• If domestic collateral is insufficient, you get
inefficiently low returns to foreign financiers and
additional domestic pain
Developing countries are
recession-prone
#of Recessions
Avg. Length
Avg. depth
(years)
of the recession
Industrial Countries
2.1
1.3
-2.0%
Latin America
2.2
1.9
-8.0%
East Asian Countries
0.7
1.0
-1.6%
South Asia
1.8
1.2
-3.5%
Other East Asian Pacific
3.7
1.5
-8.7%
Sub-Saharan Africa
3.9
1.5
-6.0%
Mid-East & N. Africa
3.2
1.7
-11.7%
Other
2.0
2.2
-18.3%
Institutions for Economic Stability
• Terms of trade risk management
• Fiscal stability
• Exchange rate and monetary regimes
• Financial systems
Institutions to reduce and manage
terms of trade risk
• To reduce terms of trade risk:
• Open trade and investment to promote efficient
export diversification ! Integration
• The volatility-concentration trap
• The volatility-protection trap
• To manage terms of trade risk:
• Diversification of ownership: the role of open
capital markets
• Hedging: Export risk through derivatives
• Institutions for self-insurance
Financial policies
• Be solvent
• Be liquid
• Be credible
Financial policies: be solvent
Problem
• Large shocks can render banks insolvent,
making them amplify the consequences
Solution
• Impose high capital-adequacy requirements
– Buffer stock
• Promote internationalization of banks
– Diversification of risks
Financial policies: be liquid
Problem
• Volatile demand for deposits and capital flows
makes banks vulnerable to liquidity shocks
Solution
• Impose high liquidity requirements
– Buffer stock
• Develop contingent credit lines
• Maintain Central Bank liquidity
• Internationalize the banking system
– Access to liquidity
Financial policies: be credible
Problem
• Asymmetric information creates lack of
confidence and potential self-fulfilling attacks
– The airline metaphor
Solution
• Empower a regulator to supervise capital
adequacy and intervene problem banks
• Support that function with disclosure and market
discipline
• Internationalize the banking system
– Indirect competition between supervisors
Fiscal policy
Fiscal policy has been pro-cyclical
Correlation coefficient with GDP; 1970-95
0.6
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
Fiscal Balance
Public Consumption
América Latina
OCDE
Inflation tax
…especially in recessions
Fiscal balance during recessions
20%
América Latina
OCDE
10%
0%
-10%
-20%
-30%
1
2
3
4
5
6
7
8
9 10 11 12 13
1
2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18
recessions
Cummulative GDP fall (%)
Change in fiscal surplus (% del PIB)
Volatility affects country risk and
hence the cost of capital
• Probability of default
• Ability to pay vs. willingness to pay
• Assume:
– Only problem is ability to pay
– Laffer curve, i.e maximum tax rate
– predetermined stock of debt
• When does default occur?
– iB > ty-g
Let y* such that iB=ty*-g
• Assume y is stochastic E(y)>y*
• Probability of default depends on B, t, y*, stdev(y)
Volatility of fiscal accounts
Volatility of fiscal variables; 1970-94
(Standard deviations of the rates of growth)
35%
30%
25%
20%
15%
10%
5%
0%
Fiscal shock
Revenues
OCDE
Current spending Capital expenditures
América Latina
Volatility and pro-cyclicality are
linked
Pro-cyclicality of government consumption
Volatility of GDP growth and
Pro-cyclicality of government consumption
1970-95
1.0
VEN
0.8
PRY
0.6
0.4
0.2
PER
MEX CRI
BRA
GTM
JAM
DEU
COL
ITA
JAP
PAN
SLV
TTOCHL
URY
HND
BOLARG
ECU
DOM
BRB
CAN
USA
0.0
GBR
-0.2
-0.4
1%
FRA
2%
3%
4%
5%
Volatility of GDP growth
6%
7%
Fiscal pro-cyclicality:
a vicious circle?
• High macroeconomic volatility requires large fiscal
adjustments
• Doubts about future fiscal adjustment creates
solvency concerns. Access to finance tends to
disappear in bad times, when more finance is needed
• This forces the government to adjust pro-cyclicaly in
bad times increasing overall macro volatility
• …and using the inflation tax to erode the value of
nominal fiscal commitments in bad times
Fiscal policy: two paradigms
• Optimize a welfare function
– Under certain constraints
• Consider strategic interactions
Terms of trade and fiscal policy:
a pure neo-classical approach
• Maintain stable spending programs
• Maintain stable tax rates
• …subject to an inter-temporal budget
constraint
• This will make the deficit anti-cyclical
• The inspiration of many stabilization funds
The problem with stabilization
funds
• Money is fungible
• Constrains liquidity management more than the
deficit
– Does not address the overall budget deficit
– E.g. Colombia
• As money in the fund grows, so does the incentive
to spend it
• Chile is prudent for other reasons
– It has very strong budget institutions
Complications
• Permanent shocks or non-stationary
processes
– Can find solutions if there is an adjustment cost
(Hausmann, Powell and Rigobon (1990)
• Uncertainty about the nature of the shocks
• What if lending (and country-risk) is procyclical?
Fiscal policy as a strategic game
• Commons problem
– Chicken and lobster
• Dynamic commons problem
– Voracity effect
• Coordination problems
– Delayed stabilization
Fiscal policy as a strategic game
• Aggregation
– Electoral rules
• Partisanship and strategic use of debt
• Credibility (time inconsistency)
• Agency
– Electoral cycles
There is a strong electoral
budget cycle
Fiscal Policy and Elections
Latin America, 1980-96
Percent of GDP
1.5
1
0.5
0
-0.5
-1
-1.5
Fiscal Outcome
Pre-election
Election year
Post-election
Electoral rules matter
• They determine the effective number of
parties
• The support for government in congress
• They affect the magnitude of the commons
problem and of the coordination problems
Proportional representation or firstpast-the-post systems
Representatives per electoral district
Lower chamber
Brazil
Mexico
Bolivia
Argentina
Venezuela
El Salvador
Costa Rica
Nicaragua
Honduras
Guatemala
Uruguay
Suriname
Colombia
Peru
Paraguay
Dom Rep
Ecuador
Chile
Panama
Belize
Jamaica
Barbados
Haiti
Trinidad
Bahamas
0
4
8
12
16
20
Guyana ha sido excluída del gráfico por razones de presentación.
Su número de representantes es 43.4.
More proportional representation,
more parties
Instituciones Electorales y Resultados Políticos
10
Número de Partidos Efectivos
BRA
CHL
ECU
VEN
PAN
DNK
NED
BEL
SLV
BOL
FRA
SWE
URY
IRE
PER
DOM
PRY
TTO
GBR
FIN
BLZ
POR
ARG
NIC
SPA
GTM
CRI
GRE
HND
ITA
DEU
MEX
GUY
AUT
COL
BRB
HTI
BHS
JAM
1
1
10
100
1000
Representatives per district (log scale)
El número de representantes por distritos en los sistemas
bicamerales es el máximo entre las dos cámaras
Representation of the executive’s party in congress
…and less support for the government in
congress
Fragmentation and minority governments
Lower chamber
0.9
JAM
BHS
HTI
0.8
0.7
BRB
MEX
COL
HND
BLZ
GUY
TTO
0.6
CHL
PER
GTM
ARG
PRY
CRI
DOM
0.5
PAN
NIC
SUR
BOL
0.4
URY
BRA
SLV
0.3
VENECU
0.2
1
10
Effective number of parties
More proportional representation,
larger deficits
Superávit Fiscal
(% del PIB)
0.04
0.02
JAM
BRB
CHL
TTO
PRY
BRA
MEX
0.00
PAN
-0.02 BHS
COLGTM
CRI
DOM
ECU
URY SLV
IREPER
ARG
FIN
BOL
FRA
-0.04 GBR
HTI
BLZ
-0.06
DNK
HND
POR
SPA
NIC
VEN
AUT
DEU
NED
SWE
BEL
-0.08
ITA
-0.10
-0.12
1
10
100
Representatives per district (log scale)
1000
…and more debt
Public debt
Percentage of revenues)
1.40
BEL
1.20
ITA
HND
PAN
1.00
JAM
IRE
ECU
0.80
GRE
PER
BOL
NED
DNK
CRI
POR
SPA ARG
VEN
0.60
DOM
GBR
FRA
TTO
0.40
SWE
AUT
DEU
FIN BRA
BLZ
CHL
URY
COL
SLV
MEX
PRY GTM
0.20 BHS
0.00
1
10
100
Representatives per district (log scale)
1000
…and more pro-cyclicality
Pro-cyclicality of government consumption
vs. district
(Correlación
entremagnitude
Gasto Público y PIB)
0.80
0.60
0.40
MEX
CRI
VEN
0.20
JAM
COL
PRY
PER
PAN
0.00
URY
TTO
CHL
BRA
GTM
HND
SLV
DOM
ECU
ARG
BOL
-0.20
FRA
GBR
BRB
-0.40
-0.60
1
10
Representatives per district (log scale)
100
Why do BI matter??
• Budget institutions matter because they
affect the rules of the game under which the
different actors involved in the budget
process interact, either by placing
constraints to the whole process, or by
distributing the power, information and
responsibilities among the different agents,
and thus affecting fiscal outcomes.
Budgetary rules
• Numerical rules
• Procedural rules
• Rules that affect the transparency of the
budget
Numerical rules: examples
• Balanced budget rules, such as those of the
U.S. states
• Maastricht criteria (which impose limits on
deficit and debt)
• Gramm-Rudmann-Hollings (in the US),
which imposes a gradual reduction of
deficits, until their elimination
Numerical rules may differ...
• Regarding the indicator of performance they refer to
• regarding the legal rank of the norm that establishes
them
• regarding their coverage
• regarding the stage of the budget process in which
they apply
• regarding their “flexibility”
– They may be non-contingent or contingent, with clearly
specified escape clauses
– may be defined on the basis of an indicator of structural deficits
– as a general rule, the greater the flexibility, the greater the
complexity, the easier it becomes to elude them
Numerical rules: pros and cons
• Pros:
– If they are enforced, they may solve the majority of the
problems identified above
•
•
•
•
they limit the strategic used of debt
they limit the transfer from future to present generations
they limit the electoral cycle
they limit the common pool problem, etc.
• Cons:
– They may generate incentives for “creative accounting”
– They limit the possibility of engaging in tax-smoothing
(a la Barro) (at least in the case of balanced budget
rules)
– They tend to be too inflexible (in particular in the case
of highly volatile regions such as Latin America)
Procedural rules
• They affect the rules of the game in the interaction
among the different agents that participate in the
budget process
• May be more “hierarchical” or more “collegial”
• Hierarchical rules concentrate the power on the
finance minister vis a vis the spending ministers,
and on the executive vis a vis the legislature
• Collegial rules tend to allocate power more
equally among all the actors involved
Examples of hierarchical and collegial rules
• During the drafting of the budget:
– Hierarchical: At the beginning of the drafting of the budget,
spending ministers receive spending caps which they must
observe.
– Collegial: each spending minister drafts its own budget, and
these are then negotiated within the cabinet.
• During the approval of the budget:
– Hierarchical : Congress can modify the composition of
expenditures, but cannot increase total expenditure or deficits
– Collegial: Congress may propose any changes, without
restrictions
Examples of hierarchical and collegial rules
• During the implementation of the budget:
– Hierarchical : The government may cut expenditures
unilaterally if revenues are lower than projected
– Collegial: Congress has the initiative to propose
increases in the budget, even after it has been approved
Procedural rules: pros and cons
• Pros:
– They may generate fiscal discipline by concentrating power
on those who are responsible for macro stability.
– May solve the common pool problem
– They are more flexible than numerical rules, and allow a
response to the cycle
• Cons:
– They do not solve the electoral cycle problem
– They do not solve the problems associated to the short time
horizon of politicians.
– They do not solve the problem of the strategic use of debt
– By allowing a greater degree of discretion, they may have a
lower effect on the credibility of fiscal policy
Budget institutions in Latin America,
1990-95
Index of budget institutions
COL
JAM
CHL
MEX
PAN
URY
TTO
BHS
GTM
ARG
CRI
ECU
PRY
VEN
PER
HND
BRA
SLV
BOL
DOM
0.1
0.76
0.75
0.73
0.72
0.66
0.62
0.58
0.57
0.57
0.57
0.56
0.56
0.55
0.55
0.54
0.52
0.50
0.50
0.47
0.45
0.2
0.3
0.4
0.5
0.6
0.7
0.8
More hierarchical institutions lead to
smaller deficits
Fiscal deficits:1990-95
(% of GDP)
0.04
JAM
CHL
PRY
0.02
TTO
BRA
0
DOM
SLV
-0.02
MEX
COL
PAN
GTM
CRI
ECU
PER BHS
ARG
URY
BOL
-0.04
HND
VEN
-0.06
-0.08
0.4
0.45
0.5
0.55
0.6
0.65
0.7
Index of budget institutions
0.75
0.8
... And lower debt
Public debt: 1990-95
(as a share of revenues)
6.0
PER
5.0
HND
4.0
DOM
BOL
PAN
ECU
CRI
3.0
JAM
SLV
VENGTM
ARG
2.0
BRA
PRY TTO
URY
MEX
CHL
1.0
COL
BHS
0.0
0.4
0.45
0.5
0.55
0.6
0.65
Index of budget institutions
0.7
0.75
0.8
…but do not improve pro-cyclicality
La Prociclicalidad:1990-95
(Correlación entre el Gasto Público y el PIB)
0.9
VEN
PER
CRI
0.8
0.7
MEX
PRY
SLV
BRA
0.6
PAN
CHL
TTO
URY
GTM
JAM
0.5
0.4
HND
0.3
COL
ARG
BOL
ECU
0.2
DOM
0.1
0.4
0.45
0.5
0.55
0.6
0.65
Index of budget institutions
0.7
0.75
0.8
…or limit electoral cycles
Los Ciclos Electorales:1990-95
(Superávit Fiscal Promedio en años electorales menos Superávit Fiscal
Promedio en años pos-electorales)
0.01
0
-0.01
-0.02
-0.03
-0.04
0.4
0.45
0.5
0.55
0.6
0.65
Index of budget institutions
0.7
0.75
0.8
Rules that affect the transparency of the
budget
• Off-budget items
• strategic use of macroeconomic forecasts used for
the drafting of the budget
• Treatment of contingent liabilities
• Creative accounting
• WHY IS IT SUB-OPTIMAL TO LIE?
• NEED FOR AN INDEPENDENT AND
CREDIBLE SCOREKEEPER
Fiscal policy: be solvent
The problem:
• Precarious access to finance in bad times
forces contractionary pro-cyclical policies
The solution
• Run a precautionary fiscal surplus in
expected cyclically adjusted terms
Fiscal policy: be liquid
Problem
• Need to refinance creates the possibility of
runs and attacks against the debt
Solution
• Prefund your needs / maintain liquidity
• Avoid short term debt
• Contract contingent credit lines
Managing volatile fiscal accounts
• Take account of your electoral and party
system
• If you are going to impose a numerical rule,
do it on spending
• Maximize transparency
• Set long-term goal for debt/gdp ratio
Managing volatile fiscal accounts
• Put anti-deficit biases wherever you can
– Give the power to estimate the budget revenues
and entitlements to an autonomous entity
– Use a rule to limit spending
– Do not allow the congress to increase spending
– Give the executive the power to cut the budget
– Move to pluri-annual budgets