Euro-Latin Network:
The Macroeconomics
Agenda
Guillermo A. Calvo
October 9, 2002
The Issues
Moral vs. Globalization Hazard
Sudden stops in capital flows:
Factors that contribute to vulnerability
Implications in terms of real exchange rate adjustment
Valuation effects on fiscal sustainability and financial
crises?
Dollarization:
 Additional vulnerability?
Convergence or escape from domestic currencies?
Can it be reversed?
The Issues (c’td)
Banking:
Universal or Narrow Banking?
Indexation in banking system and the choice of
exchange rate regime.
Public debt management:
Optimal currency composition?
Indexation mechanisms?
Inflation targeting:
Effectiveness in dollarized economies?
Credibility under large real exchange rate realignment
following sudden stops?
MORAL AND GLOBALIZATION
HAZARDS
Where The G7 Stand (?)
 G7 appear to hold the view that throwing liquidity into
BOP/financial crises is counterproductive
 Pontius Pilate’s Aproach to Crisis Prevention and
Resolution:
Avoid BOP Crises: FLOAT
if applied to the domestic banking sector, this is equivalent to
deposits being subject to floating, market-determined, prices.
problem: Fear of Floating (Terror of Floating in Argentina)
Design Chapter 11 for Sovereigns
If applied to the domestic banking sector, this is equivalent to
appealing to Chapter 11 even if banks are faced with a liquidity
crisis.
problem: sovereigns stop repaying well before they become
technically insolvent. Thus, this issue is eminently political.
The Moral Hazard View
Large bailouts starting with the Tequila
$50 billion package, induced greater
risk taking by governments and
investors,
which increased the incidence of
crises.
Moral Hazard: A Critique
Capital flows to EMs started to fall
a year after Tequila
The composition of flows shifted
in favor of Foreign Direct
Investment
Private Net Capital Flows
Emerging Markets
270
Financial globalization starts 
Tequila 
220
170
120
70
20
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
-30
Foreign Direct Investment
300
Financial globalization starts 
Tequila 
250
200
150
100
50
0
Private Flows
Private FDI
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
-50
Globalization Hazard View
Since 1989 capital flows to EMs increased at
a very rapid rate, and also collapsed very
sharply starting in 1996.
Volatility was high, and capital flow reversals
reached record-high levels
Current account adjustments are much
bigger in EMs than in Advanced Economies.
Crises could reflect institutional and
informational features that apply
especially to EMs.
KEY FEATURES OF EMs
SUDDEN STOP
Reversal of Capital
Country/Episode Inflows (% of GDP)
Argentina 1982-83
20
Ecuador 1995-96
19
Mexico, 1981-83
12
Korea 1996-97
11
Thailand 1996-97
26
Turkey 1993-94
10
Source: Guillermo Calvo and Carmen Reinhart, (2000).
Fear of Floating: Probability
of staying within narrow bands
Exchange Rate
US$/DM (2/73-4/99)
Japan (2/73-4/99)
Bolivia (9/85-12/97)
Mexico (12/94-4/99)
Peru (8/90-4/99)
Uganda (1/92-4/99)
+/-1 %
band p/m
26.8
33.8
72.8
34.6
45.2
52.9
+/-2.5 %
band p/m
58.7
61.2
93.9
63.5
71.4
77.9
Source: Guillermo Calvo and Carmen Reinhart, “Fear of Floating,” QJE, (2002).
Fear of Floating: Probability
of staying within narrow bands
Nom. Interest Rate
US (2/73-4/99)
Japan (2/73-4/99)
Bolivia (9/85-12/97)
Mexico (12/94-4/99)
Peru (8/90-4/99)
Uganda (1/92-4/99)
+/-25 bps
band p/m
59.7
67.9
16.3
5.7
24.8
11.6
+/-50 bps
band p/m
80.7
86.4
25.9
9.4
32.3
32.6
Source: Guillermo Calvo and Carmen Reinhart, “Fear of Floating,” QJE, (2002).
Cavallo Presses the Gas Pedal
(Central Bank’s Balance Sheet)
Cavallo is appointed
7,000
28,000
Foreign Reserves
26,000
5,000
Monetary Liabilities
22,000
4,000
20,000
3,000
18,000
2,000
16,000
14,000
1,000
12,000
0
Source: Central Bank of Argentina.
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
Jul-97
Jan-97
Jul-96
Jan-96
10,000
Net Domestic Credit
-1,000
Million Pesos
Million Pesos
24,000
6,000
CAPITAL FLIGHT
IN LATIN AMERICA?
LAC-7 Business Cycle: 1997-2002
(s.a. GDP, mean annualized quarterly growth rate)
9%
Deceleration
7%
Recession
Recovery
Stalling
5%
3%
1%
-1%
-3%
Includes: Argentina Brazil, Chile, Colombia, Mexico, Peru and Venezuela
2002.I
2001.III
2001. I
2000.III
2000.I
1999.III
1999.I
1998.III
1998.I
1997.I
-7%
1997.III
-5%
LAC-7 Capital Flows
(4 quarters, millions of US dollars and % of GDP )
120.000
6%
100.000
5%
% of GDP
80.000
4%
Millions of US dollars
60.000
3%
Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela
2002-I
2001-III
2001-I
2000-III
2000-I
1999-III
0%
1999-I
0
1998-III
1%
1998-I
20.000
1997-III
2%
1997-I
40.000
LAC-7 Business Cycle and Capital Flows
2%
1%
Non FDI Capital Flows
0%
-1%
GDP
-2%
-3%
Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-99
Mar-99
Sep-98
Mar-98
Sep-97
Mar-97
Sep-96
-4%
Non FDI Capital Flows (% GDP)
7%
6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
Mar-96
GDP (yoy % change)
(GDP and Non FDI Capital Flows, last four quarters)
THE IMPACT
OF SUDDEN STOPS
Sudden Stop
Capital Flows, % of GDP
1998.II
2001.III
Capital Flows
5.6
1.6
Non-FDI Capital Flows
2.0
-0.9
FDI
3.6
2.5
Reversal
-4.0
-2.9
-1.1
Note: Includes Argentina, Brazil, Chile, Colombia, Mexico, Peru, and
Venezuela. Source: Corresponding Central Banks.
Equilibrium RER
p
P = PNT/PT
p0
p*
real trade factors
SS
p**
h
hs
Liability Dollarization
Public Sector Debt Mismatch Measure
ARG
ECU
COL
BRA
B/e B*
0.08
0.02
0.59
1.76
Y/e Y*
8.63
2.94
6.36
12.34
(B/e B*)/(Y/e Y*)
0.01
0.01
0.09
0.14
Source: Own estimates. Note: Values are given for 1998.
CHL
1.30
2.85
0.45
Sudden Stop and Fiscal
Adjustment: Argentina 1998
Debt to
GDP
ratio
(%)
Req. Prim.
Surplus
Adjust.
NPV of Req.
Adjust.
(% of GDP)
36.5
0.3
9.3
(b) Change in Relative Prices to close the CA deficit
(RER depreciation of 46,2%)
49.7
0.7
22.6
(c): (b) + 200 BPS Increase in
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
(a) Baseline
Real
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
Vulnerability to Sudden
Stops
A small share of tradable goods output
relative to domestic absorption of tradable
goods
Liability dollarization, both in government
and non-tradable sectors
High initial public debt, denominated in
foreign currency
Bank assets concentrated on government
bonds and dollar credit to non-tradable
sectors.
POLICY ISSUES
BAILOUT PACKAGES
Justified under Globalization Hazard view
The mid-1990s packages were successful
because capital flowed back very quickly (the
prime example is Brazil in 1999).
At present, capital appears to be much
slower to flow back, possibly due to Russia’s
1998 crisis and recent corporate scandals.
Thus, present packages may shield the
financial but not the real sector, and
recession could be large and long-lasting.
THE EXCHANGE RATE
 The current debate is between Fixed Exchange Rate
and Inflation Targeting.
 Inflation Targeting is equivalent to fixing the
currency to a basket of goods and services.
 Actually, if the basket contains only foreign
exchange, or the pass-through coefficient is very
high, both systems would be equivalent.
 Thus, the current debate is about the best basket
to fix to. It is about fixing, not about floating.
 Neither system ensures the existence of a Lender of
Last Resort.
CHOOSING A BASKET
No basket prevents large exchange rate
misalignment. If the latter is a serious concern,
one should adopt RER Targeting, which
implies no nominal anchor!
The main focus should be on the financial
system and, in particular, the prevailing type of
indexation in the financial sector.
Thus, a highly dollarized system may call for full
dollarization.
While, a UF system like in Chile, may call for UF
targeting.
SUDDEN STOP
Learn how to prevent it
Management of reserves and public debt
Flexible financial system, contingent claims
Flexible public prices and wages
And how to be ready if it happens
Contingent credit lines
Judicious use of reserves and credit lines to bail out
private sector and financial institutions, accompanied
by dirty float.
Timely negotiation of debt restructuring.
Research Department
Inter-American
Development Bank