Speculative Attacks on Debts, Dollarization

V LACEA, IADB and Universidad Torcuato Di Tella Summer Camp in Economics and International Finances August 19-22, Buenos Aires Summary of Papers1

Contents 1. Region and Country Cases Decades Lost and Found: Chile and Mexico in the 1980s and 1990s Raphael Bergoeing, Patrick J. Kehoe, Timothy J. Kehoe, and Raimundo Soto

Sudden Stops, the Real Exchange Rate and Fiscal Sustainability: Argentina’s Lessons Guillermo Calvo, Alejandro Izquierdo, and Ernesto Talvi

Argentina’s Financial Crisis: Floating Money, Sinking Banking Augusto de la Torre, Eduardo Levy Yeyati, and Sergio L. Schmukler

The Anatomy of A Multiple Crisis: Why was Argentina Special and GAT can we Learn? Guillermo Perry and Luis Serven

The Behavior of International Bank Lending to Latin America Maria Soledad Martinez Peria, Andrew Powell and Ivanna Vladkova Hollar

2. Financial Sector and Capital Account Liberalization Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization Graciela Laura Kaminsky and Sergio L. Schmukler

Endogenous Financial Intermediation and Real Effects of Capital Account Liberalization George Alessandria and Jun Quian

On the Benefits of Capital Account Liberalization for Emerging Markets Pierre-Olivier Gourinchas and Olivier Jeanne

Anticipated Ramsey Reforms and the Uniform Taxation Principle : The Role of International Financial Markets Stephanie Schmitt-Grohe and Martín Uribe

3. Financial Sector Issues and Monetary Regime Speculative Attacks on Debts, Dollarization, and Optimum Currency Areas Aloisio Araujo and Marcia Leon

1 Prepared by Sara Calvo, LCSPE, October 2002.

1 4. Foreign Direct Investment Human Capital, Organizations, and Foreign Investment Alexander Monge-Naranjo

2 1. Region and Country Studies

Decades Lost and Found: Chile and Mexico in the 1980s and 1990s Raphael Bergoeing, Patrick J. Kehoe, Timothy J. Kehoe, and Raimundo Soto Chile and Mexico experienced severe economic crises in the early 1980s. This paper analyzes four possible explanations for why Chile recovered much faster than did Mexico. Comparing data from the two countries allows the authors to rule out a monetarist explanation, an explanation based on falls in real wages and real exchange rates, and a debt overhang explanation. Using growth accounting and a calibrated growth model, the paper finds that the difference in the performance of Chile and Mexico was driven not by differences in inputs of capital and labor stressed by traditional theories of depressions, but rather by differences with which these inputs were used, measured as total factor productivity (TFP). Using economic theory to interpret historical evidence, the paper concludes that the crucial difference between the two countries was earlier reforms in government policy in Chile. The most crucial of these reforms were in banking and bankruptcy procedures.

Sudden Stops, the Real Exchange Rate and Fiscal Sustainability: Argentina’s Lessons Guillermo Calvo, Alejandro Izquierdo, and Ernesto Talvi This paper sheds light on the following puzzle: Why was a country like Argentina, which displayed a fiscal deficit and a level of debt well within the bounds set by the Maastricht Treaty, subject to high risk premia? One possible answer is that the comparison is meaningless, given that Argentina never had a chance to become a member of the European Union. But, granting that, why did Argentina have to pay a risk premium higher than its Latin American peers, who in terms of fiscal deficits and debt levels were facing similar conditions?

The paper shares with other explanations of the collapse of Convertibility the acknowledgement of fiscal sustainability problems and RER misalignment. However, this paper places special emphasis on financial and political economy considerations. In particular, the paper argues that the impact of RER misalignment went beyond trade- competitiveness considerations. It played a major role in the fiscal and financial problems that eventually Argentina had to confront. Moreover, fixed exchange rates helped to conceal those problems and, as a result, necessary fiscal measures were postponed, thereby intensifying the crisis. As financial imbalance became apparent, a stock adjustment was necessary, which called for massive wealth redistribution. Implementation of the latter triggered a “war of attrition” situation which seriously deepened the extent of the crisis.

The paper starts with the observation that unexpected stops in capital flows of a persistent nature can generate substantial swings in the RER, which may lead in turn to fiscal sustainability problems and related political economy complications, particularly in relatively closed, highly indebted and dollarized emerging markets (EMs). The point of departure is the Russian crisis of August 1998, which drastically changed the behavior of capital markets. The authors believe that developments at the center of capital markets

3 were key to producing an unexpected, severe, and prolonged stop in capital flows to EMs, and Latin America was no exception.

Argentina’s Financial Crisis: Floating Money, Sinking Banking Augusto de la Torre, Eduardo Levy Yeyati, and Sergio L. Schmukler This paper argues that the relation between the currency board and the financial system—i.e., the link between money and banking—is essential to understand the 2001- 02 Argentine crisis. The establishment of the currency board in 1991 helped develop the Argentine financial system. Despite its strengths, the financial system remained vulnerable to real exchange rate misalignments and fiscal shocks. After 1998, Argentina fell into a currency-growth-debt trap. It tried to break away by focusing on growth, but failed to address the currency and debt components of the trap, dramatically raising uncertainty. This unleashed a depositor run, which lead to the abandonment of the currency board. The authors argue that an early exit of the currency board into dollarization would have likely prevented the run and substantially lowered the magnitude of the crisis. Dollarization would have preserved property rights and financial intermediation. Moreover, it would not have necessarily implied giving up nominal flexibility altogether, since dollarization could have been followed over time by “pesification at the margin.”

The Anatomy of Multiple Crisis: Why was Argentina Special and what ca we Learn from it? Guillermo Perry and Luis Serven In this paper the authors find that that Argentina was not hit harder than other Latin American countries by the terms of trade decline after the Asian crisis, nor by the US and worldwide slowdown in 2001, nor by the capital flows reversal and the rise in spreads after the Russian crisis. As a consequence, the fact that Argentina did worse than other countries after 1999 must be attributed to her higher vulnerabilities to shocks, weaker policy responses or a combination of both. Indeed, the paper finds that the large capital flow reversal in 2001 was driven by Argentina-specific factors. The authors view this as evidence that “sudden stops” of capital flows acted more as an amplifier than as a primary cause of the crisis. This view is in contrast with the interpretation put forward in Calvo et al. (see above), though in most other aspects our conclusions agree with those in that paper.

The message of the paper is that a key lesson from Argentina is the need to adopt economic and political institutions that align incentives to face hard choices and facilitate timely reforms, and in particular that are less prone to amplifying economic cycles. This is the main message of this paper. The paper examines the vulnerabilities associated with deflationary adjustments to shocks under a hard peg as well as those associated with a large public debt and a fragile fiscal position, and those hidden under a façade of strength in the banking sector. The paper concludes that although there were important vulnerabilities in each of these areas, neither of them on its own was larger than those affecting some other countries in the region, and thus there is no one obvious suspect. However, it also finds that they reinforced each other in such a perverse way that taken

4 jointly they led to a much larger vulnerability to adverse external shocks than in any other country in the region.

In particular, the hard peg and inflexible domestic nominal wages and prices imposed a protracted deflationary adjustment in response to the depreciation of the Euro and the real, the terms of trade shocks and the capital market shock of 1998, leading to a major overvaluation of the currency and a rapidly deteriorating net foreign asset position. Such imbalances were aggravated by weak fiscal policies during the decade, especially after 1995. The hard peg actually hid from public view the serious deterioration in fiscal solvency and the mounting financial stress. Indeed, the protracted deflationary adjustment required to realign the real exchange rate under the hard peg would have unavoidably eroded the debt repayment capacity of the Government, households and firms in non tradable sectors – the debtors whose incomes would be more adversely affected as a direct result of deflation.

The nominal devaluation in 2002 revealed in full force these latent problems and made them much worse due to the exchange rate overshooting and the disruption of the payments system derived from the deposit freeze (the so called “corralito”) – which might have been partially avoided by better policy responses. Financial stress was aggravated by the large exposure of banks and Pension Funds to increasing Government risk. Thus a vicious circle of economic contraction, fiscal hardship and financial stress ensued.

The Behavior of International Bank Lending to Latin America Maria Soledad Martinez Peria, Andrew Powell, and Ivanna Vladkova Hollar Rising international bank financing to developing countries has motivated a debate on the behavior of these claims. The authors analyze claims from seven home (lender) countries on ten host (borrower) countries in Latin America. They find that banks transmit shocks from their home countries and changes in their claims on other countries spill over to individual hosts. However, lending has become less “indiscriminate” and more responsive to host conditions over time. Responsiveness to the latter becomes less “pro-cyclical” as exposure increases. Finally, foreign bank lending reacts more to positive than to negative host shocks and is not significantly curtailed during crises.

2. Financial Sector and Capital Account Liberalization

Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization Graciela Laura Kaminsky and Sergio L. Schmukler The paper examines the short- and long-run effects of financial liberalization on capital markets. To do so, the authors construct a new comprehensive chronology of financial liberalization in 28 mature and emerging economies since 1973. They also construct an algorithm to identify booms and busts in stock market prices. Results indicate that financial liberalization is followed by more pronounced boom-bust cycles in the short run. However, financial liberalization leads to more stable markets in the long

5 run. Finally, the authors analyze the sequencing of liberalization and institutional reforms to understand the contrasting short- and long-run effects of liberalization.

Endogenous Financial Intermediation and Real Effects of Capital Account Liberization George Alessandria and Jun Quian This paper examines the impact of opening the capital account on both welfare and the structure of lending contracts. Financial intermediaries mitigate the moral hazard problem in investment choice through costly monitoring and liquidation. Depending on the quality and cost of the monitoring technology, liberalizing the capital account may improve or worsen the efficiency of financial intermediaries, leading to an improvement or worsening of the aggregate composition of investment projects. Efficient financial intermediaries are neither necessary nor sufficient for capital account liberalization to improve welfare. The paper also finds that the collapse of the financial intermediation sector, and a shift towards direct, unmonitored lending may actually increase welfare. This is a model of a small developing economy where lending and investment takes place under asymmetric information. The paper allows for different forms of financing contracts to arise endogenously in the credit market.

On the Benefits of Capital Account Liberalization for Emerging Economies Pierre-Olivier Gourinchas and Oliver Jeanne Standard theoretical arguments tell us that countries with relatively little capital benefit from financial integration as foreign capital flows in and speeds up the process of convergence. The paper shows in calibrated exercises that conventionally measured welfare gains from this type of convergence appear relatively limited for the typical emerging country. The traditional theory, then, does not seem to provide a sufficient rationale for capital account liberalization. The paper’s approach emphasizes instead that poor countries face a number of distortions that prevent the allocation of production inputs to their most efficient uses.

Liberalization of the capital account should then be understood as a means to eliminate or reduce these distortions, and it is this effect of liberalization that may create first order gains. As an illustration of this approach, the paper presents a model in which capital account liberalization improves domestic allocative efficiency because of its effect on property rights. The paper’s theory has implications for the political economy of financial integration. First, it shows that politicians may open the capital account as a way of “locking-in” domestic reform, even when they cannot commit to either decision. Second, traditional trade arguments (e.g. Stolper-Samuelson) would argue that in capital- scarce countries, domestic capitalists would oppose financial integration as it reduces the return to capital, while workers would typically favor it. The political economy of financial integration does not seem to reflect these predictions. Often, domestic capitalists favor integration while workers may or may not oppose it.

Anticipated Ramsey Reforms and the Uniform Taxation Principle : The Role of International Financial Markets

6 Stephanie Schmitt-Grohe and Martín Uribe This paper studies the role of asset-market completeness for the properties of optimal policy. A suitable framework for this purpose is the small open economy with complete international asset markets. For in this environment changes in policy represent country-specific risk diversifiable in world markets. Our main finding is that the fundamental public finance principle whereby when taxes on all final goods are available, it is optimal to tax final goods uniformly fails to obtain. In general, uniform taxation is optimal because it amounts to a nondistorting tax on fixed factors of production. In the open economy this principle fails because when households can insure against the risk of a policy reform, initial private asset holdings are contingent on actual policy and thus no longer represent an inelastically supplied source of income. Two further differences between optimal policy in the closed and open economies with complete markets are: (a) In the open economy, optimal consumption and income tax rates are unchanged in response to government purchase shocks.

By contrast, in the closed economy tax rates do respond to innovations in public spending. (b) In the open economy, the Friedman rule is optimal only if the Ramsey planner has access to consumption taxes. In the absence of consumption taxes, deviations from the Friedman rule are large. On the other hand, in the closed economy, the availability of either consumption or income taxes suffices to render the Friedman rule optimal.

3. Financial Sector Issues and the Monetary Regime

Speculative Attacks on Debts, Dollarization, and Optimum Currency Areas Aloisio Araujo and Marcia Leon This paper evaluates the comparative welfare of economies which either keep their local currency and an independent monetary policy, join a monetary union or adopt dollarization. In the two former monetary regimes, governments can issue debt denominated, respectively, in local and common currencies, which is completely purchased by national consumers. Given this ability, governments may decide to impose an inflation tax on these assets and use the revenues so collected to avoid an external debt crises. While the country that issues its own currency takes this decision independently, a country belonging to a monetary union depends on the joint decision of all member countries about the common monetary policy. In this way, an external debt crises may be avoided under the local and common currency regimes, if, respectively, the national and the union central banks have the ability to do monetary policy, represented by the reduction in the real return on the bonds denominated in these currencies. This resource is not available under dollarization. In a dollarized economy, the loss of control over national monetary policy does not allow adjustments for exogenous shocks that asymmetrically affect the client and the anchor countries, but credibility is strengthened.

On the other hand, given the ability to inflate the local currency, the central bank may be subject to the political influence of a government not so strongly concerned with fiscal discipline, which reduces the welfare of the economy. In a similar fashion, under a common currency regime, the union central bank may also be under the influence of a

7 group of countries to inflate the common currency, even though they do not face external restrictions. Therefore, the local and common currencies may be viewed as a way to provide welfare enhancing bankruptcy, if it is not abused. With these peculiarities of monetary regimes in mind, the authors simulate the levels of economic welfare for each, employing recent data for the Brazilian economy. The paper is based on the model of self-fulfilling debt crisis developed by Cole and Kehoe [4].

4. Foreign Direct Investment

Human Capital, Organizations, and Foreign Investment Alexander Monge-Naranjo This paper investigates the relationship between foreign direct investment (FDI) with the technology acquisition and the accumulation of human capital by a developing economy. The mechanism studied in the model is based on three postulates: (i) general human capital is an input in the production of specific skills, (ii) firms are organizations that embed and produce knowledge (organizational capital) and (iii) there is a complementarity in the human capital investments across generations.

The paper shows that FDI may change the structure of the set of equilibria. In particular, the possibility that foreign organizations can hire skilled workers from the developing economy eliminates the bad (stagnant) equilibrium that is always present in economies that are closed to FDI. Comparing between good (growth) equilibria, FDI speeds up the returns to and the accumulation of general human capital. Initially it can widen the differences in the organizational capital among local firms. Existing local organizations can speed up their productivity and catch up or slow down and disappear. Regardless of that, differences among organizations operating in an economy open to FDI will vanish in the long term. The model implies that countries that are open to FDI will converge in levels to the developed economies. Countries that are closed to FDI will at best retain their relative ranking in the cross-country income distribution.

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