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Dealing with an International Credit Crunch ▼ from Page 1 Inter-American Development Bank Dealing with an Research Department Volume 18 International Credit Crunch January–April, 2009 ealing with an international credit crunch tions come to mind: Can emerging countries IN THIS ISSUE is no easy task, as any policymaker in the afford expansive monetary and fiscal policies Dworld would tell you today! Credit flows in times of crisis? Should they instead restore Chile: are the blood of the world’s economic system. credibility by tightening monetary and fiscal Banking on Policy When a human artery becomes clogged and policy, or will these policies only make mat- Credibility 3 the blood flow is interrupted, the consequences ters worse? To what extent are weak initial can be dire unless the flow is restored prompt- macroeconomic conditions an important Peru: ly. Similarly, a sudden stop constraint leading to Where Reserves in capital flows that blocks disaster? Do they put a Saved the Day 4 the normal supply of inter- There is no substitute country on an irreversible national credit to countries path? Are they destiny, Brazil: can inflict serious damage for taking advantage or can their impact be A Two-Pronged on the affected economies mitigated during a crisis? Strategy for Solvency 6 unless decisive action is of periods of external Should financial shocks taken. But if you’re not a be viewed as temporary Applying the government like the Unit- bonanza to improve or persistent, and what Past to the Present 7 ed States, a safe haven for policy options are avail- global savings that can macroeconomic able? And further down pump billions of dollars the road, what implica- New Publications 8 into a stimulus package, fundamentals at home. tions does the latent risk what’s a country to do? of sudden stops have for Look Who’s Talking 11 This newsletter looks economic policies during at this question from the Latin American point periods of bonanza? Network News 12 of view. Drawing from research that explored This newsletter draws from a new IDB the region’s experience with the sudden stops book, “Dealing with an International Credit in capital flows of the 1990s, it reviews les- Crunch: Policy Responses to Sudden Stops sons learned that may be of use today. To in Latin America,” which addresses these AVAILABLE NOW! begin with, countries must realize that it’s questions from different angles, bringing not necessarily their fault. A defining charac- in both lessons from country studies as teristic of systemic sudden stops is that they well as cross-country analysis. The book originate in shortcomings in international documents policy responses to sudden stop capital markets—i.e. international capital sup- episodes of the late 1990s for eight Latin ply shocks—rather than in domestic policy American countries. But it also takes a failings. However, while the cause may come more systematic approach by analyzing the from abroad, the solutions must often be home impact of policies on output behavior for grown and if sudden stops are not handled a wider range of emerging markets. Using adequately, then output collapse can be severe both sets of information, and distinguish- and recovery more painful. ing between successful and unsuccessful In designing a strategy to confront sudden cases, it extracts policy recommendations http://www.iadb.org/res/pub_desc. Continued on page 2 stops and avoid output collapse, several ques- ▼ cfm?pub_id=B-633 Ideas for Development in the Americas . Jan – Apr., 2009 Dealing with an International Credit Crunch ▼ from page 1 for countries that might face a sud- Figure 1. Initial Conditions and Output Declines den stop in the future. As the world teeters on the brink of a major global Weak financial crisis with potentially MEX severe consequences for emerging economies, the issues addressed in this volume come back to the fore- URY front of the policy debate. ARG PER The book presents the following ECU main conclusions: Initial Conditions BRA COL • Expansionary fiscal and monetary CHL policy that does not affect cred- Strong 0 246810 12 14 16 18 20 ibility or solvency can reduce out- put collapse in the aftermath of a Output Drop (%) sudden stop. Countries that were Source: Calvo, Izquierdo and Mejia (2008). Systemic Sudden Stops: The Relevance of Balance-Sheet Effects and Financial Integration able to adopt more flexible fiscal and monetary policies in the after- math of a financial crisis had a loss crucial—countries need to be able ent levels of preparedness and may in output of less than 5%, while to afford these policies. seriously limit policy options. There nations with much less flexibil- • Initial conditions matter: the same are no good substitutes for reducing ity had output contractions above shock can have different conse- vulnerabilities during good times to 10%. However—and this is really quences in countries with differ- confront the possibility of bad times in the future. For example, suc- cessful anti-cyclical policies during financial crises work when govern- This issue of IDEA was prepared by Eduardo Cavallo and Rita Funaro. It is based on ments are prepared to boost spend- the research of Paul Castillo, Daniel Barco Rondón, Márcio Garcia, Alberto Ortiz, ing in a sustainable way—for which Pablo Ottonello, Federico Sturzenegger, Ernesto Talvi and Rodrigo Valdés as presented they need to have saved before. And in the book Dealing with an International Credit Crunch: Policy Responses to to conduct looser monetary policy Sudden Stopos in Latin America, edited by Eduardo Cavallo and Alejandro Izquierdo. that does not fuel inflation or lead to balance-sheet problems in either Eduardo Lora Rita Funaro the public or private sectors, a coun- General Coordinator Managing Editor try must have avoided the dollariza- IDEA (Ideas for Development in the Americas) is an economic and social policy tion specter during the boom years. newsletter published three times a year by the Research Department, Inter-American (Figure 1 illustrates how countries Development Bank. Comments are welcome and should be directed to IDEA’s man- that enjoyed strong initial conditions aging editor, Rita Funaro at [email protected]. limited the contraction in their eco- The views expressed herein are those of the authors and do not necessarily represent nomic output during a sudden stop.) the views and policy of the IDB. Articles may be freely reproduced provided credit is • Initial conditions are not destiny: given to IDEA and the IDB. To receive the newsletter electro­­nically, please send your even if they haven’t done all their e-mail address to: [email protected]. Past issues of this newsletter are available on homework, countries still have the Internet at: http://www.iadb.org/res/news. means at their disposal to weather the storm. A targeted use of interna- tional reserves during an internation- al credit crunch—for example, sup- Inter-American Development Bank Continued on page 5 ▼ 2 Jan – Apr., 2009 . Ideas for Development in the Americas Chile: Banking on Policy Credibility eing prepared pays off. That is factors also weighed heavily. Chile demand and regulate the deprecia- one of the big lessons of the had (and continues to have) strong tion of the exchange rate became BChilean experience with the fiscal institutions ranging from a of paramount importance. Contrac- sudden stop in capital flows in 1998. centralized state and a strong Minis- tionary monetary and fiscal policies Hit by the retrenchment of capital try of Finance to arrangements such were the government’s initial policy flows following the Asian crisis and as a copper price stabilization fund response. a decline in its terms of trade due to that allows the authority to set aside In a way, the policies were almost a drop in copper prices, Chile’s net abnormally high copper revenues in too successful. The combined effect capital inflows plummeted from the a transparent way. of the external shocks and poli- equivalent of 7% of GDP in 1998 to cies was an unexpectedly large and less than 1% of GDP in 1999 while quick adjustment. Imports of goods capital outflows reached $1.5 billion. and services transited from grow- But instead of an economic collapse, The macroeconomic ing 16% year-over-year in second Chile suffered a small recession quarter 1998 to sliding 14% in the thanks to a strong financial system, framework and final quarter of the year. Behind this healthy public finances and a flex- adjustment was a sudden decline in ible policy apparatus. conditions that Chile domestic demand of almost 8%. Throughout the 1990s, Chile This overcorrection highlights laid the groundwork for strong had built over a another important lesson. When monetary and fiscal policies. With in the eye of the storm, it is often the objective of maintaining price decade served it well difficult to assess the true nature stability, the Central Bank of Chile and duration of a crisis. Chilean used annual inflation targets as the authorities initially misjudged the predominant nominal anchor of the in the face of the type of shock at hand. However, economy. Annual announcements policymakers were able to bank aimed at ever lower inflation. An sudden stop. on previously earned credibility to exchange rate band system sought shift gears and accommodate the to maintain the current account shock with expansionary policies deficit within sustainable levels and In addition to strong monetary before it was too late. By changing the Central Bank intervened in the and fiscal policies, the Chilean econ- course, they were able to keep the foreign exchange market not only omy also enjoyed strong financial economy from slipping into a deeper at the edges of the band, but also institutions. Following the collapse recession. actively within it. From a rather of the banking system in the fallout The macroeconomic frame- rough management of interest rates to the debt crisis of the 1980s, Chile work and conditions that Chile had on instruments of different tenors worked hard to improve financial built over a decade served it well in in 1990, the Central Bank advanced regulation and supervision.
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