comment by ricardo hausmann harvard university
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Towards effective social insurance in Latin America: why can’t we afford counter-cyclical fiscal policy?. Comment by Ricardo Hausmann Harvard University. The problem. Latin America is very volatile People suffer from this Fiscal policy is pro-cyclical …aggravating volatility - PowerPoint PPT PresentationTRANSCRIPT
Towards effective social insurance in Latin America:why can’t we afford counter-
cyclical fiscal policy?Comment by
Ricardo Hausmann
Harvard University
The problem
• Latin America is very volatile
• People suffer from this
• Fiscal policy is pro-cyclical
• …aggravating volatility
• …and lowering social protection when it is most needed
Proposed solution
• Increase automatic stabilizers– Pre-commit to spend more in bad times
• Improve savings in good times– Fiscal rules and stabilization funds
• Improve creditworthiness during bad times– GDP-indexed bonds
What causes pro-cyclicality?
• Excessive spending and borrowing in good times limits creditworthiness in bad times– Hausmann, Gavin, Perotti and Talvi (1996),
Talvi and Vegh (2000)
• Solution: behave more prudently in good times so you can still borrow in bad times– Ergo: Fiscal institutions and rules
• Is this correct?
An alternative interpretation
• Debt service is highly anti-cyclical• …because debt is denominated in US$
– In good times, the real exchange rate is strong, making US$ debt cheap
• ..or in short term in pesos– Real interest rates go up in bad times, as the
government attempts to avoid further real depreciation
• Hence, procyclicality is a consequence of original sin
Real GDP growth is more volatile
Industrial Developing LAC Real GDP volatility 2.0% 4.7% 4.5%
But not that much to write home about
…but GDP measured in US$ is 9 times more volatile
Industrial Developing LAC Real GDP volatility 2.0% 4.7% 4.5%US$ GDP volatility 14.0% 27.5% 36.2%
This is the relevant measure if you borrow in US$
…movements of exchange rates are large and persistent
Industrial Developing LAC Real GDP volatility 2.0% 4.7% 4.5%US$ GDP volatility 14.0% 27.5% 36.2%Gap in RER 5-y MA 19.7% 84.5% 91.8%
This is the maximum gap between 5-yearMoving average of the real exchange rate
Dollar GDP tends to collapse at times of crises
Year Growth GrowthCountry US$ GDP Real GDPChile 1973 -69.3% -4.9%Chile 1982 -38.0% -10.3%Costa Rica 1981 -70.3% -2.3%Dominican Republic 1985 -49.7% 1.0%Ecuador 1999 -50.2% -7.3%Guatemala 1986 -44.8% 0.1%Guyana 1987 -35.1% 0.9%Honduras 1990 -56.3% 0.1%Jamaica 1978 -36.1% 0.6%Jamaica 1983 -38.1% 2.3%Jamaica 1991 -46.4% 0.7%Mexico 1976 -40.6% 4.4%Mexico 1982 -54.4% -0.6%Mexico 1994 -35.2% 4.4%Paraguay 1989 -39.5% 5.8%Uruguay 1982 -66.0% -9.8%Venezuela 1986 -47.0% 6.5%Venezuela 1989 -43.8% -8.6%Average -47.8% -0.9%
Declines in US$GDP greater than
-35%
Notice that capacityto pay in US$
collapses more than real GDP
Implications
• The capacity to pay dollar-denominated debt is dependent on the market value of GDP in US$
• But this measure is 9 times more volatile than real GDP
• …and collapses in bad times• This is associated with large and persistent
cyclical movements in the RER • The problem may not be that we borrow too much
in good times, but that we borrow too poorly
Credit ratings are low, considering that debt levels are low
ratin
g fo
r lo
ng-t
erm
fo
reig
n cu
r
de_gdp2-.430356 1.04646
4
19 Germany
Canada
Czech Re
Latvia
Estonia
Greece
Australi
Slovak R
Denmark
Poland
Italy
United K JapanUnited S
Cyprus
Dominica
Spain
MexicoEl Salva
Slovenia
Pakistan
Brazil
Norway
Paraguay
Finland
Chile
Panama
Iceland
ArgentinJordan
Belgium
Austria
Turkey
IsraelHungary
Sweden
China
MoroccoIndia
Oman
Tunisia
Costa Ri
…even considering the lower tax base
ratin
g fo
r lo
ng-t
erm
for
eign
cur
de_re2-.772123 5.49817
4
19 Germany
Canada
Czech Re
Latvia
Estonia
Greece
AustraliDenmark
Poland
Italy
United K JapanUnited S
Cyprus
Dominica
Spain
Mexico
Slovenia
Pakistan
Brazil
Norway
Paraguay
Finland
Panama
Iceland
ArgentinJordan
Belgium
Austria
Turkey
IsraelHungary
Sweden
China
Morocco India
Tunisia
Costa Ri
Would domestic peso debt be safer?
Short term real interest rates are very volatile and rise in bad times
Volatility elasticity t-stat
United States 0.9 -3.3 -4.1Latin America 10.5 -126.3 -10.9
Mexico 23.0 -73.3 -13.2Venezuela 17.6 0.1 0.0Brazil 17.2 -451.6 -3.4Ecuador 12.2 -2.4 -0.5Uruguay 11.8 2.6 0.4Peru 11.2 -151.4 -1.7Colombia 7.8 -16.6 -2.3Chile 5.4 -8.8 -1.0Costa Rica 5.0 -19.7 -5.0Argentina 4.0 -221.9 -10.3Panama 0.6 -0.4 -0.6
Note: excludes periods in which inflation exceeded 40 percent
(monthly data, 1990-1999)
Some consequences
• Domestic currency short-term or floating rate debt may be subject to large increases in nominal interest rates, especially in bad times
• This also makes debt service pro-cyclical• Volatility of the short rate limits the extension of
maturity• Under these conditions, US$ borrowing may be safer
– Hausmann and Chamon (2002) argue that this may generate multiple equilibria in monetary policy and debt denomination
Original sin and the limits to anticylical fiscal policies
• If there is a SIGNIFICANT NET foreign debt (public or private)
• …and it is in foreign currency• Exchange rate movements cause aggregate wealth effects
– Depreciations lower real income
• Makes debt service harder…• …lowering creditworthiness in bad times
– Less access to finance in bad times
• Makes governments forced to tighten fiscal policy, unless it wants to aggravate crowding out
• …and tighten monetary policy to avoid further depreciation
Implication: automatic stabilizers
• If the problem is that debt service increases in bad times, due to debt denomination,
• …then the solution is NOT to pre-commit to increase spending in bad times
• “Increase automatic stabilizers” NOT YET• This will only aggravate the collapse in solvency
in bad times and will force to cut other (presumably good) but a-cyclical social programs such as Education and Health
Implication: debt structure• Work on debt structure first• Ideal is long-term, fixed rate peso-denominated bonds
– They change in value with the real exchange rate, and with inflation
– But they are the hardest to achieve
• The paper recommends GDP-linked bonds– GDP is very hard to credibly measure
• It may be much easier to develop long-term inflation-indexed fixed rate debt– Protects against collapses in RER & US$ GDP– As in Chile (is this part of Chile’s secret?)
OS is the consequence of the currency concentration of the global portfolio
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
United States EUROLAND Japan U.K Switzerland Canada Australia
Debt by Country
Debt byCurrency
(0.9857)
(0.8859)
Implication: international agenda
• It needs an international solution• Create liquidity for instruments with EM
currency risk but no credit or country risk– IFIs could play a large role
• This would allow IFIs to lend in local currency
• Develop the swap market to undo the currency mismatch of EMs
Implication: fiscal rules
• If the problem is debt structure, fiscal rules should deal with this
• Currently, rules relate to deficits and spending• Nothing is geared to monitor the risks involved in
the debt structure• Alternative: target a risk-weighted level of debt
– Risk weights should reflect the pro-cyclicality and volatility of debt service
– Allows the political system to internalize the difference between cheap borrowing and safe borrowing
Conclusion
• It would be great if the government could offer social protection against aggregate shocks
• …but before committing to do so, it needs to be able to do so
• At present, many countries are unable to protect in bad times and in fact need to impoverish their populations in bad times to avoid greater damage
• We should develop the ability to protect before we commit to use it