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Digitized by the Internet Archive in 2011 with funding from Boston Library Consortium IVIember Libraries http://www.archive.org/details/copingwithchiles00caba2 c L 15 jDewey oi- I 3 '-1^ Massachusetts Institute of Technology Department of Economics Working Paper Series COPING WITH CHILE'S EXTERNAL VULNERABILITY: A FINANCIAL PROBLEM Ricardo Caballero J. WORKING PAPER 01-23 REVISED, January 2002 Room E52-251 50 Memorial Diive MA Cambridge, 021 42 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at http://papers.ssrn. om/abstract=274083 \(y Massachusetts Institute of Technology Department of Economics Working Paper Series COPING WITH CHILE'S EXTERNAL VULNERABILITY: A FINANCIAL PROBLEM Ricardo Caballero J. WORKING PAPER 01-23 REVISED, January 2002 Room E52-251 50 Memorial Drive MA Cambridge, 02142 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at http://papers.ssrn.conn/abstract=274083 '.GHUSETTS INSTITUTE OFTECHMOLOGY H'AR 7 2002 LiBF?ARiES Coping with Chile's External Vulnerability: A Financial Problem 01/11/2002 Ricardo J. Caballero' Abstract With traditional domestic imbalances long under control, the Chilean business cycle is driven by external shocks. Most importantly, Chile's external vulnerability isprimarily a financialproblem. A decline in the Chilean terms-of-trade,for example, is associated to a decline in real GDP that is many times larger than one wouldpredict in thepresence of perfectfinancial markets. Thefinancial nature ofthis excess-sensitivity has two central dimensions: a sharp contraction in Chile's access to internationalfinancial markets when it needs it the most; and an inefficient reallocation ofthis scarce access across domestic borrowers during external crises. In this paper I characterize thisfinancial mechanism and argue that Chile's aggregate volatility can be reduced significantly byfostering the privatesector's development offinancial instruments that are contingent on Chile's main external shocks. As a first step, the Central Bank or IFIs could issue a benchmark instrumentcontingenton theseshocks. Ialso advocate a countercyclical monetarypolicy — but mainly for ince—ntive that is, as a substitute for taxes on capital inflows and equivalentmeasures rather thanfor ex-post liquiditypurposes. ' MIT and NBER. e-mail: caball(a)mit.edu; http://web.mit.edu/caball/www. Prepared for the Banco Central de Chile. I am very grateful Vittorio Corbo, Esteban Jadresic, and Norman Loayza fortheir comments; to Adam Ashcraft, Marco Morales and especially Claudio Raddatz for excellent research assistance; and to Herman Bennett for his effort collecting much ofthe required data. First draft: 03/06/2001. Introduction and Overview I. With traditional domestic imbalances long under control, the Chilean business cycle is driven by extemal shocks. Most importantly, Chile's extemal vulnerability is primarily a financial problem. A decline in the Chilean terms-of-trade, forexample, is associated to a decline in real GDP that is many times larger than one would predict in the presence ofperfect financial markets. The financial nature of this excess-sensitivity has two central dimensions: a sharp contraction in Chile's access to international financial markets when it needs it the most; and an inefficient reallocation ofthis scarce access across borrowers during extemal crises. I argue that Chile's aggregate volatility can be reduced significantly by fostering the private sector's development of financial instruments that are contingent on the main extemal shocks faced by Chile. As a first step, the Central Bank orIFIs could issue abenchmark instrument contingent onthese shocks. I also advocate acountercyclicalmonetarypohcy (also contingentonthese shocks)butmainly for — — incentive that is, as a substitute for taxes on capital inflows and equivalent rather than for ex-posthquiditypurposes. The essence ofthe mechanism through which extemal shocks affect the Chilean economy can be characterized as follows: First, there is a deterioration ofterms-of-trade that raises the need for extemal resources ifthe real economy is to continue unaffected, but this triggers exactly the opposite reaction fi^om international financiers, who puU back capital inflows. Occasionally, the latter occurs directly as part of"contagion" effects. Second, once extemal financial markets faU to accommodate the needs of domestic fiimis and households, these agents turn to domestic financial maricets, and to commercial banks in particular. Again, this increase in demand is not matched by an increase in supply as banks — particularly resident foreign institutions - tighten domestic credit, opting instead to increase their net foreign asset positions. Third, there is significant "flight-to-quaUt}^' within the domestic financial system, which reinforces the above effects as large firms find it more attractive to seek financing in domestic markets, in circumstances that the displaced small and medium size firms cannot access intemational financialmarkets at anyprice. The costs ofthis mechanism are high. Widespread financial constraints are binding during the crisis, when major forced adjustments are needed. The sharp decline in domestic asset prices, and corresponding rise in expected returns, is driven by the extreme scarcity in financial resources andtheirhigh opportunity cost. Eventhe praisedrise in FDI that occurred duringthe mostrecent crisis is a symptom ofthese fire sales. The factthatthis investmenttakes the form of control-purchases rather than portfoUo or credit flows simply reflects some ofthe underlying problems that Limit Chile's integration to intemational financial markets: weak corporate governance and other "transparency" standards. Finally, the costs do not end with the crisis, as financially distressed firms are iU equipped to mount a speedy recovery. The latter often comes not only withthe costs ofa slow recovery in employment and activity, but also with a slowdown in the process of creative destmction and productivity growth. In the U.S., the latter may account for about 30% of the costs of an average recession (see Caballero and Hammour, 1998), which is probably a very optimistic lower bound for the Chilean economy. Moreover, the presence of a large number of financially distressed small firms, when severe enough, reduces rather than enhances the effectiveness of monetary policy in facihtating the recovery (see below). The distnbutional impact ofthis type ofcrisis is significant as well. On one end, large firms are directly affected by external shocksbut can substitute most oftheir financial needs domestically. They are affected primarily by demand factors. On the other, small and medium sized firms (henceforth, PYMES) are crowded out and are severely constrained on the financial side. They are the residual claimants ofthe financial crunch. - This diagnosis points in the direction ofa stmctural solution based on two building blocks. The first one deals with the institutions required to foster Chile's integration to international financial markets and the development ofdomestic financial markets. Chile is making significant progress alongthis margin through its capital markets reformprogram. The second one, necessary during the unavoidable slow nature of the above process, is to design an appropriate international liquidity management strategy. The latter must be understood in terms broader than just the management of intemational reserves by the central bank, and include the development of financial instruments that facilitatethedelegationofthis tasktotheprivate sector. I focus on the latter type of solutions in this paper.^ I view the pohcy problem as one of remedying a chronic private sector underinsurance with respect to external crises.' After outlining the main sources ofsuch problem and the corresponding solutions, I focus on two of them. The first one seeks to develop a key missing market. I propose the creation of a benchmark "bond" that is made contingent on the main external shocks faced by Chile. This instalment should facilitate the private sector's pricing and creation of similar and derivative contingent financial instruments. Inthe secondone, I discuss optimal monetarypoUcy and intemational reservemanagement fi-om an insuranceperspective. Providedthatthe Central BankofChilehas achieved a high degree of inflation-target credibility, the optimal response to an external shock is with a moderate injection ofreserves and an expansionarymonetarypohcy. The latter, however, is unlikelyto have a large real impact and indeed will imply a sharp short-Uved exchange rate depreciation. The main benefit of such pohcy is in the incentives it provides. Its main problem is that it is time- inconsistent. Section II describes the essence ofthe extemal shocks and the financial mechanism at work. 2 See Caballero (1999, 2001) for a discussion ofthe structural reforms aimed at improving integration and the development offinancial markets. More importantly, Chile is in the process ofenacting a major capital marketsreform. SeeCaballeroandKrishnamurthy(2001a)foraformaldiscussionofthisperspective.