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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.
