Macroeconomic Volatility and Growth: Evidence and Policies

1. Macroeconomic Volatility and Growth: Evidence and Policies Alejandro Werner March 2006

2. Macroeconomic volatility in Latin America has been relatively high. Evidence suggests that this has been a negative factor for growth in the region. Per Capita GDP Growth Volatility (Std dev., 1970-2003, %) Per Capita GDP Volatility and Growth (Avg. and std dev., 1970-2003, %) Source: Alan Heston, Robert Summers and Betina Aten, PennWorld Tables Version 6.1. For 2001-2003, per capita GDP growth data is from World Economic Outlook, IMF, September 2005.

3. Due to slow growth in Latin America, per capita GDP deteriorated in comparison to other economies. A clear exception to this regional trend since the 2nd half of the 80s is Chile. Latin America: Per Capita GDP Ranking (Position in a 98-country sample) Asia: Per Capita GDP Ranking (Position in a 98-country sample) Source: Alan Heston, Robert Summers and Betina Aten, PennWorld Tables Version 6.1. For 2001-2003, the GDP per capita growth data from World Economic Outlook, IMF, September 2005 is used.

4. Chile carried out a broad reform agenda that delivered sustained growth and reduced macroeconomic volatility. However, Chilean economic takeoff happened long after the first wave of reforms. Chile: Reforms, Per Capita GDP and Growth Volatility (Thousand dollars of 1996, and std. dev. in %) Average Annual Growth and Volatility of Chilean Per Capita GDP (Percent) Source: World Penn Tables, IFS and Larraín and Vergara, “Chile en Pos del Desarrollo: Veinticinco Años de Transformaciones Económicas” in La Transformación Económica de Chile, Larraín and Vergara (ed.)

5. Macroeconomic volatility in Latin America is explained by external and domestic sources. Endogenous sources have magnified the effect and scope of exogenous factors. • External • Terms of trade shocks • Adjustments in global financial markets • Domestic • Political instability • Fiscal and monetary policies • Financial system Exogenous Endogenous

6. Latin America has been subject to larger external disturbances than other regions. Depending on exports’ concentration, terms of trade shocks have been a leading source of instability. Terms of Trade and Capital Flows Volatility (Std. deviation) Terms of Trade Volatility (Std. deviation) Souce: IDB Economic and Social Database (GDP) and World Bank World Tables (terms of trade). Source: Inter-American Development Bank.

7. Also, the region has shown a considerable political instability. • Latin America ranks second to last (only above Africa) in terms of rule of law and corruption control.1/ • Out of 133 presidential administrations in Latin America between 1945 and 1982, 51 ended in coups.2/ • Electoral volatility in sixty percent of Latin American countries exceeded that of the most volatile European country by an average of 126%.1/ • Latin America ranks as the region with the greatest political gridlocks between 1985 and 1994, more than double any other score.1/ • Less than 40% of Latin Americans are very or partly satisfied with democracy in their countries.1/ 1/ Inter-American Development Bank (IDB) (2000): Development: Beyond Economics. Washington, D.C.: IDB. 2/ Ames, B. (1987): Political Survival: Politicians and Public Policy in Latin America. Berkeley: University of California Press.

8. Fiscal policy in Latin America has been strongly procyclical, thus amplifying macroeconomic volatility from exogenous sources. Index of Cyclicality of Fiscal Policy Souce: Kaminsky, Reinhart and Végh (2004) The ICFP is a composite index of correlations of the cyclical components of fiscal policy instruments (Real Central Government Expenditure and the Inflation Tax) and real GDP (HP Filter) and a measure of the amplitude of Real Central Government Expenditure Cycle captured by the difference in growth of real central government expenditure in "Good" and "Bad" Times. The amplitude of the real central government expenditure cycle is transformed to a (-1,1) indicator.

9. Following the liberalization of the 80s, the financial system emerged as a mechanism that also amplified these exogenous volatility sources. • Two characteristics of the financial systems of the region have accounted for this role: • Low global integration • Small size and inefficiency • Underdeveloped financial systems have fueled crises in LA • Their lack of global integration has prevented them from providing liquidity at difficult times • Small size and inefficiency have prevented them from allocating funds to distressed but profitable firms • Financial systems have helped turn balance of payments crises into macroeconomic crises across the region

10. In fact, policy volatility (endogenous sources) accounts for a large fraction of overall macroeconomic volatility and its costs across countries. Estimated Impact of Volatility on Growth* (Percent) Estimated Impact of Volatility on Growth* (Percent) Source: Inter-American Development Bank. Source: Inter-American Development Bank. *Note: For each region, numbers represent the impact on growth of volatility in excess of that observed in industrial countries.

11. The sources and amplifiers of macroeconomic volatility in Latin America reflect a poor institutional development. • Therefore, efforts should focus on developing and strengthening those institutions aimed at delivering sound and time-consistent policies: • Reduce the effects of external volatility • Curbing those channels that amplify exogenous shocks • Macroeconomic policy • Financial sector

12. Specifically, the following steps can be effective in reducing overall macroeconomic volatility • Reduce the impact of external shocks • Diversify exports • Choose an adequate exchange rate regime • Develop stabilization funds and other forms of self-insurance • Pursue trade and investment treaties • Creates long-term links to developed foreign institutions • Increases the resilience of external sector (Calvo, 2005) • Exports risks by diversifying ownership • Macroeconomic policy • Well-defined monetary policy objectives (transparency) • Prudent fiscal targets and rules for unexpected shocks • Reduce public debt sensitivity to external shocks • Financial development • Promote financial global integration • Deepen financial markets by promoting domestic saving

13. It is worth noticing that “growth acceleration” episodes have been preceded by changes in the institutional framework. • Growth Acceleration.- An increase of per capita GDP growth of 2pp or more, sustained for at least 8 years and the post acceleration growth rate has to be at least 3.5% per year (Hausmann, Pritchett, Rodrik, 2004). • While growth accelerations tend to be highly unpredictable, some common factors can be found: • Sustained accelerations are statistically predicted by political changes towards democracy (if only developed countries are considered, shifts towards autocracy have a positive effect). • Positive external shocks produce only temporary accelerations. • Sustained growth accelerations are statistically predicted by economic reforms. • An interesting question for future research is whether such acceleration episodes have been characterized by volatility drops.

14. Concluding Remarks • Even successful cases as Chile’s show that it takes time (and patience) for a growth-accelerating institutional change to yield results. So, we should keep working on the long-term institutional development. • In the meantime, second-best policies designed to operate under a weak institutional environment should be strongly considered. • For example, linking our institutions to more developed external counterparts through treaties or setting clear laws for policy actions can deliver positive results in the medium–term. • This would also shield the long-term institutional development process from volatility bouts that could jeopardize it.

15. Macroeconomic Volatility and Growth: Evidence and Policies Alejandro Werner March 2006