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Insuring Emerging Markets: Contingent Debt

Insuring Emerging Markets: Contingent Debt. Ricardo J. Caballero, MIT http://web.mit.edu/caball/www IADB, Washington, D.C. April 9, 2003. The Problem. Many structural/macro reforms but Capital Flows remain volatile IMF / Treasury proposals: Focus on extreme cases. Bankrupt economies.

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Insuring Emerging Markets: Contingent Debt

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  1. Insuring Emerging Markets:Contingent Debt Ricardo J. Caballero, MIT http://web.mit.edu/caball/www IADB, Washington, D.C. April 9, 2003

  2. The Problem • Many structural/macro reforms but Capital Flows remain volatile • IMF / Treasury proposals: • Focus on extreme cases. Bankrupt economies. • Problem is far more widespread and it starts earlier • Sudden stops, costly precautionary measures and recessions • Chile vs Australia during 97-99 • Chile’s response: 10 times larger than it should • HOW CAN WE MAKE EMs MORE LIKE AUSTRALIA (GIVEN THEIR STRUCTURE AND INSTITUTIONS)?

  3. An “Obvious” Answer: Hedging/Insurance Markets • Hedging what? • “Exogenous” Financial constraints • E.g., Chile: fc triggered by Pcu / High yield. (beyond flows and govt. revenues) • Example: Chile could embed in its external bonds a long-term put option yielding 8b if fc-trigger-indicators (e.g. Pcu) fall by more than two sd for six months or more. • “Fair” Price: 1 or 2% of GDP (very cheap compared to current precautionary measures)…

  4. Simulation from “Hedging SS and PS:…”

  5. Sudden Stop estimate from “Hedging…”

  6. The Supply Side • Specialists? • Early on: yes. Medium run: Not ideal. They are needed during difficult times. Don’t want their K to shrink at those times. • US Pension funds, insurance companies, etc. • Need to decouple contingency from emerging markets stuff. • This is harder for “endogenous” variables • And a lot harder for pure-peso-bonds; (domestic banks).

  7. Asset Class Protection Contingent EM - CDO Senior (A+) Contingent EM Contingent Debt Mezzanine Specialists IMF? (conditionality?) Subord. Debt / Equity Toxic waste? Less so…

  8. Why hasn’t it happened? • Markets are slow to develop: • CAT-bonds (act-of-God) • t0 (1997): 9xE[loss]; t0+2: 5xE[loss] • Externalities • Focus: • There are plenty of potentially contractible shocks. Identify -- Liquidity. • The IFIs have a key role in promoting and jump-starting these markets. • Forcing bad cases (e.g. Argentina) • Encouraging good cases (e.g. Mexico, Chile) [CCL] • 2003, a window of opportunity?

  9. Not far… (small/income) • Petrobonds: Mexico 1970s. • Giscards (gold): France 1973 • Corporates • Magma Copper (1988) • Standard Oil of Ohio (1986) • Sunshine Mining [Silver] (1980) • Forest Oil [Natural Gas] (1988) • …

  10. Final Remarks • “IMF” • Crisis Department • Non-contractible shocks: totally unexpected events and domestic misbehavior/blunders • Bankruptcy as Insurance / LLR • (IFIs) Contingent Markets Department • Contractible capital flows volatility • Other policies • Fiscal/monetary rules • Designed to prevent “un-insurance” • Indexed to contingencies

  11. Current Account Deficit Australia

  12. Chile (an advanced EM economy)

  13. External Vulnerability Growth of Industrial Production Interest Rates Data period: 1991 – 2002. Frequency: monthly EMBI+: percentage change in J.P. Morgan Emerging Market Bond Index Plus. Copper: Spot price of copper US$ Interest Rates: Real interest rate (U.F.) Loans (90-365 days), Banco Central de Chile Industrial Production: Annual percentage change Industrial Production Index, Instituto Nacional de Estadisticas

  14. Annex • Caballero, R.J., “The Future of the IMF.” [Also, “On the International Financial Architecture: Insuring Emerging Markets.” ] • _______, “Coping with Chile’s External Vulnerability: A Financial Problem.” • _______ and S. Panageas, “Hedging Sudden Stops and Precautionary Recessions: A Quantitative Framework.” Available at http://web.mit.edu/caball/www

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