Rekindling Hope in Latin America: What Role for the IDB?

1. Rekindling Hope in Latin America:What Role for the IDB? Ricardo Hausmann Kennedy School of Government Harvard University

2. The “lost decade” of the 80s Cumulative growth rate in GDP per working age person, relative to US1980-1990 Peru Argentina Venezuela Mexico Panama Ecuador 80-90 Brazil Uruguay Colombia Chile United States -45.0 -40.0 -35.0 -30.0 -25.0 -20.0 -15.0 -10.0 -5.0 0.0

3. The shared diagnosis • The debt coould not be paid because the funds were misallocated • ...because they were assigned to... • Public Consumption • Public Enterprises • Over-protected private companies • Financially repressed and poorly regulated banks.

4. The agreed solution • Public Consumption Fiscal Discipline • Public Enterprises Privatization • Over-Protected Private Companies Trade liberalizationFinancially repressed and poorly regulated banks.Liberalizationand Regulation

5. The initial pay-off to reform 1990-97 Brazil Venezuela Ecuador Mexico United States Colombia Argentina Panama Uruguay Peru Chile -20.0 -10.0 0.0 10.0 20.0 30.0 40.0 50.0 Cumulative growth rate in GDP per working age person, relative to the US

6. Reformers did better Change in GDP growth vs. change in policy index (1993-95 vs. 1987-89) 15% Perú 10% Nicaragua Cambios en Tasas de Crecimiento Argentina 5% El Salvador Trinidad and Tobago Brazil Ecuador Colombia Bolivia Guatemala Costa Rica 0% Uruguay Venezuela República Dominicana Paraguay Chile Honduras Mexico Jamaica -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% Cambios en Indices de Política Fuente: Lora y Barrera, 1997

7. Growth collapsed 1998-2002 Cumulative growth rate in GDP per working age person, relative to the US Argentina Uruguay Venezuela Colombia Ecuador Peru Panama Brazil Mexico Chile United States -40.0 -35.0 -30.0 -25.0 -20.0 -15.0 -10.0 -5.0 0.0

8. The whole reform period 1990-02 Argentina Venezuela Ecuador Brazil Uruguay Colombia Mexico United States Panama Peru Chile -50.0 -40.0 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 40.0 50.0 Cumulative growth rate in GDP per working age person, relative to the US

9. The two lost decades 1980-02 Argentina Venezuela Peru Ecuador Brazil Mexico Uruguay Panama Colombia United States Chile -60.0 -50.0 -40.0 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 40.0 Cumulative growth rate in GDP per working age person, relative to the US

10. What happened? • Two stories • Sudden stops and original sin • Wrong growth theory

11. As in the early 1980s, capital flows suffered a “sudden stop” Total debt flows 50 150 Latin America Others 40 100 30 50 20 0 10 0 -50 1971 1975 1979 1983 1987 1991 1995 1999 -10 -100 -20 -150 -30 -40 -200

12. Where did the “sudden stop” come from? From the Original Sin

13. The Original Sin:the impossibility to borrow abroad in domestic currency An alternative explanation of the causes of financial problems in emerging countries

14. The global portfolio (0.9857) 1 Debt by 0.9 Currency (0.8859) 0.8 Debt by Country 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 United States EUROLAND Japan U . K Switzerland Canada Australia

15. The Original Sin:an alternative hyphotesis • Most countries cannot borrow abroad in their own currency. • If they accumulate a net foreign debt, then there will be an unhedgeable aggregate currency mismatch • This makes movements in the exchange rate affect the income and the balance sheet of the nation • …making depreciations contractionary • …limiting the effectiveness of monetary policy and the capacity of the Central Bank to act as a lender of last resort • …and creates the possibility of self-fulfilling crises

16. For countries that suffer from OS what matters is the capacity to pay measured in US $

17. …by this measure they are 8 times more volatile Industrial Developing LAC Real GDP volatility 2.0% 4.7% 4.5% US$ GDP volatility 11.8% 16.3% 14.8% This is the relevant measure if you borrow in US$

18. Movements of exchange rates are large and persistent Industrial Developing LAC Real GDP volatility 2.0% 4.7% 4.5% US$ GDP volatility 11.8% 16.3% 14.8% Gap in RER 5-y MA 19.7% 84.5% 91.8% This is the maximum gap between 5-year Moving average of the real exchange rate

19. An international solution • We propose an index based on an inflation-adjusted basket of EM currencies • Historically it shows trend appreciation, low volatility and negative correlation with industrial country consumption • We propose that the WB, the IDB and other IFIs and other G-7 governments issue debt in this index

20. Step 1. Develop a new Index • Develop the new Index EM(Unit of Account) • Based on a basket of emerging market currencies • Indexed to each country’s inflation • Weights based on GDP - PPC • This Index exhibits • Trend appreciation • Low volatility (Less than the DM/$ or Yen/$) • Negative correlation with G-10 consumption • Excellent for rich country’s portfolio diversification

21. EM is stable 1.7 20 in the 80's 1.5 22 from 93-02 DM Index 1.3 Yen Index 1.1 0.9 0.7 0.5 0.3 1980Q1 1981Q1 1982Q1 1983Q1 1984Q1 1985Q1 1986Q1 1987Q1 1988Q1 1989Q1 1990Q1 1991Q1 1992Q1 1993Q1 1994Q1 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1

22. Table 20: EM Indexes: Average return, standard deviation and correlation with real private consumption . EM Index 80 EM Index 93 (1980-2001) (1993-2001) Avg. Return St Dev Consumption Avg. Return St Dev Consumption 1 1 Correlation Correlation Canada 1.56 10.9 -14.5 1.49 10.5 -33.4 France 2.58 13.6 -25.9 2.92 10.2 -36.4 Germany 0.73 14.3 12.5 3.14 10.5 -14.5 Italy 4.22 14.0 -27.5 3.36 11.1 15.8 Spain 4.50 12.9 -62.0 4.30 10.5 -65.4 Japan -3.12 13.9 4.3 0.13 11.8 34.3 United Kingdom 2.45 12.2 -35.3 -0.24 11.8 -21.4 United States 0.27 11.3 -23.4 -0.71 11.6 -25.5 Appreciation, stability, risk diversification 1 Note : Correlations with Real Consumption: for France, Germany, Italy and Spain it covers 1980-1998. For Canada, UK, US and Japan it covers 1980-01. A negative number indicates that the returns tend to be high when real private consumption is low.

23. Step 2. Have the World Bank and other IFIs issue debt in EMs • IFIs are AAA, so they have access to a broad asset class • They can hedge their currency exposure by converting loans to EM-index members into indexed local currency loans • They become a solution, not a cause of OS • Regional IFIs can swap with the WB or the governments themselves for non-regional index members • WB would calculate index lowering manipulation risk

24. Step 3. Have G-7 countries issue debt denominated in index • Also high-grade non-residents with an interest in lowering global risks • Swap currency exposure with EM-member countries • This gets read of the mismatch • Need not cost them anything • Make sure by providing put-option on the price of the swap • The swap is much safer than sovereign risk and can be made safer

25. Additional roles for the IDB • Develop a long-term fixed rate market for IDB loans in Latin American currencies in NY • This will eliminate sovereign risk from limiting the development of long-term peso markets • Bonds would be denominated in pesos but would be payable in US$ under NY law • They could be either nominal or inflation- • This will allow the IDB to lend long term in the same terms

26. Revisiting Growth Theories and Policies

27. A synthetic view of growth strategies Private income = appropiability x productivity x accumulated factors Y = (1-τ) A kα

28. Strategy 1: Accelerate factor accumulation • Increase domestic savings • Public savings • Improved financial systems • Social security reform • Facilitate access to foreign savings • Official international lending • Open capital account • Promote education • Increase allocations and improve effectiveness

29. Strategy 2. Improve expected appropriability • Adopt low and predictable taxes • Reduce the probability of expropriation through macro crises • Fiscal sustainability • Financial soundness • External balance • Improve contractability • Capital, labor, foreign trade and investment • Improve property rights protection and justice • Reduce corruption, crime • Assure political stability and governance

30. Strategy 3. Increase productivity • Do’s • Through education, although watch out for excessive university spending • Through openness to foreign trade and investment, although watch out for subsidies, protection • Through complementary public investment, although watch out for “picking winners” • Through intellectual property rights protection

31. How to construct an overall strategy? • The ‘best practice’ checklist approach • Go through the list and compare current situation to some benchmark • Focus improvements on the most glaring lags • Problems with the approach • No guarantee that identified sectors constitute an important binding constraint • No account of the interaction between areas of policy • Easy to confuse cause and effect • E.g. Lack of growth may complicate fiscal balance or political support for policies

32. An alternative view • Factor accumulation is more the consequence than the cause of growth opportunities • Growth accelerations preceed savings accelerations • Growth generates demands for factors. If they are not adequately supplied, returns go up, encouraging more factor accumulation • Increases in factor endowments without increased demand for them lowers their returns • In education, 1 more year of education lowers returns by about 1.5 percent • Capital - both physical and human - can move to other countries

33. An alternative view • Appropriability has been improved through Washington Consensus policies • More things remain to be done, but in the high reform countries, the additional pay-off does not appear too large • Many reforms reduce the expected cost of future expropriations, • but current returns should be high and are not • Without growth, political and fiscal stability are harder to sustain, while the likelihood that rules will be changed is increased

34. The self-discovery hypothesis • Most developing countries do not invent new products • They find out which of a potentially very large set of products they can profitable make in their countries • However, finding out can be very costly • you have to use a trial and error approach • However, once shown to be feasible, the idea can be more easily copied • E.g. you can profitably grow peaches in Chile, but not apples

35. The self-discovery hypothesis (cont’d) • In the non-tradable sector the innovator, by definition, becomes a monopolist • Monopoly rents may provide incentives for innovation • In the tradable sector, the national innovator enters an already competitive market and hence does not expect the monopoly rents that accrue to global innovators or domestic innovators in the non-tradable sector • This means that there is a systematic innovation bias against tradables (exports). • This helps explain the large PPP adjustment between rich and poor countries

36. The self-discovery hypothesis (cont’d) • Exports tend to be very highly concentrated in few activities • Over the long run, growth depends in finding out new sectors • Once a sector is “discovered”, it will have specific technological and human capital requirement as well as specific complementary investments. Costs may decline further over time • This creates potential increasing returns and scale effects, which create other forms of market failure

37. The self-discovery hypothesis (cont’d) • This approach helps explain why the growth impact of reform may have been larger in the initial period than in the long run • Reforms facilitate the diffusion of existing new ideas, but not the discovery of new ones • It also helps explain why the Chilean experience has been so hard to copy • self-discovery in fruit, wine, fishing, mining and forestry • Copying the same macro institutions and policies need not generate similar growth • Many of these self-discoveries predate the growth boom • It helps explain why El Salvador has not fully recovered pre-civil war income levels • It lost sugar, cotton and coffee but lacks equivalent substitute ideas

38. Self-discovery: policy implications • The market outcome is inefficient. There are low private returns to innovation. Governments can improve things • …but governments do not know where to invest. They can promote self-discovery, • …but they need to let bad ideas die • While in principle they can do so across the board, they will inevitably be forced to pick sectors • Milton Friedman vs. Isaiah Berlin • Complementary investments are sector specific

39. Self-discovery: policy implications • There is a trade-off between market failure and government failure • Rent-seeking • Inefficient subsidies: promote things that would have happened anyway • Self-discovery vs. artificial life support • The challenge is to make this trade-off less binding • push the feasible frontier out

40. What should governments be willing to do? • Focus on new ideas • Innovators, i.e. demonstration projects, not copycats • Trade protection and multi-sector loans do not discriminate between them • Identify ways to be helpful • …but this involves discretion • Limit its abuse through delegation and accountability • In general, lending in market terms is not enough • Interventions that are potentially more costly are required

41. What should governments be willing to do? • Subsidize technological adaptation • Fundacion Chile and Salmon • Competitive grants • Subsidize on-the-job training by paying for a certain proportion of the first year’s wage bill • Compatible with WTO rules • Participate as share-holder or subordinated lender • Provide complementary investments and adjust inefficient rules or regulations • Constructive role for the “Cámaras de Comercio” • Impose positive NPV fiscal impact rule

42. Self-discovery and FDI • What is special about FDI? • Foreign companies know how to do something, but do not know if they can do it in your country • They face a similar problem • Same principles apply • Demonstration projects, training subsidies, equity, subordinated lending, complementary investments, regulatory adjustments • Active promotion seems to be required • Identify and lobby potential investors

43. Role for the IDB • Support these kinds of programs • Develop a best-practice approach on the kind of institution that can adequately manage discretion in this area • Independent board with potential foreign participation • Evaluation, transparency and accountability • Should these institutions be nationally or regionally based? • Innovations could be applicable to more than one country