Sudden Stops and Economic Performance: Policy Options

1. Sudden Stops and Economic Performance: Policy Options Liliana Rojas-Suarez April 10, 2003

2. How to Deal with the Volatility of Capital Flows? The answer depends on the view regarding the causes of such volatility • For those who believe that the major reason lies in the behavior of international capital markets and developments in industrial countries, the response focuses on reforms to the international architecture. • For those who believe that the major reason is the inadequacy of domestic macro and financial policies, the response often focuses on: • Improving the macroeconomic stance, especially the fiscal outcome and the debt structure. • Emphasis on improved supervision and regulation of financial institutions. • Development of domestic capital markets to: (a) provide an alternative to bank finance and (b) offset, at least partially, the sharp reduction in sources of finance deriving from a sudden stop. For most, however, the answer is a combination of all factors

3. How Can Changes in the International Financial Architecture Help Reduce the Volatility of Capital Flows to Latin America? Once again, the answer depends on the views held with regard to the efficiency of markets • For those who support an enhancement of market forces, failures in the international architecture lie in the excessive intervention of public policies. An improvement of the architecture would include: • Changing the lending practices of international institutions to eliminate moral hazard problems. That is, by ensuring that creditors, who were compensated ex-ante to bear risk, share appropriately in the ex-post losses • Introducing adequate Collective Action Clauses (CACs) in international bond contracts to alleviate problems in debt restructuring negotiations. Ex. Mexico • Improving the transparency of policies • Recognizing that markets price liquidity high in times of stress, and therefore develop individual or collective mechanisms for liquidity provision.

4. How Can Changes in the International Financial Architecture Affect theVolatility of Capital Flows to Latin America? Moreover, it is imperative for emerging markets to raise awareness that the implementation of Basel II in industrial countries, albeit its good intentions, may exacerbate the already high volatility of capital flows to emerging markets by: • Introducing a more favorable treatment of capital requirements for short-term bank lending. • By subjecting capital requirements to the credit assessment of rating agencies (under the Standardized Approach) who already have a track record of lowering credit ratings after the emergence of problems. If instead, international banks use the Internal Rating Approach, an underestimated risk from a credit to the region will result in a sudden reversal of capital flows. See www.claaf.org

5. How Can Changes in the International Financial Architecture Help Reduce the Volatility of Capital Flows to Latin America? For those who believe that market imperfections, including information asymmetries, warrant further official intervention, appropriate policies include: • Incorporating additional controls on the activities of the markets, including regulation of hedge funds • Support the extreme interpretation of the SDRM where a statutory approach fully substitutes the contractual approach in debt restructuring operations • At the national level, impose capital controls

6. What Can Financial Regulation do to Deal with the Volatility of Capital Flows? • Because financial systems in Latin America are dominated by short-term instruments, policy responses to deal with a sudden reversal of capital flows, such as an increase in interest rates, affect the entire financial system • Well-designed Prudential Regulation can Help Dealing with the Adverse Impact of Capital Flows Volatility by contributing to offset the Distortions in Risk Pricing created by other financial and non-financial policies and by Market Imperfections • Inappropriate regulation, however, might exacerbate the adverse impact of capital flows volatility

7. What Can Financial Regulation do to Deal with the Volatility of Capital Flows? Example Ia: Capital Requirements that Correctly Weight Risk • To avoid distortions to risk allocation, capital requirements should resemble what banks would hold in the absence of a (explicit or implicit) safety net • While there is little that Latin American countries can do with respect to the implementation of Basel II in industrial countries, they need to build defenses against the potentially enhanced volatility of the flows resulting from these new regulations. Adequate and correctly constructed capital requirements can help a lot

8. What Can Financial Regulation do to Deal with the Volatility of Capital Flows? Example Ia: Capital Requirements that Correctly Weight Risk (cont.) • As capital requirements are a buffer to deal with unexpected shocks, the risk weights attached to different bank assets should take into account the volatility of those assets • As the overall financial and economic volatility of Latin America is much higher than in industrial countries, capital requirements also need to be higher • Differentiation of risks among bank assets implies recognition by governments of the true risk of their liabilities. As long as banks’ capital charges do not reflect the risk characteristics of government liabilities, there could be a regulation-induced “crowding-out” problem.

9. What Can Financial Regulation do to Deal with the Volatility of Capital Flows? Example Ib: Capital Requirements that Incorrectly Weight Risk might Exacerbate the Adverse Impact of a Sudden Stop in Capital Flows • A sudden stop of flows usually brings about a decline in the price of government bonds. • If risk weights attached to government paper held by banks are below those corresponding to the true market risks, banks would find themselves holding an excessive amount of government paper and the sudden stop will bring about a deterioration in banks’ portfolio above what is warranted by the shock.

10. What Can Financial Regulation do to Deal with the Volatility of Capital Flows? Example IIa: Adequate Loan-Loss Provisions can Help Mitigate the Effects of Volatile Capital Flows • Differently from capital requirements, loan loss provisions need to reflect expected losses. • Experience shows that a sudden stop brings about a sharp depreciation in the real exchange rate that adversely hits the non-tradable sector. • It follows from the experience in Latin America that ex-ante non-tradables are riskier than tradables. Therefore loan-loss provisions should be higher for loans to the former sector than to the latter. • Adequate provisioning would create an incentive for banks to allocate relatively more resources to the tradable sector. This would help mitigate the effects of the volatility of capital flows.

11. What Can Financial Regulation do to Deal with the Volatility of Capital Flows? • Example IIb: Inadequate Loan-Loss Provisions can Exacerbate the Adverse Effects of Volatile Capital Flows • If loan loss provisions do not correctly assess risk, in good times banks would lend excessively to the non-tradable sector • If the economy is “partially dollarized”, many of these loans would be in dollars, constraining the policymakers’ capacity to let the exchange rate depreciate Exchange Rate Risk Transforms into Credit Risk • In this situation, a sudden stop would hurt banks’ portfolio more than it would have done had the provisioning been adequate.

12. What Can Financial Regulation do to Deal with the Volatility of Capital Flows? Indeed, the problems associated with liability dollarization can be alleviated by adequate provisioning rules that reflect the risks specific to Latin America

13. Wouldn’t it be Easier to De-dollarize? • Not really. Voluntary dollarization occurred and got stronger for a reason; • long history of hyperinflation • establishment of foreign banks as holding dollar-denominated deposits in these banks is viewed as safer

14. Wouldn’t it be Easier to De-dollarize? • The challenge for policymakers is to create incentives for savers to diversify their portfolios by increasing their holdings of domestic-currency denominated assets • This could be done by creating incentives for the offering of indexed bonds once an adequate structure for the functioning of capital markets is in place • However, it is important to stress that capital markets can not develop where uncertainties regarding the soundness of banks persist because: • banks are the ultimate providers of liquidity for capital markets • bank deposits need to serve the function of safe assets relative to the riskier nature of assets traded in the capital markets It may precisely be the existence of safe deposits denominated in dollars that would allow for the expansion of the riskier domestic-currency denominated assets.