RDP 2004-03: Fear of Sudden Stops: Lessons from Australia and Chile 3. Taking Stock and Short-run Recommendations

Why do countries like Australia and Chile respond so differently to similar shocks? And what can the Chiles of the world do to react more like Australia? We split our answer to these questions in two parts. In this section we explain the role of country-trust and currency-trust in recent shocks and, taking these as given, discuss policy options for countries like Chile. In Section 4 we look more closely at the experience of Australia over the 20th century to extract lessons on how to build country-trust and currency-trust that may be relevant for emerging market economies.

3.1 Why So Different?

There are at least three ingredients that helped Australia, and not Chile, during the recent episode: (i) Australia had no concern (at least in relative terms) with capital flow reversals; (ii) Australia could count on ex-ante external hedging against exchange rate fluctuations; and (iii) Australian banks had access to a deep currency derivatives market to insulate themselves (and their borrowers) from exchange rate fluctuations. We discuss these in turn.

3.1.1 No fear of sudden stop in Australia

The first ingredient is due to country-trust. In Chile there was widespread fear of a capital flow reversal. Net capital outflows could lead to a balance of payments crisis that would turn out to be much more costly than the contraction brought about by high interest rates. Contractionary monetary policy was seen as a way of reducing the need for external financing (by reducing domestic absorption) and the extent of the capital flow reversal (by sending a pragmatic signal to investors). This perception went beyond the CBCh since resident banks and other private agents were also taking aggressive precautionary measures. While the fear of a sudden stop may have been a consideration for Australia at the time, the degree of concern was surely much lower.

Chile's inflation target is generally perceived to be credible and so the exchange rate could probably have been allowed to float more freely than it did during the Asian-Russian crisis. It is also possible that a significant part of the adjustment of the AFPs was a once-and-for-all portfolio adjustment to an unfortunately timed regulatory change. But there seems little hope that sudden stops and the expectation of sudden stops will suddenly disappear. Copper continues to be Chile's ‘bellwether’ for foreign investors, who are primarily specialists subject to a variety of shocks. Recent research on ‘institutional’ determinants of contagion confirms this view by linking financial contagion to characteristics of developed economy markets and investors. A country like Chile may be ‘contaminated’ by a crisis event in another emerging market economy if they both belong to a particular asset class (Rigobon 2001), borrow from the same banks (Van Rijckeghem and Weder 2000) or share a set of overexposed mutual funds (Broner and Gelos 2003). While Chile may have come a long way in overcoming other aspects of its financial fragility, it seems unlikely that it will be able to insulate itself completely from shocks to its external supply of funds in the near future simply because of ‘specialists’ and ‘neighbourhood’ effects.

3.1.2 Exchange rate based insurance and ‘original sin’

The second ingredient is due to both country-trust and currency-trust. Foreigners are willing to hold assets denominated in Australian dollars. This provides an implicit insurance arrangement for Australia in which resources are automatically transferred to Australia when a terms of trade shock results in a depreciation.

Note that this – and only this – is what is behind the ‘original sin’ literature. While important, it should be apparent that this is not the only ingredient behind external crises in emerging markets. It is not even likely to be the main ingredient in most cases. Australia did not develop currency-trust until the mid 1980s, or at least did not use it before then as an insurance arrangement since it did not have a floating currency.^[15] Foreigners did not start holding Australian local-currency debt until the 1980s, as described in Section 4.2.2.

Furthermore, Chile needs external insurance more than Australia does, precisely because the direct terms of trade shocks are amplified by the resulting contraction in the supply of external funds. So ‘original sin’ is a more serious problem for Chile than for Australia. But importantly, ‘original sin’ is not the primitive problem behind the need for substantial insurance; the problem is a lack of country-trust.

3.1.3 Decoupling of risks

The third ingredient, currency hedging for banks, is based on currency-trust. Banks are highly leveraged institutions that can manage idiosyncratic credit risk but not exchange rate volatility risk (or other aggregate risks). Faced with a supply of funds in a foreign currency, a bank has three options. The first is to lend in the local currency and take on exchange rate risk directly. The second is to pass on the exchange rate risk to its borrowers, and in doing so take on the credit risk of borrowers with a currency mismatch. The third is to off-load exchange rate risk to other investors. Such investors could be domestic investors that are less leveraged than banks, or foreign investors willing to take on local-currency risk. If the banking sector is unable to off-load the exchange rate risk without taking on credit risk, then external shocks that raise the volatility of the exchange rate lead either to a withdrawal of the banks from local lending or to an increase in financial fragility.

In both Australia and Chile domestic savings are in the local currency and so banks only have to deal with currency mismatches when borrowing from abroad. In Australia, the deep currency derivatives market allows banks to hedge the currency risk inherent in borrowing from abroad in foreign currency and lending to domestic firms in Australian dollars. They can decouple their lending activity from exchange rate risk. In Australia, currency-trust is combined with country-trust as foreigners take some of this exchange rate risk. However, Chilean banks are not able to hedge exchange rate risk and so they refrain from intermediating foreign funds. In addition, external shocks that raise the volatility of the exchange rate leads to a natural withdrawal of banks from local lending.

The case of highly dollarised banking systems, such as Argentina or Peru, provides a more dramatic example of the difficulties for banks of not being able to decouple exchange rate risk from credit risk. Banks in these economies are hard pressed to find even domestic agents willing to take on currency risk. As a result of this (and prudential regulation limiting accounting mismatches) they end up passing on the exchange rate risk to their borrowers. Clearly the first step for these economies must be to understand and address the factors that drive the decision of domestic investors to save almost exclusively in US dollars.

In the absence of other mechanisms to remove exchange rate risk, some countries fix the exchange rate to eliminate this risk for key investors, such as banks. Argentina's strategy during the 1990s could be thought of in these terms. Dollarised economies effectively operate in this fashion as well. Of course, fixing the exchange rate involves other costs. These include the possibility that domestic positions become even more mismatched in the process, thereby increasing the fragility of the economy. Except for extreme circumstances, fixing the exchange rate is unlikely to be the most efficient mechanism to unbundle (micro) credit and aggregate shocks risks.

3.2 What Can Be Done Given Weak Country-trust and Currency-trust?

Credibility cannot be bought and so even in the best of circumstances, improvement in country-trust and currency-trust are likely to be gradual. In this section we discuss three sets of policies aimed at ameliorating the effects of low levels of country-trust and currency-trust. The first two of these seek to develop markets for contingent instruments that reduce the cost of external and internal insurance. The third – contingent macroeconomic policy – seeks to improve the private-sector incentives to take adequate precautions against external crises, i.e., to purchase this insurance.

3.2.1 External insurance

‘Original sinners’ have no currency-trust with foreigners, hence they cannot use exchange rate fluctuations as an insurance mechanism. Unfortunately, these countries need external insurance even more than countries such as Australia since terms of trade shocks are leveraged many times by the sudden stops associated with their weak country-trust.

These countries should then look for external contingent contracts that are not dependent on domestic policy actions, or even on understanding the workings of the particular country. But such contracts should be highly correlated with sudden stops and external shocks. Good examples of these variables are the price of copper for Chile, the price of oil and an index of US activity for Mexico, the high-yield spread in the US for most emerging markets, and so on.^[16]

Importantly, such instruments would provide the needed insurance regardless of the exchange rate system and degree of fear of floating. External insurance is effectively separated from the exchange rate, thus breaking the connection between low currency-trust and limited external insurance.

3.2.2 Domestic insurance

Affected countries want to prevent banks, especially foreign-owned, from cutting back their lending in the face of exchange rate risk. They need a mechanism that will allow banks to decouple their lending activity from explicit or implicit exchange rate risk. Even if a country has limited external currency-trust, it is often the case that there is an opportunity to efficiently redistribute currency risk among domestic agents. For example, given much of their consumption and expenses are in non-tradable goods, domestic households, especially those with foreign assets, are likely to be willing to absorb some of the exchange rate risk. So it is important to develop the domestic currency derivatives markets to help domestic agents offset their opposing currency hedging needs and to enable banks to offload this risk onto willing residents. In time, with the gradual evolution of currency-trust, foreigners will begin to participate in this market and absorb more exchange rate risk. Interestingly, as we will describe in Section 4.2.3, a key first step for developing these markets seems to be to develop a domestic currency bond market. It also appears that this can be done quicker with public bonds than with private bonds.

Of course, in economies with limited domestic currency-trust, such as in the heavily dollarised economies, there is limited scope for such developments. In effect, dollarisation of domestic liabilities is an extreme form of the absence of a market to transfer the differential risks associated with exchange rate fluctuations.

3.2.3 Contingent macroeconomic policy

As we will discuss in the next section, clear and credible macroeconomic policies are key in the long-term process of building both country-trust and currency-trust.

In addition to adopting standard good practices on inflation targeting and structural fiscal mechanisms, authorities in emerging markets ought to analyse the interaction between these practices and the sudden stop mechanism. For example, Caballero and Krishnamurthy (2003, 2004) show how indexing inflation targeting and foreign exchange interventions to the same contingencies that are behind the external insurance discussed above can be used to improve the private sector's incentives to take adequate precautions against external crises.

The key is to avoid providing – or generating the perception of – free exchange rate insurance to the private sector. Free insurance could come directly from the government, or from potential lenders through low expected returns due to the illiquidity of domestic markets during crises. A countercyclical monetary policy, while limited in terms of its aggregate demand impact, can help alleviate the incentive problems caused by free insurance and the optimal injection of international reserves during external crises.

Of course, economies that lack domestic currency-trust cannot afford to use monetary policy and its impact on exchange rates as an incentive mechanism. Such countries may have to resort to taxing short-term capital inflows and imposing tight liquidity ratios on foreign borrowing. These are costly measures that ought to be recognised as yet another cost of lacking monetary credibility.

Footnotes

Strictly, currency-trust could play an important insurance role even under a fixed parity since it could allow agents to modify out-of-equilibria scenarios and therefore prevent some perverse outcomes. However, this would still require extensive contracting with foreigners in local currency. [15]

See Caballero (2003) and Caballero and Panageas (2003). [16]