Volatility and Crisis:Three Lessons for Developing Countries
Norman Loayza
World BankWorld Bank
The Big Scare…The Big Scare…
• Just one year agoJust one year ago,– Developing countries faced collapsing,
• world productionworld production
• world trade
• remittances
• capital inflows
• investor confidence
Collapsing world demandReal GDP Growth in Advanced Countries
QoQ annualized growth (%), 2004 Q1 – 2009 Q1
0
5
-10
-5
-20
-15
20
2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1
Euro Area Japan United States
Collapsing world demand… and recoveryReal GDP Growth in Advanced CountriesReal GDP Growth in Advanced Countries
QoQ annualized growth (%), 2004 Q1 – 2009 Q3
0
5
-10
-5
-20
-15
20
2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1
Euro Area Japan United States
Collapsing developing country exports
50
Growth (%) in nominal exports of developing countries, year-over-year
30
40
0
10
20
-20
-10
0
-40
-30
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Collapsing developing country exports… and recovery
50
Growth (%) in nominal exports of developing countries, year-over-year
30
40
0
10
20
-20
-10
0
-40
-30
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Collapsing investors’ confidence
2000
Corporate EMBI & U.S. High Yield Bond Spreadin basis points
Corporate EMBI & U.S. High Yield Bond SpreadIn basis points
1600
000
1200
800
High Yield ECA
LAC
0
400g
EAP0
Jan-
07M
ar-0
7
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08M
ar-0
8
May
-08
Jul-0
8
Sep-
08
Nov
-08
Jan-
09M
ar-0
9
May
-09
Jul-0
9
Sep-
09
Nov
-09
Jan-
10M
ar-1
0
Collapsing investors’ confidence… and recovery
2000
Corporate EMBI & U.S. High Yield Bond Spreadin basis points
Corporate EMBI & U.S. High Yield Bond SpreadIn basis points
1600
2000
1200
800
High Yield ECA
LAC
0
400g
EAP0
Jan-
07M
ar-0
7
May
-07
Jul-0
7
Sep-
07
Nov
-07
Jan-
08M
ar-0
8
May
-08
Jul-0
8
Sep-
08
Nov
-08
Jan-
09M
ar-0
9
May
-09
Jul-0
9
Sep-
09
Nov
-09
Jan-
10M
ar-1
0
A remarkable recovery…A remarkable recovery…
• In almost all dimensions of the crisisIn almost all dimensions of the crisis
• Most developing countries showed notable resilienceresilience
What have we learned?What have we learned?
• Contrary to popular claimsContrary to popular claims,– The 2008 world financial crisis was not so unique
that it invalidated our knowledgethat it invalidated our knowledge
– In fact, it confirmed the lessons drawn from years of experience and researchof experience and research
• especially on volatility and vulnerability
1 S lf i fli t d i th t(or, stop blaming globalization…)
1. Self-inflicted crises are the worst(or, stop blaming globalization…)
Openness and vulnerability (I)Openness and vulnerability (I)
• Does openness lead to more vulnerability toDoes openness lead to more vulnerability to external shocks?
→ YES→ YES
E id f h f h f hi i i– Evidence from the aftermath of this crisis:• Lane and Milesi-Ferretti (2010)
• Calderón and Didier (2009)• Calderón and Didier (2009)
Loayza and Raddatz (2007):
THE EFFECT OF A TERMS-OF-TRADE SHOCK
0.025
0 015
0.020
tion
0 005
0.010
0.015
t Dev
iat
0.000
0.005
Out
pu
-0.0050 2 4 6 8 10
YearsHigh Openness Low Openness
Yes, openness leads to vulnerability, bbut…
• Vulnerability to external shocks is the cost of doing business in the modern worlddoing business in the modern world– Victimization research analogy:
Wh t lik l t ff f i ?• Who are most likely to suffer from crime?
The real sources of volatility…The real sources of volatility…
• Raddatz (2007): In low income countriesRaddatz (2007): In low income countries,
Variance of GDP per capita
Exogenous Shocks Endogenous Shocks
- Commodity price changes - Inflation- Commodity price changes- Aid shocks- Climatic disasters- Famines and epidemics
- Inflation- RER overvaluation- High public deficits- Political instability
- Volatility of high-income countries- Interest rate shocks
- Violent conflict
? ?
The real sources of volatility…The real sources of volatility…
• Raddatz (2007): In low income countriesRaddatz (2007): In low income countries,
Variance of GDP per capita
Exogenous Shocks Endogenous Shocks
- Commodity price changes - Inflation- Commodity price changes- Aid shocks- Climatic disasters- Famines and epidemics
- Inflation- RER overvaluation- High public deficits- Political instability
- Volatility of high-income countries- Interest rate shocks
- Violent conflict
11% 89%
So, should we just ignore l h kexternal shocks?
• No!
• If the economy is well-prepared, the harm from negative shocks can be mitigatedg g– Prudent macro policies
» Blanchard, Faruqee, Das (2010)» Calderón and Didier (2009)
– Political stability» Malik and Temple (2009) » Loayza, Rancière, Servén, and Ventura (2007)
• Another victimization research analogy…– For people in the streets, who are most likely to be victims of a crime?
2 Implicit insurance is2. Implicit insurance is seldom sustainable, always distortionary,
d ll hi
(or, don’t promise what you can’t deliver…)
and usually catastrophic
(or, don t promise what you can t deliver…)
Chronicle of a Death Foretold…Chronicle of a Death Foretold…
G t
Large, growing social cost
• Government implements a policy that
ff i li it• Distorted
ti b• Policy breaks
doffers implicit insurance
Unintended
actions by private sector
down
CRISIS!Unintended incentives
CRISIS!
A Death Foretold: Argentina’s currency board 1990 20001990-2000
d
RER overvaluation
Unemployment• Fixed-exchange rate regime • Borrowing in
d ll h l
Unemployment
• Devaluation
Ignore currency
dollars, while income is in pesos Macroeconomic Ignore currency
mismatch CRISIS!
Another Death Foretold: U.S. current financial crisis
Loss of asset value
Large public deficits• A history
of banking bail-outs • Excessive risk
Large public deficits
• Interrupt
Ignore corporate
taking• “Too big to fail”
bail-outs: Lehman!
g presponsibility PANIC, CRISIS!
Stop bailouts!Stop bailouts!
• Easier said than doneEasier said than done…
• But there are good precedents:I fl ti h i fl ti d h th– Inflations, hyperinflations, and how they were ended:
• Central Banks stopped bailing out governments• Central Banks stopped bailing out governments
• Institutional rules that gave central bank autonomy and prevented fiscal dominance
• Ex. Inflation targeting, used now by over 30 countries» Mishkin and Schmidt-Hebbel (2007)
The challenge remains…The challenge remains…
• Develop fiscal institutions and rules p»to avoid implicit, unsustainable insurance»to stop bailouts
We are in an ever-increasing cycle of risk-taking and too-big to fail bailouts The [next] crisis will be biggerbig-to-fail bailouts… The [next] crisis will be bigger.Where will it come from? State and local governmentdefaults? Pension funds? A new Asian Bubble? Default byGreece Italy or Ireland? Who knows?Greece, Italy, or Ireland? Who knows?
John Cochrane, 2010
3. It’s large fluctuations, not regular l tilit hi h h th
(or, better frequent shakes than a big
volatility, which harms the economy (or, better frequent shakes than a big
earthquake…)
The effect of macro volatility on long-hrun economic growth
• Ramey and Ramey (1995):Ramey and Ramey (1995):• Macroeconomic volatility exerts a significant negative
impact on long-run growth
• Hnatkovska and Loayza (2005):• Decompose volatility into “normal” and “crisis” p y
components
• Only the negative effect of “crisis” volatility is t ti ti ll i ifi t d 4 ti l th th ff tstatistically significant and 4 times larger than the effect
of “normal” volatility
Normal and Crisis Volatility
Argentina, 1960-2008
5.4
a G
row
th
"Normal"1.3
-2.8
per c
apita Normal
volatility
GD
P p "Crisis"
volatility
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008 Year
Good volatility?Good volatility?
• Small doses of certain types of volatility can serveSmall doses of certain types of volatility can serve as “vaccine” against large recessions
• When is volatility good?When is volatility good?– When it reflects flexibility in the allocation of
resources and the communication of information • Changes in relative prices
» Decrease real wages to reduce unemployment» Depreciate real e change rate to red ce trade deficit» Depreciate real exchange rate to reduce trade deficit
• Changes in asset values» Decrease in stock market value of failing enterprisesf f g p
The Dot Com Crisis and the Subprime M t C i i Wh diff t ff t ?Mortgage Crisis: Why so different effects? • Dot Com Crisis:Dot Com Crisis:
– Wiped out $5 trillion in market value from March 2000 to October 2002
– But, no financial crisis and only a mild recession
• Subprime Mortgage Crisis:p g g– Subprime mortgage losses around $400 billion
– Yet, enormous financial crisis and large recession, g
• The difference? » No price adjustment and market breakdown!» No price adjustment and market breakdown!
Chile and Russia: Two different reactions to the l i iexternal crisis (Blanchard, Faruqee, Das, 2010)
• Both countries are large commodity producers• Both received a large trade shock• Both are financially integrated with the world• Russia had larger FX reserves relative to short term debt• Russia had larger FX reserves relative to short-term debt
than Chile• So, did Russia fare better with the crisis?
» NO!• Chile did better,
» More effective fiscal stabilization mechanism» More flexible exchange rate regime
• Early exchange rate depreciation prevented speculative outflows
Shock absorbers, Escape Valves, S f t S it hSafety Switches…
• The economy needs these mechanisms to adjust y jcontinuously and grow
• Macroeconomic stabilization policiesC li l fi l li i» Counter-cyclical fiscal policies
» Responsive monetary and exchange rate policies
• Microeconomic flexibility (e.g., Collier and Goderis, 2009)y ( g )» Flexible entry and exit of firms» Flexible labor markets
• The quasi-paradox is that in order to avoid abrupt• The quasi-paradox is that in order to avoid abrupt fluctuations, the economy needs constant movement and adjustment
Bergoeing, Loayza and Repetto (2004):
Severity of Recessions and Regulatory Burden
0.25
0.3
ssio
ns
Correlation = 0.36**
0.15
0.2
y of
Rec
es
0.1
Seve
rity
0
0.05
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8
Regulation IndexDevelopingIndustrializedLinear (Developing)
Loayza, Oviedo, and Servén (2010):
TGO
.06 Correlation: 0.35***
Overall Regulation
IDNMWIPNGTHA4
ARGCOG
HTIJOR
KORMARMYS
NERPER
THA
TUR
VENZMB
ZWE
.04
BRABWA
CHLCIV
COG
COLCRI
DOM
ECU
FINHND
IRL
IRN
ISL KEN
MEXNER
NIC
PHLPRT SEN
SWE
SYR
TTO
URY
.02
AUSAUTBEL
BFA
BGD
BOLCAN
CHEDNK
EGY
ESPFRA
GBR
GHA
GMBGRC
GTM
INDIRL ISL
ISRITAJAM
JPN KEN
LKA
MDGNGA
NLDNOR
PAK PANPRYSLV
SWE TUN
USA
ZAF
0
0 .2 .4 .6 .8 1Overall Regulation Index
In summary…In summary…
1. Domestic policies and institutions continue to be the1. Domestic policies and institutions continue to be the main drivers of volatility and crisis
2. Unsustainable implicit insurance and the practice of bailouts are usually behind the worst crises
3. Flexibility to adjust to new conditions is the best antidote against large macroeconomic disruptionsg g p
Volatility and Crisis:Three Lessons for Developing Countries
Norman Loayza
World BankWorld Bank