Global Financial Turmoil: Is Latin America Sheltered?

transcript

Global Financial Turmoil: Global Financial Turmoil: Is Latin America Is Latin America

Sheltered?Sheltered?

Ernesto TalviErnesto Talvi

Prepared for Presentation at the XXVI Meeting of the Latin American Prepared for Presentation at the XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries, IADB, Washington DCNetwork of Central Banks and Finance Ministries, IADB, Washington DC

October 16October 16thth, 2007, 2007

CERESCERES

MAIN POINTS OF THE PRESENTATION

In every major episode of global financial turmoil Latin America suffered In every major episode of global financial turmoil Latin America suffered a severe blow.a severe blow.

Tequila Crisis

Asian Crisis

LTCM / Russian Crisis*

Debt Crisis

Subprime Crisis

Global Financial Turmoil Episodes in Perspective*

10y Mov.Avg. + 1

10y Mov.Avg. + 2

(Moody’s US Baa Spread over US Treasuries)

*A *A global financial turmoil episodeglobal financial turmoil episode is defined as an aggregate-spread window containing a spike in the US Baa spread exceeding two standard deviations is defined as an aggregate-spread window containing a spike in the US Baa spread exceeding two standard deviations from its mean (which starts when the aggregate US Baa spread exceeds one standard deviation, and ends when it is smaller than one standard deviation). from its mean (which starts when the aggregate US Baa spread exceeds one standard deviation, and ends when it is smaller than one standard deviation). If between the end of an episode and the beginning of the next there is less that one year, both are considered part of the same episode.

(Moody’s US Baa Spread over US Treasuries and Gross Capital Flows to LAC-7 in billions of 2006 US dollars)

Spread on Risky Assets

Gross Capital Flows to LAC-7

Global Financial Turmoil Episodes and Sudden Stops in LAC-7*

400LTCM / Russian Crisis

Debt Crisis

126.5 129.5

-116.6-146.9

-40-20

20406080

100120140

10y Mov.Avg. + 1

10y Mov.Avg. + 2

*LAC-7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, which represent 93% of Latin America GDP

(LAC-7 GDP, real index)

Global Financial Turmoil Episodes and Output Performance*

*Talvi, E. (forthcoming), “Sudden Stops in the 80s and the 90s: a Fresh Look at Latin America’s Debt Crisis”

Avg. growth 1974-1980:

4.5% Avg. growth 1981-1985:

Debt Crisis

1980s: Debt Crisis

Peak to Trough

Duration of Recession

-5.4% 2 yrs

Recovery to pre-crisis peak levels

Output Contraction

LTCM/ Russian Crisis

1990s: LTCM / Russian Crisis

Peak to Trough

-1.3% 1 yr

Output Contraction

Global Financial Turmoil Episodes and Investment Performance*(LAC-7, Gross fixed capital formation, real indices)

Debt Crisis

6.8% Avg. growth 1981-1985:

1980s: Debt Crisis

Peak to Trough

-27.6% 2 yrs

Output Contraction

11 yrs

1990s: LTCM / Russian Crisis

LTCM/ Russian Crisis

Peak to Trough

Output Contraction

-13.9% 1 yr 7 yrs

Global Financial Turmoil Episodes and Social Impact:An Ilustration from Argentina and Uruguay*(% of people under the poverty line)

Argentina 90s: LTCM / Russian Crisis

Recovery to pre-crisis

trough levelsTrough to peak

30% 9 yrs

LTCM / Russian Crisis

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Uruguay 90s: LTCM / Russian Crisis

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Trough to peak

trough levels

7+ yrs

If recent episodes of capital market turbulence are any indication, the If recent episodes of capital market turbulence are any indication, the unfolding of a full blown global financial turmoil episode, would be a unfolding of a full blown global financial turmoil episode, would be a ‘lethal combo’. Given past experience, it will send once again Latin ‘lethal combo’. Given past experience, it will send once again Latin America diving.America diving.

Recent Episodes of Global Financial Turbulence (US High Yield Spread, basis points)

Expectations of Fed

Tightening

Greenspan’s Conundrum Testimony US Inflation

ScareSubprime

Crisis

China’s Stock Market Sell Off

X-Ray of Recent Episodes of Global Financial Turbulence

Data Sources: JPMorgan, Bloomberg and MSCI

(bond price equivalent*, peak to trough variation)Bond Prices

-4% -3% -2% -1% 0% 1% 2%

Japan T-Bonds

Europe T-Bonds

US T-Bonds

AAA Corporate

BBB Corporate

EM Asia

EM Europe

US High Yield

Latin America

* Own calculations assuming an 11% coupon and 10-year maturity

Credit Spreads(basis points, peak to trough variation)

-20 0 20 40 60 80

Japan T-Bonds

Europe T-Bonds

US T-Bonds

AAA Corporate

BBB Corporate

EM Asia

EM Europe

US High Yield

Latin America

Flight to Quality Flight to Quality

Commodity Prices(peak to trough variation)

-10.5%

-12% -10% -8% -6% -4% -2% 0%

AgriculturalProducts

Goldman Sachs

Industrial Metals

Commodity Index

+ 480 bps

LTCM / Russian CrisisTequila

CrisisAsian

Crisis

(US High Yield Spread over US Treasuries)

Simulation of a Global Financial Turmoil Episode

10y Mov.Avg. + 1

10y Mov.Avg. + 2

“Combo Shock”: Simulation of Collateral Damage of a Global Financial Turmoil Episode

Shock to the US High Yield Spread (bps, High Yield Spread over US

Treasuries)

+480 bps

10Y Treasury Yield Dynamics (10Y T-Bond Yield)

-35 bps

Terms of Trade Dynamics (LAC-7, 91.I = 100)

G-7 Industrial Production Dynamics (1991.I = 100)

Estimation Strategy: Vector Error Correction Model (VECM) Estimation Strategy: Vector Error Correction Model (VECM)

tptpttt yyycy 1111 ...'

wherewhere

yt = ( gdp_latt ip_xt tot_latt financ_xt riskt )’

gdp_lat: (log of) Simple average of GDP indices of LAC-7 countries

ip_x: (log of) G-7 industrial production index

tot_lat: Principal component weighted average of (the log of )

terms of trade indices of LAC-7 countries

financ_x: Return on 10 year US T-bonds

risk: US High-Yield Bonds Spread

Booms and Busts in Latin America: The Role of External Factors*

*A. Izquierdo, R. Romero and E.Talvi (2007), “Booms and Busts in Latin America: The Role of External Factors”.

Booms and Busts in Latin America: The Role of External Factors*(GDP LAC-7, annualized quarter on quarter growth rate)

Actual

Fitted

15%Tequila

CrisisAsian Crisis

A Vector Error Correction Model

*A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.

Commodity Prices

World Growth

External Factors

International Financial Conditions

US T-Bond Interest Rate

Spread on US HY Bonds

Steady State GDP Dynamics

-4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

GDP Dynamics w. “Combo Shock”

Output Performance: Simulation of the Overall Impact of a Global Financial Turmoil Episode

Output Response to “Combo Shock”*

*Impulse response simulations based on the model by A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.

peak levels

Peak to Trough

Duration of Recession Phase

Output Contraction

-4.5% 1.5 yrs“Combo Shock” 3.3 yrs

-5.4% 2 yrsDebt Crisis 4 yrs

-1.3% 1 yr 2 yrs

The analysis based on past experience is faulty, since the external The analysis based on past experience is faulty, since the external environment is less risky and Latin America’s fundamentals are much environment is less risky and Latin America’s fundamentals are much stronger today. Thus, the region is less vulnerable to global financial stronger today. Thus, the region is less vulnerable to global financial turmoil episodes than in previous expansions.turmoil episodes than in previous expansions.

The ‘This Time is Different’ Hypothesis

The World is a safer place The World is a safer place (“Great Moderation” period)(“Great Moderation” period)

US UK FRANCE GERMANY ITALY CANADA JAPAN

60s 70s 80s 90s 00s0,0

Real Interest Rates

(“perfect foresight” real ex-ante rates

for long term instruments) 1.6

0.9Excluding Japan 1.2

Growth, Inflation and Interest Rates Volatility in G-7 Countries(standard deviation)

Inflation

3.9%3.7%

Economic Growth

1.6%2.0% 2.1% 2.1%

The ‘This Time is Different’ Hypothesis

The World is a safer place The World is a safer place ( “Great Moderation” period)( “Great Moderation” period)

Latin America is more resilient than in Latin America is more resilient than in previous expansionsprevious expansions

Latin America: Growth and Inflation

Source: WEO

90s Boom Current BoomLTCM / Russian Crisis

6,26,0 6,1

Average:

Inflation(LAC-7, CPI annual variation)

*Median

Average 91.I-98.II: 20.3%

Average 98.II-02.IV: 6.2%

Growth Performance(LAC-7, real annual growth rate)

Millions of USD

% of GDP

-85,000

-65,000

-45,000

-25,000

-5,000

15,000

35,000

55,000

Dec.02-Aug.07

Variation: 147%

Jan.91-Jun.98

Variation: 271%

Jun.98-Dec.02 Variation:

External Balance(LAC-7, current account, in millions of USD and % of GDP)

International Reserves(LAC-7, billions of US dollars)

Latin America: External Balance and International Reserves

Colombia 2.2

Argentina 1.9

Peru 2.3

Mexico 2.4

Aug.07/Jun.98

LAC-7 2.1

2.3Brazil

Venezuela 1.8

Chile 1.0

Latin America: Fiscal Stance and Latin America: Fiscal Stance and Debt ManagementDebt Management

*Adjusted by Argentina’s debt exchange

Public Debt Level*(LAC-7, % of GDP)

Dollarization of Publc Debt(LAC-7, foreign currency debt, % of total debt)

Source: Cowan, Levy, Panizza, Sturzenegger (2006) and own calculations based on official data.

Fiscal Balance(LAC-7, % of GDP)

Latin America: Credit Ratings(LAC-9** excluding Ecuador, Standard & Poor´s Credit Ratings)

BBB+14

BBB-12

BB+ 11

*A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” *A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” (forthcoming)(forthcoming)

Numerical Transformation of Credit Ratings*

InvestmentGradeInvestment Grade

ChileColombia

Mexico

Investment Grade

Mexico

** LAC-9 includes the Latin American countries currently covered by JPMorgan EMBI** LAC-9 includes the Latin American countries currently covered by JPMorgan EMBI

At closer look, the world is still a risky place and Latin America’s At closer look, the world is still a risky place and Latin America’s underlying vulnerabilities to a global financial turmoil episode are still underlying vulnerabilities to a global financial turmoil episode are still large, but the current bonanza is disguising a host of fundamental large, but the current bonanza is disguising a host of fundamental fragilities.fragilities.

The World is still a risky placeThe World is still a risky place

‘‘Plus Ça Change, Plus Ça Reste La Même Chose’ Plus Ça Change, Plus Ça Reste La Même Chose’ ((The more things change, the more they remain the same)The more things change, the more they remain the same)

Great Moderation?The Calm Before the Storm…

Moody’s Baa Corporate

Spread

(basis points)

Moody’s Baa Corporate Spread

Volatility

(3 year moving standard deviation,

in basis points)

Debt Crisis LTCM / Russian Crisis

1978-2007 Avg.

Mean+2

The Global Financial Turmoil Histogram(Moody’s Baa Spread Histogram, 1978 – 2007)

12.6%90 11

Global Financial Turmoil Probability: 4.5%

Mean+1

Latin America’s fundamentals are weaker Latin America’s fundamentals are weaker than meets the eyethan meets the eye

The World is still a risky placeThe World is still a risky place

‘‘Plus Ça Change, Plus Ça Reste La Même Chose’ Plus Ça Change, Plus Ça Reste La Même Chose’ ((The more things change, the more they remain the same)The more things change, the more they remain the same)

Assessing Performance in Latin America: A Counterfactual Exercise*

Forecast for GDP: 2003 – 2006(LAC-7, Values in logs)

Forecast for GDP: 1998 – 2001(LAC-7, Values in logs)

Observed GDP

*Simulations based on the model by A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.

Predicted GDP w. Observed

External Factors

Observed GDP

90% confidence interval

Steady State GDP

90% confidence interval

Predicted GDP w. Observed

External Factors

Steady State GDP

Millions of USD

% of GDP

Latin America External Balance: A Different Perspective* (LAC-7, current account, in millions of USD and % of

Terms of Trade Adjusted at I.2002

prices

-85,000

-65,000

-45,000

-25,000

-5,000

15,000

35,000

55,0001

* G. Calvo and Talvi, E. (2007): “Current Account Surplus in Latin America: Recipe Against Capital Market Crises?”; www.rgemonitor.com (forthcoming)

Reserves / M2

Latin America: International Reserves (billions of US dollars and % of M2)

Reserves

Source: IFS and own calculations

Average 1991.I-1998.II: 45.6%Average 1991.I-1998.II: 45.6%

Average 1998.II-Average 1998.II-2002.IV: 40.3%2002.IV: 40.3%

Average 2002.IV – Average 2002.IV – 2006.III: 48.3%2006.III: 48.3%

M2 = Currency outside banks + demand deposits + time, savings and foreign currency deposits of resident sectors

Latin America: Structural Fiscal Balance*

1.0%Observed Balance

LAC-7 (% of GDP)

Beginning of Current Boom

LTCM / Russian

Crisis

*A. Izquierdo, Ottonello, P., Talvi, E. (forthcoming), “ *A. Izquierdo, Ottonello, P., Talvi, E. (forthcoming), “ If Latin America Were Chile: A Comment on Structural Fiscal Balances and Public DebtIf Latin America Were Chile: A Comment on Structural Fiscal Balances and Public Debt” .” .

Structural Balance

Chile (% of GDP)

LTCM/ Russian

Crisis

Observed Balance

Structural Balance

Structural Balance**

**Excluding Venezuela

Latin America: Fiscal Revenues and Expenditures*

Fiscal Expenditures

LAC-7 (Mar-91 = 100)

Fiscal Revenues

Adjusted Revenues

LTCM / Russian

Crisis

Fiscal Expenditures

Chile (Mar-91 = 100)

LTCM/ Russian

Crisis

Fiscal Revenues

Adjusted Revenues

Prociclicality in Public Expenditures

(in % of increase in fiscal revenues, 2002-2006)

Increase in Public Expenditures for LAC-7

0% 20% 40% 60% 80% 100%

Colombia

Argentina

Mexico

Brasil

Venezuela

(in % of increase in fiscal revenues, 2002-2006)

Increase in Public Expenditures per Country

68%Primary

Expenditures

Interest Payments 2%

Increase in Total Revenues

Latin America: Structural Debt: Structural Debt(LAC-7, in % of GDP)

Observed Debt

Current Boom90s Boom LTCM / Russian Crisis

42%Structural Debt

November 1994

November 1998

December 1993

August 1997

Debt Mutation: Two Compelling Examples*

Pre-Asian Crisis Pre-Devaluation Pre-Tequila

CrisisPre-Devaluation

Brazil(Federal Domestic Securities, exchange rate

linked + Selic linked, % of total debt)

Mexico(Federal Government Domestic Securities, exchange rate

linked Tesobonos, % of total debt)

* E. Cavallo, Izquierdo, A., and Talvi, E. (in progress), “* E. Cavallo, Izquierdo, A., and Talvi, E. (in progress), “External Financial Conditions and Debt Composition: the Mutation FactorExternal Financial Conditions and Debt Composition: the Mutation Factor”.”.

At closer look, the world is still a risky place and Latin America’s At closer look, the world is still a risky place and Latin America’s underlying vulnerabilities to a global financial turmoil episode are still underlying vulnerabilities to a global financial turmoil episode are still large, but the current bonanza is disguising a host of fundamental large, but the current bonanza is disguising a host of fundamental fragilities.fragilities.

The evidence from credit ratings and the behavior of asset prices is The evidence from credit ratings and the behavior of asset prices is consistent with the view that Latin America is still vulnerable to global consistent with the view that Latin America is still vulnerable to global turmoil, but financial shocks so far have been “too small to hurt”.turmoil, but financial shocks so far have been “too small to hurt”.

Credit Ratings Agencies Verdict

*A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” (forthcoming)*A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” (forthcoming)

BB+BB+

BBB+14

BBB-12

BB+ 11

Numerical Transformation of Credit Ratings*

InvestmentGrade

(LAC-9 excluding Ecuador, Standard & Poor´s Credit Ratings)

Investment Grade

ChileColombiaMexico

Investment Grade

ChileMexico

Russian Crisis

Investment Grade

ChileColombiaUruguay

Systemic Turmoil Period

(US High Yield and Latin EMBI spreads, basis points)

Relatively Tranquil Recent Period

Let Prices Talk: EMBI Spreads Reaction to Spikes in US High Yield Spreads

Latin EMBI

US High Yield

Recent Period Average

19-Apr to 17-May-04

10-Mar to 18-May-05

10-May to 27-Jun-06

26-Feb to 7-Mar-07

23-Jul to 16-Aug-07

Dating Δ US HY Spread

Δ LA EMBI Spread

Naïve Beta

3-Aug to 19-Oct-98

12-Sep to 15-Dec-00

7-Feb to 9-Apr-01

21-May to 4-Oct-01

10-May to 14-Oct-02

1.3Systemic Turmoil Period Average

(1) (2) (3) (4)

(3) / (2)

Measuring Contagion:The Forbes-Rigobon Adjustment*

Correlation Adjustment

where is the actual correlation coefficient and

is the unadjusted correlation coefficient

*K. Forbes and Rigobon E. (1999), “No Contagion, Only Interdependence: Measuring Stock Market Co-Movements”

Beta Coefficient

where is the correlation coefficient between x and y,

and and are the variance of x and y,

respectively

Variance Adjustment Coefficient

where is the variance of x during a period of market

turmoil and is the variance of x during a period of

relative market stability

*Adjusted using Forbes, Rigobon (1999) methodology

Beta Coefficient(average beta per period,

US high yield vs. Latin EMBI)

(US High Yield and Latin EMBI spreads, basis points)

Latin EMBI

US High Yield

Let Prices Talk: EMBI Spreads Reaction to Spikes in US High Yield Spreads

IN SUMMARY

When scratching the surface, Latin America is still highly vulnerable to a global financial turmoil episode

This analysis should not be construed as a gloomy forecast, but rather as a warning against “irrational exuberance”.

Although we should enjoy the good times, policy makers in the region should be on guard and fire departments (i.e. multilaterals) in full alert mode

Ernesto TalviErnesto Talvi

Prepared for Presentation at the XXVI Meeting of the Latin American Prepared for Presentation at the XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries, IADB, Washington DCNetwork of Central Banks and Finance Ministries, IADB, Washington DC

October 16October 16thth, 2007, 2007

CERESCERES

Global Financial Turmoil: Is Latin America Sheltered?

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