Dollars, Debt, and Deficits Sixty Years after Bretton Woods

Dollars, Debt, and Deficits Sixty Years after Bretton Woods Conference Proceedings

Banco de España International Monetary Fund

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Dollars, debt and deficits : sixty years after Bretton Woods : conference proceedings [Washington, D.C.] : International Monetary Fund : Banco de España, [2005] p. cm. Organized by Banco de España and the International Monetary Fund. ISBN 1-58906-453-4 1. International finance — Congresses. 2. Dollar — Congresses. 3. Debt — Congresses. 4. Foreign exchange rates —Congresses. 5. International Monetary Fund Congresses. I. International Monetary Fund. II Banco de España. HG3881.D67 2005

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Contents List of Participants

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Foreword Rodrigo deRato and Jaime Caruana

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INTRODUCTION Raghuram Rajan and Jose Vinals

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OPENING SPEECHES Rodrigo de Rato Pedro Solbes Jaime Caruana

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BLOCK I: GLOBAL IMBALANCES, EXCHANGE RATE ISSUES, AND DEBT

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Session 1; Global Imbalances A Map to the Revised Bretton Woods End Game: Direct Investment, Rising Real Wages, and the Absorption of Excess Labor in the Periphery Michael P. Dooley, David Folkerts-Landau, and Peter Garber Macroeconomic Dynamics and the Accumulation of Net Foreign Liabilities in the US: An Empirical Model Giancarlo Corsetti and Panagiotis Th. Konstantinou

29 47

Session 2; Exchange Rate Issues Financial Globalization and Exchange Rates Philip R. Lane and Gian Maria Milesi-Ferretti What Makes Balance Sheets Effects Detrimental for the Country Risk Premium? Juan Carlos Berganza and Alicia Garcia Herrero

93 135

Session 3; Debt in Emerging Economies Public Debt, Fiscal Solvency, and Macroeconomic Uncertainty in Latin America: The Cases of Brazil, Colombia, Costa Rica and Mexico Enrique G. Mendoza and Pedro Marcelo Oviedo Exchange Rate Regimes and Debt Maturity Structure Matthieu Bussière, Marcel Fratzscher, and Winfried Koeniger

165 197

Contributions; Daniel Cohen (discussant) Stanley Fischer (panelist) Malcom Knight (panelist)

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KEYNOTE SPEECHES Agustin Carstens Jean-Claude Trichet

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BLOCK II: INTERNATIONAL FINANCIAL ARCHITECTURE

233 237

Session 4; The Role of the IMF A Model of the IMF as a Coinsurance Arrangement Ralph Chami, Sunil Sharma, and Ilhyock Shim The IMF in a World of Private Capital Markets Barry Eichengreen, Kenneth Kletzer, and Ashoka Mody

249 291

Session 5; Innovations in Private and Multilateral Lending Dollars, Debt, and the IFIs: Dedollarizing Multilateral Lending Eduardo Leyy-Yeyati Optimal Collective Action Clause Thresholds Andrew G. Haldane, Adrian Penalver, Victoria Saporta, and Hyun Song Shin

325 363

Contributions; Lorenzo Bini-Smaghi (discussant) John Murray (discussant) Guillermo Ortiz (panelist)

383 3 87 391

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List of Participants Enrique Alberola, Unit Manager, Banco de Espaiia Juan Carlos Berganza, Economist, Banco de Espaiia Lorenzo Bini-Smaghi, Director General, Italian Ministry of Economy and Finance Jorge Blazquez, Advisor, Economic Office of the President of the Spanish Government Geoffrey H. Board, Board Chief Representative, Reserve Bank of Australia Jan Brockmeyer, Deputy Executive Director, De Nederlandsche Bank Ariel Buira, Director of the G-24 Secretariat Matthieu Bussiere, Senior Economist, European Central Bank William Calvo, Chief Economist, Banco Central de Costa Rica Jose Manuel Campa, Professor, IESE Agustin Carstens, Deputy Managing Director, International Monetary Fund Jaime Caruana, Governor, Banco de Espaiia Miguel de las Casas, Economist, Banco de Espaiia Michael Casey, Head of the Funds Supervision, Central Bank & Financial Services Authorities of Ireland Ralph Chami, Division Chief, International Monetary Fund Roberto Cippa, Director of International Monetary Relations, Swiss National Bank Kenneth Coates, Director, Centre for Latin American Monetary Studies Daniel Cohen, Professor, Ecole Normale Superieure Giancarlo Corsetti, Professor, European University Institute Daniel Daco, Head of Division, European Commission Thomas Dawson, Head of the External Relations Department, International Monetary Fund Guillermo de la Dehesa, Member of the Board, AVIV A Michael Dooley, Professor, University of California and Deutsche Bank Special Advisor Sonsoles Eirea, Economist, Banco de Espaiia Santiago Elorza, Technical Advisor, Spanish Ministry of Economy Yuchuan Feng, Deputy Governor's Assistant, People's Bank of China Roger Ferguson, Vice Chairman, Board of Governors of the Federal Reserve System Vicente Javier Fernandez, Advisor, Spanish Secretariat of State for the Economy Santiago Fernandez de Lis, Director of the International Economics and International Relations Department, Banco de Espaiia Inigo Fernandez de Mesa, Deputy Director General of EMU Affairs, Spanish Ministry of Economy and Finance Stanley Fischer, Member of the Board, Citigroup Inc. Allen Frankel, Head of the CGFS, Bank for International Settlements Marcel Fratzscher, Senior Economist, European Central Bank Luis de Fuentes, Deputy Director General, Spanish Ministry of Industry, Trade and Tourism Peter Garber, Global Strategist, Deutsche Bank Alicia Garcia Herrero, Head of Division, Banco de Espaiia Luis Garcia Lombardero, Advisor, Spanish Secretariat of State for the Economy Jose Garcia Solanes, Professor, University of Murcia Francisco Gismondi, Director of Macroeconomic Analysis, Banco Central de la Republica Argentina Giorgio Gomel, Director of International Affairs, Banca d'ltalia Jane Haltmaier, Division Chief, Board of Governors of the Federal Reserve System Herve Hannoun, Deputy Governor, Banque de France Claudio Irigoyen, Director of Monetary and Financial Policy, Banco Central de la Republica Argentina Zhongxia Jin, Director General of the International Department, People's Bank of China Alfred Kammer, Deputy Managing Director's Advisor, International Monetary Fund Kenneth Kletzer, Professor, University of California Malcolm Knight, General Manager, Bank for International Settlements Panagiotis Konstantinou, RTN Research Fellow at the University of Rome III Philip Lane, Director of the HIS, Trinity College Dublin and CEPR Nuno Leal de Faria, Deputy Director of the International Relations Department, Banco de Portugal

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Eduardo Levy Yeyati, Professor, University Torcuato Di Telia Ruogu Li, Deputy Governor, People's Bank of China Zhengming Liu, Chief Representative, People's Bank of China Representative Office in Frankfurt Jose Luis Malo de Molina, Director General of Economics, Statistics and Research, Banco de Espafia Luis Marti, Executive Director, International Monetary Fund Manuel Martinez, Economist, Banco de Espafia Aurelio Martinez Estevez, Professor, University of Valencia Jose R. Martinez Resano, Economist, Banco de Espafia Enrique Mendoza, Professor, University of Maryland Gian M. Milesi-Ferretti, Division Chief, International Monetary Fund Ashoka Mody, Division Chief, International Monetary Fund Joaquin Muns, Member of the Board, Banco de Espafia John Murray, Advisor, Bank of Canada Michael Mussa, Senior Fellow, Institute for International Economics Franz Nauschnigg, Head of Division, Oesterreichische National Bank Emilio Ontiveros, Member of the Board, API Guillermo Ortiz, Governor, Banco de Mexico Adrian Penalver, Economist, Bank of England Jose Perez, President, Intermoney Kristina Persson, Deputy Governor, Sveriges Risksbank Jean Pisani-Ferry, Professor, University of Paris-Dauphine Richard Portes, Professor, London Business School and CEPR Federico Prades, Advisor, AEB (Spanish Banking Association) Raghuram Raj an, Economic Counsellor and Director of Research, International Monetary Fund Rodrigo de Rato, Managing Director, International Monetary Fund Luis Ravina, Rector, University of Navarra Carmen Reinhart, Professor, University of Maryland Rafael Repullo, Director, CEMFI Jose Juan Ruiz, Head of Department, Santander Central Hispano Juan Ruiz, Economist, Banco de Espafia Sinikka Salo, Member of the Executive Board, Suomen Pankki Javier Santiso, Chief Economist for Latin America and Emerging Markets, BBVA Jesus Saurina, Head of Division, Banco de Espafia Miguel Savastano, Division Chief, International Monetary Fund Miguel Sebastian, Director of the Economic Office of the President of the Spanish Government Sunil Sharma, Division Chief, International Monetary Fund Pedro Solbes, Second Vice President of the Spanish Government and Minister for Economy and Finance Alberto Soler, Advisor, Spanish Ministry of Economy and Finance Michel Soudan, Assistant of the International Service, National Bank of Belgium Marc Olivier Strauss-Kahn, Director General, Banque de France Gyorgy Szapary, Vice President, Central Bank of Hungary David Taguas, Economist, BBVA Fernando Tejada, Head of Division, Banco de Espafia Panayotis Thomopoulos, Deputy Governor, Bank of Greece Jens Thorn sen, Member of the Board, Danmarks Nationalbank Jean-Claude Trichet, President, European Central Bank Juan Jose Toribio, Director, IESE Jose Uribe, Head of the Management Office, Banco de la Republica de Colombia Pierre Van der Haegen, Director General of International and European Relations, European Central Bank Felix Varela, Head of Research and International Economy, University of Alcala Manuel Varela, Emeritus Professor, University Complutense Madrid Fernando Varela, Former Executive Director, International Monetary Fund David Vegara, Secretary of State for the Economy Jaume Ventura, Professor, University Pompeu Fabra Pedro Pablo Villasante, Director General of Banking Supervision, Banco de Espafia Jose Vinals, Director General of International Affairs, Banco de Espafia Regine Wolfinger, Economist, European Central Bank

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Foreword Concerns over the major challenges the international monetary and financial system currently faces and the attendant debate on the policy-related and academic facets of the international financial architecture have arisen from the lessons imparted by the financial crises of recent years and from the need to redefine the international financial community's strategies and strengthen crisis-prevention mechanisms. A new landmark in this connection has been the international conference Dollars, Debt and Deficits: Sixty years after Bretton Woods, which took place at the Banco de Espafia headquarters on 14-15 June 2004. The conference was jointly organized by the Banco de Espafia and the International Monetary Fund (IMF). The conference commemorated the 60th anniversary of the Bretton Woods meetings in July 1944. These meetings were one of the most significant events for the world economy in the last century and gave rise to the birth of an economic, monetary and financial system that has played a crucial role in promoting economic and financial stability, improving global welfare, and alleviating poverty. Representatives from 45 countries met at Bretton Woods against the backdrop of a world economy devastated by war and marked by protectionist trade policies and unstable exchange rates. The foundations were laid there for a stable framework of economic cooperation and an international financial and monetary system, and two institutions which have proved pivotal for the attainment of these goals were created: the IMF and the International Bank for Reconstruction and Development, later the World Bank. Spain's growing ties with the Bretton Woods institutions reached a high in autumn 1994 when Madrid hosted the IMF/World Bank annual meetings, coinciding with the 50th anniversary of the agreements. Marking another pinnacle was the IMF's obliging acceptance of the proposal to commemorate the 60th anniversary with the organization of an international conference at the Banco de Espafia. Significantly, this has been one of the few occasions on which the IMF has decided to hold a meeting of this nature outside its Washington headquarters. Conference preparations were set in train in December 2003, when the coorganizers made a call for papers to the academic community for contributions on economic development, policy measures and implications of debt sustainability, exchange rates and global imbalance in the capital account, debt and exchange rate crises, crisis-resolution strategies, the relationship between the adopted exchange rate regime and economic development, the link between fiscal development and exchange rate regimes, and regional integration and the main international currencies. The selection of contributions from among those received was by a committee made up of representatives from the IMF and the Banco de Espafia. The committee was pleasantly surprised by the number and quality of the contributions submitted, ten of which were finally chosen. For the session chairs, discussants and expert panels, prestigious academics and expert staff from central banks, international agencies and economic research institutes were called upon. The outcome was a high-quality program that

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generated notable expectations about the conference, expectations which were more than fulfilled thanks to the calibre of the participants and the results of the debates. Among conference speakers and participants, a significant total of 27 countries were represented. The conference was therefore an excellent opportunity to reflect on the major challenges currently facing the international monetary and financial system and on the future role of the Bretton Woods institutions. It has provided for better understanding of the development of and changes in the international financial architecture and has helped offer a perspective as to how a global response should be designed in the future to avert the perverse effects of crises on the world economy. The conference also allowed a fruitful exchange of views on exchange rate fluctuations in an increasingly integrated world economy, the consequences of political uncertainty and other issues relating to exchange rates, and the term structure of interest rates and the sustainability of public debt. The main contributions and debates turned on the dynamics of international disequilibria, such as the US external deficit, the effects of exchange rate fluctuations, the impact of uncertainty on public and private external debt, the role of the IMF and of international financial institutions in reducing emerging economies' foreign currency financing needs, and the prospects for the international financial architecture in light of the emergence of new international lending instruments and mechanisms. In sum, the tight but stimulating conference agenda highlighted once again the need for national authorities and international financial institutions to coordinate their work in areas of common interest, harnessing their experience and comparative advantages, and providing the degree of technical rigour needed to address global financial problems. Rod rigo de Rato IMF Managing Director

Jaime Caruana Governor of the Bank of Spain

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Introduction Raghuram Raj an International Monetary Fund Jose Viiials Banco de Espana In their opening remarks given to the Conference, Rodrigo Rato, Pedro Solbes and Jaime Caruana reviewed the history and future challenges of the IMF sixty years after its creation. They emphasize the role of the IMF in monitoring the financial system, and in preventing and managing financial crises, stressing the importance of coordination between international financial institutions (IFIs), national authorities, central banks, and supervisory agencies. The main discussions gathered in this book focus on issues related to debt, deficits, exchange rates, and the international financial architecture, with authors underscoring the importance of these topics for the future configuration of the international monetary system. Block I: Global Imbalances, Exchange Rate Issues, and Debt The dynamics of global imbalances, with special attention to the US and China, is the first topic of debate in this book. The paper by Michael Dooley, David FolkertsLandau, and Peter Garber outlines the process for a smooth adjustment of global imbalances, especially in China, in contrast with the alternative scenario of a sudden and disorderly exchange and interest rate correction. The key hypothesis at the heart of their prediction of an orderly adjustment is that periphery governments (in particular, China) will gradually adjust their policies before the onset of speculative capital flows. Financial policies in these countries are seen as a component of a more general portfolio management policy with the objective of creating an efficient domestic capital stock at the end of the process. In this paper's view, intervention in financial markets is an important part of their development strategy, and thus it will continue to be large and persistent enough to generate predictable deviations of exchange rates and nominal wages from normal cyclical patterns. In particular, in the case of China, a gradual adjustment of real wages through inflation and nominal exchange rate targeting will allow China to attain two main objectives: (i) absorb 200 million rural workers into the industrial sector, which will ease political pressures and increase those workers' productivity, and (ii) attain an efficient capital stock at the end of the adjustment period, so that China can be competitive in international markets without the need of distorted prices. The challenge of absorbing these vast quantities of labor in China is to set up a sharing of the benefits with the country importing an increasing flow of Chinese goods (e.g., the US), as this "beggar-thy-neighbor" policy might disrupt the importing 1

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country's labor market. A crucial element, therefore, is the depression of real wages in China and therefore an increase in the returns of foreign capital directly invested there. Over time, these returns on investment would converge to normal levels, at the same time as the Chinese real wage increases and the pool of rural labor is successfully transferred into the industrial sector. To this aim, financial repression and capital controls are seen as crucial by the authors, because in order to control the real wage the government needs to control the rate of inflation and the nominal exchange rate, and that requires breaking the link between domestic and international interest rates. On a different front, Giancarlo Corsetti and Panagiotis Konstantinou offer support to the so-called intertemporal approach to the current account. This approach has two basic predictions, which the authors confirm using US data. First, a temporary positive shock to output should, on average, improve the current account. That is, consumption should not increase as much as the temporary increase in output, therefore creating a (temporary) current account surplus, which for the US seems to last around 10 years after the shock. Second, a permanent positive shock to productivity would tend to generate a current account deficit, as consumption would tend to increase more than with a temporary shock. A permanent shock in productivity would also tend to raise the return on investment in the US above world levels, thus attracting capital from abroad. In the US data, a permanent increase in productivity tends to generate an increasing current account deficit, which starts to close gradually after one year, reaching balance eight years after the initial shock. Philip Lane and Gian Maria Milesi-Ferretti explore the interconnections between financial globalization and exchange rates. In particular, they show how exchange rate movements affect the dynamics of net foreign asset positions not only through the traditional effect on trade flows but also through the valuation of inherited stocks of foreign assets and liabilities. Their paper finds that the co-movement of the exchange rate and the return on financial assets is crucial to understand valuation effects. In theory, the impact of exchange rate depreciations depend on: (i) the level of gross holdings of foreign assets and liabilities, in addition to their net position, as their rates of return might respond differently to exchange rate movements; (ii) the currency composition of foreign assets and liabilities (for instance, a depreciation raises the domestic currency payments on foreign, dollar-denominated debt); and (iii) the maturity (short- versus long-term) and composition mix (equity, FDI and debt) of a country's assets and liabilities, as the sensitivity of rates of return to exchange rate movements might be different across investment categories and maturities. Lane and Milesi-Ferretti present empirical results pointing to exchange rate movements as important determinants of rates of return, which gives support to the valuation channel described before. Furthermore, the composition of the international balance sheet is important for valuation effects, since the sensitivity of returns to exchange rates varies across investment categories. For emerging countries, the relation between domestic currency rates of return and movements in exchange rates is quite strong, as would be expected since those countries are, in general, unable to borrow or lend in domestic currency. The idea that balance sheet effects are relevant for emerging economies is also the main message of the paper by Juan C. Berganza and Alicia Garcia Herrero. For a 2

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sample of 27 emerging economies, they find evidence that real exchange rate depreciations increase a country's risk premium. In particular, the analysis shows that: (i) large real exchange depreciations increase a country's risk premium, whereas a real appreciation does not reduce it significantly; (ii) exchange rate movements affect country risk mainly through the sudden increase in the stock of external debt and domestic dollar-denominated debt after a real depreciation; (iii) the increase in export competitiveness following a depreciation does not outweigh the detrimental impact of balance sheets outlined before; and (iv) fixed exchange rate regimes appear to amplify the negative impact of balance sheet effects on the risk premium. These results highlight that countries with small trade openness, large financial imperfections and pegged exchange rate regimes should worry most about large real exchange rate depreciations. Given that these three characteristics can be influenced by economic authorities, there is a clear role for policy action to mitigate the problem. Emerging markets seem to have difficulties borrowing in their own currency, which leads to the dollarization of their liabilities. The last two papers in the first block analyze different implications of this fact for emerging economies, focusing on why these countries cannot borrow as much as developed economies and why they disproportionately borrow at short maturities. Enrique Mendoza and Marcelo Oviedo explicitly introduce the effect of uncertainty on short- and long-run forward-looking measures of sustainable public debt. This effect is crucial in the analysis of debt sustainability for emerging economies, especially after considering three stylized facts: (i) countries with less variation in their ratios of public revenues to GDP support, on average, higher ratios of debt to output; (ii) countries with less variation in GDP tend to support higher average debt to output ratios; and (iii) emerging economies display significantly lower variation in public revenues and larger fluctuations in economic activity than industrial countries. In their model, governments' difficulties implied by low levels of public expenditure lead them to impose "natural debt limit" (NDL) on themselves that is directly related to the worst-case-scenario for public finances: the lowest possible level of public revenues and the minimum, indispensable level of expenditure. If the government borrows above the NDL, it exposes itself to the risk of lowering expenditures to extremely low and suboptimal levels. Applying the model to the Mexican economy, the authors show the importance of uncertainty, financial imperfections and the dollarization of liabilities for the determination of sustainable debt levels. In particular, Mendoza and Oviedo find that real exchange rate fluctuations undermine a country's fiscal position. They also find that the long-run sustainable debt ratio is lower for (i) a higher level of a government's "basic needs" expenditure—because of the required slack for additional borrowing in case of a succession of years of low tax revenues; and (ii) higher variability of adverse shocks, as it reduces the ability to service debt in the worst scenarios. Matthieu Bussiere, Marcel Fratzscher and Winfried Koeniger present a theoretical model that tries to explain the disproportionately high level of liabilities in the form of short-term debt (debt maturity mismatch) observed in most emerging economies. In their model, a situation where liabilities are mostly denominated in dollars and assets are denominated in domestic currency (a balance sheet currency mismatch) might in turn create and worsen a maturity mismatch. As in the previous 3

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paper, the basic mechanism builds on the effect of uncertainty. Solvency problems tend to tilt financing toward short-term debt: a longer horizon increases uncertainty, and therefore it lowers the amount of long-term lending that investors are willing to provide. In turn, a larger share of short-term debt increases the variability of output, as there is the risk that part of that short-term debt would not be rolled over during bad times, thus affecting production. The authors also provide empirical evidence that the effects of the variability of the real exchange rate on the level of debt and its maturity composition and on the variability of growth for emerging economies are broadly consistent with the model. In particular, they find that (i) higher exchange rate variability is associated with lower total debt and a higher share of short-term debt (maturity mismatch); (ii) larger political risk is linked to higher short term debt; and (iii) higher maturity mismatch and higher political and economic risk are linked to higher variability of growth rates. Comments by Daniel Cohen focus first on the difference found by Lane and Milesi-Ferretti between two types of countries: those with big capital inflows and outflows (like China and Taiwan), and those with only big inflows, but no outflows (like most of Latin America). He interprets the first case as a good signal, reflecting countries' ongoing process of diversification of risk; whereas he acknowledges that future research should also focus on why the second group of countries seems unable to generate those bilateral flows. Regarding the relevance of balance sheet effects, he agrees with Berganza and Garcia-Herrero on the importance of taking into account the link between exchange rate depreciations and the increase in sovereign risk, although he expresses reservations about the relatively big size of the effect found in the paper. Closing this first block, Stanley Fischer and Malcolm Knight address the correction of external imbalances—mainly the US external deficit—and discuss the continuation of foreign reserve accumulation in East Asian countries. They both share an optimistic view of the correction of global imbalances, with a high likelihood of avoiding a hard landing, although they also recognize that the needed correction will require a fiscal consolidation in the US and might end up hindering the dynamism of the global economy. They also agree that it is very unlikely that East Asian countries will continue the pace of foreign reserve accumulation they have sustained until now. Fischer, in particular, points out that the main global imbalances correspond to the US current account deficit, about half of which can be explained by Asia in general and China in particular. Although there seems to be an implicit strategy from some Asian countries to build up foreign exchange reserves to avoid speculative attacks like those at the end of the 1990s, he also acknowledges that it is hard to see Japan and China continuing the process of reserve accumulation at the current pace. He reckons that if the process of reserve accumulation in Asia slows down, a US current account deficit of the order of 2 to 3.5 percent of GDP seems sustainable, and in order to achieve those levels, the two possible channels are lower growth (through fiscal adjustment) and exchange rate movements, especially against Asian currencies. According to his view, this does not necessarily mean a hard landing for the US. He also points out that a big change in exchange rates need not be disruptive, as the recent movements of the euro/dollar exchange rate suggest. Finally, he envisions a process whereby, in the very long run, the world will turn into regional currency blocs 4

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(probably starting in Asia) with a tendency towards a global currency, where current account deficits will not matter much, as they do not matter now for countries inside the euro area, for example. Knight, for his part, concentrates on the similarities and differences between the current US external imbalance and that of the 1980s. He agrees with Fischer that the current US external deficit now is a reflection of surpluses in developing countries, as opposed to the 1980s, when those surpluses were mainly in developed regions. As it happened between 1985 and 1987, the dollar has also depreciated in effective terms in the last few months. He points out that in the 1980s, that depreciation took some time to effect an improvement of the US current account. In his view, the experience of the 1980s suggests that the adjustment to reduce the large US current account will take place without very large disruptions, because the US is at the center of the international financial system, and therefore can finance its external and fiscal deficits in domestic currency, which means that the effect of the adjustment will be spread out internationally, and not be confined to the US. But this also suggests that without a fiscal consolidation, closing the external imbalance will need a large exchange rate correction. He also mentions three aspects of the current situation that are different from the previous exchange rate correction in the 1980s, which make adjustment harder: (i) the emergence of Asia and the difficulty it imposes on the US's need to shift resources to an intensely competitive traded goods sector; (ii) the possibility that the next adjustment could combine both recession and inflation, as prices of commodities have increased because of high demand and low investment in productive capacity; and (iii) the lack of growth in other developed areas, as opposed to the 1980s, when Japan was a clear source of growth. Block II: International Financial Architecture A paper co-authored by Ralph Chami, Sunil Sharma and Ilhyock Shim examines the role of the IMF as a coinsurance arrangement. In particular the paper addresses (i) whether an IMF-like coinsurance arrangement is beneficial for the global financial system, and (ii) how should a contract between a country and the IMF be structured in order to create the right incentives. In particular, should the IMF commit to a contract before the onset of a crisis, or should the contractual details be decided after the country is in crisis? The authors argue that the existence of a coinsurance arrangement between countries increases their welfare. Furthermore, the best option is the formation of an IMF-like centralized institution to function as a delegated monitor and to provide liquidity for temporary balance of payment problems. The key question is whether an ex-ante agreement on the IMF loan contracts between the IMF and the member country designed prior to the advent of a crisis is preferable to an ex-post contract designed once a crisis has already erupted. The paper demonstrates that in the presence of information asymmetries and given the mandate of the IMF to safeguard its own resources and to care about the welfare of borrowing countries, the IMF should pre-commit to a lending contract. Such a pre-commitment elicits the right policy effort from countries to prevent crises and recover from them. 5

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This theoretical exercise also supports the idea that discretion and renegotiations once a crisis has erupted should be constrained in IMF operations to provide countries the right incentives for crisis prevention and crisis resolution. Barry Eichengreen, Kenneth Kletzer and Ashoka Mody contribute to the debate on the capacity of the IMF to boost private capital flows (acting as a catalyst) in bank and bond markets. Their paper concentrates on two questions: (i) is it possible to find a stronger catalytic effect of the IMF on bond issues than on bank loans?, and (ii) does a country's level of indebtedness affect the capacity of the IMF to catalyze capital flows? The departing hypothesis is that the IMF is more likely to foster access to bond markets than to bank lending, since banks already perform some sort of monitoring function, which is much weaker in bond markets. Thus, the presence of an IMF program might redress the monitoring and coordination disadvantages of bond markets vis-a-vis bank lending. Indeed, their empirical exercise finds support for this insight. First, the presence of an IMF program has a stronger effect on the bond market than on bank lending. Second, a country's level of solvency appears to have an impact on the ability of an IMF program to increase access to bond markets. The IMF presence, rather than its lending, appears to lower bond spreads when countries are not yet insolvent but are under a risk of liquidity crisis. Beyond a debt ratio of 65 to 70 percent, it is the size of IMF lending, rather than its mere presence, which seems to contribute to lower spreads and to improve market access. Finally, they also find that precautionary programs—those in which, in principle, the borrowing country declares its intention not to withdraw the funds made available by the IMF—are associated with lower borrowing costs in both loan and bond markets. The results of the analysis suggest that an IMF-supported program is likely to have a stronger catalytic effect when a sizable share of the country's external debt takes the form of bonds, and when countries are not yet insolvent but only face a risk of liquidity crisis. These facts should therefore be taken into account when designing such a program. Financial dollarization, and the associated financial fragility it introduces into emerging economies, has become a crucial issue in the policy debate in those countries and has shifted the stance towards a more proactive dedollarization. This is the starting point of Eduardo Levy-Yeyati's paper on the dedollarization of multilateral credit. In developing countries, as a consequence of the high nominal volatility and credit risk, a large part of domestic savings moves abroad. This generates a heavy dependence on foreign credit and specially on multilateral funding from international financial institutions. This, in turn, becomes one of the most important sources of dollarization in emerging economies. Levy-Yeyati discusses theoretical and practical arguments in favor and against IFIs lending in local currency and concluded that IFIs are natural candidates to launch investment-grade, local-currency credit markets. As opposed to existing proposals, he argues that an initiative of this kind should and could rely on the demand from emerging markets residents searching for local currency assets that minimize the volatility of returns, and which are, at the same time, reluctant to take on sovereign risk. According to his view, the intermediation of IFIs as a first step towards the dedollarization of developing countries' external debt has several advantages: (i) it would voluntarily dedollarize part of a country's liabilities with no cost either for the 6

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local investor or for the IFIs; (ii) it would start an international market in local CPIindexed bonds that can be used in the future by domestic borrowers as a source of financing that is free from real exchange rate and sovereign risk;; and (iii) it could eventually attract funds from non-residents willing to hold a speculative position in the local currency, or in search for currency diversification, without assuming that country's sovereign risk. In the context of recent developments in the adoption of collective action clauses (CACs)—provisions introduced in sovereign bond contracts to facilitate the restructuring of debt in the case of crisis, especially in those jurisdictions where they had not been traditionally used—Andrew G. Haldane, Adrian Penalver, Victoria Saporta and Hyun Song Shin present a paper which adds to the debate on the determination of optimal voting thresholds for collective actions and on the convenience of standardizing these clauses across issuing countries. This paper analyzes the factors determining the optimal threshold and the reasons why different issuers may choose different thresholds. Despite the assurance that a lower threshold may provide to the debtor, there are disadvantages in following this strategy. A lower threshold benefits debtors by increasing its ex-post payout in the event of a crisis. However, it also means higher ex-ante interest charges. Therefore, a lower threshold might not be preferable since it increases the likelihood of creditors "running for the door" and, consequently, the probability of liquidity crisis. The choice of thresholds can depend on the degree of creditor risk aversion and debtor creditworthiness. In particular, for risk-averse creditors, it may be more convenient to choose lower thresholds, thereby reinforcing the insurance role of CACs. On the other hand, the more creditworthy is the debtor the lower is the tolerable CAC threshold. This occurs because creditors considering a rollover require increasingly more compensation as creditworthiness declines. Thus, there might be costs to encourage threshold uniformity. Finally, the authors point out that their model nests both liquidity runs and debt restructurings after a solvency crisis. They argue that the tools for dealing with liquidity and solvency crisis—which had typically been treated separately—cannot and should not be considered in isolation. The interaction and spillovers between them need to be weighted carefully when designing both sets of policy. In particular, how debtors resolve financial crises affect the likelihood of one. Lorenzo Bini-Smaghi, commenting on the paper by Chami, Sharma and Shim, points at time inconsistency as the main problem in IMF programs, especially in those that involve big emerging countries. This leads to the question of enforcement of IMF rules—mainly the limits established for access to Fund's resources—and how to keep them credible, even if occasionally they have to be violated. In his view, private agents demand a more strict application of rules if IMF credibility is to be safeguarded. He also raises the issue of the potential erosion of the preferred creditor status of the IMF. Regarding the paper by Eichengreen, Kletzer and Mody, Bini-Smaghi highlights the importance of IMF surveillance and the need to strengthen it both in countries under an IMF program and in non-program scenarios. As main policy implications, he mentions the key role of surveillance in highly indebted countries and the possibility of implementing a non-borrowing facility as a means to provide countries with high 7

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frequency monitoring without increasing IMF exposure. This non-borrowing facility would consist of a voluntary arrangement between the IMF and a country, with similar characteristics to those of a conventional Fund-supported program (in terms of conditionally, standards, IMF Board involvement, etc) but without lending. John Murray comments on the issue of international lending by posing some important questions. Regarding Levy-Yeyati's proposal, he expresses doubts regarding (i) the potential of measures put forward in promoting local markets in local currency, (ii) the possibility of stripping away funds from domestic markets instead of attracting offshore savings, and (iii) the real attractiveness of the new instruments to be issued for residents with offshore savings. As a more general comment, he considers whether dollarization is always such a bad thing. On the paper by Haldane et al., Murray casts doubts on the real relevance of CAC thresholds for investors, based on the recent experience of the use of different thresholds. As a future line of research, he also points out that there are other features of C ACs which also need to be studied in depth. Guillermo Ortiz, commenting on the future of the international financial architecture, emphasizes the importance of crisis prevention and resolution. In the area of prevention he especially highlights the usefulness of transparency and of the documents jointly prepared by the IMF and the World Bank to strengthen countries' economies, such as the Reports on the Observance of Standards and Codes (ROSC) and the Financial Sector Assessment Programs (FS AP). He also regrets the passing of the contingent credit line (CCL), a former IMF facility aimed at providing insurance to well-performing countries, and proposes its revival. Regarding crisis resolution, he supports the IMF's work. Furthermore, he expresses his satisfaction at the abandonment of the statutory sovereign debt restructuring mechanism proposed by Anne Krueger of the IMF. He is also confident of the usefulness of CACs, and cast doubts about the practical consequences of a code of good conduct for sovereign debt restructuring. Finally, this book includes the addresses by Agustin Carstens and Jean-Claude Trichet to participants of the conference. Trichet reviews the changes of the international financial architecture over the recent years. In the context of a changing environment he highlights four key areas: (i) the strengthening of the international institutional set-up that has taken place since the 1990's; (ii) the significant progress achieved in transparency and in the promotion of best practices; (iii) the improvement of financial regulation in industrialized countries, in which important developments have been achieved but still further work is needed; and (iv) the importance of crisis prevention and resolution initiatives, and the need to draw lessons from the experience of the last decade. Carstens' remarks focus on the factors that have to be understood in order to improve the policy response to financial crises. First, he underlines the complexities involved in the design of these responses in the midst of a crisis, associated mainly with high levels of uncertainty and volatility. Second, he stresses the difficult tradeoffs faced by the policymaker, not only in the economic field but also on political grounds. The persistence of vulnerabilities after overcoming the crisis and the resulting need for continued reforms constitute the third part of his speech. Finally, Carstens referred to the role of the Fund in crisis resolution and the ways in which this institution is working to reduce the frequency and severity of crises. 8

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OPENING SPEECHES

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Opening Remarks by Rodrigo de Rato y Figaredo, Managing Director of the International Monetary Fund The IMF at 60—Evolving Challenges, Evolving Role

Introduction: Welcome and a Few Words on the IMF's Mission Ladies and Gentlemen, on behalf of the IMF, let me welcome you all to this conference, which has been organized jointly with the Bank of Spain. Thank you all very much for your presence here in Madrid, where 10 years ago we celebrated the 50th anniversary of the IMF and the World Bank. This is of course a very timely conference from my personal point of view, and I look forward to hearing your ideas on how the IMF can do its job better. I see the IMF's main job as promoting financial stability and thereby improving the prospects for sustained growth. By doing so, the IMF also helps the international community in the global war on poverty. An Institution with a History of Responding to Challenges Safeguarding financial stability has always been at the core of the IMF's mandate. It is why the institution was set up 60 years ago. But what it takes to promote financial stability has changed markedly over these 60 years because of global developments. The IMF's tools—surveillance, lending, and technical assistance—have been developed and constantly adapted in response to these changes. The breakdown of the Bretton Woods system, and the adoption of floating exchange rates in many countries, marked a radical departure from the world of pegged exchange rates that the IMF was set up to monitor. The IMF's member countries amended the Articles of Agreement to give the institution a mandate to carry out a regular, comprehensive analysis of the economic situation and policies of each member country. This remains the essence of the Fund's surveillance function. Around the same time, the oil shocks of the 1970s, combined with macroeconomic instability in much of the industrialized world, created balance of payments problems of unprecedented severity for a large proportion of the IMF's membership. It was at this time that developing countries became significant borrowers from the IMF, and that it became clear that many balance of payments problems were structural rather than cyclical in nature. This led to the fashioning of new lending policies and instruments geared at helping developing countries with these problems. Recent Challenges to Financial Stability: Promise and Perils of Global Capital Flows Over the last decade or so, the major challenge to promoting financial stability has come from the growth in the size and sophistication of international capital markets. A large number of countries have gained access to these markets. In many ways, this financial 11

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globalization is a welcome development. It provides opportunities to channel large-scale private capital flows to finance investment and growth in countries where they can be used most productively. Capital market integration also, in principle, provides a way for countries to adjust to external shocks with reduced reliance on official funds. But this promise of the gains from financial globalization has yet to be fully realized. In fact, in many emerging market countries, capital flows have themselves been a source of volatility. This has added a new breed of shocks—capital account shocks— which have proved much harder to manage than the current account imbalances with which the IMF traditionally dealt. Arresting a reversal of capital flows requires measures that restore investor confidence, supported in some cases by substantial financial help from the official sector. Financial globalization has also raised the risks of contagion. It has added new channels—in addition to the traditional linkages through trade—through which one country's vulnerabilities can spread through the global economic system. The IMF's Response: Improved Surveillance and Better Crisis Prevention and Resolution As in the past, the IMF has been adapting its tools to cope with these latest challenges to global financial stability. The lessons learned from the financial crises of the last decade are being used to improve the IMF's performance of its key task, namely, surveillance and crisis prevention. Surveillance remains at the heart of the IMF's work. Imbalances and vulnerabilities must be identified and corrected before they can harm not only the country itself, but other countries and the global system. Surveillance should tell us when economies might be headed for trouble. It should cover the right issues for each country and the system as a whole. The findings of this surveillance, as reflected in the conclusions of our Executive Board, should be expressed clearly: they should signal potential problems with countries' economic policies both to its policymakers and to markets. Under my predecessors, Michel Camdessus and Horst Kohler (now President Kohler), there has already been significant progress toward better crisis prevention. Transparency has taken a quantum leap in the last decade. The Fund and its members publish more and better information than ever before. This is promoting greater accountability and helping markets assess risks more accurately. Intensive health checkups of financial sectors are being carried out through a new program, the Financial Sector Assessment Program. Active monitoring of international capital markets is now a big part of our surveillance. And the Fund has sharpened its analytical tools to assess vulnerabilities and risks faced by countries and regions. Assessments of balance sheet risk and debt sustainability figure more prominently in our surveillance than in the past. But however good our surveillance, it is unrealistic to expect that crises will disappear. Indeed, a dynamic market economy will face occasional crises—and the Fund's role must then be to help mitigate their impact and shorten their duration through its policy advice and financial support. This sometimes requires the commitment of substantial amount of Fund resources. But in most cases, this investment has paid off: it has supported strong domestic reform programs and helped to limit or avoid contagion. The IMF's loan to Korea in December 1997—$21 billion—was a very large loan by any standards. But it

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helped restore financial stability by early 1998 and strong growth the following year. And Korea repaid the IMF ahead of schedule. That was a case where large-scale support was appropriate and successful. The Fund played a similar role in Mexico in 1995 and Brazil in 1998. Of course, we do need guidelines for large-scale access to IMF resources, but these cases also show that exceptional situations can call for exceptional steps to resolve them. In short, over the past 60 years, the IMF has risen to the challenges faced by its members. I do not mean to suggest that it has always been right. And the description of the reforms already undertaken by the Fund is not meant to suggest that we are at the end of the road. After all, ten years ago here in Madrid, Michel Camdessus spoke of "strengthening Fund surveillance" and "adapting the Fund's financing facilities to a world of globalized markets." So this is an ongoing process of adaptation and change, and many challenges lie ahead. Promoting Financial Stability: Dealing with the Challenges Ahead In the area of surveillance, success cannot rely on early warning alone; it must also prompt early action. There is substantial room for improvement here. IMF surveillance still consists to some extent of confidential policy advice, coupled with peer pressure from other countries in the international community. But peer pressure can also mean peer protection. There is a need to sharpen the incentives for countries to take IMF surveillance seriously. Moreover, with increasing financial integration, surveillance must focus not just on crisis-prone countries but increasingly on the stability of the system as a whole. Even if a country is not itself at risk, it may be contributing to global imbalances and placing the rest of the world at risk. The Fund, as the impartial voice of the international community, has a particularly important role to play here in highlighting major economic challenges that the world has to tackle. This is why, despite the controversy our advice often provokes, the IMF calls on the United States, Europe and Japan to contribute to more balanced and sustained global growth. This means active efforts by the United States to reduce its deficit, and by the European Union and Japan to promote sustained growth through structural reforms. Surveillance of the major industrial countries is critical, and multilateral surveillance, including of global capital markets, needs to be constantly strengthened. We may also have to adapt our surveillance further in anticipation of some of the likely developments in the world economy in the coming decades. Current trends imply that financial globalization will intensify. Emerging markets will represent an even larger share of the world economy than they do today. The future emerging market giants, India and China, may pose particular systemic challenges. And the aging of industrial country populations may also imply higher cross-border capital flows, which will require monitoring. In the area of crisis resolution the challenges also are daunting. Even in cases where we have managed to help resolve crises relatively quickly, the economic and social disruptions have sometimes been enormous. And the crux of the problem of large-scale IMF lending—namely, how to provide large-scale financial support in a way that imparts incentives for sound economic policies—is still unresolved. Abandoning large-scale 13

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financial support entirely is undesirable in view of the volatile character of international capital flows and the needs of our membership. Some large IMF-supported programs raise concerns because they appear to suggest that a country's geopolitical importance or other such factors play a role in IMF loan decisions. It is important that IMF lending decisions reflect the principle of uniformity of treatment of member countries in comparable circumstances. But the institution has an array of financial arrangements to take into account the specific situation facing each country. In most cases, our normal access policies leave room for the Fund to provide adequate financial support to ease the adjustment process. And, as in the case of Korea that I mentioned, in rare cases, exceptionally large access to Fund resources can be necessary to guard against risks to the global financial system. While such cases draw a lot of attention, the Fund has also given major support to countries whose situation does not pose systemic risks or which may not rank high on the geopolitical agenda of our largest shareholders. For example, our financial support to Uruguay has been quite substantial in relation to the country's GDP and to its IMF quota. In short, the Fund continues to be a lender that countries can turn to when they have balance of payments needs, and when other financing options are drying up. That said, we also clearly need a Fund that can say "no" selectively, perhaps more assertively, and, above all, more predictably than has been the case in the past. The prospect of the Fund declining to provide financial support would help strengthen the incentives to implement sound policies, thus avoiding the need for Fund support in the first place. To do this, we may have to think of ways of linking access to Fund resources more explicitly to a country's policy efforts before the crisis, and perhaps to its responsiveness to the surveillance process and its adherence to standards and codes. The Fund's proposal for contingent credit lines took some steps in this direction but it was not found useful by the membership. But the issues of the design of precautionary arrangements and contingent access to Fund credit remain on the agenda. The IMF's Role in the Global War on Poverty: Progress and Challenges Let me turn now to our role in the global war on poverty, where of course we work closely with the World Bank. The IMF's mandate here has been shaped partly by the expansion in our membership over the past 60 years. In the 1950s and 1960s, newly independent countries in Asia, the Middle East, and Africa became members of the IMF. As a result, by 1970 there had been a four-fold increase in the IMF's membership. Then, in the 1990s, there was a further expansion to include countries of Eastern Europe and the former Soviet Union. The concerns of this expanded membership brought the issues of structural transformation and poverty reduction into the IMF's domain. The UN conference in Monterrey in 2002 gave some coherence to global efforts to meet the challenge of reducing world poverty. Under the "Monterrey Consensus," developing countries acknowledged that they must help themselves through good governance and sound policies. Developed countries in turn recognized their responsibility to provide a helping hand through increased trade and aid. The Monterrey Consensus provides a common stage—and the Millennium Development Goals a common script—to enable the many actors involved in the fight against poverty to play their roles better. 14

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Within this broad framework, the IMF has taken steps to ensure that while focused on its core responsibilities of macroeconomic stabilization, it is also actively helping our members achieve their development goals. The IMF is working to ensure that our financial support to low-income countries is based on a development and poverty reduction strategy devised by the country's policymakers after consultation with its stakeholders. The IMF is examining how its concessional lending window, the Poverty Reduction and Growth Facility, can help countries get started on the right track, and stay on it, without the need for prolonged or large-scale financial assistance from the Fund. And, working closely with the World Bank, the IMF is helping with the global monitoring effort to assess the progress countries are making toward achieving the MDG. The many challenges that low-income countries face make rapid progress difficult to achieve. But where governments have established stable macroeconomic frameworks and pushed ahead with structural reforms we have begun to see encouraging results. Tanzania and Uganda, for instance, have seen a sustained improvement in economic performance. Growth rates have also picked up in other African countries that have made progress in curbing inflation and establishing better control of the public finances. But, as with our work on crisis prevention and resolution, we are not at the end of road in strengthening our work in low-income countries. We are just getting started. Many of the Fund's initiatives in this area are quite new. They need to be assessed and course corrections made as required. Our Independent Evaluation Office's forthcoming assessment of this new approach to helping low-income countries will be very useful in this regard. Coming out of these assessments, I would hope to see greater clarity in what the role of the Fund should be in low-income countries. We need better coordination of our work with that of other institutions—the World Bank, the UN and its agencies, regional development banks, and the WTO—so we fulfill our core responsibilities while giving our member countries the full range of assistance they need. This challenge of defining clearly what we are trying to achieve when we help a member country—and ensuring that we have the right tools to achieve it—is present in our work with all countries. But it is especially important for our work in low-income countries, where we are only one partner among many in helping them achieve their longer-run development goals. Conclusion I have only just begun as Managing Director of the IMF. I am proud to lead an institution that has strong traditions of successful international cooperation, of learning from research and from experience, and of constantly adapting its tools to meet the needs of a changing global environment. We cannot foresee the changes that lie ahead in the next 60 years, but I am certain that the keys to an effective IMF response will be rigor in our analysis, evenhandedness in our treatment, and a cooperative spirit among our member countries. I am confident these will continue to be the hallmarks of the IMF.

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Opening Remarks by Pedro Solbes, Second Vice-President of the Government and Minister of Economy and Finance of Spain Introduction Dear Governor, dear Managing Director, ladies and gentlemen, let me first welcome you all to this seminar on the sixtieth Bretton Woods anniversary, which I have the pleasure to introduce. I would like in the first place to thank the Spanish Central Bank and the International Monetary Fund for their efforts in organizing the event. As you know, the Bretton Woods Meeting in 1944 gave birth to an economic, monetary and financial system which has, beyond doubt, played a vital role in promoting both economic and financial stability while contributing to global welfare and poverty alleviation. As a matter of fact, international economic and financial events over the past years cannot be analyzed without considering the leading role of the Bretton Woods institutions. So first and foremost I would like to express my congratulations to the World Bank and the International Monetary Fund. Thanks to them we have learnt important lessons from economic globalization and crisis resolution, let alone the strong relationship between economic growth, macroeconomic stability and poverty reduction. I am quite sure that this seminar will provide us all with a good opportunity to better understand the evolution and changes within the structure of the international financial architecture. I am also convinced it will allow us to gain insight into the future global response that should help avert the perverse effects of systemic crises in the world economy. I will focus my intervention on three aspects that I consider especially relevant. First I will very briefly share with you my views about the evolution of the world economy and the Bretton Woods institutions in these last 60 years. Second, I will briefly address the role my country has played within the Bretton Woods institutions, a role that we intend to intensify in the future. Third, I will refer to the challenges that, in my opinion, still lie ahead of us. Developments of the World Economy and the Bretton Woods Institutions When the 44 country delegations met some 60 years ago, private financial flows were much more limited, in both scope and importance, than they are now. Then, the financial events that occurred from the 1960s onwards and, in particular, the emergence of the eurodollar and other offshore financial markets and the continuous globalization of capital movements, hammered out a quite different financial system. And, by the 1990s, international capital flows had already become an essential source of finance for both industrial and emerging market economies. Today, financial markets are much more interconnected than they were in the central decades of the twentieth century, and this clearly improves resource allocation in terms of the so-called intertemporal trade. At the same time, however, it also increases concerns about contagion effects and reversal of capital flows. This new framework brought about various effects on the way the Bretton Woods institutions do their job. I will mention just a few: first, a stronger relationship between the Bretton Woods institutions and the private sector in terms of what we know today as "private sector involvement"; second, the introduction of new financing policies able to provide the emerging market economies with faster and more powerful 17

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responses to external shocks and potential coordination failures linked with systemic crises; and finally, the consideration of a new approach to the relationship between economic growth and macroeconomic stability. Role of Spain in the Bretton Woods Institutions But let me also briefly refer to the role that my country has played in the financial institutions that emerged from Bretton Woods. In 1958, Spain joined the Bretton Woods institutional system and became a member of both the International Monetary Fund and the International Bank for Reconstruction and Development. Spain was then an isolated and developing nation, about to start a process of liberalization of its economy and its trade. A process that, one could say, ended in 1986 with our accession to what at that time was called the Common Market of the European Union. It is easy to understand that the role of Spain in the international financial architecture has changed significantly since 1958. Such a transformation is related to two main factors: first, the already mentioned evolution of the international financial architecture and the role of the multilateral institutions, and second, the overhauling process within the Spanish economic structure, coupled by a prolonged period of growth. According to the latter, in the early 1980s Spain became a creditor country and, since then, it has intensified its participation in the global financial system. The Spanish quota in the World Bank and the Fund is well below its theoretical value and we are all aware of the problems this poses. But our contribution to some initiatives, such as the Highly Indebted Poor Countries (HIPC initiative, is quite a bit higher. In fact, Spain is, in global terms, the seventh largest donor country under the HIPC initiative, just behind six G-7 countries. In the last few years it has assumed a debt relief burden which represents some 3.89 percent of the total debt relief provided by the industrial countries and our per capita contribution ratios are even higher than those of the main G-7 countries. Besides, Spain has undertaken bilateral debt relief actions beyond the relief provided under the Cologne treatment within the Paris Club framework. Along the same line, the Spanish contribution to the Poverty Reduction and Growth Facility Trust Fund amounts to 4.5 percent, fifth among the donor countries. Spain has also provided regular funding to other World Bank Group institutions such as the International Development Association, and to other key initiatives, such as the Global Environment Facility and the Global Fund to Fight AIDS, Tuberculosis and Malaria. Other important contributions have also been made to the International Financial Corporation and the World Bank Institute, while three Consultancy Trust Funds have been opened within the same group. Moreover, similar actions have been carried out in other regional development banks. Additionally, Spain provides some emerging and poor countries with technical assistance accounts, which will contribute to promote economic growth and strengthen the poverty reduction strategies in the destination countries. Along this line, it is worth mentioning the aid planned to some Central American countries under a Special International Monetary Fund Technical Assistance Account for Costa Rica, El Salvador, Guatemala, Honduras Nicaragua and Panama. To close my intervention, let me finally address the issues I think will be pivotal in the near future. The first would be the need to continue to improve the work of the international financial institutions, developing a more pre-emptive stance and

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developing new and better targeted financial instruments. The second relates to low income countries and how we can improve their financial conditions. Future Challenges In the future, the multilateral financial institutions will need to deepen the reform process as a reaction to the new challenges posed by the size and speed of global capital flows, especially with respect to those issues related to emerging market economies and low income countries. The systemic changes within the international capital markets have underscored the role of emerging market economies as destinations for capital flows, both in the short and in the long term. Thus, multilaterals must know to focus not only on crisis resolution but also on enhanced prevention mechanisms. To this end it is my view that surveillance must be strengthened, in particular in those areas related to external and public debt sustainability. This approach should be coupled with the implementation of stronger transparency criteria and with wider surveillance on the financial sector. Let me also say that in my view there is a clear need for multilateral institutions to intensify efforts in terms of both transparency and accountability. By doing so they will be allowing the general public to better understand the vital role these institutions play in the international financial system. A role, let me remind you, that is especially crucial for low-income countries and emerging economies. On the one hand, and concerning crisis prevention and resolution, I feel that the international community must define a predictable framework for exceptional access to IMF resources. The debate about exceptional precautionary access must also be firmly dealt with. In this respect I understand that, in order to prevent currency markets from speculative attacks, an ex-ante or ex-post financial support from the IMF could make a difference. Of course, in order to avoid potential moral hazard problems it is important that some conditions are met. Namely, first, the country concerned should not have debt sustainability problems and therefore should be in a good position to fulfil its obligations with respect to the IMF. Second, a clear definition of the exceptionality criteria is also of great importance. And third, it would also be necessary to retain some degree of tailored level of access so the IMF continues to be able to help the countries concerned in the design of their macroeconomic policies. In this very same vein, I think that the debate about future reforms should take into account the possibility of rewarding the implementation of sound economic policies in circumstances where the threat of contagion is present. In this sense, the discussion on a new policy framework aimed at replacing the already expired contingent credit line and at providing correct incentives in favor of sound policies might also bear some interesting fruits in the future. On the other hand, crisis resolution mechanisms must be strengthened via promotion of both collective action clauses in sovereign emissions, the use of which should be broadened, and the Code of Conduct. Nonetheless, both tools have their shortcomings, too, and I believe that further analysis of some other options should not be put aside. Undoubtedly, crisis resolution is strongly related to macroeconomic stability, but surveillance on microeconomic and structural reforms must not be weakened. This is particularly true given the strong relationship between flexible and competitive internal markets on the one side, and economic growth together with better response to shocks on the other. 19

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Finally, technical assistance should be included as a key plank of the multilateral institutions' policy framework, since good governance and institution building-related assistance have a very positive effect on credibility. This would, in turn, ease country access to international markets. Moreover, those reforms would help restore market confidence and trigger new external direct investment inflows, the benefits of which are known by all of us. As I mentioned before, the second challenge of the future financial architecture will be to address the financing of development in low-income countries. In this regard, I would distinguish three main aspects: i)

ii)

iii)

First, debt sustainability analysis should be a key issue of the multilaterals' strategy. In this sense, the access to fresh international credit, even under concessional conditions, should be graduated in order to avoid feeding unsustainable progress. From this perspective, the latest initiative by the International Monetary Fund and the World Bank aimed at developing new instruments to set reference thresholds on a case-bycase basis is worth mentioning. When it comes to the outstanding stock of debt, there is little doubt that its size must be adjusted when necessary through debt relief in order to permanently eliminate the burden on growth for these countries. On the other hand, it is important that a preemptive stance also be adopted here in order to avoid possible incentives to excessive indebtedness stemming from implicit bailout clauses. Having this in mind, I think that the global volume of grants by the multilateral financial institutions should probably increase, especially for low-income countries. This increase, of course, should always by accompanied by a serious study of the debt position of the countries involved in order to avoid the adverse incentives already mentioned. Second, we should bear in mind that even if we consider the exit for the debt burden problem of low-income countries one of our main priorities, these countries do also, in many cases, lack solid and credible institutional and regulatory systems. Consequently, the Bretton Woods institutions should enhance their approach to technical assistance and keep refining their conditionally in these areas. Finally, the technical assistance activities of the multilaterals should continue to converge in order to maximize progress in the area of trade liberalization. This is a basic step towards a realistic elimination of external financing gaps in low-income countries. And it should all come together with an important effort in developed countries to deepen the removal of trade barriers and subsidies, culminating the Doha Round and allowing for renewed impulse in the fight for growth and poverty alleviation. In this sense I would like to finish my intervention by inviting other developed countries to follow the example of the European Commission and show enough flexibility so that we can indeed culminate the Doha Round in a successful manner.

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Opening Remarks by Jaime Caruana, Governor of Banco de Espana

Mr. Managing Director of the IMF, Mr. Second Vice-President of the Government and Minister of Economy and Finance, ladies and gentlemen, it is a pleasure for me to welcome you all to the Banco de Espana and to the inauguration of this conference, which is jointly organized by the International Monetary Fund and the Banco de Espana in commemoration of the 60th anniversary of the Bretton Woods agreements. For our country, which previously hosted the annual meetings of the Fund and the World Bank on the occasion of the 50th anniversary of these agreements, in autumn 1994, it is a source of satisfaction that this meeting should be held ten years later in Spain. I am also particularly pleased to welcome our distinguished audience—both from Spain and abroad—of representatives from official institutions, from academia and the private sector, who are going to participate in the busy sessions scheduled over the next two days. The Banco de Espana and the International Monetary Fund are tied by longstanding and deep-rooted links. Not only have we worked hand-in-hand for many years on various matters; we also share a similar mission and vocation, as well as similar concerns in many respects. The world has changed in the past 60 years, and the transformations that both institutions have undergone bear witness to this. We have moved from a system of fixed but adjustable exchange rate parities to one where floating is the norm. Economic integration has made enormous headway during these years, both multilaterally and through regional agreements, the European Union being perhaps the most advanced. From a world of widespread capital controls and multiple exchange rates, we have moved to a very different one in which enormous cross-border flows take place daily in the form of a wide array of financial instruments, among them derivatives, which were virtually non-existent at the end of the Second World War. Undoubtedly, free capital movements have contributed to a significant improvement in the allocation of global saving to more profitable uses, although they have also entailed a swifter transmission of financial shocks across highly integrated markets, a phenomenon behind some of the recent crises. Economic policies—fiscal, monetary and structural—have been increasingly geared to providing a framework of stability and appropriate incentives for decision-making by agents. In addition to contributing to smoothing cyclical fluctuations, these policies help set in place the right conditions to achieve sustained economic growth based on flexible, competitive and efficient markets where comparative advantages are tailored to the changing circumstances of international markets. The International Monetary Fund has adapted to these changes, seeking to respond in its capacity as the guardian of international monetary stability to the new problems that have arisen. It has evolved from focusing essentially on monetary stability and on countries' external transactions and the management of their exchange rates, to areas more related to the overall quality of macroeconomic policies and to the design of structural policies and sound institutions. More recently, the Fund has devoted particular attention to financial stability. To a certain extent, central banks have also undergone changes similar to those at the Fund. Developments in macroeconomic theory and the experience built up over the years have forged an increasingly broad consensus on the need to apply stability21

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oriented macroeconomic policies and, in particular, to conduct an independent monetary policy with the primary objective of achieving and maintaining price stability, which is vital for sustained economic growth. Central banks have also focused increasingly on financial stability issues, both in countries where the central bank is the supervisor of the banking system and in those where such functions are entrusted to a different supervisory agency. In the case of the Banco de Espana, these transformations have also been induced by far-reaching changes in our environment and in the role of the central bank, including most notably the adoption of the euro as the single currency for an ample group of European Union countries. Spain's relationship—and that of the Banco de Espana—to the International Monetary Fund is certainly today very different from what it was in 1958, when our country joined the Bretton Woods institutions. In the early years of its participation in the Fund, Spain received financial and, most importantly, technical assistance from this institution, as part of the process of external openness and liberalization that allowed its economic take-off in that period. The Fund's excellent technical guidance in this process supported those economic sectors in favor of liberalization, which nevertheless met notable resistance in pushing through their program of reforms. I believe that Spain, since then, has a considerable debt of gratitude with the International Monetary Fund. Currently, the framework for our relationship to the Fund is very different. As part of the euro area, monetary policy discussions take place in a broader context spanning the whole of the euro area. As a member of the Eurosystem however, the Banco de Espana remains deeply involved in such discussions. In other realms, relations with the Spanish authorities remain on a bilateral footing, as is notably the case with the close contact each year on the occasion of the analysis of the Spanish economy via the Article IV report. That said, the European dimension is becoming increasingly important. Beyond the single monetary policy, there are various areas of European coordination in IMF-related matters, although, as is well known, the different European states are represented on an individual basis in the Bretton Woods institutions. Spain, which adhered to the New Arrangements to Borrow (NAB) since their creation in 1998, is today an IMF creditor country. And though we continue to benefit from the Fund's excellent technical advice, we also provide technical assistance, in some cases in collaboration with the Fund, to other countries in the process of implementing systems or procedures in which we have a certain comparative advantage. Moreover, the Spanish authorities and, in particular, the Banco de Espana, cooperate increasingly closely with the Fund on matters relating to national and international financial stability. As I indicated earlier, this issue is becoming more and more important, and the objectives and the interests of the Fund tend to coincide in this connection with those of the competent national authorities. The reasons why national and international authorities pay greater attention to financial stability can be found in the crises a significant number of countries have undergone in recent years. These have highlighted the complex linkages between the real sector and the financial sector and the risk that the latter may not only be a source of instability, but also amplify the imbalances or shocks generated in other sectors of the economy. The links between exchange rate crises and banking crises—the so-called twin crises—and the feedback mechanisms between the two are, along with the propagation and contagion channels from one country to another, matters of particular importance here. National regulators and supervisors, in addition to their initial aim of safeguarding the solvency of individual institutions, have given increasing importance to 22

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combining the presence of flexible, efficient financial markets and intermediaries with the absence of excessive volatility on financial markets, and to preventing the so-called systemic risks—which affect the whole of the financial system—from materializing. International financial institutions have also become increasingly oriented towards the need to ensure a proper functioning of international financial markets and to limit the transmission of shocks from one country to another in a world of ever deeper and swifter linkages. The relationship between national and international financial stability is obviously all the more important for countries, such as Spain, whose banking system has a significant presence abroad. The expansion of Spanish banks into Latin America explains why the Banco de Espana has, in recent years, promoted the monitoring and analysis of financial stability problems in this region in particular, and in the emerging market economies in general, an area in which the role of the International Monetary Fund has become increasingly important. Key lessons may be drawn from the recent crises that have affected emerging economies—though not only them—which should be borne in mind when designing mechanisms to reduce their frequency and cost. They include, most notably: the need for a sound and well-designed institutional framework that protects property rights, prevents excessive public or private sector debt from accumulating and ensures economic stability; the importance of ensuring consistency between the exchange rate regime and the domestic economic policies and institutional framework; the risks entailed by the vulnerability associated with exchange rate instability processes for the balance sheets of different sectors in the economy, especially when there is a high degree of polarization; the marked sensitivity of emerging market economies to potentially very volatile capital flows, the direction of which can change suddenly due, at times, to factors that may even be exogenous to the country experiencing them; the importance of an appropriate regulatory and macro-prudential supervisory system to prevent crises generated in the financial system and to alleviate the ensuing costs if such crises finally occur, and to cushion the effects of shocks stemming from the real sector of the economy; and, finally, the importance of distinguishing, to the greatest extent possible, between liquidity and solvency crises in countries' external debt and in governments' public debt, as a first step towards applying suitable remedies for resolving each type of crisis. As a result of these crises, and in collaboration with other international agencies and with national authorities, the Fund conducted a far-reaching review of the so-called "international financial architecture." Numerous initiatives were adopted over recent years with the aim of lessening the frequency and cost of crises and of improving the stability of the international monetary system. Accordingly, there has been a notable effort to increase the transparency of member countries' economic policies and to improve the information at the disposal of economic agents and, in particular, international financial markets so that the latter may exert market discipline more effectively. Specific measures have been adopted to reinforce financial systems. And it has also been sought to improve the crisis prevention and crisis resolution mechanisms available to the international financial community, including those particularly difficult cases in which sovereign debt restructuring proves inevitable. Moreover, instead of relying on exhaustive international regulations which, as experience has shown, are difficult to approve and even harder to implement, all these reforms have relied on voluntarily mechanisms, based frequently on the adoption of codes of best practices, international standards and systems that offer incentives for their application. 23

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Over the next two days the Conference will address these and other matters of interest to us all, among them the risks associated with the persistent imbalances between the current account positions of the main economic areas; the consequences of adopting different exchange rate regimes in the current environment of free capital flows; the problems that arise from excessive public debt levels both in the emerging and industrialized countries; and the role of the Fund in the face of the challenges of economic and financial globalization. All these issues have interested authorities, the private sector and the academic community for many years, although the way to deal with them has evolved in step with changes in the international economy. In what is an exceedingly dynamic environment, then, it is crucial to identify the root of the problems and possible solutions for them, which is precisely the chief aim of conferences such as this. We have an intense and fascinating agenda for discussion. It highlights, once more, the need for national authorities, international financial institutions and the academic community to work together in areas of common interest, taking advantage of their experience and comparative advantages and with the degree of technical excellence these matters require. I trust that these sessions will shed light on how to improve the functioning of the global economy and, in particular, the international monetary system

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BLOCK I

Global Imbalances, Exchange Rate Issues, and Debt

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Session 1 Global Imbalances

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A Map to the Revived Bretton Woods End Game: Direct Investment, Rising Real Wages, and the Absorption of Excess Labor in the Periphery

Michael P. Dooley University of California David Folkerts-Landau Deutsche Bank Peter Garber Deutsche Bank

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The consensus opinion on China's and Asia's currency policy is that it is destabilizing and must ultimately come to a bad end.1 The "undervaluation" of currencies in order to generate large trade surpluses, the accumulation of immense foreign exchange reserves, the distortion of world interest rates, investment patterns, and cross-exchange rates all evidence the instability.2 The longer it lasts the worse and more abrupt the end will be, both for Asia and the rest of the world. Among the many ills forecast are: •

Currency crises resulting in discontinuous appreciations of periphery exchange rates vs. USD • Crisis in periphery country banking systems and insolvency of nonfmancial firms • a rapid rise beyond the normal cyclical pattern in US yields with balance sheet problems across the world • Excessive US government and US foreign debt • Large flow problems as the periphery reallocates resources away from traded goods and a mirror image reallocation in the center A stepping-stone along the way to this disaster is an overheating Chinese economy with rapid inflation. This all adds up to the intensely sour taste of a massive misdirection of the world's savings. The only question is when the adjustment will occur: a big hit now or a much bigger one later. In this paper, we argue that the adjustment—which indeed must eventually occur— can proceed smoothly. The catastrophic losses and abrupt price breaks forecast by the conventional wisdom of international macroeconomics arise from a model of very naive government behavior. In that model, periphery governments stubbornly maintain a distorted exchange rate until it is overwhelmed by speculative capital flows.3 In our view a more sensible political economy is the source of current imbalances. The objectives are the rapid mobilization of underemployed Asian labor and the accumulation of an efficient capital stock. The mechanism that regulates the mobilization is a cross-border transfer to countries like the United States that are willing to restructure their labor markets to accommodate the restructuring of labor markets in Asia. Describing the policies that generate this transfer and their optimal settings over a finite adjustment period is equivalent to describing the nature of the current international monetary system, lr

The discomfort with the current situation was carefully set out several years ago (Mann, 1999; Obstfeld and Rogoff, 2000). The logic is that although international capital markets were much larger and more resilient than in the past they could not support a US current account deficit of 5% of GDP for long. Moreover, even a mild withdrawal of credit from the US—for example a reduction in financing that required a return to current account balance—would generate a very large and sudden depreciation in the real value of the dollar. The sensitivity of real exchange rates to changes in current accounts is related to the limited integration of goods markets across countries. A related concern then and now is that the low level of private and government savings in the US is generating a perverse flow of world savings to the United States. Summers (2004) has recently argued, for example, that the single engine for world recovery, US growth and US fiscal deficits, is a recipe for disaster both for the US and the rest of the world. 2 We add the flight quotes here because we believe that invoking "undervaluation" in the context of profound underemployment and internal imbalance is more a rhetorical than scientific usage. 3 No one loves these models more than we do; we just do not think the political economy behind speculative attack models fits the current situation. 31

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all its balance-of-payments relationships, and its evolution. We argue below that a simple but powerful economic analysis of an exhaustible resource problem suggests that current conditions in international markets are consistent with a stable and properly functioning system. Our analysis suggests that the system is not headed for a crisis and will serve to manage the great economic problem of our time, the economic emergence of China. We Don't See Much Evidence of an Abrupt Break in the System To some extent the warnings have proven correct. The dollar has depreciated sharply against the euro and other floating currencies as private investors have reduced their demand for dollar investments. But, as we have argued elsewhere, the other two legs of the story are missing to date. US interest rates have not gone up to reflect foreign reluctance to lend, given the current stage of the cycle, and the flow of world savings to the US has not diminished. Moreover, economic growth in Asia has not been derailed by domestic overheating or a breakdown in the international trading system. The Quick Erosion as the Game Ends The reason is no mystery; governments in Asia are providing the necessary financing. The issue now is how long this can continue. The conventional view is that the Asian governments can fill the gap for only a short interval and, when the wheels fall off, the adjustment costs for the world economy will be very heavy.4 The mechanism for the disaster is a familiar refrain. Expectations for the large exchange rate change "needed" to "correct" current imbalances generate massive private capital flows to the periphery. Capital controls and financial repression are no match for a determined private sector. If inflows are not sterilized, the monetary base explodes and the "needed" real exchange rate adjustment comes through inflation. Faced with this unpleasant reality central banks give up and revalue nominal exchange rates. But We Are Not Yet at Half Time In the alternative interpretation that we will develop here, the mechanism set out above is a good description of the final days of the original Bretton Woods system. It is relevant for countries that are ready to graduate to the center. But it ignores the fact that the system lasted for two decades. The erosion of the effectiveness of capital controls and domestic financial repression follows the development of domestic financial markets, and this process typically takes many years. In a series of papers, we have argued that the current international monetary system can be understood as a reemergence of the Bretton Woods system.5 In this system, the center comprises industrial countries with integrated capital markets and floating exchange rates. An economically important part of the periphery comprises capital account countries (Latin America) that also allow free capital movements and allow their exchange rates to float. The periphery also comprises an increasingly ascendant set of trade account countries (Asia) that fix or manage undervalued exchange rates and are willing as a group 4

See Rogoff (2003). As Rogoff puts it, flying on one engine is easy as compared to landing on one wheel. Dooley, Folkerts-Landau, and Garber (2003a, 2003b, 2004a, 2004b).

5

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to generate official capital flows needed to finance both the consequent current account surpluses and net private capital inflows. None of the rest of the world's net savings flows into this periphery.6 The blunt policy instrument used by the trade account region is an "undervalued" exchange rate that is maintained by capital controls, domestic financial repression and official intervention. This policy is used during a transition until the periphery country graduates to the center. The challenge is to explain how these policies generate current accounts, growth rates and relative prices that resemble those observed today and then to project these variables into the future. In particular, we are interested in the nature of optimal policies during the transition and the nature of the endgame. Exhaustible Resources The economics underlying the current global imbalance is best viewed through the lens of an exhaustible resource model. The exhaustible resource is the huge pool of Asian labor that is underemployed by industrial country standards. Left underemployed, it is politically dangerous and socially costly. Once employed it produces a stream of product marginally valued at the global real wage and contributes to social and political stability. But the faster it is employed, the greater the socially costly dislocation of labor in other countries. So, to avoid commercial policy retaliations, other countries must be compensated through one transfer policy or another. Put another way, a larger piece of the new product stream must be paid to the importing country the faster is the absorption of the unemployed pool. Since the pool is exhaustible, these transfer policies are temporary features of the transition. What Force Drives the Global System? China has about 200 million unemployed or underemployed workers to bring into the modern labor force. For political stability, there is a need for 10-12 million net new jobs per year in the urban centers. A growth rate of around 8+% has served to employ about 10 million new workers each year. About 3 million have been in the export sector. If the world can absorb politically only the output of an additional 10 million workers per year (3 million in the export sector), then simple arithmetic indicates that this surplus is a force for twenty years more in the global system. If it can absorb the surplus faster, say at a rising absolute rate that will keep the Chinese growth rate constant at 8% until the surplus is eliminated, then straightforward compounding and linearity assumptions indicate that this will drive the global system ever more relentlessly for the next 12 years (see Chart 1). 6

This policy has been criticized as wrongheaded in that FDI should be the source of global finance for a deficit on current account. The principle behind this argument seems to be that the external accounts should be properly balanced as a priority over the internal balance. See Goldstein and Lardy (2003). The alternative argument is that being a net capital exporter seems to work. 7 Exports generate 10% of value added in GDP. The export sector grows twice as fast as the rest of the economy. So 25% of all growth is from the export sector. Because of a lower capital-labor ratio than in the rest of the economy, the export sector accounts for about 30% of employment growth. 33

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Note that if the growth rate of 8% is maintained, then a growing pressure will be put on the rest of the world's labor market, peaking out at the end of the process. We argue below, however, that the optimal adjustment path front loads the absorption of labor. We do not take a stand on how long this force will drive the global system. But twelve to twenty years has defined an era for any recent international monetary system. The Political Economy Tradeoffs In trying to understand Asia today, it is not sensible to argue that the governments' policy is to maintain mindlessly undervalued exchange rates indefinitely in a beggar-thy-neighbor policy. The better approach is to look behind the current exchange rate policy to see what the government is trying to accomplish.8 Our interpretation is that a sensible desire to absorb unproductive labor is at the root of the array of policy choices.

8

We are really referring to China's development strategy. The exchange rates of other Asian countries fly in formation with the CNY to maintain relative competitiveness. 34

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We assume the government has two objectives: •

•

It wants to move workers from an unproductive pool to produce positive marginal product in the industrial sector. The benefits are both economic and political. The real wages of workers newly absorbed into the industrial sector rise, although at the cost of keeping the overall wage of existing productive workers low. Moreover, the pool of potentially disruptive excess labor is reduced. The larger the size of the remaining unproductive labor pool, the greater the political cost to the government. The government wants to reduce this pool quickly, but faces increasing foreign economic and political costs that increase with the speed of employment from the pool. The government wants the capital stock accumulated as the pool of labor is absorbed into the industrial sector to be efficient: at the end of the transition period, the capital stock should be capable, when combined with domestic labor paid the world real wage, of producing goods going forward that are competitive with those produced in other countries.

This last objective is a crucial constraint', not just any junk make-work project will do because the history of development has shown repeatedly that this is the way to endgame crisis. Our guess is that this objective reduces the chances that a sudden change in relative prices, notably exchange rates and asset prices, at the end of the transition period is likely to be an outcome. Optimal Absorption Rates for the Labor Pool: An Exhaustible Resource Problem The political economy set out above suggests that the challenge is to set up a sharing of benefits with the receiving country (the destination for this surplus labor product) so that it will accept the political costs of the rapid restructuring of its own labor market to accommodate the increased flow of imports.9 We will argue that the structure of this fundamental problem in international finance is also remarkably analogous to an exhaustible resource pricing problem. In the current global system, benefits are shared with importing countries by initially giving foreign capital access to Asian labor at a low domestic real wage relative to the world real wage. This gives the capitalist excess profits for some time period and provides the resources for the capitalist to utilize to keep home country import markets open. The trick is to set the real wage (real exchange rate) low enough and to adjust it gradually upward to the expected real wage in the rest of the world until the excess labor pool is exhausted, all at a minimum cost. We show in the appendix that the optimal path for the real wage is something like AB or CD in diagram 1. The important feature of this adjustment path is that domestic Consumers of cheap imports in the center benefit from rapid import penetration but we observe that although their willingness to compensate losers is important, it has often failed to outweigh the power of import competing industries in what could be characterized as a beggar-thy-neighbor policy. Competitive devaluation or commercial policy has, therefore, often been imposed. A contribution from the periphery to capital in the center is a possible additional sweetener to avoid this impasse. 35

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labor (the real exchange rate) is initially undervalued but converges to world levels at the end of the adjustment period. This means that the real exchange rate is initially distorted but converges to a sustainable level. In evaluating the stability of the system, this feature of the optimal adjustment path is all important. Diagram 1 Reel wages and Adjustment

A country with a very large stock of labor to employ will want to set a real exchange rate that appears to be grossly undervalued by conventional measures. But the undervaluation fades away over time and with it the need for controls over capital flows and other policies needed to insure internal balance discussed below. We can summarize this section as follows. The optimal exchange rate and inflation policy are derived from the exhaustible resource problem. For a fixed exchange rate regime only one initial real exchange rate is optimal and only one rate of inflation generates the optimal path for the real wage over time. At the end of the adjustment period the following conditions hold: • • • •

The domestic real wage equals the world real wage in the manufacturing sector. The initial pool of surplus labor is employed. The capital stock has increased to match the world capital/labor ratio in manufacturing. The political costs of adjusting displaced labor and capital in the importing country have been compensated for their costs of adjustment. This co-opts attempts to use commercial policy to freeze out the exports that are vital to the development policy. 36

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An Indeterminacy: Adjust Nominal Wages or Nominal Exchange Rates? The optimal adjustment path for the real wage allows the central bank to choose a path for the nominal wage rate or the nominal exchange rate but not both independently. In fact Asian central banks use both techniques. For a fixed exchange rate regime the central bank manages the inflation rate in order to regulate the dollar value of domestic wages and prices. In this case we would expect wage inflation to be above that in the center so that domestic real wages rise over time. The alternative would be to set domestic wage and price inflation at or below that in the center and then allow the nominal exchange rate to appreciate over time but at a controlled rate. As long as private market participants understand that policy is driven by the objectives set out above—the optimal path for the real wage rate—the same pattern of real private capital flows and trade account will be generated by either a fixed or managed float exchange rate arrangement. From the balance-of-payments accounting identity, it follows that the path of real and nominal official intervention is invariant to whether a fixed rate or managed float regime is chosen. Those who argue the necessity of switching to a managed appreciation because of the large accumulation of official reserves are missing the basic policy problem and its resolution. Moreover, switching from fixed to managed floating, perhaps in the face of political pressure from the center, would not alter the real nature of the transition. The Key Role of Financial Repression A key to this regime is the ability of the government to repress real wages for an extended period of time. In our framework, this is equivalent to controlling the rate of inflation and the nominal exchange rate. Given a foreign rate of inflation and an international interest rate, this clearly requires that the link between domestic and international interest rates be broken. In our view China has more than adequate controls on domestic and international financial transactions to make this possible. < • Purchases of international bonds are strictly controlled. State owned or controlled banks provide all the claims available for domestic savers. • The government sets the interest rate on these bank liabilities and rations bank credit to the private sector growth in the foreign part of the monetary base is determined by the current account surplus plus targeted net direct investment inflows. • In this repressed domestic financial system, growth in domestic credit from the banking system is a residual, that is, the difference between desired money base growth, (determined by the desired rate of inflation), the growth in the demand for money and the growth in the foreign part of the base. Domestic savings not purchased by the banking system are absorbed by sales of domestic treasury or central bank securities to households and firms. Note that as long as 37

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the real interest rate that clears this market is not above the return on US treasury securities or other forms of investing the fx reserves the government can absorb domestic savings and intermediate into foreign bonds at a profit. The government rations credit to the private sector by forcing the banks to buy government securities through liquidity and reserve requirements and then rations the remaining credit to the private sector at fixed lending rates. This of course sets up strong incentives for private lenders and borrowers to go offshore or to alternative domestic intermediaries. We assume that the government is an effective counterforce to such financial innovation for the requisite amount of time. Internal Balance The macro management problem for the government in implementing this policy is daunting but simple enough to set out. In pursing the employment objective, a distorted real exchange rate will create imbalances in the economy that require an additional policy instrument. As noted above, the bottom line is that the government must be able to manage the domestic real interest rate throughout the adjustment period to keep the domestic economy in balance. The good news is that the problems are large but diminish overtime. To make this argument, assume the economy, aside from the 200 million, is in full employment equilibrium with effective capital controls, no initial net international investment position, and an exchange rate that balances trade. To set the problem in motion, now imagine that 200 million unemployed people appear from the provinces. As discussed above, the path for the real exchange rate that solves the absorption problem involves a sudden real depreciation that is gradually eliminated. The exchange rate path that solves the absorption problem therefore subsidizes exports relative to imports and the trade balance initially moves from balance to surplus.10 The initial current account surplus must equal the amount by which domestic (government plus private) savings exceeds domestic absorption. It follows that a rise in the domestic interest rate is needed to reduce absorption relative to savings. But what happens to the interest rate that insures internal balance over time? During the adjustment period the trade surplus as a share of GDP will decline and may move into deficit as the real exchange rate appreciates and domestic income grows more rapidly than foreign income. A surplus on the service account will appear and grow as net asset accumulation generates net capital income. But the overall current account as a percent of domestic GDP will fall for any reasonable set of parameters. It follows that the domestic interest rate will fall over time as a smaller share of domestic absorption is crowded out by net transfers abroad. This mitigates the interest differential pressure on capital controls.

10

An important mitigating factor is that adjustments in commercial policy are likely to encourage imports. For example, the initial condition for China is a large gap between the effective exchange rate for imports and exports. In fact, China has not run a large overall trade surplus to date. In part, this probably reflects large declines in tariffs associated with ascension to the WTO.

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Sterilization and Inflation The relevant capital flow "problem" in the face of expected revaluation is large private capital inflows. Clearly if private capital inflows augment the monetary base and in turn increase domestic inflation, real wage growth will be too rapid and the transition will be too short to accomplish the government's objectives. However, if capital inflows are sterilized, and if domestic financial repression allows the government to finance reserve creation by issuing low interest domestic securities, the inflationary impact is eliminated. This is an empirical issue. Capital controls and financial repression do not last forever but neither does the regime we are describing. We simply observe that to date the Chinese government has been very successful in hitting an aggressive inflation target. Some observers have suggested that overheating and an inflationary spiral are already underway. In our view, that is more of a prediction than an observation. Time will tell, but we would point out that there are many reasons why inflation may have increased in recent months. In general, a growth rate of 8+% has not generated inflation in China. In our view increases in reserve requirements last year, a form of sterilization, have already reduced the growth in money and credit. Moreover this has been accomplished with no increase in administered interest rates.

If the capital account is liberalized, expectations of appreciation that are a central feature of the regime discussed below will generate capital inflows. Moreover, marketdetermined domestic interest rates would make sterilization expensive and so inflation would be the eventual result. But we do not expect opening of the capital account or deregulation of domestic interest rates. It follows that the economic linkages between exchange rate policy and inflation clearly relevant for capital account countries do not now exist, and we do not expect them to materialize for many years.

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The Transfer to Foreign Capital The regime set out so far encourages capital formation in export industries and makes room for this new investment in the domestic market. But it does not suggest that nonresident direct investors are the best placed to do the investing. Recall however that the investor has to expect that the foreign markets for exports remain open and that the political costs of displaced workers in the importing countries must be compensated. A transparent but unrealistic example will help make the point. Suppose the right to supply capital is allocated by the government through licenses on a project-by-project basis. The gap between the domestic and world real wage would then be captured by selected capitalists.11 Moreover, the government could lend through domestic balance sheets to the direct investor and finance this by sales of securities to the domestic market. The government can reduce the political costs to foreign governments associated with rapid export growth by allocating some of this capital to foreign investors from countries that allow the rapid growth of imports. In the present context, with the US absorbing much of the exports, this allocation would go to US firms. This provides an economic rent until the convergence of real wages at T, which is not competed away because entry into foreign direct investment is rationed by the Chinese government. The foreign investors then become a well-financed and effective lobby to counteract the resistance to the restructuring of the US labor force away from import substitutes.12 Each time a worker is matched with foreign capital, the direct investor gets a benefit equal to the discounted value of the wage differential plus the normal return to capital. The excess returns are implicitly paid by the Chinese workers accepting the low but rising real wage. Indeed, from the US balance sheet perspective, there is no real export of capital from the US to China. All is financed by forced Chinese savings, both the US current account deficit and the onshore loans to the foreign investor. The US balance sheet taken as a whole simply intermediates between low yielding Chinese deposits and high yielding FDI investments. But perhaps this method of local intermediation is too transparent and difficult politically. Instead, the government could sell the same domestic security mentioned above but, rather than make a loan to a direct investor, purchase international reserves in the direct investor's home credit market. This acquisition of foreign assets favors the importing country in general rather than just the foreign investor. The foreign investor then has to borrow in the importing country at his own normal cost of funds, and then buy yuan to make it investment. Part of the subsidy to the foreigner is then given to the importing country as a whole, and part to the FDI investor in the form of rents from access to low real wage labor. Again, no real capital flows from the US to China—both the US current account deficit and the measured FDI outflow are financed by Chinese savings. Whether it is booked as FDI or investment managed by foreigners is irrelevant.

n

More precisely, shared between the investor and the government and perhaps government officials. See Razin and Sadka (2002) for an interesting discussion of the allocation of rents. 12 We refer to "foreign investors" and not "foreign direct investors" because in this example they are financed by Chinese saving intermediated through domestic balance sheets.

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Politically, this is perhaps better because there is an arms length relationship between the government and the foreign investor. With this more competitive mechanism we would expect that the surplus generated by access to low wages in China would be absorbed by adjustment costs. In this case direct investors from countries with open import markets might enjoy a competitive advantage over other foreign and domestic investors because they can more effectively mobilize profits to make transfer payments to their fellow residents. At this point we do not understand well the mechanism that allocates investment in the export sector, its profitability or the distribution of those profits. It is also quite possible that direct investment is restricted and/or the risk that the regime might end prematurely requires excess profits in order to insure entry. The net profitability of direct investment is an important ingredient in the evolution of net international investments positions during the transition. Data on profitability of direct investment in China is anecdotal at best. We can make a reasonable guess about the gap between the real wage and marginal product of labor, but we do not have much information about the distribution of the implied surplus. This is an important topic for further research. What about the Accumulating Balance Sheet Positions? Headline numbers for reserve accumulation and the US current account deficits seem to suggest that the main end game problem is the accumulated net international investment position of the center and the periphery. But net positions are the difference between two much larger gross assets and liabilities. Just as in the original Bretton Woods System, official intervention, that is, large official capital outflows from the periphery are largely associated with private capital inflows to the periphery. In our view the financial intermediation and the capital gains and losses generated will substantially mitigate problems associated with the net international investment positions generated by export led growth. At the end of the transition period the government of China will hold a large stock of US treasury and other securities on which it has earned a relatively low but positive rate of return. It will also have incurred a large stock of liabilities to domestic claimants. But at the end of the game, both of these will carry the same international interest rate. The US will hold a large stock of direct investment which pays the world equity rate going forward but which has paid a much higher rate during the adjustment interval. It may be instructive to take another look at the end of the original Bretton Woods system with these two points in mind. While a careful historical comparison is beyond our resources at the moment, it is clear that the United States did not run large trade deficits leading up to the 1971-73 crisis that ended the regime. The "balance of payments deficit" that observers focused on at the time was the liquidity balance, a concept that put short term capital inflows below the line. As Depres, Kindleberger and Salant (1966) pointed out in their celebrated letter to the Economist, this concept of a deficit ignores the legitimate role of financial intermediation in international financial arrangements. To be sure, financial intermediation can lead to instability and crises. But the problem is much more subtle and the "lessons" from countries that have run large and persistent current account deficits may not be of much use in evaluating the new Bretton Woods.

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Conclusions What makes this perpetual motion machine run is, of course, the assumed zero (actually negative) product of the pool of excess labor that we are implicitly associating with the outcome of a market-determined real exchange rate and allocation of domestic and international savings. This provides a free lunch that everyone can share through current Asian policies. We have done some simulations with plausible rates of accumulation and returns and find that the transition to the new steady state need not imply a large continuing net transfer. So the system ends with a smooth adjustment. The government of China will have a more productive capital stock and will have managed to employ 200 million people in world-level wage jobs. The US will own a nice chunk of the Chinese capital stock, and will have made a fine excess return during its accumulation. There are even mutually offsetting cross-border claims against each other that can serve as escrow against confiscation. During the adjustment period, many dimensions of this development program are distorted in the periphery. But one thing that is not distorted is the knowledge that at the end of the transition capital invested in traded-goods industries will have to compete on an equal basis with capital invested in other countries. We see no practical alternative to imposing this discipline on an emerging market and at the same time accelerating the absorption of a large and politically dangerous pool of labor. The feasibility of maintaining an undervalued exchange rate through monetary policy and controls on domestic and international capital markets for a long time can, of course, be questioned. But this is an empirical question. At the moment we do not see a mechanism in the case of China for significant circumvention of their financial arrangements and regulations.

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References Despres, Emile, Charles P. Kindleberger and Walter S. Salant (1966) "The Dollar and World Liquidity—A Minority View", The Economist 5th February; reprinted in Kindleberger, Charles Poor (1981 ed.) International Money. A Collection of Essays, London, George Allen and Unwin: pp. 42-52. Dooley, Michael, David Folkerts-Landau, Peter Garber, "Dollars and Deficits: Where Do We Go From Here?", (June 18, 2003 a), "An Essay on the Revived Bretton Woods System", September 2003b, "The Cosmic Risk: An Essay on Global Imbalances and Treasuries", (February, 2004a), "Asian Reserve Diversification: Does it Threaten the Pegs?", (February, 2004b), Deutsche Bank, Global Markets Research. Goldstein, Morris and Nicholas Lardy (2003), "Two-Stage Currency Reform For China" Asian Wall Street Journal, September 12. http ://www.iie.com/publications/papers/goldstein0903 .htm Hotelling, Harold, (1931) "The Economics of Exhaustible Resources," Journal of Political Economy 39, 137-175. Mann, Cathrine (1999). Is the U.S. Trade Deficit Sustainable, Washington, DC : Institute for International Economics, McKinnon, Ronald and Gunther Schnable, (2003 a), "A Return to Exchange Rate Stability in East Asia? Mitigating Conflicted Vitue," mimeo, October. 9 (2003b) "The East Asian Dollar Standard, Fear of Floating and Original Sin," mimeo, September. Nurkse, Ragnar (1945) "Conditions of Monetary Equilibrium," Princeton Essays in International Finance, Spring. Razin, Assaf and Efraim Sadka, (2002), "Gains from FDI Inflows with Incomplete Information," NBER Working Paper No. w9008, June. RogofF, Kenneth (2003), "WorldEconomic Outlook Press Conference, September 18, 2003" in http://www.imf.org/external/np/tr/2003/tr030918.htm Smarzynsk, Beata and Shang-Jin Wei (2000), "Corruption and Composition of Foreign Direct Investment: Firm-Level Evidence," NBER WP w7969, October. Summers, Lawrence (2004), "The United States and the Global Adjustment Process," Third Annual Stavros S. Niarchos Lecture , Institute for International Economics, March, http://www.iie.com/publications/papers/summers0304.htm

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Appendix: The Logic of the Dynamic Path for Real Wages The optimal strategy for the government is to set the initial wage and the rate of change in the wage in order to fully employ the stock of labor at a minimum cost. Consider first the rate of change for the real wage. An additional unit of labor employed provides a nonnegative yield to the government b. A unit of unemployed labor costs government a yield of -r. The yield b can be thought of as tax revenue or political support for the government. The yield -r might be transfers to the unemployed or political opposition. The "price" the government expects to pay the foreign investor to encourage the global absorption of this labor must fall.

Diagram 1 Real wages and Adjustment

To see this, suppose instead that the government kept the wage constant for two consecutive time periods. A constant wage generates a constant excess rate of return, which is sufficient to overcome the resistance of the labor restructured in the importing country. It therefore generates a constant flow of new employment. If the wage in the first period was set slightly lower than in the second period, for the same average wage, less unemployed labor will be carried over into the second period. The carryover is costly so a constant wage cannot be optimal. The government can get the same increase in employment at a lower cost by frontloading the adjustment. The incentive with which the government sweetens the provision of labor to investors is the difference between the domestic real wage and the world real wage. This difference must fall, that is, the market wage must be expected to rise. 44

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There are two reasons for the flow demand by the foreign direct investor to be decreasing in the wage rate. First, we make the usual assumption that investment installation costs rise in the rate of investment over time, the usual bottleneck argument. It follows that a rapid adjustment requires a greater cost of capital per worker. Second, investors have to make transfers to offset the political power of displaced workers in the importing country. Again, it seems likely that the adjustment costs in the country restructuring its labor market are increasing in the rate of import penetration. The optimality of the rising price path is the central insight of the exhaustible resource model. Diagram la is a stylized representation of the problem of absorbing an exhaustible excess labor pool. Paths AB and CD satisfy this rate of change condition. Path AB starts from wi, a relatively high initial real wage, path CD begins with W2 and rises at the same rate. The full solution to the Hotelling (1931) problem requires that the government set the initial wage so that the initial stock of labor is employed when the domestic wage rises to the world wage. Clearly a lower initial real wage path CD generates more total employment over the interval from to to T2 as compared to path AB from to to TI. It follows that the integral of employment increases as the initial wage declines and only one initial wage fully employs the initial labor supply. It also follows that a country with a very large stock of labor to employ will want to set a real exchange rate that appears to be grossly undervalued by conventional measures.

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Macroeconomic Dynamics and the Accumulation of Net Foreign Liabilities in the US: An Empirical Model*

Giancarlo Corsetti* European University Institute, University of Rome III, and CEPR Panagiotis Th. Konstantinou* University of Rome III

* Paper prepared for the special volume of the conference "Dollars, Debt and Deficits: 60 Years After the Bretton Woods", co-organized by the IMF and the Banco de Espana. For useful comments we would like to thank Charles Engel, Soren Johansen, our discussant Jaume Ventura, as well as conference participants in the aforementioned Conference. This paper is part of the research network on 'The Analysis of International Capital Markets: Understanding Europe's Role in the Global Economy,9 funded by the European Commission under the Research Training Network Programme (Contract No. HPRNCT-1999-00067). t Correspondence to: European University Institute, Department of Economics, Villa San Paolo, Via della Piazzuola 43,1-50133 Florence, Italy. Email: [email protected]. Tel: +39-055-4685760, Fax: +390554685770. * Correspondence to: University of Rome HI, Department of Economics, Via Ostiense 139, 1-00154 (RM) Rome, Italy. Email: [email protected]. Tel: +39-06-57374258, Fax: +39-06-57374093.

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Introduction The size of the external deficits run by the US through the second half of the 1990s and the beginning of the new century has raised controversial issues in the current policy debate - ranging from sustainability of US current account imbalances, to the main macroeconomic and international implications of the required adjustment in the next few years, especially as regards the rate of dollar depreciation in nominal and real terms compatible with global equilibrium. Macroeconomic and policy exercises are quite complex, as their results are sensitive to assumptions regarding basic macroeconomic parameters (e.g., expectations about growth rates and real interest rates), policy interactions among sovereign domestic policy makers (e.g., explicit or implicit currency target pursued by central banks, fiscal-monetary policy mix in different regions of the world), the structure of asset markets (including the possibility of sudden changes in the desired portfolio composition by international investors, perhaps reflecting coordination problems in financial markets) and so on. But the current policy debate has also motivated a thorough reconsideration of economic theories of the current account and external solvency, as well as of the empirical evidence on the determinants and dynamic behavior of foreign liabilities. In this paper, we contribute to the current debate by providing novel empirical evidence on the dynamic evolution of the stock of US net foreign liabilities. Building on our previous work (Corsetti and Konstantinou [2004]), we resort to a small set of assumptions to derive an empirical model that synthesizes the joint dynamics of net debt and key macroeconomic variables such as consumption, output and investment. Using the restrictions implied by the external solvency constraint of a country, we identify empirically transitory and permanent shocks to the variables in our system, and study the dynamic response to these shocks (on the methodology, see Campbell and Mankiw [ 1989] and Lettau and Ludvigson [2001, 2004]).l In the first part of the text, we will briefly summarize the results from the three variables system developed in our previous work. An important result is that our empirical model for the US appears to lend support to the basic theoretical propositions of the theory of the current account. Namely, shocks that raise output and consumption temporarily also raise the stock of net foreign assets - a pattern implied by the consumption smoothing hypothesis, but at odds with procyclical views of current account imbalances. Conversely, shocks that raise output and consumption permanently - which can be naturally interpreted as a permanent technology shock -are associated with the build up of foreign liabilities. Our discussant during the Conference preceding this volume pointed out the possibility that the behavior of the US macroeconomy in the second half of the 1990s be affected by an asset market bubble. If this is the case, it may be possible that part of the US current account deficit has been recently financed with the sale of ultimately worthless paper to the rest of the world. This observation is relevant for our purposes insofar as our empirical results will be sensitive to the inclusion of the 'bubble years' in

Relative to the literature on the current account, our analysis of the net foreign position dynamics requires a minimal set of equilibrium restrictions. In the three-variable model developed in our previous contribution, the main assumption is that the external solvency constraint holds, complemented by a stationary distribution for the portfolio share of foreign wealth (see also Kraay and Ventura [2000, 2002] and Ventura [2003]). In our four-variable model, two additional conditions follow from balanced growth: the "great ratios" consumption to output and investment to output should be stationary - see King et al. [1991] among others.

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the empirical analysis. We therefore run our model on a subsample that exclude the years from 1998 on, showing that our main conclusions are substantially unaffected. In the second part of the text, we will develop a four variables system, studying the joint dynamics of output net of government spending, consumption, investment and net foreign liabilities. Compared to the three-variable model studied in Corsetti and Konstantinou [2004], a four-variable system provides a more general empirical model of the dynamic behavior of foreign liabilities. However, the cost of generality is that it becomes harder to find an approximate expression for the capital account, which now cannot be identified separately due to the balanced growth assumptions. While the stochastic structure of the system changes, we can still identify one permanent shock (which can be interpreted as a permanent productivity shock), whereas we identify two permanent shocks in our earlier work. Our findings in the four-variable model can be summarized as follows. First, we find strong evidence that three long-run relations exist for the variables in our system, two of which correspond to stationary 'great ratios' - consumption to output and investment to output ratios - while a third one is a relation between the logs of net foreign liabilities and output. Second, by adopting Generalized Impulse Responses (GIR), we find that positive shocks that increase consumption and investment also worsen the US net foreign asset position. On the other hand, a shock that raises output leads to some improvement in the US net foreign position - although such improvement is not significant. Interestingly, we find that an exogenous shock to the stock of foreign liabilities has a marked transitory effect on the level of this variable, which accounts for a large share of its variance over short- and medium-term horizons. Third, as in our previous work, we identify a permanent shock as an innovation with permanent effects on the variables in our system. The dynamic effects of this shock are similar to the ones studied in our three variable model: a shock with positive permanent effects on per capita output and per capita consumption also raises net foreign liabilities. In addition, consistent with the interpretation of the shock as a permanent improvement in productivity, it is associated with higher per capita investment. We find that this permanent shock dominates the variation of net foreign liabilities at horizons of six years and more, whereas transitory shocks dominate its variation at shorter horizons. The rest of the paper is organized as follows. Section 2 reconsiders the main findings of our prior work using a different sample. Section 3 provides a further theoretical motivation for our work. Section 4 lays out our empirical methodology. Sections 5 and 6 contain the empirical results from the four variables model. The last section concludes. The Response of US Net Foreign Wealth to Temporary and Permanent Shocks: A Review of Our Main Findings In this section we briefly review the main features and results of the empirical methodology developed in Corsetti and Konstantinou [2004] and applied to the US, as an introduction to the extension of the same analysis presented below. The text will be developed in a non-technical way, leaving details to Corsetti and Konstantinou [2004] as well as to the next section, where a more general model is presented. Many analysts argue that the second half of the 1990s is characterized by an asset pricing bubble driving the boom of assets markets in the US and elsewhere. A bubble could affects the intertemporal budget constraint - as the US deficit could at 50

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least in part be financed by issuing ultimately worthless assets. This consideration raises the important issue of whether our results are sensitive to the inclusion of the last part of our sample in the analysis. To address this issue, in summarizing our main results from previous work we will refer also to an application of our methodology to a sample truncated in 1997, i.e., 1963:Q1-1997:Q4. Variable definitions and a discussion of the data are provided in appendix. Implications of Budget Constraint In our analysis, as in Campbell and Mankiw [1989] and Bergin and Sheffrin [2000], we derive an approximate expression for the budget constraint of a country by taking a first-order Taylor approximation of the intertemporal budget constraint, imposing the appropriate transversality conditions and taking expectations. In doing so, we assume that the portfolio share of foreign wealth in domestic private wealth is stationary - so that the expected value of this share exist. Domestic private wealth is defined as the present discounted value of net output Zr, which is GDP net of government spending and investment. Let Dt denote the stock of net foreign liabilities (the negative of net foreign wealth), while C, denotes private consumption. Referring to our previous work for detail, our procedure allows us to obtain an approximate expression for the capital account in the form: 0)

where lower-case variables denote the log of the corresponding upper-case variables,2 and q>2 is a function of the expected value of the foreign wealth to domestic private wealth ratio. The above expression defines the variable to be used in our empirical analysis. Specifically, Ct is real per-capita expenditure on nondurables and services.3 Net output, Z,, is gross domestic product net of government expenditure, investment and expenditure on durables, expressed in real, per-capita terms. The stock of net foreign liabilities, A, is also expressed in real, per-capita terms. We stress here that A records more than bonds - as it includes the whole array of assets and liabilities traded internationally. The variable Dt is derived by cumulating the current account deficits over the sample period. Data limitations do not allow us to use series of net foreign liabilities allowing for capital gains and losses on a wide array of assets - as proposed by Lane and Milesi-Ferretti [2001]. Namely, the series built in this study is at a lower frequency (annual), and for a smaller sample than the one we adopt in our work. Yet we should note here that our series and the Lane & Milesi-Ferretti series are quite correlated.4 Now, it can be shown that, under the weak maintained hypothesis that the real rate of return rt, the rate of growth of consumption and net output are covariance stationary, the budget constraint implies that the logs of consumption, net output and 2

Throughout this paper we use lower case letters to denote log variables (e.g., ct = ln(C,), xt = ln(A!i) etc). Since we are mainly interested in the net foreign liabilities dynamics generated by consumption, we prefer to exclude expenditure on durables expenditure - as they replace (or add to) capital stock rather than buying a service flow from the existing capital stock. We include durable expenditure in private investment. ^e correlation between our measure of net foreign liabilities and that reported in Lane and MilesiFerretti [2001] (based on adjusted cumulative current account) is 0.987. See also the discussion in Corsetti and Konstantinou [2004]. 3

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net foreign liabilities must be cointegrated. Even if the level of net foreign wealth is non-stationary in levels (as predicted by standard infinite-horizon intertemporal model), the transversality condition prevents it to wander away from net output and consumption. Hence, in line with the literature, KAt is stationary. As mentioned above, when we log-linearize the intertemporal budget constraint, we assume that 2 is also constant when such ratio varies over time following a stationary distribution. Indeed, in our econometric study we are unable to reject the hypothesis that q>2 is constant - which may correspond to a portfolio share of foreign assets in wealth that is either time-invariant, or (more plausibly) follows some stationary distribution. With a time varying portfolio share, however, it is possible that a country switches its international net position during the sample period. Since in deriving our log-linear approximation we have assumed that no variable switches sign, a problem in applying our methodology to the US is that this country is a net creditor in the first part of our sample, and becomes a net debtor during the 1980s. Below, we will address this issue in two alternative ways. In one application of our methodology, we rescale the debt series so as to make it positive throughout the sample. In another application, we employ Dt in deviation from its sample mean. Summary statistics for the variables used are provided in Table 1. Our empirical approach exploits the cointegrating relation (1) - without imposing additional structure on, say, preferences of the national representative agents or technology. As long as budget constraints - which can be derived from the transversality conditions of the problem of the national representative consumers hold, a country's net output, consumption and net foreign debt should commove in the long-run and therefore be cointegrated. In fact, as we discuss below, our empirical findings support this hypothesis. Specifically, we are unable to reject (marginally) the hypothesis that there is at most one cointegrating vector among net output, consumption and the stock of net liabilities (all measured in logs or, in the case of net foreign liabilities, measured in deviation from average), while we easily reject the hypothesis that there is not cointegration. The estimates of the cointegrating coefficients have the right sign and satisfy an important inequality: they imply that the value of net foreign debt is strictly smaller than the present value of net output. The log-linearized budget constraint also implies that these coefficients should sum to minus one. A point stressed by Lettau and Ludvigson [2001, 2004] is that measurement errors may make it unlikely that these coefficients sum to minus one in empirical implementations of the model: nondurable consumption flows are not directly observable and need to be proxied; our measure of net foreign liabilities is a rough proxy of the true theoretical variable. The restriction on the cointegrating coefficients is rejected at conventional significance levels when we use our full sample 1963-2002; but it is not rejected when we consider the sample limited to the period 1963-1997. Table 2 shows the cointegrating coefficient estimates in the two

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applications that we consider, along with the likelihood ratio tests of the aforementioned parameter restriction.5 Dynamic Effects of Temporary and Permanent Shocks The empirical approach in Corsetti and Konstantinou [2004] consists of using the restrictions implied by cointegration to identify the permanent and transitory components of the three-variable system. Identification is possible because cointegration places restrictions on the long-run multipliers of the shocks in a model where innovations are distinguished by their degree of persistence, as shown, for example, in Johansen [1995], King et al [1991], and Warne [1993]. While this approach does not identify shocks that are structural in any sense, it yields results that have some natural structural interpretation. The steps involved in the procedure are as follows. We first estimate the VEqCM, and then use the estimated parameters to back out the long-run restrictions. More specifically, cointegration restricts the matrix of long-run multipliers of shocks in the system, which identifies the permanent components. The transitory components are identified in a 'residual' manner. In order to study the dynamic impact of the transitory innovations, it is assumed that these are orthogonal to the permanent innovations - a description of our methodology is provided in an appendix. In our baseline identification, the first permanent shock is the only shock that has a long-run impact on net output per capita. Hence, it has a natural interpretation as a permanent technology shock. More generally, this shock can be read as a linear combination of structural shocks that would have a permanent effect on net output. The second permanent shock in our baseline model structure has a long-run impact on consumption and foreign wealth, but no persistent effect on output. The transitory shock only affects net output in the short run, and can therefore be read as a linear combination of structural shocks that lead to transitory changes in zt - including temporary technology shocks. Referring to our previous work for details on full sample estimation, and to Table 2 for estimates of the long-run parameters in the 1963-1997 sub-sample, we now briefly discuss two main results, regarding the response of the system to the first permanent shock and the temporary shock. The impulse responses for these shocks are shown in Figure 1 for the case of variables measured in logs, and in Figure 2 for the case in which we consider Dt in deviation from its sample mean. For the sake of comparison, Figure 1 also reports the point estimates of the impulse responses for the full sample (see Corsetti and Konstantinou [2004]). First, in response to a positive transitory shock raising net output, both consumption and iiet output rise on impact, but consumption rises by less than net output. Correspondingly the country runs a current account surplus and accumulates foreign assets: net foreign liabilities jump down on impact and remain negative for at least ten years. The simplest intertemporal models of the current account predicts that national agents lend abroad to smooth consumption in the face of positive temporary shocks to 5

We estimate the relation where It is worth clarifying that there are three alternative ways of expressing this theoretical restriction: (i) the sum of all the coefficients of p should be zero; (ii) the sum of the coefficients on z/ and dt should be minus one; (iii) or solving, where the sum of the two coefficients equals one. These are alternative ways of expressing the same parameter restriction.

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their net output - see e.g. Obstfeld and Rogoff [1996], chapter 2 and especially chapter 3, where in overlapping generation models the effects on foreign assets and consumption disappear over time. The pattern of our impulse response is strikingly consistent with this prediction - although our model does not allow us to reach any conclusion about optimality of the response to the shock. We stress that our result does not lend support to procyclical current account deficits. Temporary output expansions are not associated with a widening of the external imbalance, as implied by traditional models stressing the role of real demand shocks (e.g. government spending) in generating business cycle fluctuations. Second, in response to the first permanent shock - that, we argued above, can be interpreted as a technology shock - consumption increases on impact and keeps increasing over time, while net output increases more slowly. The permanent shock increases net foreign liabilities on impact, which keep increasing for a few years after the shock - although they revert to a lower level in the long run, but strictly above zero. The standard intertemporal model predicts that permanent productivity shocks that raise per capita net output and consumption in the long run - generate a current account deficit and raise net foreign liabilities: higher returns to domestic capital attract foreign investment, higher permanent income tends to reduce domestic saving. Our empirical results are once again consistent with this prediction. We will reconsider this specific result in the framework of our four variable model below. Note that, given that the US is large in the world economy, one may expect a shock raising US productivity and US demand (i.e. reducing US net saving) to put upward pressure on the world real interest rate. To the extent that the upsurge in the US demand translates into a temporary higher real rate of return, the consumption Euler equation implies that the marginal utility of US consumption should fall gradually along the transition path. Consistent with this view, as shown by the figure the US consumption increases gradually in response to the shock. Variance decomposition is shown in Table 3. Most of the long run variance of output and consumption is explained by the first permanent shock. Temporary shocks explain a high share of variance of output and consumption in the short run, but the influence of this shock remains relevant also over long-horizons. In addition, as in Corsetti and Konstantinou [2004], the transitory shock accounts for a respectable share to the variation in the US net foreign position. The second permanent shock explains a very limited share of the variance of net output and consumption, but its influence on the variability of net liabilities is sensitive to sample specification. An important result emerging from our analysis is that our main conclusions regarding the response of the system to the first permanent shock and the temporary shock are virtually unaffected by using a shorter sample, and measuring net foreign liabilities in deviations from its sample mean rather than in logs. They provide the core of what we interpret as empirical evidence that qualitatively lend support to the intertemporal approach to the current account. A Richer Model: Long-Run Relationships Between Consumption, Output, Investment and Net Foreign Liabilities We now develop our analysis by specifying a four variable model. Above, we have defined net output Zt as GDP net of government consumption and total investment. We now add investment as a separate variable to our system, and defined a new variable for output as GDP net of government spending - for simplicity, we will refer to it simply as output. Namely, Yt will now denote GDP net of government spending, while /, will 54

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include private investment and consumption expenditure on durables (all in real percapita terms). As mentioned before, a full description of the data is provided in the appendix. An important building block of our work is the empirical evidence on comovement, at least in low frequencies, between output, consumption and investment. This can be clearly seen from Figure 3, where the three series are plotted. Although the aforementioned variables are well characterized as integrated processes, it is usually found that the ratios of investment to output and consumption to output are usually found to be stationary (see e.g. King et al. [1991]). Essentially, there is a long tradition of empirical support for balanced growth in which output, investment and consumption all display positive trend growth but the consumption-output and investment-output "great ratios" do not. Consistently, DSGE one-sector models restrict preferences and production possibilities so that balanced growth occurs asymptotically - implying that permanent shifts in productivity will induce long-run equiproportionate shifts in the paths of output, investment and consumption. To wit, as in King et al. [1991] suppose that total factor productivity is well described by a logarithmic random walk with drift: (2)

Then, yA would be the average growth rate of the economy while £t would represent deviations of actual growth from this trend. In this case realizations of §t change the forecast of trend productivity equally at all future dates: Etlog(At+s) = E M /0g(4+,)+g t . A positive productivity shock raises the expected longrun path and therefore there is a common stochastic trend in the logarithms of consumption, investment and output. Under these circumstances, the great ratios CJYt and I/Yt become stationary. Taking logs, we have that: (3) (4)

which are two theoretical relations that should hold in the data. Now, building on the framework of Corsetti and Konstantinou [2004], let us consider the intertemporal budget constraint:6 (5)

where Bt is the (initial) stock of net foreign assets, rt+j is the world real rate of return at period t+j, which may vary over time and Rts is the market discount factor for date s consumption, so that

Then by defining the stock of

net foreign liabilities as Dt = -Bt, the intertemporal budget constraint may be written as:

6

We have imposed the usual transversality condition

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(6)

Following Campbell and Mankiw [1989], Bergin and Sheffiin [2000] and Corsetti and Konstantinou [2004], we derive an approximate expression for the above intertemporal budget constraint, by taking a first-order Taylor approximation of (6), imposing three transversality conditions and taking expectations.7 By defining rt ~ ln(l+rf), we obtain:

(7)

where

and,

while

and Our previous considerations about stationarity of portfolio shares of foreign wealth (Dt/¥t) apply also here. By the same token, the existence of the log-linearization parameters p^9pt and pd also implies stationarity of the present value of consumption and investment as a share of the present value of net output - corresponding to stationarity of the great ratios (see also the discussion in the appendix). Under the realistic assumption that the rate of interest, the rate of growth of consumption, output and investment are all stationary, the left hand side of the above expression is also stationary. It should also be stressed that our approximation of the intertemporal budget constraint implies a restriction on the parameters of the right hand side of (7). More specifically, the sum of the coefficients on output, investment and net

7

The three transversality conditions are:

where the appendix.

. Details of the derivation and discussion are provided in

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foreign liabilities should equal minus one, i.e. (see the appendix for a discussion). But, as we explain in greater detail in the appendix, estimating a long-run relation like the left-hand side of (7) is virtually impossible, if the great ratios (3) and (4) are stationary. Furthermore, the parameters (l//v)>A and/?* cannot be identified separately, given that (3) and (4) hold. Instead, one may aim at estimating a long-run relationship of the form: (8)

which would essentially be a linear combination of (3), (4) and the left-hand side of (7). Thus, the parameter restriction that -(l//?,p)-p. - pd = -1 cannot be tested, since as we already mentioned - the three parameters are not separately identified. In fact, if the three long-run stationary relations (3), (4) and (8) are stationary, any linear combination of the three would also be stationary. I.e., if we estimate (3), (4) and (8), taking a linear combination of them will yield a stationary relation:

Since the A's are arbitrary, we can chose among an infinity of linear combinations, including those satisfying the aforementioned restriction. The empirical approach we describe below simply exploits the above cointegrating relations. We focus on the dynamics of the US net foreign position and examine, how the dynamic behavior of the net position is affected by changes in output, investment and consumption. Data and Econometric Framework This section describes the econometric methodology underlying our empirical approach. The problem is to analyze the dynamic behavior of a vector of variables xt with n elements. In our application, x, =(it,ct,dt,yty, where // denotes loginvestment, ct log-consumption, dt log of net foreign liabilities and yt log of output. An important point stressed in the previous section is that our main results are quite similar whether we use our full sample, or the subsample ending in 1997. Different from the analysis above, we will now carry out our study using the full sample. Preliminary Analysis Table 4 reports the summary statistics of the data. The standard deviation of the quarterly net foreign liabilities growth is roughly ten times as high as that of consumption growth, over four times as high as that of output growth and almost twice as high as the standard deviation of investment. Investment and consumption appear to have similar average growth rates, whereas output seems to be growing at a higher average rate. The first order autocorrelation is roughly 0.04 for investment growth, 0.42 for consumption growth, 0.28 for output growth and 0.88 for net foreign liabilities growth. The correlations between investment, consumption and net foreign liabilities and output growth rate are roughly 0.23, 0.07 and 0.80 respectively; the growth rate 57

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consumption is positively correlated with the growth rate of net liabilities (0.05) and output (0.52), while the growth rate of NFL is also positively correlated with output growth (0.04). Figure 4 plots the series used in the analysis, in level and growth rates. The Econometric Framework Here we present the basic elements of our econometric modeling framework and in order to avoid clutter, we defer the reader to the appendix for a more general discussion. In our econometric analysis we use a vector autoregression (VAR) with k lags, which in it Vector Equilibrium Correction (VEqCM) form can be written as: (9)

The key idea behind cointegration is that the matrix II above, that pre-multiplies the levels of the variables, may not be of full rank (see Johansen [1995], Hamilton [1994]). More specifically, the hypothesis that xt is 1(1) is formulated as the reduced rank hypothesis of the matrix II (see Johansen, [1995]), which can be decomposed into the product of two matrices ap f , where a, p are eachwxr and have full rank r0 for s—*9 hence the effect of an impulse vanishes over time and hence it is transitory. Since the components of ut may be instantaneously correlated (i.e., the underlying shocks may not occur in isolation), orthogonal innovations are often preferred in impulse response analysis. For example, if a lower triangular Choleski decomposition is used to obtain B (E u = BBf), the actual innovations will depend on the ordering of the variables in the vector xt so that different shocks and responses may result if the vector xt is rearranged. For nonstationary cointegrated processes the Cs will not converge to zero as s—*» in this case. Consequently, some shocks may have permanent effects. Distinguishing between shocks with permanent and transitory effects can also help in

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finding identifying restrictions for the innovations and impulse responses of a VEqCM (see Breitung et al. [2004] for an introduction to structural VEqCMs and Corsetti and Konstantinou [2004] for an application in a similar context). Specifically, if one finds r cointegrating relations and thus n-r common stochastic trends, one can identify n-r permanent and r transitory shocks employing a 'small' number of identifying restrictions (see King et al. [1991], Warne [1993]). Essentially, taking advantage of the assumption of orthogonality among structural shocks, one needs (n-r)((n-r)-l)/2 restrictions to identify the permanent shocks and r(M)/2 restrictions to identify the transitory shocks, relative to the total of n(n-\)!2 usually needed in structural VAR (SVAR) applications. As mentioned above, the results of analyses based on orthogonalization assumptions depend on the ordering of the variables to obtain the orthogonalization. Recent work by Koop et al. [1996] and Pesaran and Shin [1998] suggested a different approach to impulse response analysis that does not require ordering of the variables. Instead of orthogonalized impulse responses from Cholesky decompositions, they propose generalized impulse responses (GIR henceforth) that are based on a "typical" shock to the system. The average response of the system to this typical shock is compared to the average baseline model where the shock is absent. Rather than examining the effect of a pure shock to, say, investment, GIR analysis considers a typical historical innovation, which embodies information on the contemporaneous correlations between the innovations. Cointegration Analysis and Long-Run Trends In order to analyze the dynamic behavior of our system of variables, we first need to determine the cointegrating rank. Based on univariate and multivariate misspecification statistics (reported in the appendix), we choose an empirical model with three lags. In Table 5, we report the trace test statistics for cointegration (Johansen, [1995])8 along with the asymptotic p-values (Doornik [1998]). Notice that the trace test statistics support a choice of r=3, implying the existence of one common stochastic trend (Stock and Watson, [1988]). Specifically, we reject the hypotheses that there exist n-r=4 common stochastic trends (no cointegration), n-r=3 common trends, «-r=2 common trends, while we do not reject the hypothesis that there are at most three cointegrating vectors (see also the associated /7-values reported in Table 5). Having established the cointegrating rank, we need to impose some restrictions on the cointegrating vectors in order to achieve identification. The estimates of the cointegrating parameters p are obtained using maximum likelihood (Johansen, [1995]). These are summarized in Panel A of Table 6. The first two cointegrating vectors show that investment and consumption tend to commove positively and almost at a one-to-one rate with output - consistent with theoretical results from DSGE models. We also estimate a stationary relation of the form dr=6.32lyt+stat. error. We can then examine whether the theoretical restrictions on the cointegrating parameters are valid, namely whether the log differences of consumption and investment with output- the 'great ratios' - are stationary. Panel B of Table 6 shows our results, together with the estimated cointegrating vectors. These two overidentifying restrictions imposed are not rejected at conventional significance levels. Together with the budget constraint, they imply a stationary relation between net foreign liabilities and output which now reads dt=lQ.7Q8yt+stat. error. It is useful to Needles to say that similar results were obtained using the maximum-eigenvalue test statistics.

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rewrite this relationship asyf*Q.ldt+stat. error: ceteris paribus, an increase in the stock of foreign liabilities by 1 percent in equilibrium is associated with a 0.1 percent increase in the flow of output net of government spending. Given the above estimates of the cointegrating vectors, the VEqCM representation of xr takes the form:

(12) where Ax, is the vector of log first differences, vector of constants,

is a (4x1) matrix of the adjustment coefficients

and p is the (4x3) matrix of the cointegrating coefficients discussed above (see Panel B of Table 6).9 In general it is possible to impose some restrictions on the short-run parameters that are insignificant, and apply standard econometric systems estimation procedures such as feasible GLS. The standard f-ratios and F-tests retain their usual asymptotic properties when applied to the short-run parameters: thus, one can impose individual zero coefficients based on the f-ratios of the parameter estimators, and eliminate sequentially those regressors with the smallest absolute values of f-ratios until all f-ratios (in absolute value) are greater than some threshold value o>. Alternatively, restrictions for individual parameters or groups of short-run parameters may be based on model selection criteria. Using our estimated cointegrating relations (see Panel B of Table 6), we have performed a model reduction exercise starting from a model with two lagged differences of the variables. The procedure for model reduction is based on a sequential selection of variables and the AIC. Our results are summarized in Table 7. First, note that formal statistical testing reveals that our reduction is valid, since both the Likelihood Ratio and Wald tests do not reject the null of valid model reduction at conventional significance levels. Second, there is quite some predictability in all the system's equations, with adjusted R2 ranging from 0.22 (equation for Act) to 0.79 (equation for Adt). This is partly due to the stationary relations 0f XM., but also to the inclusion of lagged growth rates of all variables in our information set. The equation for net foreign liabilities displays the highest degree of predictability. Finally, all variables are shown to 'equilibrium correct' to at least one of the long-run relations. That is, all variables respond to the previous period's equilibrium error p1 x,_,. The Dynamic Behavior of Net Foreign Liabilities In this section, we finally arrive to the core of our empirical contribution, whereas we derive and examine the dynamics of our system. Although the results presented in Table 7 already shed some light on it, an exact interpretation of the complicated dynamic behavior of the four variables is quite cumbersome. A simpler way to present the adjustment dynamics consists in presenting impulse responses and analyzing the 9

We have examined whether the adjustment coefficients for each of the variables in the analysis, at , are statistically significant. In Panel C of Table 6, we report two different statistics, a Likelihood Ratio and Wald statistics, which examine the null that none of the variables 'equilibrium corrects' in order to restore the equilibrium relations, pf XM , back to their means following a shock to the system. Both types of tests indicate that all the variables show strong evidence of equilibrium correction, thereby rejecting the null. Finally, all the adjustment coefficients are reported in Panel D of Table 6. 60

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forecast error variance decomposition of net foreign liabilities. In what follows, we will do so by exploiting different impulse-response methodologies. We proceed in our analysis by using both the VEqCM - with no restriction imposed on the short-run parameters - and the subset VEqCM, obtained from our model reduction exercise (to which we will refer as VEqCM and subset VEqCM respectively).10 We compute impulse responses from both the full VEqCM and the subset VEqCM to investigate the dynamic effects of shocks on net foreign liabilities, providing bootstrap confidence bands for all our experiments. Generalized Impulse Responses Since the estimated instantaneous residual correlations are large (see Table 7), it is not appropriate to consider the forecast-error impulse responses. The first methodology we adopt is the Generalized Impulse Responses proposed in Pesaran and Shin [1998]. As mentioned above, GIRs do not require identifying restrictions - they are order free: all variables are endogenous and affect each other taking into account the historical distribution of the (reduced form) shocks. So, for example, in analyzing the effect of investment on net foreign position, GIRs enable us to study the total effect of the former variable on the latter after taking into account the implications of investment shocks for output and consumption, as well as all the feedback effects through the system. Thus our results should not be interpreted as a 'partial effect' of investment on net foreign liabilities, holding the rest of the variables constant. However, dynamic responses are by no means structural, in that no shock is identified in a structural sense. The impulse responses of net foreign liabilities to a one standard deviation generalized shocks to each of the variables in the system are shown in Figure 5. Notable results are as follows. A one standard deviation rise in investment ultimately leads to a permanent increase in net foreign liabilities,11 though with some fluctuations in the short and medium run. The effect of consumption on net foreign liabilities has the same sign as investment. Note that the response appears to be significant for a year following the shock, and it becomes again significant roughly eight years after the shock. On the other hand, a one standard deviation rise in net foreign liabilities has a pronounced impact on the level of this variable, but its effects are transitory. One way to interpret this result is that there might be some inherent short-term dynamics of the US net foreign position, reflecting the behavior of international financial markets (see Figure 6). Finally, an increase in output leads to a temporary improvement of the US net foreign position (decrease in the level of net foreign liabilities). A similar picture emerges when examining the generalized forecast error variance decomposition of net foreign liabilities, which is reported in Panel A of Table 8. The variation of net foreign liabilities is dominated by generalized innovations to itself at all horizons. More specifically, at a horizon of one year, the generalized innovations in dt account for roughly 95% of its variation. On the other hand, at longer 10

In the first case (VEqCM) we estimate (12) with no restrictions on the short-run parameters and deterministic terms (a,!"] ,r 2 ,d) as explained above. For the purpose of estimating impulse responses, results from Briiggemann, Krolzig and Liitkepohl [2002] indicate that strategies using a liberal model selection criterion (e.g. AIC) are well suited. In this method the significance of adjustment coefficients a is tested within the Johansen framework, before the VEqCM is estimated. Then further restrictions on 8,r; andF2 are imposed by sequentially deleting variables with /-ratios smaller than a threshold value. Applying this method to our VEqCM model reduces the number of parameters by 20. 11 We stress that, in light of our description of the GIRs, this result is not a mere reflection of a national account identity, as it takes into account simultaneously movements in all variables in the system.

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horizons (about 8 years) the generalized innovations in consumption seem to account for a non-negligible amount of the variation in dt while investment and output have only minor contributions to the variation of net foreign liabilities. The Effect of Permanent (Technology) Shocks Given that we have found three cointegrating relations in our model, we know that there is one permanent shock and three transitory shocks in the system. Following the methodology spelled out in previous work (Corsetti and Konstantinou [2004]), we now proceed by assuming that these four shocks are orthogonal. This assumption automatically identifies the permanent shock. As discussed above, since this shock raises per capita output (as well as consumption and investment) in the long run, it has a natural interpretation as a permanent technology innovation. In what follows, we focus exclusively on this shock, for two reasons. First, identifying the three transitory shocks separately in our four variables system requires further identifying assumptions - for which theory offers limited or no guidance. Second, the results of the three variables system show that permanent shocks raise net output, consumption and net liabilities. We would like to address the important question as of whether investment dynamics is consistent with our interpretation of this shock as a technology shock, i.e. whether this shock raises the rate of capital accumulation. The effects of a one standard deviation permanent shock are shown in Figure 7. As apparent from the figure, our permanent shock raises consumption (cr), output (yr), net foreign liabilities (dt) and investment (it) rise. Strikingly, the effects of this shock are quite similar to those presented in Corsetti and Konstantinou [2004] and reviewed above - derived in the context of a quite different empirical exercise. Relative to our previous results, the valuable additional information is that investment indeed increases, consistent with our interpretation of the shock as a domestic technology shock, and in accord with standard open economy models. Consumption responds to the permanent shock by increasing gradually over time -possibly reflecting equilibrium changes in the real interest rates - as in our three variable model. Investment, instead, increases rapidly, reaches a peak after approximately one year, and then converges slowly to a new higher steady state level. Net liabilities also increase gradually: the change becomes significantly different from zero after one year. Panel B of Table 8 reports the fraction of the total variance in the forecast error of Adt that can be attributed to the permanent shock as opposed to the sum of the three transitory shocks. For a horizon between one and four quarters, the transitory shocks account for a portion between 98% and 93% of the variance in net foreign liabilities. At a horizon of eight to 20 quarters ahead, the transitory shocks continue to contribute a considerable amount to the forecast error variance of Adt (between 85 and 58 percent). However, the permanent shock now accounts for roughly 15% - 42% of the variance. At a horizon of forty quarters, the permanent technology shock accounts for 70% of the variance of net foreign liabilities. Notably, at a horizon of forty quarters, the transitory shocks still contribute 30% to the variance of Mt, while the permanent shock accounts for the total of the long-run error variance in dt (and in fact for all variables).12 Again, these findings are similar to those reported in Corsetti and Konstantinou [2004], 12

The property that only permanent shocks affect the variables in the long run, whereas transitory do not, follows from cointegration and is not specific to the rotation of the shocks we have chosen. See also Gonzalo and Ng [2001 ] for a discussion. 62

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in that permanent shocks account for the majority of the variation in Adt in the medium to long-run, whereas transitory shocks contribute a non-negligible fraction of the variation of the US net foreign position. Conclusions In this paper we have studied the long- and short-run dynamic behavior of the US net foreign position. The analysis was performed using quarterly data on real per-capita output, real per-capita consumption, real per-capita investment and real per-capita net foreign debt, and applying several recent developments in the econometric analysis of non-stationary processes and cointegration. In the first part of the paper we have reviewed results of our earlier contribution (Corsetti and Konstantinou [2004]) and we have also addressed concerns about a potential influence on our result of a possible asset price bubble in the asset markets at the end of the 1990s, by considering a shorter sample. We have found that net output, consumption and the stock of net liabilities (either in logs or in deviations from the sample mean) are cointegrated, as implied by the intertemporal budget constraint. We have then identified transitory and permanent shocks to the system. As suggested by the intertemporal approach to the current account, a permanent shock that raises percapita net output permanently (which has a natural interpretation as a permanent technology shock) also raises consumption and net foreign liabilities. Conversely, transitory improvements in net output lead to a build up of foreign asset - in contrast with traditional models predicting pro-cyclical current account balances. In the second part of the paper, we extended our methodology to a four-variable model, including investment as a separate variable. Using a cointegrated VAR model, we uncovered three long-run relationships: two correspond to the "great ratios" discussed in recent DSGE models and are stationary, and the final one results from combining these two ratios with a log-linear version of the intertemporal budget constraint, i.e., a long-run relation between the level of US net foreign wealth and US output. Second, we have examined the propagation of historical-typical shocks to the system by means of Generalized Impulse Responses. We found that shocks raising consumption and investment tend to worsen the US net foreign position; shocks that increase output tend to improve it mildly, whereas shocks that exogenously increase the stock of US net foreign liabilities have a pronounced but transitory effect on the level of this variable. In addition, the later type of shocks accounts for the vast majority of the fluctuations in the net foreign position at short- and medium-term horizons. Finally, reconsidering the exercise in the first part of the paper, we have used the estimated cointegrated VAR to analyze the effect of permanent innovations in explaining the dynamics of US net foreign position. We found that a permanent technology shock raising per-capita output and consumption also increases investment and worsens the US net foreign position. Such result confirms our interpretation of the permanent shock that in our system raises long run output, as a permanent technology shock. In the four-variable model, the dynamic behavior of investment is fully consistent with the dynamics response to a permanent productivity shock that raises the returns to capital in the US. This shock accounts for the vast majority of the variation of net foreign liabilities at medium- and long-term, whereas temporary shocks account for most of its variability at shorter horizons.

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References Bergin, P. R. and Sheffrin, S. M. [2000] Interest Rates, Exchange Rates and Present Value Models of the Current Account, Economic Journal, 110, 535-558 Bruggemann, R., Krolzig, H.-M. and Liitkepohl, H. [2002] Comparison of model specification methods, Discussion Paper 80, Sonderforschungsbereich 373, Humboldt-Universitftt zu Berlin Breitung, J., Briiggemann, R. and Liitkepohl, H. [2004] Structural Vector Autoregressive modeling and impulse responses, in Liitkepohl, H. and Kratzig, M. (eds), Applied Time Series Econometrics, Cambridge: Cambridge University Press, forthcoming. Campbell, J. Y. [1987] Does Saving Anticipate Declining Future Labor Income? An Alternate Test of the Permanent Income Hypothesis, Econometrica, 55, 124973 Campbell, J. Y., Lo A. W. and MacKinlay, A. C. [1997] The Econometrics of Financial Markets, Princeton, NJ: Princeton University Press Campbell, J. Y. and Mankiw, N. G. [1989] Consumption, Income, and Interest Rates: Interpreting the Time Series Evidence in Blanchard O.-J. and Fisher, S. (eds.) NBER Macroeconomics Annual, Cambridge MA: MIT Press, 185-244 Campbell, J. Y. and Shiller, R [1987] Cointegration and Tests of Present-Value Models, Journal of Political Economy, 95, 1063-1088 Corsetti, G., Dedola, L. and Leduc, S. [2004] International Risk-Sharing and the Transmission of Productivity Shocks, European Central Bank Working Paper no. 308 Corsetti, G. and Konstantinou, P. Th. [2004] The Dynamics of US Net Foreign Liabilities: An Empirical Characterization, CEPR Working Paper (forthcoming) Doornik, J. A. [1998] Approximations to the Asymptotic Distribution of Cointegration Tests, Journal of Economic Surveys, 12, 573-593 Doornik, J. A. and Hansen, H. [1994] An Omnibus Test for Univariate and Multivariate Normality, University of Oxford, Nuffield College Working Paper Engle, R. F. and Granger, C, W. J. [1987] Cointegration and Error-Correction: Representation, Estimation, and Testing, Econometrica, 55, 251-276 Glick, R. and Rogoff, K, [1995] Global versus Country-specific Productivity Shocks and the Current Account, Journal of Monetary Economics, 35, 159-92 Gonzalo, J. and Ng, S. [2001] A Systematic Framework for Analyzing the Dynamic Effects of Permanent and Transitory Shocks, Journal of Economic Dynamics and Control, 25, 1527-1546 Hamilton, J. D. [1994] Time Series Analysis, Princeton, NJ: Princeton University Press Johansen, S. [1995] Likelihood-Based Inference in Cointegrated Vector Autoregressive Models, Oxford: Oxford University Press International Monetary Fund (IMF) [2002] Essays on Trade and Finance, Chapter 3 in World Economic Outlook, 65-107 King, R. G., Plosser, C., Stock, J. H. and Watson, M. W. [1991] Stochastic Trends and Economic Fluctuations, American Economic Review, 81, 819-840 Koop, G. , M. H. Pesaran and Potter, S. M. [1996] Impulse Response Analysis in Nonlinear Multivariate Models, Journal of Econometrics, 74,119-147 Kraay, A. and Ventura J. [2000] Current Accounts in Debtor and Creditor Countries, Quarterly Journal of Economics, November 2000

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Kraay, A. and Ventura J. [2002] Current Accounts in the Long and Short Run, Working Paper, Department of Economics, MIT Lane, P. R and Milesi-Ferretti, G.-M. [2001] The External Wealth of Nations: Measures of Foreign Assets and Liabilities in Industrial and Developing Countries, Journal of International Economics, 52, 263-94 Lettau, M. and Ludvigson, S. [2001] Consumption, Aggregate Wealth and Expected Stock Returns, Journal of Finance, 109, 815-849 Lettau, M. and Ludvigson, S. [2004] Understanding Trend and Cycle in Asset Values, American Economic Review, 94, 276-299 Liitkepohl, H. [1991] Introduction to Multiple Time Series Analysis, Heidelberg: SpringerVerlag Nason, J. M. and Rogers, J. H. [2003] The Present-Value Model of the Current Account Has Been Rejected: Round Up the Usual Suspects, Federal Reserve Bankof Atlanta Working Paper 2003-7 Obstfeld, M. and Rogoff, K. [1996] Foundations of International Macroeconomics, Cambridge MA: MIT Press Osterwald-Lenum, M. [1992] A Note with Quantiles of the Asymptotic Distributions of the Maximum Likelihood Cointegration Ranks Test Statistics: Four Cases, Oxford Bulletin of Economics and Statistics, 54, 461 -472 Pesaran H. M. and Shin, Y. [1998] Generalized Impulse Response Analysis in Linear Multivariate Models, Economics Letters, 58, 17-29 Quah, D. [1992] The Relative Importance of Permanent and Transitory Components: Identification and Some Theoretical Bounds, Econometrica, 60, 107-18 Sheffiin, S. M. and Woo, W. T. [1990a] Testing and Optimizing Model of the Current Account via the Consumption Function, Journal of International Money and Finance, 9, 220-33 Sheffrin, S. M. and Woo, W. T. [1990b] Present Value Tests of an Intertemporal Model of the Current Account, Journal of International Economics, 29, 237-53 Stock, J. H. and Watson, M. W. [1988] Testing for Common Trends, Journal of the American Statistical Association, 83, 1097-1107 Tille, C. [2003] The Impact of Exchange Rate Movements on U.S. Foreign Debt, Federal Reserve Bank of New York, Current Issues in Economics and Finance, 9, 1-7 Ventura, J. [2003] Towards a Theory of Current Accounts, The World Economy, April 2003. Wame, A. [1993] A Common Trends Model: Identification, Estimation and Inference, Institute for International Economic Studies (IIES, Stockholm University) Working Paper No. 555

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Appendix Data Description This appendix briefly describes the variables employed in the analysis. For all variables except net foreign liabilities, our source is the FRED II Database of the Federal Reserve Bank of Saint Louis. CONSUMPTION C, Consumption is measured as expenditure on non-durables (PCNDGC96) and services (PCESVC96). The quarterly series are seasonally adjusted at annual rates, in billions of chain-weighted 1996 dollars. OUTPUT NET OF GOVERNMENT SPENDING 7, This is defined by the identity Yt = GDPt - Gt. GDPt is the real gross domestic product (GDPC1) and Gt is real government consumption expenditures & gross investment (GCEC1). All series are seasonally adjusted at annual rates, in billions of chainweighted 1996 dollars. .

PRIVATE INVESTMENT /,

Investment It is defined as real gross private domestic investment (GPDIC1) + real change in private inventories (CBIC1) + real personal consumption expenditure on durable goods (PCDGCC96). All series are seasonally adjusted at annual rates, in billions of chain-weighted 1996 dollars. NET OUTPUT Zt This is Z, = GDPt - Gt - /,. GDPt, Gt and /, are defined above. NET FOREIGN DEBT A We build our series of net foreign liabilities by cumulating the negative of the US Current Account (BOPBCA). We scale the resulting series by 1.000, so that the series become positive throughout our sample. In the cumulated current account series, the minimum observation (largest negative in absolute value) is -699.77. So we have experimented using different additive constants (750, 800, 900, 1000, 1100), verifying the absence of any qualitative difference in our results. POPULATION Our measure of population was obtained by sampling at the end of each quarter the monthly population series. PRICE DEFLATOR To deflate net foreign liabilities, we employ the personal consumption expenditure chain-type deflator (1996=100), seasonally adjusted (PCECTPI), as a proxy of the unobserved price deflator corresponding to our measure of consumption.

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Lag-Length Selection and Misspecification Statistics Table A.I; Misspeciflcation Statistics of VAR with k=3 lags Panel A: Univariate Statistics Equation

a£ x 100

AR(12)

ARCH(3)

NORM(2]

R2

Ait Act

2.4337 0.3986

0.875 1.872*

0.515 0.138

3.725 9.608**

0.349 0.275

Adt

2.0146

1.432

17.093**

72.164**

0.823

Ayt

0.9226

0.821

1.591

9.309**

0.342

Panel B: Multivariate Tests TM'I

LMJ

IM&

LM12

L - B(40)

NORM (6)

17.307

27.986

31.702

11.445

754.558

89.684

[0.366]

[0.032]

[0.011]

[0.781]

[0.000]

[0.000]

Panel C: Lag-Length Selection k

logi

£7i(fc-l/fc)

p- value

0 1

614.8208 1914.306

N/A 2517.752**

N/A [0.000]

2 3

2057.462 2072.621

270.207** 27.854*

[0.000] [0.033]

4

2084.135

20.581

[0.195]

NOTES for Table A.I: The R2 can be interpreted as the fit of the model for each variable relative to a random walk with drift. AR(12) is an LM test statistic for autocorrelation (F(12,136) distributed), ARCH (3) is the test for ARCH effects (F(3,142) distributed), and NORM is the Jarque-Bera test for normality (X2(2) distributed), while * (**) denotes significance at the 5% (1%) level. The LM\ are tests of i-th order autocorrelation distributed as a %2(9). The NORM (6) is a multivariate Normality test (Doornik-Hansen, 1994) which is distributed as a X2(6)- The IrB(30) is the multivariate version of the Ljung-Box test for autocorrelation based on the estimated auto- & cross-correlations of the first [T/4=39] lags and is distributed as a %2(333). log L denotes the value of the log-likelihood, CfR, is sequential (i.e. k vs k — 1 lags) Likelihood Ratio test statistic corrected by a degrees of freedom adjustment. The lag order selected is given in boldface.

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The Log-Linearized Intel-temporal Budget Constraint The intertemporal budget constraint is given by:

(13) where Dt is the initial (period t) net foreign debt. We can write (13) as:

(14) where

Similarly:

Taking logs (15)

The LHS of (15) can be approximated by taking a first-order Taylor approximation (see Campbell etal. [1997]):

(16)

Defining

we can rewrite (16) as:

(17)

and the approximate expression for (15) can be written as:

(18)

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or: (19) Notice that:

so

Log-linearizing as above we have: (20)

where difference equation in the

Using the trivial identity and (20), equating the LHS, we obtain a ratio. Then solving forward:

(21) where the condition limT^ Pc$(ct+r ~ 0/+T-)-* ^ has been imposed. Observe what the last condition implies. We have: ,, pd defined above all depend on Dt, Yt and 0t. Consider for instance/ty. Using definitions, we can right it explicitly as:

This expression shows that py depends on the average (steady-state) share of foreign wealth Dt in domestic wealth the mean value of the "great ratio" (7/7*) and the relative growth rates of investment and output. Using similar steps it is also easy to see that p, and pd will also depend on the share of foreign liabilities in domestic wealth, as well as the "great ratio" of investment and output and their relative growth rates. Finally, using the fact that

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if the parameter p y exists, with,

the means of CD/IP), (I/Yt) and the growth rates of investment and consumption also exist-so that

implying that the present value of investment and consumption to output will also be stationary (with mean value bounded by unity - as far as p^ e [0,l). Econometric Methodology In our econometric analysis we employ a vector autoregression (VAR) with k lags, namely:

(29) where is a matrix polynomial in the lag operator, x, is a H*l vector of variables in the system, and 5 is (n*l) a vector of constants. We assume that ut is a sequence of independent Gaussian variables with zero mean and covariance matrix Su and we write the system as an observationally equivalent vector equilibrium correction (VEqCM henceforth) given by: (30)

where the coefficient matrices are defined as The notion of cointegration stems from the fact that the matrix II above, that pre-multiplies the levels of the variables, may not be of full rank (see Johansen [1995], Hamilton [1994]). In particular, we first note that the general condition for x, ~ 1(0) (i.e. stationary) is that II has full rank, so it is non-singular. In this case, |A(1)| = |II| = 0 corresponding to the usual condition that all the eigenvalues of the companion matrix (or the roots of the characteristic polynomial) should lie within (outside) the unit circle (see Hamilton [1994], Liitkepohl [1991]). As stationary variables cannot grow systematically over time (that would violate the constant-mean requirement), if xr ~ 1(0), then E[xJ = p*. Taking expectations of (30) yields:

(31) so when II has full rank, E[X J =-II~'8. Thus, the levels of stationary variables have a unique equilibrium mean. When x, exhibits 1(1) behavior, II is not full rank and therefore (31) leaves some of the levels indeterminate. Conversely, when 11=0, we 73

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write the VAR in differences, these are stationary if has full rank, in which case xr-I(l). As we have already mentioned in text, the hypothesis that x, is 1(1) is formulated as the reduced rank hypothesis of the matrix II, in which case it can be decomposed into:

(32) Following this parameterization, there are r linearly independent stationary relations and n-r linearly independent non-stationary relations, which define the common stochastic trends of the system. In this case the moving average representation (or solution) of x, as a function of the disturbances u,, the initial conditions x0, and the deterministic variables 5 is given by: (33)

where and p± are matrices orthogonal to a and p respectively, C* (L)is a polynomial in the lag operator, and A is a function of initial conditions, such that p' A = 0. It should further be noted that under the assumption of cointegration, there are n-r linear combinations of the reduced form shocks that have permanent effects on the levels variables, while there are also r linear combinations of the reduced form innovations that do not have long-run effects on any of the variables in the system. We discuss these issues below. Under the cointegrating restrictions one can estimate a VEqCM representation for jLt which takes the form: (34)

The term p f x,_j gives last period's equilibrium errors; a is the vector of "adjustment" coefficients (or loadings) that tells us which of the variables react to last periods equilibrium errors (cointegrating residuals) - that is, which variable, and by how much, adjusts to restore the equilibrium relations p f x M back to their mean when a deviation occurs. By virtue of the Granger Representation Theorem (CRT, Engle and Granger [1987]), if a vector of variables xr is cointegrated, then at least one of the adjustment parameters in the n*r matrix a must be non-zero in the VEqCM representation (34). Thus if Xj does at least some of the adjusting needed to restore the long-run equilibrium subsequent to a shock that distorts this equilibrium, then some of the parameters in the Ixr vector a/ should be different from zero in the equation for Ax, in the VEqCM representation (34). Dynamic Responses For an 1(0) process xr, the effects of shocks in the variables are easily seen in its Wold moving average (MA) representation, (35) 74

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The coefficient matrices of this representation may be obtained by recursive formulas from the coefficient matrices Ay of the levels VAR representation, A(L)X, = 5 + u, (see Liitkepohl [1991] or Hamilton [1994]). The elements of the Cs's may be interpreted as the responses to impulses hitting the system. In particular, the (/-th element of Cs represents the expected marginal response of Xj,t+s to a unit change in xit holding constant all past values of the process. Since the components of u, may be instantaneously correlated, orthogonal innovations are often preferred in impulse response analysis. Using a Cholesky decomposition of the covariance matrix E(U,U/) = £ U is one way to obtain uncorrelated innovations. Let B be a lower-triangular matrix with the property that E u =BB'.. Then orthogonalized shocks are given by e, =B~X • Substituting in (35) and defining D, = C,B (i = 0,1,2,...) gives:

(36) Notice that Do=B is lower triangular so that the first shock may have an instantaneous effect on all the variables, whereas the second shock can only have an instantaneous effect on X2t to xnt but not on x\t. This way a recursive Wold causal chain is obtained. The effects of the shocks et are sometimes called orthogonalized impulse responses because they are instantaneously uncorrelated (orthogonal). A well-known drawback is that many matrices B exist which satisfy BBf = E u the Choleski decomposition is to some extent arbitrary if there are no good reasons for a particular recursive structure. Clearly, if a lower triangular Choleski decomposition is used to obtain B, the actual innovations will depend on the ordering of the variables in the vector x, so that different shocks and responses may result if the vector x, is rearranged. For nonstationary cointegrated processes the Wold representation (for the levels of the process x/) does not exist. Still the Cs impulse response matrices can be computed as for stationary processes from the levels version of a VEqCM (see Liitkepohl [1991]). Generally the Cs will not converge to zero as s —> oo in this case and some shocks may have permanent effects. Distinguishing between shocks with permanent and transitory effects, as we discussed in text and explain below, can also help in finding identifying restrictions for the innovations and impulse responses of a VEqCM. As we mentioned, the results of analyses based on orthogonalization assumptions depend on the ordering of the variables to obtain B and hence the orthogonalized shocks. Recent results of Koop et al. [1996] and Pesaran and Shin [1998] though have re-examined the concept of orthogonalized impulse responses, aiming to remove this shortcoming. Instead of orthogonalized impulse responses from a Choleski decomposition, they suggested generalized impulse responses (GIR henceforth) that are based on a "typical" shock to the system. The argument about GIR may be explained as follows. Let the Vector Moving Average (VMA) representation of the ^-variable cointegrated VAR model be given by:

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where K O is a vector of constants, KJ are the coefficients of the deterministic trend, and u, is a vector of unobserved "shocks", where and let



{°-002>

{°-00°}

Panel D: Adjustment Coefficients it - yt

A»t -0.163

Act 0.010

Adt 0.118

Ayt -0.048

ct-yt [t-atoll dt-10.708yt

0.142 I1-384) -0.0003

0.031 I2-963! -0.0002

0.465 f3-845! -0.013

0.083 I3'522) 0.002

[*-atoll

[t-«tol]

1-3.619]

1-0.133]

[1.574]

[-3.660]

[2.508]

[-4.132]

[-3.301]

[1.205]

NOTES for liable 6: Panel A of the table reports the Full Information Maximum Likelihood (FIML) estimates of the Cointegrating vectors ft subject to exactly identifying restrictions. The numbers in parentheses are the associated (conditional) standard errors. Panel B of the table reports the estimates of the Cointegrating vectors subject to over-identifying restrictions. The likelihood ratio test is distributed as a x2 (2); the number in curly brackets are the asymptotic and bootstrapped p-vaiue (based on 5000 replications) respectively. Panel C of the Table reports two variants of a test of no long-run feedback from the levels relations to the growth rates (also referred to as 'weak exogeneity* test). Q (3) is the likelihood ratio test and W (3) is the Wald test with heteroscedasticity-consistent standard errors, both distributed as £2 (3). Finally, Panel D of the Table reports the adjustment coefficients oty along with the associated t-statistics (in square brackets). Statistically significant parameter estimates are given in boldface. The sample spans the first quarter of 1963 to the fourth quarter of 2002.

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Table 7: Parsimonious VEqCM Estimates Panameter Estimates

System Reduction Tests WA£T>: W (20) = 9.979 {0.968}, CU : Q (20) = 17.258 {0.636} System Statistics 0.285 0.224

0.799

2.462 0.398 2.073

0.271 0.937

2.018 1.924 2.013 1.892 NOTES for Table 7: The Table reports the estimated coefficients from a parsimonious cointegrated vector autoregressive (VAR) model, where some restrictions have been imposed on the short-run dynamics; tstatistics are given in square brackets. The Table also reports two tests for the reductions (a Wald and a Likelihood Ratio test) both distributed as a x2 (20) and some specification statistics for each equation The sample spans the first quarter of 1963 to the fourth quarter of 2002.

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_

Table 8: Forecast Error Variance Decomposition Panel A: Generalized Innovations

Horizon h

1 2 3 4 8 12 16 20 40

0.01 0.03 0.04 0.05 0.05 0.04 0.04 0.04 0.08

0.00 0.01 0.02 0.03 0.07 0.09 0.09 0.09 0.16

1.00 0.98 0.96 0.95 0.90 0.82 0.69 0.56 0.25

0.01 0.01 0.01 0.01 0.01 0.01 0.03 0.04 0.02

0.01 0.05 0.06 0.07 0.07 0.05 0.04 0.04 0.06

0.00 0.00 0.01 0.01 0.03 0.04 0.04 0.05 0.11

1.00 0.98 0.97 0.96 0.92 0.86 0.76 0.65 0.34

0.01 0.01 0.01 0.01 0.01 0.01 0.03 0.05 0.04

Panel B: Permanent and Transitory Innovations

Horizon h

1 2 3 4 8 12 16 20 40 co

0.01 0.01 0.02 0.02 0.10 0.21 0.33 0.44 0.74 1.00

0.99 0.99 0.98 0.98 0.90 0.79 0.67 0.56 0.26 -

0.02 0.04 0.05 0.07 0.15 0.24 0.33 0.42 0.70 1.00

0.98 0.96 0.95 0.93 0.85 0.76 0.67 0.58 0.30 ~

NOTES for Table 8: Panel A of the table reports the fraction of the variance in the h step-ahead forecast error of the Net Foreign Liabilities dt that is attributable to generalized innovations in w$, tt£, u^ and u%. Notice that by construction these fractions may not sum to unity. Panel B of the table reports the fraction of the variance in the h step-ahead forecast error Net Foreign Liabilities that is attributable to permanent (P) and transitory (T) innovations. Horizons are in quarters, and the underlying VEqCM is of order 2. The sample spans the first quarter of 1963 to the fourth quarter of 2002.

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Figure 1. Impulse Responses for sub-sample 1968-1997 (o) and the full sample (-).. Notes for Figure 1: The first permanent shock is assumed to have a long-run impact on all three variables in the system, the second permanent shock (not reported here) is assumed to have a no long-run effect on £*, but it has a long-run impact on c* and dt and the transitory shock is assumed to have no long-run effect on any of the variables. The horizon in the figure is measured in years after the shock. The figure shows the response of each variable to a one-unit shock for the sub-sample 1963-1997 (o) and for the full sample 1963-2002 (-). The first column shows the responses to the first permanent shock and the second the responses to the transitory shock, all with the associated bootsrap confidence bands obtained from estimating the model for the sub-sample.

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Figure 2. Impulse Responses employing (Dt — D) /D as the Net Foreign Liabilities Variable. Notes for Figure 2: The figure reports impulse responses for a model that includes (Dt — JD) /D as the net foreign liabilities variable, where D is the sample average of Dt. The first permanent shock is assumed to have a long-run impact on all three variables in the system, the second permanent shock (not reported here) is assumed to have a no long-run effect on zt, but it has a long-run impact on Ct and di « (Dt — .D) /D and the transitory shock is assumed to have no long-run effect on any of the variables. The horizon in the figure is measured hi years after the shock. It shows the response of each variable to a one-unit shock for the sub-sample 1963-1997. The first column shows the responses to the first permanent shock and the second the responses to the transitory shock, all with the associated bootsrap confidence bands obtained from estimating the model for the sub-sample.

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Figure 4. The Series employed in the Analysis.

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ddt/dyt

9dt/dyt

Figure 5. Generalized Impulse Responses of Net Foreign Liabilities, NOTES for Figure 5: The figure shows the effects of a one-standardrdeviation increase in each of the variables shown in the denominator. The results are ordering independent. The horizon is in quarters after the shock. Panel A reports the results for the unrestricted VEqCM(2) and Panel B the results for the subset VEqCM(2) (see Table 7). The 95% confidence intervals were obtained by bootstrap Monte Carlo simulation (10000 replications).

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Figure 6. Generalized Impulse Responses to Shocks in Net Foreign Liabilities. Notes for Figure 6: The figure shows the effects of a one-standard-deviation increase in net foreign liabilities on each of the variables in the system. The results are ordering independent. The horizon is in quarters after the shock. Panel A reports the results for the unrestricted VEqCM(2) and Panel B the results for the subset VEqCM(2) (see Table 7). The 95% confidence intervals were obtained by bootstrap Monte Carlo simulation (10000 replications).

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Figure 7. Impulse Responses to the Permanent (Technology) Shock. NOTES for Figure 7: The figure shows the effects of the permanent, technology shock on investment z$, consumption c$, net foreign liabilities dt and output y$. The horizon is in quarters after the shock. Panel A reports the results for the unrestricted VEqCM(2) and Panel B the results for the subset VEqCM(2) (see Table 7). The 95% confidence intervals were obtained by bootstrap Monte Carlo simulation (10000 replications).

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Session 2 Exchange Rate Issues

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Financial Globalization and Exchange Rates' Philip R. Lane HIS, Trinity College Dublin and CEPR Gian Maria Milesi-Ferretti International Monetary Fund and CEPR

*Revised version of a paper prepared for the "Dollars, Debt, and Deficits: Sixty Years After Bretton Woods" Conference co-organized by the Banco de Espana and the IMF, Madrid, June 14-15 2004. The authors thank their discussant Daniel Cohen, conference participants in Madrid and Budapest, and participants at the Kiel Institute for World Economics seminar and the Glasgow-Strathclyde joint seminar for useful comments, and Abdel Senhadji and Cedric Tille for data on Australia and the United States. Marco Arena, Charles Larkin, and Vahagn Galstyan provided excellent research assistance. Part of this paper was written while Lane was a visiting scholar at the International Monetary Fund. Lane also gratefully acknowledges the financial support of the Irish Research Council on Humanities and Social Sciences (IRCHSS) and the HEA-PRTLI grant to the HIS. This paper is also part of a research network on "The Analysis of International Capital Markets: Understanding Europe's Role in the Global Economy', funded by the European Commission under the Research Training Network Programme (Contract No. HPRN-CT-1999-00067).

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Introduction Financial globalization has been one of the most important trends in the world economy in recent decades. This process has involved sharply rising foreign asset and liability positions, whether scaled by GDP or by domestic financial variables (Lane and MilesiFerretti 2003, Obstfeld and Taylor 2004). In addition to larger gross positions, financial globalization has also allowed a greater dispersion in net foreign asset positions, with a significant number of countries emerging as either large net creditors or net debtors (Lane and Milesi-Ferretti 2002a). In general, financial globalization is one of the key trends that has reshaped the global economy relative to the environment envisaged by the designers of the Bretton Woods system in 1944 and understanding its macroeconomic implications is crucial in formulating a view on the appropriate future direction for the international monetary system. One consequence of financial globalization is that the international spillovers from asset price and currency movements have been enhanced. In addition to affecting the direction and magnitude of net capital flows, asset price dynamics also generate changes in the valuation of existing investment positions. For instance, the value of the net liability position of the United States is quite sensitive to the relative movements in the U.S. versus non-US, equity markets and swings in the value of the dollar. Indeed, such valuation effects may be as important as current account imbalances in driving the dynamics of net foreign asset positions (Lane and Milesi-Ferretti 200la, 2002a, Gourinchas and Rey 2004). Of course, asset price and currency movements cannot be viewed as exogenous influences on the value of international investment positions, since shifting global demands for various assets and liabilities are an important driver of financial returns and exchange rates (e.g. through the determination of country and currency risk premia). Moreover, there is an obvious interplay between the financial and trade accounts that provides another link between net foreign asset positions and exchange rates: a long-term debtor may require real depreciation in order to generate the trade surpluses that are the counterpart of sustained net investment income outflows (Lane and Milesi-Ferretti 2002b, 2004b). In this paper we explore the interconnections between financial globalization and exchange rates. To establish the stylized facts about financial globalization, the first part of the paper examines trends in gross and net international investment positions and their components for a large set of advanced and emerging economies. In Lane and MilesiFerretti (2003) we documented for industrial countries an acceleration in the pace of financial globalization since the mid-1990s; in this paper we update our estimates of external assets and liabilities for a sample of emerging markets as well. l As noted above, a central aspect of our analysis is the focus on the factors explaining the changes in external positions: not only capital flows but also valuation effects, such as those caused by asset price and exchange rate fluctuations. In the second part of the paper we first provide an analytical framework that is useful in understanding the dynamics of net foreign assets, and then explore the contribution of currency movements to the revaluation component of net foreign asset dynamics. This relationship depends on a number of factors. For instance, the impact of an exchange rate depreciation will depend on gross foreign asset and liability holdings (in addition to the net position); the currency composition of both sides of the international !

Lane and Milesi-Ferretti (2004c) explain the construction of the data. 95

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balance sheet; and the co-movement between exchange rate changes and other financial returns.2 These factors will vary across countries, according to the level of development, country size and other characteristics. Along one dimension, a high proportion of the liabilities of a major industrial country is likely to be denominated in its own currency, whereas a typical emerging market economy exhibits significant liability dollarization. Countries also differ as to the mix of short- and long-term debt and the levels of portfolio equity and FDI holdings in the international balance sheet: the impact of currency movements on the net external position is undoubtedly sensitive to the external capital structure.3 Our analysis suggests that theoretical work on open economy macroeconomics should strive to incorporate elements such as persistent non-zero net foreign asset positions, large gross asset cross-holdings and mixed portfolios of equity and debt instruments and illustrate why these features can make a difference to model dynamics and welfare analysis. Finally, in the last part of the paper we draw out the implications of our empirical work for policy analysis. In particular, we highlight that the valuation channel is unlikely to be open to policy manipulation on a sustainable basis. Trends in International Financial Integration In Lane and Milesi-Ferretti (2002a, 2003), we documented a number of stylized features of international capital flows and external positions in industrial countries. Flows to and from such countries increased substantially in recent years, both in absolute terms and as shares of GDP and domestic wealth. In this context, the increase in FDI and portfolio equity investment is particularly noteworthy. The increase in gross external assets and liabilities means that valuation effects have become more important. We highlight these features again below, with an updated dataset including both industrial countries and emerging markets. Net Flows and Net Positions, Industrial Countries Figure 1 plots net foreign assets (as a ratio of GDP) against GDP per capita, measured in current U.S. dollars, for the year 2003. There is a wide dispersion in net external positions among industrial countries, with Switzerland being by far the largest creditor, and New Zealand and Iceland the largest debtors in relation to GDP. The positive relation between net foreign assets and GDP per capita, shown in the Figure to hold in the cross-section, holds also along the time-series dimension—as a country gets richer, relative to trading partners, its net foreign asset position tends to improve (Lane and Milesi-Ferretti, 2002a). Table 1 summarizes net capital outflows from industrial countries over the period 1999-2003, together with changes in their external position. In absolute terms, Japan has been the largest capital exporter, while Switzerland and Norway had the highest net outflows relative to their GDP. On the other side, the United States had by far the largest net inflows in absolute terms, and also as a ratio of GDP. 2

Tille (2003) provides an interesting analysis for the United States. Lane and Mflesi-Ferretti (200 Ib) analyze some of the determinants of the composition of the international balance sheet. 3

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While there is clearly a positive relation between net outflows and change in the net external position, the Table highlights the importance of valuation effects: for example, the United Kingdom was a net capital importer during this period, but its net external position improved by 7.5 percent of GDP; Canada instead was a net capital exporter, but its net position deteriorated. In absolute terms, the difference between net capital inflows and the change in the net asset position is particularly large for the United States—net inflows were over $600 billion higher than the net accumulation of liabilities. The reasons for this discrepancy are further discussed below. Gross Flows and Gross Positions, Industrial Countries Figure 2 summarizes the evolution of gross external assets and liabilities in industrial countries during the past 20 years. The growth in international financial interdependence is striking: during this period, aggregate assets and liabilities tripled as a share of GDP, FDI assets and liabilities increased four-fold, portfolio equity assets and liabilities six-fold, and debt assets and liabilities 2 l/2 times. Focusing on the most recent period, the chart also shows the effects of the global decline in stock market valuations between end-1999 and end-2002, which is the main factor behind the reduction in the stock of portfolio equity assets and liabilities during this period, and the recovery in stock market valuation and flows in 2003 4 Table 2 summarizes gross capital flows to and from industrial countries during the most recent period (1999-2003). The size of gross flows is remarkable, particularly to and from financial centers such as Switzerland and the United Kingdom, but also to and from the euro area and, relative to GDP, Scandinavian countries. While net flows are also substantial, the data suggest that portfolio diversification, rather than intertemporal borrowing and lending, is the dominant motive for international asset transactions among industrial countries. The data in Table 2 also confirm the importance of valuation effects, in addition to gross flows, in explaining the dynamics of external assets and liabilities. For example, external liabilities (and, to a lesser extent, assets) in the United States increased by substantially less than the underlying flows. The primary reason was the decline in U.S. stock market valuations during this period, which reduced the value of both foreign equity and FDI holdings in the United States. The smaller decline in stock market valuations (measured in U.S. dollars) in other countries during this period helps explain the smaller capital losses incurred by U.S. investors on their foreign equity holdings.5

4

Only a few countries in our sample (including the United States) measure FDI at market value: hence, stock market fluctuations have a less dramatic impact on FDI stocks compared to portfolio equity holdings. Of course, the fall in foreign portfolio equity assets and liabilities relative to GDP does not imply a decline relative to total domestic equity holdings. 5 The difference in stock market performance between the United States and world markets is entirely accounted for by the year 2003, during which the sharp depreciation of the U.S. dollar raised foreign stock returns measured in dollars. Between end-1998 and end-2002 the decline in stock market valuations in the United States and world markets was similar. 97

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Net Flows and Net Positions, Emerging Markets We focus on a sample of 21 emerging markets (listed in the Appendix). Figure 3 plots the evolution of the average current account balance as a ratio of GDP in our emerging markets' sample. The key cycles in capital flows to emerging markets stand out clearly from this picture: the deterioration of current account imbalances in the late 1970s until the debt crisis, their sharp reversal during the remainder of the 1980s, the increase in imbalances during the early 1990s, and the new reversal following the 1994-95 Mexican crisis and especially the Asian crisis. Indeed, both the average and aggregate current account position of the emerging countries in our sample turned positive in 1998 and increased further in recent years. The dynamics of the net external position, expressed as a ratio of GDP, are plotted in Figure 4. It shows the deterioration caused by the debt crisis and its aftermath, a subsequent sharp improvement, the stabilization of the net external position from 1990 to 1996, the deterioration caused by the sharp declines in GDP and real exchange depreciation characterizing the Asian crisis, and the subsequent improvement associated with current account surpluses and strengthening currencies in Asia. In the data, there is no evidence of an increased dispersion in current account balances across the countries in our sample (that is, there is a significant common trend in the net capital flows to this emerging market group), while the dispersion of the underlying net external positions has increased. Figure 5 plots the net foreign asset position, scaled by GDP, in relation to GDP per capita in current US dollars at end-2002. While there is still a positive relation between net foreign assets and GDP per capita, this relation is much weaker than for industrial countries. Indeed, creditors include economies with high GDP per capita, such as Taiwan province of China, but also economies with much lower GDP per capita, such as Russia and Venezuela.6 Table 3 shows the size of net capital flows among some countries in the sample, both in absolute terms and as a ratio of GDP, during 1999-2003. The table shows a number of Latin American and Central European countries as the largest net recipients of net capital flows, although Turkey and Argentina experienced net outflows if IMF and "exceptional" financing are netted out. 7As the data on current account dynamics suggest, a number of emerging markets—particularly Asian countries, together with Russia—have been on average net capital exporters to a substantial degree. For example, Thailand's cumulative net outflows over the 5-year period total over 30 percent of its 2003 GDP. Gross Flows and Gross Positions, Emerging Markets Figure 6 provides a longer-term perspective on the size of external assets and liabilities in these emerging markets. Both assets and liabilities have increased substantially as a ratio of GDP during the past 20 years. However, there is virtually no increase in average external liabilities when scaled by exports, rather than GDP, while the trend increase in external assets is still visible. This stands in contrast with the evidence for the advanced 6

In addition to the standard macroeconomic drivers of net foreign asset positions that were emphasized by Lane and Milesi-Ferretti (2002a), political risk and natural resource endowments are other variables that may be important, especially in reference to the countries listed here. 7 See IMF (1993) for a description of balance-of-payments transactions classified as exceptional financing. 98

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economies, where the increase, especially since the mid-1990s, is very strong even as a share of exports. As noted earlier, an interesting question is whether the composition of external assets and liabilities has changed over time. Table 4 provides evidence that highlights the increased relative importance of direct investment and portfolio equity liabilities. The averages hide substantial heterogeneity—countries such as Chile and the Central European economies in our sample (Czech Republic, Hungary, and Poland) have external equity liabilities above 50 percent of GDP, while the levels tend to be lower in Asian economies. The table also documents the increase in foreign exchange reserves, expressed as a share of GDP, during the past 20 years. It should be noted, however, that this increase has gone hand in hand with the increase in other external assets, so that at the end of 2002 reserves in our sample account for the same share of total external assets as in 1982 (over one third). Direct investment and portfolio equity assets have also increased during the past two decades, and by 2002 represented around 12 percent of GDP and over 20 percent of total external assets. Table 5 characterizes gross capital flows to and from some emerging economies during the period 1999-2003. The pattern reveals an interesting dichotomy. For a number of countries, gross flows primarily reflect intertemporal borrowing or lending decisions, with countries accumulating net assets or net liabilities—either cumulative inflows or cumulative outflows are clearly dominant (see also Table 3). Among countries that accumulated substantial net assets, a number of East Asian countries stand out, particularly Indonesia, Korea, Malaysia, and Thailand, together with oil-exporting countries such as Russia. For another group of countries, instead, gross inflows and gross outflows have both been large and roughly similar in magnitude, reflecting increased financial integration with the world economy. Examples include Chile and India. China has experienced large inflows and outflows, but also significant net foreign asset accumulation. Of course, similar aggregate levels of gross inflows and gross outflows can conceal significant net imbalances within specific asset categories: for instance, China is a major net recipient of FDI flows while simultaneously accumulating a significant volume of foreign reserves. Having provided a broad characterization of the growth in international balance sheets in recent years for both advanced and emerging economies, we next turn to providing a simple framework for understanding the underlying drivers. External Asset Dynamics In this section, we provide a simple accounting framework that relates the dynamics of net foreign assets to trade flows, growth, rates of return, and real exchange rates. The goal is to lay out the various channels by which exchange rates and other macroeconomic fundamentals can affect the external adjustment process. We then decompose the factors underlying changes in net foreign assets over the past decade for a set of emerging markets. Accounting for External Asset Dynamics The change in net foreign assets B can be written as the sum of net capital outflows and net capital gains:

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(1) where AFXt is net accumulation of foreign exchange reserves, FA^ is net capital inflows (excluding reserves), and KG is the net capital gain on the net external position outstanding (change in stock minus underlying flow). Denote by CA the current account balance, KA the capital account balance, and EO net errors and omissions.8 Making use of basic balance of payments identity CA+KA + FA - AFX + EO = 0, we can rewrite (1) as:

(2) In line with statistical reporting practices, all variables are expressed in US dollars. Equation (2) can also be expressed as follows: (3)

where BGST is the balance of trade in goods and services plus net transfers, A and L are external assets and liabilities, respectively, and i f , if are the nominal yields on these assets and liabilities. Taking ratios of GDP and indicating such ratios with lower-case letters, we can express (3) as follows: (4)

where yt is the growth rate of nominal GDP measured in US dollars. Another way to re-write the above expression is as follows: (5)

where g is the economy's real growth rate, n is the rate of inflation (measured with the GDP deflator), and d is the rate of nominal exchange rate depreciation vis-a-vis the US dollar. In other words, changes in the net external position can be due to several factors: 1. 2. 3. 4.

The current account; Net capital gains (measured in US dollars); The capital account and net errors and omissions; The effect of exchange rate changes on the past net foreign asset position;9

8

In balance of payments' statistics (IMF, 1993) the so-called "capital account" measures certain transfers (such as debt forgiveness); capital flows are recorded in the financial account 9 If external assets and liabilities are all denominated in domestic currency, the capital gain effect will go exactly in the opposite direction from the exchange rate change effect. Indeed, assume for simplicity that asset prices in domestic currency do not change. In this case, the capital gain expressed in domestic currency

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5. the effect of real GDP growth on the past net foreign asset position. An alternative way to express eauation (5) is in terms of overall rates of return on external assets and liabilities. Define as the rate of capital gain on external assets (liabilities), measured in US dollars, so that be the real rate of return on foreign assets, measured in US dollars, with an analogous definition holding for the rate of return on foreign liabilities ftL. In this case we can rewrite (5) as follows: (6)

Equation (6) shows several factors that can account for the dynamics of net foreign assets: the adjusted trade balance, the difference between the real rate of return and the growth rate, adjusted for the bilateral real exchange rate vis-a-vis the US dollar, and differences in returns between foreign assets and liabilities. If we express the real rates of return in domestic currency and denote them by A L rt ,rt , equation (6) takes the more familiar form: (7)

This framework delivers several important insights. First, the gap between current production and current absoiption (i.e. the trade balance) is only one factor in determining the aggregate evolution of the net foreign asset position: it is vital to also keep track of valuation and "denominator" effects. Second, as is shown by the third term on the right hand side (RHS) of equation (6), the difference between the rate of return and the growth rate, interacted with the inherited net foreign asset position, exerts a potentially powerful influence on its current dynamics. Third, as captured by the last term on the RHS in equation (6) , the gross scale of the international balance sheet matters in addition to the net position: even if the inherited net foreign asset position is zero, the accumulated levels of gross foreign assets and liabilities will influence the overall dynamics to the extent that the rates of return differ between the two sides of the international balance sheet.

is zero, but expressed in dollars it becomes : to the term

similar (with an opposite sign)

in equation (5).

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The Evolution of Net Foreign Assets in Emerging Markets In Table 6 we provide a simple decomposition of changes in the ratio of net foreign assets to GDP between end-1990 and end-2002 for a selection of emerging markets in our sample. The breakdown follows equation (4), so that changes in net foreign assets are given by the sum of the current account (itself divided into trade balance and investment income), capital account and errors and omissions, capital gains (including the effects of exchange rate changes on the net external position), and the effects of growth on net external assets. A number of features are worth highlighting: •

•

Despite a cumulative current account in balance or surplus, countries such as Indonesia and Thailand experienced a deterioration in the ratio of net foreign assets to GDP. For both countries, this occurred because of 'capital losses'—linked to the real depreciation of their currencies during the period. On the other side, the Czech Republic's and Mexico's external position deteriorated by much less than the large cumulative current account deficits would suggest, thanks to substantial capital gains on their net external position—linked to the real appreciation of their currencies between end-1990 and end-2002.

More generally, the tables highlight the need to focus not only on the current account (which includes the yield on external assets and liabilities), but also on economic growth and the overall rates of return on the external portfolio in order to understand the evolution of net foreign assets. Indeed, growth and especially valuation effects can have an impact on the evolution of the external position that is of the same order of magnitude as trade imbalances. Exchange Rates and the Adjustment Process The framework summarized in equation (6) highlights the potential contribution of shifts in exchange rates in determining the dynamics of external asset positions. In this section, we first briefly review the "traditional" channels by which exchange rates influence the adjustment process, before focusing on the valuation channel (i.e. the impact of the exchange rate on the rates of return earned on holdings of foreign assets and liabilities). Exchange Rates, the Trade Balance and Real Output The inter-connection between the exchange rate and the trade balance is among the most-studied questions in international economics, in both academic and policy circles. From a long-run perspective, the classical transfer problem postulates that persistent creditor nations should have more appreciated real exchange rates. The mechanism underlying the transfer problem hypothesis is that the positive international investment returns earned by long-run creditors have their counterpart in trade deficits and attendant real appreciation. Lane and Milesi-Ferretti (2002b, 2004b) find considerable empirical support for the transfer problem, for both industrial and developing countries. However, they find the magnitude of the effect differs with country characteristics such as openness, size and the

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level of development. In relation to financial globalization, important findings are that the transfer problem is smaller in the absence of current and capital account restrictions and that equity financing reduces the size of the transfer effect relative to debt financing. At a shorter horizon, the interplay between the exchange rate and the trade balance is complex and less well understood. In particular, the cyclical correlation between the variables will depend on the nature of the shocks hitting the economy, with nominal, fiscal and real shocks generating different co-movement patterns between the variables. However, in policy terms, there is a broad consensus that exchange rate depreciation is typically required if the objective is to engineer an improvement in the trade balance. Empirical studies of the elasticities of trade volumes to exchange rates and income levels provide extensive support for this proposition (Hooper et al 2000). Again, the pace of financial globalization and "real" globalization (in terms of product market integration) will influence these key elasticities. For instance, the scale of exchange rate adjustment is eased, as foreign goods become better substitutes for domestic goods. In terms of financial globalization, wider trade imbalances are more feasible, the more diversified are international portfolios. In tracking the dynamics of the ratio of net foreign assets to GDP, real exchange rates also operate by determining the real value of domestic output in terms of international price comparisons. For instance, if variables are measured in US dollars, a foreign asset that is constant in real dollar terms will shrink relative to the constant-dollar value of GDP if real appreciation vis-a-vis the US dollar occurs. This "denominator" effect is highlighted in equation (8) in the previous section and is powerful channel by which the real exchange rate may influence the dynamics of the NFA/GDP ratio. However, in addition to these well-known channels, exchange rates also potentially influence the dynamics of international asset holdings through influencing the rates of return on foreign assets and liabilities.10 We focus on this valuation channel in the rest of this section. The Valuation Channel: A Conceptual Framework As outlined earlier in the paper, the dynamics of net foreign assets depend not only on the trade balance but also on the rates of return earned on accumulated foreign assets and paid out on foreign liabilities. In domestic-currency real terms, the net impact is given by (8)

where the stocks of foreign assets and liabilities A and L are now expressed in domestic currency. Since these positions are predetermined from a time-/ perspective, the net valuation impact of a change in the real exchange rate is given by (9) 10

Clearly, in tracking a ratio, there is some discretion in terms of attributing the impact of an exchange rate change to the numerator or the denominator via the choice of the reference currency. In the next subsection, we look at the levels of foreign assets and liabilities in terms of real domestic currency. 103

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It is clear from this expression that exchange rate changes can have a non-zero valuation impact even if the initial net foreign asset position is balanced, so long as the rates of return on foreign assets and liabilities are differentially affected by a shift in the exchange rate.11 The magnitude of the valuation channel is directly increasing in the gross scale of the international balance sheet: the relevance of this channel for aggregate net foreign asset dynamics is growing in line with the spectacular accumulation of gross foreign asset and liability holdings in recent years. Relatedly, the valuation channel also depends on the composition of the international balance sheet, since the sensitivity of returns to exchange rates will vary across investment categories and will also depend on the currency composition of foreign assets and liabilities (and on the extent of hedging). Of course, even if the exchange rate does indeed have a valuation impact, it does not mean that the net foreign asset position will move one-for-one. First, exchange rate changes also have a direct impact on the trade balance. Second, a valuation gain represents a positive wealth effect that will plausibly raise consumption and investment, leading to a negative comovement between the net returns term and the trade balance (Lane and MilesiFerretti 2002a, 2002b). Third, from another angle, a sufficiently large negative valuation effect may lead to a sudden stop in capital flows that forces the trade balance to move into surplus. Finally, it is important to remember that it is the net valuation effect that matters: a capital gain on foreign assets may be fully offset by a capital gain on foreign liabilities.12 In addition, equation (9) only captures the contemporaneous impact of a change in the exchange rate. Some returns may respond to the exchange rate only with a lag (for instance, the future profitability of FDI positions may be affected by current exchange rate movements). In addition, current exchange rate movements may lead to a revision of expectations about future exchange rate changes, which in turn feed into the ex-ante returns required to hold particular foreign asset and liability positions. As was discussed earlier in the paper, there are polar cases in which the impact of exchange rate movements on rates of return is straightforward. For instance, the domestic rate of return on an unhedged foreign asset that offers a fixed foreign-currency return will fall one-for-one with the rate of real appreciation: a given foreign-currency return will be diminished by the fall in the real domestic value of foreign currency. Conversely, the domestic rate of return on a foreign liability that offers a fixed domestic-currency return will be unaffected by a shift in the real exchange rate. However, the domestic rate of return on a foreign liability that offers a fixed foreign-currency return (e.g. foreign currency debt or domestic debt that offers a dollar-linked rate of return) will also fall in proportion to the rate of real appreciation. More generally, the net impact of exchange rate movements on the value of "Strictly speaking, the impact on the returns on foreign assets and liabilities is not the only "valuation" effect of exchange rate changes. As highlighted by the debate over the Marshal 1-Lerner condition and reemphasized by the current debate about limited exchange rate pass-through, exchange rate movements also exert a "pure" valuation effect on the trade balance to the extent that import and export volumes are unresponsive to exchange rate changes. There are also potential valuation effects even on domesticallyowned assets, but we restrict attention to the cross-border positions through which valuation effects have asymmetric redistribution effects on home and foreign investors. 12 Cross-border hedging could automatically generate such a positive comovement. However, the extent to which hedging takes place is unclear: much hedging activity occurs between counterparties of the same nationality, with no net impact on the national risk profile. 104

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holdings that carry a variable market return depends on the nature of the co-movements between exchange rates, asset prices and profitability (in the case of non-market assets such as FDI positions and some bank claims). In some cases, the inter-connections between exchange rates and the determinants of market returns can be quite subtle and complex and may also depend on the underlying source of an exchange rate shock. For instance, devaluation may be associated with an increase in the rate of return on foreign liabilities if it is associated with an increase in the profitability of foreign affiliates operating in the domestic market or, alternatively, if it engenders an increase in the country risk premium. On the other hand, a devaluation may be generated by a negative domestic productivity shock that also lowers the return earned by foreign investors. With respect to foreign assets, domestic real depreciation may be the result of superior overseas economic performance that raises the overseas rate of return. However, a negative domestic productivity shock may also reduce the overseas earnings of domestic multinationals, such that devaluation is accompanied by a decline in the overseas rate of return.13 In view of the range of possible theoretical scenarios, the strength of the valuation channel is ultimately an empirical issue. We first consider some case study evidence, before turning to cross-country quantitative exploration in the subsequent subsection. Case Studies: the United States and Australia It is possible to gain some insight into the quantitative importance of the valuation impact of exchange rate movements for those countries that calculate the accounting decomposition about the relative importance of capital flows, market value capital gains and exchange rate capital gains in determining the dynamics of foreign asset and liability positions. This is possible to for two countries in our sample (the United States and Australia). Of course, an accounting decomposition does not reveal the complete contribution of the exchange rate valuation channel, since it does not take into account the potential indirect impact of the exchange rate on market values or on the revaluation of investment income flows. Tables 7 and 8 present the decompositions for the United States and Australia respectively, showing the average annual relative contributions of each component in proportion to the inherited stocks of foreign assets (liabilities):

13

A further complication is that exchange rate movements may also affect the international tax planning of multinational corporations that may affect the distribution of reported earnings in different locations. See Sullivan (2004) on the trend increase in the shifting of reported profits by U.S. multinationals to overseas affiliates. 105

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In addition, the tables display the standard deviations for these components. Figure 7 and Figure 8 present similar data, but scale the size of capital flows and valuation changes by GDP, so as to provide a ready reckoning of their macroeconomic impact. Table 7 and Figure 7 show the statistics for the United States over 1990-2003. While financial flows have traditionally been the dominant source of balance sheet growth, the 1996-2003 period saw a much greater role for capital gains. Indeed, the contribution of market-value capital gains exceeded that of financial flows in the growth of the foreign asset holdings of the United States during the global stock market boom of 1995-1999, with a similar contribution to the growth in the value of foreign liabilities. Conversely, and consistently with the evidence in Tables 1 and 2, the global correction in asset prices during 2000-2003 saw a decline in the market value of both foreign assets and liabilities. Table 7 highlights the role of the exchange rate valuation channel. The 5.1 percent average annual dollar appreciation during 1996-2001 was associated with an annual average 1.7 percent fall in the value of US foreign assets. In contrast, the sharp dollar depreciation during 2002-03 was associated with an annual average 5.5 percent increase in its foreign asset position. This gain helped to offset the impact of the growing current account deficit on the U.S. net external position. (Throughout, in line with expectations, the exchange rate channel had a near-zero impact on the stock of US foreign liabilities.) In terms of relative stability, capital flows have been much less volatile than either of the capital gain components. Turning now to the Australian evidence, Table 8 and Figure 8 show that the exchange rate valuation channel has been more important than in the US case. For instance, the exchange rate valuation term was a bigger contributor than either financial flows or market-value capital gains in the growth of foreign assets during the 1997.22001.1 period of real depreciation of the Australian dollar. Although, in contrast to the US case, Australian foreign liabilities are also sensitive to the exchange rate, this side of the international balance sheet is only about half as sensitive as the foreign asset position. This is consistent with a larger role for holdings denominated in domestic currency in foreign liabilities than in foreign assets. These case studies of the United States and Australia provide suggestive evidence about the importance of the valuation channel in driving fluctuations in international asset holdings. We next turn to regression-based analysis for a broader panel of countries. Regression Analysis, Industrial Countries In this section, we analyze the sensitivity of rates of return on foreign assets and liabilities to movements in trade-weighted multilateral exchange rates. 14In addition to the aggregate positions, we also examine returns for the separate investment categories (FDI; portfolio equity; portfolio debt; and other (debt)), since the relation between exchange rate movements and rates of return should depend on the specific characteristics of each investment class. Our specification is given by:

14

While the most appropriate real exchange rate measure would be a "finance-weighted" index, reflecting the relative importance of host or source countries in external holdings, the strong correlation between the geographical pattern of trade and financial flows ensures that a trade-weighted exchange rate is a reasonable proxy. 106

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(10)

where the dependent variable is the real domestic-currency return on foreign assets in investment category / and the regressor is the log change in the trade-weighted real effective exchange rate.15 We run an analogous equation for the rate of return on foreign liabilities.16 Our primary interest is just in establishing the direction and magnitude of the contemporaneous co-movement between the exchange rate and rates of return.17 We do not attempt to distinguish between anticipated and unanticipated changes in the real exchange rate: however, real exchange rates are largely unpredictable at an annual horizon (at least for our sample of advanced countries), such that this may be a fairly-innocuous assumption.18 We begin by examining the rates of return on foreign assets in Table 9.19 The results for total foreign assets are given in column (1). In all cases, the estimated coefficient is negative: real appreciation is associated with a fall in the domestic-currency rate of return earned on foreign assets. For a number of countries, the estimated coefficient is in fact very close to -1: this one-to-one mapping is consistent with a process by which the foreign-currency real return on foreign assets is orthogonally determined and the exchange rate just acts to convert the foreign-currency return into domestic terms.20 The smallest estimated coefficient (in absolute value) in the sample is for the U.S. at -0.37. This admits a number of interpretations. First, some proportion of U.S. foreign assets is denominated in dollars and hence their value is not directly affected by exchange rate movements. Second, dollar appreciation could be associated with an increase in returns on foreign-currency foreign assets. One example would be a positive productivity shock in the U.S. that both appreciates the dollar and raises returns in U.S. financial markets. If foreign financial markets positively co-move with the U.S., foreign-currency asset returns would also rise at the same time. A positive U.S. productivity shock could

15

The rate of return on foreign assets in year t is measured as the sum of investment income and capital gains earned in that year, divided by foreign assets at the end of year / -1. 16 Clearly, this is a very parsimonious setup. However, in addition to being suited to our short data span, capturing the simple bivariate relation is an obvious first step, even if it does not rule out the possibility that any impact of the exchange rate on the rate of return may just be proxying for the role played by some omitted variable that commonly influences both the rate of return and the exchange rate or may just reflect endogeneity bias. 17 We could alternatively present the simple correlations between returns and exchange rate changes. See Lane and Milesi-Ferretti (2003). 18 We return to the issue of the predictability of exchange rates in the discussion of results. 19 In terms of country selection for the regressions, we only include those with at least thirteen years of data on rates of return. In addition, we rule out observations that may be contaminated by factors such as revisions in methodology and other corrections. 20 In some cases, we observe a coefficient above unity, which means that real appreciation is associated with a fall in foreign-currency returns on foreign assets: the domestic investor "loses twice" by suffering both a low foreign-currency return and an unfavorable conversion rate back into domestic real terms. Such a pattern could be generated, for instance, if the domestic business cycle is asymmetric with respect to the international business cycle: the domestic currency appreciates when international partners are doing badly (as proxied by poor foreign-currency rates of return). This, of course, is a risk-leveraging pattern of comovement between foreign-currency returns and the domestic real exchange rate. 107

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also raise the profits earned overseas by U.S. multinationals, such that foreign-currency return rises in that case as well. The results for FDI assets are given in column (2).21 For most countries, FDI positions are still measured at book value, rather than market value, and therefore the valuation channel is typically understated. However, currency movements should still matter, since these would affect factors such as the current replacement cost of capital goods and fixtures, both domestically and overseas. In column (2), the fixed-effects panel estimate of the impact of real appreciation on the real return on FDI foreign assets is -0.76. However, there are some cases in which the coefficient is substantially above unity: for these countries, real appreciation tends to be associated with low foreign-currency real returns on FDI assets. We next examine the returns on portfolio equity assets in column (3). The fixedeffects panel estimate is very close to -1, which is consistent with orthogonal contributions of exchange rate movements and foreign-currency rates of return to the domestic-currency real rate of return. Two exceptions to this rule are Germany and Switzerland: for these countries, real appreciations have coincided on average with periods of strongly negative world stock market returns, and hence disappointing foreign-currency returns on their equity portfolios. Column (4) displays the results for foreign assets in the portfolio debt category. There is strong covariation between the exchange rate and domestic-currency returns and the estimated coefficients are consistent with the foreign-currency returns on foreign portfolio debt assets being exogenously determined with respect to the domestic real exchange rate. However, the United States coefficient is only -0.65, consistent with the fact that a considerable proportion of its foreign bond holdings are denominated in US dollars. Finally, we turn to the "other" investment category in column (5). This category largely comprises bank lending. Since banks do not "mark to market" all assets and liabilities but rather carry a high proportion at book value, the rates of returns in this category will be dominated by the yield component, with capital gains and losses understated. However, on the assets side, the broad picture is quite similar to that for portfolio debt Again, an important exception is the US, where the coefficient estimate is insignificant: again, a good candidate explanation is that a high proportion of its foreign lending is in US dollars. We turn to the rates of return on foreign liabilities in Table 10. In terms of the results for total foreign liabilities in column (1), we see quite a mixed pattern in terms of the estimated exchange rate coefficients across countries. As was shown also in Table 7, For the United States, the rate of return paid out on foreign liabilities is totally unaffected by movements in the real exchange rate—consistent with the fact that foreign liabilities are almost entirely dollar-denominated and offer returns that are not linked to exchange rate fluctuations (e.g. bank deposits or fixed-interest debt instruments). At the other extreme,

21

In the sample represented in this table, only the Netherlands and Australia record FDI at market value. The US reports positions measured at both book and market value. For comparability with the countries that only report book values, the US estimates in these tables refer only to the book value measure of FDI. However, for the US, if we use the rate of return based on FDI at market value then the exchange rate coefficient in the FDI asset equation is -0.71 (t-stat 1.38) and it is 0.15 (t-stat 0.37) in the FDI liability equation.

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I

the estimated coefficient for Finland is -1.8.22 The fixed-effects panel estimate is -0.68: this generally indicates that exchange rate appreciation is associated with some deterioration in domestic real returns on foreign liabilities.23 With respect to FDI liabilities, column (2) of Table 10 suggests that there is little covariation between exchange rate fluctuations and real domestic returns. In part, this may be attributed to the fact that FDI positions are mostly measured at book value but the insignificance of the exchange rate also suggests that the earnings of foreign affiliates in the domestic market are not (contemporaneously) affected by exchange rate swings. This pattern is worth exploring further but would require the availability of higher-quality data. Similar to the case for FDI liabilities, most of the estimated country coefficients for portfolio equity liabilities are insignificantly different from zero: the domestic-currency real return offered by portfolio equity liabilities is not systematically affected by the exchange rate. Again, this is somewhat surprising to the extent that we might expect domestic stock market booms to be associated with real appreciation.24 Only Canada and Australia show a significant connection between exchange rate movements and the rate of return paid out on foreign bond liabilities. For the others, the results support the caricature of bond liabilities that offer a domestic rate of return that is invariant to exchange rate fluctuations.25 With respect to other liabilities, a number of countries display significantly negative coefficients, with the estimates far above unity for Australia and Spain. For this pair, the pattern is akin to that experienced by emerging 22

Albeit significant only at the 10 percent level. Although a pattern of high real returns plus exchange rate depreciation is also evident in the early 1990s, the most striking period for Finland is the post-EMU 19992002 period: in 1999 the return on its foreign liabilities was large (driven by gains in Nokia's share price during the equity market boom), while its real exchange rate depreciated (on account of the fall in the external value of the euro). In contrast, the stock market reversals of 2001-2002 were accompanied by an appreciating real exchange rate (as the euro's external value recovered). This case is a vivid illustration of the importance of co-movements between exchange rates and asset prices. It also underlines that exchange rates need not always move in a "risk-sharing" manner, which applies a fortiori for members of a currency union that have little influence on the external value of the currency. 23 In no case is the estimated coefficient significantly positive. This is quite surprising, since some of the mechanisms discussed earlier in order to explain a negative relation between exchange rate appreciation and the rate of return on foreign assets should symmetrically imply a positive association between exchange rate appreciation and the rate of return on foreign liabilities. For instance, a positive domestic productivity shock might raise profitability of foreign affiliates operating in the domestic market and generally boost domestic asset prices, while at the same time generating real appreciation. 24 Indeed, there is only one significant country coefficient (Germany), but it is negative and large (-2.9) negative. This means that declines in the German stock market are typically associated with real appreciation. Since the point coefficient is fairly similar for both assets and liabilities, this implies that German real appreciation tends to occur during phases of disappointing global stock returns, since the returns on German overseas assets fall in addition to the returns paid out on domestic stocks owned by foreign investors. 25 Even for Canada and Australia, the pattern of co movement is negative: real appreciation is associated with low domestic rates of return on their foreign bond liabilities. In part, this may suggest that exchange rate movements for these countries have a substantial predictable component, since foreign investors would be prepared to accept a low domestic-currency return if real appreciation were anticipated. The predictability hypothesis receives some support from the empirical work of Chen and Rogoff (2003), who show that "commodity" currencies (such as the Australian and Canadian dollars) are more predictable than other currencies. Of course, another potential contributory factor is the extent to which these countries issue bond liabilities in foreign currency.

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markets: real depreciation is associated with an increase in the foreign-currency return paid to foreign investors. In summary, the regression analysis in Tables 9 and 10 delivers a number of interesting lessons. First, especially on the foreign assets side, exchange rate movements are an important covariate of rates of return, consistent with the operation of a powerful valuation channel. Second, real appreciation is typically associated not only with lower real returns on foreign assets, but also lower real returns on foreign liabilities: at least for small net positions, this implies that the net valuation impact of exchange rate movements on the net foreign asset position has been limited. Third, the sensitivity of returns to exchange rates does vary across investment categories: the composition of the international balance sheet is an important determinant of the aggregate valuation effect. Fourth, the United States behaves quite differently to other countries in that the rates of return on its liabilities (in all investment categories) are unaffected by currency movements. Since dollar depreciation raises the return on its foreign assets, this means that the valuation channel in the US case may indeed be a powerful adjustment mechanism in correcting its large external liability position. We return to the feasibility of this option later in this paper. Exchange Rates and Rates of Return, Emerging Markets In general, we would expect the relation between domestic-currency rates of return and changes in the real exchange rate to be even stronger for emerging markets, which in general have less scope for borrowing or lending in domestic currency. Careful empirical work has to face the severe difficulties in measuring such rates of return: among these, the lack of precise historical data on international investment positions; stock-flow discrepancies; debt reduction and debt forgiveness agreements, and default episodes. While aware of these limitations, we have constructed rough estimates of rates of return on external assets and liabilities for our emerging-market sample. The methodology is based on estimating the stock of external assets and liabilities (Lane and Milesi-Ferretti, 2004c), and using data on interest payments and capital flows to back out rates of return. A simple panel regression with fixed effects of real domestic-currency rates of return on external liabilities on changes in the real effective exchange rate gives a coefficient of -0.86 with a t-statistic of 19.26 As Figure 9 shows, this relation holds not only along the time-series dimension, but also in the cross-section. The Figure shows a strong negative relation (plotted for the year 1997, a year of large exchange rate depreciations in the Asian countries of our sample) between the domestic currency rate of return on external liabilities and the real effective exchange rate. The Valuation Channel in International Macroeconomic Models The preceding empirical analysis has indicated that revaluations are an important contributor to net foreign asset dynamics. However, it has been standard in both the traditional Mundell-Fleming approach and contemporary "new open economy macroeconomics" to consider scenarios in which the initial net foreign asset position is zero and the gross scale of international balance sheets is ignored. This rules out any 26

A similar regression for assets gives a coefficient of -1, consistent with the fact that overseas assets are entirely denominated in foreign currency. 110

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consideration of the valuation channel in terms of macroeconomic behavior and the analysis of alternative policies. However, two important recent exceptions are provided by Benigno (2001) and Tille (2004). In a two-country model, Benigno (2001) shows that monetary shocks have much larger real effects if the initial global steady state is characterized by imbalances in net external positions, since exchange rate movements generate a net valuation effect that has asymmetric effects on home and foreign countries. One implication is that countries will disagree about the optimal monetary policy, since the valuation channel acts to transfer wealth between home and foreign citizens. Tille (2004) considers the case of initially-balanced net foreign positions but allows for different levels of scale in terms of gross holdings of foreign assets and liabilities. Matching the US data, he shows that an increase in gross cross-holdings of domesticcurrency and foreign-currency bonds means that the welfare impact of a surprise monetary expansion is greatly magnified in the case that the foreign-currency share of foreign assets is larger than the foreign-currency share of foreign liabilities. Indeed, his calibration suggests that the welfare impact of the valuation channel is 350 percent more powerful than the traditional channel, since devaluation confers a sizeable capital gain on the home country in his setup. Clearly, much remains to be done to improve the theoretical treatment of the valuation channel in macroeconomic models. For instance, it would be highly desirable (albeit extremely challenging) to incorporate a realistic profile of the international balance sheet (with its mix of FDI, portfolio equity and debt instruments) and jointly determine the equilibrium response of real variables, asset prices and exchange rates to various shocks and policies. In this regard, Hau and Rey (2003) and Pavlova and Rigobon (2003) have made interesting recent attempts to jointly model financial returns and exchange rates. Finally, another important research question is to assess the contribution of the valuation channel to persistent shifts in net foreign assets. That is, the valuation effects induced by currency and asset price movements can generate volatility in the value of external assets and liabilities but it is an open question as to how important are valuation effects versus current account imbalances in driving the lower-frequency component of net foreign asset dynamics. On the agenda for future research is a better characterization of the relation between exchange rate movements and net foreign asset positions over time: for instance, the impact effect may primarily operate through the valuation channel, with a longer-term contribution via gradual adjustment in the current account to a sustained real exchange rate movement. Policy Implications As was emphasized in discussing equation (6) above, financial globalization increases the empirical relevance of the valuation channel for exchange rate movements. Improving quantitative understanding of the valuation channel is obviously desirable, in order to keep better track of the dynamics of net foreign assets and international wealth effects. One helpful innovation would be for the relevant national statistical agencies to collect more information on the role played by currency movements in determining rates of return on foreign assets and liabilities. From a policy perspective, does the valuation channel offer a reliable method to address an excessive net external liability position? Gourinchas and Rey (2004) provide 111

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some evidence for the US that historical adjustment in its net foreign asset position has indeed in part relied on the valuation channel, with the exchange rate responding in a predictable, systematic manner during phases when its external position was "unsustainable." However, there is good reason to be skeptical that the valuation channel can be relied upon to solve adjustment problems. Even for those countries for which a one-time surprise devaluation may indeed generate a positive valuation effect that improves the net foreign asset position, such a move would involve a reputational cost: future investors would require a larger premium in order to compensate for the risk of subsequent devaluations. Indeed, such manipulation of the exchange rate creates a classic timeconsistency problem, with the standard recommendation that policymakers take steps to commit to not using the devaluation option as a form of capital levy. While the severity of this problem is one of the underlying factors behind the prevalence of liability dollarization and short-maturity debt among the emerging market nations, it may yet have increasing bite for major debtors among the advanced nations.27 Moreover, as has been highlighted repeatedly in this paper, it is important to recognize that the U.S. is a special case, in view of its ability to issue a large proportion of its liabilities in dollars. This capacity is related to the dollar's status as the default reserve currency and "safe haven." In turn, the dollar status helps explain the systematic positive difference between the rate of return gained on U.S. external assets and the one paid out on its liabilities. Nevertheless, further substantial increases in the U.S. net debtor position would raise the prospect of a substantial U.S. dollar depreciation, with the associated capital losses inflicted on U.S. creditors. In turn, this may threaten the special status of the dollar, also in light of the emergence of the euro as an alternative international reserve currency, and raise the rate of return required by foreign investors on dollar instruments. It is interesting to speculate on the trend implications of financial globalization for exchange rate volatility. Along one dimension, if financial globalization improves international risk sharing, then more similar wealth dynamics could lead to more correlated aggregate demand patterns and thereby reduce the need for exchange rate shifts. However, as has been recently emphasized by Kalemli-Ozcan et al. (2003) and Heathcote and Perri (2004), greater cross-border risk-sharing could also permit increased specialization in production, with sectoral shocks under that scenario translating into greater real exchange rate variability. Along another dimension, the diversification of risks afforded by financial globalization may also permit greater dispersion in net foreign asset positions, through a weakening of the association between external imbalances and country risk premia. If that is the case and the pace of "real" globalization (i.e. the international integration of product markets) does not proceed sufficiently quickly, then large-scale real exchange rate movements may increase in frequency, as part of the adjustment process in coping with enlarged global imbalances. 27

Alberola (2003) discuss the impact of liability dollarization on the path of exchange-rate adjustment in emerging markets. He argues that the real exchange rate will tend to overshoot its equilibrium level, due to the need to foster higher current account surpluses in the aftermath of depreciation to make up for to the increase in liabilities.

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In light of these opposing forces, it is difficult to make a firm prediction about the net impact of ongoing financial globalization on exchange rate volatility. In turn, while financial globalization shifts the terms of the debate about the relative merits of alternative exchange rate systems, it does not obviously tilt the balance in one direction or the other in deciding between floating and fixed regimes. Of course, the acceleration of financial globalization in the 1990s also had a large impact on exchange rates, by arguably increasing the prevalence and severity of currency and financial crises. The policy response to the 1990s series of crises has been to emphasize the importance of adequate domestic financial regulation, the fragility of pegged exchange rates and robust fiscal control. However, our emphasis on the roles played by exchange rates and rates of return in driving net foreign asset dynamics also raises the question of whether national governments should seek to mould the international balance sheet in some fashion, either directly or by providing incentives to the private sector to insure against particular financial vulnerabilities. The rapid growth in official external reserves in many countries in recent years can be interpreted as one response to the risks associated with financial globalization. In addition, increased direct investment and portfolio equity flows can in principle improve risk-sharing by tying rates of return on external liabilities to domestic macroeconomic conditions. Although the literature is expanding rapidly, more research on this question is clearly needed. Concluding Remarks This paper has been concerned with the macroeconomic implications of financial globalization. Having established recent patterns in terms of gross and net international asset trade for both advanced and emerging market economies, we have shown that the dynamics of net foreign asset positions crucially depend on an array of factors beyond the value of the trade balance: stocks matter, as well as flows. In particular, we have focused on the importance of the valuation channel of exchange rate adjustment: currency fluctuations influence the rates of return on the inherited stocks of foreign assets and liabilities, in addition to operating through the traditional trade balance channel. In turn, this raises a set of substantive policy questions about the optimal external capital structure and the exploitability of the valuation channel as an adjustment mechanism. An open question is how much further the financial globalization process will go: is the end point the idealized scenario of "perfect market integration", or will barriers such as trade costs and imperfect information place a limit on the extent of integration? The impact of financial globalization on exchange rate behavior and the international adjustment mechanism is likely to remain near the top of the research and policy agendas. We hope that much clearer answers can be given at the "100 Years After Bretton Woods" conference in 2044.

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References Alberola, Enrique, (2003), Misalignment, Liabilities Dollarization, and Exchange-Rate Adjustment in Latin America, Banco de Espafla, Documento de Trabajo 0309. Benigno, Pierpaolo, (2001), "Price Stability with Imperfect Financial Integration," mimeo, New York University. Chen, Yu-Chin, and Kenneth Rogoff, (2003), "Commodity Currencies," Journal of International Economics, Vol. 60, pp. 133-160. Gourinchas, Pierre-Olivier, and Helene Rey, (2004), "International Financial Adjustment," mimeo, UC-Berkeley and Princeton University. Hau, Harald, and Helene Rey, (2003), "Exchange Rates, Equity Prices and Capital Flows," mimeo, INSEAD and Princeton University. Heathcote, Jonathan, and Fabrizio Perri, (2004), "Financial Globalization and Real Regionalization," Journal of Economic Theory, forthcoming. Hooper, Peter, Karen Johnson, and Jaime Marquez, (2000), "Trade Elasticities for G-7 Countries," Princeton Studies in International Economics No. 87. International Monetary Fund, (1993), Balance of Payments Manual, 5th edition, Washington, DC. Kalemli-Ozcan, Sebnem, Bent Sorensen, and Oved Yosha, (2003), "Risk Sharing and Industrial Specialization: Regional and International Evidence," American Economic Review, 93, June 2003, pp. 903-918. Lane, Philip R., and Gian Maria Milesi-Ferretti, (2001 a), "The External Wealth of Nations: Measures of Foreign Assets and Liabilities for Industrial and Developing Countries," Journal of International Economics, 55, pp. 263-294. —, (2001b), "External Capital Structure: Theory and Evidence," in H. Siebert (ed.) The World's New Financial Landscape: Challenges for Economic Policy, BerlinHeidelberg: Springer-Verlag, pp. 247-284. ———, (2002a), "Long-Term Capital Movements," NBER Macroeconomics Annual 16, pp. 73-116. —, (2002b), "External Wealth, the Trade Balance and the Real Exchange Rate," European Economic Review, 46, pp. 1049-1071. , (2003), "International Financial Integration," International Monetary Fund Staff Papers, 50(S), pp. 82-113. , (2004a), "International Investment Patterns," IMF Working Paper 04/134, June. — , (2004b), "The Transfer Problem Revisited: Net Foreign Assets and Real Exchange Rates," Review of Economics and Statistics 86, November. , (2004c), "The External Wealth of Nations Mark H: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2003," in progress. Obstfeld, Maurice, and Alan Taylor, (2004), "Global Capital Markets: Integration, Crisis, and Growth," Cambridge University Press. Pavlova, Anna, and Roberto Rigobon, (2003), "Asset Prices and Exchange Rates," mimeo, MIT. Sullivan, Martin A., (2004), "Shifting of Profits Offshore costs US Treasury $10 Billion Or More," Tax Notes, 104, pp. 1477-1481.

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Tille, Cedric, (2003), "The Impact of Exchange Rate Movements on U.S. Foreign Debt," Current Issues in Economics and Finance 9(1), Federal Reserve Bank of New York. — , (2004), "Financial Integration and the Wealth Effect of Exchange Rate Fluctuations," mimeo, Federal Reserve Bank of New York.

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Appendix Industrial countries sample: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, United Kingdom, United States. Emerging markets sample: Argentina, Brazil, Chile, Colombia, Mexico, Venezuela, China, India, Indonesia, Korea, Malaysia, Philippines, Taiwan province of China, Thailand, Czech Republic, Hungary, Poland, Russia, Israel, South Africa, Turkey.

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Table 1. Net capital outflows and changes in net external position Industrial countries, 1999-2003 Net outflows Pet. of 2003 GDP Billions US$ Japan Switzerland Norway Canada Euro Area* Sweden Denmark New Zealand Australia United Kingdom United States

558 167 75 74 40 33 24 -7 -88 -139 -2246

13.0 53.8 34.1 8.5 0.5 10.9 11.4 -9.7 -17.3 -7.8 -20.4

Change in net foreign assets Billions US$ Pet. of 2003 GDP 452 82 86 -43 -205 9 9 -4 -157 134 -1594

10.5 26.6 38.9 -5.0 -2.5 2.8 4.2 -4.9 -30.8 7.5 -14.5

* Change in the net foreign asset position calculated as the sum of the change in the net positions of Austria, Belgium, Finland, France, Germany, Greece, Italy, Netherlands, Portugal, and Spain. Source: IMF, Balance of Payments Statistics, and Lane and Milesi-Ferretti (2004c).

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Table 2. Gross capital flows to and from industrial countries (1999-2003) Capital inflows billions US$

United States

4167

Euro Area United Kingdom

Capital outflows

percent of 2003 GDP

trillions US$

percent of 2003 GDP

billions US$ 3250

1922

17

3569

38 44

3609

2387

133

2247

44 125

111 26

Sweden

343 223 212 190

165 34 24 74

Denmark

143

68

510 297 124 223 167

Norway Japan New Zealand

121 106 23

55 2.5 29

196 664 15

89 15

Switzerland Canada Australia

42 63

Change in foreign liabilities

79

20

percent of 2003 GDP

Change in foreign assets

biilionsUSS

percent of 2003 GDP

30

1656

15

...

...

...

2794

468 301 346 191 184

148 151 35 68 63 87

551 258 189 199

155 178 30 37 66

167 147 24

75 3 31

193 253 599 20

91 114 14 26

2660

Source: IMF, Balance of Payments Statistics and Lane and Milesi-Ferretti (2004c).

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Table 3. Cumulative net capital flows to selected emerging markets, 1999-2003 Total billions US$

74.8 70.3 37.9 22.1 16.7 14.8 14.1

Brazil Mexico Poland Hungary Czech Republic Turkey Argentina

excluding IMF and exceptional financing Percent of billions Percent of 2003 GDP US$ 2003 GDP "Borrowers" 15.2 11.2 18.1 26.7 18.7 6.2 11.1

52.9 78.2 37.9 22.1 16.7 -6.4 -21.2

10.7 12.5 18.1 26.7 18.7 -2.7 -16.7

-131.5 -118.4 -62.5 -40.8 -44.8 -33.5 -27.7

9.3 27.3 21.8 6.7 31.3 16.1 26.7

"Lenders" China Russia Taiwan pr. of China Korea Thailand Indonesia Malaysia

-131.5 -117.4 -62.5 -56.7 -44.1 -33.3 -27.7

9.3 27.1 21.8 9.4 30.8 16.0 26.7

Source: authors' calculations based on IMF, Balance of Payments Statistics.

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Table 4. Indicators of International Financial Integration, Emerging Markets (percent of GDP)

1982

1992

2002

Average net external position

-32.6

-24.5

-26.2

Average external assets of which: foreign exchange reserves FDI + portfolio equity

15.8

24.9

55.5

5.7 1.3

10.9 3.0

19.61 12.1

Average external liabilities of which: FDI + portfolio equity

48.4

49.4

81.7

7.4

11.1

32.9

Source: authors5 calculations based on Lane and Milesi-Ferretti (2004c) and IMF, Balance of Payments Statistics

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Table 5. Gross capital flows to and from selected emerging markets, 1999-2003 Capital inflows Total Excluding IMF and except, fin. billions Percentage billions US$ Percentage of US$ 2003 GDP of 2003 GDP

Total

Capital outflows

billions US$

Percentage of 2003 GDP

1

FX reserves

billions Percentage of US$ 2003 GDP

18.3

259.1

18.3

390.6

27.7

258.6

18.3

24.4

69.9

24.4

132.4

10.9

81.7

13.5

122.5

72.1 91.9

25.2 15.2

63.7 110.4 80.3

86.7

63.5 88.4 88.2

86.5 18.0

3.6 2.1 28.0

4.9 0.4 4.5

26.2 5.7 50.7

54.8

Chile

54.8 32.9 34.1

34.1

14.1 26.2 5.7 50.7

82.1 35.6 10.0

46.3 20.2 111.7 7.2 1.6

16.9 37.9 29.0

8.1 6.5 43.0

2.2 41.0 -1.2

1.1 7.1 -1.8

Indonesia Thailand

-21.6 -32.2

-10.4 -22.5

-21.8 -32.9

-10.5 -23.0

11.7 11.9

5.6 8.3

10.8 8.6

5.2 6.0

China Taiwan prov. of China Korea Philippines Brazil Mexico

Poland India

259.1 69.9 65.7

22.4

12.8

33.3

Source: authors1 calculations based on IMF, Balance of Payments Statistics and national sources.

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W~V~~»WWVWI~VM«~~VVV~M*~J

Table 6. Decomposition of change in foreign assets for selected emerging markets, 1991-2002 (percent of GDP) -,,_ . ?ange«.ne roreign assets

0 1 * . ' Cumulative current account Cumulative trartp.

Brazil Czech Republic Indonesia Mexico Thailand Turkey

-30.6 -29.4 -6.1 -8.8 -10.0 -21.3

Cumulative halanre.

2.8 -23.5 59.3 -6.2 31.0 14.2

-30.6 -16.2 -53.3 -36.3 -31.8 -23.1

„ t . , Cumul. capital acct + etrcls& omissions

Other factors Growth

K-gainsetc

investm Tnrntnfi

-0.6 -0.2 0.8 -2.9 -6.7 -0.1

effent

10.9 -0.1 26.1 17.7 19.4 11.6

Note: the breakdown of changes in the net foreign asset position reflects equation (5) in the text. Source: IMF, International Financial Statistics, and Lane and Milesi-Ferretti (2004c).

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_ , Perc. change in realeff exchange rate

-13.1 10.5 -39.0 19.0 -21.9 -23.9

-47.9 35.8 -16.1 32.5 -18.2 -2.9

Table 7. US: Relative Contributions of Flows, Market Values and Exchange Rates to Dynamics of the International Balance Sheet, 1990-2003 Mean 1990-95 1996-2001 2002-03

Standard Deviation 1990-2003

CON FLOW_FA CON_FLOW_FL

0.056 0.081

0.081 0.108

0.034 0.082

0.030 0.029

CON MV FA CON_MV_FL

0.031 0.022

0.038 0.034

-0.016 -0.021

0.088 0.066

CON_ER_FA CON_ER_FL

0.008 0.000

-0.017 -0.003

0.055 0.005

0.030 0.004

Source: US Bureau of Economic Analysis (BEA). We thank Cedric Tille for kindly sharing in electronic form his history of the BEA data releases. Table 8. Australia: Relative Contributions of Flows, Market Values and Exchange Rates to Dynamics of the International Balance Sheet, 1988.3-2004.2 1988.31993.3

Mean 1993.41997.21997.1 2001.1

CON FLOW_FA CON]_FLOW_FL

0.090 0.017

0.078 0.040

CON MV_FA CON__MV_FL

0.017 0.014

CON ER_FA CON] ER_FL

0.020 0.014

Standard deviation 2001.22004.2

1988.3-2004.2

0.081 0.061

0.090 0.016

0.072 0.036

0.040 0.005

0.061 0.024

0.016 0.007

0.128 0.052

-0.023 -0.013

0.083 0.031

-0.022 -0.012

0.11 0.047

Source: Authors' calculations based on data from the Australian Bureau of Statistics.

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Table 9. Exchange Rates and Rates of Return on Foreign Assets I 1

iI 1 USA

(1) Total

(2) FDI

-0.37***

-0.57***

~ -1.24

| UK

-1.01***

-0.83***

| Austria

-1.34**

-3.85**

j

j

France

(3) Port Eq

(4) Port Debt

(5) Other

-0.65***

-0.11

-0.74

-1.01***

-0.96***

-2.49***

-1.16***

-0.45***

-0.61

-0.37

-0.42

-0.36

Germany

-0.88***

-1.04***

| Italy

-1.08***

-1.17***

| Netherlands

-0.38

-0.33

-0.74*

-0.63**

Sweden j

•

! Switzerland

i

-1.07***

-0.62**

Canada

-0.66***

-0.46*

Finland

-1.09***

-1.07**

Iceland

-0.85

-0.5

Spain

-0.69***

-1.62***

-0.55

-1.62***

-0.61**

I Australia

-0.57***

-0.65**

-0.55*

-0.89***

-0.41*

I Panel

-0.78***

-0.76***

-0.97***

-0.89***

-0.63***

!

-2.43***

-0.8**

-0.93***

-0.97***

-0.86*** i

!

Note: Beta coefficients from regression of rate of return on real appreciation. ***^**5* denote significance at the 1,5 and 10 percent levels respectively. OLS with robust standard errors. Panel estimation includes country fixed effects (not reported). Full regression results available from the authors upon request. Data availability varies by country, within 1980-2003 span. Source: authors' calculations based on IMF, Balance of Payments Statistics, and Lane and Milesi-Ferretti (2004c).

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Table 10. Exchange Rates and Rates of Return on Foreign Liabilities

(lj Total

(2) FDI

(3) PortJEq

(4) PortJDebt

(5) Other

USA

0.014

0.08

0.36

-0.26

0.05

UK

-0.92***

-0.1

-0.52

-0.46*

-0.78***

Austria

-0.95

-0.35

-2.9**

-0.45

-0.15

-0.48

-0.03

-0.20

-0.57

-0.77

-0.84***

-0.81***

-0.67***

France

0.85

Germany

-0.49**

-1.04

Italy

-0.71***

-0.14

Netherlands

-0.12

-0.33*

Sweden

-0.77***

-0.21

Switzerland

-0.73***

-0.14

Canada

-0.52***

0.06

| Finland

-1.79*

0.91

Iceland

-1.33***

-1.43

Spain

-0.69***

0.15

-1.28

-0.9

-1.52**

Australia

-0.31***

0.02

-0.44

-0.64***

-1.68***

Panel

-0.68***

-0.09

-0.56*

-0.60**

-0.79***

!

|

Note: Beta coefficients from regression of rate of return on real appreciation. ***9**5* denote significance at the 1, 5 and 10 percent levels respectively. OLS with robust standard errors. Panel estimation includes country fixed effects (not reported). Full regression results available from the authors upon request. Data availability varies by country, within 1980-2003 span. Source: authors' calculations based on IMF, Balance of Payments Statistics, and Lane and Milesi-Ferretti (2004c).

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Figure 1. Net foreign asset position (ratio of GDP) and GDP per capita Industrial countries, 2003

Sources: IMF, World Economic Outlook (GDP per capita) and Lane and Milesi-Ferretti (2004c) (net foreign assets).

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Figure 2. Composition of international portfolio, industrial countries (sum of assets and liabilities as a ratio of GDP, 1980-2003)

Note: Chart plots the sum of aggregate equity, FDI, and debt assets and liabilities as a share of aggregate GDP for a sample of industrial countries including: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Iceland, Italy, Japan, Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom, United States. The sample choice is dictated by data availability. Source: Lane and Milesi-Ferretti (2004c).

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Figure 3. Average and aggregate current account to GDP ratio Emerging markets sample, 1970-2003

Figure 4. Average & aggregate net external position, emerging market sample, 1982-2003*

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

9

Source: authors calculations based on IMF, Balance of Payments Statistics and Lane and Milesi-Ferretti (2004c).

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2002

Figure 5. Net foreign assets and GDP per capita Emerging markets sample, 2002

Sources: IMF, World Economic Outlook (GDP per capita), and Lane and Milesi-Ferretti (2004c) (net foreign assets).

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Figure 6. Indicators of international financial integration, emerging markets

1982

1984

1986

1988

1990

1992

1994

1996

1998

Source: Authors' calculations based on Lane and Milesi-Ferretti (2004c).

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2000

2002

Figure 7. United States: Components of change in external assets and liabilities, 19902003

Source: Authors' calculations based on Tille (2003) and updated data provided by Cedric Tille.

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Figure 8. Australia: Components of change in external assets and liabilities, 1989-2003

Source: authors1 calculations based on Australian National Statistics

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Figure 9. Real rate of return on external liabilities and changes in real exchange rate Emerging market sample, 1997

Note: the real domestic currency rate of return on external liabilities is constructed as the sum of the yield (interest payments in 1997 divided by the stock of liabilities at end-1996) and the capital gain rate (change in stock of external liabilities between 1997 and 1996 minus flow, divided by stock of external liabilities at end-1996). The change in the real exchange rate is the percentage change in the CPI-based real effective exchange rate between end-1997 and end-1996. Source: authors9 calculations based on IMF, Balance of Payments Statistics, International Financial Statistics, and Lane and Milesi-Ferretti (2004c).

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What Makes Balance Sheet Effects Detrimental for the Country Risk Premium?*

Juan Carlos Berganza Alicia Garcia Herrero Banco de Espafia

*This paper is a draft as of May 2004. Correspondence may be directed to the authors at [email protected] or [email protected] The opinions expressed are those of the authors' and not necessarily those of Banco de Espana. The authors would like to thank Lucia Cuadro for excellent research assistance, and Raquel Carrasco, Eduardo Levy-Yeyati, Juan Manuel Ruiz and Jose Vinals for their useful comments on a previous draft of the paper. Remaining errors in this preliminary draft are only ours.

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Introduction During the second half of the 1990s emerging countries have experienced very large swings in the external cost of capital as well as several financial crises, with a large impact on economic growth. For this reason, academics and practitioners interested in emerging economies are paying increasing attention to the determinants of a country's risk premium. An important one is the real exchange rate, since it is particularly volatile in emerging regions, as compared to industrial ones. Besides, there is a strand of literature exploring the direct link between real exchange fluctuations and economic performance, which can serve as a basis to analyze the relation between the real exchange rate and the risk premium. Conventional open economy models, and in particular the influential MundellFleming, argue that real depreciations have an expansionary effect by switching global demand towards domestic production. Already in 1986, Edwards (1986) challenges this view on several grounds: the possible contractionary effect of a higher price level after a devaluation as well as a potential negative impact on income distribution. He also finds some evidence of a small contractionary effect for a sample of 12 developing countries. More recently, theories based on what has started to be known as the open economy Bernanke-Gertler-Gilchrist financial accelerator, have challenged the Mundell-Fleming view. If a country's debt is denominated in foreign currency, a real depreciation will reduce the country's net worth through a balance sheet effect and, in the presence of financial imperfections, may increase the cost of capital. This is particularly relevant for emerging economies given their relatively large share of foreign currency denominated debt, the frequency of large real depreciations and the presence of financial imperfections. In an earlier work, Berganza, Chang and Garcia Herrero (2003) develop a simple theoretical framework to understand the relation between balance sheets stemming from the increase in the external debt service after a real depreciation - and a country's risk premium and find evidence a positive relation between the two. This could have several policy implications, such as the need to reduce foreign currency indebtness and/or limit, to the extent possible, financial imperfections. It could also have implications for the choice of the exchange rate regime since avoiding real exchange rate depreciations becomes crucial for a country's cost of credit. Given the relevance of the matter, it seems worthwhile investigating the issue further. In particular, we would like to understand why - and under which circumstances- balance sheet effects increase a country's cost of borrowing. Among these questions we shall study: (i) Whether real exchange depreciations are detrimental for country risk; and to what extent and under which circumstances this is the case, (ii) Whether real exchange appreciations are beneficial, (iii) Which are the channels of influence of a real depreciation on country risk; in particular, whether "domestic" balance sheets, stemming from the increase in domestic foreign currency denominated debt after a real depreciation are as important as "external" balance sheet effects, (iv) What is the role of competitiveness, as the most important channel in the traditional literature of the expansionary effects of real depreciations, (iv) Whether balance sheet effects are influenced by the existence of financial imperfections, as one would expect from the financial accelerator literature. And, finally (iv) Whether the exchange rate regime plays a role in how balance sheets affect country risk, beyond the extent of real depreciation. Investigating these issues will help us delimit the extent to which emerging countries should worry about real depreciations, depending on their own characteristics. 137

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In the same vein, it should contribute to identifying which are the most appropriate policy actions to minimize this problem. Review of the Literature Most theoretical models on the impact of balance sheet effects draw from the open economy version of the financial accelerator, developed by Gertler, Gilchrist and Natalucci (2003). They generally show that balance sheet effects, related to a sudden reduction in net wealth, are detrimental either in terms of the cost of capital or output. However, this result hinges on the existence of financial imperfections. Given these conditions, the ultimate answer to the question of whether balance sheet effects are detrimental and when will be an empirical one. To our knowledge the only work which deals with this issue at the macro level is that of Berganza, Chang and Garcia-Herrero (2003), who find that balance sheet effects -stemming from the increase in the external debt service after a real depreciation - raise a country's risk premium for emerging economies. As for firmlevel data, Forbes (2002) analyzes the impact of 12 major depreciations on a sample of emerging countries' large firms and finds no significant balance sheet effects on performance although firms with higher debt ratios tend to show lower net income growth. It should be noted, though, that Forbes does not take into account the currency composition of debt. In the same vein, Bleakley and Cowan (2002) show evidence that the competitiveness effect associated with exchange rate depreciations offsets the potential contractive balance sheet effect on investment for a panel of Latin American firms. The authors, therefore, conclude that there is no severe currency mismatch of output and liabilities in their sample. This optimistic result should, however, be taken cautiously, since no country fixed effects are considered and Brazilian firms account for half of the observations. In fact, when each country is analyzed separately, always with firm-level data, there is evidence of detrimental balance sheet effects on investment in some countries (namely, Colombia, Mexico and Peru) but not in others (Brazil, Chile)1. Furthermore, a macroeconomic empirical analysis, such as ours, may offer a more pessimistic picture of balance sheet effects in as far as it is not only the tradable sector which is considered but the whole economy. This has fewer possibilities to hedge its negative wealth in foreign currency than the group of large firms considered in the firm-level empirical studies. Objective of the Paper The objective of this paper is to investigate, at the aggregate level, whether and in which way real exchange rate depreciations increase a country's risk premium, with particular attention to balance sheet effects. To this end, a number of questions are analyzed. The first is whether an exchange rate depreciation increases a country's risk premium and under which circumstances this is the case. In principle, this should happen if balance sheet effects more than counterweigh the expected increase in competitiveness associated with a real depreciation. The question is why it is so for some countries and not for others. Identifying these differences is not an easy task but certainly interesting for policy makers, so as to know to which extent they should worry about real depreciations. ^alindo, Panizza and Schiantarelli (2003) offer a survey of the results.

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A second interesting question is whether the impact of real exchange rate depreciations and appreciations is symmetric. An asymmetry - whereby appreciations had no significant impact - would make the volatility of the real exchange rate more of a cause of concern for policy makers since there would be no instance to benefit from it (i.e., from appreciations). Financial accelerator theories argue in favor of an asymmetric effect of changes in net wealth since agency problems may only be binding when the debtor's situation worsens (Bemanke and Gertler, 1989). Another reason for such an asymmetry could be drawn from the literature on liquidity constraints, which should only be relevant when a sudden increase in indebtness occurs and not when there is a net worth gain. A related question is whether the extent of a real depreciation affects the risk premium more than proportionally; that is, if its impact is non-linear. If the answer is yes, this may have a bearing on the choice of the exchange rate regime since there may be no need to worry about small depreciations but only about large events. Such non linearity could be expected on the basis of the same arguments as before since large changes in net worth should make financial and liquidity problems much more binding than relatively smaller ones. The third question relates to the channels through which real exchange depreciations affect the risk premium. The most well known channel, the gain in competitiveness, should reduce the risk premium the more open a country is to trade. The other crucial channel is that of balance sheet effects, stemming from a sudden reduction in net financial wealth. In the case of emerging countries, it seems safe to think of negative net financial wealth because of the generally large stock of debt that they have accumulated. In the financial accelerator literature, however, balance sheet effects hinge on the existence of financial imperfections, which we also need to test for. One interesting issue for policy makers is whether all balance sheets are the same; in other words, whether an increase in the stock of foreign currency-denominated debt held by non residents ("external" balance sheets) can have the same detrimental effect on the risk premium as an increase in the stock of foreign currency-denominated debt held by residents ("domestic" balance sheet effects). If the former were larger, this would be an argument in favor of increasing a country's domestic indebtness, even if in foreign currency, as compared to external indebtness.2 The rationale behind a lower cost of domestic balance sheet effects may be that having residents as holders of a country's dollar liabilities, these will benefit from a real depreciation compensating, at least partially, the loss of wealth of the borrowers. In other words, the real depreciation will have distributional effects but will not necessarily reduce net financial wealth, as for external balance sheets. The extent of the wealth effects of domestic balance sheets may depend on what resident creditors do with their wealth gain. If they are uncertain about repayment and/or the economic situation deteriorates sharply, they may opt for capital flight, eliminating the positive impact of the wealth gain on domestic spending or investment. The extent to which they reinvest their additional wealth may actually hinge on the existence of financial imperfections. The fourth question relates to the existence of financial imperfections, a crucial condition for balance sheet effects to be relevant in the financial accelerator theories. Given that our sample is composed of emerging countries, one could argue that they all suffer from financial imperfections. However, the degree to which this is the case varies from country to country. This is why it seems worth testing whether the countries with larger imperfections are also those who suffer from larger balance sheet 2

This, however, might not be in the range of options available to policymakers if domestic savings are very low.

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effects. In addition, the role of financial imperfections could be different for domestic and external balance sheets. On the one hand, one could argue that external creditors are less affected by financial imperfections if the external debt is issued outside the country, but it is also true that the sovereign debtors have the power to change the rules of the game even in this case. In addition domestic creditors may be better informed of their rights, or possible changes in their rights. The fifth and final issue is the role of the exchange rate regime on how balance sheets affect country risk, beyond the extent of exchange rate change. Several authors have developed this idea theoretically but no empirical test exists yet. Based on the financial accelerator literature, Gertler, Gilchrist and Natalucci (2003) argue that fixed exchange regimes amplify balance sheet effects because they force the central bank to adjust interest rates in a manner that enhances financial distress. Cespedes, Chang and Velasco (2000) show that flexible exchange rates play an insulating role in the presence of real external shocks so that the output and investment fall by less than under fixed exchange regimes. The channel is the higher expected real depreciation under a pegged regime, and thereby the increase in interest rates, since policy makers will tend to maintain the exchange rate regime during a relatively long period so as to minimize the size of the change in the relative prices. Another idea for pegged exchange rate regimes to be detrimental for financial fragility is that agents tend to feel more protected from exchange rate risk and do not hedge against it (Burnside, Eichenbaum and Rebelo (2001)). In this line, Ize and Levy-Yeyati (2003) and Broda and Levy-Yeyati (2003) argue that a pegged exchange regime may induce dollardenominated indebtness, and financial dollarization in general, because it can be taken as an implicit insurance by the private sector, as well as a demonstration effect from the part of the government that the exchange rate regime is credible and will be maintained.3 On the other hand, Elekdag and Tchakarov (2004) show that fixed regimes can be superior for countries with a high level of indebtness and whose monetary policy is constrained. This is, therefore, a question worth tackling empirically. We interact each country's exchange rate regime with external and domestic balance sheets, and test whether their detrimental effect on the risk premium is larger for fixed regimes. Both de-jure and de-facto regime classifications are used. Data Issues and Empirical Strategy The focus on the country as a whole and, thus, the use of macroeconomic data substantially limits the number of observations for this study. This is even more the case given the difficulties of proxying our dependent variable, country risk. The most widely used proxy in the literature are the returns implicit in the Emerging Markets Bond Indices (Embi) provided by JPMorgan, after having subtracted total returns of US treasury bonds4 (from now onwards this variable shall be named Embi). Appendix II offers details on variable definitions and data sources. The choice of the Embi, together with the condition we impose that at least four observations of Embi returns exist, limits our sample to 27 emerging economies and to the period 1993 to 2002 for most 3 Although this idea cannot be fully tested with the data available, Galiani, Levy Yeyati and Schargrodsky (2003) find indirect evidence that the currency board acted as an implicit insurance for the case of Argentina. 4 It should be noted that Embi spreads reflect sovereign risk while our objective is broader: country risk in general since we do not concentrate on public debt only but in all debt denominated in foreign currency, be it public or private. In any event, the Embi spread continues to be the best available proxy as sovereign spreads are generally a floor for private sector country risk.

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countries (for some countries the timeframe is even shorter). This yields an unbalanced panel with a total of 210 annual observations (Table 1 in Appendix I). The geographical distribution of the observations among regions can be found in Table 2 in Appendix I. All major emerging regions are represented although Latin America is overweighted (with 9 countries and 71 of the observations) and the Middle East is underweighted. Apart from the dependent variable (Embi\ the focus of this study is the change in the real exchange rate. Two different measures are calculated: The first is relevant for foreign currency indebtness, namely the bilateral nominal exchange rate against the US dollar adjusted by the domestic inflation (Real Exchange Rate Change). We use the bilateral exchange rate since we assume that all foreign currency debt is denominated in US dollar. This is a relatively safe assumption for the countries in our sample. The second measure is relevant for competitiveness, namely the effective real exchange rate against the major trading partners (Multilateral Real Exchange Rate Change). The other crucial concept is that of balance sheet effects, which stem from a reduction in financial net wealth after a real depreciation. In emerging countries we can safely assume that financial wealth is negative and corresponds with the increase in the stock of foreign currency-denominated debt. In other words, although we use a concept of gross (negative) financial wealth, net financial wealth is bound to be negative, although probably smaller. The main difference probably lies in the size of international reserves, which we shall include as a robustness exercise. Our results do not change. Another interesting issue is whether what matters to measure balance sheet effects is the change in the stock of debt, because of the depreciation, or the change in the amount a country needs to pay on that year (the debt service). We shall use the stock of debt as first option, since it is more in line with the concept of net wealth in the financial accelerator literature, but robustness test will be conducted with the debt service. The results do not change. We differentiate between domestic and external balance sheet effects. External Balance Sheets are composed by the foreign-currency denominated debt held by non residents at the end of the previous period (External Debt_l) multiplied by the Real Exchange Rate Change. In turn, Domestic Balance Sheets are composed of the foreigncurrency denominated debt held by residents at the end of the previous period (Domestic Debt_l) multiplied by the Real Exchange Rate Change. We take the previous period to avoid mixing quantity effects, stemming from new indebtness from t-1 to t, with price effects, from the real exchange rate change. The best available proxy for Domestic Debt for the sample of countries in this study,5 are the banking system's dollar denominated deposits. De Nicolo, Honohan and Ize (2003) and Levy-Yeyati (2004) argue that the banking system's dollar denominated deposits should be very close to the banking system dollar-denominated credit to the private sector. In fact, prudential regulations generally oblige banks to maintain very small open positions in foreign currency. In addition, banks' dollar denominated credit to the private sector should practically be equal to the total domestic indebtness of the private sector in foreign currency except for the dollar-denominated debt this sector may issue domestically. This is bound to be negligible in most emerging countries. As for the case si External Debt, Domestic Debt is a gross concept of (negative) financial wealth since the private sector can hold assets in foreign currency and not only liabilities. The difference between the two, however, is that External Debt includes all sectors of the 3 We would also like to use data on domestic public debt denominated in foreign currency as collected by Reinhart, Rogoff and Savastano (2003) but it is only available for a small number of the countries we have included in our analysis.

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economy and Domestic Debt only the private sector. In any event, it seems reasonable to think that the public sector will also have negative wealth in foreign currency held by residents. Financial imperfections are proxied by a variable measuring the quality of the institutional setting affecting the risk of investment (Creditor Rights). It is the sum of three subcomponents: contract viability or expropriation, profits repatriation and payment delays. Since this definition of creditor rights is more oriented towards external creditors, we can consider it as a ceiling for the creditor rights of domestic creditors in as far as emerging countries generally give priority to external debt payments in case of difficulty. Competitiveness, the other relevant channel of influence of real exchange rate depreciations, is measured by the interaction of a country's openness (Openness) and the change in the effective real exchange rate (Multilateral Real Exchange Rate Change). As regards the exchange rate regime, we use both de facto and de jure classifications. In the former, the underlying exchange rate regime is inferred from the observed exchange rate movement. The classification by Rogoff and Reinhart (2004) is the preferred option since it allows us to keep a larger number of observations than other classifications, such as Levy-Yeyati and Sturzenneger (2003). The de jure classification is based on the IMF Annual Reports on Exchange Rate Arrangements and Exchange Restrictions. Given the data limitations, we opt for grouping the classification into three broad ones: fixed, intermediate and flexible regimes (See Appendix II for details). Finally, a number of control variables are included in all specifications. The first is the lag of the sovereign risk (Embi_l\ to account for its persistence, as will be shown later. The second is the Embi spread for all emerging countries for which it is available (Emerging Embi). This should capture a possible similar co-movement stemming from the market integration of this asset class and potential contagion effects. At the same time, this control variable allows us to pick up possible time effects in the regression. From the statistical tables in Appendix 1 (3, 4 and 5), some stylized facts are worth mentioning: First, the average of the Real Exchange Rate Change is a small real appreciation, as opposed to a slight real depreciation in the case of'the Multilateral Real Exchange Rate Change. Second, the average External Debt is around five times that of Domestic Debt. Third, the average Real Exchange Rate Change varies only slightly among different exchange rate regimes, both in the dejure and de facto classifications: Dejure, flexible exchange rate regimes appreciate slightly on average while the other two depreciate; de facto, intermediate regimes appreciate slightly while the other two depreciate. As could be expected, the largest standard deviation is that of de facto flexible exchange rate regimes. These differences between classifications can be better understood comparing where each observation stands in the two classifications, as shown in Table 3 of Appendix 1. From the 203 available observations only 111 find themselves in the same exchange rate regime in the de facto and dejure classifications. 51 are more flexible de jure than de facto, which we could generally label as "fear of floating" cases. The remaining 41 are more flexible de facto than announced, which in 16 of cases coincide with "freely falling" experiences of relatively fixed regimes, as labelled by Rogoff and Reinhart (2004). Finally, from the matrix of correlations in Table 4, Appendix 1, we can outline other characteristics of the data. First, the dependent variable (Embi) is very persistent (with a correlation of 0.71 between t and t-1). Second, the correlation between Embi 142

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and either the Real Exchange Rate Change or the External Debt, and therefore External Balancesheet, is positive, in line with the a priori of the financial accelerator literature. However, the correlation betwen Embi and ^External Debt is negative, which hints at the idea (confirmed later in our results) that it is not so much the new external indebtness that matters for country risk, but the sudden increase in the stock of external debt due to a real depreciation (in other words, the balance sheet effect and not the quantity effect). Third, while the correlation between Embi and Domestic Debt is negative but very close to zero, that between Embi and Domestic Balancesheet is positive and relatively high (higher than for External Balance sheet). Only judging from these correlations, we should expect a negative net wealth effect also in the case of domestic balance sheets and not only for external ones. Fourth, the fact that the correlation between External Debt and Domestic Debt is close to zero seems to indicate that there is no clear pattern of complementarity or substitution between the two. Finally, as one would expect, the quality of Creditor Rights, ^Exports and Openness are negatively correlated with the dependent variable but, contrary to the theoretical literature, the degree of Competitiveness (i.e., the product of Openness and Real Exchange Rate Change) is positively correlated. As for the empirical strategy, we opt for a Generalized Method of Moments (GMM), following Arellano and Bover (1995). We prefer this option to using OLS so as to (i) remove unobserved time-invariant country-specific effects; (ii) account for the potential endogeneity arising from the inclusion of the lagged dependent variable in addition to other possibly endogenous right-hand side variables (particularly the real exchange rate); and (in) deal with the possibility that the dependent variable is not stationary. The second reason is particularly important since there might be instances of reverse causality (from country risk to the real exchange). The GMM empirically strategy allows us to take our results on safer grounds. The Arellano-Bover estimator, or GMM system estimator combines the regression expressed in first differences (lagged values of the variables in levels are used as instruments) with the original equation expressed in levels (this equation is instrumented with lagged differences of the variables)6. The disadvantage with this empirical strategy, though, is the relatively small number of observations while the conditions to use GMM should be complied with asymptotically. As a robustness test, we run all regressions in OLS, with robust standard errors. The results remain unchanged. Results (i)

The net impact of real exchange depreciations and appreciations

As a first step, it seems important to confirm whether real exchange rate depreciations raise a country's risk premium. Controlling exclusively for the persistency of the risk premium (Embi_J) and the evolution of the asset class (Emerging Embi), a statistically significant positive relation is found between the change in the real exchange rate and the risk premium (Table 1, column I)7. Although this first approximation is very general and does not specify the channels through which the real exchange rate ^n all the estimations we present results for a Sargan test of over-identifying restrictions that checks the overall validity of the different moment conditions and in all the cases we fail to reject the null hypothesis. 7 The result holds when the change in the real exchange rate is defined in effective terms and not in bilateral ones, exclusively against the US dollar.

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influences country risk, the result could be understood as a net effect. Such negative relation, more in line with the recent open-macro financial accelerator models than with the more traditional literature, offers a warning signal to emerging countries, which often suffer from real exchange rate depreciations. It seems interesting to test whether the effects of real exchange rate changes on a country's risk premium are symmetric, in other words, whether real appreciations lower the country risk premium in the same way as real appreciations raise it. As Table 1, column II indicates, real exchange rate appreciations (Appr*Real Exchange Rate Change) do not seem to contribute to reducing country risk since we cannot reject the hypothesis that their coefficient is equal to zero8. This result is in line with the models of financial imperfections, which expect detrimental effects of balance sheets only for negative shocks to productivity, based on the argument that agency problems may only be binding on the down side (Bernanke and Gertler, 1989). Another plausible explanation is liquidity constraints. The asymmetric impact of real depreciations and appreciations may have an important policy implication: other things given, it should make emerging countries more reluctant to allow for fluctuations in the real exchange rate, not being able to profit from the "good times" (real appreciations) while suffering from the bad ones (real depreciations, particularly if sharp) . In particular, a real exchange depreciation of one percentage point has an immediate impact on the risk premium of 25 basis points. The question is whether the impact of a real exchange rate depreciation is linearly proportional to the size of the latter. In other words, whether it is the same in terms of the country's risk premium to experience small depreciations over time or a sudden large real one. Our results offer a negative answer. Table 1, column III shows evidence of a non-linear effect of real exchange rate depreciations, accounted for as the square of this variable, and the country risk premium.

B

It should be noted that the asymmetry is a short-run effect, which may disappear in the long run. If the current coefficients could be interpreted as long-run ones (dividing them by one minus the estimated coefficient for£mfc/__7), the asymmetry could disappear. 144

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Table 1: Impact of real exchange rate changes on the country risk premium17 Specifications Number of obs Dependent variable: Embi Embi 1 Emerging Embi Real Exchange Rate Change Appr * Real Exchange Rate Change (fr)

1 183

II 183

III 183

0.78 *** (0.10) 0.64*** (0.18) 1533.62** (606.38)

0.64 *** (0.11) 0.33* (0.18)

0.68 *** (0.11) 0.39** (0.17)

Diff Effect Dep * Real Exchange Rate Change (£2)

-97.28 (604.54)

120.95 (649.11)

2474.57 *** (634.17)

-892.38 (623.40)

[Real Exchange Rate Change] 2 Constant

4170.78*** (545.02)

-260.77** (119.04)

Appr Constant

-62.98 (114.57) -99.01 (85.62)

Diff Effect Dep Constant Sargan test

25.56(1.00)

22.49(1.00) H0:p1+p2=0 (p-value) 0.00 HQ can be rejected

-122.95 (95.72) 1 29.59 * (75.57) 19.69(1.00)

The dynamic panel estimation uses one step GMM system estimators with heteroskedasticlty-consistent standard errors. Lags dated t-2, t-3 and t-4 for Real Exchange Rate Change, Appr * Real Exchange Rate Change, Diff Effect Dep * Real Exchange Rate Change and [Real Exchange Rate Change]2 were included as instruments. Standard errors in parenthesis (p-values for the Sargan tests). Significance of coefficients: * at 10% ; - at 5%; *** at 1%

I/ Results are maintained (i) using OLS with robust standard errors instead of GMM, (ii) including the debt service instead of the stock of debt, and/or (ii) subtracting a country's international reserves to the stock of debt

Although real depreciations tend to be detrimental for a country risk premium, we find a few observations where the opposite is true. The question is what makes these cases different. As a tentative answer, since the small number of observations does not allow us to explore the issue more rigorously, we look at the commonalities in the observations in which exchange rate depreciations lead to a reduction in a country's risk premium (23 out of a total of 75 depreciations). We refer to this group as the optimistic case. Taking the general case as a benchmark (namely the 52 observations in which real exchange rate depreciations lead to an increase in the risk premium) and making them equal to 100, the optimistic case is characterized by a lower external debt (about 20% lower than in the general case), higher tradability (15% higher), and better creditor rights, all as expected (Figure 1). However, they also have a much higher domestic dollar-denominated debt (50% more on average than in the general case). It is important to notice that exchange rate depreciations are much smaller in the optimistic case, which mitigates the relevance of the previously mentioned differences. We shall analyze this issue in more detail later.

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Figure 1: Characteristics of the optimistic case17 against the general one27

I/ Real depreciations reduce the cost of borrowing 21 Real depreciations increase the cost of borrowing.

In the case of real appreciations, there are a few observations where we find the expected positive impact (i.e., a reduction in country risk). We call this the "optimistic case", since it is not generally confirmed in our empirical results, and compare it with the "pessimistic one" (where real exchange rate appreciations increase the risk premium). As one would expect, the former has more debt (both external and domestic dollar denominated) so that it can profit more from its reduction in value after the appreciation. It is also less open to trade, so that it is less damaged by the appreciation. Creditor rights are lower but this is probably a less relevant variable than for depreciations since we are not in a binding situation, when net wealth falls.

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Figure 2: Characteristics of the pessimistic case v against the optimist one 2/

I/ Real appreciations increase the cost of borrowing 2/ Real appreciations decrease the cost of borrowing.

(ii)

Channels for a real exchange depreciation to influence the risk premium

We, now, specify the channels through which the real exchange rate may influence a country's cost of borrowing, based on the existing literature. The most important ones might be balance sheet effects, from external and domestic dollar denominated debt, and competitiveness. Also financial imperfections could be a potential channel in as far as financial accelerator theories make balance sheet effects dependent on the existence of such imperfections. Focusing exclusively on the external debt, we find that the External Balance sheets after a depreciation clearly increase the risk premium while they are not significant after an appreciation. (Table 2, column I). The same result is found for Domestic Balance sheets (Table 2, columns II and III).9 The latter seems to indicate that domestic private sector indebtness in foreign currency has negative wealth effects and not only redistributive ones. In turn, competitiveness affects country risk symmetrically and in the expected direction (reducing it with a real depreciation and increasing it with an appreciation)10. Better creditor rights tend to lower country risk. Finally, we try to separate quantity effects from price ones by including in the regression the increase in external and domestic dollar denominated debt and export growth, all in US dollar. None of the quantity effects are found significant. In the case 9

The significance of domestic balance sheets, after a depreciation, is weakened (from a level of significance of 1% to 10%) when both external and domestic balance sheets are included in the regression (Column III). This is probably due to the collinearity between the two variables (Table 5 in Appendix I show a correlation of 0.52) 10 The correlation between External Balancesheet and Competitiveness is very high, pointing to collinearity problems. An analysis of the correlation between parameters confirms this problem. This is why we shall exclude Competitiveness in the following regressions, substituting it for Increase Exports which accounts mainly for the quantity effect, as Exports are measured in dollars.

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of external and domestic debt, this result can be understood as if the country risk premium were not affected by new indebtness but rather by the sudden reduction in net wealth, due to real depreciation. This is in line with financial accelerator theories. Table 2: Channels of influence of changes in the real exchange rate l/ Specifications Numberofobs

1 179

Dependent variable: Embi Embi 1 Emerging Embi Appr* External Balancesheet Diff Effect Dep * External Balancesheet Increase External Debt

II 152

0.65 *** (0.11) 0.25* (0.14) -39945 (776.30) 491 7.25 *** (1.567.73)

Appr * Domestic Balancesheet Diff Effect Dep * Domestic Balancesheet Increase Domestic Debt Appr* Competitiveness Diff Effect Dep* Competitiveness Increase Exports Creditor Rights Appr* Constant Diff Effect Dep* Constant Sargantest

2205.09 ** (977.31) -5048.16*** (1.792.62) -37.04* (21.30) 283.62 (237.24) -55.37 (49.99)

0.65 *** (0.07) 0.20 (0.14)

0.61 *** (0.08) 0.15 (0.14) -427.05 (834.89) 3324.59 ** (1.673.84)

-466.38 (388.54) 14455.44 *** (2.111.46)

-262.96 (497.92) 7826.1 1 * (4.819.81)

1846.57 ** (784.68) -898.91 (1.045.50)

2096.28 ** (968.15) -4062.94*** (1.500.05)

-48.43** (23.01) 393.01* (227.28) 21.35 (55.48)

19.42(1.00)

III 152

15.39(1.00)

-47.41** (21.44) 428.82* (223.46) -18.03 (45.17) 6.96(1.00)

IV 122 0.61 *** (0.06) 0.25*** (0.16) -357.98 (1.036.92) 3496.77 *** (1.737.62) -0.46 (1.89) -583.40 (808.42) -1758.74 (4.752.85) 0.02 (0.03) 2277.10 * (1.246.20) -4441.31*** (1.672.54) -495.61 (311.58) -56.76* (30.01) -7.90 (46.84) 480.10 (291.02) 11.98(1.00)

The dynamic panel estimation uses one step GMM system estimators with heteroskedasticity-consistent standard errors. Lags dated t-2. t-3 and t-4 for Appr * External Balancesheet, Off Effect Dep • External Balancesheet Increase External Debt, Appr * Domestic Balancesheet, Diff Effect Dep" Domestic Balancesheet, Increase Domestic Debt, Appr •Competitiveness and Diff Effect Dep • Competitiveness were included as instruments. Standard errors in parenthesis (p-values for the Sargan tests). Significance of coefficients: * at 10%; " at 5%; — at;1%

I/ Results are maintained (i) using OLS with robust standard errors instead of GMM, (ii) including the debt service instead of the stock of debt, and/or (ii) subtracting a country's international reserves to the stock of debt

(Hi)

Haw do financial imperfections influence balance sheet effects

In the previous set of regressions we have found direct evidence of the detrimental effect of financial imperfections on the risk premium. However, financial accelerator theories consider financial imperfections more as a condition under which balance sheet effects can increase the cost of borrowing than as a separate channel. To test this hypothesis, we interact each country's financial imperfections -proxied with the quality of creditor rights - with balance sheet effects, both external and domestic. We separate countries in three groups, those with the best creditor rights, those with intermediate ones and those with the poorest. Balance sheet effects are clearly larger in the last group, followed by the intermediate one (Table 3, columns I and II, respectively). In particular, for Domestic Debt only do countries with the poorest creditor rights see their risk premium increase because of domestic balance sheet effects. In the case of intermediate creditor rights we cannot reject the hypothesis that domestic balance sheets have no effect on the risk premium or is even negative for good creditor rights

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(Table 3, bottom of Column III). This could be explained by the fact that domestic creditors in the countries with the poorest creditor rights do not trust the system enough to use - or keep - their additional net worth at home. Table 3: Financial imperfections and the influence of external and domestic balance sheet effects on the risk premium ll Specifications Number of obs

I 174

Dependent variable: Embi EmbM

0.78 *** (0.11) 0.51 *** (0.18) 2514.32*** (667.56) -659.22 (662.47) -1483.08 * (653.56)

Emerging Embi Low Creditor Rights * External Balancesheet (YI) Diff Effect Medium Creditor Rights * Exteranal Balancesheet (Y2) Diff Effect High Creditor Rights * External Balancesheet (v3) Low Creditor Rights * Domestic Balancesheet (6,) Diff Effect Medium Creditor Rights • Domestic Balancesheet (63)

II 151 0.63 *** (0.04) 0.49 *** (0.19)

15868.14*** (1.706.31) -1 51 48.1 9 *** (1.901.49) -18861.95 *** (2.705.76) -440.31 (343.59) 86.13 (166.94) -237.62 ** (119.19) -279.09 ** (123.16)

.

Diff Effect High Creditor Rights * Domestic Balancesheet (63) Increase Exports

-493.69** (242.69) -37.79 (169.61) -1 56.65 (99.92) -1 74.69 * (109.67)

Low Creditor Rights Constant Diff Effect Medium Creditor Rights Constant Diff Effect High Creditor Rights Constant Sargan test

20.25(1.00) H0:Yi+Y3=0 (p-value) 0.01 HO can be rejected

17.33(1.00) H0: 6^62=0 (p-value) 0.46 HO cannot be rejected H0: 6^63=0 (p-value) 0.04 HO can be rejected

The dynamic panel estimation uses one step GMM system estimators with heteroskedasticity-consistent standard errors. Lags dated t-2, t-3 and t-4 for Low Creditor Rihgts * External Balancesheet, Diff Effect Medium Creditor Rights * External Balancesheet, Diff Effect High Creditor Rights * External Balancesheet, Low Creditor Rights * Domestic Balancesheet, Diff Effect Medium Creditor Rights * Domestic Balancesheet, and Diff Effect High Creditor Rights * Domestic Balancesheet were included as instruments. Standard errors in parenthesis (p-values for the Sargan tests). Significance of coefficients: * at 10% ; - at 5%; •*' at 1 %

I/ Results are maintained (i) using OLS with robust standard errors instead of GMM, (ii) including the debt service instead of the stock of debt, and/or (ii) subtracting a country's international reserves to the stock of debt

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(iv)

How does the exchange rate regime influence balance sheet effects

After identifying when balance sheet effects are particularly a problem, we now analyze to what extent they are influenced by the exchange rate regime in place. This is particularly interesting if we consider that the exchange rate regime is an important policy variable for the economic authorities. As previously mentioned, several theoretical models argue that a fixed exchange rate regime amplifies balance sheet effects on the risk premium. This is confirmed in our results, when interacting the exchange rate regime and domestic and external balance sheet effects. The exchange rate regime is lagged one period to avoid that what was originated by a certain regime is assigned to another one. We use both de jure and de facto classifications and compare the results. Starting with external balance sheet effects, fixed exchange rate regimes, de jure, amplify their detrimental impact on the cost of borrowing (Table 4, column III). This is so when compared with the average balance sheet effect, i.e., when the exchange rate regime is not considered (Table 4, column I). The flexible regime is clearly superior since we cannot reject the hypothesis that external balance sheets under this regime leave the risk premium unchanged (Table 4, bottom of column III). When taking the de facto classification, fixed regimes are also the most detrimental (Table 4, column II), with a larger coefficient than the average case (Table 4, column I). This time the differential effect of the flexible exchange rate is not significant but the intermediate one is clearly better than the pegged, although not to the extent of eliminating the detrimental effect of external balance sheets on the risk premium. In sum, although the results are relatively similar in the two classifications for the fixed exchange rate regime, this is not the case for the intermediate and flexible ones. One possible explanation is that the de facto classification has twice as many observations under the intermediate regime than the de jure classification. The opposite is true for flexible exchange rate regimes. This difference is probably explained by the wellknown phenomenon of "fear of floating", as countries tend to announce that the exchange rate will move more flexibly than they actually allow for.

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Table 4: The exchange rate regime and external balance sheets " Specifications Number of obs

1 178

Dependent variable: Embi EmbM

II 170 DE FACTO

0.78 *** (0.13) 0.55 *** (0.16) 2489.84 *** (769.48)

Emerging Embi External Balancesheet Fixed. 1 • External Balanacesheet (0,) Diff Effect Intermediate..! * External Balancesheet (02) Diff Effect Flexible.! ' External Balancesheet (03) Creditor Rights

-50.21* (29.69) -470.18 ** ^ (249.37) ' 194.83 (324.66)

Increase Exports Constant Constant Fixed. 1 Diff Effect Intermediate^ Constant Diff Effect Flexible.! Constant Sargan test

22.84 (1 .000)

III 177 DEIURE

0.71 *** (0.15) 0.59 *** (0.14)

0.73 *** (0.12) 0.57 — (0.17)

3333.64**' (1.158.73) -2741.70" (1.283.98) -1844.16 (1.591.65) -29.35** (12.18) -366.91 (178.14)

3145.73*** (1.226.52) -439.06 (1.633.45) -2488.72 ** (1.244.84) -44.53** (22.60) -544.85 " (276.72)

147.72 (171.55) -140.66** (66.87) -1 70.01 *** (64.07) 23.20 (1 .000)

238.28 (276.96) -38.73 (60.47) -1 28.84 ** (58.78) 18.1 1 (1 .000)

^10^02=0 (p-value) 0.06 H0 can be rejected

H.:G,+Q3-0 (p-value) 0.16 H0 cannot be rejected

The dynamic panel estimation uses one step GMM system estimators with heteroskedasticity-consistent standard errors. Lags dated t-2, t-3 and t-4 for External Balancesheet, FixecM * External Balancesheet, Diff Effect Intermediate.1! • External Balancesheet, Oiff Effect Ftexibte.1 • External Balancesheet were included as instruments. Standard errors in parenthesis (p-values for the Sargan tests). Significance of coefficients: • at 10% ; - at 5%; — at 1%

I/ Results are maintained (i) using OLS with robust standard errors instead of GMM, (ii) including the debt service instead of the stock of debt, and/or (ii) subtracting a country's international reserves to the stock of debt

In the case of domestic balance sheets, pegged regimes are clearly worse on the basis of the de lure classification with double the coefficient than for the average case (Table 5, columns III and I, respectively). Intermediate and flexible regimes are clearly superior since we cannot reject the hypothesis that balance sheet effects under any of these two regimes leave the risk premium unchanged (Table 5, bottom of column III). The differences among de facto regimes are not significant (Table 5, column II).

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Table 5: The exchange rate regime and domestic balance sheets17 Specifications Number of obs

1 151

Dependent variable: Embi EmbM

II 143 DE FACTO

0.61 *** (0.07; 0.43 ** (0.18) 8100.45 * (4614.37)

Emerging Embi Domestic Balancesheet FixedJ* Domestic Balancesheet (p,)

0.54 *** (0.12) 0.52 *** (0.15)

Diff Effect FlexibleJ * Domestic Balancesheet (p3) -411.67 (374.42) -67.37** (46.55) 500.59 (477.63;

Creditor Rights Constant Constant FixecM Diff Effect Intermediate.! Constant Diff Effect Flexible_1 Constant Sargan test

20.32(1.000)

0.63 *** (0.06) 0.51 *** (0.15)

6710.74 (5.110.24) -2323.34 (5.545.48) -674.53 (9.472.57) -236.83 (175.40) -35.85** (10.29)

Diff Effect Intermediate.. 1 * Domestic Balancesheet (p2)

Increase Exports

III 177 DEIURE

309.68 (156.25) -149.44 (104.02) -132.10 (105.82) 17.51(1.000)

16319.13*** (717.04) -15153.64*'* (1.605.39) -13334.29*** (1.987.78) -495.17 (332.18) -48.43* (28.94) 267.86 (278.76) 80.70 (62.24) -37.61 (38.23) 15.10(1.000) He:pi+Pz"0 (p-value) 0.41 Ho cannot be rejected H0: p^pa'O (p-value) 0.22 HQ cannot be rejected

The dynamic panel estimation uses one step GMM system estimators with heteroskedasticity-consistent standard errors. Lags dated t-2, t~3 andt-4 for Domestic Balancesheet, Fixed_1 * Domestic Balancesheet, Diff Effect lntermediate_1 • Domestic Balancesheet, and Diff Effect Ftexible_1 * Domestic Balancesheet were included as instruments. Standard errors in parenthesis (p-values for the Sargan tests). Significance of coefficients: • at 10%; ** at 5%; — at 1%

I/ Results are maintained (i) using OLS with robust standard errors instead of GMM, (ii) including the debt service instead of the stock of debt, and/or (ii) subtracting a country's international reserves to the stock of debt

Given its policy implications, it seems worth exploring why it is the case that pegged regimes behave worse than others. As a tentative answer (since the small number of observations does not allow us to explore the issue more rigorously) we look at the commonalities in the observations under a fixed regime and compare them with those for intermediate and flexible regimes11. Fixed exchange rate regimes tend to accumulate more external debt and domestic dollar-denominated debt, as argued by Ize and Levy-Yeyati (2003) and Broda and Levy-Yeyati (2003)12 This is more the case in de facto than de jure classification (Figure 2 and 3)13, which might be explained by the fact that some of the announced pegged regimes are not expected to be maintained (in fact there are much fewer observations for de facto pegs than de jure). The same might be true for some of the intermediate regimes which are announced (particularly crawling pegs). No clear trend appears for Domestic debt. 11

The number of observations for each group can be found in Table 3, Appendix 1. This is the case not only in levels, as shown in Figures 3 and 4, but much more so when we look at the rates of change of external debt form t-1 to t. This is not included in the graph because of the differences in scale. 13 In the specific intermediate regimes, dejure, domestic dollar denominated debt is actually lower. 12

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Another plausible explanation, other than the accumulation of foreign currency debt, could be that real exchange rate depreciations are larger under fixed exchange rate regimes. As Table 3 in Appendix 1 shows, this is not the case either in the dejure orde facto classifications, since the observations under the pegged regime do not have the largest average real depreciation. It could, nevertheless, happen that pegs suffer more frequently from events of very large depreciations, which we have shown to be more detrimental. Looking at the 5% extreme values of the right tail of our distribution (i.e., the largest real depreciations), this does not seem to be the case. In fact, most of the extreme observations fall under intermediate regimes both in the de jure or de facto classifications.

Figure 3: Characteristics of managed and flexible exchange rate regimes against fixed ones: De facto classification

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Figure 4: Characteristics of managed and flexible exchange rate regimes against fixed ones: Dejure classification

In sum, from this cursory exploration of the data, the most plausible explanation for the more detrimental balance sheet effects under pegged regimes is the relatively larger accumulation of dollar-denominated debt, coupled with the existence of poorer creditor rights, and not so much the accumulation of a larger depreciation or extreme depreciation events under pegged regimes. This is in line with the idea that fixed exchange rates tend to be perceived as an implicit insurance by the private sector and that public authorities may increase their dollar-denominated indebtness as a demonstration effect that the regime will be maintained. Conclusions and Policy Implications This paper builds upon the empirical literature on the impact of real exchange rate depreciations for the economy as a whole. In particular, it confirms Berganza, Chang and Garcia Herrero (2003)'s finding of a positive relation between changes in the real exchange rate and a country's risk premium for a sample of 27 emerging economies and explores additional questions to determine what makes balance sheet effects so detrimental for the risk premium. We show evidence that the effect of a real depreciation is neither symmetric nor linear. On the former, real appreciations are not found significant in reducing a country's risk premium, while real depreciations clearly increase it The immediate effect of a real depreciation of one percentage point is an increase in the country risk premium by 25 basis points. On the latter, sharp real depreciations have much larger negative effects than smaller ones. This should make policy makers wary of real exchange rate volatility, particularly if large, since there is no period when they clearly benefit from it. There are, however, a few cases in our sample, where exchange rate depreciations reduce the risk premium. A cursory look at the characteristics of these observations points to the importance of having a relatively low level of external debt, 154

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higher trade openness and better creditor rights, for real exchange rate depreciations to be beneficial. We also show that the main channels for the exchange rate to affect country risk are external and domestic balance sheets, stemming from the sudden increase in the stock of external debt and domestic dollar-denominated debt after a real depreciation. In the case of domestic balance sheets, this can be interpreted as evidence of the presence of wealth effects and not only redistribution ones. In addition, the same asymmetric impact is found for balance sheets as for the real exchange rate; that is, the reduction in the stock of foreign-currency debt after a real appreciation does not reduce country risk. On the contrary, the degree of competitiveness appears to have a symmetric effect - and with the expected sign - on country risk. In any event, The evidence of a positive and highly significant relation between the exchange rate change and country risk, which can be considered a net effect, indicates that competitiveness is not an important enough factor to outweigh the detrimental impact of balance sheets. New external and domestic dollar denominated indebtness is not found significant, suggesting that what matters is not so much the amount of new borrowing but rather the sudden reduction in net financial wealth because of a price change. When financial imperfections are considered (proxied by the quality of creditor rights) our results confirm the a priori of the financial accelerator literature: the poorer creditor rights are, the more external and domestic balance sheet effects increase the risk premium. Finally, fixed exchange rate regimes appear to amplify the negative impact of balance sheet effects on the risk premium. This seems to be related to the fact that pegged regimes have a bigger (and faster growing) stock of external debt, on average, and not so much to the extent of the real depreciation. The latter is not larger, on average, under this regime, not even the number of events of large depreciations, which have been found to be particularly detrimental through the result of nonlinearity. A plausible explanation for the potential causal relation between a pegged regime and a larger external debt is that this regime is perceived as an implicit insurance by the private sector. In the same vein, public authorities may increase their dollar-denominated indebtness as a demonstration effect that the peg will be maintained. In sum, a number of policy conclusions can be drawn from these results. The volatility of the real exchange rate, especially if large, is something to worry about in emerging countries. This is because it tends to increase country risk, a key variable for economic growth, in an asymmetric and non-linear way. The main channels through which the real exchange rate affect the risk premium are external and domestic balance sheet effects and, to a lesser extent, competitiveness, in the opposite direction. Therefore, the countries that should worry most are those with small trade openness, large financial imperfections and pegged exchange rate regimes, which are associated with bigger and faster growing external indebtness. The combination of these three characteristics can make real exchange rate depreciations particularly detrimental for a country's risk premium, an extremely important variable for emerging countries in need of external financing because of its strong impact on economic growth. Given that these three characteristics can be influenced by economic authorities, there is clear a role for policy action to mitigate the problem.

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References Arellano and Dover (1995). "Another Look at the Instrumental-Variable Estimation of Error-Components Models", Journal of Econometrics, Vol. 68, pp. 29-52 Berganza, Chang and Garcia Herrero, (2003) "Balance Sheet Effects and the Country Risk Premium: An Empirical Investigation", Working Paper No. 0316, Banco deEspana Bemanke and Gertler, (1989) "Agency costs, Net Worth, and Business Fluctuations", The American Economic Review, Vol. 79, pp. 14-31. Bleakley and Cowan, (2002) "Corporate dollar debt and depreciations: much ado about nothing?". Working Papers No. 02-5, Federal Reserve Bank of Boston. Broda and Levy-Yeyati (2003), "Endogenous Deposit Dollarization", Staff Report 160, Federal Reserve Bank of New York. Burnside, Eichenbaum and Rebelo (2001), "Hedging and Financial Fragility in Fixed Exchange Rate Regimes" European Economic Review, Vol. 45 (7), pp. 11511193. Cespedes, Chang and Velasco, (2000) "Balance Sheet Effects and Exchange Rate Policy". NBER Working Paper No. 7840. De Nicolo, Honohan and Ize (2003), "Dollarization of the Banking System: Good or Bad?", IMF WP/03/146. Edwards (1986), "Are Devaluations Contractionary?", The Review of Economics and Statistics, Vol. 68, Issue 3, pp. 501-508. Elekdag and Tchakarov (2004), "Balance sheets, Exchange Rate Policy and Welfare", IMFWP/04/63. Forbes, (2002) "How do large depreciations affect firm performance?", NBER Working Paper No. 9095. Galiani, Levy Yeyati and Schargrodsky (2003), "Financial Dollarization and Debt Deflation under Currency Board", Emerging Markets Review, Vol. 4, pp. 340367. Galindo, Panizza and Schiantarelli, (2003) "Debt composition and balance sheet effects of currency depreciation: a summary of the micro evidence", Emerging Markets Review, Vol. 4, pp. 330-339. Gertler, Gilchrist and Natalucci, (2003) "External Constraints on Monetary Policy and the Financial Accelerator", mimeo. International Monetary Fund, "Annual Report on Exchange Rate Arrangements and Exchange Restrictions-, various issues. Ize and Levy-Yeyati (2003), "Financial Dollarization", Journal of International Economics. 59, pp. 323-347. Levy-Yeyati (2004) "Financial Dollarization: Evaluating the Consequences", mimeo, Universidad Torcuato di Telia. Levy-Yeyati and Sturzenneger (2003), "A de facto Classification of Exchange Rate Regimes: A Methodological Note", American Economic Review, vol. 93, pp. 1173-1193. Reinhart, Rogoff and Savastano (2003). "Addicted to Dollars", NBER Working Paper No. 10015. Rogoff and Reinhart, (2004) "The Modem History of Exchange Rate Arrangements: a Reinterpretation", Quarterly Journal of Economics, Vol.119, pp. 1-48.

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APPENDIX I: STATISTICAL ISSUES Table 1 Countries and years included Country name Algeria Argentina Brazil Bulgaria Chile China Colombia Cote D'lvoire Croatia Ecuador Malaysia Mexico Morocco Nigeria Panama Peru Philippines Poland Republic of Lebanon Russian Federation Slovakia South Africa South Korea Thailand Turkey Venezuela Zimbabwe

Years

Number of years

1999-2002 1993-2002 1993-2002 1994-2002 1999-2002 1994-2002 1997-2002 1998-2002 1996-2002 1995-2002 1996-2002 1993-2002 1993-2002 1993-2002 1996-2002 1997-2002 1993-2002 1994-2002 1998-2002 1997-2002 1993-2002 1994-2002 1993-2002 1997-2002 1996-2002 1993-2002 1997-2002

4 10 10 9 4 9 6 5 7 8 7 10 10 10 7 6 10 9 5 6 10 9 10 6 7 10 6

vJo. of observations

210

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Table 2 Geographical distribution of the sample Region

Number of countries

Number of observations

as a % of total sample

5 9 6 6 1 27

42 71 48 44 5 210

20.0 33.8 22.9 21.0 2.4 100

Asia Latin America Eastern Europe Africa Middle East TOTAL

Table 3: Descriptive Statistics of the regression variables Variable Embi Emerging Ernbi Real Exchange Rate Change Fixed real exchange rate change de facto Intermediate real exchange rate de facto Flexible real exchange rate de facto Fixed real exchange rate change de iure Intermediate real exchange rate de iure Flexible real exchange rate de iure Effective real exchange rate change External Debt Increase External Debt External Balancesheet Domestic Debt Increase Domestic Debt r\M*VLa.eti/« Dal'»K/«««' *»•»•»* uomesoc baiancesneei Dpenness uompeimveness Increase Exports Creditor rights

No.Obs.

Mean

Sfd. Deviation

Minimun

Maximun

210 210 208 55 109 38 73 68 67 210 209 208 207 155 143 172 208 207 203 208

560.40 617.47 -0.019 •0.009 0.011 -0.036 -0.009 -0.012 0.0159 0.0044 0.5683 3.75 0.0018 0.1132 69.68 -0.0024 0.3642 -0.0017 0.0714 7.21

515.95 143.61 0.1561 0.152 0.115 0.231 0.164 0.167 0.135 0.1477 0.2589 10.43 0.0928 0.2721 478.83 0.0248 0.2107 0.0388 0.1485 2.11

60.233 352.72 -0.8126 -0.319 -0.257 -0.813 -0.448 -0.813 -0.266 -0.3746 0.1473 -17.43 -0.3071

3925.75 1007.55 0.895 0.895 0.415 0.616 0.895 0.529 0.415 1,137 1,561 41.66 0.6432 2,109 5091.47 0.163 1,195 0.2254 0.7998

0

-100 -0.1485 0.05903 -0.1348 -0.3651

2

12

Table 4 Relation between the classification of de jure and de facto exchange rate regimes

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Table 5: Matrix of correlation Real Multilateral Exchange Real Increase Emerging Rate Exchange External External External Domestic Increase Domestic Increase Creditor Embi EmbiJ Embi Change Rate Change Debt Debt Balancesheet Debt Domestic Debt Balancesheet Openness Competitiveness Exports Rights Embi 1.00 EmbiJ 0.71 1.00 Emerging Embi 0.1B 0.07 1.00 Real Exchange Rate Change 0.31 0.00 0.00 1.00 Multilateral Real Exchange Rate ( 0.35 0.06 0.16 0.63 1.00 External Debt 0.36 0.35 0.01 -0.02 -0.02 1.00 Increase External Debt -0.29 -0.33 -0.02 -0.22 -0.13 -0.20 1.00 External Balancesheet 0.32 0.02 0.07 0.93 0.87 0.00 -0.17 1.00 Domestic Debt -0.07 -0.11 0.01 -0.09 -0.08 0.04 0.09 -0.09 1.00 Increase Domestic Debt 0.06 0.02 0.02 -0.10 -0.15 -0.02 -0.03 -0.10 -Q.05 1.00 Domestic Balancesheet 0.35 0.14 -0.04 0.51 0.45 -0.02 -0.13 0.52 -0.81 0.01 1.00 Openness -0.17 -0.09 -0.03 -0.04 -0.06 0.36 -0.02 -0.04 -0.22 -O.D5 0.10 1.00 Competitiveness 0.20 -0.10 0.04 0.71 0.84 -0.13 -0.17 0.75 -0.02 -0.11 0.26 -0.12 1.00 Increase Exports -0.10 0.11 0.15 -0.17 -0.10 -0.14 0.16 -0.15 0.05 -0.05 -0.16 0.08 -0.10 1.00 Creditor Rights -0.40 -0.32 -0.16 -0.07 -0.14 -0.01 0.01 -0.11 0.09 -0.20 -0.08 0.21 -0.10 -0.10 1.00

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APPENDIX II: DATA SOURCES AND VARIABLE DEFINITIONS Below we list the variables and sources used for this study, as well as the transformations made to the data. The data are annual and cover the periods and countries shown in Table 1. Dependent variable; * Embi Country risk premium or spread in the external cost of borrowing: equals returns for U.S. dollar-denominated Brady bonds, loans, Eurobonds, and U.S. dollardenominated local markets instruments for emerging markets minus total returns for U.S. Treasury bonds with similar maturity (the stripped yields of the Emerging Markets Bond Index, Embi, for each country). The spreads are measured in basis points. Source: JP Morgan. Objective variables; * External Debt: equals the total debt in convertible currencies owed to nonresidents, as the end of the reporting year in U.S. dollars divided by the nominal GDP in 1995 in U.S. dollars, so as to take into account the relative size of the country. Source: The Institute of International Finance (IIF). * Domestic Debt: proxied by the domestic deposits in U.S. dollars divided by the nominal GDP in 1995 U.S. dollars to take into account the relative size of the country. Source: International Financial Statistics (IFS) of the International Monetary Fund (IMF) and Levy-Yeyati (2004). * "Real" Exchange Rate: equals the average number of units of local currency per U.S. dollar during the year adjusted by the inflation price index (with 1995=1) divided by the nominal exchange rate in 1995. Thus, in 1995, Real Exchange Rate is equal to 1 and an increase (decrease) in Real Exchange Rate is a depreciation (appreciation). Source: IIP. * Multilateral Real Exchange Rate: is an annual average index of the nominal effective exchange rate of the local currency with respect to six leading trading partners, deflated by the relative consumer prices. An increase (decrease) in Multilateral Real Exchange is a depreciation (appreciation) Source: IIF. * "Real" Exchange Rate Change: equals the changes in "Real" Exchange Rale between year t and year t-1. (A/« "real" exchange rate). * Multilateral Real Exchange Rate Change: equals the changes in Multilateral Real Exchange between year t and year t-1. (bdn effective real exchange rate). * Exports', equals the total value of export of goods and services to nonresidents, valued at market prices in millions of U. S. dollars. Source: IIF. * Openness: is defined as the ratio of Exports to the nominal GDP in 1995 U.S. dollars. Source: The IIF.

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* External Balancesheet: equals the product of External Debt in year t-1 and "Real" Exchange Rate Change between the years t-1 and t. * Domestic Balancesheet: equals the product of Domestic Debt in year t-1 and "Real" Exchange Rate Change between the years t-1 and t. * Competitiveness: equals the product of Openness in year t-1 and Multilateral Real Exchange Rate Change between the years t-1 and t. * Creditor Rights: measure the quality of the institutional setting affecting the risk of investment. The rating assigned is the sum of three subcomponents, each with a maximum score of 4 and a minimum score of 0. A score of 4 indicates a very good environment for creditors and 0 a very poor. The subcomponents are: contract viability/expropriation, profits repatriation and payment delays. Countries are divided into three groups: tow, medium and high creditor rights. Source: International Country Risk Guide. Control variables; * Emerging Embi. equals the average of the stripped yields of the Emerging Markets Bond Index, Embi. Source: JP Morgan. * Appreciation (Appr): is a dummy variable that takes on a value of one if Real Exchange Rate Change is negative and zero otherwise. Real Exchange Rate Change is never zero throughout our sample. * De facto classification of exchange rate regimes: From the 15 groups considered in Rogoff and Reinhart (2004), we group them in three groups: (infixed, which includes codes such as "no separate legal tender", "pre announced peg or currency board arrangement", "pre announced horizontal band" and "de facto peg"; (ii) intermediate, composed of "pre announced crawling peg", "pre announced crawling band", "de facto crawling peg", "de facto crawling band", "moving band" and "managed floating"; and (inflexible, including "freely floating" and "freely falling". The group "dual market in which parallel market data is missing" (7 observations in our sample) is left out of the classification. A dummy variable is defined for each group. Source: Rogoff and Reinhart (2004). * De jure classification of exchange rate regimes: Every IMF member country is required to report and publish each year the stated intentions of the central bank yielding a de jure classification. From the 8 groups considered, we group them in three groups: (i) fixed, which includes "exchange arrangement with no separate legal tender", "currency board arrangement", "conventional pegged arrangement" and "pegged exchange rate within horizontal bands"; (ii) intermediate^ composed of "crawling peg", "crawling band" and "managed floating with no pre-announced path for the exchange rate"; and, (iii) flexible, including "independently floating". A dummy variable is defined for each group. Source: Annual Reports of Exchange Rate Arrangements and Exchange Rate Restrictions (IMF).

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Session 3 Debt in Emerging Economies

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Public Debt, Fiscal Solvency, and Macroeconomic Uncertainty in Latin America: The Cases of Brazil, Colombia, Costa Rica and Mexico*

Enrique G. Mendoza University of Maryland and the National Bureau of Economic Research Pedro Marcelo Oviedo Iowa State University

* This paper is based partly on material we developed for the World Bank's project on Assessing Fiscal Sustainability in Latin America and in work on a method to evaluate fiscal sustainability that we did while visiting the Research Department of the Inter-American Development Bank. We are grateful to Manuel Amador, Andres Arias, Guillermo Calvo, Umberto Delia Mea, Arturo Galindo, Santiago Herrera, Claudio Irigoyen, Alejandro Izquierdo, Guillermo Perry, Tom Sargent, Alejandro Werner and participants at the XIX Meeting of the Latin American Network of Central Banks and Finance Ministries for helpful comments and suggestions. The views expressed here are the authors5 only and do not reflect those of the World Bank or the Inter-American Development Bank. Addresses for the authors are: Enrique G. Mendoza, Department of Economics, University of Maryland, College Park, MD 20742; Pedro Marcelo Oviedo, Department of Economics, Iowa State University, Ames, IA 50011.

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Introduction The ratios of public debt to GDP have been rising steadily in the economies of Latin America. Comparing averages for the period 1996-2002 with those for the period 19901995, the average debt ratios of Brazil, Colombia, and Mexico increased by about 10 percentage points in each country. In Costa Rica, the public debt ratio did not change much, but it was already at a relatively high level of around 50 percent at the beginning of the 1990s. Given that growing public debt has traditionally been an indicator of financial weakness and vulnerability to economic crisis in the region, there is concern for assessing whether these high levels of debt are in line with the solvency of the public sector or should be taken as a warning signal that requires policy intervention. The goal of this paper is to assess the consistency of the public debt ratios of Brazil, Colombia, Costa Rica and Mexico with the conditions required to maintain fiscal solvency. This assessment is based on a variant of the framework proposed by Mendoza and Oviedo (2004). In particular, we apply their one-sector model with exogenous government expenditure rules. This methodology produces estimates of the short- and long-run dynamics of public debt ratios in a setup in which public revenues are subject to random shocks and the government aims to maintain its outlays relatively smooth in the face of this uncertainty. The government is handicapped in its efforts to play this insurer's role because markets of contingent claims are incomplete. The government can only issue oneperiod, non-state-contingent debt. Mendoza and Oviedo (2004) show that, in this environment with incomplete contingent-claims markets, a government averse to a collapse in its public outlays and facing revenue uncertainty will impose on itself a "natural debt limit" (NDL) determined by the growth-adjusted annuity value of the primary balance in a state of "fiscal crisis." They define a state of fiscal crisis as the one at which a country arrives after experiencing a sufficiently long sequence of adverse shocks to public revenues and the government adjusts its outlays to minimum admissible levels. An important implication of the NDL is that it allows the government to offer its creditors a credible commitment to remain able to repay "almost surely" at all times (including during fiscal crises). It is important to note that this commitment is not an adhoc assumption but an implication of the assumptions that (a) government is averse to suffering a collapse of its outlays, (b) public revenues are stochastic, and (c) markets of contingent claims are incomplete. However, the commitment is in terms of an "ability to pay criterion," and as such it does not rule out default scenarios that may result from "willingness to pay" or strategic reasons. The NDL sets the upper bound for public debt but is not, in general, the same as the "sustainable" or equilibrium level of debt. The model does not require public debt to remain constant at the level of the NDL. Instead, the path of "sustainable" or equilibrium public debt depends on the initial conditions of debt and revenue, the probabilistic process driving revenues, and the policy rules governing public outlays. In the short-run, the dynamics of the distribution of public debt are driven by the government budget constraint. In the long run, depending on alternative sequences of realizations of public revenues, the government can end up retiring all the debt or hitting the debt limit. This extreme behavior of the long-run debt dynamics is particular to this basic version of the Mendoza-Oviedo

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model. The two-sector general equilibrium variant of their framework with endogenous government outlays features a unique, invariant long-run distribution of public debt (see Mendoza and Oviedo (2004) for details). The results suggest that current debt ratios in Brazil and Colombia are near the natural debt limits that would be consistent with fiscal solvency only if one assumes perceived commitments to large reductions in non-interest outlays (in excess of 6 percentage points of GDP) in a fiscal crisis. Mexico was also near its debt limit in 1998. However, in Mexico's case the reduction in outlays that would have been needed to keep the government solvent if revenues had continued to suffer adverse shocks was smaller (at 1.5 percentage points of GDP). Still, in all three cases the implied level of adjustment in outlays to keep the government solvent in a state of fiscal crisis is more than two standard deviations below recent averages, indicating that the likelihood that the countries could produce the required adjustment in outlays if they were called to act on their perceived commitment is low. In contrast, the model indicates that Costa Rica's largest public debt ratio of the last 12 years could be financed in a state of fiscal crisis with a modest cut in outlays equivalent to 1.2 times the standard deviation of outlays. The above results are very sensitive to underlying assumptions regarding the longrun real interest rate and growth rate. Current debt ratios in all four countries are found to be unsustainable for plausible reductions in growth rates to the averages of the last 20 years, instead of the average of the last 40 years used in the baseline scenario. Similarly, the current debt ratios are found to be unsustainable if the long-run real interest rate is set at 8 percent instead of the 5 percent value of the baseline estimates. The Mendoza-Oviedo framework was designed as a forward-looking policy tool that intentionally sets aside the risk of default. This was done because the framework is intended to produce the sustainable debt ratios that a government that does not consider the option of defaulting on its obligations could support. This is in line with the assumptions of the traditional approaches to assess debt sustainability based on deterministic steadystate estimates or empirical applications of the intertemporal government budget constraint. However, while this approach is the ideal benchmark in a forward-looking policy analysis, it does have the drawback that it does not take into account how default risk considerations could affect sustainable debt dynamics. To address this issue, we study in this paper how estimates of natural debt limits and simulated debt dynamics vary when the basic Mendoza-Oviedo model is modified to incorporate exogenous default risk. Introducing default risk results in marked reductions in the levels of natural debt limits. We also compare the results of the Mendoza-Oviedo model with those produced by the conventional methodology based on calculations of steady-state debt ratios (or "Blanchard ratios"). In the countries where the average of revenues exceeds that of outlays by a large enough margin (Costa Rica and Mexico), the Blanchard ratio yields higher debt ratios than the natural debt limits of the Mendoza-Oviedo model. This finding shows that assessments of sustainable debt based on steady-state calculations that use averages of revenues and outlays and fail to take into account aggregate, non-insurable fiscal shocks can lead countries to borrow more than what is consistent with fiscal solvency. In the countries where the averages of revenues and outlays are very similar (Brazil and Colombia), the Blanchard ratios yield negligible debt ratios. The Mendoza-Oviedo model can explain high levels of debt in these cases if the government can commit (credibly) to large enough cuts in outlays in a state of fiscal crisis. To be credible, however, these cuts 168

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must not represent unusually large deviations relative to the historical mean (i.e., they should not be larger than two standard deviations in percent of the mean). The paper is organized as follows. Section 2 is a short survey of the existing methods for calculating public debt ratios consistent with fiscal solvency. Section 3 summarizes the one-good variant of the Mendoza-Oviedo model. Section 4 applies the model to the cases of Brazil, Colombia, Costa Rica and Mexico and discusses the results. This Section includes sensitivity analysis and an extension to incorporate exogenous default risk. Section 5 reflects on important caveats of the analysis and provides general conclusions. Computing Public Debt Ratios Consistent with Fiscal Solvency: A Survey A central question in fiscal policy discussions is how to determine whether the stock of public debt is "sustainable," in the sense of being consistent with the fiscal solvency conditions implied by current and future patterns of government revenue and outlays. Developing effective tools for computing these sustainable public debt ratios has proven a difficult task. The first problem that studies in this area face is how to give operational content to the notion of fiscal sustainability. There is a tendency to associate the notion of unsustainable public debt with failure to satisfy the government budget constraint, or with the government holding a negative net-worth position. However, from an analytical standpoint these can be misleading because the "true" government budget constraint (as an accounting identity relating the overall public sector borrowing requirement to all sources and uses of government revenue) must always hold. Thus, an analysis that shows that a given stock of public debt fails a "particular" definition of the budget constraint is ultimately reflecting the fact that the analysis failed to incorporate important features of the actual fiscal situation of the country under study. How this failure translates into a judgment about the sustainability of public debt depends on assessments (typically implicit in the analysis) about the macroeconomic outcomes associated with the different mechanisms that can be used to maintain fiscal balance. Arguments about sustainability are therefore implicitly arguments about the pros and cons of these alternative mechanisms, not about whether the intertemporal budget constraint of the government holds. Consider a basic example. In the canonical long-run analysis of public debt sustainability, we consider long-run, average levels of public revenue and expenditures, and view as the sustainable debt-output ratio the annuity value of a long-run target of the primary balance-output ratio. If a government has a large stock of contingent liabilities because of the high risk of a banking crisis, the stock of public debt may be judged to be unsustainable because, once these contingent liabilities are added, the debt-output ratio exceeds the long-run indicator of sustainability. However, the government budget constraint must hold, and thus if a banking crisis does occur the government will ultimately have to adjust the primary balance or rely on other "sources" of financing such as the inflation tax or a debt default. Adjustment via the primary balance is generally judged as consistent with this canonical view of sustainability, while adjustment via inflation or default would not because these would be viewed as alternatives inferior to adjustment of the primary balance in terms of social welfare. 169

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Beyond the problem of defining an operational concept of public debt sustainability, there are also problems in the design of methods for calculating sustainable debt levels. These difficulties reflect the gap between the aspects of fiscal policy emphasized in the different methods and those aspects that seem empirically relevant for explaining the actual fiscal position of governments. The literature on methods for assessing public debt sustainability reflects the evolution of ideas on these issues. In the lines below we review the main features of the different methods. The intent is not to conduct a comprehensive survey of the literature (as there are already a number of excellent surveys, see, for example, Chalk and Hemming 2000 or IMF 2002, and 2003 a) but to highlight the central differences among the existing methods. The starting point of most of the existing methods for calculating sustainable public debt-output ratios is the period budget constraint of the government. This constraint is merely an accounting identity that relates all the flows of government receipts and payments to the change in public debt:

0) where Bt+i is the stock of public debt issued by the end of period /, Bt is maturing public debt on which the government pays principal and the real interest rate rr, Tt is total real government revenue and Gt are current real government outlays (i.e., Tt- Gt is the primary fiscal balance). Long-Run Methods As the example of the long-run approach to debt sustainability given earlier illustrated, the long-run approach is based on steady-state, perfect-foresight considerations that transform the government's accounting identity (1) into an equation that maps the long-run primary fiscal balance as a share of output into a "sustainable" debt-to-output ratio that remains constant over time (see Buiter 1985, Blanchard 1990, and Blanchard, Chouraqui, Hagemann and Sartor 1990). In particular, if we define the long-run rate of output growth as y and after some basic algebraic manipulation, the accounting identity in (1) yields: (2)

where b is the long-run debt-to-GDP ratio, t and g are the long-run GDP shares of current revenue and outlays, and r is the steady-state real interest rate. Condition (2) can be read as an indicator of fiscal policy action (i.e., of the "permanent" primary balance-output ratio that needs to be achieved by means of revenue or expenditure policies so as to stabilize a given debt-output ratio), or as an indicator of a "sustainable" debt ratio (i.e., the target debt-output ratio implied by a given projection of the long-run primary balance-output ratio)

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Intertemporal Methods An important shortcoming of the long-run approach is that it fails to recognize that the "long run" is essentially a theoretical construct. In the short run governments face a budget constraint that does not reduce to the simplistic (albeit significantly more tractable) formula of the long-run analysis. There can be temporarily high debt ratios, or temporarily large primary deficits, that are consistent with government solvency, and indeed incurring in such temporarily high debt or deficits could be optimal from a tax-smoothing perspective. To force a country into the straight jacket of keeping its public debt-output ratio no larger than the level that corresponds to the long-run stationary state can therefore be a serious mistake. The realization of these flaws in the long-run calculations led to the development of intertemporal-budget-constraint methods that shifted the focus from analyzing directly the debt-output ratio to studying the time-series properties of the fiscal balance, so as to test whether these properties are consistent with the conditions required to satisfy the government's intertemporal budget constraint. This intertemporal constraint serves as a means to link the short-run dynamics of debt and the primary balance with the long-run solvency constraint of the government. In their original form (see Hamilton and Flavin 1986) the intertemporal methods aimed to test whether the data can reject the hypothesis that the condition ruling out Ponzi games on public debt holds. This condition states that at any date / the discounted value of the stock of public debt /+/' periods into the future should vanish as j goes to infinity: In other words, in the long run the stock of debt cannot grow faster than the gross interest rate. If this no-Ponzi-game (NPG) condition holds, the forward solution of (1) implies that the intertemporal government budget constraint holds: The present value of the primary fiscal balance is equal to the value of the existing stock of debt, and hence the exiting public debt or public debt-output ratio is deemed "sustainable." A number of articles tried different variations of this test by testing for stationarity and co-integration in the time series of the primary balance and public debt, and produced different results using U.S. data (Chalk and Hemming, 2000, review this literature). These intertemporal-budget-constraint methods also began to introduce elements of uncertainty into public debt sustainability analysis, but mostly in an indirect manner as sources of statistical error in hypothesis testing, or by testing the NPG condition in expected value or as an orthogonality condition that considers the fact that at equilibrium the sequence of real

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interest rates used to discount the "terminal" debt stock must match the intertemporal marginal rate of substitution in private consumption.l The article by Bohn (1998) provided an alternative interpretation of intertemporal methods that reduces them to testing if the primary balance responds positively to increases in public debt. In particular, // the primary balance-output ratio and the debtoutput ratio are stationary, the following regression can be used to test for sustainability: (3)

where st is the ratio of the primary fiscal balance over GDP, st is a well-behaved error term and Zt is a vector of determinants of the primary balance other than the initial stock of public debt. In Bohn's case, he included in Zt the cyclical variations in U.S. GDP and a measure of "abnormal" government expenditures associated with war episodes. He found strong evidence in favor of p > 0. Thus, controlling for war-time spending and the business cycle, the debt-output ratio is mean-reverting in U.S. data. Moreover, the positive coefficient p, indicating that the primary balance displays a linear response that is both positive and systematic to increases in debt, is sufficient (albeit not necessary) to ensure that the intertemporal government budget constraint holds. This is because, as the more recent methods for evaluating fiscal sustainability under uncertainty emphasize, ensuring fiscal sustainability requires that above a certain critical maximum level of debt 6*, the primary balance responds positively (in either linear or non-linear fashion) to changes in public debt. The intuition is that if this is the case any large increase in debt due to " large negative shocks" is eventually reversed through primary surpluses. Chapter HI of IMF (2003b) applied Bohn's method to a panel of industrial and developing country data. The results identified a group of developing countries where the sustainability condition p > 0 holds, and others where it does not. Moreover, the study also shows evidence of non-linearities in the relationship between debt and primary balances, indicating that countries that were able to sustain larger debt ratios in the data also displayed a stronger response of the primary balance to debt increases. Recent Development: Probabilistic Methods and Methods with Financial Frictions Recent developments in public debt sustainability analysis follow two strands. The first strand emphasizes the fact that governments, particularly in emerging markets, face significant sources of uncertainty as they try to assess the patterns of government revenue and expenditures, and hence the level of debt that they can afford to maintain. From the perspective of these probabilistic methods, measures of sustainability derived from the long-run approach or the intertemporal analysis are seen as inaccurate for governments that

1

In expected value the NPG condition is

, in the "equilibrium" tests the

condition becomes 172

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hold large stocks of debt and face large shocks to their revenues and expenditures. The key question here is not whether public debt is sustainable at some abstract steady state, or whether in a sample of a country's recent or historical past the NPG condition holds. The key question is whether the current debt-output ratio is sustainable given the current domestic and international economic environment and its future prospects. The second strand aims to incorporate elements of the financial frictions literature applied to the recent emerging-markets crises. For example, public debt in many emerging markets displays a characteristic referred to as "liability dollarization" (i.e., debt is often denominated in foreign currency or indexed to the price level.). As a result, abrupt changes in domestic relative prices that are common in the aftermath of a large devaluation, or a 'sudden stop' to net capital inflows, can alter dramatically standard longrun calculations of sustainable debt ratios and render levels of debt that looked sustainable in one situation unsustainable in another. Calvo, Izquierdo and Talvi (2003) evaluate these effects for the Argentine case and find that large changes in the relative price of nontradables alter significantly the assessments obtained with standard steady-state sustainability analysis. The general version of the Mendoza-Oviedo model also incorporates these effects (see Mendoza and Oviedo 2004). The probabilistic methods for assessing fiscal sustainability propose alternative strategies for dealing with macroeconomic uncertainty. A method proposed at the IMF by Barnhill and Kopits (2003) incorporates uncertainty by adapting the value-at-risk (VaR) principles of the finance industry to debt instruments issued by governments. The aim of this approach is to model the probability of a negative net worth position for the government. The method requires estimates of the present values of the main elements of the balance sheet of the total consolidated public sector (financial assets and liabilities, expected revenues from sales of commodities or other goods and services, as well as any contingent assets and liabilities), and an estimate of the variance-covariance matrix of the variables that are viewed as determinants of those present values in reduced form. This information is then used to compute measures of dispersion relative to the present values of the different assets and liabilities that determine the value at risk (or exposure to negative net worth) of the government. A second probabilistic method recently considered for country surveillance at the IMF (2003c) modifies the long-run method to incorporate variations to the determinants of sustainable public debt in the right-hand-side of equation (2), and also examines short-term debt dynamics that result from different assumptions about the short-run path of the variables that enter the government budget constraint in deterministic form. For example, deterministic debt dynamics up to 10 periods into the future are computed for variations of the growth rate of output of two standard deviations relative to its mean. The same IMF publication proposes a stochastic simulation approach that computes the probability density function of possible debt-output ratios. This stochastic simulation model, like the VaR approach, is based on a non-structural time-series analysis of the macroeconomic variables that drive the dynamics of public debt (particularly output growth, interest rates, and the primary balance). The difference is that the stochastic simulation model produces simulated probability distributions based on forward simulations of a vector-autoregression model that combines the determinants of debt dynamics as endogenous variables with a vector of exogenous variables. The distributions 173

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are then used to make assessments of sustainable debt in terms of the probability that the simulated debt ratios are greater or equal than a critical value. Xu and Ghezzi (2002) developed a third probabilistic method to evaluate sustainable public debt. Their method computes "fair spreads" on public debt that reflect the default probabilities implied by a continuous-time stochastic model of the dynamics of treasury reserves in which exchange rates, interest rates, and the primary fiscal balance follow Brownian motion processes (so that they capture drift and volatility observed in the data). The analysis is similar to that of the first-generation models of balance-of-payments crises. Default occurs when treasury reserves are depleted, and thus debt is deemed unsustainable when the properties of the underlying Brownian motions are such that the expected value of treasury reserves declines to zero (which occurs at an exponential rate). The Basic Version of the Mendoza-Oviedo Model The probabilistic methods summarized in the last section make significant progress in incorporating macroeconomic uncertainty into debt sustainability analysis but they are largely based on non-structural econometric methods. In contrast, the Mendoza -Oviedo (MO) method aims to provide an explicit dynamic equilibrium model of the mechanism by which macroeconomic shocks affect government finances. The MO method also differs from the other probabilistic methods in that it models explicitly the nature of the government's forward-looking commitment to remain solvent, instead of focusing on computing estimates of exposure to negative net worth or depletion of treasury reserves. As explained below, the MO method determines sustainable debt ratios that respect a natural debt limit consistent with a credible commitment to repay similar in principle to the one implicit in the long-run and intertemporal methods. The structural emphasis of the MO approach comes at the cost of the reduced flexibility and increased complexity of the numerical solution methods required to solve non-linear, dynamic stochastic equilibrium models with incomplete asset markets. At the same time, by proceeding in this manner the MO framework seeks to produce estimates of sustainable public debt that are robust to the Lucas critique. The non-structural or reducedform tools used in the other probabilistic methods to model the dynamics of public debt are vulnerable to the policy instability problems resulting from the Lucas critique. This is not a serious limitation when these methods are used for an ex-post evaluation of how well/7orf debt dynamics matched fiscal solvency conditions, but it can be a shortcoming for a forward-looking analysis that requires a framework for describing how equilibrium prices and allocations, and hence the ability of the government to raise revenue and service debt, adjust to alternative tax and expenditure policies or other changes in the environment (including, for example, a Sudden Stop limiting the access to international capital markets or a collapse in the real exchange rate triggered by a devaluation of the currency). The basic principles of the MO method are as follows. Assume that output follows a deterministic trend (so that it grows at a constant, exogenous rate y) and the real interest rate is constant. Public revenues follow an exogenous stochastic process. The government is extremely averse to suffering a collapse in its outlays. Hence, it aims to keep its outlays smooth unless the loss of access to debt markets forces it to adjust them to minimum tolerable levels. The government can only issue non-state-contingent debt. The government budget constraint in (1) can then be re-written as: 174

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0+r)**, =*,(!+')-(',-*,)

(4)

where lowercase letters refer to ratios relative to GDP. Since the government wants to rule out a collapse of its outlays below their tolerable minimum levels, it would not want to borrow more than the amount of debt it could service if the primary balance were to remain forever (or "almost surely" in the language of probability theory) at its lowest possible value, or "fiscal crisis" state. A state of fiscal crisis is defined as a situation reached after a "sufficiently" long sequence of the worst realization of public revenues and after public outlays have been adjusted to their tolerable minimum. This upper bound on debt is labeled the "Natural Debt Limit" (NDL), which is the term used in the precautionary-savings literature for an analogous debt limit that private agents impose on themselves when they can only using non-state-contingent assets to try to smooth consumption (see Aiyagari 1994). The NDL is given by the growth-adjusted annuity value of the primary balance in the state of fiscal crisis. The "history of events" leading to a fiscal crisis has non-zero probability (although it could be a very low probability) as long as that crisis state is an event within the support of the probability distribution of the primary balance, and as long as there are non-zero conditional probabilities of moving into this crisis state from other realizations of the primary balance. Under these conditions, the government knows that there is some probability that it could suffer a fiscal crisis in the future, and to ensure it can pay for its minimum level of outlays it must not hold more debt than it could service then. Since the NDL is a time-invariant debt level that satisfies the government budget constraint with revenues and outlays set at their minimum, it follows that the NDL implies that the government remains able to service its debt even in a state of fiscal crisis. Thus, the NDL that a government imposes on itself in order to self-insure so as to rule out a collapse of public outlays below its tolerable minimum also allows that government to offer lenders a credibly commitment to remain able to repay its debt in all states of nature. To turn the above notions of the NDL and its implied credible commitment to repay into operational concepts, we need to be specific about the factors that determine the probabilistic dynamics of the components of the primary balance. On the revenue side, the probabilistic processes driving tax revenues reflect the uncertainty affecting tax rates and tax bases. These processes have one component that is the result of domestic policy variability and the endogenous response of the economy to this variability, and another component that is largely exogenous to the domestic economy (which typically results from the nontrivial effects of factors like fluctuations in commodity prices and commodity exports on government revenues). The one-sector version of the MO model used in this paper incorporates explicitly the second component.2 On the expenditure side, government expenditures adjust largely in response to policy decisions, but the manner in which they respond varies widely across countries. Industrial countries tend to display countercyclical fiscal policies while fiscal policy in 2

Note that the exogenous determinants of public revenue dynamics can be important even in economies that have successfully diversified their exports away from primary commodities. In Mexico, for example, oil exports are less than 15 percent of total exports but oil-related revenues still represent more than 1/3 of public sector revenue. 175

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emerging markets is generally procyclical (as the recent literature on procyclical fiscal policy has shown). In addition, the "adjustment" or minimum level of public outlays to which the government can commit to adjust in a fiscal crisis is particularly important for determining the NDL and the sustainable debt ratios in the MO model. Labeling the fiscal-crisis level (or lowest realization) of the government revenueGDP ratio as f mm and the minimum level of the ratio of outlays to GDP that the government can commit to deliver as g"in (for g^m < tmn\ it follows from the government budget constraint in (4) that the NDL is the value of b* given by: (5)

This NDL is lower for governments that have (a) higher variability in public revenues (for example, if fiscal revenue follows a symmetric Markov chain that obeys the rule of simple persistence, the value off" can be written as a multiple of the standard deviation of public revenues and hence lower values of tmm reduce the debt limit), (b) less flexibility to adjust public outlays, and (c) lower growth rates or higher real interest rates. The NDL represents a credible commitment to repay in the sense that it ensures that the government remains able to repay even in a state of fiscal crisis for a given known stochastic process driving revenues and a given policy setting the minimum level of outlays. However, this should not be interpreted as suggesting that the need to respect the NDL rules out the possibility of sovereign default. Default triggered by "inability to pay" remains possible if there are large, unexpected shocks that drive revenues below what was perceived to be the value of tmm or if the government turns out to be unable to reduce outlays to g^m when a fiscal crisis hits. In addition, default triggered by "unwillingness to pay" remains possible since the NDL is only an ability to pay criterion that cannot rule out default for strategic reasons. Later in Section 4 we explore an extension of this framework that incorporates default risk into the basic MO setup. Consider a government with exogenous, random fiscal revenues (say, for example, oil export revenues) and an ad-hoc smoothing policy rule for government expenditures, such that gt = g (for g^g*71"7) as long as &,+; > &*, otherwise gt adjusts to satisfy condition (4). By (4) and (5), if at a particular date the current debt ratio is below 6* and the realization of the revenue-output ratio is tmm, the government finances g by increasing bt+j. In contrast, if at some date the current debt ratio is at b* and the realization of revenues is f", (4) and (5) imply that g^g*'". In a simple example with zero initial debt, it is straightforward to show that if the government keeps drawing the minimum realization of public revenue, it will take the T periods that satisfy the following condition for the government to hit the NDL: (6)

This result indicates that, in the worst-case scenario in which revenues remain "almost surely" at their minimum, the government can access the debt market to keep the ratio of public outlays at the level g for a longer period of time the larger is the excess of 176

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"normal11 government outlays over minimum government outlays relative to the excess of normal outlays over the minimum level of revenues. Thus, the government uses debt to keep its outlays as smooth as possible given its capacity to service debt as determined by the volatility of its public revenues, reflected in the value of tmm , and its ability to reduce public outlays in a fiscal crisis, reflected in the value of g7""2. It is critical to note that the key element of the expenditure policy is not the level of g"m per se but the credibility of the announcement that outlays would be so reduced during a fiscal crunch. The ability to sustain debt and the credibility of this announcement depend on each other because a government with a credible ex ante commitment to major expenditure cuts during a fiscal crisis can borrow more and access the debt market for longer time, and hence, everything else the same, this government faces a lower probability to be called to act on its commitment. In a more general case in which public revenue is not an exogenous probabilistic process but it is in part the result of tax policies and their interaction with endogenous tax bases, the credibility argument extends to tax policy. Governments that can credibly commit to generate higher and less volatile tax revenueoutput ratios will be able to sustain higher levels of debt, and to the extent that this helps the economy produce stable tax bases it helps support the credibility of the government's ability to raise revenue. The condition defining the NDL in (5) has a similar form as the formula for calculating sustainable debt ratios under the long-run method:

However, the

implications for assessing fiscal sustainability under the two methods are sharply different. In general, the long-run deterministic rule will always identify as sustainable a debt-output ratio that is unsustainable once uncertainty of the determinants of the fiscal balance and the NDL are taken into account. This is because the long-run method ignores the role of the volatility of the elements of the fiscal balance, while in the MO model one finds that, everything else the same, governments with less variability in tax revenues can sustain higher debt ratios. Consider the case of two governments with identical long-run averages of tax revenue-output ratios at 20 percent. The tax revenue-output ratio of government A has a standard deviation of 1 percent relative to the mean, while that of Government B has a standard deviation of 5 percent relative to the mean. Assuming for simplicity that the distributions of tax revenue-output ratios are Markov processes with tmm set at two standard deviations below the mean, the probabilistic model would compute the natural debt limit for A using a value of tmm of 18 percent, while for B it would use 10 percent. The deterministic long-run method yields the same debt ratio for both governments and uses the common 20 percent average tax revenue-output ratio to compute it. In contrast, the MO method would find that debt ratio unsustainable for both governments and would produce a debt limit for B that is lower than that for A. Another important difference between the two methods is in the way that the MO method views the debt limit vis-a-vis the way in which the long-run method views the steady-state debt ratio. In the long-run analysis, the debt ratio is viewed as either a target ratio to which a government should be forced to move to, or as the anchor for a target primary balance-GDP ratio that should be achieved by means of a policy correction. In contrast, in the MO method condition (5) defines only the maximum level of debt. Unless the NDL binds, this maximum level of debt is not the equilibrium or sustainable level of 177

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debt that should be issued by the government (although it clearly plays a central role in determining both). Depending on the probabilistic and policy assumptions driving revenues and expenditures (and, generalizing condition (5), depending also on the stochastic processes of the real interest rate and output growth), a country can have levels of debt lower (even much lower) than this critical level, and may take a very long time on average to enter a state of fiscal crisis or even never arrive at it. The MO methodology models uncertainty in the form of discrete Markov processes. Given information on the current stock of public debt, the current tax revenueGDP ratio and the assumed behavioral rules for government outlays and statistical moments of the public revenue process, the model produces conditional one-period-ahead and unconditional long-run distributions of the debt-output ratio, as well as estimates of the average number of periods in which b* is expected to be reached from any initial bt. Again, depending on the nature of the stochastic processes and policy rules of revenues and outlays, it may take a few quarters to hit the debt ceiling on average or it may take an infinite number of quarters to do it Results of the MO Method for Brazil, Colombia, Costa Rica, and Mexico This section applies the MO method described in the last section to the cases of Brazil, Colombia, Costa Rica and Mexico. The section begins with a brief review of the recent growth performance and evolution of public debt, public revenues and public expenditure ratios in these countries. This review serves to identify key parameters needed to simulate the debt dynamics and solve for natural debt limits. Review of Growth Performance and Fiscal Dynamics The growth performance of the four countries examined in this study over the last two decades was weak. As shown in Table 1, average growth in GDP per capita for the period 1981-2000 ranged from a minimum of 0.5 percent in Brazil to a maximum of 1.25 percent in Costa Rica. These countries grew at faster rates in the past. Taking averages starting in 1961, the smallest average per-capita GDP growth rate was 1.8 percent for Costa Rica and the largest was 2.6 percent for Brazil. Given the apparent structural breaks in the trend of GDP per capita of these countries since the early 1980s, we conduct our public debt analysis under a baseline growth scenario that uses 1961-2000 average growth rates, and compare the results with a scenario that views the growth slowdown of the last two decades as permanent by using 1981-2000 average growth rates. Reliable cross-country estimates of public debt stocks and interest rates on public debt at the general government level are hard to obtain. We use the figures documented in IMF (2003b) for ratios of public debt to GDP for the period 1990-2002. As shown in Table 1, the mean debt-GDP ratios for the full sample range from 33.7 percent in Colombia to 49.5 percent in Costa Rica. However, these full-sample averages hide the fact shown in Figure 1 that debt ratios have been growing rapidly (except in the case of Costa Rica, where the ratio has been fairly stable but also fairly high). If we split the sample to create averages for 1990-1995 and 1996-2002, we find that the mean debt ratios of Brazil, Colombia and Mexico increased by about 10 percentage points between the first period and the second periods. By the end of the sample period, all four countries displayed debt 178

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ratios of about 50 percent (see Figure 1). The key question to answer is therefore whether a debt ratio of 50 percent is consistent with fiscal solvency given the pattern of growth and interest rates and the volatility of fiscal revenues that these countries face. Real interest rates on public debt are hard to measure because of differences in maturity, currency denomination, indexation factors, and residence of creditors for the various debt instruments that each country issues, and also because of the existence of time-varying default and exchange-rate risk premia. One useful proxy is the measure of sovereign risk proposed by Neumeyer and Perri (2003), which is the spread of the EMBI+ index relative to the U.S. T-Bill rate deflated by an estimate of expected inflation in the U.S. GDP deflator. The sample period of this measure is relatively short (starting in 1994) and biased because it includes mainly observations for a turbulent period in world capital markets. Still, this measure of real interest rates on public debt shows substantial premia over the world's risk free rate (the average real interest rates including the risk premia for a quarterly sample from 1994:1 to 2002:2, are 12.9 percent for Brazil and 10.3 percent for Mexico). The real interest rate on debt instruments will deviate from these figures to the extent that (a) debt instruments are domestic rather than external, (b) debt is denominated in domestic currency rather than in foreign currency or in terms of an indexation factor, and (c) the debt instruments have liquidity or transactions value for the holders. The lower bound of the interest rate on public debt is set by the real interest rate on U.S. public debt. The 1981:1-2000:4 average of the U.S. 90 day T-bill rate deflated by observed U.S. CPI inflation is about 2.8 percent. Given the above considerations, we consider two interest rate scenarios in our calculations. The baseline scenario considers a real interest rate of 5 percent, which incorporates a small long-run default risk premium of about 2.2 percentage points above the U.S. T-bill rate. The alternative is a high-real-interest-rate scenario in which the real interest rate is set at 8 percent (i.e., the long-run default risk premium is about 5.3 percentage points above the T-bill rate). In both scenarios we remain relatively optimistic about growth prospects, using average growth rates for the period 1961-2000. The measure of public revenues that we need to isolate for conducting the debt analysis is the total of all tax and non-tax government revenues excluding grants. For government expenditures we require the total non-interest government outlays (including all expenditures and transfer payments and excluding all forms of debt service). Once again, limitations of the existing international databases make it difficult to retrieve consistent measures of these variables that apply at the level of the entire non-financial public sector and, in the case of the outlays, that include the annuity values of all contingent liabilities resulting from obligations like banking- or pension-system bailouts. We put together estimates of the revenue and outlay ratios for the four countries under study by combining data from IMF (2003 b) and World Development Indicators (see the footnotes to Table I for details). The former shows data for the non-financial public sector but it does not separate interest and non-interest expenditures for some countries. The latter separates interest and non-interest expenditures but reports data only for the central government. Thus, the revenue and expenditures data are not exactly comparable across countries. The average ratios of total public revenue to GDP during the period 1990-2002 ranged from 12.6 percent in Colombia to 23 percent in Mexico (Table 1). Turning to examine the volatility of public revenues, Costa Rica displays the lowest coefficient of 179

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variation in the revenue-output ratio, at 5.4 percent of the mean. The coefficient of variation of revenues is similar in Colombia and Mexico (8.9 and 8 percent respectively). Brazil shows the highest coefficient of variation of public revenues at 14.1 percent. Interestingly, the country with the lowest coefficient of variation in public revenues (Costa Rica) is also the one with the highest average public debt-GDP ratio. The average of total non-interest outlays as a share of GDP is very similar in Brazil, Costa Rica and Mexico, at about 19 percent. The average outlays ratio for Colombia is much lower, at 12.8 percent, but this is one of the measures that applies only to the central government, so the actual ratio for the non-financial-public sector must be higher. With regard to the variability of non-interest outlays, Mexico shows the smallest coefficient of variation (about 4 percent), followed by Costa Rica (10 percent). Brazil and Colombia show the highest coefficients of variation in the outlays ratio, at about 14 percent for both. Natural Debt Limits: Baseline Scenario and Two Alternatives Table 1 reports three sets of calculations of natural debt limits for Brazil, Colombia, Costa Rica and Mexico. The baseline scenario considers the 1961-2000 average growth rates of GDP per capita and a 5 percent real interest rate. The growth- slowdown (GS) scenario uses the 1981-2000 average growth rates (with the real interest rate still at 5 percent). The high-real-interest-rate (HRIR) scenario uses a real interest rate of 8 percent (with the growth rates set at the 1961-2000 averages). The baseline scenario differs from the other two because it is designed to produce a coefficient of fiscal adjustment that yields an NDL equal to the largest debt ratio observed for each country in the 1990-2002 period. Table 1 reports this coefficient of "implied fiscal adjustment" in terms of how many standard deviations relative to the mean of noninterest outlays are needed to yield a debt limit equal to maximum observed debt (given the data for means and coefficients of variation of revenues and outlays, the average growth rates, the real interest rate, and assumed floors of public revenue equal to two standard deviations below the corresponding means). The Table also shows the implied minimum ratio of outlays to GDP resulting from the coefficient of fiscal adjustment. The GS and HRIR scenario keep the same fiscal adjustment coefficient and just alter either the growth rate or the real interest rate. The public debt-GDP ratios of the four countries under study peaked at similar levels during the 1990-2002 period (ranging from 50 percent in Colombia to 56 percent in Brazil). The coefficients of implied fiscal adjustment reported in Table 1 show that, in order to produce NDLs that can support these high levels of debt, three of the four countries (Brazil, Colombia and Mexico) need credible commitments to undertake large cuts in outlays if they were to hit a fiscal crisis. The adjustment measures 2 standard deviations below the mean of non-interest government outlays in Mexico, 2.3 in Colombia and 2.6 in Brazil (which are equivalent to cuts relative to the average outlays-GDP ratios of 1.5, 4 and 6.7 percentage points respectively). The fact that these adjustments are outside the two-standard-deviation threshold of the data for non-interest outlays of the previous decade suggests that the probability that the governments could produce these large expenditure cuts if they needed to act on their commitment is low. 180

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The situation in Costa Rica seems more favorable. Costa Rica can support a credible commitment to repay a debt-output ratio as large as 53 percent of GDP with a fiscal adjustment of 1.2 standard deviations below the mean of non-interest outlays (which is equivalent to about 2 percentage points of GDP). Thus, the model is consistent with the data in predicting that Costa Rica, the country with less volatility in public revenues, should be the one that has a better chance of sustaining a high debt ratio. This is the case even though Costa Rica's growth rate is the same as Colombia's and is lower than the growth rates in Mexico and Brazil by 0.4 and 0.7 percentage points respectively. The potential dangers of using the Blanchard ratios for conducting debt sustainability analysis are illustrated in the baseline results. The case of Mexico is particularly striking. The Blanchard ratio, which would compute a sustainable debt ratio using the difference between the average public revenue and the average government outlays, yields a debt ratio of about 132 percent, nearly 2.5 times larger than the NDL produced by the MO model. In the case of Costa Rica, the Blanchard ratio also exceeds the NDL but by a very small margin. In contrast, in the cases of the two countries where complying with the NDLs would require the largest expenditure cuts (i.e., where the consistency of the high debt ratio with fiscal solvency is more questionable), the Blanchard ratio yields public debt ratios so low that are of little practical relevance. The Blanchard ratio for Brazil is 3.5 percent and for Colombia the ratio is negative, at -5.3 percent (because in the data the average outlays exceed the average revenues by 0.16 percentage points of GDP). In these cases the Blanchard ratio would be switched to its alternative interpretation, where a target debt ratio would be chosen and the Blanchard ratio would then be used to set an average primary fiscal balance that the governments should aim to obtain by adjusting fiscal policy. Consider next the natural debt limits in the GS and HRIR scenarios. If the growth slowdown of the last two decades persists, and even assuming that the coefficients of fiscal adjustment were to remain as high as estimated in the baseline scenario, the current debt ratios would exceed the natural debt limits of all four countries by large margins. The situation of Brazil would be particularly compromised, because the current debt ratio of 56 percent would exceed the maximum debt ratio consistent with a fully credible commitment to repay in the GS scenario by nearly 26 percentage points of GDP. The HRIR scenario, in which for example a retrenchment of world capital markets, increased long-run default risk, or the pressure of large fiscal deficits in industrial countries push the real interest rate on emerging markets public debt to 8 percent, has even more damaging effects. In this case, even if the growth rates recover to the 1961-2000 averages and even with the large fiscal adjustment coefficients set in the baseline scenario, the natural debt limits of all four countries fall to a range between 25.2 percent for Brazil to 27.4 percent for Costa Rica. Notice, however, that the prediction of the model is not that an increase of the interest rate to 8 percent would trigger immediate fiscal crises in all four countries. For a fiscal crisis to occur immediately, the increase in the interest rate would have to be once-and-for-all and permanent. A transitory hike in the real interest rate could be absorbed in an analogous manner as a transitory downturn in public revenues, and hence a fiscal crisis would only be triggered after a sufficiently long sequence of adverse shocks.

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This last observation highlights again the fact that the NDL is not (in general) the same as the sustainable or equilibrium level of debt, which is determined by the dynamics driven by the government budget constraint. We turn now to study these dynamics. Debt Dynamics The simulations of debt dynamics consider a grid of public debt-GDP ratios that spans the interval from 0 to the NDL (the model assumes that if the government budget constraint yields negative debt at any time, the corresponding fiscal surplus is instead rebated to the private sector as a lump-sum transfer). The dynamics of sustainable debt can be traced from any initial public debt ratio in this interval. However, one needs to be careful in studying the long-run dynamics of debt ratios because this basic version of the MO model features at least two long-run distributions of public debt, one converging to 0 and the other to the NDL. Which of these two distributions is attained in the long run depends on initial conditions. The prediction that the long-run debt ratio is not determined within the model (i.e., that the long-run debt ratio depends on initial conditions) is not a peculiarity unique to the MO model. An outcome like this is the key prediction for debt dynamics of the classic tax-smoothing framework of Barro (1979), and it is also in line with the findings on Ramsey optimal taxation problems in which smooth taxes are optimal taxes (see Chapter 12 of Ljungqvist and Sargent 2000). The stochastic processes of public revenues used in the simulations are characterized by time-invariant Markov chains. The Markov chains are defined by three objects: an /7-element vector of realizations of the revenues, /, an nxn transition probability matrix, P, and a probability distribution for the initial value of the realization of revenues, Tio. The typical element of P, Py , indicates the probability of observing revenues f=f ; in the next period given that revenues are t—t\ in the current period. For each country, the vector of realizations of revenues has 5 elements (w=5). The lowest value oft is set two standard deviations below average revenues in each of the four countries under analysis. We use Tauchen's (1986) univariate quadrature method in order to construct the rest of the elements of / and the matrix P so as to approximate the firstorder autocorrelation and standard deviation of public revenues observed in the data. The stochastic simulations require also that we generate a 7-period time series of realizations of revenues, i.e. /;, t2, ... tT, drawn from the Markov vector t. This time series is constructed using realizations of a uniform random variable u in [0,1] that indicates how to pick one realization of tax revenue in period t+1 given the realization at time t. The tax revenue at t+1, tj say, is determined according to or

The first application of the stochastic simulations is illustrated in Figure 2, which shows the number of periods that it takes to hit a fiscal crisis (i.e., to hit the NDL) for the country-specific calibrated parameters and seven initial debt ratios that span the range between 0.25 and the maximum debt ratio observed in each country in the 1990-2002 sample. From each initial condition of the debt ratio, there are different stochastic paths that public debt, revenues and outlays can follow in the future, and each of these paths 182

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features a different number of periods to hit a fiscal crisis. The tall bars in the figure report the average time to a fiscal crisis from 1000 simulations of the public-debt dynamics induced by the government budget constraint in equation (4). The simulated tax revenues correspond to the realizations of revenues drawn from the Markov chains calibrated to the revenue processes of each country (see Table 1 for the corresponding averages and coefficients of variation). Depending on initial conditions, there are simulation in which a fiscal crisis never occurs (particularly for low initial debt ratios). In these cases, the average measure of time to fiscal crisis would go to infinity, and hence is omitted from the charts. The short bars in the plots show the minimum possible number of periods before hitting the fiscal crisis. This extreme adverse scenario corresponds to simulations of debt dynamics under the assumption that, in every period, the government draws the lowest realization of the public revenue contained in the vector of realizations of revenues. The top two graphs in Figure 2 show that in Brazil and Colombia the mean time to a fiscal crisis is high (15 years or more) for an initial debt ratio equal to 0.25. A fiscal crisis can occur much sooner on average (in less than 2.5 years) when then initial debt ratio is around 0.5. The difference between the mean and extreme time to hit a fiscal crisis is larger in Brazil than in Colombia for all initial debt ratios. Furthermore, the extreme scenario indicates a shorter time to a fiscal crisis in Brazil than in Colombia regardless of the initial debt ratio. This is because the lowest realization of revenues are calibrated to be two standard deviations below the mean, so the higher volatility of revenues in Brazil implies that the crisis-level of revenues for Brazil is more distant from the mean than for Colombia. The bottom two graphs in Figure 2 (for the cases of Costa Rica and Mexico) serve to illustrate how uncertainty affects the dynamics of public debt and the fact that the NDL is not in general the same as the equilibrium or sustainable debt. The fact that these plots only show bars for the mean time to a fiscal crisis for high debt ratios (above 50 percent) indicates that in the sampling of 1000 stochastic simulations starting from debt ratios below 0.5, there were many cases in which the debt ratio converged to zero instead of reaching the NDL. Consider for example the initial debt ratio of about 0.35 in the plot for Costa Rica. The extreme measure of time to a fiscal crisis shows that a fiscal crisis will occur after 10 years of experiencing realizations of revenues two-standard-deviations below the mean. However, in the 1000 stochastic simulations used to calculate the mean time to a fiscal crisis, only about half of the simulations reached the NDL and the rest converged to a zero public debt position in the long run. Similarly, for an initial debt ratio of 0.4, the debt ratio never reached the NDL in 127 out of 1000 simulations. Thus, the Costa Rican and Mexican cases illustrate examples in which the sustainable debt dynamics deviate sharply from the NDL. Figure 3 shows a sample of simulated time series of the public debt ratio and illustrates further how much the NDL and the sustainable debt ratios differ. The figure shows 50 simulations of debt ratios all starting from a common initial ratio of 0.35, using the parameter values calibrated to Costa Rica. At each date /, a random draw of public revenues, along with the date-/ debt and the fiscal rules for public outlays, are used to determine the value of the debt at t+L Notice that, whereas for some paths the debt ratio increases rapidly to reach the NDL, for other paths it takes a long time to reach it and for other paths the debt goes to zero. As explained above, for a large range of initial values of

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public debt the model predicts that debt ratio will reach the debt limit while for other initial values the debt ratio goes to zero. This implies that for starting values of the debt ratio above 0.35, the fraction of paths driving the debt to its maximum level increases and for starting values below 0.35 that fraction decreases. Default Risk Up to this point we followed the methodology proposed by Mendoza and Oviedo (2004) in which sovereign default was set aside to focus on modeling the optimal debt policy consistent with fiscal solvency and an ad-hoc rule smoothing public outlays. Default risk was only taken into account in setting the value of the long-run real interest rate used to solve for the NDLs and the debt dynamics (5 percent in the benchmark case, 8 percent in the high-interest-rate scenario). However, time-varying default risk premia are an important feature of public debt in emerging markets. It may make sense for a government to conduct a forward-looking debt sustainability exercise in which it assumes that default risk is time invariant as a benchmark scenario, but it is important to study how the results change when time-varying default risk is introduced. One important limitation of the analysis of default risk is that existing theoretical models of default on optimal sovereign debt contracts face serious challenges in explaining observed debt ratios. The canonical model of Eaton and Gersovitz (1981) considers a riskneutral lender and a risk-averse borrower that has the option of defaulting at the cost of facing permanent exclusion of the debt market. The lender is willing to take on the risk of default by charging a rate of interest that incorporates a premium consistent with the probability of repayment (as implied by a standard arbitrage condition between the expected repayment on defaultable debt and the return on risk-free bonds). There are wellknown theoretical problems with this setup, related to the classic Bulow-Rogoff critique showing that the threat of exclusion may not be credible because of the option to enter in deposit contracts with lenders, but even if the model were not affected by these problems, recent quantitative studies show that models in the Eaton-Gersovitz tradition support very small debt ratios of less than 10 percent of GDP (see Arellano 2004). This is because the models yield probabilities of default that increase too rapidly at very low levels of debt. Given the above difficulties with the theory of endogenous default risk, we follow a pragmatic approach that takes into account the same risk-neutral lender of the EatonGersovitz model but incorporates an exogenous probability of repayment calibrated to match observed default risk premia in emerging markets. The arbitrage condition of the risk-neutral lender implies: (?)

In this expression, R™ is the gross world risk-free real interest rate and Afbj is the probability of repayment (i.e., l-h(bd is the probability of default). The repayment probability is modeled as an exponential probability distribution expf-a6^, where the curvature parameter a determines the speed at which the repayment probability falls as debt increases.

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The exponential formulation of default risk has the advantage that it is consistent with two key properties of the endogenous default probability of the Eaton-Gersovitz line of models: (a) the probability of default is increasing and convex on the level of debt and (b) the probability of default is zero if the stock of debt is zero. The formulation fails to reproduce the property of the Eaton-Gersovitz setup that the probability of default approaches 1 for a finite "rationing" level of debt at which debtors always find it preferable to default than to repay (the exponential probability of default approaches 1 asymptotically as debt goes to infinity). However, the formulation still allows for values of a that yield very large risk premia for high levels of debt comparable to those observed in the data. We calibrate the value of a so that the arbitrage condition in (7) holds taking as given the EMBI+ country risk premium and the public debt ratio observed in Mexico in 1998 (the year of Mexico's maximum debt ratio in the 1990-2002 sample). Mexico's debt ratio in 1998 was bt = 0.549 and the real interest rate that the country faced on this debt, measured as the U.S. 90-day T-bill rate plus the EMBI+ spread, was R(bt) = 10.48 percent. The risk-free rate (i.e., the real U.S. 90-day T-bill rate) was 7?w =3.2 percent. Plugging these figures into (7) and solving for a yields a = 0.124. Interestingly, the observed maximum debt and the real interest rate with default premium for Brazil in the year 2002 are very similar to Mexico's 1998 figures (Brazil's debt ratio was 0.56 and the real interest rate with default risk was 10.8 percent). This suggests that using a common value of a for the four countries under study is not a bad first approximation. As we show below, default risk has two important implications for the analysis of sustainable debt based on the MO model. First, it lowers the levels of NDLs, since the real interest rates considered in Table 1 are lower than those resulting in the worst state of nature with default risk. Second, it alters the dynamics of public debt, since the rate of interest now increases with the level of debt. These two effects result in lower NDLs, reduced levels of sustainable debt and faster convergence to states of fiscal crisis. Table 2 shows the effects of introducing time-varying default risk in the calculations of NDLs.3 In all the estimates shown in this Table, the risk free rate is set at the 1990-2002 average of the real 90-day T-bill rate, which is 2.36 percent, and the curvature parameter of the probability of repayments is kept at a = 0.124. The first panel of Table 2 shows how the benchmark estimates of NDLs change when default risk is introduced. These benchmark estimates take the same growth rates and minimum levels of public revenues and outlays as in the benchmark scenario of Table 1. The resulting NDLs are significantly smaller (by 17 to 26 percentage points of GDP) than those in the benchmark case without default risk. Note that this sharp decline of the NDLs occurs despite the fact that the risk-free rate at 2.36 percent is about half the longrun real interest rate used in the benchmark scenario of Table 1. The repayment probabilities at 96 percent and the default risk premia around 4.35 percent are similar across countries. The NDLs in this case ensure that governments would be able to repay even during a fiscal crisis, but they still may choose to default on debt ratios about 0.33 with 4 percent probability.

3

Note that with default risk, the constant rate of interest in the denominator of the formula for the NDL is replaced with the interest rate including default risk defined in equation (7). Since this interest rate depends on the level of debt, the NDL is now the solution to a non-linear equation. 185

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The second panel of Table 2 shows how NDLs change in the growth slowdown scenario (which is perhaps more relevant since the data used to calibrate the risk free rate and the repayment probability function are for the 19901-2002 period). Again, relative to the growth slowdown scenario of Table 1, we are lowering the risk-free rate from 5 to 2.36 percent and introducing time-varying default risk. To isolate the contribution of the latter, the third panel of Table 2 shows the NDLs obtained using the growth rates of the growth slowdown scenario but assuming that there is no default risk so that countries can borrow at the 2.36 percent risk free rate. Since this rate is about half the one used in Table 1, we obtain very high NDLs (ranging from 73 to 152 percent of GDP). Two comparisons are interesting to make using the second and third panels of Table 2. First, the fact that the NDLs of the growth slowdown scenario in Table 1 (ranging from 30 to 45 percent of GDP) are much smaller than those of the no-default-risk case in panel 3 of Table 2, shows that our strategy of setting a long-run real interest rate of 5 percent as a proxy for default risk in the estimates of Table 1 was not a bad approximation. Second, the calculations of NDLs of the second and third panel differ only because the second incorporates the time-varying default risk premium (i.e., both have the same riskfree rate of 2.36 percent). Since the NDLs without time-varying default risk are 3 to 5 times larger than those with default risk, this comparison shows that default risk has major implications for estimates of NDLs. The last panel of Table 2 re-computes the required adjustments in outlays (i.e. the values of g71"") needed to support the observed maximum debt ratios of each country in the 1990-2002 sample as NDLs taking into account time-varying default risk. The adjustments in outlays are significantly larger than those reported in Table 1. Measured in standard deviations, the required adjustment in outlays exceeds the two-standard deviation threshold for all countries and it is larger for Mexico than for the other countries. Measured in terms of percentage points of GDP, the adjustments rank from 9.4 and 6 percentage points for Brazil and Colombia respectively to about 7 percentage points for Costa Rica and Mexico. This ranking suggests again that the debt positions of Brazil and Colombia are more difficult to reconcile with fiscal solvency considerations than those of Costa Rica and Mexico. Figure 4 illustrates the implications of default risk for the dynamics of public debt reflected in the measures of time to hit a fiscal crisis. The average time to hit a fiscal crisis is generally lower once the fact that the default risk premium rises with the level of debt is considered. Moreover, default risk produces debt dynamics that hit NDLs more often. This can be seen in the plots for Costa Rica and Mexico. In Costa Rica's plot, for example, an initial debt ratio of 40 percent produced at least some stochastic simulations in the sampling of 1000 runs in which the debt vanished when we use a fixed interest rate. With default risk, however, all 1000 stochastic simulations eventually hit the NDL and on average it takes about 9 years for the economy to hit a fiscal crisis. Conclusions, Caveats and Extensions This application of the basic version of the MO model to the cases of Brazil, Colombia, Costa Rica and Mexico shows that, with the exception of Costa Rica, public debt ratios are already close to the natural debt limits that the governments of these countries should respect if they wish to preserve smooth access to debt markets, and protect the credibility

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of their perceived commitment to be able to repay their debts. This is the result assuming a relatively optimistic scenario in which the growth slowdown of the last two decades is reversed to recover the average per-capita growth rates observed between 1961 and 2000, and the real interest rate remains at a relatively low level of 5 percent. This baseline scenario is also optimistic in that it requires credible commitments to large cuts in government outlays which recent experience indicates are a low-probability event (in terms of a coefficient of adjustment defined in units of standard deviations relative to the mean of the ratio of outlays to GDP). Considering less optimistic scenarios in which growth continues at the low trend of the last two decades or the real interest rate increases to 8 percent, current debt ratios would exceed NDLs even with the same tough stance to cut outlays in a state of fiscal crisis assumed in the benchmark scenario. The model predicts that the long-run dynamics of the public debt ratio are undetermined (or more precisely that there is no unique, invariant limiting distribution for the debt output ratio). This result needs to be considered carefully. On one hand, the result does not require very strong assumptions: stochastic revenue, relatively inflexible outlays and some limit to debt market access (whether an NDL or some an ad-hoc debt limit). Also, the same outcome would result if we take outlays as given and consider instead arguments for tax smoothing as in Barro (1979). If these are the maintained assumptions of fiscal solvency analysis, the estimates of time to a fiscal crisis and the stochastic simulations of debt ratios shown in Figures 2-4, together with the natural debt limits, summarize all relevant information for assessing whether observed public debt dynamics are sustainable. In addition, we would need to worry about how this nonstationarity property affects other statistical methods of debt sustainability analysis that rely on the existence of a well-defined long-run distribution of debt. On the other hand, we may question the validity of the assumptions that led to the result of an indeterminate long-run distribution of debt. In Mendoza and Oviedo (2004) we propose a setup in which government chooses its outlays optimally instead of setting ad-hoc rules. In particular, we assume that government outlays yield utility to the private sector, with the added feature of a Stone-Geary-like utility function that sets minimum levels of government expenditures. We preserve the spirit of the "tormented insurer's" problem by keeping the assumption that the government aims to maximize its contribution to private utility given the randomness of fiscal revenue and the fact that it can only issue non-state-contingent debt. In this setup, the government has a precautionary-savings motive that yields a unique, invariant limiting distribution of public debt (resulting from the trade off between the need to self-insure against the risk of persistent revenue shocks and the desire to smooth government outlays). The role of the NDL is made clearer because the desire to respect it emerges from the fact that otherwise the government is exposed to the risk of experiencing states in which its outlays can be very low, and the government is very averse to these states because of the constant-relative-risk-aversion nature of the utility function of public expenditures. Most of the analysis was conducted giving a limited role to default risk (by simply setting a long-run, time-invariant real interest rate with a premium above the risk-free rate). This was done following the approach of the MO model to provide a forward-looking tool to design fiscal programs with the explicit intention of preserving the government's ability to fulfill its financial obligations. However, default risk is an important feature of 187

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emerging markets of sovereign debt, and hence it is worth adding it to the analysis of debt sustainability. We introduced default risk by adopting an exogenous, exponential probability of repayment that varies with the level of debt. We assumed that lenders are risk neutral and hence are willing to take default risk by lending at a rate that incorporates the premium that equates the expected return of risky lending with the risk-free interest rate. The risk premium function was calibrated to match observed debt ratios and EMBI+ spreads on sovereign debt. Introducing this change into the basic version of the M-O model produces smaller debt limits and speeds up the dynamics that lead to states of fiscal crisis in which NDLs are reached. NDLs that completely ignore default risk support dynamic paths of sustainable debt with much higher debt ratios than those obtained when default risk is introduced. However, since the basic M-O model approximated the long-run component of default risk by adding a constant premium above the risk-free interest rate, it yields results for debt dynamics that are a much closer approximation to those produced by the model with time-varying default risk than those of a model that ignores default risk completely. The application of the MO model undertaken in this paper did not consider two other important elements of the dynamics of public debt in emerging economies: the endogeneity of the tax bases and fiscal policy choices and the role of financial frictions like liability dollarization. The endogeneity of the tax bases can be incorporated into the structure of the MO model. This requires introducing the decisions of the private sector with regard to the variables that determine the allocations and prices that conform tax bases (such as labor supply, consumption, the current account and capital accumulation). Similarly, liability dollarization can be introduced by modifying the model to incorporate tradable and nontradable goods. The dynamic stochastic general equilibrium model studied in Mendoza and Oviedo (2004) tries to make progress in these two directions.

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References Aiyagari, S. Rao (1994), "Uninsured idiosyncratic risk and aggregate saving," Quarterly Journal of Economics, 109(3):659-684. Arellano, Cristina (2004), "Default Risk, the Real Exchange Rate and Income Fluctuations in Emerging Economies", mimeo, Duke University. Barnhill Jr., Theodore M. and George Kopits (2003), "Assessing Fiscal Sustainability Under Uncertainty," IMF Working Paper No. WP/03/79. Barro, Robert J, (1979), "On the Determination of Public Debt," Journal of Political Economy. Blanchard, Olivier J., Jean-Claude Chouraqui, Robert P. Hagemann and Nicola Sartor (1990), "The Sustainability of Fiscal Policy: New Answers to an Old Question," OECD Economic Studies, No. 15, Autumn. Blanchard, Olivier J., (1990), "Suggestions for a New Set of Fiscal Indicators," OECD Working Paper No. 79, April. Bohn, Henning, (1998), "The Behavior of U.S. Public Debt and Deficits," Quarterly Journal of Economics, v. 113, August, 949-963. Buiter, Willem H. (1985), "Guide to Public Sector Debt and Deficits," Economic Policy: An European Forum, Vol. 1., November, 13-79. Calvo, Guillermo A., Alejandro Izquierdo and Ernesto Talvi (2003), "Sudden Stops, the Real Exchange Rate and Fiscal Sustainability: Argentina's Lessons," mimeo, Research Department, Inter-American Development Bank. Chalk, Nigel and Richard Hemming (2000), "Assessing Fiscal Sustainability in Theory and Practice," IMF Working Paper No. WP/00/81. Eaton, Jonathan, and Mark Gersovitz (1981), "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, v. XLVn, 289309. Hamilton, James D. and Marjorie A. Flavin (1986), "On the Limitations of Government Borrowing: A Framework for Empirical Testing," American Economic Review, v. 76, September, 809-819. International Monetary Fund (2002), "Assessing Sustainability," SM/02/166. , (2003), "Sustainability-Review of Application and Methodological Refinements," mimeo, Policy Development and Review Department. Ljungqvist, Lars and Thomas J. Sargent (2000), Recursive Macroeconomic Theory, MIT Press. Mendoza, Enrique G. Assaf Razin and Linda L. Tesar (1994), "Effective Tax Rates in Macroeconomics: Cross-Country Estimates of Tax Rates on Factor Incomes and Consumption," Journal of Monetary Economics, December, v. 34:3, 297-323. Mendoza, Enrique G. and Pedro Marcelo Oviedo (2004), "Fiscal Solvency and Macroeconomic Uncertainty in Emerging Markets: The Tale of the Tormented Insurer," mimeo, Iowa State University. Reinhart, Carmen, Kenneth S. Rogoff and Miguel A. Savastano (2003), "Debt Intolerance," mimeo, IMF Research Department.

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Table 1. Fiscal Sector Statistics and Natural Debt Limits (in percent of GDP) Brazil 1/

Colombia 21

Costa Rica 21

Mexico 3/

Public debt average maximum year of maximum

1990-2002 40.68 56.00 2002

1990-2002 33.71 50.20 2002

1990-2002 49.46 53.08 1996

7990-2002 45.92 54.90 1998

Public revenue average coeff. of variation two-standard dev. Floor

1990-2002 19.28 14.13 13.83

7990-7999 12.64 8.86 10.40

7990-2000 20.28 5.41 18.09

1990-2002 22.96 8.04 19.27

Non-interest outlays average coeff. of variation

1991-1998 19.19 13.76

7990-7999 12.80 13.55

7990-2000 18.54 9.98

1990-2002 19.27 3.96

2.55 12.46

2.30 8.81

1,16 16.40

2.02 17.73

1.86 50.49 -5.29

1.83 53.31 54.80

2.20 54.92 131.54

Fiscal sector statistics

Implied fiscal adjustment 4/ Implied minimum non-interest outlays

Benchmark Natural Debt Limits (1961-2000 growth rates, 5 percent real interest rate) 2.55 Growth rate 56.09 Natural debt limit 3.52 Blanchard ratio

Growth Slowdown Scenario (1981-2000 growth rates, 5 percent real interest rate, benchmark fiscal adjustment) 1.25 0.48 1.05 Growth rate 45.10 40.10 30.34 Natural debt limit 46.36 •4.20 1.90 Blanchard ratio

0.83 36.96 88.52

High Real Interest Rate Scenario (1961-2000 growth rates, 8 percent real interest rate, benchmark fiscal adjustment) 2.55 1.86 1.83 Growth rate 25.81 27.39 25.19 Natural debt limit 28.16 1.58 -2.70 Blanchard ratio

2.20 26.53 63.55

Note: The source of public debt data is IMF, World Economic Outlook, October 2003. The sources of revenue and non-interest outlays are as noted in country footnotes. 1/ Revenue data from IMF, World Economic Outlook, Oct. 2003., non-interest outlays data derived from data for the Central Government in World Development Indicators. 21 Revenue and non-interest outlays data for Central Government from World Dev. Indicators. 3/ Revenue and non-interest outlays data from IMF, World Economic Outlook, October, 2003. 4/ Implied fiscal adjustment is the number of standard deviations relative to the mean needed to obtain a benchmark natural debt limit equal to the largest public debt ratio observed in the data.

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Table 2. Natural Debt Limits with Default Risk Brazil

Colombia

Costa Rica

Mexico

33.28 95.96 4.31

33.18

95.97 4.30

34.14 95.86 4.42

33.88 95.89

30.38 96.31 3.93

32.12 96.10 4.16

29.12 96.46 3.76

NDLs in the growth slowdown scenario without default risk and risk free rate of 2.36 percent 121.60 Natural debt limit 72.95 152.30

100.80

Required fiscal adjustment to support observed maximum debt ratios as NDLS 2/ 50.20 56.00 Natural debt limit 93.97 Probability of repayment 93.30 6.57 7.35 Default risk premium 6.85 9.82 Implied minimum non-interest outlays -5.95 -9.37 relative to average outlays 3.43 3.55 in number of St. devs.

54.90 93.43 7.20 15.23 -4.04 5.30

Benchmark NDLs with default risk 1/ Natural debt limit Probability of repayment Default risk premium

NDLs in the growth slowdown scenario with default risk Natural debt limit 26.12 Probability of repayment 96.82 3.37 Default risk premium

53.08 93.64 6.95 14.12 -4.42 2.39

4.39

Notes: Calculations done as described in the text, using a risk free rate of 2.36 percent, which is the 1990-2002 average of the inflation-adjusted 90-day U.S. T-bill rate, and a curvature parameter for the risk function of a =0.124, which was calibrated to match the EMBI+ spread and the debt ratios observed in Mexico in 1998. 17 Based on the benchmark values of growth rates and minimum revenue and outlays shown in Table 1 21 Values of minimum outlays required to support maximum debt ratios shown in Table 1 as NDLs in the setting with default risk, using growth rates from the benchmark scenario.

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Figure 1. Total Public Debt as a Share of GDP

-*— Brazil "-afir- Costa Rica

-*- Colombia *»*%&*, Mexico

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Figure 2. Number of Periods before Hitting a Fiscal Crisis

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Figure 3. Simulations of Debt-to-GDP in Costa Rica. Starting Value bg= 0.35

Time periods

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Figure 4. Time to Hit a Fiscal Crisis with and without Default Risk

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Exchange Rate Regimes and Debt Maturity Structure*

Matthieu Bussiere European Central Bank Marcel Fratzscher European Central Bank Winfried Koeniger IZA, Bonn; Finance and Consumption in the EU, European University Institute

*We would like to thank for their very helpful comments Carmen Reinhart and seminar participants at the IMF-Banco de Espaiia conference on "Dollars, Debt, and Deficits - Sixty Years after Bretton Woods" in Madrid 2004. The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Central Bank. This draft is as of October 2004.

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Introduction Do exchange rate regimes matter for macroeconomic performance? This is an old question of major importance for policy-makers which explains the persistent scientific debate on the topic. The recent empirical findings of Husain et al. (2004) suggest that exchange-rate regimes imply quite heterogeneous outcomes in countries with different economic development. In order to understand better this heterogeneity, this paper focuses on a specific interaction between exchange-rate regimes and economic performance which has been relatively unexplored so far. We investigate whether and how the exchange-rate regime affects the maturity mix of private debt in emerging markets that only have access to credit denominated in foreign currency. The importance of credit in foreign currency in emerging markets can hardly be overemphasized. For example, Levy-Yeyati (2003) documents that more than 70% of bonded debt in emerging markets is denominated in foreign currency. At the same time many emerging markets have substantial maturity mismatches which are frequently identified as one major culprit of the Asian financial crisis of the 1990s (see, for instance, Chang and Velasco, 2000, Corsetti, Pesenti and Roubini, 1999, or Rodrik and Velasco, 1999).1 Yet, while many papers have explained how imbalances in the asset and liability structure of emerging markets can cause currency and financial crises, the factors that trigger such imbalances in the first place have received relatively little attention so far. In particular, few papers have considered the possibility that the exchange-rate regime influences the debt structure. Instead of the more prevalent view that maturity mismatches lead to volatile exchange-rates, we stress that highly flexible and volatile exchange rates may shift the debt profile towards short-term maturities, thereby increasing the vulnerability of emerging markets to liquidity crunches. First, we provide a model which links exchange-rate regimes and maturity mismatch in open emerging market economies. We show theoretically how currency mismatch may lead to and exacerbate maturity mismatch in economies with flexible exchange rates resulting in higher output volatility. Compared with much of the literature on the subject, our model abstracts from asymmetric information and moral hazard (see, e.g., Diamond, 1991, Jeanne, 2000, and Tirole, 2003), and focuses instead on the role of market incompleteness. Although we recognize that asymmetric information and moral hazard may be important, we show that such model ingredients are not necessary to explain the joint phenomena of currency depreciation and asset liquidation accompanied by high short-term debt ratios. Thus, the removal of market failures may not suffice to tilt the debt profile towards safer, long-term debt. Instead our model assigns a crucial role to the development of financial markets or instruments that allow agents to insure better against risk. Second, we provide empirical results that support the predictions of the model for a set of 28 open emerging market economies. We add to the literature on exchangerate regimes and macroeconomic performance (see, for example, Husain et al., 2004, and their references) by analyzing the influence of exchange-rate regimes on the debt structure in some detail.2 In our analysis we take into account that the choice of the exchange-rate regime or the degree of intervention in the currency market is influenced by macroeconomic factors (the fear of floating discussed in Calvo and Reinhart, 2002). We use annual data from the World Economic Outlook (WEO) for macro-economic !

Arteta (2002) establishes the additional result that floating regimes seem to increase currency mismatches in domestic financial intermediation. 2 For a more on the related literature see Bussiere, Fratzscher and Koeniger (2004).

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variables and the Bank of International Settlements (BIS) for debt variables. Our main finding is that countries with more flexible exchange rates hold a higher share of debt with short maturity. This maturity mismatch of foreign debt is associated with more volatile output. The remainder of the paper is structured as follows. Section 2 presentw a simple model to show how exchange-rate regimes can change the debt-maturity structure and output volatility. We empirically test the main predictions of the model more formally in Section 3. Finally, we discuss policy implications and conclusions in Section 4. A Simple Model In this section we illustrate how flexible exchange rates might shift the debt structure towards short-term maturities.3 More specifically, we model how the exchange-rate regime influences solvency and the choice of debt maturity (the model draws on work in Bussiere, Fratzscher and Koeniger, 2004). Forward-looking and impatient riskneutral agents choose whether to consume or to invest, financing their investment with short- or long-term foreign debt. We assume that debt (i) can only be obtained in the international capital market, (ii) is denominated in foreign currency and (iii) is constrained by solvency, which requires that agents can always repay. Agents face a simple trade-off in their choice of debt maturity. Since flexible and volatile exchange-rates tighten solvency constraints relatively more for long-term debt, borrowers have an incentive to raise the share of short-term debt. However, shortterm debt is risky and the investment project can be liquidated before the investment return materializes so that agents have smaller collateral if they borrow short term As a consequence, a larger share of short-term debt raises the share of investment projects at risk. In our model, liquidation of the collateral, and a larger fraction of short-term debt are the result of optimal choices of individual agents. We now present the structure of the model in more detail. Consider an economy with 3 periods. Impatient risk-neutral agents with endowment K either can invest K into a project or immediately consume it. If agents invest they can decide whether to finance consumption with short or long-term debt. Agents with short-term debt need to rollover their debt in the second period. The decision to invest yields an immediate flow jK, 1 > / > 0 . Instead, the project income Y only becomes available in period 3. All debt is denominated in foreign currency. This is realistic for emerging market economies in which most of the debt is in foreign currency (see Levy-Yeyati, 2003, or Corsetti, Pesenti and Roubini, 1999). The different currency denomination of investment returns and debt liabilities implies that exchange-rate flexibility influences the borrowing choices of investing agents. If financial markets are incomplete, borrowers will have to bear at least some of the exchange-rate risk. We assume as benchmark case that all risk is in fact borne by borrowers: markets are incomplete in that borrowers only have access to a risk-free asset with interest rate r. This implies that investing agents face constraints that ensure repayment of their debt in all states of the world. These constraints differ with respect to maturity and crucially depend on the pledgeable income and the maximum depreciation of the exchange rate. We now characterize these constraints for flexible and fixed exchange-rate regimes. 3

Of course, the choice whether to adopt flexible exchange rates might depend on the stock of short-term debt in the economy: countries with a large amount of short-term debt might fear to float the exchange rate. Since this endogeneity is extensively discussed in the literature (see Calvo and Reinhart, 2002), we focus entirely on the direct effect of flexible exchange rates on debt maturity in the theoretical part. Instead, the empirical estimation will try to account for the endogeneity of the exchange-rate regime.

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Solvency Constraints Flexible Exchange Rates Given the endowment K and nroiect income 7, agents that invest and borrow short term cannot borrow more than in the first period where R is the interest factor, Xi denotes the maximum possible depreciation of the exchange rate until period 2 and the exchange-rate in the first period is normalized to 1. If the agent invests and borrows long-term instead he cannot borrow more than in the first period where Xs denotes the maximum possible depreciation of the exchange rate until period 3. Note that access to credit becomes relatively tighter for long-maturity debt, the larger R and the larger X3 relative to X2 . Since long-term debt needs to be repaid in period 3 the pledgeable income K+Y is worth less in present-value terms. This is especially so, if the maximum possible depreciation of the exchange rate increases over time. Instead, long-term debt increases the pledgeable income from AT to K+Y, since the agent earns the project returns with certainty. Thus, more credit is available short-term if the difference in pledgeable income Y is relatively small compared with the additional possible depreciation of the exchange rate X3 / Xi . Note that if exchange rates are characterized by a stochastic process with increasing variance for longer time horizons, Fixed Exchange Rates As a stylized conparison let us consider exchange rates that are fixed with certainty. In this case the pledgeable income is independent of debt maturity and agents cannot borrow more than (K + Y)/R2 in the first period where the exchange-rate in the first period is normalized to 1. Note that agents can always borrow more than KIR in the first period since arbitrage implies that the return to the project 7+y, where y^Y/K , needs to be larger than R2 . That is, for agents to find it optimal to invest, projects have to yield a return at least as high as the risk-free asset over two periods. More importantly, more credit is available if exchange rates are fixed rather than flexible. Optimal Maturity Assuming that the debt roll-over in the second period implies an infinitesimally small transaction cost e, all debt has long maturity if exchange rates are fixed with certainty. Instead, flexible exchange rates imply a non-degenerate choice of debt maturity. We analyze this choice focusing in particular on the role of different degrees of exchangerate volatility captured by the paramete] This corresponds to investigating the effect of different exchange-rate regimes on the debt-maturity structure in the empirical section. We assume that agents are impatient: the discount factor . This together with risk neutrality implies that agents prefer to bring forward consumption as much as possible to the present. Thus, the solvency constraints determine the consumption profile of investing agents and also the optimal maturity choice.

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Table 1: Consumption profile

No debt K

Period 1 Period 2 no depreciation depreciation Periods no depr. in period 1

LTdebt

ST debt

0 * no depr. in period 2

0

depr. in period 2 depr. in period 1 no depr. in period 2 depr. i n period 2

^ ^ ^

0 0 0

0

We assume that in each period the exchange rate depreciates by factor X >\ with probability p and remains constant with probability 1-p. That is the worst possible exchange rate from the perspective of the borrower is X in period 2 and X in period 3. For simplicity we assume that the agent always needs to liquidate the project if the exchange rate depreciates and the agent borrows short-term. This implies the following restriction on the parameter space: 1 + y < RX .5 Table 1 summarizes the consumption profiles for the different choices of the agent. Using these consumption profiles we can easily spell out utility for the different choices as a function of the model's parameters. Normalizing by K and denoting utility with Uj , j = nj,s , with the subscript n for no investment, / for investment financed with long-term debt and s for investment financed with short-term debt, we get

Note that

and

, i=/,$ , as long as agents are

impatient. Figure 1 plots utility as a function of X. Table 2 contains the parameter values that were chosen for illustration purposes. In Bussiere, Fratzscher and Koeniger (2004) we endogenize the probability of liquidation. This makes the algebra more cumbersome but does not change the basic insights. In the second period the agent cannot roll-over the debt if ^—f — RX-j^ un and us > un . Interestingly, long-term debt is preferred for small X, ul>us , but higher X can shift debt towards short maturity: HS>UI . Moreover, as mentioned above the scope for borrowing short-term becomes smaller for high project returns: in Figure 1, the region of the X fs in which the agent finds it optimal to borrow short-term becomes smaller as y increases from 0.1 to 0.15 .

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Linear utility implies that for given X and y the agent either borrows only long-term or only short-term if he invests. In order to generate predictions about the debt structure in the aggregate economy in a simple way, we add heterogeneity in the project return y. Consider an economy populated by a continuum of agents with heterogeneous project returns yf in the interval [0;^]. One can show that for each X there exists a critical value of .y at which the agent finds it optimal to borrow longterm6 As the intuition obtained from the discussion of the solvency constraints and illustration in Figure 1 suggest, this critical value is higher for larger X so that the share of projects financed with short-term debt increases for larger JSf(see Bussiere, Fratzscher and Koeniger, 2004, for an elaboration of this point). Of course, also the total number of projects decreases because investment becomes less attractive. However, relative to a benchmark with a fixed exchange rate, a flexible exchange-rate regime results not only in a smaller level of total debt but also in larger share of debt with short maturity. This increases volatility (as long as some projects are financed short-term): projects financed on a short-term basis are liquidated with probability p in which case the project return Y is lost. This is the basic insight we want to convey: if a country adopts a flexible exchange-rate regime, additional macroeconomic volatility can result from an endogenous shift of the country's debt structure towards short-term maturities. We now try to find some empirical support for this hypothesis. Empirical Evidence To test empirically whether the choice of the exchange rate regime has an impact on debt structure in emerging markets, we use financial and macroeconomic data for 28 emerging market economies: 9 in Asia, 8 in Latin America, 8 Central and Eastern European Countries (CEECs), as well as South Africa, Russia and Turkey. Time series on debt were taken from the BIS and start in the 1980s. The country sample was selected to include mostly open emerging markets (i.e., countries that opened up their financial account during or before the period under consideration), and based on data availability criteria. For CEECs, the first part of the 1990s had to be dropped due to data unavailability and because the first years of the transition to a market economy were characterized by very high volatility. Such high volatility can be considered as a one-off event, not representative of the mechanisms we aim at analyzing.

6

Of course, if this critical y is larger than y, no debt is borrowed long-term at all. 204

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Table 3: Exchange rate regime, distribution by period (%). Total ! 1960-69 1970-79 1980-89 1990-99 2000-2004 0.4 A. No separate legal tender 3.2 B. Pre announced peg or currency board arrangement 249 50.5 33.2 7.3 14.1 22.6 C. De facto peg 5.8 2.7 2.3 5.0 9.5 9.7 0.6| D. Pre announced crawling peg 1.4 0.9 0.7 E. Pre announced crawling band 1 narrower than or equal to +/-2% 1.9| 5.6 3.2 F. De facto crawling peg 0.5 16.4 10.2 4.0 6.7I G. De facto crawling band narrower I than or equal to +/-2% 16.41 8.2 22.7 25.9 13.8 8.9 1 H. Pre announced crawling band that is _ _ wider than or equal to +/-2% 0.9l 0.5 1.6 3.2 1 1. De facto crawling band narrower than • or equal to +/-5% 10.9 14.1 16.4 4.6 11.2 6.5 J. Managed floating 11.7 15.9 6.4 14.1 4.9 25.8 K. Freely floating 1.8 2.6 9.7 L Freely falling 15.1J 4.1 13.6 23.6 22.7 3.2 M. Dual market in which parallel I market data is missing 2.9, 4.6 3.6 1.8 3.0 Number of observations 1088) 220 220 220 304 124

ii

Source: Reinhart and Rogoff, 2004. The sum of each column is by construction equal to 100%.

Data on exchange-rate regimes were provided by Reinhart and Rogoff (2004). This classification allows distinguishing 13 types of exchange-rate regimes, listed in Table 3 (the original classification included 15 categories but two of them never appeared in the sample)7. The Reinhart-Rogoff classification is a de facto classification in that the authors analyzed to what extent announcements of de jure regimes truly hold de facto. They find that many of the countries1 de jure regimes deviate significantly from the actual exchange-rate behavior. Table 3 shows that for the countries in our sample, pre-announced pegs or currency board arrangements are the most common regimes over the entire period, representing nearly one fourth of the observations. However, the proportion of countries with such regimes fluctuates considerably over time: whereas it was above 50% in the 1960s, it fell to a third in the 1970s with the end of the Bretton Woods system, and less than 10% in the 1980s. Since then, the number of countries with a preannounced peg has increased again, to reach 22.6% of the country sample in the years 2000-2004. Conversely, the most extreme form of floating exchange rate ("freely falling") has increased regularly between the 1960s and the 1980s, to become the most common category in the 1990s with 22.7% of the cases in the sample. After 2000 however, this category has fallen considerably to slightly above 3%, whereas managed floating exchange-rate regimes have become in the past four years the most common form of arrangement, with more than a fourth of the observations.

These categories were (a) pre announced horizontal band that is narrower than or equal to +/-2% and (b) moving band that is narrower than or equal to +/-2% (i.e., allows for both appreciation and depreciation over time).

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Figure 2: Share of pegged exchange rate regimes (categories A,B,C in Table 3) and de facto exchange-rate volatility in the sample.

Note: The scale is on the left and right vertical axis, respectively. In addition to this classification, we also consider an alternative classification based on actual exchange-rate volatility.8 Such measure is in fact strongly correlated with the above mentioned de jure classification, as presented for instance on Fig. 2 9. To make the Reinhart and Rogoff measure amenable to econometric testing, we attribute values to the categories presented in Table 3 (1 for category A, 2 for B, etc, assuming that each increment is equal).10 In the Reinhart and Rogoff (2004) paper, two measures are presented: a socalled "fine measure" with the categories of Table 3, and a "coarse measure" with only six categories, each one aggregating two or three levels of the "fine measure". By and large, these two measures yielded similar results in the specifications we have estimated (see below), suggesting that results do not depend on the mapping of the categories into numbers. A simple regression of the de facto volatility measure on the Reinhart-Rogoff measure using fixed effects - not reported here - shows a positive coefficient, significant at the 1% level, suggesting that more flexible exchange-rate regimes are linked to higher actual exchange-rate volatility. Clearly, the link between the Reinhart-Rogoff measure and the de facto volatility measures of exchange-rate 8

We computed, for each year, the standard deviation of the first-differenced real effective exchange rate, using monthly data. 9 In Figure 2, pegged exchange rate correspond to the first three categories A, B and C of Table 3. 10 We tested this assumption using a set of 0/1 dummy variables, one for each of the categories represented in Table 3 (we took the first category as benchmark). Results suggested that the increment may actually be declining in the case of short-term debt: moving from regime A to regime B has a stronger effect on short-term debt than moving from B to C, etc. However, this effect is difficult to measure with precision given the degrees of freedom, which is why we resorted to the more straightforward linear specification.

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regimes are more complex than this simple regression suggests. For instance, a fixed peg regime is likely to exhibit low exchange-rate volatility but this does not mean that exchange-rate uncertainty is equally low: economic agents may anticipate a speculative attack against the peg which would have the effect to transform the regime into a floating exchange rate, accompanied by higher exchange-rate volatility. To account for this phenomenon, we computed four different measures of de facto exchange-rate volatility, measuring the standard deviation of the exchange rate over (i) the past three years, (ii) the past year, (iii) the year ahead and (iv) the three years ahead. Table 4: summary statistics, total and regional breakdown Lat. Am. Asia New EU M. S. 198019901980199019941989 2003 1989 2003 < 1994 2003 Pegged ER (% total) 11.3 21.4 16.4 27.3 NA 51.1 4.8 3.3 Exchange rate volatility 1.8 2.1 NA 1.9 53.2 48.9 38.5 38.3 NA 42.8 Debt/GDP (%) 17.6 14.8 Short-term/total debt (%) 19.0 15.9 NA 24.5 7 Growth volatility 0.7 0.6 1.3 1.1 NA 0.6

all EMFs 1980-19901989 2003

12.3 2.9 33.9 19.4 1.0

Note: unweighted average over sample period. 1/Normalised to 1 for all EMEst 1980-1989.

Turning to the dependent variables, Table 4 presents key stylized facts, broken down by region and by time period. All debt variables presented in Table 4 are debt to banks, taken from the BIS database.11 This particular definition of debt is not without caveat as it excludes in particular other debt instruments which also play an important role as well; however, it has the advantage to be available for many countries over a long period of time. In addition, this source offers a convenient breakdown by maturity: short-term debt is defined as debt whose maturity is below one year. Interestingly, for Latin America and Asia a larger ratio of exchange-rate pegs over time is negatively correlated with the amount of short-term debt. For all emerging market economies this decrease is less pronounced but instead the higher ratio of pegged exchange-rate regimes is positively associated with total debt. This is suggestive for the mechanisms highlighted by the simple theoretical perspective. However, Table 4 also shows pronounced heterogeneity across regions. Overall, Latin American countries hold more debt, as a percentage of GDP, than Asian countries and new European Union Member States. Such differences do not seem to be directly linked to the above described measures of exchange-rate regimes. As we will see below in the econometric results, other factors such as fixed country effects and other (time varying) control variables have an impact on the total debt level of a country and need to be controlled for in the econometric analysis. To estimate the impact of exchange-rate volatility on the debt structure, we followed the GMM methodology developed by Arellano and Bond (1991) using lagged differences as instruments. The results reported below are robust to using a standard fixed-effect estimator (see Bussiere, Fratzscher and Koeniger, 2004, for further discussion of the econometric methodology in our application). In order to control for other factors that may influence debt, we included on the right-hand side a set of control variables: real PPP adjusted GDP per head (as a proxy for catching up effects),

11We focus on private rather than government debt since the theoretical model outlined in the previous section applies to the former.

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27.1 26 41.7 18.7 0.8

the government budget balance (to account for the possible presence of non-Ricardian agents), investment (see Bleakley and Cowan, 2002), a dummy variable for capital account liberalization and a dummy variable for currency crises. The presence of the latter in the specification stems from the specific problem arising from currency crises, relatively frequent in our sample of emerging markets: as the debt ratios to GDP are computed using the exchange rate to convert foreign into national currency, such ratios mechanically jump up during crises times. Arguably, this variable is then not strictly exogenous. Likewise, the assumption that exchange-rate volatility is exogenously given is debatable and the endogeneity issue is only partly dealt with in the GMM methodology. Ideally, one would use instrumental variables in this context, that is, variables correlated with exchange-rate volatility but not with the debt ratios. However, we are not aware of a good instrument for our application. One should note however that if endogeneity plays a role, the link between exchange-rate volatility and debt that we measure in our regressions is actually a lower bound. If policy makers intervene in the foreign exchange markets to reduce to reduce exchange-rate volatility when the debt maturity structure is tilted towards short-term debt (fear of floating), the positive correlation between volatility and the share of short-term debt should be downward biased and thus less positive. Table 5: Exchange rate regime and debt S. T. debt Dependent variable: (% total debt) Reinhart-Rogoff: Fine measure

S. T. debt (% GDP)

0.23**

Coarse measure

0.32*** 0.09

0.10

0.63 **

0.88 ***

0.28

0.25

-0.02

-0.04

0.08

0.04

One year lag

0.02

0.01

Three years lead

0.14

One year lead

0.17*

De facto definition Three years lag

0.08 0.18

0.11

Total debt (% GDP) 0.82*** 0.17

2.28 *** 0.49

-0.46 *** 0.16

-0.29 ***

0.05

0.12

-0.24 *

-0.46 *

0. 16

0.27

-0.05

-0.21

0.10

0. 16

Standard errors in italics *, **, *** denote significance at the 10%, 5%, 1% level, resp.

Table 5 reports the results. Each of the three columns corresponds to one of the three following dependent variables: short-term debt as a share of total debt, short-term debt as a percentage of GDP, and total debt as a percentage of GDP. According to the simple theoretical results presented in the previous section, more exchange-rate volatility (measured as either de jure or de facto) should have a positive impact on short-term debt (first two columns), and a negative one on total debt. The table is synthetic in that it reports only the coefficient in front of the exchange-rate regime variables and not the control variables (estimated in different regressions, one at a

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time). The full results are available upon request. Regressions including the de facto exchange-rate volatility measures are estimated over 304 to 336 observations (taking three years to compute lags implies losing some of the observations). Those including the Reinhart and Rogoff measure are estimated with around 350 observations. Overall, the results provide substantial evidence in favor of the model's predictions. The coefficient of the Reinhart and Rogoff measures of exchange-rate volatility are positive and significant in the first two regressions, when the dependent variable is short-term debt. The de facto volatility measures are not as clear-cut, as many of the variables we used do not show up significantly, particularly in the second specification. However, interestingly, the de facto variable using the forward-looking one-year ahead volatility measure, which accordingly is the most relevant measure for debt with maturity under one year, enters the specification significantly and with a positive sign. Turning to the last column of Table 5, the impact of the de facto volatility measure on total debt is clearly negative and significant for three of the four measures, whereas it is negative but insignificant for the last one. This result is very much in line with the results of the theoretical section: more exchange-rate uncertainty is associated with lower total debt. More surprisingly, the impact of the Reinhart and Rogoff measure appears to be positive instead of negative. This result is counter-intuitive and seems to be driven by the currency crisis episodes: in the immediate aftermath of crises, countries often move to a more flexible exchange-rate regime but at the same time the debt ratio jumps up since the exchange rate depreciates and GDP falls. In fact, when currency crisis episodes are dropped from the sample, the impact is no longer significant. Although our currency crisis variable should pick up this effect, it does not completely solve the issue because the increase of the debt ratio often lasts a couple of years, whereas the crisis variable was set equal to one only at the time of the crisis. Finally, Table 6 reports results using output volatility as the dependent variable (again with one of the reported regressors at a time). The results suggest that more exchange-rate volatility is indeed correlated with larger output volatility, although it seems mostly through the impact on the debt maturity structure. Table 6: Exchange rate regime and output volatility coef. S.E. Reinhart-Rogoff: Fine measure 0.18 0.24 Coarse measure 0.22 0.69 De facto definition Three years lag One year lag Three years lead One year lead S.-T. debt (% tot. debt) S.-T. debt (% GDP) Total debt (% GDP)

-0.15 0.30 0.31 0.32 2.85 0.01 0.004

0.23 0.17* 0.62 0.20 0.98** 0.01 0.01

Dependent variable is volatility of real output *, **, *** denote significance at the 10%, 5%, 1% level, respectively.

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Conclusions This paper has investigated the role of exchange-rate regimes for macroeconomic stability, focusing in particular on the influence of the exchange-rate regime on the maturity structure of debt. A simple theoretical model suggests that a more flexible exchange-rate regime may shift the debt structure towards short-term debt, which in turn can increase output volatility. Taking the model to the data, we find broad support for the model. In particular, more exchange-rate uncertainty seems to be associated with a larger share of short-term debt. A possible extension for future research would be to allow for the possibility of default in the model and to introduce moral hazard and asymmetric information, since these phenomena are important for capital markets in reality. However, better data are necessary to test predictions of such a model. Data on interest rates across different maturities for private debt would allow to analyze the interaction of credit prices and credit demand, instead of focusing only on credit supply and credit volumes. Our model emphasizes the importance of market incompleteness and does not rely on asymmetric information or moral hazard to explain the debt structure and the inclination of emerging markets to be subject to financial crises and substantial real volatility in the economy. If market incompleteness is important, it is crucial to develop financial markets or instruments that allow agents to insure better against risk so that financial crises in emerging markets can be avoided. Concrete policy proposals to address this issue have started to emerge. Some of the proposals call for the development of domestic financial markets for local-currency substitutes to dollarized debt (Levy-Yeyati, 2003) or for the issuance of bond contracts denominated in units of a basket of emerging-market currencies (Eichengreen and Hausmann, 2003).

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References Arteta, Carlos (2002), "Exchange Rate Regimes and Financial Dollarization: Does Flexibility Reduce Bank Currency Mismatches?", International Finance Discussion Papers, Number 738, September 2002, Board of Governors of the Federal Reserve System. Bleakley, Hoyt and Kevin Cowan (2002): Corporate Dollar Debt and Depreciations: much ado about nothing?, UC San Diego, mimeo. Bussiere, Matthieu, Marcel Fratzscher and Winfried Koeniger (2004): Currency Mismatch, Uncertainty and Debt Maturity Structure, forthcoming ECB Working Paper. Calvo, Guillermo A. and Carmen M. Reinhart (2002): Fear of Floating, Quarterly Journal of Economics, vol. 67, 379-408. Chang, Roberto and Andres Velasco (2000): Banks, Debt Maturity and Financial Crisis, Journal of International Economics, vol. 51, 169-94. Corsetti, Giancarlo, Paolo Pesenti and Nouriel Roubini (1999): What Caused the Asian Currency and Financial Crisis?, Japan and the World Economy, vol. 11, 305-73. Diamond, Douglas W. (1991): Debt Maturity Structure and Liquidity Risk, Quarterly Journal of Economics, vol. 106, 709-37. Eichengreen, Barry and Ricardo Hausmann (2003): Original Sin: the road to redemption, in: Eichengreen, Barry and Ricardo Hausmann, eds., Other People's Money: Debt Denomination and Financial Instability in Emerging Market Economies, University of Chicago Press, Chicago. Husain, Aasim, Aska Mody and Kenneth S. Rogoff (2004): Exchange Rate Regime Durability and Performance in Developing Versus Advanced Economies, NBER Working Paper No. 10673. Jeanne, Olivier (2000): Debt Maturity and the Global Financial Architecture, CEPR Discussion Paper No. 2520. Levy-Yeyati, Eduardo (2003): Financial Dollarization: where do we stand?, Conference on Financial Dedollarization: Policy Options, IADB, Washington D.C., mimeo. Reinhart, Carmen and Kenneth S. Rogoff (2004): The Modern History of Exchange Rate Arrangements: A Reinterpretation, Quarterly Journal of Economics, vol. 69, 1-48. Rodrik, Dani and Andres Velasco (1999): Short-Term Capital Flows, Annual World Bank Conference on Development Economics, 1999. Tirole, Jean (2003): Inefficient Foreign Borrowing: a dual- and common-agency perspective, American Economic Review, vol. 93, 1678-702.

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COMMENT Financial Globalization and Exchange Rates (Philip R. Lane and Gian Maria Milesi-Ferretti)

Daniel Cohen Ecole normale superieure

This is a wonderful paper, crisp and full of insights. The core idea is the following: countries are rarely in the comer position of being either strictly debtor or creditor. They are most often simultaneously both. They hold claims on the rest of the world and they are in debt with respect to it. The most obvious example that comes to mind is the US. It is not only the largest debtor on earth but the largest creditor as well. Over the period 1999-2002 alone, the US has borrowed the equivalent of 31% of its GDP. But over the same period, it also accumulated claims over the rest of the world worth about 15% of GDP. This pattern is frequent for industrial countries, but is also visible for emerging countries as well. In the case of Korea, for instance, the inflows represent 10% of GDP, the outflows stand at 12% of GDP. In Taiwan, the numbers are 25% of GDP both ways (again from 1999 to 2004). The benefit of being in and out simultaneously is obvious within any theoretical framework where countries want to diversify their portfolio. For countries which are high in debt and do not cash in the benefits of being on both sides of the fence, this adds to the ills of debt crises. For countries which do cash in the benefits of being on both sides, the macroeconomics of exchange rate fluctuations become quite interesting. What happens when the exchange rate depreciates? For most industrial countries, the paper shows that the return on foreign assets appears to be almost orthogonal to the exchange rate of the country. What happens on the liability side? The surprising result of the paper is that liabilities appear to follow pretty much the same pattern which implies that "the net valuation impact of exchange rate movements on the net foreign asset position has been limited" The exception to this rule is the US. Contrary to other industrialized countries, liabilities are unaffected by currency movements, a fact which quite obviously results from the US borrowing in dollar. But the surprising result is that assets follow almost the same pattern. It all appears to be as if the US was living in a dollar zone, with little implications of exchange rate fluctuations on assets and liabilities. This is not necessarily good news if one counts on the dollar depreciation to solve, through the sheer force of wealth effects, the debt problem of the US.

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The only exceptions to the rule that flows are important in and out come from countries which are deep in debt. This is the case of Brazil, for instance, that brought in 17% of GDP over 1999-2004 and brought out -1.4% of GDP (i.e., decumulated over its gross position abroad) over the same period. I would like to suggest here some connection with the work that we have done with Richard Fortes. We explore the dynamics of debt for middle income debtors and try to differentiate the role of "risk", growth, and policies on the pattern of debt accumulation on emerging countries. We characterize risk through real interest rate, which involves both interest cum spread and deviation of exchange rate to PPP. The bulk of this latter term is quite often enormous. We have decomposed the debt dynamics into the following identity: Increase of the Debt-to-GDP ratio = real interest rate * Debt-to-GDP ratio - Growth rate of the economy * Debt-to-GDP ratio - Primary Surplus/GDP The real interest rate is the nominal rate (risk free rate + spread) adjusted for the deviation of the exchange rate from PPP. The dynamics are computed up to the year of the debt crisis itself. We present this decomposition below by dividing each of the three terms of the right-hand side by the sum of their absolute values (the sum of absolute value then adds to one). I take here four cases of importance. Interest+Change Growth Deficit Brazil 0.47 -0.51 0.02 India 0.35 -0.49 0.16 Russia +0.50 -0.50 0 Turkey 0.52 -0.10 -0.39 Each item expressed as a fraction of the sum of absolute value

The first term is roughly interpreted as a confidence premium, the second term as a measure of the underlying fundamentals and the third term as a measure of the policy choices. We see that in all four cases the countries are heavily burdened by the interests-exchange rates term, which almost entirely cancels the (beneficial) growth factor. The fact that these countries appear to be in the Lane-Milesi-Ferretti comer situation has certainly much to do with it. Countries which are deep in debt and have no precautionary assets are likely to be more vulnerable to confidence shocks. More work is needed to thorough this connection, but at this stage much already has been learnt.

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COMMENT Stanley Fischer Member of the Board, Citigroup, Inc. It is a great pleasure to participate in this panel, surrounded to left and right by former IMF colleagues, each of whom has moved on to better things - whether inside the Fund or out of it. I will discuss six points, very briefly. First, what are the imbalances about which we worry? Second, do they need to be fixed? Third, how? Fourth, what about the role of China? Fifth, is the US dollar going to have a hard landing and do we need to worry about that? And finally, I would like to talk a bit about currency blocks. 1. The imbalances. Typically people worry about one imbalance, the US current account deficit, which exceeds five percent of GDP. Of course there are corresponding current account surpluses in other countries, though there seems to be less concern about that side of the equation. Consider date for 2003. The US current account deficit was about 530 billion dollars in 2003. The corresponding surpluses were in Japan ($140 billion) and the rest of East Asia (approximately another $140 billion). The mysterious statistical discrepancy accounted for 120 billion dollars. The remaining counterpart of the US deficit consisted of the surpluses of the EU, Russia, other oil producers, and other countries. Fundamentally, then, over half the US current account deficit was with Japan and East Asia. 2. Do the deficits need to be fixed? There is a certain inconsistency in the way we all talk about current account imbalances. Almost every country prefers to have a current account surplus. Many countries that are quite happy with their surpluses complain that the US is running a large deficit and acting irresponsibly in the global economy. In the aftermath of the Asian crisis, in which countries with more reserves on the whole surmounted the crisis better, many countries wanted to build up their reserves. These countries were content to run current account surpluses. In the midst of its lengthy recession, Japan has not wanted the yen to appreciate. So it too has been content to run large current account surpluses and build up reserves. Dooley, Folkerts-Landau and Garber have described this as a new Bretton Woods system, one that will enable the world to absorb the massive supplies of labor in China that are now entering the global economy. The only problem with that argument is that the current level of the US current account deficit is unsustainable. Under reasonable assumptions, the US external debt to GDP ratio will continue rising without limit. That means the process cannot continue. That is not to say that the US current account deficit has to be reduced to zero. Rather it needs to be reduced to a sustainable level, which would be about 2.5-3 percent of GDP. That would still leave room for countries that want to do so to accumulate reserves, and for foreign capital to flow to the United States. Similarly, with China receiving foreign direct investment inflows, it could run a current account deficit. 215

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The question is sometimes raised of whether it is appropriate for the world's richest economy to run a current account deficit. Shouldn't capital flow from the rich to the poor countries? If risk-adjusted rates of return in poor countries were higher than those in the United States, capital would flow towards the poor countries until rates of return equalized. However we need also to recognize that individuals want to invest where markets are reasonably liquid, and where they have the assurance that their property rights will be protected. In those respects, individuals from around the world will continue to want to invest in the United States. So it is likely that capital will continue to flow to the United States. 3. How will the adjustment occur? The adjustment can take place either through US exports growing more rapidly than imports as a result of more rapid growth abroad, or through a depreciation of the dollar. It would be bad for the US and for the world economy if the adjustment takes place as a result of slower growth in the US - though the fiscal correction that will be needed in the United States will tend to reduce US growth. If growth rates remain close to potential, i.e. if there is no major recession in the US, the dollar will have to depreciate. And it will have to depreciate primarily against the yen and therenmimbi. It has often been said by European officials that so far the Euro has borne the main runt of the need to reduce the US current account deficit. They seem to believe that when the Asian currencies appreciate, the Euro will be able to depreciate somewhat against the dollar. Yusuke Horiguchi, formerly of the IMF, now the chief economist at the Institute for International Finance has made the following argument. It is that the appreciation of the Euro against the dollar will over a period of a few years help adjust that part of the US deficit that is due to US imbalances with Europe. US imbalances with Asia have so far been handled through Asian central bank purchases of reserves. When the Asians allow their exchange rates to adjust, that appreciation will essentially compensate for their former purchases of reserves, and leave the exchange rate of the Euro to a first approximation unaffected 4. China. It is very difficult to predict when China and Japan will allow their respective exchange rates to adjust. Given that the yen is not pegged, that is easier for Japan to do than for China. Indeed Japan has already stopped intervening, although the exchange rate has not moved much since then. Nonetheless it is safe to predict that Japan will resume intervening if the yen begins to appreciate rapidly. China is comfortable with its pegged exchange rate at present, and will delay moving so long as inflationary forces in China remain under control. But given China's desire to reduce overheating, it would be useful to allow some appreciation of the currency, perhaps by adjusting the central rate, pegging to a basket, and gradually opening up a band. In the medium term, China will need to allow for greater exchange rate flexibility if it is to become a major international financial center - as it no doubt wishes to do 5. Hard landing for the dollar? Will the dollar collapse once it starts adjusting, a possibility brought to mind by the Dornbusch overshooting model? The Asian central banks have sufficient reserves to prevent an excessively rapid adjustment of the dollar. Since they will be reluctant to see their currencies appreciate too fast, they will likely intervene to slow any appreciation that begins to get out of hand. 216

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Nonetheless, there is one circumstance in which the dollar could suffer a hard landing. Since the early 1980s there has been a basic confidence in the stability of the United States economy. That has meant that a depreciation of the dollar makes United States assets more attractive to foreigners. If this basic confidence is lost - for instance because of a belief that the fiscal deficit is too large - then the dollar could come under enormous pressure as private investors react to an initial decline of the dollar by expecting that it has further to go. Given the volume of foreign holdings of US assets, the potential outflow could be very large, and would put pressure on the exchange rate that would be too powerful for even the Asian central banks to handle. Such a scenario would require a sharp reaction from policy, along the lines of the Volcker monetary policy of 1979-81. That would slow the US and the global economies. It is not the most probable outcome, but it is a possible result, dependent in large part on whether investors continue to maintain confidence in the economic policies of the United States. In appraising the probability of a hard landing, we should recognize that we have been worried about that possibility for a long time, and that it has not so far happened. In addition, we need to recognize the increased capacity of the international financial system to deal with exchange rate movements, in part because of the development of hedging instruments. For instance, the Euro has appreciated about 50 percent against the dollar over the past two years, but the consequences have been manageable. 6. Currency blocs. Asian central banks are already stabilizing their exchange rates relative to the yen and the dollar - and with the renmimbi pegged to the dollar, also against the renmimbi. There appears to be real political momentum behind the idea of an Asian exchange rate arrangement. That will be difficult since in the medium and long term both the yen and the renmimbi will be important Asian currencies. In one scenario, all of East Asia, including Japan, could eventually agree on the use of a common currency. Alternatively, a common currency could be used on the Asian mainland with the yen continuing its separate existence - along the lines of the Euro and the pound sterling. But all that is a very long way away. And by that time, we could even be moving towards the use of one global currency. When that happens, current account deficits will not matter, and we will not even know what they are. for instance, we do not pay much attention to payments imbalances among American states. And even in Euroland, it is already possible to run very large current account deficits. For instance, Portugal's current account deficit in 2000 was 11 percent of GDP. But it will only be in the Keynesian long run, in a system without national currencies, that we will cease to care about national balance of payments deficits.

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COMMENT Global Imbalances and Exchange Rates Malcolm Knight General Manager, Bank for International Settlements

It is a great pleasure for me to participate in this conference on the occasion of the sixtieth anniversary of Bretton Woods. It is also an honour because the IMF, which was established by the Bretton Woods Conference of 1944, has a long tradition of thinking deeply about the topic of this panel discussion—"global imbalances and exchange rates". The near-term outlook for global output growth and external adjustment over the next 18 months or so currently appears relatively benign. But over the medium term—that is, roughly the rest of this decade—I believe that global imbalances will pose a major challenge for the achievement of solid output, employment and price performance in many countries. Indeed, with due difference to Deputy Governor Li Ruogu of the People's Bank of China, who is also present on this panel, I would hazard the view that the ancient Chinese curse—"may you live in interesting times"—is rather appropriate to the subject of this session. From the point of view of global imbalances, I think we certainly are living in "interesting times". If we look at the adjustment of external current account balances over the past forty years of so, it is only a modest oversimplification to assert that the major swings in global imbalances correspond roughly to each chronological decade. For example, the decade of the 1960s was a period of relatively small current account imbalances, strong growth, and low inflation. To put it another way, that decade was marked by a salubrious environment for external adjustment. In sharp contrast, the decade of the 1970s—at least after the huge oil price increase of 1973-74—as characterised by very large external current account imbalances, stagflation, and weak macroeconomic growth performance. The decade of the 1980s saw a very large swing in the real exchange rate of the US dollar. The large real appreciation of the dollar from the beginning of the decade through the mid-1980s was associated with a sharp increase in the US current account deficit, and the subsequent large dollar depreciation was marked by a return to rough balance in the US current account over the latter part of the 1980s, especially with the fall in domestic investment that began as the US economy moved into recession towards the end of the decade. The decade of 1990s began with a marked recession in a number of countries, but thereafter it was generally marked by strongly improving fiscal balances in a 219

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number of large countries, by monetary policies that were directed at maintaining low and stable inflation, and by relatively small external imbalances. In other words, the past decade was a salubrious one, a bit like the 1960s. Currently we are experiencing a synchronized upturn in the world economy that has gradually gathered momentum. Does this mean that the first decade of the third millennium will also be one of solid macroeconomic performance, like the 1960s or the 1990s? While I agree that the short-term global outlook is relatively benign, I have major concerns about the longer-term prospects for external adjustment, and for the achievement of solid output and employment performance. There are a number of reasons for these concerns. First, the current juncture is marked by very large external current account imbalances—particularly the deficit in the United States and the surpluses in Asia, the transition economies, and Latin America. Second, the stance of both fiscal and monetary policies in many countries is currently much more expansionary than is likely to be sustainable over the longer term. Third, partly because industrial production is shifting from regions where the primary input content of industrial production (including energy inputs) is relatively low at the margin to emerging market countries where it is higher, inflationary pressures from energy and other primary product prices are emerging earlier than would typically be the case at this stage in a global economic upturn. To put things in a nutshell, external adjustment at the global level is likely, over the current decade, to be much more challenging than it was in the 1990s. This challenge comes from the need to adjust major external imbalances at the same time that a number of major emerging market economies, in particular in Asia, are being integrated into the global economy. The first task—moving to a more sustainable pattern of payments balances—is a macroeconomic adjustment issue which will require shifts in macroeconomic policy. But the second task—that of adjusting to large and rapid changes in comparative advantages and trading patterns—will require deep and painful structural adjustments. This challenge will create frictions and structural problems that are largely separate from those of trade imbalances per se. In particular, the increasing supply of goods and services from major emerging economies—and I am not just speaking of China and India, though they are by far the largest examples—will trigger profound changes in production, international trading patterns, and relative prices. In particular, deficit countries will need to shift resources into the production of tradables at a time when the integration of large low-wage economies into the global economy is creating intense competition in international goods markets and is putting strong and sustained downward pressure on unit labour costs all around the globe. A Comparison of Current Account Cycles Before I expand on these themes, let me briefly review major current account swings by contrasting recent developments in the external payments position of the US economy which is almost one fifth of the global economy - with those in the rest of the world. These developments are summarised in the table below.

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CHANGES IN CURRENT ACCOUNT BALANCES: 1981-2003

Country/region United States

In billions of US dollars

As per cent of GDP

-421

-3.4

-42

-0.9

39

1.0

Emerging Asia

130

3.0

Latin America

71

3.5

Transition economies

37

3.2

Others

58

Na

-128

-0.4

Euro area Japan

Total

Country/region

In billions of US dollars

As per cent of GDP

164

3.5

Euro area

-104

-1.7

Japan

- 16

-1.5

United States

Country/region United States Euro area Japan

In billions of US dollars

-166 57 79

As per cent of GDP

-3.6 1.7 3.0

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The top panel of this table indicates that, over the six-year period 1997-2003, the US current account position deteriorated by over 420 billion dollars, an increase in the US external deficit of some 3.4 percentages of GDP-which brought the level of the external current account deficit to around 5% of GDP by 2003. In dollar terms, the main identified counterparts to this widening US current account deficit are not found in the industrial countries, but in the changes to the current account positions of emerging Asia (plus US$130 billion), Latin America (plus US$70 billion) and the central and eastern European transition economies (plus US$40 billion). Note also that some 30% of the US deficit is unaccounted for. Many commentators agree that these changes in relative current account positions are not sustainable over the long term. If they are indeed unsustainable, how will the adjustment take place? What challenges will it present? And what are the policy implications? These are not easy questions to answer, we are naturally led to look for guidance from past historical episodes. I think the decade of the 1980s presents one. Over 1981-87 the US real effective exchange rate appreciated by some 40%. US fiscal deficits were also large, and US economic growth was strong. The middle panel of the table indicates that the deterioration in the US current account deficit over this period was slightly larger as a percentage of GDP, 3.6 percentage points, than it was over 1997-2003. This deterioration amounted to some US$66 billion, and almost the exact counterpart in dollar terms was a strengthening of the current account positions of just two regions, Europe and Japan. The bottom panel of the table shows how the US external imbalance of the first half of the 1980s was corrected in the late 1980s and early 1990s. From 1987 to 1991 the US current account position improved by 3.5 percentage points of GDP. It is very interesting that most of this improvement of 164 billion dollars was the counterpart of rising external current account deficits in the same two regions: Europe (US$104 billion) and Japan (US$16 billion). These deficits reflected the strong economic growth that marked the European and Japanese economies at that time. If we compare this full current account cycle of the 1980s with the uncompleted cycle in recent years we see that during 1997-2002, the US dollar also appreciated strongly and the US current account deteriorated by about the same percentage as had been the case in the early 1980s. The question is—what will happen next? Again, if we look at historical experience in the last full US balance of payments cycle the current account improvement that took place after 1985 was associated with a very large real depreciation of the US dollar, which was quite orderly. Is this relatively orderly and benign adjustment likely to prevail again over the remainder of the first decade after 2000? In order to answer this question it helps to look into the reasons why the US current account deficit rose after 1997. If the causes were similar to those of the 1980s, then the swing in the real exchange rate over the current external adjustment cycle should be associated with an opposite swing in the external current account deficit as a percentage of US GDP. Graph 2 shows that one reason for the widening US current account deficit over the seven years to 2003 was that cumulative real domestic demand growth in the US was above that in the Euro area by some 15 percentage points and exceeded demand growth in

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Japan by a cumulative 25 percentage points. The role of relative demand growth in the widening of the US current account imbalance is particularly important given that there is also an asymmetry between US export and import elasticities. US demand for imports is much more income-elastic than foreign demand for US exports. Hence the US current account balance tends to deteriorate even if the US is growing at the same rate as its trading partners. Graph 3 looks at the widening of the US current account deficit since 1997 from a saving - investment perspective. The rise in the US external deficit and the associated US external borrowing needs of the past seven years can be divided into two phases. In the first phase, over 1997-2000, the US current account deficit essentially reflected a modest decline in net private saving as a percentage of GDP, and a high rate of net private investment associated with a sustained rise in the rate of growth of productivity and improved long-term growth prospects for the US economy. With significant fiscal consolidation during this period, the external current account deficit was financed by sharply rising capital inflows. By contrast, from 2001 onwards there was a sharp decline to a lower level of net private investment, but at the same time tax reductions and rising government expenditures led to a very marked shift from fiscal surplus to a large fiscal deficit. Graph 4 shows that net long-term private capital inflows into the United States, which rose sharply from 1998 to 2000, financed the rising current account deficit. Nevertheless, although net long-term private inflows remained fairly high thereafter, in the second phase after 2001, the role of official foreign exchange purchases became much more important in financing the continuing rise in US current account deficits. With this historical perspective, I return to the question of what the global adjustment process might look like going forward. More specifically, will it look like the latter half of the 1980s? From the first quarter of 1985 to the end of 1987, the US dollar depreciated by exactly the same amount (40%) as it had previously appreciated in the five years to 1985. In other words, it depreciated to about its 1980 level and remained there for the next four years. In addition to the lagged effects of the sharp depreciation of the dollar that began in 1986, the main features of the improvement in the US external account position were the marked strengthening of activity in Japan and Europe in the late 1980s. As a result of these factors, the US current account began to improve late in 1987, reaching a surplus in 1991 (see graph 5). The four panels of graph 6 consider how the present level of the US real exchange rate and external current account may look relative to the exchange rate/current account cycle that took place in the 1980s. In these graphs the vertical line is the year of the peak in the real exchange rate of the US dollar during each decade-long exchange rate/current account cycle (1985 for the cycle of the 1980s and 2001 for the current (uncompleted) US current account cycle). As shown in the south-west panel of this graph, the pattern of current account deterioration in the five years preceding the exchange rate peak and in the two years following it is about the same thus far in the current cycle as it was in the 1980s. However, the current account imbalance is about 1.5% points of GDP worse than it was at the peak of the previous cycle. As the top left-hand panel of graph 6 indicates, the real effective appreciation of the US dollar was slightly smaller over the five years preceding the exchange-rate peak this

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time around than it was in the 1980s. The adjustment in the 1980s involved a complete turnaround in the real effective rate of the dollar. By contrast, in the current cycle the decline in the real effective rate of the dollar up to June 2004 has been only a fraction of the preceding appreciation. This may give pause to those who think that, since its peak two years ago, the US dollar has depreciated enough to adjust the current US position. Of even more concern is the difference in the US structural fiscal position over the two cycles. As the top right-hand panel shows, the structural fiscal position in the 1980s basically deteriorated steadily prior to the maximum-deficit point of the cycle before improving slightly thereafter. Thus the current account effects of the exchange rate depreciation over 1985-87 were not strongly offset by changes in the fiscal position. In contrast, the US fiscal position was improving until 2001. In the two years since then it has deteriorated to a level that is almost the same as the fiscal position two years after the peak of the previous cycle. This weak fiscal position is likely to offset the positive adjustment effects of future US dollar depreciation, suggesting that the dollar may have to fall by more this time around unless active measures of fiscal restraint are taken. The lower right-hand panel looks at relative demand patterns in the two episodes of US current account change. Whereas demand in the rest of the world was strengthening relative to US demand after the US cyclical peak had been reached in the mid-1980s, thereby reinforcing the strengthening of the US current account, the demand gap between the United States and the rest of the world has been essentially zero during the current cycle. Adjustment Challenges Today History never repeats itself exactly. The experience of the US external current account cycle that took place during the 1980s suggests that the adjustment to reduce a very large US current account deficit can take place without cataclysmic disruptions, (not least because the United States is at the centre of the international monetary system and can borrow in its own currency). But this experience also suggests that, especially in the absence of fiscal consolidation, the current account adjustment is likely to require a rather 'large depreciation of the dollar's real effective exchange rate, that the adjustment process will take a number of years, and that it will be marked by relatively lacklustre economic growth performance. Moreover, there are aspects of the current situation that were not present last time and that could make the future adjustment process more challenging. A first key consideration is the impact of emerging Asia. Future adjustment of global imbalances will require that the key current account deficit country (the US) shifts resources into the production of tradables in the face of intense competition in world markets for goods and services coming from China, India and the other emerging market countries. This was a far less important factor in the 1980s balance of payments cycle. The so-called ccNewly Industrialised Countries" that entered the world trading system in the 1980s accounted for less than 2% of the world's population. By contrast, India and China alone have one third of the world's population. The result is a huge labour force, much of which is educated, and much of which is currently underemployed. This is likely to put strong downward

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pressure on unit labour costs in all developed countries for many years and exacerbate the problem of shifting resources to tradables as the US economy endeavours to adjust. It seems to me that this observation has two implications. First, for the United States, the real effective exchange rate is likely to have to depreciate more than it did in the 1980s, in order to produce the required shift into tradables in a fiercely competitive world goods market. It goes without saying that this correction will be even larger if fiscal adjustment in the US is delayed. Second, for all developed countries, even if productivity growth remains at current levels, real wage growth will tend to be slower than it has been in the past. This in turn suggests weak consumption growth in the developed world, so that the adjustment is likely to be characterised by larger than normal output gaps and weaker output growth. The second challenging aspect of today's adjustment process is that the next adjustment could also be more stagflationary than the 1980s adjustment. I have already noted that this time, primary commodity prices have risen more, and at an earlier stage in the upswing, than was the case in the 1980s. This rise in costs risks creating stagflationary effects. Indeed, I believe that if goods production is shifting to countries which, at the margin, have a higher input of commodities per unit of output, the effects will be stagflationary even if the second—round effects of prices on wages are much weaker than they were in the 70s and 80s. In the late 1980s, the reduction of the large US current account deficit was also made easier by the fact that aggregate demand in Europe and Japan was accelerating. This time, as I have already suggested, slower wage growth will result in weaker growth of domestic consumption. Finally, the negative wealth effects of the global adjustment process will be much larger than they were in the 1980s. The large US current account deficits of the last few years mean that residents of the rest of the world are now holding a larger stock of dollar-denominated financial assets, currently estimated at some US$9 trillion. A depreciation of the US dollar that was of similar magnitude to that which occurred from 1985 to 1987 would reduce the real value of these assets by some 40%. Like the other effects, such a reduction in wealth would also tend to weaken demand and economic activity. And these effects could be very large. Policy Implications Going forward, therefore, the risks in the global adjustment process lean towards a marked weakening of growth performance. How should national economic authorities respond to achieve smooth adjustment of global imbalances to sustainable levels? I do not think the answer lies in monetary policy. Monetary policies are currently very expansionary in a number of key industrial countries. In order to avoid exacerbating the inflationary side of a possible stagflation, monetary policy in the key currency countries/regions must shift to a more neutral stance. But in order to avoid overshooting of exchange rates among the key currencies, the timing of this withdrawal of monetary stimulus will have to be consistent across key currency zones. The precept for the coordination among monetary policy makers over the next several years must be: "first, do no harm". By contrast, fiscal adjustments could, in principle, assist the external adjustment process. Most obviously,

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active policy measures to reduce the fiscal deficit in the US to a sustainable level would contribute to a smoother adjustment of a global external imbalance. But these adjustments, even if they are vigorous and in the right direction, may not appear to yield much in terms of output and employment improvements as key emerging economies that have low unit labour costs in an ever-broadening range of industrial sectors are becoming more and more prominent in the international market place. Viewed in this light, the adjustments needed for the US to achieve sustainable fiscal and current account deficits may be large. The first decade of the twenty first century may indeed be "interesting times."

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Graph 1

US real effective exchange rate In terms of relative consumer prices; January 1997 = 100

Graph 2

Real total domestic demand 1997 Q1= 100

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US saving and investment

Graph 3

As a percentage of GDP

1

Defined as gross saving less gross investment.

Source: US Bureau of Economic Analysis (SCB table 5.1).

Graph 4

Current account and long-term capital in the United States In billions of US dollars

1997

1998

1999

Source: US Bureau of Economic Analysis.

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Graph 5

US current account and domestic saving-investment balances As a percentage of GDP

Source: US Bureau or tconomic Analysis.

Graph 6

Current and previous cycle in the United States

Years (cycle peak = O5) 1 1n terms of relative consumer prices; peak year =100. 2 General government cyclically adjusted financial balance, as a percentage of potential GDP (OECD definition). 3 As a percentage of GDP. 4 US gap less rest-of-OECD gap; in real terms. 5 Defined by a peak in the real effective exchange rate; current and previous peak: 2001 and 1985 respectively.

Sources: National data; OECD; BIS.

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KEYNOTE SPEECHES

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Improving the Policy Response to Financial Crisis Remarks by Agustin Carstens, Deputy Managing Director, International Monetary Fund at the Bank of Spain and IMF International Conference on Dollars, Debt, and Deficits—60 Years After Bretton Woods June 14, 2004 It is a pleasure and an honor to have the opportunity to address such a distinguished audience at this international conference that celebrates the 60th anniversary of the creation of the Bretton Woods institutions. At the outset, I would like to thank the Banco de Espana for its superb hospitality and for the very close collaboration with the IMF in putting all of this together During the last 60 years, the Fund and its member countries have been struggling with the challenge of improving the policy response to financial crisis. As many of us know quite well, when a crisis occurs, resolution is far from an easy task. Ideally, policy measures will aim to limit disruptions, stabilize the economy, and lay the groundwork for the resumption of long-term growth. Yet, the policy response involves difficult judgments and unpleasant tradeoffs amid significant uncertainty. Measures may have temporary side effects and—especially if reforms are not fully carried through—a country can remain exposed to significant post-crisis vulnerabilities. It is striking how, over the last thirty years, crises in many countries have become recurrent. Recent research we have undertaken at the Fund shows that this is particularly true in Latin America. Since 1980, 22 Latin American countries have suffered either a financial crisis or financial distress, in the latter case narrowly averting a full-blown crisis. Of these 22, three countries have experienced four episodes each; three countries have experienced three episodes each; and nine countries have experienced two episodes each. For example, Argentina has suffered four crises, in 1980, 1989, 1995 and 2001. Ecuador suffered three crises, in 1982, 1996 and 1998, and narrowly averted one in 2002. Brazil and Bolivia each experienced two crises between 1985 and 1995, and pulled back from the brink in 2002 and 2003, respectively. I feel that more systematic research on recurrent crises is urgent. In trying to advance some ideas on the issue, I would venture to say that—all too frequently—the compromises that are made with the intent of resolving current difficulties may actually sow the seeds for the next crisis. Accordingly, I would like to focus my remarks today on four issues, which I think are critical for the international community to better understand our efforts to improve the policy response to financial crisis: •

First, the complexities involved in designing an appropriate policy framework; 233

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• • •

Second, the "ugly" tradeoffs policy makers face in formulating policy options; Third, the post-crisis vulnerabilities that might remain and the need for countries to persevere in their efforts to reform and to "crisis-proof their economies; and Last, the role of the Fund in this context.

First, consider how difficult it is to identify the appropriate policy framework. There is uncertainty regarding the scope and impact of a crisis. In the midst of a crisis, key macroeconomic variables tend to display unusually high volatility. The resilience of the economic system and the severity of the crisis are uncertain. As a matter of fact, once a crisis has erupted and the Fund's mission starts its groundwork, it is not uncommon that preliminary assessments need to be revised as, in a crisis environment, hidden liabilities— both public and private—can pop up like rabbits out of a hat. Balance sheet interlinkages across sectors of the economy can amplify weaknesses in individual sectors and propagate a crisis across sectors, to the balance of payments, and to the sovereign. Such interlinkages may complicate the policy response and magnify the costs of crisis resolution. There is also uncertainty regarding the effectiveness of policies, which depends critically on the perceived credibility of the corrective measures when the reputation of the authorities tends to be at its lowest level. And there is uncertainty regarding the political support for reforms. Policy makers face the additional challenge of quickly mobilizing public support for often unpopular measures. Against this background of economic and political uncertainty, the policy response is often subject to "ugly" trade-offs. A prime example is the fiscal consolidation that may be required to reduce imbalances or debt burdens. This must be sufficient to strengthen confidence in the sustainability of public finances, but not so much as to undermine medium-term growth prospects. In cases where a banking crisis is part of the problem—such as the recent crises in Argentina, Turkey and Uruguay—public support will likely be required to safeguard the functioning of the domestic financial system. But this support can exacerbate debt sustainability concerns and make the previously mentioned tradeoff even more difficult. Moreover, in extreme situations, administrative measures may be seen as unavoidable for quelling a banking crisis—although these risk eroding confidence in the banking system and triggering capital flight and financial disintermediation. In cases where sovereign debt restructuring is needed, the benefits of alleviating the liquidity or solvency constraint must be weighed against the implications for future access to capital markets. In addition, policymakers may need to factor in the potential costs to the domestic financial system if bank portfolios are significantly exposed to government debt. Next, consider how—even if a credible adjustment quickly restores confidence—a number of vulnerabilities can linger and perhaps even increase. Public finances may remain vulnerable to shocks. If public debt remains at high levels, gross financing requirements continue to be large, and thus vulnerable to shocks or spells of market drought. Banks may remain vulnerable to debt servicing difficulties of household and corporate sectors, or because of a large exposure to sovereign debt. And in cases of sovereign debt restructuring, a country may lose access to markets for a prolonged period of time. 234

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Perhaps most importantly, there is always a danger of "reform fatigue." As countries move out of the critical stage in the process of crisis resolution, it is not unusual to see some of them lose their drive towards reform. Several factors contribute to this: a) the erosion of political capital; b) an early positive response from investors that might lead to complacency; and c) the fact that many of the needed reforms do not induce immediately higher growth and wellbeing of the population. But here is precisely where the recurrent crises have their genesis. Once the most urgent measures have been implemented, the tendency is to put aside the important ones for later. The message is clear: it is critical that countries persevere with reforms to "crisis-proof their economies and avoid recurrence of financial distress. Finally, let me say a few words about the role of the IMF in crisis resolution, and how we are working to improve it. A key role of the Fund is to work with members to achieve a durable exit from crisis. The Fund helps members to consider the relevant constraints and trade-offs and to design an appropriate adjustment program that addresses underlying macroeconomic problems, as well as anchors investors' expectations about the formulation and implementation of economic policies. In helping to design this program, the Fund has to form a judgment about the appropriate balance between the availability and scale of IMF financing, the amount of domestic policy adjustment, and securing the support of other stakeholders (official and private creditors). And in forming this judgment, the Fund must also consider the implications a crisis country may have on the stability of the international financial system. Based on previous experience, we are continually examining policies that could help reduce the frequency and severity of crises. We are focusing on several issues at present, including reinforcing the rigor of our debt sustainability analysis, especially through a more thorough analysis of contingent claims. We are working to raise awareness of balance-sheet vulnerabilities, to ensure that risks are properly assessed and effectively addressed. We have taken steps to improving clarity about IMF lending decisions, especially with regard to the situations when exceptional access to IMF financing may be appropriate. And we are working to improve the process for restructuring sovereign debt within the existing legal framework. This includes encouraging the use of collective action clauses (CACs) in new sovereign bond issues, as well as supporting private sector efforts to formulate a voluntary Code of Conduct. Strong banking systems are a foundation for financial stability. Therefore, we have been working also with the Basel Committee and its chairman, Governor Caruana, in encouraging emerging market countries to move towards the adoption of the new set of standards embodied in the Basel II Accord, ensuring that this transition occurs at their own pace and based on their own priorities. Ladies and Gentlemen, notwithstanding all these efforts, there is no doubt that substantial challenges are still in front of us. Therefore, in closing, I would like to commend the organizers of this conference for bringing together distinguished economists and policymakers that through their interventions will shed some light on the critical issues involved in building a more stable international financial system. Yet our main challenge will be to put all of these ideas together, into a coherent strategy for crisis prevention and resolution that is both effective and durable. If we can do this, we may also be able to abate the recurrence of crisis.

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The International Financial Architecture Where Do We Stand? Remarks by Jean-Claude Trichet, President, European Central Bank, at the Bank of Spain and IMF International Conference on Dollars, Debt and Deficits - 60 Years after Bretton Woods June 14, 2004

It is a great pleasure to be here in Madrid at the invitation of the Banco de Espafia and the International Monetary Fund. The 60th anniversary of the Bretton Woods institutions is indeed an important opportunity to take stock of key events, developments and issues that have shaped and are shaping the international financial system. Let me thank the organisers, and especially our host Jaime Caruana, for setting up a very interesting programme for this conference that encompasses all these key topics. Tonight, I would like to offer some thoughts on the question 4Hhe international financial architecture - where do we stand?" In my remarks, I will first have a short look back at the changes to the international architecture over time, before concentrating on reform efforts that have been undertaken in four areas, namely the institutional setup, transparency and best practices, regulation of financial markets and crisis prevention and resolution. Let me briefly look at the changes to the international financial architecture over time. The key aim of today's policy makers has not changed compared to those at the Bretton Woods times - it has been, and still is, global prosperity and stability - but the environment in which we are acting has changed profoundly. The founders of the IMF and the World Bank wanted to create institutions that prevent countries from falling back into autarky and protectionism and that help them to raise growth and increase stability in a world of fixed exchange rates with still a large degree of capital controls. Today we are striving for stability of the international financial system in a world of free capital flows with a growing importance of private flows and increasing trade and financial integration. Among the major factors that we have to take into account, I would like to mention in particular: The financial globalisation phenomenon: capital market liberalisation, both domestically and internationally, technological advances and buoyant financial innovations have contributed to set up a totally unknown degree of financial globalisation - with great benefits, but also new risks. The policy responsibility which still lies mainly with sovereign states; thus, the challenge is to promote global financial stability very largely through national actions enlightened and co-ordinated through a larger degree of intimate international co-operation. A very large consensus on giving the private sector and markets a central role on the one hand, and relying upon sound public institutions to provide market participants with the appropriate environment on the other hand. This shift from 237

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•

direct public involvement to private activities is particularly striking when looking at financial flows to emerging markets: in the 1980s, official flows were dominant, reaching on average over 60% of total flows to emerging markets. By contrast, the 1990s saw a dramatic increase in private flows, which on average accounted for around 85% (in the period from 1990 until 2003). Equally striking is the shift from bank loans to negotiable securities as the major financing tool for the developing countries. The integration of the European Union, reinforced with the introduction of the euro, has increased the economic, monetary and financial stability of a region that constitutes today the world's largest trading partner and the second largest economy. The EU has also been crucial in anchoring the transition process in central and Eastern Europe, and in fostering stability and prosperity in this region.

The dynamics of today's world call for continued adjustment at a global level. New challenges have been added to existing ones, such as poverty reduction. New actors gained prominence on the international scene, with developing and emerging markets becoming progressively full participants in the globalised economy. The financial crises of the 1980s and the 1990s, characterised by large and sudden private financial flow reversals, marked by a very powerful contagion phenomenon and demonstrating some of the potential and actual vulnerabilities of the newly globalised financial system, led to an ambitious reform agenda to strengthen the international financial architecture. Let me focus on the lessons from the crises in the 1990s and the ensuing work on the international financial architecture. On the basis of the experience with the Mexican crisis in 1994/95, the G7 summit in Halifax in June 1995 initiated work on improved crisis prevention and management. It called for improved transparency, both at the level of individual countries and at the IMF, and for strengthened IMF surveillance. The Halifax summit also pointed to the importance of effective financial regulation, market-reinforced prudential supervision and enhanced international co-operation among regulators and supervisors. As for crisis management., concrete proposals were presented in the Rey report to G10 Ministers and Governors in May 1996. Work was stepped up in the aftermath of the Asian crises, which revealed further vulnerabilities in national and international financial systems. But most importantly, the crises in the later 1990s showed that the systemic changes in the world's financial markets required systematic changes in the policy framework that underlies the international financial system Almost a decade later, we can say that many of these proposals have been implemented. Let me now focus on four different areas, which I consider most important: The first area concerns the international institutional set-up, which, in my view, has been strengthened significantly since the 1990s. The existing international financial institutions, in particular the IMF, the World Bank and the BIS maintained their central role in the system. But they were subject to several changes to sharpen their respective focus, to reinforce their policy advice and financial support, to enhance their transparency and accountability and to strengthen their governance. The Bretton Woods institutions, and particularly the IMF, underwent profound changes to adapt to the new environment. In addition, new fora have been created in response to the widening of the number of actors in the global economy and the growing importance of international financial markets. The creation of the G20 in 1999 constituted in my view a decisive and highly welcomed step to reflect adequately the newly globalised 238

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economy. The G20 has turned into the international forum for appropriate dialogue and consensus building between all economies that have a systemic influence, whether industrialised, emerging, or in transition. Equally important is the Financial Stability Forum, which is the first informal grouping to fully recognise the existence of a globally integrated economic and financial system It is also the first forum to set the goal of systemic optimisation of each of the subcomponents of the system, whether it is banking surveillance, insurance surveillance, securities market control, accounting rules, good practices of public and private sectors, functioning of the major market places, governance of the IFIs etc. At the regional level, the European Union has established a whole universe of arrangements for co-operation that is constantly being adjusted to its changing needs and European institutions are becoming increasingly involved at the international scene, for instance with the EU-US regulatory dialogue. Overall, improving the governance of the international institutions and optimising the work of the informal groupings will always remain a moving target given that these entities permanently will have to adapt to a changing environment. However, with the changes introduced in the recent years, the foundations of the international financial system have been strengthened considerably. The second area I would like to highlight regards the work to enhance transparency and promote best practices, where significant progress has been achieved in a number of fields. Indeed, a wide-spread consensus has developed, which considers reliable and timely information on economic and financial data as a precondition for well-functioning markets, since it facilitates better risk assessment and management and hence strengthened market discipline. The IMF's special standard for dissemination of economic and financial data has become a widely recognised benchmark to which a large and increasing number of countries have subscribed. There is now a presumption that IMF papers on Article IV consultations and on Fund programmes are published. International codes of good practices have been agreed upon, such as the ones on transparency in fiscal policy and on transparency in monetary and financial polices. Moreover, countries' compliance with the 12 most important standards and codes are regularly examined by the IMF and the World Bank in socalled ROSCs (Reports on the Observance of Standards and Codes), many of which are made publicly available and have a positive impact on the market's assessments of the countries concerned.11 consider that the progress made in the field of transparency after the Asian Crisis is one of the main explanations for the absence of contagion in the emerging world when the Argentine crisis erupted. Transparency in the private sector is also crucial for well-functioning international financial markets. Reliable and timely company information are one key element to transparency, which is provided mainly through financial statements. Recent corporate scandals have again brought to our minds the crucial role that accounting standards play in this respect. In this context, I attach great importance to the reform of the International Accounting Standards (IAS) and the key role of these standards in advancing the European single market. The IAS, which will apply to all listed companies in the EU, are expected to have a major impact on the European banking system The banking sector will particularly be affected through the proposed valuation rules for financial instruments and through the rules on disclosure. ! The IMF and the World Bank have recognised 12 standards as useful for their operational work. These comprise accounting; auditing; anti-money laundering and countering the financing of terrorism (AML/CFT); banking supervision; corporate governance; data dissemination; fiscal transparency; insolvency and creditor rights; insurance supervision; monetary and financial policy transparency; payments systems; and securities regulation.

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The EGB has a strong interest in this debate mainly from its focus on contributing to the maintenance of financial stability. Thus, the primary objective of this reform has our full support as it aims to minimise the gap between the reported information and the true risk profile of a company. I am also fully aware of the complexities stemming from the interrelation of accounting standards with other reporting schemes .for supervisory and statistical purposes. However, some proposals have given rise to concerns also within the ECB. In particular, those proposals relating to an extensive use of fair values raised concerns about the possible adverse implications on the volatility of bank income and, eventually, on bank behaviour and on financial stability. As a consequence, the ECB contributed to this debate, highlighting the concerns and showing their relevance. The more recent proposals from the IASB moved into the direction of limiting the use of fair values for those items that can be reliably measured. The revised proposals should help to avoid undesirable consequences such as an artificial increase in income volatility. At the current juncture, the ECB is carrying out an exercise to check the likely impact of the new standard. While these issues apply to all financial markets, the EU faces a particular challenge relating to the advancement of the single market. The introduction of harmonised EU rules regarding the setting-up of financial statements are considered to be a crucial step towards the further integration of the financial markets in the euro area and the European Union. Indeed, improved comparability of disclosed information would facilitate cross-border investment and further market integration. Thus, in 2002 the European Parliament and Council adopted a Regulation requiring listed companies to prepare consolidated financial statements in accordance with I AS from 1st January 2005. A specific endorsement process is in place to ensure legal certainty and consistency with EU public policy concerns. This process already allowed to endorse all I AS with the exception of the two standards concerning recognition, measurement and disclosure of financial instruments. Recently, in order to deal with the remaining controversial issues, the Commission took the initiative to establish a high-level dialogue between all the constituencies interested in high quality accounting principles. I remain confident about the positive impact of prudently implemented International Accounting Standards on the stability and efficiency of financial markets in the EU. The third area relates to the strengthening of financial regulation in industrialised countries. Here, let me recall that recent crises exposed weaknesses in the risk management practices on the part of creditors and investors in industrial countries, pointing to the importance of financial market regulation and supervision. We all are aware of the importance of effective financial regulation and supervision to maintain financial stability and protect consumers, also in light of the increased complexity of financial services and products. Let me say one word on one important aspect of financial regulation, which is the reform of the Basel Capital Accord, coined Basel II. I am convinced that our host, Mr. Caruana, who is the chairman of the Basel Committee on Banking Supervision, could off hand fill the evening by elaborating over the main features of this reform. From what I gather, your efforts are bearing fruits and we may expect a final text to be hopefully endorsed by the G10 Governors and the Heads of banking supervisory authorities in the forthcoming weeks. The Basel II reform is of key importance. New and bold developments in the banking industry are the ultimate reason for engaging in this reform. The ECB has expressed on various occasions its supportive stance to the new framework. The ECB was also among the first to point out the possible macro-financial implications of any banking prudential scheme, highlighting the potential procyclical 240

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effects that might be induced by any framework relying on a comprehensive real time risk analysis. These concerns have been taken into account in the final version of the new framework which aims at being neutral over the cycle. Looking ahead, we have to recognise that we stand at the beginning of the road. The success of this reform will crucially hinge on a sound implementation of the new framework requiring strong coordinating efforts among the supervisory authorities on a global basis. With regard to the EU context, the new institutional setting based on the Lamfalussy framework comprising a two-tier structure of regulatory and supervisory committees is expected to play an important role in ensuring a more uniform and flexible EU regulation and consistent implementation resulting from convergence in supervisory practices. As the fourth and last area, I would like to mention crisis prevention and management. Of course, the various efforts I mentioned so far should be conducive to prevent crises from happening. However, crisis prevention primarily rests with every single country with strengthened macroeconomic policies and financial systems. In that context, the experience of the past decade has highlighted the crucial importance of well-functioning domestic rules, regulations and institutions namely the legal framework, the regulatory system, the enforcement mechanisms, and authorities that shape and permit the optimal functioning of a market economy with its financial markets. This includes, in particular, central bank independence, rules for monetary policy and for fiscal policies, appropriate supervisory frameworks and authorities. There is strong evidence linking well-functioning institutions and good governance to positive economic and social outcomes. Institutional factors appear to be as important as productive factor endowments or any other explanations in determining crosscountry differences in the overall level of development. I am confident that these lessons feed into improving domestic policy-making in emerging market economies, making them more resilient to withstand shocks. The continued efforts to strengthen IMF surveillance play also a crucial role in that respect. It is clear that crisis prevention must remain the key area of all our efforts. Crises are costly for the countries concerned and also for the international system. Given the increasing economic and financial importance of emerging markets, major events in these countries are bound to have spill-over effects to the rest of the world. Let me underpin this argument with some figures: In the last four years, major emerging markets contributed to about half of global real GDP growth (in PPP terms), accounted for roughly 30% of world exports and received about 20% of global FDI. Turning to crisis management, important lessons have been learnt. There has been a growing recognition that more predictability is required on the side of the official sector in order to set the right incentives for all the actors involved. Moral hazard concerns and the limited availability of official funds also led to increasing discussions about the appropriate involvement of the private sector in crisis management. Of course, every single crisis is different and hence there is in each case the need to find the appropriate balance in the triangle of domestic adjustment, private sector involvement and official support. Therefore, crisis management in practice still has to struggle with the inherent tension between rules and clarity on the one hand and discretion and flexibility on the other. However, considerable progress has been achieved. First, specific criteria and procedures have been set up last year to make exceptional access to Fund resources subject to rules and hence more predictable. We in Europe have been very much in favour of setting such clear rules and clear limits to Fund financing in view of the very large financing packages provided to countries in the 1990s. The IMF's debt sustainability analysis will play an important role in that context, since clear limits to 241

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official financing must be respected especially when a country faces an unsustainable debt burden and hence requires a debt restructuring. All IMF shareholders now need to stick by these rules, not least in order to provide the right signals to the markets and to avoid the impression that the official sector suffers from time inconsistency between the approval of policy principles and their actual implementation. Second, following Mexico's bond issue with Collective Action Clauses (CACs) in February 2003, several emerging markets included CACs in bonds issued under New York law. More than 70% of new bond issues since early 2004 include CACs. As you probably know, no discernible impact on borrowing costs could be detected. In order to help making CACs a standard feature in sovereign bond contracts, the EU Member States committed themselves to include CACs when issuing new bonds under foreign jurisdiction. All this progress is very remarkable, especially when comparing it to the rather sceptical stance many countries and many private sector representatives have taken in the past vis-a-vis the recommendations in the Key report after the Mexican crises. Of course, so far these clauses have not been tested in practice and it will take some time until CACs are included in the entire stock of debt. Finally, work is proceeding on a so-called Code of Good Conduct, which I suggested myself at the IMF Annual Meetings in September 2002. Such a Code would define best practices and guidelines for the behaviour of debtor countries and creditors regarding information-sharing, dialogue and close co-operation in times of financial distress. While the IMF and the G7 encouraged further work and the G20 is closely following the process, at present the official sector confines itself to a catalysing role and leaves the floor to the true stakeholders in the process, i.e. emerging market issuers and private sector representatives. I understand that currently intensive discussions are taking place on the main elements of such a Code. I would like to encourage all parties to be as active and constructive as possible in working out what could be a significant new tool to prevent and help solving potential crises. Closing Remarks We have the unique chance of living in a world which is full of opportunities, very inspiring and very complex, very rewarding and very demanding, full of chances and of risks. We have all been the witness of two incredible transformations of the global economy over the last twenty five years. The technological surge which has permitted to compute and to transfer information at practically no cost. The globalisation process which aims at connecting all economies and finances of the world within the same market-economy based framework. So that goods, services, capital, technologies, concepts, ideas are moving very rapidly or even instantaneously all over the globe, expanding considerably, in quality and in quantity, the domain of the Ricardian comparative advantage. The significant surge of labour productivity in a number of industrialised economies, the taking off of India, China and a very large number of emerging countries, the rapid race of global growth. These are great successes of today's economic world of which global finance, mirror-image of a global economy, is both the emblem and the very powerful tool. But there is no economic success without risks. We have been living permanently in a risky environment over the last twenty-five years. Amongst many risks, we might mention: the debt crisis during the 1980s, starting with Poland and Mexico and spreading to Latin America, Africa, the Middle East and the Soviet Union; the stock exchange fall in 1987; the Mexican crisis in 1994; the bond market crash in 1994; the Asian crisis starting in 1997; the LTCM and Russian crises in 1998; the recent stock exchange fall and the collapse of the 242

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technology bubble in 2000. We have surmounted all these crisis episodes. We have learned a lot and we have improved a lot in these occasions. One of my friends used to say: "Good management comes out from experience and experience comes out from bad management!" I think we are pretty experienced now and I take it that thanks to the lessons drawn we have now achieved a level of crisis prevention which is much better. But we should never forget that the risks are still there because they are intimately associated with the structural transformation of the global economy. This is not, in any respect, a time for complacency. If I had to sum up what should be our today's mottos, I would make the following five recommendations: •

Let us not forget the crucial role of the IFIs, in particular the Bretton Woods institutions, in the management of the present global economy. The constant improvement of their management and instruments is key; • Let us tirelessly improve transparency in all fields: it is the best recipe for avoiding both misallocation of capital and global crisis contagion; • Let us continuously improve the flexibility of our economies through bold structural reforms. Not only because it improves efficiency but also, all the more, because it improves resilience in a world where shocks are to be expected; • Let us reinforce our methodology to ensure that we do not amplify "pro-cyclical" phenomena: the best envisaged at a local or sectoral level can be the enemy of the good at a global systemic level. In this respect such informal groupings like the G20 and the Financial Stability Forum are of the essence; • Let us join efforts to improve our scientific knowledge of the new world economy. Still today, academics and practitioners are observers and actors within the environment of largely uncharted territories. The more profoundly we understand the functioning of today's global economy, the more efficient we will be to weather stocks, to prevent crisis, and to pave the way for continental and global job creation, steady growth and overall stability.

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BLOCK II

International Financial Architecture

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Session 4 The Role of the IMF

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A Model of the IMF as a Coinsurance Arrangement" Ralph Chami International Monetary Fund Sunil Sharma International Monetary Fund Ilhyock Shim Bank for International Settlements

"This paper has benefited from the input of many colleagues, and the comments of participants at the conference on "Dollars, Debt, and Deficits: 60 Years After Bretton Woods" organized by the Bank of Spain and the IMF in June 2004. In particular, the authors would like to thank Lorenzo Bini-Smaghi, Sajjid Chinoy, Tom Cosimano, Burkhard Drees, Jeff Fischer, Connel Fullenkamp, Rex Ghosh, Herve Hannoun, Mohsin Khan, Tim Lane, Jaewoo Lee, Leslie Lipschitz, Alan MacArthur, and Miguel Messmacher. Tala Khartabil provided superb research assistance. This paper should not be reported as representing the views of the IMF. The first draft of this paper was dated August 7, 2003. The current draft is dated November 12,2004. The views expressed in this paper are those of the authors and do not necessarily reflect the views of the IMF or IMF policy. Authors' e-mail addresses: |^ynii@iin£cffg; [email protected]; ilhyock. [email protected].

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Introduction Financial liberalization, capital account convertibility, and the increasing importance of private capital flows have dramatically changed the international environment in which the IMF operates. For many countries, access to international capital markets has brought opportunities for loosening funding constraints and underpinning more ambitious growth strategies, as well as developing financial institutions that can hold their own in the international financial arena. However, these opportunities have come with new attendant hazards—a greater exposure to international liquidity cycles, changes in the moods and expectations of foreign investors, contagion, and external shocks in general. And the financial crises of the last decade—Mexico (1994), Thailand (1997), Korea (1997), Indonesia (1997), Russia (1998), Brazil (1999), and Argentina (2001-02)—have shown that when there is a massive withdrawal of external financing, the cost to the economy can be punitive, and the demand for IMF resources can be huge by the standards of earlier decades.l These large IMF programs have reopened the debate on the nature and role of IMF financing. Some observers argue that recourse to IMF financing generates moral hazard on the part of both borrowers and lenders—leading to less due diligence by private lenders, and allowing borrowers to incur larger debts and get by with weaker policies and institutions. Hence, IMF financing, though offering a cushion in times of financial crises, increases the likelihood of such events occurring. Others argue that the moral hazard associated with international financial support is limited and that the focus should be on containing the real hazards generated by the structural and policy deficiencies of emerging markets and their pernicious interaction with the global financial system Markets do not always work to provide appropriate discipline, the extent of access and the lending terms may not be justified by fundamentals, and when problems are eventually recognized, markets may impose punishments that are overly severe.2 The rationale for IMF financing has remained the same—overcoming market imperfections and enhancing the world's ability to provide international public goods that would otherwise be in short supply.3 There are a number of factors that lead to countries being rationed or excluded from international financial markets: imperfect information about country prospects and institutions, problems related to enforcing sovereign loan contracts, and coordination problems among lenders. On the supply of public goods, just as openness to trade is considered an international public good worth cultivating, a cautious openness to international financial markets also contributes to the development of countries and to the common good. By providing funds temporarily to deal with external payment difficulties so that countries do not adopt policies that are destructive of national and international prosperity, the IMF supplements private markets when necessary, and helps countries to become more open to trade and capital. It enables countries to bear the risks associated with reforming and developing their financial systems and economies, and opening them to achieve a more efficient global allocation of resources. 'See, for example, Jeanne and Zettlemeyer (2001), Ghosh etal. (2002), Haldane and Taylor (2003), and Independent Evaluation Office (2003). 2 For a discussion see Bordo and Schwartz (1999), Calomiris (1999), Mussa (1999), Meltzer et al. (2000), Jeanne and Zettlemeyer (2001), the recent review by Haldane and Taylor (2003) and references therein. 3 See, for example, Masson and Mussa (1995) and Krueger (1998). Also, see Cordelia and Levy Yeyati (2004) who argue that the insurance provided to countries by the presence of the IMF may encourage long-term reforms in developing economies.

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This paper uses a stylized framework to examine the role of an IMF-like institution in the world financial system. First, it shows that a coinsurance arrangement among countries can, in principle, play a useful role in helping countries bear the risks involved in developing their economies and becoming part of the global financial system.4'5 The moral hazard inherent in such an insurance arrangement can be reduced by peer monitoring, but given the coordination and administrative costs of peer monitoring, countries may decide to create an institutional monitor like the IMF. The IMF, along with administering the common pool of funds created for making loans to members, undertakes country surveillance to limit moral hazard in the system Second, the paper tries to model the operation of the coinsurance arrangement by examining the nature and timing of interventions. The question asked is: how should the loan contract between a borrowing country and the IMF be structured and when should the contractual details be decided to create the right incentives—encourage countries to take prudent risks, do their best to prevent external payment imbalances from emerging, and should they run into trouble take the policies to rectify the situation. Should the IMF precommit to a predetermined contract or should the contractual details be decided ex post after the country is in crisis? To examine these issues, we use a two-period repeated moral hazard setting in a principal-agent framework (with the IMF being the principal and the borrowing country the agent). The problem is examined under two objectives for the IMF: safeguarding of its resources and a concern for the borrowing country's welfare. If the country runs into trouble, the IMF provides funding over the two periods—a tranche in each period. After the two periods the IMF is paid back by the country. The IMF cannot observe the policy effort but can observe the country's output performance. A higher policy effort in the first period increases the probability of avoiding a crisis, and should the country get into one, a higher policy effort in the second period increases the probability of recovery. In our model, the IMF and the member country take sequential decisions to maximize their respective utilities. Three cases are considered for the timing of IMF intervention: (i) the ex ante contract, where the IMF precommits to a contingent loan contract for the two periods—the contract specifies the first and second tranches before the country has chosen its policy in the first period; (ii) an ex post contract, where the IMF chooses the contract after the country has chosen its policy effort in the first period and fallen into a crisis—the contract specifies the first and second loan tranches after observing the outcome in the first period; and (iii) a variation on the preceding ex post contract, where the IMF chooses the first tranche after observing that the country is in a 4

In this paper, we use the term "coinsurance" synonymously with "mutual insurance." The coinsurance arrangement can be thought of as an emergency lender envisaged in Fischer (1999), who makes the case that such an institution need not have the power to create money, as long as it has the resources to play a useful role as crisis lender and manager. For a more traditional interpretation of the lender-of-last-resort see, for example, Capie (1998). 5 The Chiang Mai Initiative among the ASEAN countries, China, Japan, and Korea can be thought of as a coinsurance arrangement designed to alleviate temporary liquidity shortages. Member central banks can swap their own currencies for certain international currencies for a short period of time. The size of the "borrowing" can be some multiple of the amount committed by the member under the arrangement. Note also that the original conception of the IMF was based on the idea that most countries would be both creditors and debtors to the IMF over time. In the 1950s and 1960s, with the exception of Germany and the United States, most members fit this description and at some point used IMF resources to help fix external payment imbalances. However, by the 1980s most industrial countries had begun to rely exclusively on private capital flows, and the IMF membership became divided into creditor and debtor groups (see Boughton 2004). 6 See, for example, Laffont and Martimort (2002) and references therein. 252

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crisis and then chooses the second tranche after observing the output of the program country. The size and design of the IMF loan contract turns out to depend crucially on the objectives of the Fund and the timing of Fund intervention. If the Fund were to be concerned only with safeguarding its resources, then it would demand full repayment irrespective of the country's situation. However, if in addition to safeguarding its resources, the Fund also cares about the welfare of its borrowers, the contractual repayment scheme in the second period is in general contingent on the economic situation of the country. The size of the first tranche lowers the policy effort both for avoiding a crisis as well as for overcoming one. This is because the first tranche has to deal with two dilemmas in our setting, the Samaritan's dilemma and King Lear's dilemma.7 The first tranche, which is given after a country chooses its effort in the first period, lowers the incentives for preventing a crisis because the country knows that the IMF cares about its welfare and will provide a cushion in a crisis—the Samaritan's Dilemma (Buchanan 1975). On the other hand, providing the first tranche before the country decides on policy in the second period does not create the right incentives for a program country to solve the crisis. Once the first tranche is delivered, the country's choice of policy in the second period need not be optimal from the IMF's perspective—King Lear's dilemma (Hirshleifer 1977). We argue that to deal with these dilemmas it is best for the IMF to commit to an ex ante contract—that is, design and offer the contract before a crisis arises. Such a contract specifies the first tranche and the state-contingent second tranche, penalizing the country for low output, but rewarding it if the output is high and the country emerges from crisis. In the presence of information asymmetries and given the mandate of the IMF to safeguard its resources and care about the welfare of members, the timing of a Fund program has a critical effect on the country's effort to avoid a crisis, and on its effort to recover from a crisis. We show that ex post contracts—that is, IMF intervention after a country has fallen into crisis—does not elicit the highest policy effort from a country. In such cases, the program country is likely to reduce its effort to recover from the crisis, knowing that if it does not recover, a suitable loan will be available from a "caring" Fund. In contrast, deciding on the IMF program ex ante tends to result in higher effort by the country to avoid and to recover from a crisis. However, we show that such a contract is subject to time-inconsistency problems, as the Fund and the country may both find it in their interest to renegotiate the Fund's ex ante contract, once the country enters into a crisis. Hence, it may be best for the Fund to precommit to a loan contract, raising the interesting question of how such a precommitment can be enforced. The rest of the paper is organized as follows: Section 2 develops a model of coinsurance, first with exogenous risks and then with endogenous risks. It then examines the issue of moral hazard in coinsurance and how it can be reduced through monitoring arrangements. Section 3 deals with the operation of the coinsurance arrangement and the optimal choice of loan contracts for the IMF and member countries. The last section concludes. Proofs of all results are given in the Appendix.

7

For a discussion of these dilemmas and related issues, see for example, Becker (1974), Buchanan (1975), Hirshleifer (1977), Bemheim, Shleifer and Summers (1985), Cox (1987), Bergstrom (1989), Bruce and Waldman (1990), Chami (1996,1998) and Jurges (2000).

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A Model of Coinsurance Consider the possibility of voluntary coinsurance between two countries. Suppose each country is subjected to a shock (for example, a crisis) with probability n and that the shock results in a (fixed) loss of output. The probability n of being subjected to an adverse shock can be either exogenous or a function of the country's policy efforts to decrease vulnerability to shocks—that is, policies conducive to economic growth, macroeconomic and political stability, and a healthy financial sector. Exogenous Risk Case: No Moral Hazard We consider two countries / and j that face income shocks that are exogenous and i.i.d. A shock leads to a fixed loss in income, 8, where 6>Q. Two states of nature, good (G) and bad (5), occur with probability (1-tf) and n, respectively, where Q 0. For simplicity, a country's utility function is assumed to be additive and separable, and given by (4)

The expected utility of country / is (5)

When we adopt the Nash assumption, each country maximizes utility taking J3 and the effort of the other country as given. For country / , the first order condition with respect to ei is (6)

and a similar condition holds for country j. Together, these two reaction functions provide the optimal (Nash) policy efforts for the countries: ei =ef.[./?,ej and By symmetry, we get the

equilibrium policy

effort

levels:

The next question to ask is whether providing coinsurance exacerbates the moral hazard problem. The following lemma answers that affirmatively.

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Lemma 2. If income risk is endogenous, larger income transfers under the coinsurance arrangement reduce the policy effort to prevent the bad outcome i.e. The change in J3 affects the expected utility through two channels: the direct effect of J3, jand the indirect effect of /? through e. The proposition below shows that countries value coinsurance even in the presence of moral hazard. Proposition 1. Even if the income risk is endogenous, countries may prefer to have a coinsurance arrangement, that is, However, in the presence of moral hazard, the optimal income transfer is smaller than in the absence of moral hazard, i.e. 0;

Further, under assumptions (l)-(5), the optimal policy efforts elicited by the contracts satisfy (c)

Proposition 10 shows that when the policy efforts of the country to prevent and overcome a crisis are not fully observed by the IMF, under some conditions a precommitment to a lending contract, B* 9 elicits a greater amount of crisis prevention effort and crisis-overcoming effort from countries, than the offering of the contract C* after the crisis has occurred. It also shows that some commitment is better than none at all, since contract C* induces higher efforts than contract D*. In terms of debt forgiveness, precommitment leads to the least amount of forgiveness if the program country cannot get out of the crisis. On the other hand, if the program country is successful in getting out of the crisis, contract C* provides the largest amount of debt forgiveness to the program country. The intuition for this is that under contract D* the IMF decides on the amount of forgiveness after it observes whether the program country is successful in getting out of the crisis or not. Once the IMF knows that the country is out of the crisis, as it does under contract D*, it is optimal for the IMF to reduce the amount of debt forgiveness compared to the situation under contract C*, where the terms are decided before such information is available to the IMF. From Propositions 9 and 10, Corollary 3 follows immediately. Corollary 3. It implies that, compared to contract D*, under contract C* debt forgiveness by the IMF is lower when the program country remains in crisis, and higher when it is able to get out of a crisis. 270

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Preconunitment and Time-consistency The idea of precommitment entails an ex-ante agreement on the contingent loan contract between the IMF and a member country. But commitment to an ex ante contract (that is a contract agreed to before problems arise) suffers from the timeinconsistency problem (Kydland and Prescott 1977). If the country knows that ex post (that is, after a country's situation deteriorates) the IMF will be willing to renegotiate the contract, ex ante country ownership of the contract is less likely.17 The problem of time inconsistency arises even in an environment of complete and perfect information. For an altruistic lender, there is the additional dimension that the borrower knows that it will be optimal for the lender to renege on penalties agreed to ex ante—the economics of fait accompli (Bernheim and Stark 1988), Lindbeck and Weibull 1988). The presence of informational asymmetries exacerbates the problem even further—the lender cannot easily verify the policy effort and hence cannot contract on such effort; it also changes the prescription for dealing with the dilemmas posed by altruism and sequential decision making. This paper shows that, for an altruistic lender facing information asymmetries, it may be best to precommit to an ex ante loan contract rather than define the contract ex post.18 Suppose, for the sake of simplicity, that the menu of contracts consists of two contracts—the ex ante contract B* and the ex post contract C* defined in the previous section. Then, Proposition 10 shows that the IMF will choose contract B* before a crisis occurs. Now consider what happens when a country runs into trouble. Once e* is chosen and the country falls into a crisis, the optimal contract for the IMF is C*. Since B* and C* need not be the same, the IMF has an incentive to change its contract once the country descends into a crisis. The intuition is as follows: When the IMF offers contract B* to a surveillance country, its objective is to provide the country with the incentive to both, prevent a crisis, and should a crisis occur, to expend effort to change course. Thus, the contract is designed to achieve these goals, while giving consideration to the country's welfare. However, once a crisis erupts, the IMF's focus is to encourage the country to exert adequate effort to get out of the crisis. Under the new circumstances, a different contract, C*, is optimal. Hence, the IMF is willing to change the contract over time.19

17

See, Drazen and Fischer (1997) and Khan and Sharma (2003). Aside from altruism, the IMF faces additional hurdles in its operation compared to a traditional lenderof-last-resort (Tirole 2002 and Khan and Sharma 2003). First, lending takes place on the promise that country authorities will implement policies to rectify imbalances, and it is difficult, if not impossible, to establish the value of such "collateral." Second, the information asymmetries and hence the moral hazard is likely to be more pronounced. The IMF faces what in agency theory is called "moral hazard in teams"—while program negotiations are conducted with certain representatives of the government (central bank, finance ministry), the success of the program depends on the acceptance and effort of many other stakeholders in society (other ministries, political parties, trade unions, professional associations, civic groups, NGOs) (Holmstrom 1982). Third, the enforcement mechanism for ensuring that borrowing countries live up to their obligations essentially amounts to some combination of moral suasion, maintenance of the borrower's reputation, peer pressure, and the threat of being shut out of international capital markets. 19 To go further, once the country chooses -e^, then depending on whether the country gets out of the 18

crisis or not, the IMF may find that yet another contract D*, different from C*, is optimal.

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Now consider the problem the country faces over time. A country in crisis may prefer the contract C* to going through with B* which may have been preferred before the crisis was encountered. If the program country obtains higher expected utility from C", renegotiation by the IMF and the country may make both of them better off. Again, time inconsistency stems from the fact that the IMF may prefer to change its contract as the situation changes. This begs the question whether such contract renegotiation should be permitted and whether it is in the global interest.20 The community of nations may well prefer that contract 5* be offered and enforced, since it leads to higher country effort to prevent problems from emerging, higher country effort to escape crises, and a smaller transfer of resources by the IMF. The model presented in the paper has analyzed a single interaction between the IMF and a country. In a setting where there is repeated lending, it may be in the IMF's interest to precommit to a contract such as U*3 and build a reputation for enforcing the contract. Over time, this could lead to the emergence of an international norm under which the IMF offers and enforces a "standard" contract. Renegotiation would be allowed only under exceptional circumstances, for example, when it is perceived that the country in crisis poses a systemic threat to the world economy. Concluding Remarks This paper argues that in the presence of information asymmetries and given the mandate of the IMF to safeguard its resources and care about the welfare of borrowing countries, the IMF should precommit to a lending contract.21 Such a precommitment elicits the right policy effort from countries to prevent crises and to recover from them. However, a contract agreed to before a crisis erupts is subject to time-inconsistency problems, since the Fund and the country may both find it in their interest to renegotiate the ex ante contract, once the country enters into a crisis. Hence, a country, knowing that the IMF will renegotiate the contract if it experiences a crisis, is less likely to own the program ex ante and give credence to statements that additional funds or concessions will not be made. Our results can be taken as a defense of existing IMF procedures that define annual and overall access limits to resources for program countries. Limits on IMF lending and rewards for good housekeeping were also favored by the independent task force sponsored by the Council on Foreign Relations (1999). The Meltzer Commission also suggested that the IMF should provide resources up to specific limits, but only to prequalified countries and at penalty interest rates.22 A key objection to the 20

In the context of our model, the parameter 6 can be given a different interpretation to capture the "toobig-to-fail" issue. One could think of 6 as the importance the IMF attaches to a country, with the size of 6 depending on the consequences a crisis in that country would have for the international financial system. Large systemically important countries would be assigned larger 6 s and for these countries the time inconsistency problem would be more severe. Knowing this, such countries are more likely to be successful in renegotiating their contracts and obtaining weaker programs. 21 Note that precommitment to a lending contract for all members is quite different from prequalifying members for access as was done for the IMF's Contingent Credit Line (CCL) facility. The CCL facility had to contend with the concern that signing up for it may be taken as a signal of weakness, and that ineligibility at a future date may have a negative fallout. 22 See Meltzer et al. (2000). Prequalification was to be based on four factors: (i) free entry of foreign financial institutions; (ii) regular and timely publication of the maturity structure of sovereign and government guaranteed debt; (iii) adequate capitalization of commercial banks; and (iv) a fiscal

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prequalification requirement was that it would exclude a large number of member countries, and hence would be fundamentally inconsistent with the rights of all members to access IMF resources under the Articles of Agreement.23 In many recent programs, normal IMF access limits (100 percent of a country's quota annually and 300 percent of quota cumulatively) have been breached by wide margins. This paper does not address the difficult question of how large the IMF should be for effectively performing its role as a coinsurance arrangement and crisis manager. In an era of capital mobility, country quota levels and access limits may need to be recalibrated. Among other things, the size of the IMF will depend on the size distribution and health of member countries; the extent to which countries have access to private capital markets; the volatility of international finance (or more generally the real hazards that have to be dealt with); the effectiveness of IMF surveillance; and the catalyzing role of IMF lending.24 The design of an ex ante loan contract will also involve specifying the interest rate charged, and the maturity of the loan. If the IMF is limited in its ability to charge different credit spreads across countries, to safeguard its resources the IMF could still attach different policy conditionality to the loan contract depending on a country's characteristics and the imbalances the country is facing. Countries could be allowed to choose loans from a predefined set of maturities, and the rate of charge could increase with maturity to create an incentive for countries to deal with the situation quickly and repay the IMF. An IMF commitment to a loan contract that ex ante stipulates access limits, size of tranches, interest rates, and maturities may have other advantages. First, it would make it easier for countries to decide how much self-insurance they should buy.25 Second, it would make clear to private creditors the extent of IMF resources a country could tap if it ran into liquidity problems, and hence contribute to limiting creditor moral hazard. As a country accumulates debt in international and domestic markets, private lenders, knowing the limits of IMF support, may be quicker to react to signs of emerging imbalances than they would if the extent of IMF support was not specified (Haldane and Kruger 2001). Third, an international coinsurance arrangement among countries is essentially a self-regulatory club. It can be argued that when members do not live up to their obligations, like other self-regulated organizations, the IMF may not impose the discipline the international tax payers would deem appropriate. Hence, an international norm that restricts the access of countries to IMF resources through prespecified limits and terms, except when there is a systemic threat, may be a useful commitment mechanism

requirement. 23 For more on the debate see Eichengreen (1999), Goldstein (2000), and U.S. Treasury (2000). 24 For a discussion on the nature and size of the IMF, see Jeanne and Wyplosz (2001). For the catalyzing role of IMF lending see the recent survey by Hovaguimian (2003) and the references therein. 25 For a discussion of foreign exchange reserve accumulation and self-insurance, see Lee (2004).

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Appendix: Proofs Proof for Lemma 1. Since

diminishing

marginal

Therefore, holding for

utility

gives

with equality Q.E.D.

Proof for Lemma 2.

Let

and u. = u.

From equation

(6),

—

where

by thej convexity of n and v.

Thus, Q.E.D. Proof for Proposition 1. Let y,, = y, St=S, and u,r = u. —

jf

•

j

(i) Evaluating (i) at ft = 0, the second term in (i) disappears, and we get

Evaluating (i) at ft = \, the first term in (i) disappears, and we get

Q.E.D.

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Proof for Proposition 2.

The first-order condition with respect to ei is

(ii) As we did in Lemma 2, by symmetry, we can use

and

From equation (ii),

where

for all A > 0. Thus,

'(Hi) We know from the first order condition with respect to/? that, in the symmetric equilibrium, J3* = $2 should hold to make the marginal utilities equal. Plugging this into (iii), as A -» 1, we get —- -> 0. Alternatively, as A -> 1, and the countries tend to attach the same relative weight to each other's utility. Therefore, their marginal utilities in each state will tend to equality and the term will converge to zero.

Q E.D.

Proof for Proposition 3. Without loss of generality, we assume that yi > y^. Then, proceeding in the same way as in the proof of Proposition 2, we get the following:

Note that no we* * e*. due to the asymmetry y. > y^.

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As 2 -> 1, unless holds, Q.E.D. Proof for Proposition 4. From (14),

Then,

Q.E.D. Proof for Proposition 5. From (15), using the envelope theorem, we get

Hence,

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where

Q.E.D. Proof for Corollary 1.

Q.E.D. Proof for Corollary 2.

Q.E.D. Proof for Proposition 6. From the expected utility function of the IMF under contract A and the assumption I} >max(zH9zL), we can see that the IMF's utility is maximized when I*A = ZL* = z**, and the corresponding level of the IMF's utility is u(x) for any value of e, and e2. Then, from the assumption that

we get

cmin(wtf,^). Q.E.D. Proof for Proposition 7. Note that the sum of the right-hand side of (16), (17) and (18) is zero. Thus, if the righthand side of (17) and (18) is negative, then the right-hand side of (16) must be positive. Suppose x —» oo and 6 » 0. Then, the second and the third terms on the righthand side of (17) and (18) converge to zero while the first term of (17) and (18) is negative and not close to 0. Thus, the right-hand side of (17) and (18) becomes negative, which means z"* = z£* = 0 and I*B = nq. Next, consider the case where x is small (i.e. close to 0). We know that now the first and second terms on the right-hand side of (17) and (18) are positive and the first terms in (17) and (18) are close to oo. Thus, the right-hand side of (17) and (18) becomes positive, which means as long as Q.E.D.

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Proof for Proposition 8. Let

and note that

The results in Proposition 8

follow directly from (14), (15) and the fact that ~£ is a strictly increasing function of effort. Q.E.D. Proof for Proposition 9. The proof is by contradiction. Suppose that z£ * < ZL* . Then, the following holds:

Now, from (22), we get

Also, from (23), we get

But, from the first order condition with respect to e2, u'(y2 +7, -z£) >uf(y" +7, -z"). Thus, it follows that

which implies

This is a contradiction.

Q.E.D

Proof for Proposition 10 and Lemma 3. Throughout the proof, we denote the general expected utility of the IMF by EUIMF, and make the following assumptions: Assumption 1. H

(i.e. twice continuously differentiate) with respect

L

to T , T and K, where K is defined in (PART 1) below. This assumption is necessary for well-behaved second-order conditions. Assumption 2. ire interior solutions. Assumption 3. 278

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This assumption assures that the second-order condition for a maximum holds. It also guarantees that the expected utility of the IMF is more sensitive to its own wealth compared to that of the country. The proof has two parts: the first part shows that the second part shows that

and and T"* > Tg* ,

(PARTI) First, we show that When we compare the IMF's expected utility functions under contracts B and C, we find that the first order conditions, after normalization, differ only in that each of the first order conditions under contract B has an additional term

where / = / 19 z L ,z // . Thus, we can represent the solution of the problem under both the contracts in one system of equations using the following term

where i = I},zL,zH . For ^ = 0, we get the appropriate conditions for contract C, and for K = 1, we get them for contract B. To show that e^B > e*c, first we derive the change of ZH , ZL , and I} when we move from contract B to contract C, then we calculate the change of e* due to the changes in ZH , ZL , and I} between the two contracts, and finally we combine these two effects to get the total effect. In particular, define Then, we need to solve the following system of equations to get

where

and so on.

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Thus, we need to show that

holds. Note that F + G + // = 0, \/I},zL,zh ,K . Thus, from Assumption 2, one of the terms F9 G or H is redundant. Therefore, we can redefine the problem as a 2-equation2-variable problem using the following change of variables: TH =I}-zH and TL = 7, -Z L , where TH,TL>0 from the assumption that /, - max(z H ,Z L ) > 0. Now we can rewrite the IMF's expected utility functions under contracts B and C using TH,TL, calculate the derivatives e*TH9e* L9e*TH,e*TL, and redefineFand G as follows:

Note that

Thus, from Assumption

1, we have

and

To show that

we need to show that

holds, where the first term on the left side of the inequality represents the increase in e\ through when we move from contract C to B, and the second term represents the decrease in through when we move from contract C to B. To this end, it is sufficient to show that To derive get the following:

where ~

and

~

we differentiate F and G with respect to

~

and so on.

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and

Since F}, F2, F3, G13 G2, G3 are continuous, by Young's theorem, F2=G}. We can also show that F3 < 0 and G3 < 0. From Assumption 3, we get Then,

. Denote

and

It foliows that T£* > Tg* and T? > T^. To prove Lemma 3, first note that

Since we already know, from the first-order condition of P with respect to e2, that

once we have

holds.

Therefore, Lemma 3 is true. By Lemma

3,

Using Assumption and hence

4,

/V(yt}) will be rolled over into new loans, while debts that will not be repaid in present value will be renegotiated. The expected net return to creditors is given by (2)

9

For low debt levels, an increase in debt may indicate improving fundamentals and thus result in narrower spreads, as suggested by Pattillo et al. (2003). 10 For example, banks can have a comparative advantage in creditor coordination in the context of debt renegotiation (when there are advantages to getting all creditors to take the same position). They may also be in a relatively favorable position to arrange concerted lending and thus control strategic uncertainty that can cause liquidity crises. 296

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where r is the return on alternative investments. The interest rate spread will be the difference between ERt IDt and (1+r). This spread is increasing with the level of debt for positive probabilities that V(yt] is less than Dt. When the level of debt is low, this probability can be zero, in which case the spread does not rise with indebtedness. But as indebtedness rises further, the probability of default becomes positive, as does the risk premium. Models of debt renegotiation with perfect information thus imply that spreads will not increase with debt at low debt-to-GDP ratios but that they will start rising at an accelerating rate after the debt-to-GDP ratio passes a critical threshold. This is corroborated by our empirical work, below. To motivate the role of monitoring, it is necessary to introduce information asymmetries. Assume that the debtor's willingness to pay is known by others with uncertainty. Specifically, suppose that lenders only know the distribution, of the debtor's willingness to pay, within an interval, For simplicity, the distribution can be taken as uniform around a mean equal toV(yt). The debtor can offer repayment,

less than its true willingness to repay. Consistent with standard

analyses, the equilibrium offer accepted by lenders yields r e p a y m e n t , e q u a l to the debtor's actual willingness to pay when this equals its minimum value . For larger realizations of , the debtor will transfer less than its true willingness to pay and realize a positive surplus given by the difference The debtor pays in full if . Because actual repayments are less than the debtor's true capacity, the probability of default is higher and creditors' expected returns are lower when information is asymmetric. Creditors can extract more surplus if monitoring helps them to become better informed about the debtor's future policy actions. Monitoring increases willingness to pay, raising returns in the event of renegotiation and reducing the probability that renegotiation occurs. If lenders learn about the characteristics of borrowers from repeat lending, as appears to be the case from the evidence reported below, then spreads should fall with repeat transactions. Similarly, if the IMF has an advantage in monitoring the policy actions of the debtor, then agreement to establish an IMF program should reduce spreads and increase debt issuance for a debtor with a positive probability of having to renegotiate. Our empirical analysis in Section 5 below points to differences in the impact of repeat lending and IMF programs on bank loans and bond spreads.11 An explanation consistent with our findings is that banks and bondholders have different monitoring abilities. Banks will cater to smaller, less well established borrowers, since they presumably possess a superior monitoring technology. Bondholders will focus on large, well-known borrowers.12 The private information revealed by clients to their banks will then make more precise the bankers' views of their capacity to repay. On the other hand, if banks have a monitoring advantage over bondholders, then an improvement in public information resulting from an IMF program could reduce (or in the limit remove) that

1]

See the section on the pricing of bonds and loans. See Petersen and Rajan (1994, 1995) for U.S. evidence consistent with this pattern.

12

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informational advantage, reducing bond spreads and encouraging bond issuance relative to bank loans. With asymmetric information, the adoption of an IMF program can reveal information to capital markets about country policies and willingness to pay. This does not hinge on the assumption that the IMF has superior ability to collect or interpret data; the Fund may simply have the ability to commit to actions to which private investors cannot or will not commit.13 To the extent that the IMF has a superior ability to commit or objectives that differ from those of private investors, adoption of a Fund program can also reveal information about the debtor country. In turn this allows the government to signal its intentions.14 For example, the conditionality associated with an IMF loan might be less onerous for governments for which policy reforms are less costly, thus making it incentive compatible for such governments to sign up with the Fund in order to signal its type. Countries with stronger policies or a greater will to enact policy reform are thus able to reveal this information by negotiating a Fund agreement. Of course, adopting a program may also reveal poor fundamentals, and not just a superior capacity to enact policy reforms, resulting in an overall ambiguous impact on spreads. IMF programs sometimes turn precautionary: borrowing stops, but the government continues paying a commitment fee that gives it the option to resume borrowing. By turning a program precautionary, the debtor country government can thus reveal that it has a diminished need for official finance but a continuing commitment to prudent policies. This good news should be reflected in a reduction in spreads on both bank loans and bonds. Debt restructuring can also give rise to differences between banks and bondholders if the members of a bank syndicate can more easily coordinate their actions. Recall that equation (1) separates current willingness to pay into the sum of current resources available for repaymentw(y t ) and discounted expected future willingness to pay. If coordination failures prevent bondholders from restructuring debts quickly, then banks can move first and secure a larger share of the pie. They can do so even when all creditors have identical information and learn at the same time that the debt is unsustainable. Recall that (3)

where Bt and Lt are outstanding bonds and bank debt, respectively. Banks can reschedule their loans and avoid immediate default by reducing repayments currently due while at the same time increasing future repayments by rolling over their loans at higher interest rates. Subsequent renegotiations incorporating equal sharing between bondholders and bank lenders will then divide the settlement amount between banks and bondholders on the basis

13

It should be possible to model the IMF as endogenously gaining a monitoring advantage through its ability to commit to lend only in a crisis in a repeated game. The approach of self-enforcing equilibrium taken by Kletzer and Wright (2000) in the sovereign debt context could be used to model de facto IMF seniority and why countries might meet IMF conditionality. 14 Marchesi and Thomas (1999) offer a model in which Fund conditionality serves as a screening device. 298

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I

of the new bank share of the total debt. To illustrate, let the banks reschedule an amount ALt of current debt repayments so that (4)

where and are interest payments due on bonds and loans, respectively. The banks then increase loans in period t+1, LM, by an amount r'AL,. The banks' share of future repayments rises to

(5) Since the increase in the value of bank claims comes out of the expected returns to bondholders in the event that current total debt is unsustainable, the interest rater1 can then be chosen to maximize the increase in expected returns,

(6) If the banks can reschedule a sufficient share of their debt, they can eliminate their current expected loss at the expense of bondholders. This strategic advantage contrasts with a simple principal-agent model in which improved monitoring by banks raises the probability of repayment and returns to banks and bondholders alike.15 The banks' strategic advantage can be reduced or eliminated by the presence of a more senior official-sector creditor. Since the first-mover advantage arises from the prospect of default, it can be reduced by availability of official support under an IMF program, assuming that such funding reduces the risk of renegotiation. Absent differences in bank and bond markets, the basic model of sovereign debt renegotiation with asymmetric information would imply that IMF monitoring and financial resources lead to equivalent reductions in bond and bank loan interest spreads.16 Similarly, if IMF conditionally improves fundamentals and growth prospects, then both bond and bank lending should increase. However, if banks have a monitoring advantage and can better manage creditor coordination and debt restructuring problems, as assumed here, then IMF monitoring that reveals debtor characteristics and IMF lending that reduces the likelihood of default will benefit bondholders more than banks. Finally, we consider the role of liquidity crises, adapting the model of Morris and Shin (2003).1? In their model, the fundamental has a distribution that is public knowledge, 15

The sharing of negotiated repayments here contrasts with the assumptions of Bolton and Jeanne (2003) that bonds are not renegotiable but bank loans are and separate penalties apply in selective defaults. 16 Gai and Vause (2003) present a model in which the IMF acts as a delegated monitor motivated by private creditor coordination failures. Our emphasis on asymmetric private abilities to coordinate is different. 17 Similar models by Rochet and Vives (2001) and Corsetti, Dasgupta, Morris and Shin (2001) also take a global games approach to catalytic finance. Chui, Gai and Haldane (2002) also discuss the policy implications of sovereign liquidity crises. 299

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but each lender in a continuum receives a privately observed noisy signal of its realization in the current period.18 In this setting, private information can generate coordination failures and produce liquidity crises even when debt is sustainable. We reinterpret their model by distinguishing between banks and bondholders, assuming that banks coordinate whereas bondholders do not. If V(yt) exceeds total debt but the country's current liquid resources fall short of current net payments due, then a liquidity crisis is possible. When debtor liquidity falls below a critical level, bondholders facing uncertainty about one another's actions will be unwilling to purchase new bond issues to replace amortizing debt.19 This may give rise to an incipient crisis. That crisis may be prevented, however, if bank syndicates replace the maturing bonds with additional bank loans. Banks are able to do this, in principle, because they can coordinate among themselves. Suppose that banks observe both a private signal drawn from the same distribution as that of bondholders and the failure of the debtor to place new bond issues. They can then halt a liquidity-driven crisis by replacing the maturing bonds with new loans. They can move after bondholders exit and have an incentive to do so in order to avoid unnecessary defaults on their long-term loans. Such models thus imply that bank loans and bond issues should be negatively correlated if crises are caused by illiquidity. Two further implications follow. First, a deterioration in market liquidity or increased uncertainty that reduces bond issuance can be mitigated by the presence of bank lending, since banks have an incentive to fill the gap. Second, the IMF, as lender in a liquidity crisis, can help to avoid costly default and renegotiation.20 Assume that potential purchasers of bonds are as poorly informed about what banks will do as they are about what other bondholders will do. Banks move on the basis of private information and the reluctance of bondholders to reenter the market. But both bondholders and banks should be able to anticipate the IMF's strategy when a program is in place. Then the existence of an IMF program should raise bond issuance relative to bank lending for countries susceptible to liquidity-driven crises. We examine this proposition empirically below. The Setting Although international lending through bond markets was prominent in the late 19th and early 20th centuries, from the 1960s through the 1980s private credit flows to developing and emerging economies took place mainly through banks. Lending via bond markets was about 10 percent of bank lending in the 1970s and early 1980s (Edwards 1986). This changed following the debt crises of the 1980: between 1991 and 2002, credit obtained via banks and bonds was of about the same order of magnitude, just under $700 billion through each channel (Table 1). 01

18

Morris and Shin also distinguish short-term debt that amortizes in the current period from other debt. Morris and Shin (2003) detail the determination of the critical level of liquidity. For our interpretation, we leave out additive debtor effort in their model. 20 Jeanne (2001) among others discusses the lender of last resort role of the IMF. 21 While we include all bonds issued in our analysis, we restrict the sample of loans to those that were priced based on Libor. These form the vast majority of international syndicated loans, both in terms of numbers and in the amount borrowed. By limiting the loans to those priced off Libor, we believe that more precise estimates of loan pricing become possible. 19

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Differences persisted, however, in the characteristics of the typical bank loan and bond. To show this, for each loan and bond in our data set we extracted the initial price, the initial maturity, the amount, and the currency of denomination. Borrowers are distinguished as sovereign, non-sovereign but public sector, and private sector.22 On average, bank loans are more numerous and smaller. Between 1991 and 2002, Loanware reports 6,747 Libor-based syndicated loan transactions; during the same period, Bondware reports the issuance of just over 3700 bonds.23 On average, a bond issue was about 70 percent larger than a loan transaction. We construct a measure of repeat borrowing, /?, separately for bank and bond borrowing. Starting with January 1, 1991, the measure takes the value 1 the first time a borrower enters into an international debt contract. With each subsequent instance of borrowing we then increment the value of R by one. The results show that repeat borrowing is more common in bond markets, where the median number of borrowings over the period 1991 to 2002 is 3 (the 75th percentile is 8 and the 90th percentile is 27); for banks, the median is 2 (the 75th percentile is 4 and the 90th percentile is 8). Thus, compared with banks, which allow a diverse set of clients to episodically borrow, the bond market caters to borrowers with name recognition who return frequently. Relative to bank loans, bonds were more likely to be issued when the issuing country had an IMF-supported program. About 22 percent of loans were contracted when a country had a Fund program in place (Table 2). In contrast, just over a third of bonds were issued in the presence of a program. To put the point another way, when countries were under an IMF program they were about as likely to borrow through a loan or a bond, but a loan was more than twice as likely when there was no program. While IMF programs appear to shift borrowing toward bonds, this shift does not occur uniformly. Table 2 shows that countries with external-debt-to-GDP ratios below 30 percent had few bond or loan transactions while under IMF programs. When the debt-ratio was between 30 and 40 percent, more borrowing occurred under IMF programs, especially through bonds; however, the number of credit contracts was still higher in countries without, rather than with, IMF programs. Countries with debt/GDP ratios in the 40-60 per cent range play an important role in our analysis. In this category, the distribution of credit contracts between program and no program is more even: indeed, more bonds are issued under a program than when there is no program. Finally, when external debt exceeds 60 percent of GDP, countries once again limit their international borrowing. When they do borrow, loans and bonds are equally prevalent. Patterns of Borrowing In this section, we analyze the borrowing decision and the choice between bank loans and bonds. The first probit equation (Table 3) estimates the correlates of borrowing by sovereign, non-sovereign/public, and private entities in each country-quarter. The second 22

We use these distinctions to also construct an estimate of the numbers that did not borrow. Thus, for a given country in a given quarter, the absence of borrowing by the sovereign implied that the sovereign had either forgone the opportunity to borrow or had not had access to international funds. Similarly, we identify country-quarters where no public (non-sovereign) and private borrowing occurred. For more on this, see below. 23 Of which spreads are available for about 3 500

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equation reports the likelihood of bond issuance rather than a bank transaction. Throughout we report the change in the probability for an infinitesimal change in each independent, continuous variable at its mean and the discrete change in the probability for dummy variables. Standard errors are adjusted for clustering since the number of borrowing transactions varies from country to country.24 Explanatory variables include issuer characteristics (in this regression, the borrower type, with sovereign as the omitted category), global variables (U.S. growth, the swap rate, EMBI volatility), and a vector of country characteristics.25 Among the global variables, U.S. growth appears to facilitate borrowing, especially by bond issuers in the medium-debt range (with a debt/GDP ratio between 40 and 60 percent). An interpretation is that global growth acts as collateral that supports additional borrowing. If the average monthly growth of U.S. industrial production rises from its mean of 0.3 percent to 0.4 percent, the probability of borrowing increases by just over one percent.26 Higher volatility of J.P. Morgan's Emerging Market Bond Index, reflecting greater uncertainty about pricing, is associated with reduced borrowing. If daily volatility increases from its monthly mean of 2 per cent to 3 per cent, the probability of borrowing declines by 1V4 to 2 percent. Higher bond-market volatility also lowers the frequency of bond issuance relative to bank loans by borrowers from countries with debt/GDP ratios below 60 percent.27 A one percentage point increase in daily volatility reduces the likelihood of bond issuance relative to a bank transaction by 2V£-4 percent. An interpretation is that short-run liquidity concerns and financial market disorder are more likely to generate strategic uncertainty among bondholders, who may then withdraw to the sidelines on the fear that others are doing the same. In contrast, banks, which are better able to coordinate among themselves, are more likely to continue lending.28 Improved credit quality (proxied by Institutional Investor credit ratings, which run from a low of 0 to a high of 100) allows for more borrowing both from banks and on bond markets. The importance of the credit rating increases when the external-debt/GDP ratio exceeds 40 percent. An increase in rating by 10 points from a mean of 52 strongly raises the likelihood of borrowing with no apparent shift in its composition.29 An interpretation is that whereas ratings influence the willingness of lenders to lend, a country's demand for foreign exchange determines how much it wishes to borrow. Thus, a higher ratio of debt service to exports increases the demand for external resources, thereby raising the likelihood of international borrowing, provided that the debt/GDP ratio is below 60 percent. Interestingly, as the debt/GDP ratio rises, the demand for external borrowing is increasingly met through loans. Similarly, when countries face higher export volatility,

24

This same correction for clustering is made throughout. More detail on variable definitions and sources can be found in the appendix, below. 26 The measure of US growth used in the regressions is the average of monthly growth rates in the quarter in which the transaction occurred. 27 Where debt ratios are higher, such compositional shifts are not statistically significant. 28 The Korean crisis in 1997-98, and other similar episodes, remind us that there may be limits to such coordination. But an important fact about the Korean crisis is that, in the end, the banks did roll over their loans, albeit at high interest rates. See, for example, Goldstein (1998). 29 The likelihood of borrowing rises by between 16 and 25 percent 25

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they are less likely to borrow abroad; in particular, they are especially prone to reduce their borrowing on bond markets. Bond issues tend also to be larger and longer in term. Whereas the average maturity of loans in our sample is 4V£ years (the median is just over 3 years), that for bonds is 6% years (with a median of 5 years).30 IMF programs have limited influence on aggregate borrowing by countries at low debt levels, as already suggested by Table 2. Presumably structural problems that limit the ability to borrow also cause countries to seek Fund assistance. Table 3 suggests, however, that such borrowers are more likely to issue bonds than borrow from banks. In the medium-debt range, a Fund program raises the probability of borrowing by 14 per cent. At high debt levels, the influence of IMF programs remains positive, although the effect is not statistically significant. We also distinguish precautionary programs. A first case is where IMF programs are designated as precautionary at outset Country authorities declare that they do not intend to draw on resources made available.31 Borrowing via both loans and bonds is lower in such cases, but mainly for countries in the intermediate debt range. There is thus some suggestion in the data that countries choosing to approach the Fund for precautionary reasons also behave conservatively in their borrowing from banks and on bond markets. A second case is when programs turn precautionary. In this instance the member stops drawing on resources available through the program but continues to pay the commitment fee to retain access. Aggregate borrowing does not appear to be affected by such arrangements.32 The Pricing of Loans and Bonds To analyze pricing, we use the model developed by Eichengreen and Mody (2000, 2001) and extended by Mody and Saravia (2003). The spreads equation is linear of the form: log (spread) =

(1)

where the dependent variable is the logarithm of the spread; Xis a vector of issue, issuer, and period characteristics; and uj is a random error. X contains a dummy variable for the existence of an IMF program, program characteristics if any, and interactions between the program and country characteristics.33 Since the spread will be observed only when there is a decision to borrow and lend, we correct for sample selection. Assume that spreads are observed when a latent variable B crosses a threshold Bf defined by: (2)

where Z is the vector of variables that determines the desire of borrowers to borrow and the willingness of lenders to lend (and will also contain the IMF program variables and their 30

A borrower wishing to increase the length of maturity from the average from the average bank loan to the average bond maturity is about 3.5 percent (1.75*0.02) more likely to issue a bond. 31 This declaration is not binding, as noted above. 32 Although borrowers from countries with high debt/GDP ratios appear to be less likely to issue bonds. 33 As discussed below. 303

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interactions). 2/2 is a second error term. We assume that: uj ~ N(0,o), u^ ~ N(0,I), and corr (uj, 1*2) = />. This is a sample selection model a la Heckman (1979). Equations (1) and (2) can be estimated simultaneously by maximum likelihood. Estimating the determinants of market access requires information on nonborrowers. As noted above, for each country we consider three categories of issuers: sovereign, other public, and private. For each quarter and country where one of these issuers did not come to the market, we record a zero, and where they did we record a one.34 We use our measure of repeat borrowing, R, to proxy for private monitoring. It is likely that the incremental information declines as R rises. Moreover, since R is correlated with the number of debt obligations outstanding, a larger value of R may also create greater coordination problems in the event of restructuring.35 The IMF dummy appears in both the selection and spreads equations. In contrast, R appears only in the spreads equation. Other variables in the selection equation are the global and country variables from Table 3. In addition, transaction-specific variables such as the maturity and amount of the credit transaction and dummy variables for the currency of issue and production sector of issuer (not shown to conserve space) are included in the spreads equation.36 Results are in Table 4. U.S. growth is associated with lower spreads and raises the likelihood of borrowing through banks and bond markets. This is again consistent with the idea that stronger global growth and export opportunities act as collateral for emerging markets. These effects are especially important for the middle debt group: an increase in monthly growth rate of 0.1 percent (a 1.2 percent increase in annual growth) reduces loan spreads in the mid-debt range by 2 per cent and bond spreads in that same range by about 4 per cent. Increases in issuance probabilities are somewhat smaller. Among the global variables, an increase in EMBI volatility has a particularly important quantitative effect on bond issuance when a country's debt-to-GDP ratio is below 60 per cent. If daily volatility rises by one per cent (at the daily mean of 2 per cent), bond issuances fall by between 5 and 7 per cent (in that same debt range). Improved credit ratings raise the probability of borrowing while lowering spreads, consistent with the idea that their main effect is to increase investors' willingness to lend. A 10-point improvement in the Institutional Investor rating has a large impact on spreads (with the largest effect in the mid-debt range, 32 per cent for loans and 48 per cent for bonds). For borrowers from countries with debt/GDP ratios below 60 per cent, improved credit ratings have a relatively small impact on bank lending, suggesting that public rating information, while relevant to access in both markets, is less valuable for bank decision making under normal circumstances.

34

Leung and Yu (1996) note that the estimation does not require the variables in the selection equation and the spread equation to be different but rather that the variables not be concentrated in a small range and that truncated observations (no bond issuance) not dominate. We do include in the selection equation (the probit), the ratio of debt service to exports, which appears to influence the issuance decision but not the determination of spreads. 35 In the regressions, we use the log of/?, which has a distribution that is much closer to normal than the (skewed) distribution of/?. We also allow all coefficients—and not just the variables of immediate interest, R and the IMF program dummy—to vary by debt category. 36 For a more extended discussion of the joint interpretation of the selection and spreads equation, see Eichengreen and Mody (2000).

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Our main result is that repeat borrowing reduces spreads on syndicated loans, while IMF programs reduce spreads in bond markets. The coefficient on the log of repeat bank borrowing is negative, significant and larger than the corresponding coefficient for bond markets. This is true for each of the three debt/GDP categories. The effects in the loan market are large. A second loan reduces spreads by about 10 per cent.37 A third loan has a spread about 6 per cent lower than the second loan, after which the impact declines to low levels. In bond markets, in contrast, only lightly indebted countries gain from repeat borrowing. IMF programs, on the other hand, reduce spreads and enhance access mainly in bond markets. This effect is most evident in medium-debt countries with debt/GDP ratios in the 40-60 per cent range. Bond issuance by countries in this category is about 13 per cent higher when there is a Fund program and spreads are 40 per cent lower. Evidently, bondholders become more willing to lend to such countries following the negotiation of a Fund program. IMF programs also facilitate bank borrowing by countries in this mediumdebt range, but the impact on spreads is insignificant. Finally, as noted in Table 2, in the low-debt range (especially when the debt/GDP ratio is below 30 per cent), countries with IMF programs borrow little. Countries with modest debts that nonetheless negotiate IMF programs appear to have unobserved characteristics that raise rather than lower spreads.39 In sum, repeat transactions have a significant effect mainly on bank borrowing, while IMF programs improve the terms of access to a greater extent for bonds. no

Extensions We now explore further the robustness of these results, varying the cutoff points, considering the size of IMF programs, and distinguishing private and public borrowers. We first ask whether the results are sensitive to cut-off points for the debt/GDP ratio. Table 5 reports results for overlapping debt/GDP ratios, starting with the 10 to 30 per cent range and then raising the end points by 10 percentage points over 6 intervals.40 Panel A, for loans, confirms the value of repeat borrowing which is significant in all 6 intervals. Comparison with the corresponding coefficients in Panel B shows that the value of repeat borrowing is greater for loans than for bonds in every debt category. Panel A also confirms that IMF programs do not reduce spreads significantly and are associated with higher spreads until the debt/GDP ratio is between 40 and 50 per cent. However, once the debt/GDP ratio exceeds 50 per cent, IMF programs are associated with a higher frequency of borrowing from banks with no apparent adverse effect on spreads. Panel B confirms that repeated bond issuance lowers spreads only in the 10-30 per cent debt/GDP range and has limited value thereafter, in fact raising spreads as if a multiplicity of bonds creates coordination problems. The contrasting importance of IMF programs is also evident. At the low end of the debt/GDP range, there is a tendency for 37

A coefficient on the log of repeated borrowing of 0.14 times the difference between log 2 and log 1,0.69. This finding of a strong impact of Fund programs for bond market access is also a central result in Mody and Saravia (2003). 39 Even more for loans than bonds. 40 Ending with the 60 to 80 per cent range. We exclude the low and high ends of the debt/GDP spectrum where outliers tend to drive the results. Thus, for example, some of the transition countries had very low levels of debt in the mid-1990s, which may not have been an accurate reflection of their external obligations. 38

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Fund programs to be neutral or to reduce spreads modestly, but the effect strengthens noticeably as the debt/GDP ratio approaches 40-60 per cent. Beyond that, the influence of IMF programs on spreads falls. Fund programs are also associated with more bond issuance. This effect is strongest when indebtedness is between 20 and 60 per cent of GDP.41 In Table 6 we examine the influence of the size of IMF programs.42 We interact the IMF program dummy with the country's debt/GDP ratio and normalize the amount of IMF lending by the country's external debt. For bonds, all the action is in the intermediate debt category where, as above, IMF programs have their major impact on spreads. The results in Table 6 thus reinforce the earlier finding that higher debt/GDP levels reduce the impact of IMF programs on bond markets. At the same time, the amount of lending does not influence spreads. These results are consistent with the Fund's value as a monitor rather than a provider of liquidity that prevents the occurrence of a financial crisis on account of strategic uncertainty among creditors. In the market for bank loans, the larger is IMF assistance the higher are spreads in the two low-debt categories at least. Thus, while availability of additional IMF resources allows for additional borrowing, it is as if the creditor coordination advantage is eliminated.43 In Table 7 we again consider precautionary programs. For bank loans and to a lesser extent for bonds, programs that are precautionary at outset reduce both issuance and spreads, as if countries entering such programs are more cautious in seeking access to private markets.44 Spreads show a tendency to decline, as if lenders wish to acquire more of their debt because their credit quality is perceived favorably. But programs that turn precautionary tend not to have an impact on the frequency of either bank loans or bond issuance. However, they do have a spread-reducing effect. This is largest for countries in the high-debt zone. In this range borrowers both from banks and on the bond market enjoy lower spreads, although the impact is larger in bond markets. Thus, when a country is coming off a period during which it has relied on official finance, a continued precautionary relationship with the Fund appears to enhance market access. That the relationship rather than the amount lent is what matters supports the idea of a Fund monitoring/country signaling function.45 Finally, Table 8 considers whether the market access of private borrowers is differentially affected by the existence of an IMF program. In fact, repeat borrowing reduces spreads more strongly for bank loans than bonds irrespective of whether the borrower is a private- or public-sect or entity. But the effect is larger for private sector borrowers.46 Less is publicly known about private borrowers. Their repeat borrowing 41

These results support those obtained by Mody and Saravia (2003). Based on the findings reported in Tables 4 and 5 we again allow for the effect of programs and repeat borrowing to vary by the level of indebtedness. But to avoid excessively detailed results, we return to presenting results by three debt categories. 43 However, in the medium-debt range, the adverse effects of increasing debt levels from 40 to 60 percent of GDP are mitigated by the presence of an IMF program. 44 Recall that this was what was suggested by our earlier analysis. 45 That this function is important also to bank lenders when a country is in the high-debt range suggests that bank monitoring may not be enough when there is a high risk of insolvency. 46 Thus, a second loan reduces the spreads charged private bank borrowers by about 13 percent, while public borrowers achieve, on average, a 7 percent spread reduction. 42

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therefore provides particularly valuable information in the syndicated loan market. In the bond market, in contrast, better-known private borrowers gain little from repeat borrowing. In fact, public borrowers face rising spreads as they borrow more, presumably reflecting the dominance of coordination effects over information gains. The stronger influence of IMF programs when borrowing occurs through the bond market survives splitting the sample. Again, private borrowers gain the most. The principal action is still in the intermediate debt category. In addition, the effects for private borrowers are substantially stronger than those for public borrowers. A Fund program reduces bond spreads for private borrowers from countries in this intermediate debt zone by 47 per cent while raising the probability of bond issuance by 27 per cent.47 Conclusions Bank loans and bonds are alternative ways of transferring capital to emerging markets. The growth of global bond markets is of course one of the signal features of the last 15 years of international financial history. Transacting through bond markets has advantages for investors, notably greater scope for diversifying country risk. Given the advance of securitization across a broad front, it is therefore important to observe that bank finance continues to play an important role in international financial markets. Bank loans are easier to access for borrowers new to such markets, since banks have a comparative advantage in bridging information asymmetries. Banks' intermediation technologies are also better suited to providing small loans. We show in this paper how the ability of banks to bridge information asymmetries is supported by repeat borrowing. As borrowers return for credit, they reveal information about themselves, reducing uncertainty and incurring a lower risk premium on their loans. Since the issuers of bonds are better known, the value of information obtained through repeat issuance is less. Indeed, to the extent that it results in a proliferation of separate bond issues, repeat borrowing may in fact increase the risk premium, reflecting the greater difficulty of coordinating the holders of different issues in the event of debt-servicing difficulties. These observations have obvious relevance to arguments about IMF monitoring and surveillance. Our results suggest that IMF monitoring and surveillance matter more in bond markets. This role for the IMF has the largest impact when debts reach 40 per cent of GDP and countries are therefore vulnerable to liquidity shocks. However, as debts continue rising from there, the impact of monitoring declines. There being relatively little uncertainty about the nature of the problem, lenders now care mainly about whether the IMF is providing real resources that help to keep debt service current. But as debt and insolvency risk grow still higher, even significant amounts of additional official finance may not make a difference. At that point, what matters most is when programs turn precautionary, signaling that conditions have improved sufficiently that the country no longer requires financial assistance. The approach taken here points to the importance of distinguishing international capital flows by instrument and intermediary. Macroeconomic analyses lumping together bank loans and bonds tend to neglect important differences between these market segments 47

The direction of influence is the same for public issuers, but the size and statistical significance of the outcome is weaker.

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stemming from the nature of the information environment, the monitoring technology, and the scope for creditor coordination. We have shown in this paper that these distinctions are important for understanding the impact of IMF programs. We would conjecture that they are equally important for understanding a variety of other issues in international finance.

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References Bolton, Patrick and Olivier Jeanne, 2003, "Structuring and Restructuring Sovereign Debt: The Role of Seniority," Unpublished. Bordo, Michael, Ashoka Mody, and Nienke Oomes, 2004, "Keeping Capital Flowing: The Role of the IMF," Unpublished. Bulow, Jeremy and Kenneth RogofF, 1989, "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy 97, pp. 15 5-178. Chui, Michael, Prasanna Gai and Andrew Haldane, 2002, "Sovereign Liquidity Crises: Analytics and Implications for Public Policy," Journal of Banking and Finance, 26, pp. 519-546. Corsetti, G., A. Dasgupta, S. Morris and H.S. Shin, 2001, "Does One Soros Make a Difference? A Theory of Currency Crises with Large and Small Traders," Review of Economic Studies, forthcoming. Cottarelli, Carlo, and Curzio Giannini, 2002, "Bedfellows, Hostages, or Perfect Strangers? Global Capital Markets and the Catalytic Effect of IMF Crisis Lending," IMF Working Paper No. 02/193 (Washington: International Monetary Fund). Diamond, Douglas, 1984, "Financial Intermediation and Delegated Monitoring," Review of Economic Studies 51: 393-414. Eaton, Jonathan and Mark Gersovitz, 1981, "Debt with Potential Repudiation," Review of Economic Studies 48, pp.289-309. Edwards, Sebastian, 1986, "The Pricing of Bonds and Bank Loans in International Markets: An Empirical Analysis of Developing Countries' Foreign Borrowing," European Economic Review30 (3): 565-589. Eichengreen, Barry and Ashoka Mody, 1998, "Lending booms, reserves, and the sustainability of short-term debt: inferences from the pricing of syndicated loans," Journalof Development Economics 63 (1): 5-44. Eichengreen, Barry and Ashoka Mody, 2000, "What Explains Changing Spreads on Emerging Market Debt?" In Sebastian Edwards, ed., Capital Flows and The Emerging Economies: Theories, Evidence, and Controversies (Chicago: The University of Chicago Press). Eichengreen, Barry and Ashoka Mody, 2001, "Bail-Ins, Bail-Outs, and Borrowing Costs," IMF Staff Papers, Vol. 47, pp. 155-87. Eichengreen, Barry, Kenneth Kletzer and Ashoka Mody, 2004, "Crisis Resolution: Next Steps," Brookings Trade Forum 2003, Washington, DC: The Brookings Institution, pp. 279-352. Fama, Eugene, 1985, "What's Different about Banks?" Journal of Monetary Economics 15:29-36. Gai, Prasanna and Nicholas Vause, 2003, "Sovereign Debt Workouts with the IMF as Delegated Monitor - A Common Agency Approach," Bank of England Working Paper no. 187. Goldstein, Morris, 1998, The Asian Financial Crisis, Washington, D.C.: Institute of International Economics. Heckman, James, 1979, "Sample Selection Bias as a Specification Error," Econometrica, Vol.47,pp.l53-161.

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International Monetary Fund, 1999, "Involving the Private Sector in Forestalling and Resolving Financial Crises," (Washington: International Monetary Fund). Available via Internet, http://imf.org. James, Christopher, 1987, "Some Evidence on the Uniqueness of Banks," Journal of Financial Intermediation 19:217-23 5. Jeanne, Olivier, 2001, "Sovereign Debt Crises and the International Financial Architecture, IMF working paper, (unpublished). Kletzer, Kenneth, 2003, "Sovereign Bond Restructuring: Collective Action Clauses and Official Crisis Intervention." Paper for Bank of England conference, "The Role of the Official and Private Sectors in Resolving International Financial Crises," July 23 and 24, 2002, revised. Kletzer, Kenneth and B. D. Wright, 2000, "Sovereign Debt as Intertemporal Barter," American Economic Review 90, pp. 621-639. Leung, S. F., and S. Yu, 1996, "On the Choice between Sample Selection and Two-Part Models" Journal of Econometrics, Vol. 72, pp. 197-229. Marchesi, Silvia and Jonathan Thomas, 1999, "IMF Conditionally as a Screening Device," Economic Journal, 109, pp. 111 -125. Mody, Ashoka and Diego Saravia, 2003, "Catalyzing Capital Flows: Do IMF-Supported Programs Work as Commitment Devices?" IMF Working Paper WP/03/100, Washington D.C. Morris, Stephen and Hyun Song Shin, 2003, "Catalytic Finance: When Does It Work?" Yale University, Cowles Foundation Discussion Paper No. 1400, February. Pattillo, Catherine, Helene Poirson and Luca Ricci, 2004, "Through What Channels Does External Debt Affect Growth?" Brookings Trade Forum 2003, Washington, DC: The Brookings Institution, pp. 229-277. Penalver, Adrian, 2004, "How Can the IMF Catalyse Private Capital Flows? A Model," Bank of England Working Paper no. 215. Petersen, Mitchell A. and Raghuram Raj an, 1994, "The Benefits of Lending Relationships: Evidence from Small Business Data," Journal of Finance 49: 3-37. Petersen, Mitchell A. and Raghuram Rajan, 1995, "The Effect of Credit Market Competition on Lending Relationships," Quarterly Journal of Economics 110: 407443. Reinhart, Carmen, Kenneth S. Rogoff, and Miguel A. Savastano, 2003, "Debt Intolerance," Brookings Papers on Economic Activity, 1 (Spring): 1-74. Rochet, Jean-Charles and Xavier Vives, 2002, "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?" CEPR Discussion Paper no. 323., Tirole, Jean, 2002, Financial Crises, Liquidity and the International Financial System, Princeton, NJ: Princeton University Press.

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Table 1: Trends in International Bond and Bank Lending Aggregate Value of Transactions (US$ billions)

Number of Transactions Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Total

Bonds 81 177 357 307 369 522 555 234 334 284 290 219

Loans 209 252 376 508 750 1,066 1,248 550 402 532 470 384

Total 290 429 733 815 1,119 1,588 1,803 784 736 816 760 603

Bonds 10 21 45 39 48 81 100 52 65 59 78 63

Loans 24 18 27 40 56 83 125 62 47 81 62 44

Total 34 39 73 79 104 164 225 114 113 141 140 107

3,729

6,747

10,476

661

669

1,331

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Table 2: Number of Transactions, by Debt Category and IMF Program Type of Credit None Bonds Loans

Debt/GDP Range (0-30 percent) No Program IMF Program 389 1,301 1,244 57 2,606 99

None Bonds Loans

Debt/GDP Range (30-40 percent) No Program IMF Program 501 190 680 453 1375 240 Debt/GDP Range (40-60 percent)

None Bonds Loans

No Program 670 380 999

IMF Program 500 595 775

Debt/GDP Range (more than 60 percent) None Bonds Loans

No Program 471 151 309

IMF Program 679 169 344 Full Sample

None Bonds Loans

No Program 2,949 2,455 5,289

IMF Program 1,758 1,274 1,458

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Table 3: The Decision to Borrow and the Choice between Bonds and Loans

Lamount Maturity US Industrial Growth Log of Swap Rate EMBI volatility Credit Rating Debt/GDP Debt Service/Exports Real GDP growth Export Volatility Short-term/Total Debt Reserves/Imports Reserves/ST Debt Private Credit/GDP Public Issuer Private Issuer IMF Program Precautionary Turned Precautionary Pseudo R-squared Observations

(1) 1 (2) Debt/GDP 0.

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It is immediate to see that the presence of country-risk free offshore assets restores (9), as the borrower can now meet his financing needs by borrowing pesos abroad (at the peso risk-free rate plus the transaction cost 0, which is the cost that this creditor would face if creditors collectively chose to reject a restructuring offer from the debtor. It captures the disutility arising from the costs of taking the debtor to court and prolonging the bargaining process The probability distribution function of legal costs across the creditors is common knowledge. The bond is short term. Creditors face the choice of whether to roll over their funding at an interim stage and can decide not to roll over their funding to the last period of the game. The project's return depends on the realisation of a fundamental, 0. We assume that the ex-ante distribution of 0 is uniform on [0,b]. Before creditors make their decision to foreclose or roll over they receive a private signal about the fundamentals Xj= 0+$ where si is i.i.d. with a uniform distribution over the interval [-E ,e ]. The noise term s; is independent of i's legal costs. Creditors who foreclose receive a fixed pay-off of 1. Creditors who roll over get a gross return (1+r) if the project succeeds. If the project fails, they participate in a bond restructuring.6 The bond restructuring proceeds as follows. The debtor makes an offer to write down the debt according to the contractual conditions of the bond. The creditors vote to accept or reject the offer. If K or more creditors vote to accept the offer, it goes ahead. Otherwise, creditors get a pro-rata share of the residual project return less their private legal costs.7 More precisely, the extensive form of the game is as follows: 1. The debtor chooses a CAC threshold K from [K!,KU] to insert into the bond contract used to finance a risky project. 2. The bond contract is offered to multiple risk-neutral creditors who buy an equal share of the total debt stock (normalised to one here) at a market-determined interest rate r. 3. Creditor i observes signal x*= 0+$, as described above. 5

There are many reasons why such costs may differ across creditors. For example, some creditors (e.g., bond mutual funds) may have investors with shorter investment horizons than others (e.g., pension funds and life insurance companies). There may also be differences in balance sheet structures, in agency problems related to compensation structure, and in accounting and regulatory rules. Equivalently, lj can be thought of as measuring the elative degree of risk aversion of different sets of creditors, in deciding between choosing a certain option (accepting the offer) and an uncertain one (holding out). 6 We have allowed for secondary market trading because there are no pure strategy equilibria to such a subgame (full proof available from the authors). Vulture funds have weak incentives to bid for bond issues when: (i) ownership of the issue is widely dispersed; (ii) each creditor owns a small proportion of the total issue; and (iii) contractual provisions ensure that during the subsequent restructuring stage holdouts are kept in check, so that all creditors that hold on to their bonds get the same return. In essence, the argument is identical to the one made by Grossman and Hart (1980) but in the context of corporate raids. Creditors (shareholder) have very little incentive to tender their bonds (shares) to a vulture fund (raider) whose participation in the restructuring stage (in management of the company) is expected to increase the value of the debtor's offer (the value of the stock) for all, when each creditor (shareholder) is small enough not to affect the outcome of the vulture's (raider's) bid. For the purpose of our analysis, this assumption can be interpreted to mean that foreign creditors are able to attache assets with value equal to the residual project return in the jurisdiction where the bonds were issued. In practice, there are few tangible assets that creditors can attach in foreign jurisdictions. The important aspect of this assumption is that the higher the available project return, the greater the payout to creditors who decide to pursue their claim in courts. Other aspects of the analysis can be generalised as long as this assumption is maintained. See also Haldane et al. (2003).

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4. Creditors decide whether to flee or roll over their bond contracts. We denote by f the proportion of creditors who flee. 5. Fundamental 0 is realised. This in turn determines the return on the project which is given by

where f is the deadweight damage to the project from early liquidation.8 The project succeeds if there is enough project return to pay the creditors who stay after the fleeing creditors have been paid out. That is, if

then the debtor repays the creditors who roll over in full and keeps the residual project return for itself. The game ends. Otherwise, the project fails, the debtor defaults and we enter the restructuring phase of the game described below. 6. The debtor makes an offer to write down (1 -f)(l +r). 7. Creditors vote to accept or reject. 8. If the offer is accepted all creditors receive a payment equal to the offer. In the event that the offer is rejected, each creditor i gets a pro-rata share of the return to the project less their private legal costs lj.9 9. Final pay-offs are determined. We proceed to solve the game. Restructuring Subgame Stages 6-8 of the game are a voting subgame. The debtor makes a request to its creditors to write down the repayment on its bond. Creditors decide whether to accept or reject the offer. Since the bond has collective action clauses, the debtor's offer will bind any dissenting creditors as long as the incidence of accepting creditors is K or higher. If fewer than K creditors accept the offer, claims are pursued through the courts and the debtor remains in default. In this event, each creditor will eventually receive a pro-rata share of gross project return, 0, net of payouts to fleeing creditors, f, and net of the damage done by early liquidation, f, and less the legal costs spent pursuing their claim.10 The debtor receives whatever is left from the project after it has paid its creditors. Implicitly, we have assumed that the marginal damage to the project of one fleeing creditor is equal to 1. The model can be easily generalised by assuming that the damage is equal to kf with& ^ 1. All the results that follow are still valid as long as we allow for the possibility of a liquidity crisis, i.e., as long as k>r. ^e model does not nest the case of unanimity provisions according to which all creditors are required to agree before an offer can go through. The reason is because it is assumed that creditors lie on a continuum. For a welfare analysis of CACs versus unanimity provisions from an ex-post perspective, see Kletzer (2003) and Haldane et al. (2003). 10 This restructuring subgame is very similar to the one set out in Haldane et al. (2003). The main difference is that here we do not assume that the debtor exerts adjustment effort after learning the outcome of the vote. For our purposes, including adjustment effort would complicate the notation without changing the analysis.

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So the debtor's pay-offs are: U(6-2f-offer) U(0)

if K or more creditor accept otherwise

(1)

where U(.) is the utility function of the debtor. The pay-off to the creditor in the (l-K)-th quantile of the distribution of legal costs from a given offer is: offer 0-2f-li.K

if K or more creditors accept Otherwise

(2)

So from the point of view of the creditor and assuming full information, it is a weakly dominant action to vote to accept the offer provided that the debtor's offer is greater or equal to 6-2f-li.K. From the point of view of the debtor, again under full information, and since legal costs are positive it is optimal to make an offer which is just large enough to persuade the (l-K)-th creditor to accept, that is to offer: (3)

This offer would be exactly equal to the net project return (after payouts to fleeing creditors have been met) less the legal costs of the (l-ic)-th most stringent creditor from the pool of (1-f) creditors who participate in the restructuring.n From (2), this offer is just large enough for the marginal (l-K)-th creditor who votes on a restructuring to accept the offer and for the deal to go through. In this setup, CACs ensure that restructuring is not delayed and resources are not expended on litigation; they neuter rent-seeking among bondholders.12 In the event of a restructuring, therefore, the pay-off to the debtor is (4)

whereas the pay-off to each creditor who rolled over is equal to the offer made by the debtor, given by (3). Comparing (3) and (4) we can see that after default has occurred, a lowering of the CAC threshold would shift the allocation of residual project return from the creditors to the debtor and vice versa. Hence looking at solvency crises in isolation, debtors would always prefer a lower voting threshold. We will see below, however, that this result is modified when crises are neither pure insolvency nor pure liquidity, i.e., when we have 'grey-zone' crises. Rollover Subgame Working backwards, we now determine the proportion of creditors who flee. This involves solving stages 3-6 of the extensive form of the game, which form a rollover global game in the manner of Morris and Shin (1998). 11

Say the threshold K is 75%, then for the offer to go through the debtor needs only to persuade the creditor with the highest legal cost in the first quartile of the distribution of legal costs. 12 Haldane et al. (2003) show that this outcome in no longer guaranteed when there is two-sided information asymmetry between the debtor and its creditors about how much they stand to gain or lose if the restructuring does not take place.

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The aggregate strategy of creditors is a rule of action which depends on whether the signal creditors receive is above a critical threshold x*. A creditor will flee if his private signal is lower than x* and will roll over otherwise. More formally, the strategy u(x*) is an indicator function which takes the value one if x