Towards effective social insurance in Latin America: why can

1
Towards effective social insurance in Latin
Americawhy cant we afford counter-cyclical
fiscal policy?

• Comment by
• Ricardo Hausmann
• Harvard University

2
The problem

• Latin America is very volatile
• People suffer from this
• Fiscal policy is pro-cyclical
• aggravating volatility
• and lowering social protection when it is most
  needed

3
Proposed solution

• Increase automatic stabilizers
• Pre-commit to spend more in bad times
• Improve savings in good times
• Fiscal rules and stabilization funds
• Improve creditworthiness during bad times
• GDP-indexed bonds

4
What causes pro-cyclicality?

• Excessive spending and borrowing in good times
  limits creditworthiness in bad times
• Hausmann, Gavin, Perotti and Talvi (1996), Talvi
  and Vegh (2000)
• Solution behave more prudently in good times so
  you can still borrow in bad times
• Ergo Fiscal institutions and rules
• Is this correct?

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An alternative interpretation

• Debt service is highly anti-cyclical
• because debt is denominated in US
• In good times, the real exchange rate is strong,
  making US debt cheap
• ..or in short term in pesos
• Real interest rates go up in bad times, as the
  government attempts to avoid further real
  depreciation
• Hence, procyclicality is a consequence of
  original sin

6
Real GDP growth is more volatile
But not that much to write home about
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but GDP measured in US is 9 times more volatile
This is the relevant measure if you borrow in US
8
movements of exchange rates are large and
persistent
This is the maximum gap between 5-year Moving
average of the real exchange rate
9
Dollar GDP tends to collapse at times of crises
Declines in US GDP greater than -35
Notice that capacity to pay in US collapses more
than real GDP
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Implications

• The capacity to pay dollar-denominated debt is
  dependent on the market value of GDP in US
• But this measure is 9 times more volatile than
  real GDP
• and collapses in bad times
• This is associated with large and persistent
  cyclical movements in the RER
• The problem may not be that we borrow too much in
  good times, but that we borrow too poorly

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Credit ratings are low, considering that debt
levels are low
Austria
Germany
United K
United S
Norway
19
Japan
Denmark
Finland
Sweden
Canada
Australi
Spain
Belgium
Italy
Iceland
Cyprus
Slovenia
Greece
Israel
Czech Re
Chile
Hungary
Estonia
Poland
rating for long-term foreign cur
Latvia
China
Tunisia
Oman
Slovak R
Mexico
El Salva
Panama
Costa Ri
India
Morocco
Argentin
Brazil
Jordan
Turkey
Dominica
Paraguay
Pakistan
4
-.430356
1.04646
de_gdp2
12
even considering the lower tax base
United S
Germany
United K
Japan
Norway
Austria
19
Denmark
Finland
Sweden
Canada
Australi
Spain
Belgium
Italy
Iceland
Cyprus
Slovenia
Greece
Israel
Czech Re
Hungary
rating for long-term foreign cur
Estonia
Poland
Latvia
China
Tunisia
Mexico
Panama
Costa Ri
India
Morocco
Argentin
Brazil
Jordan
Turkey
Dominica
Paraguay
Pakistan
4
-.772123
5.49817
de_re2
13
Would domestic peso debt be safer?
14
Short term real interest rates are very volatile
and rise in bad times
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Some consequences

• Domestic currency short-term or floating rate
  debt may be subject to large increases in nominal
  interest rates, especially in bad times
• This also makes debt service pro-cyclical
• Volatility of the short rate limits the extension
  of maturity
• Under these conditions, US borrowing may be
  safer
• Hausmann and Chamon (2002) argue that this may
  generate multiple equilibria in monetary policy
  and debt denomination

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Original sin and the limits to anticylical fiscal
policies

• If there is a SIGNIFICANT NET foreign debt
  (public or private)
• and it is in foreign currency
• Exchange rate movements cause aggregate wealth
  effects
• Depreciations lower real income
• Makes debt service harder
• lowering creditworthiness in bad times
• Less access to finance in bad times
• Makes governments forced to tighten fiscal
  policy, unless it wants to aggravate crowding out
• and tighten monetary policy to avoid further
  depreciation

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Implication automatic stabilizers

• If the problem is that debt service increases in
  bad times, due to debt denomination,
• then the solution is NOT to pre-commit to
  increase spending in bad times
• Increase automatic stabilizers NOT YET
• This will only aggravate the collapse in solvency
  in bad times and will force to cut other
  (presumably good) but a-cyclical social programs
  such as Education and Health

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Implication debt structure

• Work on debt structure first
• Ideal is long-term, fixed rate peso-denominated
  bonds
• They change in value with the real exchange rate,
  and with inflation
• But they are the hardest to achieve
• The paper recommends GDP-linked bonds
• GDP is very hard to credibly measure
• It may be much easier to develop long-term
  inflation-indexed fixed rate debt
• Protects against collapses in RER US GDP
• As in Chile (is this part of Chiles secret?)

19
OS is the consequence of the currency
concentration of the global portfolio
(0.9857)
1
Debt
by
0.9
Currency
(0.8859)
0.8
Debt
by Country
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
United States
EUROLAND
Japan
U
.
K
Switzerland
Canada
Australia

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Implication international agenda

• It needs an international solution
• Create liquidity for instruments with EM currency
  risk but no credit or country risk
• IFIs could play a large role
• This would allow IFIs to lend in local currency
• Develop the swap market to undo the currency
  mismatch of EMs

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Implication fiscal rules

• If the problem is debt structure, fiscal rules
  should deal with this
• Currently, rules relate to deficits and spending
• Nothing is geared to monitor the risks involved
  in the debt structure
• Alternative target a risk-weighted level of debt
• Risk weights should reflect the pro-cyclicality
  and volatility of debt service
• Allows the political system to internalize the
  difference between cheap borrowing and safe
  borrowing

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Conclusion

• It would be great if the government could offer
  social protection against aggregate shocks
• but before committing to do so, it needs to be
  able to do so
• At present, many countries are unable to protect
  in bad times and in fact need to impoverish their
  populations in bad times to avoid greater damage
• We should develop the ability to protect before
  we commit to use it