Economic and Financial Linkages in the Western Hemisphere Seminar organized by the Western Hemisphere Department International Monetary Fund November 26, 2007 Booms and Busts in Latin America: The Role of External Factors Alejandro Izquierdo, Randall Romero, and Ernesto Talvi Presented at the Economic and Financial Linkages in the Western Hemisphere Seminar organized by the Western Hemisphere Department International Monetary Fund November 26, 2007 The views expressed in this presentation are those of the author(s) only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the paper.
Booms and Busts in Latin America: The Role of External Factors Alejandro Izquierdo Randall Romero Ernesto Talvi IADB IADB CERES Economic and Financial Linkages in the Western Hemisphere Seminar IMF, November 26, 2007
Outline I. Introduction and Motivation II. Estimation Strategy and Results III. Putting the Model to Work: Growth Performance and Global Financial Risks IV. Conclusions
Introduction and Motivation Back in the early 1990s capital flows started to flow back to Latin America after the drought of the 1980s Result: Booming asset markets, real exchange appreciation, booming investment and strong growth performance This phenomenon was largely attributed to the wave of fundamental reforms the region was undertaking In the midst of the euphoria, Calvo, Leiderman and Reinhart (1993) warned that capital was flowing despite wide differences in macro policies and performance across countries in the region
Introduction and Motivation Their take: External factors, particularly financial shocks in the center were affecting the periphery (an idea stressed by Diaz-Alejandro (1983, 1984)) Domestic reforms alone could not possibly explain the renewal of capital inflows to the region Their concern: What if external factors deteriorate just as easily as they had improved during the bonanza?
Gross Capital Flows and Economic Performance in Latin America: Dejá Vu all over Again? Gross Capital Flows (Billions of 2006 Dollars) 140 120 100 80 60 40 20 0 LAC-7 GDP Variation*. (Annual Growth Rate) 8% 6% 4% 2% 0% -2% 1 3 5 7 Average: 4.3% 9 11 13 Average: 0.7% 15 1990 1992 1994 1996 17 1998 2000 2002 2004 2006 Average: 5.4% * LAC-7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, which account for 93% of Latin America's GDP
Aims of the Paper Expand work in several directions: Rather than than focusing on capital flows and RER, we analyze the relevance of external factors directly on output performance We extend the menu of external factors to incorporate new developments in financial and commodity markets: A large international emerging bond market (correlation between EM bond spreads and the US T-bond rate was 0.7 by end-1994 but 0.4 by end- 2000) Sharp movements in terms of trade due to the incorporation of Asia to world markets
Aims of the Paper Use the empirical findings of this paper (which suggest that the region is still heavily exposed to external factors) to: Bring to the forefront the relevance of incorporating external factors in policy evaluation analysis of Latin America, i.e., in assessing the region s growth performance (counterfactual exercises) Highlight the need to filter out external factors when assessing the strength or weakness of economic fundamentals Assess the risks to the region posed by the possibility of an episode of global financial turmoil resulting in a large re-pricing of risk.
Outline I. Introduction and Motivation II. Estimation Strategy and Results III. Putting the Model to Work: Growth Performance and Global Financial Risks IV. Conclusions
Estimation Strategy Departure point: Vector Error Correction Model (VECM) : Δ yt = c + ' yt 1 + Δyt 1 +... + p 1Δyt p+ 1 αβ + ε where y t = ( gdp_lat t ip_x t tot_lat t financ_x t risk t ) t gdp_lat: (log of) Simple average of GDP indices of LAC7 countries ip_x: (log of) G7 industrial production index tot_lat: principal component weighted average of (the log of ) terms of trade indices of LAC 7 countries financ_x: Return on 10 year US T-bonds risk: High-Yield Bonds Spread
Estimation Strategy We restrict dynamics (error-correction adjustments coefficients and short-run coefficients) so that average LAC7 GDP does not have an impact on external variables: * α = α 0 0 0 0 1 * j j 0 = 0 0 0,1,1 j,1,2 j,2,2 j,3,2 j,4,2 j,5,2 j,1,3 j,2,3 j,3,3 j,4,3 j,5,3 j,1,4 j,2,4 j,3,4 j,4,4 j,5,4 j,1,5 j,2,5 j,3,5 j,4,5 j,5,5 We use standard tests to obtain optimal lag length We identify one cointegrating relationship
Results: Key Characteristics of the Model Cointegrating vector: Terms of trade and G7 industrial production affect LAC 7 GDP positively, while T-bond rate and High-yield bond spread affect it negatively (coefficients significant at one percent level) Error-correction adjustment coefficient is negative (model is stable) and significant at the one percent level This parsimonious representation based on external variables explains 54 percent of the variance of LAC7 GDP growth
Results: LAC7 GDP Response to Impulses in External Variables
Results: Elasticities 1% increase in G7 Industrial Production 1% increase in TOT Largest Impact on Quarterly Growth 0.6% 0.11% Difference Between Shocked & Non-shocked GDP (after 20 periods) 2.2 points 0.74 points 100 bps increase in HY spread 100 bps increase in T-bond rate -0.36% -0.33% -2.05 points -1.25 points
Outline I. Introduction and Motivation II. Estimation Strategy and Results III. Putting the Model to Work: Growth Performance and Global Financial Risks IV. Conclusions
Growth Performance: GDP Forecasts Conditional on External Variables: Bonanza vs. Crisis Bonanza Crisis Passive scenario Average growth: 3.8% Actual average growth: 5.6% Passive scenario Average growth: 2.9% Actual average growth: 0.5% Differences in the dynamics of external factors can account for large and significant differences in average growth performance.
Latent Risks: Impact of Financial Turmoil on Growth Performance Sudden Stop á la Russia Sudden Stop cum TOT Deterioration Reduced form shock to HY spread in 1998:q3: 203bps (largest in sample) Highlights large and unexpected nature of SS In latest turmoil episodes, spread increases were accompanied by falls in commodity prices Likelihood of this event depends on impact of financial turmoil on global demand
Implications for GDP Levels GDP response in very much in line with recent evidence of fast bounceback to pre-crisis levels following a Sudden Stop (Calvo et al (2006), but no convergence to pre-crisis trends (Cerra and Saxena (2005) Given that fluctuations in external conditions strongly affect the path of output, the evaluation of macroeconomic fundamentals should account for cycles in external conditions Evolution of GDP Level Consistent with Impulse-Response (Sudden Stop cum Terms of Trade Shock)
Outline I. Introduction and Motivation II. Estimation Strategy and Results III. Putting the Model to Work: Growth Performance and Global Financial Risks IV. Conclusions
Message I Differences in the dynamics of external factors can account for large and significant differences in growth performance Care should be exercised when passing judgment on the success or failure of domestic macro policies and reforms, i.e., judgment should not be made in a vacuum, but rather, by factoring in external conditions before signaling thumbs up or down The region might be currently surfing on a wave of unjustified euphoria that is not necessarily a consequence of good policies, but the result of a string of good luck
Message II Given that external conditions strongly affect the path of output, actual levels of fundamentals such as the fiscal position, or the public debt could be completely misleading when the external environment is unusually favorable A proper assessment of structural fiscal balances and structural debt levels should account for cycles in external factors 1/ It is important to make the effort to incorporate these issues into the public debate and into performance indicators to avoid praising those lucky enough to ride the bonanza, and punish the unlucky, irrespective of their abilities 1/ See for example Izquierdo, Ottonello, and Talvi (forthcoming) If Latin America were Chile: A Comment on Structural Fiscal Balances and Public Debt
Message III Although we do not discuss this directly in the paper, it is crucial to distinguish between transitions that are a by-product of level effects and sustained growth The nature of the estimated model suggests that one time increases in commodity prices or reductions in interest rates spreads generate level effects on output, that may translate into relatively prolonged above-average growth phases given frictions implicitly captured by the error correction term However, these should not be interpreted as sustained growth
Booms and Busts in Latin America: The Role of External Factors Alejandro Izquierdo Randall Romero Ernesto Talvi IADB IADB CERES Economic and Financial Linkages in the Western Hemisphere Seminar IMF, November 26, 2007
Credit Ratings Agencies Verdict (LAC-9 excluding Ecuador, Standard & Poor s Credit Ratings) Numerical Transformation of Credit Ratings* 11,0 10,5 10,0 BB+ Russian Crisis Investment Grade Chile Colombia Uruguay Investment Grade Chile Colombia Mexico BB+ AAA 21 AA+ 20 AA 19 AA- 18 A+ 17 A 16 A- 15 BBB+ 14 Investment Grade 9,5 BBB 13 BBB- 12 BB+ 11 9,0 BB 10 BB- 9 B+ 8 8,5 B 7 B- 6 8,0 7,5 BB Investment Grade Chile Mexico CCC+ 5 CCC 4 CCC- 3 CC 2 SD 1 Dic-96 Dic-97 Dic-98 Dic-99 Dic-00 Dic-01 Dic-02 Dic-03 Dic-04 Dic-05 Dic-06 *A. Powell and J.F. Martinez, (2007), On Emerging Economy Spreads and Ratings (forthcoming)
Let Prices Talk: EMBI Spreads Reaction to Spikes in US High Yield Spreads 1600 1200 Systemic Turmoil Period Relatively Tranquil Recent Period (US High Yield and Latin EMBI spreads, basis points) Latin EMBI (1) (2) (3) (4) Dating Δ US HY Δ LA EMBI Naïve Beta Spread Spread (3) / (2) 3-Aug to 19-Oct-98 12-Sep to 15-Dec-00 7-Feb to 9-Apr-01 21-May to 4-Oct-01 10-May to 14-Oct-02 299 139 97 218 409 444 109 96 430 539 1.5 0.8 1.0 2.0 1.3 800 Systemic Turmoil Period Average 1.3 19-Apr to 17-May-04 55 77 1.4 400 US High Yield 10-Mar to 18-May-05 10-May to 27-Jun-06 26-Feb to 7-Mar-07 158 43 30 80 47 20 0.5 1.1 0.7 0 23-Jul to 16-Aug-07 90 49 0.5 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Recent Period Average 0.8
Let Prices Talk: EMBI Spreads Reaction to Spikes in US High Yield Spreads Systemic Turmoil Period Relatively Tranquil Recent Period Beta Coefficient (average beta per period, US high yield vs. Latin EMBI) 1600 (US High Yield and Latin EMBI spreads, basis points) Latin EMBI 1.4 1.27 1200 1.2 1.0 800 0.8 0.76* 0.86 400 US High Yield 0.6 0.4 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 0.2 Systemic Turmoil Period Relatively Tranquil Recent Period *Adjusted using Forbes, Rigobon (1999) methodology
Great Moderation or the Calm Before the Storm? Moody s Baa Corporate Spread (basis points) 450 400 350 300 250 200 150 100 50 Debt Crisis 116 375 LTCM / Russian Crisis 379 1978-2007 Avg. 169 165 0 80 70 66 Moody s Baa Corporate Spread Volatility (3 year moving standard deviation, in basis points) 60 50 40 30 20 10 24 11 48 1978-2007 Avg. 15 0 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
X-Ray of Recent Episodes of Global Financial Turbulence Latin America US High Yield EMBI EM Europe EM Asia BBB Corporate AAA Corporate US T-Bonds Europe T-Bonds Japan T-Bonds Bond Prices (bond price equivalent*, peak to trough variation) -3.5% -3.3% -3.1% -2.7% -2.6% -1.2% -0.5% Flight to Quality 0.4% 0.6% 1.0% -4% -3% -2% -1% 0% 1% 2% Latin America US High Yield EMBI EM Europe EM Asia BBB Corporate AAA Corporate US T-Bonds Europe T-Bonds Japan T-Bonds Commodity Prices (peak to trough variation) Credit Spreads (basis points, peak to trough variation) -9-10 -5 10 23 Flight to Quality -20 0 20 40 60 80 50 56 64 66 72 Industrial Metals -10.5% Gold -8.1% Goldman Sachs Commodity Index -4.2% Agricultural Products -3.1% Oil -1.0% Data Sources: JPMorgan, Bloomberg and MSCI -12% -10% -8% -6% -4% -2% 0% * Own calculations assuming an 11% coupon and 10-year maturity