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COPING
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CHILE'S
EXTERNAL
VULNERABILITY:
A
FINANCIAL
PROBLEM
Ricardo
J.Caballero
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2001
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COPING
WITH
CHILE'S
EXTERNAL
VULNERABILITY:
A
FINANCIAL
PROBLEM
Ricardo
J.Caballero
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MAY
2001
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COPING
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CHILE'S
EXTERNAL
VULNERABILITY:
A
FINANCIAL
PROBLEM
Ricardo
J.Caballero
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2001
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?abstract_id=XXXXXX
Coping
with
Chile's
External
Vulnerability:
A
Financial
Problem
05/11/2001
Ricardo
J.
Caballero'
Abstract
With
traditionaldomestic
imbalances
longunder
control, theChilean
business cyclehas
been,
and
most
likely will continue to be, primarily triggeredby
external shocks.Most
imporiantly, Chile's external vulnerability isprimarily
a
financialproblem.
A
decline inthe
Chilean
terms-of-trade,for example,
is associated toa
decline in realGDP
that ismany
times larger thanone
would
predict in thepresence of
perfect financial markets.The
financial natureof
this excessive sensitivityhas
two
centraldimensions: a sharp
contraction in Chile'saccess to internationalfinancial
markets
when
itneeds
it themost;and
an
inefficient reallocationof
this scarce access acrossborrowers during
externalcrises. In this
paper
I characterize this financialmechanism
and
argue
that Chile'saggregate
volatilitycan
be
reduced
significantlyby
fostering the private sector'sdevelopment
of
financial instruments that are contingenton
Chile'smain
externalshocks.
As
a
first step, the CentralBank
or
IFIsshould
issuea
benchmark
instrumentcontingent
on
theseshocks.'
MIT
and
NBER.
e-mail: caball@mit.edu; http://web.mit.edu/caball/www.
Prepared
for theBanco
Central de Chile. Iam
very grateful toAdam
Ashcraft,Marco
Morales
and
especiallyClaudio
Raddatz
for excellent research assistance,and
toHerman
Bennett
forI.
Introduction
and Overview
With
traditionaldomestic imbalances
longunder
control, the Chilean business cycle hasbeen,
and
most
likely will continue to be, primarily triggeredby
external shocks.Most
importantly, Chile's external vulnerability is primarily a financial problem.
A
decline in theChilean terms-of-trade, for
example,
is associated to a decline in realGDP
that ismany
times larger than
one
would
predict in thepresence
of perfect financial markets.The
financial nature
of
this excessive sensitivity hastwo
central dimensions: a sharpcontraction in Chile's access to international financial
markets
when
itneeds
it themost;
and
an inefficient reallocationof
this scarce accessacrossborrowers
during external crises.I argue that Chile's
aggregate
volatilitycan be
reduced
significantlyby
fostering theprivate sector's
development of
financial instruments that are contingenton
themain
externalshocks
facedby
Chile.As
a first step, the CentralBank
or IFIscould
issue abenchmark
instrument contingenton
these shocks.The
essence ofthemechanism
through which
externalshocks
affect the Chileaneconomy
can
be characterized as follows: First, there is a deteriorationof
terms-of-trade that raisesthe
need
for external resources if the realeconomy
is to continue unaffected, but thistriggers exactly the opposite reaction
from
international financiers,who
pullback
capital inflows. Alternatively, ashock
directly to the financialmarkets
facedby
emerging
economies
reduces capital inflows immediately.Second,
once
external financialmarkets
fail to
accommodate
theneeds
ofdomestic
firmsand
households, these agents turn todomestic
financial markets,and
tocommercial banks
in particular. Again, this increase indemand
is notmatched by
an increase in supply asbanks
—
particularly resident foreigninstitutions
-
tightendomestic
credit, opting instead to increase their net foreign asset positions.The
costsof
thismechanism
are large.Widespread
financial constraints are binding duringthe crisis,
when
major
forced adjustments are needed.The
sharp decline indomestic
assetprices,
and corresponding
rise inexpected
returns, is drivenby
theextreme
scarcity infinancial resources
and
their high opportunity cost.Even
the praised rise inFDI
thatoccurred
during themost
recent crisis is asymptom
of
these fire sales ofdomestic
firms.The
fact that this investment takes theform
of
control-purchases rather than portfolio orcredit flows simply reflects
some
of the underlyingproblems
that limit Chile's integration to international financial markets:weak
corporategovernance and
other "transparency"standards. Finally, the costs
do
notend
with the crisis, as financially distressed firms are illequipped
tomount
aspeedy
recovery.The
latter oftencomes
not only with the costs ofaslow recovery
inemployment
and
activity, but also with aslowdown
in the processof
creative destructionand
productivitygrowth.
In the U.S., the lattermay
account
forabout
30%
of the costs ofan average
recession (see Caballeroand
Hammour,
1998),which
isprobably
a very optimisticlower
bound
fortheChileaneconomy."
^ This decline in collateral is probably one ofthe reason why, paradoxically, the sharp reductions in
domestic rates that took place in Chile during 1999
came
with a reallocation of domestic loans towardlargefirms and awayirom small firms, rather than the other
way
around. See Caballero (1999) and theMoreover,
this type of financial crisis has different real effects across firm size.On
one
end, large firms are directly affected
by
externalshocks
butcan
substitutemost
of their financialneeds
domestically.They
are affected primarilyby
demand
factors.On
the other, smalland
medium
sized firms (henceforth,PYMES)
arecrowded
outand
are severelyconstrained
on
the financial side.Together
withconsumers,
they are the residual claimantsofthe external-domestic financialcrunch.
This diagnosis points in the direction of a structural cure
based
on
two
building blocks.The
firstone
deals with the institutions required to foster Chile's integration to international financialmarkets
and
thedevelopment
ofdomestic
financial markets.The
second
one,most
important in the long transition createdby
the unavoidableslow
natureof
theabove
process, is to design an appropriate international liquiditymanagement
strategy.The
lattermust
beunderstood
interms
broader
than just themanagement
of
international reservesby
the central bank,and
include thedevelopment
of
financialinstrumentsthat facilitate the delegation ofthis taskto the private sector.
It is this
second
setof
cures that I focuson
in this paper, with an effort to formulatesolutions that
maximize
the role playedby
the private sector in achieving them.' Thissector has large
comparative advantages
in thedevelopment
of financial instruments,perhaps
with a little"nudge"
from
the CentralBank
and
international institutions.Chief
among
these, is the creation of abenchmark
"bond"
that ismade
contingenton
themain
externalshocks
facedby
Chile. This instrumentshould
facilitate the private sector's pricingand
creationof
similarand
derivativecontingent financial instruments.Section II describes the essence
of
the externalshocks
and
the financialmechanism
atwork.
Section III follows with a discussion of theimpact
of
thismechanism
on
the realside of the
economy
and
the differenteconomic
agents. SectionIV
sketches a policyproposal,
and
SectionV
concludes.SeeCaballero (1999)for a discussion ofthe structural reforms aimed at improving integration andthe
development offinancial markets.
More
importantly, Chile is in the process of enacting a major capitalmarkets reform, including the removal of a series of obstacles to its full integration to international
II.
The Shock
and
the Financial
System
In this section I illustrate the
mechanism
though
which
externalshocks
affect the Chileaneconomy.
A
deterioration in a country's terms-of-trade should lead to an increase ininternational
borrowing,
but inemerging
economies
thisshock
has typically led to capitaloutflows.
A
shock
directly to financialmarkets can
generate thesame
result: anextreme
scarcity of financial resources for the
economy.
As
agents are turnedaway
from
foreign lenders, theyturn to residentbanks
tomake
up
the difference. This increase indemand
isnot
met by
an increase in supply,however,
asbanks
(likeeveryone
else) readjust theirportfolios
toward
foreign assets.I organize
my
discussionof
the roleplayed
by
each of
these ingredientsaround
demand
and
supply factors affecting thedomestic banking system
-
thebackbone
of the Chileanfinancial system.
An
overview
of the Chilean financial institutions is presented inBox
1.Moreover,
I focuson
themost
recent cyclical episode, as thechanging
natureof
theChilean financial
system
makes
older data lessrelevant.//.1
The
External
Shock
and
itsImpact
on Domestic
Financial
Needs
The
triggerof
themechanism
is illustrated in Figure 1. Panel (a)shows
the pathof
Chile'sterms-of-trade
and
the spread paidby
prime
Chilean instrumentsover
the equivalent U.S.Treasury
instrument. It is apparent that Chilewas
severely affectedby both
at theend
ofthe 1990s. Panel (b) offers a bettermetric to
gauge
themagnitude of
these shocks.Taking
the quantities
from
the1996
currentaccount
as representativeof
those thatwould
have
occurred
in theeconomy
absentany
real adjustment, it translatesthem
into the dollarlosses associated to the deterioration in terms-of-trade
and
interest rates. Starting in 1998,Box
1:
The
Chilean
Banking
Sector
Banks
are an important source of financingfor Chilean firms.
The
composition of financing (table A.l) is similar to that ofadvanced European economies. Unlike the
latter, and
much
like the US, the maturitystructure of Chilean bank loans is
more
concentrated on the short end:
57%
of totalloans, and
60%
ofcommercial loans, have a maturity of less than 1 year." Insummary,
Chilean banks look like Europeans in termsof their relative importance but like
US
banks in theirfocus onshort maturities.^
Relative
importance:
Loans
versus
other instruments.
TableA.l:
The
relativeimportanceofbank
loans. Sourceof financing Loans Equity Bonds Stock Flows
43%
51%
54%
33%
3%
16%
Note: Participations built using the stocks at December
2000. Flows were computed as the difference in stocks
betweenDecember 1999andDecember 2000except forthe
flow ofnew equity, which was built using information on
equityplacement duringthe period.
Composition
of
Loans.
Besides being relatively important
compared
to markets as sources of funds, Chilean
banks concentrate most of their activity on
firms.
Commercial
loans represent around60%
of total bank loans (see Table A.2).Adding
trade loans, about70%
oftotalbank
credit supply isdirectedtofirms.
'' Computed using the stock
of loans in December 1999. Source Stiperintendenda de Bancos e Institiidoties Fitianderas.
^ In Germany, for example, more that 70% of the commercialloansarelongterm. In contrast,in the
US
short term loans account for about 60% of non-residentialloans.TableA.2: Compositionofloansbyuse. Typeof loan Fraction oftotalloans
Commercial
60%
Residential
15%
Consumption
10%
Trade
10%
Other
5%
Source: Superintendencia deBancose Instituciones Financieras.
Composition
of
commercial
loans
by
firm
size.Chilean banks concentrate their lending
activity on large firms, at least
when
proxied by the average size of loans.
Around
65%
of commercial loans werewritten for amounts above
US$
1.The
relative importance ofdifferentloan sizes
is summarized inTableA.3.
TableA.3:
The
relative importanceof different loansizes.Loan size Fraction ofcommercial
loans
Large
64%
Medium
14%
Micro
22%
Note: Large:allloansabove 50,000LIF(around US$ 14millions(endof1999dollars));Medium: loans between 10,000 and50,000UF(US$ 280,000and US$ 1,400,000); Micro: loans below 10,000 UF (US$ 280,000).
Source: Superintendencia de Bancos e Instituciones
Financieras.
Banks
versus other
financialinstitutions.
Banks
in Chile are importantwhen
compared
with other financialinstitutions as well. Table A.4 compares
the total assets ofbanks, pension funds,
and insurance companies*. Bank's total
assets represent the
60%
of the grandTotal assetsisthesumoffinancial andfixedassets.
Fixedassets are notincludedforinsurance
companies.Nevertheless, fixedassetsrepresenta
total.
TableA.4:
Banks
andotherfinancialinstitutions. Relative asset level
Bank
s60%
Pensio n Funds30%
Insurance companie s10%
Note: Ratios basedon thestock ofassetsat December 2000.
Sources: Superintendencia deBancose Instituciones Financieras,Superintendenciade Valores y Seguros.
Domestic
and
Foreign banks.
Banks
owned
by internationalconglomerates represent a significant
share of credit supply in Chile. Table A.5
shows
that loans by foreign banksrepresented around
40%
oftotal loans. It is important tonotethatChileanBanking
Law
does not recognize subsidiaries offoreign banks as part of their
main
headquarter, therefore in practice the distinction between domestic and foreign
banks is just a matter of ownership.
Reflecting the withdrawal
from
domestic loans by foreign banks described in themain
text, the bottom ofthe tableshows
that difference in the portfolio
composition of domestic and foreign
loans attheendof 1999.
TableA.5: Domestic
and
ForeignBanks
Domestic Foreig n Relativeimportance
(%
totalloans)58%
42%
Portfoliocomposition Loans80%
67%
Securities11%
14%
Foreignassets6%
15%
Reserves3%
4%
Note: Ratios based onDecember1999values.
Source:SuperintendenciadeBancose Instituciones
Figure 1: ExternalShocks
(a)TenreofTradeandSoveragn Spread (b)TermsolTrade andInterestRateellecl (fixed quantities)
Efefe^
[SI S3
Notes: Preliminary datausedfar1999and2000. Tlieyearly Figure for2000 wascomputedmultiplying the3 quarters cumulative valueby4/3. (a) Tenns-of-trade isthe ratioofexports price index and import price indexcomputed by the Central Bank. The
sovereignspreadwasestimatedasthespreadofENERSlS-ENDESAcorporate bonds.Tliespreaddata for1996wasestimatedb\'the
authorusinginformationfromtheCentralBank ofChile, (d)TJietenns-of-tradeeffectwas computedasthe differencebenveen the
actual terms-of-tradeandthetenns-of-tradeat1996quantities.Tlieinterest rale effectwascomputedinsimilarfashion Source:BancoCentral deChile.
How
should Chilehave
reacted to this sharp decline in nationalincome,
absentany
significant financial friction (aside
from
thetemporary
increase in the spread)?Theory
suggests the
answer
depends
on
the persistenceof
the terms-of-trade shock: likeindividuals, countries should largely
smooth
the effectof temporary
income
shocks
butmore
or lessaccommodate
the effectof permanent
income
shocks. Figure 2 hints theanswer.
The
thin line depicts the pathof
actualconsumption growth,
while the thick lineillustrates the hypothetical path of Chile's
consumption
growth
if itwere
perfectly integrated to international financialmarkets and
terms-of-trade the onlysource ofshocks.^There
aretwo
interesting features in the figure. First, there is a very high correlationbetween
Chile's business cycleand
shocks
to its terms-of-trade.Second,
and
more
importantly for the
argument
in this paper, the actual response of theeconomy
is beingmeasured
on
the left axis while that ofthe hypothetical is beingmeasured
on
theright axis.Since the scale in the
former
is ten times larger than thatof
the latter, it is apparent thatthe
economy
over-reacts to theseshocks
by
a significant margin. In practiceshocks
to theterms-of-trade are simply too transitory, especially
when
they are drivenby
demand
as inthe recent crisis, to justify a large
response
of the real sideof
theeconomy.^
The
income
^ Consumption growth is very similarto
GDP
growth for this comparison. Adding the income effect ofinterest rate shocks would not change things too
much
as these were very short-lived. I neglect thepresence of substitution effects because there is no evidence of a consumption overshooting once
effect that is
measured
in panel (b) of Figure 1 should in principle, but itdoes
not inpractice, translate almost entirelyin increased
borrowing
from
abroad.Figure2: ExcessSensitivity ofReal Consumption
Growth
toTerms-of-TradeShociisNotes:consumptiongrmvtfifromIFS.copperprices(London Metal
Exchange) fromDatastream,copperexportsfromMin.de Hacienda.
Returning
to the recent crisis, panel (a)of
Figure 3 illustrates that international financialmarkets
did notaccommodate
this increase indemand
for foreign resources as capitalflows actually declinedrapidly
over
the period. Panel (b)documents
that while the centralbank
offset part of this declineby
injectingback
some
of its international reserves, itclearly
was
not nearlyenough
to offsetboth
the decline in capital inflowsand
the rise inexternalneeds.
8
The
price ofcopper has trends and cycles at different frequencies, some of which are persistent (seeMarshall and Silva, 1998). But there seems tobe no doubt that the sharp decline in the price ofcopper during the current crisiswas mostlythe result ofa transitory
demand
shock brought about by the Asiancrisis. As the latter economies have begun recovering, so has the price of copper. I would argue that
conditional on the information that the current shock was a transitory
demand
shock, the univariate process used to estimate the present value impact of the decline in the price of copper in Figure 2, overestimates the extent ofthis decline. The lower decline in future prices is consistent with this view.The
variance of the spot price is 6 times the variance of 15-months-ahead future prices. Moreover, the expectations computed from theAR
process track reasonably well the expectations implicit in futuremarkets but for the very end ofthe sample, when liquidity premia considerations
may
havecome
into play.Figure3: CapitalFlowsandReserves
B,0O0
(a)Capital^tcouit exceptReserves
6000 [ 4000 '- "" 1000 r " hi.-- J (b)Balance otPayrrerrts r
—
TT-im
1999 StXMSource:BancoCentraldeChile
How
severewas
themismatch
between
the increase in Chileandemand
for financialresources
and
thechange
in their supplyby
the internationalcommunity?
One
answer
appears in panel (a) of Figure 4,
which
graphs the actual currentaccount
(the light bars)and
the currentaccount
with quantities fixed at1996
levels (thedark
bars). This exercise highlights that at itsworst
time, the actual currentaccount
deficitwas
almost$4
billionsmaller than
what
one
would
have
predicted using only the actualchange
interms-of-trade.
Moreover,
this dollar adjustment underestimates the quantity adjustment behind it,asthe deterioration
of
terms-of-trade typicallyworsens
the currentaccount
deficit forany
path ofquantities.
The
importance
ofthis price-correctioncan be
seen in panel (b),which
graphs the actual current
account
(again with light bars),and
the currentaccount
fixed at1996
prices(dark bars). Clearly, the lattershows
a significantly larger adjustment than theformer.
Figure4:
The
Current Account(a)CurertAxoirtandCuralPccoirtat1996qiBitrties (b)CurrerlAccout(actualanJin1996prices)
I
i
I1
I1
^
[oCuTg^AmmBCAte, al96l>a;<ha\
[CimrtAi^irrtnUSSIC^rcrtAg(mmUSSMI|
Notes:(a)Thecurrentaccountal1996quantitieseachyear was computedbymultiplyingthe1996quantitiesbyeachyear'sprices.
Thelatterare theprice ofexports,imports,andspreadofENERSISbonds.Theothercomponentsofthecurrentaccount werekeepi atcurrentvalues, (b)Thecurrentaccountin1996priceswascomputedfi-xingtheprices while usingeachyear'squantities.Source: BancoCentral deChile.
Figure 5 reinforces the
mismatch
conclusionby
reporting increasingly conservativedescribes the path
of
thechange
indemand
for resourcesstemming from
the decline interms-of-trade, increase in spreads,
and
the decline in capital inflows. Panel (b) subtractsfrom
capital inflowsthe reduction in reserveaccumulation by
the central bank, while panel(c) subtracts further the decline in capital inflows to the
banking
sector.During
1999, thisincrease in financial
needs
rangesfrom
justunder $8
biUionon
the highend
toabout
$2.5billion
on
thelow
end. Regardlessof
theconcept
used, themismatch
is large, creating a potentially large surge in thedemand
for resourcesfrom
thedomestic
financial system.The
differencebetween
panel (b)and
(c), as well as the next sectionmore
extensively,show
that the latter sector not onlydoes
notaccommodate
this increase indemand,
butworsen
the financial stress.Figure5:
The
IncreaseinPotentialFinancialNeeds(a)Conpfehensrve (b) (a)lessreservesaccumulation
:
\'V.V^\
(c) (b)lessHowstobankingsector
;•,..
Notes: Theincreaseinpotentialneedscorrespondtothesum oftheterms-of-tradeeffect,the interestrateeffect,andthedecline in capital inflows. Both the lenns-of-trade,andthe interestrate effectsaremeasuredat 1996quantities. Thedecline in capitalflows
correspondsto thedifference ofthecapitalaccountexceptreseri'eswithrespecttoits1996value.Relativeto (a),panel(b)subtracts
fromcapitalflowsthenetchangein CentralBankreser\'es.Panel(c)subtractstopanel(b) the netincrease inflowstothebanking
sector. Source:BancoCentraldeChile
To
conclude
this section. Figure6
shows
that it is not only the external sector that putspressure
on
thedemand
for resourcesfrom
resident banks. Panel (a)and
(b) carries therelatively
"good"
news.
The
former
panelshows
that issues ofnew
equityand
corporatebonds
do
not decline very sharply, although they hide the fact that the required returnon
these instruments rose significantly.
The
latter panel illustrates that while theAPPs
increased their allocation of funds to foreign assets during the period, this portfolio shift
occurred mostly
against public instruments.However,
this declineprobably
translated intoa large
placement
ofpublicbonds
on
some
othermarket
or institution thatcompetes
withthe private sector, like
banks
(see the discussion below). Panel (c),on
the other hand,indicates that retained earnings, a significant source of investment financing to Chilean
firms declined significantly
over
the period, puttingmore
pressureon
thedemand
forfinancial resources.' Finally, panel (d) illustrates that
workers
didnot helpaccommodating
the financialbottleneck either, asthe laborsharerose steadily
throughout
the period.Figure6: OtherPressuresonChileanFirms
(a)Changeinthe slock of corporatedebtandnewequity (b)AFPholdings as fraction ofGDP
-S1000 J;
1
i S 1 5»,.-eV
^
tffl+ii'Tl
i-i
III
199T
|DN»i* gqjty emiiBOriiBChangcinouBlandngcorporaled
(c)RetainedEarnings
IpPiiMicBFinancialQCprnpanigsQFonriCFi|
(d)Labor share
'
'-).-^2^;^^
iDFVjw/OperattCTi Stech/Total
|
Notes:(a)Source:BolsadeComerciode SantiagoandSuperintendenciade Valores y Seguros. Equity emissions arevaluedat issue price, anddeflated using CPl The stock ofcorporate debt outstanding was also deflated according to CPI. The values were
transformedintodollarsusingthenominalexchangerateinthebase monthoftheCPlindex:December1998(432pesos perdollar), (b)Source: Superintendencia deAFP. Thevalues are expressed as fraction oftheannual
GDP
oftherespective year,(c)Thedataonretainedearnings isfrom Bolsa de Comerciode Santiago (Santiago Stock Exchange) andcorrespond to the stocks of retained earning reportedinthebalance sheets ofallthesocietiestradedinthatexchange.Itexcludesinvestmentsocieties,pensionfunds,and insurance companies.The marginal valuewascomputedasthedifference inthestockattandt-1properly deflated, (d) Source: BancoCentral deChile.
The
bottom
line of this section is clear: during external crunches, Turnsneed
substantial additional financialresourcesfrom
resident banks.11.2
The
(Supply)
Response
by
Resident
Banks
'Before
thecrises, in 1996,thestockof retained earnings represented a
20%
oftotalassets for themedianfirm. Similarly, the difference between profits and dividendpayments, a measure ofthe flow of retained
earnings, represented arounda
50%
oftotal capitalexpendituresforthemedian firmin 1996.How
did residentbanks respond
to increaseddemand?
Panel (a) in Figure 7shows
thatfarfrom accommodating
this increase,domestic
loangrowth
actuallyslowed
down
sharplyduring the late 90s,
even
as deposits keptgrowing.
This tightening can also be seen inprices in panel (b)
through
the sharp rise in the loan-deposit spread during the earlyphase
of the recent crisis.
Moreover,
while spreads started to fallby
1999, therewas
a strongsubstitution
toward prime
firms thatmakes
it difficult to interpret this decline as aloosening incredit standards (see below).
Figure 7:
The
CreditCrunch
(a)Loans andDeposits:BankingSystem (b)InterestRate Spreads {Annual%)
s s s s s s
t i i
Hi'
iS S 8 8 i i S i
2r -• 5 3
Notes:(a)Loansincludes commercial, consumption, trade,andresidential(housing)loans.Itdoesnot includeresidentialloans with equityemission ("letrasde credito").Deposit includes sightdepositsandtimedeposits. The values were expressedin dollarsof
December 1998 multiplying the Figures in pesos ofDecember 98 by the average nominal exchange rale in that month (472
pesos/dollar),(b)}Theunderlying30-dayinterestrates are nominalwhilethe90-365arereal(toafirst order, this distinctionshould
not matter forthe spreads).
Sources:BancoCentral,andSuperintendenciadeValores y Seguros.
The
main
substitutes for loans in banks' portfolios arepubbc
debtand
external assets.Panel (a) in Figure 8
shows
it is the latter thatwas
behind
theslowdown
in loans.The
central
bank
policy of fighting capitaloutflows
seems
tohave been only
temporarilysuccessful(see the reversal during the last quarter
of 1998)
indoing
so. Instead, the rise ininterest rates during the
Russian
phase of
the crisisseems
tohave succeeded mostly
inslowing
down
the decline in banks' investment in public instrument,and encouraged
substitutionaway
from
private lending.Banks,
rather thansmooth
the lossof
externalfunding, exacerbated it
by becoming
partof
the capital outflows. In fact, while panel (b)illustrates that the
banking
sector alsoexperienced
a large capitaloutflow
during thisepisode, panel (c) reveals that
much
of
the netoutflow
was
notdue
to a decline in theirinternational credit lines or inflows, but rather
due
to anoutflow
toward
foreign depositsand
securities.Figure8: CapitalOutflowsbythe Banking System (a)InvestmenlinDomeslicandExternalAssetsBankingSystem
(b)Netcaprta) inftovfi tobankingsedor
*<f** * *"'^»* =?-'^ -^^ ^.<^*c»f»^*(*<*'',<'4># q^
##
(P#/V^
s^V^'^'/V*^**c,'*'y/y^":^=,<*'^'^/^j**'j^S'*'-^'^^"y^ (c)CompositbnofForeignAssets BankingSystemE -Foreigo secunfrca[
Notes:(a)Domesticassetsinclude CentralBanksecuritieswithsecondarymarketandintermediatedsecurities. Externalassetsare thesum of depositsabroadandforeignsecurities. Depositsabroadconsistmainlyon sightdeposits of Chilean banksonforeign banks. Foreignsecuritiesconsistmainlyinforeign bonds,(b) Tiiespreadreported isthe differencebetween the90-365 daysloan interest rate (real)andthe interest rateofoneofthecentralbankbonds.- thePRBCwithmaturityin90days.
Sources:BancoCentralandSuperintendencia de Bancos.
While most
residentbanks
exhibited this pattern tosome
degree, it is resident foreignbanks
thattook
the leadand
made
themost
pronounced
portfolio shifttowards
foreignassets. This is apparent in panels (a)
and
(b) in Figure 9,which
present the investment indomestic
and
foreign assets across foreignand domestic
(private) banks, respectively.While
allbanks
increased their positions in foreign assets, foreign banks' trend ismore
pronounced.
Moreover, domestic banks
"financed" a larger fraction of their portfolio shiftby
reducing other investments ratherthan loans. Thisconclusion isconfirmed
by
panel (c),which
shows
the paths of the loans to deposit ratios for foreign (dashes)and domestic
(solid) banks."'
"*
This figureexcludes two banks(BHIF andSantiago)that changed from domestic toforeign ownership
during theperiod. The changein statistical classification took place in
November
1998 for Banco BHIF,and in July 1999 for Banco de Santiago. In the case ofBanco de Santiago, the takeover operation took
place in
May
1999 byBancoSantander(the largest foreign bankin Chile). Assumingthat thetwo banks were going tomerge, theChilean banks regulatoryagency (Superintendencia de Bancos) asked Bancode Santiago to reduce its market presence (the two banks had a joint presence equivalent to29%
of totalloans). The banks finally decided not to merge and therefore their joint market presence have remained
unaltered so far. Most likely the confusion created by the potential participation limits did not help the
creditcrunch Chile experiencedatthetime.
Figure 9:
Comparing
Foreignand DomesticBank
Behavior(a)InvestmentinDomesticandExternalAssets' ForeignBanks (b)InvestmentinDomestK:and ExiemalAssets:DomestcBanks
i.sc
I
Ejteiral • -- DotTiBBti:|
(c)Loans over Deposits domestic andforeignbankse Santiago xceptBHIFand ... ' " •--'-N.s^ •• "-^ -.^
___._/
—
\
: \._ I i I i 1 i ^ p OnnMsiic Ftmt(tfi|Notes: Domestic banks do not include Banco del Estado. (a), (b) Domestic assets include Central Bank securities with
secondarymarketandintermediatedsecurities.Externalassets arethesumofdepositsabroad andforeignsecurities.
All Figuresare expressed in dollars by multiplying the series in constantpesos ofDecember98 by the average nominal
exchangerateofthatmonth(472pesos/dollar), (c)Ratiosof Loans overdepositshave been normalizedtooneinMarch1996.
Deposits includesightandtimedeposits. Loansincludecommercial, consumption,trade, andresidential(housing)loans. The
nvobanksthatchangedstatistical classificationfromdomestictoforeignduringthe lastyears ---BancoBHIFch inNovember
1998and Bancode SantiagoinJidy1999--were excludedfromthesample. Theinformationusedtoseparate thesetwobanks
isfromtheBolsa de ValoresdeSantiago (Santiago Stock Exchange).
The
question ariseswhether
it is not the nationality but other factors (e.g., riskcharacteristics)
of
thebanks
thatdetermined
the differential response.While
this iscertainly a
theme
tobe explored
more
thoroughly, theevidence
inFigure 10 suggests thatthis is not the case. Panel (a)
shows
that foreignbanks
did not experience a rise in net foreigncurrency
liabilities thatcould account
for additional hedging.When
compared
withdomestic
banks, they did not experience a significantly sharper rise innon-performing
loans as is indicated
by
panel (b), orwere
affectedby
a tighter capital-adequacy constraintin panel (c).
Figure 10: RiskCharacteristics ofForeignand Domestic
Banks
(a)ForeignCurrency Assels andLiabilities:ForeignBanks (b)Nonperforming toans aspercentageoltotalloans:domestic and foreignbanks \
»n
mi
1—
^B
^9
SSi^3
6% -'—
^M
i
H!
^n
i:H| jHj 07\|h
ilH
—
'B
—
nn
lODomeslgBForcigr (c)Basle IndicatorE -OcnvstEPtHalc 8anlu
Notes: (a)Foreign assetsinclude foreignloans, depositsabroadandforeignsecurities. Foreignliabilitiesincludefttndsborrowed
fromabroadanddepositsinforeign currency, (b)
ROE
isthe ratiooftotal profitsovercapitalandreserves(aspercentage),(c)Basleindexcorrespondsto thecapitaladequacyratio.DomesticprivatebanksdonotincludeBancodelEstado. Source:Superintendencia deBancose InstitucionesFinancieras.
Foreign
banks
usually playmany
useful roles inemerging
economies
but theydo
notseem
to
be
helping tosmooth
externalshocks
(at least in themost
recent crisis). It is probablythe case that these banks' credit
and
risk strategies are being dictatedfrom
abroad,and
there is
no
particular reason to expectthem
tobehave
too differentlyfrom
other foreign investors during these times.In
summary,
during1999
-perhaps
theworst
full year during the crisis—banks
seem
tohave reduced
loangrowth
by about
$2
billion dollars," while the increase in financialneeds
by
thenon-banking
private sector estimated in Section II.1was
about $2.5 billions(see figure 5c).
Although
there aremany
general equilibriumissues ignored in these simplecalculations, it is
probably
not too far-fetched toadd
them
up and conclude
that thefinancial
crunch
was
extremely large,perhaps around
$4.5 billion dollars (about6%
ofGDP)
inthat single year."
A
numberclose totwobillion dollarsisobtained fromthedifferencebetween theflow of loansduring 1999 (computedasthechangein thestock ofloansbetween December 1999 andDecember 1998) andthe
flow of loans in 1996 (computedin similarmanner).
III.
The
Costs
The
impact of the financialcrunch
on
theeconomy
is correspondingly large. Itsignificantly
worsens most
aggregate indicators,and
it particularly hurts smalland
medium
size firms.///.1
The
Aggregates
Figure 2 already
summarized
the first-orderimpact
of
the financialmechanism,
with adomestic
business cycle that ismany
timesmore
volatile than itshould
be with perfectcapital markets. This "excess volatility"
was
particularlypronounced
in the recentslowdown,
as isillustratedby
panel (a) in Figure 1 1.The
paths ofnationalincome
(solid)and domestic
demand
(dashes) not onlyappear
tomove
together, but the latter adjustsmore
than the former, implying that the largely transitory terms-of-tradeshock
is notbeing
smoothed
over
time. Panel (b) illustrates the sharp rise in theunemployment
ratethat
followed
and
that has yet tobe
undone
(asof
May,
2001).Figure 11: Chilean Output,
Demand,
andUnemployment
(a)Nationalincome and DomesticDemand (b)Unemptoymentrate
Notes: (a)Seriesare seasonally adjustedandannualized. Source:BancoCentraldeChile, (b)Source: INE.
Aside
from
the directnegativeimpact
of
theslowdown
and any
additional uncertainty thatmay
have been
createdby
the untimely discussionof
anew
laborcode,
the buildup
inunemployment
and
its persistencecan
be
linked totwo
additional aspectsof
the financialmechanism
described above. First, in the presenceof
an external financial constraint thereal
exchange
rateneeds
a largeradjustment
forany
given decline in terms-of-trade.'^As
a result
of
this, a big share of theadjustment
fallson
the labor-intensive non-tradablesector, asillustrated in panel (a) of Figure 12.
Second, going
beyond
the crisisand
into therecovery, the lack of financial resources
hampers
job
creation, aphenomenon
that isparticularly acute in the
PYMES
(see below). Panel (b) suggests that thiscould
beimportant
by
illustrating that investment (solid line) suffered adeeper
and
more
prolonged
'"
The larger real exchange rate adjustment corresponds to the dual of the financial constraint. See
Caballeroand Krishnamurthy(forthcoming).
recession than the rest of
domestic
aggregatedemand
(dashed
line).While
notshown
here, the costs of financial constraints during the
recovery
can
extend
beyond
theunemployment
cost as they also depressone
of themain
engines of productivitygrowth:
the restructuring process. If the U.S. isany
indication of the costs associated to thisslowdown
in restructuring -- possibly a very optimisticlower
bound
for the Chilean costs—
thismechanism
may
add
a significant productivityloss thatamounts
toover
30%
of
theemployment
cost ofthe recession.''Figure12: Transmissionof theShock toOtherSectors
(a)GDPtradeableandnon-tradeablesectors (b)Evolution o(domesticdemand ' ---. . ,', -
-'
^
/~ ^^\
25000^
—
^
^
^
—
-^^---^
™» i ,»»> ^ ,0000 SOOO |- -HEST^—FBkF]Notes:(a)Preliminary dala usedfor year 2000. Series are seasonally adjustedandwere normalizedtoMarch 1996=1. Tradeable sector includes agriculture, fishing, mining, and manufacturing. Non-tradeable sector includes electricity, gas and water, construction, trade, transport and telecommunications, and otherservices, (b) Seriesare seasonally adjusted, andannualized. Source:BancoCentral deChile.
Given
the increase in spreads as the external constraint tightens, arbitrage dictates that thestock
market
must
also decline sharply in order to offer significant excess returns to thosewilling to
buy
these assetswhen
most
foreign investors are not. Panel (a)of
Figure 13illustrates this v-pattem. Panel (b) illustrates that foreign direct investment
(FDI)
increasedby
almost $4.5 billion during 1999,and
created abottom
to the fire saleof domestic
assets.
While
FDI
is very useful since it provides external resourceswhen
they aremost
scarce, its presence during the crisis reflects the severe costs
of
the external financialconstraint as valuable assets are sold at
heavy
discounts.13
SeeCaballeroand
Hammour
(1998).Figure 13: Fire Sales
(a)ValueotChileanslocks (index) (b)Foreign DirectInveslmenI(FDt)
1
^fe
&fep
.,
Notes:(a)IGPAisthegeneral stock price index oftheSantiago StockExchange.Sources:Bloombergand BancoCentralde Chile (b)Onlyconsiderstheflows ofFDI fromabroad(excludestheflowsofFDI associated with investmentsmadeby Chileanresidentsin foreigncountries).Source:BancoCentraldeChile.
111.2
The Asymmetries
The
realconsequences
of the externalshocks
and
the financial amplificationmechanism
are felt differently across firms
of
different sizes.Large
firms are directly affectedby
the externalshock
butcan
substitute their financialneeds
domestically.They
are affected primarilyby
priceand
demand
factors.The
PYMES,
on
the other hand, arecrowded
outfrom
domestic
financialmarkets
and
become
severely constrainedon
the financial side.They
are the residual claimants—
and
to a lesser extent, so are indebtedconsumers
—
of
the financialdimension
ofthemechanism
described above.Figure 14 illustrates
some
aspectsof
thisasymmetry,
starting with panel (a) thatshows
thepath of the share
of
"large" loans asan
imperfectproxy
for residentbank
loansgoing
to large firms.Together
with panel (b),which
shows
a sharp increase in the relative sizeof
large loans, it hints at a substantial reallocationof domestic
loanstoward
relatively largefirms. In the policy sectionI will
argue
thatsome
ofthis reallocation is likely tobe
sociallyFigure 14:Flight-to-Quality
(a)Shareoflarge loansin tolalloans (b)Averagesize of smallandlargetoans
i ^ i I *
Ei
Notes: (a)Tiieshare of large loansintolalloanswascomputedusinginformationonthedecomposition ofthestock of loans by loan size.Itwasassumedthatloans largerthan50000UF(around dollarsatthecurrentexchangerate)wereentirelyassignedto largefirms.Theshare of large firmsintotalloanswasthencomputedastheshare of loans greaterthe50000UFinthe totalstockof
loans, (b)Small loans are thosebetween400 and10000 UF(dollars);large loansare those greater than50000UF. The average
sizecorrespondstothestockofloansineachclassdivided bythenumberofdebtors.
Source: SuperintendenciadeBancose InstitucionesFinancieras.
The
next figure looks at continuing firms fi"om the FECUs.''^ Despite allof
these firmsbeingrelatively largepubliclytraded
companies,
one can
already see important differencesbetween
the largestof
them
and
"medium"
size ones. Panel (a) in Figure 15shows
thepath of
medium
and
large firms' bank-liabilities (normalizedby
initial assets) during therecent
slowdown.
It is apparent that larger firms fared better asmedium-sized
firmssaw
their level of loans frozenthroughout
1999.Perhaps
more
importantly, since thesum
of
loans to
medium
and
large firms rose during this period while total loans declinedthroughout
the crisis, the contractionmust have been
particularly significant in smallerfirms (thosenot inthe
FECUs).
FECU
is the acronym for Ficha Estadistica Codificada Uniforme, which is thename
of thestandardized balance sheetthatevery public firm in Chileis requiredto report tothe supervisor authority (Superintendencia de Valoresy Seguros) on a quarterlybasis. Ourdatabase contains the information on
thosestandardizedbalance sheets for every public firm reportingtothe authoritybetweenthe first quarter of1996 and thefirst quarter of 2000.
Figure 15:
Bank
DebtofPubliclyTraded
FirmsBy
Size(a)Bankliabilitiesofmediumandlarge lirms
Notes.- (a)Thedata source istheFECI!reportedbyalllistedfirmsto theChilean stockmarket
regulatory agency: Superintendeiicia de Valores y Seguros. The sample includes allfirms that continuously reported informationbetweenDecember1996andMarch2000. Withinthissample, themedium(since they are largerthan firms outside thesample) sizefirms are thosewith total assetsbelowthemedianleveloftotalassetsinDecember1996. Theseriescorrespondto the total stock ofbank liabilitiesatallmaturitiesexpressed in 1996pesos, dividedby the total levelof
assets in December1996). Thenominalvaluesweredeflated using the CPl. The totallevel of
assets in December 1996 was 788millions ofdollars for the groupofmedium size firms, and
59,300millions of dollarsforthegroup oflargefirms.
In
summary,
despite significant institutionaldevelopment over
the lasttwo
decades, theChilean
economy
is still very vulnerable to external shocks.The
main
reason for thisvulnerability
appears
tobe
adouble-edged
financialmechanism,
which
includes a sharptightening ofChile's access to international financialmarkets,
and
a significant reallocationof resources
from
thedomestic
financialsystem
toward
larger corporations, publicbonds
and,
most
significantly, foreignassets.IV.
Policy
Considerations
and
a
Proposal
The
previous diagnostic points at the occasional tightening of an external financialconstraint
—
especiallywhen
terms-of-trade deteriorate—
as the trigger for the costlyfinancial
mechanism.
IV. 1
General
Policy
Considerations
If this
assessment
is correct,it callsfor a structural curebased
on
two
building blocks:a)
Measures
aimed
atimproving
Chile's integration to international financialmarkets
and
thedevelopment
ofdomestic
financial markets.b)
Measures
aimed
atimproving
the allocation offinancial resources during timesof
external distressand
across statesof
nature.While
in practicemost
structural policiescontain elementsof both
building blocks, I focuson
(b) as the guiding principle of thepobcy
discussionbelow
because
(a), at least as anobjective, is already broadly
understood
and
Chile is alreadymaking
significant progressalong this
dimension
thought its capitalmarket
reform.'^That
is, I focus primarilyon
theinternational liquidity
management
problem
raisedby
the analysisabove.'^International liquidity
management
is primarilyan
"insurance"problem
with respect tothose (aggregate)
shocks
that trigger external crises.Of
course
solutions to thisproblem
must have
a contingent nature.The
first step is to identify a—
hopefully small—
setof
shocks
that capture a large shareof
the triggers to themechanism
described above. In thecase
of
Chile, terms-of-tradeand
theEMBI-i-
probably
represent agood
starting point, butthe particular index
chosen
is a central aspectof
the design thatneeds
tobe
extensivelyexplored before it is
implemented.
The
second
step is to identify the ex-post transfers (perhapstemporary
loans rather thanoutright transfers) that are desirable.
At
abroad
level these are simply:i)
From
foreigners to domestics.ii)
From
less constraineddomestics
tomore
constrained ones.At
a generic level these transfers are clear, but in practice there is great heterogeneity inagents'
needs
and
availability, raising the information requirements greatly. It is thushighly desirable to letthe private sectortake
over
the bulkof
the solution,which
begs
thequestion of
why
is it that this sectorisnot alreadydoing
asmuch
as isneeded.
The
answer
to this question
most
likely identifies the policygoals with the highest returns.'^Here,
I usetheconcept of"structural policies"incontrast toex-post(discretionary) interventions.
'*
SeeCaballero (1999)forgenera] policyrecommendationsfortheChilean economy,includingmeasures
type(a).
My
objectivein thecurrent paper isinstead tofocusand deepen thediscussion of a subset ofthosepolicies,adding an implementation dimensionas well.
The
main
suspectscan be
grouped
intotwo
types: supplyand
demand
factors.Among
the supplyfactors, there are at least threeprominent
ones:a)
Coordination problems.
The
absence of
a well-definedbenchmark
around
which
themarket can be
organized.b)
Limited "insurance"
capital.These
may
be
due
to structural shortages ordue
to a financial constraint (in the sense thatwhat
is missing is assets thatcan be
crediblypledged by
the "insurer," rather than actual funds during crises).A
closely relatedproblem,
but with coordination aspects as well, is that an insufficientnumber
ofparticipants in the miarketraises theliquidity
and
collateral risk facedby
the "insurers. " c)Sovereign
(dual-agency)problems.
While
contracts are signedby
private parties,government
actions affect thepayoffsof these contracts.'^Among
thedemand
problems,one
should consider at least three sourcesof
underinsurance:
a)
Financial
underdevelopment.
This
leads to a private undervaluationof
insurancewithrespect to aggregate shocks.
The
latter depresses effective competition fordomesticallyavailable external liquidityat times ofcrises, reducing the private (but not
the social) valuation ofinternationalliquidity during thesetimes.'^ b)
Sovereign problems.
Implicit (free) insurance.c)
Behavioral problems.
Over-optimism.
In
my
view,domestic
financialunderdevelopment
is still aproblem
in Chile,which
givesrelevance to
demand
factor (a) and, primarilythrough
it, to supply factor (b) as it reducesthe size
of
the effectivemarket.The
remedy
to thisproblem,
however, should be pursued
through
financialmarket
reforms
rather than with extensive liquiditymanagement
strategies. Similarly,demand
factor (c)seems
tobe
a pervasivehuman phenomenon
(see forexample
Shiller 1999), but thisis tobe
dealt with apublic educationcampaign.
Having
said this, all these
problems
justifysome
limitedamount
of
centralized liquiditymanagement,
although thismust
be
done
with great care not to generate a sizeabledemand-(b)
type problem,which
is otherwise not likely to be present inany
significantamount
in the caseof
Chile.'^Ifthese conjectures are correct, they leave us with supply-(a)
and
supply-(c) as themain
issues to deal with.
At
today'sadvanced
level (foremerging
economies
standards) inChile's institutional
development,
I believe that supply-(c) is not a serious concern, exceptfor issues that
concern
exchange
ratemanagement.
As
I will discussbelow,
this exceptionis an important consideration in
my
claim that, at least fornow,
the "internationalization ofthe
peso"
isnot likely to fullyresolveChile's underinsuranceproblem.
Thus,
my
proposal
below
has supply-(a) as itsmain
concern."
See,e.g.,Tirole (2000).'^
See Caballeroand Krishnamurthy(forthcoming).
"
See Caballeroand Krishnamurthy(2001).IV.2
A
concrete proposal:
Issuing
a benchmark-contingent-instrument
The
basic proposal is extremely simple:The
CentralBank
or, preferably,one
ofthe IFIsshould issue a financialinstrument
-a
"bond"
fornow—
contingenton
theshocks
identifiedin step one. Ideally,
and hence
the role playedby
a reputable first issuer, thisbond
shouldbe free of other risks.
The
issue shouldbe
significantenough
to attract the participation ofinternational institutional investors
and hence
generate its liquidity.While
some
of thedesired insurance
may
be achieved directlyby
thisbond,
itsmain purpose
is simply tocreate the market.
With
the basic contingency well priced, it shouldbe
substantiallysimplerfor the private sector to engineer its
own
contingent instruments.It is important to realizethat the
contingency
generated via thismechanism
addresses onlythe
expected
diiferentialimpact
ofthe aggregateshocks
contained in the index. Individualagents will generate heterogeneity in their effective
hedging through
their net positionsrather than
through
achange
in the specific contingency.'" Other,more
idiosyncraticunderinsurance
problems
are also welfare reducing but are lessconnected
with aggregatestabilization,
which
is theconcern
in thispaper.''While
in principle the question ofhow
responsive shouldbe
thecontingency
to theunderlying insurance factors or indices is irrelevant since the private sectorshould be able
to
develop
the derivativemarkets
thatcan
generateany
slope theymay
need, financialconstraints
and
liquidity considerations suggest otherwise.With
thelatterconsiderationsinmind,
it is desirable tomake
thebond
contingency
very "steep," so as tominimize
theleverage
and
derivative instruments required to generate an appropriateamount
ofinsurance for large crises.
The
counterpart will probablybe
a very limited insuranceof
small
and
intermediate shocks,which
shouldbe
fine since theseshocks
seldom
triggerthefinancial amplification
mechanism
highlightedin thispaper.How
much
insurancedoes
thecountry
need?
This question is noteasy
toanswer
as itinvolves
many
general equilibrium considerations, but a very conservativeanswer
for afull-insurance
upper
bound
should
notbe
very farfrom
the partial equilibrium answer.Crises
deep
enough
to trigger thecomplex
scenarios experiencedby
Chile recently areprobably
once
in adecade
events,and
according toour
estimates earlieron
the shortfall ofresources is
about
5 billion dollars a year, lasting for atmost
two
years (recessions longerthan this are
most
likely the result ofthedamage
createdby
the lackof
insurance, ratherthan the direct effect ofthe external shocks).
But
the required insurance is only a fraction^° See
Shiller's (1993) seminal work on promoting the creation ofmacro-markets as a mechanism for
insuring microeconomic risks. While
much
ofhis reasoning applies in the context I have discussed aswell,
my
ultimate focus ison theequilibrium (macro)-benefits ofmicroeconomicinsurance with respect tomacroeconomic shocks, rather than on the direct microeconomic welfare enhancing features of such
insurance. ^'
Also, insurance against aggregate shocksis morelikely tosupport a market instrument as its solution, asopposed tomoreexpensive(lessliquid)individuallytailoredinsurancecontracts.
of
this shortfall since all that isneeded
is that these resourcesbe
lent, not transferred. Ifwe
conservatively
assume
that theaverage
spreadon
Chilean external debt risesby
400
basispoints, the required insurance is effectively
200
millions per crisis year (with the loancommitment
or credit line).Gathering
all these factors puts the fair price of full-insuranceat
around
40
millions a year.Of
course
prices for this typeof
insurance arenever
fair, butthe point of this "back-of-the-envelope" calculation is that the
amounts
involved are notlarge.
The mapping from
theabove
tothe sizeof
the contingentbond
issues requireddepends
on
the slope of the contingency,
amount
of insurance required (full insurance is highlyunlikely to be optimal),
and
other design issues.Of
course, thebenchmark bond
should
represent only a small fraction of the total
amount,
as hopefully the private sector willfollow behind, but it
cannot be
too smalleither, since itneeds
tobe
liquidenough from
theoutset.
All the
above
refers to the insurancebetween
foreignersand
domestics, but there is also aneed
to create a substantialamount
of domestic
insurance.Large
corporations with betteraccess to international financial
markets
should be able to profitfrom
arbitraging theiraccess to smaller
domestic fums,
rather thanmove
inward
toborrow
in thedomestic
markets
during timeof
distress, as ithappened
in the recent episode.Probably
thedomestic
banking
system
isthe natural institution to administer this side of the contingentstrategy,
which
willprobably
require regulatorychanges
toaccommodate
thisnew
roleefficiently.
The
question ariseson
whether
thedevelopment
ofsuch contingency
hasany obvious
advantage over
the admittedly simpler strategyof
"internationalizing the peso;" that is, ofplacing
abroad
bonds
denominated
in Chilean pesos. This is the strategy currently beingpursued, with the support
of
a recentWorld Bank
issuance forUS$
105
million." Inmy
view, while the
shocks
indexing thecontingency
will in all likelihood put pressureon
theexchange
rate,and hence
thepeso-bonds
serve a role similar to the contingent instrumentsI
have
proposed, there is a clear disadvantage in them:The
Chilean authorities largelycontrol the value
of
the peso,and
therefore thiscontingency
is unlikely to appeal theinsurers (or
bond
holders) asmuch
as anexogenous
contingency.Moreover,
and
somewhat
paradoxically, apeso-denominated
bond
may
not onlybe
subjected to a higherpremium
due
to the riskof
CentralBank's
manipulationof
theexchange
rate, but itmay
also not
prove
a veryeffective insurancemechanism
if, forexample,
the authorities decideto
dampen
anexchange
rate depreciationthat is riskingan
inflation target.'^The
disadvantage of the contingentbond,
on
the other hand, is that it ismore
difficult to^^
The
bond wasfloated in
May
31, 2000,foran amountof$55,000nnillion ofChilean pesos.The
bondshave5 years of maturity(toberepaidon June4"^,2005), acouponof6.6%, and areindexedtoChilean
inflation. Mostofthe issuewas acquiredby Chilean institutional investors(75%),whiletherest was
placed
among
international investors. Chase Manhattan International Ltd,New
York,actedas directorbank.
^^
The
socalled "fearoffloating"(CalvoandReinhart 2000).