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Policy Responses to Sudden Stops in Capital Flows: The Case of Chile in 1998 Rodrigo Valdés Central Bank of Chile Motivation: Why Chile 1998? • Chile confronted a large “sudden stop”: – Net capital inflows were equivalent to 7% of GDP in the year ending in 98Q1 and dropped to less than 1% of GDP in 99Q1. • In comparison to other episodes, with financial sector meltdown and a deep recession, this case could be considered a successful one: mild recession. • In many Chileans’ minds, strong doubts remain on the efficiency of the adjustment. 2 The paper: • Revisits the 1998 Chilean episode, underpinning the following: 1. The policy framework and initial conditions; 2. Shocks; 3. Immediate policy responses and macro adjustment; 4. Subsequent overhaul of the policy framework; 5. The Chilean case in perspective; 6. Some lessons 3 1. Policy Framework and Initial Conditions Macro policy framework-key components before the episode: • An independent CB in transition to price stability: – Annual inflation targets; – XR target band with PPP adjustments; – Capital account regulations. • Orderly managed fiscal policy: – Public debt declined from 38% of GDP in 1989 to 5% in 1997; – Most of external debt was private. • Strong financial institutions – Well regulated and supervised banks. 5 Cyclical conditions in 1997: • Against a backdrop of very strong GDP growth (7.7% in 19901997), signs of overheating in 1996-97 included: – Current account deficit above 4% of GDP; – Marked FX appreciation, with signs of misalignment, despite heavy intervention; – Increasing core inflation in 1996. • The economy’s overheating was a public policy issue: – Special commission to design ways to foster savings; – Strong discussion on role of fiscal policy (surplus 2% in 97); – Extra provisions for consumer credit. 6 2. Shocks In late 1997, ToT dropped suddenly and threatened to increase the CA deficit… Unit Price of Exports in US Dollars in Real Time 1997Q2-1999Q2 (% annual change) 5 As of May 15 1998 As of Aug 15 1998 As of Nov 15 1998 As of Today As of Feb 15 1999 0 1997Q2 1997Q3 1997Q4 1998Q1 1998Q2 1998Q3 1998Q4 1999Q1 1999Q2 -5 -10 -15 -20 8 …while domestic demand remained strong and fiscal accounts weakened. Current Account Deficit in Real Time (cumulative four quarters, US$ million) As of Feb 15 1998 As of Nov 15 1998 Final As of May 15 1998 As of Feb 15 1999 As of Aug 15 1998 As of May 15 1999 1000 0 1997Q3 1997Q4 1998Q1 1998Q2 1998Q3 1998Q4 1999Q1 1999Q2 1999Q3 1999Q4 -1000 -2000 -3000 -4000 -5000 -6000 -7000 9 External financing was expensive, but gross outflows dominated dynamics. Changes in Gross Assets and Liabilities (Transactions) (cumulative four quarters US$ millions) 15,000 Liabilities 10,000 5,000 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 0 Assets -5,000 -10,000 -15,000 Assets Ex International Reserves 10 3. Immediate policy responses: Restrictions and effects Policy objectives and restrictions: • Central objective: cool down the economy: – Diagnosis: It would happen anyway, either through domestic policy or market-induced. – Market induced more costly (fear of “sudden stop”). • Restrictions: – Limit nominal depreciation: • Short-term inflation target and imperfect credibility; • Large perceived XR pass-trough; • Fear of balance sheet effects due to perceived mismatches. – Political constraints to implement fiscal policy. 12 Non sterilized FX intervention and tight monetary policy… Monetary Policy and Interbank Overnight Interest Rate in 1998 (% + UF) 60 Fiscal Adjustment Announcements: 50 Jan. 19th Mar. 21st 40 Jun. 25th 30 20 10 0 Jan Fe Ma Apr Ma Jun Jul Au Se Oc No De 13 “Commitment technology” increased rigidities and vulnerability. Exchange Rate Target Band 1997-1999 (pesos per US dollar) 560 540 520 500 480 460 440 420 D O S J J A M 1999 D O S J J A F 1998 N O A J M A F 1997 400 14 CA Adjustment: absorption contracted strongly with little demand switching… • RER depreciated only in late 1999; • Share of tradable goods stable in value added; • Stable contribution of exports to GDP growth. Domestic Demand and Exports’ Contributions to GDP Growth (%) Tradable Goods Participation in Value Added (%) 20% 10 18% 8 16% 6 14% 4 12% 2 10% -4 2000,2 2000,1 1999,4 1999,3 1999,2 1999,1 1998,4 1998,3 1998,2 1998,1 1997,4 1997,3 1997,2 -2 1997,1 0 8% 6% 4% -6 2% -8 Net Domestic Demand Exports 0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Agriculture Fisheries Mining Manufacturing 15 Policy effects and adjustment. • Financial market calmed down after CB policy actions. • Fiscal policy announcements had no evident effect on financial markets. Real- time “opinions” were mixed/negative. • Credit followed a very pro-cyclical pattern. Banks’ indicators deteriorated, but remained in OK zone. • Capital outflows in early 1999 driven by pension system (made possible by change in foreign investment limits). • Large turnaround of macro policies in 1999, particularly fiscal. 16 4. Subsequent overhaul of the policy framework Results led to deep changes in the macro policy framework in 1999-2001… • XR floating regime; • Deepening of XR hedging market; • Full fledged inflation targeting; • Fiscal policy rule based on structural target; • Capital account liberalization; • Nominalization of monetary policy; … which combined with a different cyclical position implied a very different policy mix after 2001-2002 shocks. 18 5. The Chilean case in perspective Among Sudden Stop episodes, Chile’s intensity is around average... Distribution of Shock Severity as % of Trade (kernel, 55 cases) 6 5 4 3 2 1 Chile 1998 Perc. = 40 0 -.6 -.5 -.4 -.3 -.2 -.1 .0 20 …but the policy response and outcome stand out in a few dimensions: • Fairly good inflation performance; • Average growth outcome; • Not very intensive in FX reserve intervention; • Rather mild RER depreciation; • Rather high real interest rates. 21 6. Some Lessons Among other things, the Chilean case shows the following: • Financial system resilience and public finance (ex-ante) seem key to avoid meltdown and give room for aggressive macro management. • With hindsight adjustment could have been more efficient (more RER less AD) – Some priors proved unfounded: low pass-through, low currency mismatches. – Other priors yet “untested”: (costly) market induced adjustment • Policy framework too rigid: annual inflation target, XR band… 23 Among other things, the Chilean case shows the following: • Potentially large costs of interest rate spikes (liquidity crunches). • Implementing “macho” credibility can be self-defeating (Europe ’92). • Private sector AD responds to fundamentals. • Although the counterfactuals are unknown, fiscal policy announcements apparently did not buy much credibility. • Outflows were a key element behind the story limiting applicability to other EMEs. 24 Policy Responses to Sudden Stops in Capital Flows: The Case of Chile in 1998 Rodrigo Valdés Central Bank of Chile …but relatively stronger drop in importintensive demand components. Contributions to Domestic Demand Growth (%) 15 12 9 6 3 2000,2 2000,1 1999,4 1999,3 1999,2 1999,1 1998,4 1998,3 1998,2 1998,1 1997,4 1997,3 1997,2 -3 1997,1 0 -6 -9 -12 Durable consumption (5.1%) M&E (9.9%) Construction (16,0%) Rest (69.0%) 26 Major drop in GDP growth was largely unexpected (as was CA adjustment…) 10 Expected and Actual GDP Growth (cumulative four quarters, % annual change) 8 6 4 2 0 1998Q1 1998Q2 1998Q3 1998Q4 1999Q1 1999Q2 1999Q3 1999Q4 -2 -4 1999 CB and MoF Forecast 1999 Consensus Actual Base 1986 Actual Base 1996 27