global financial turmoil: is latin america sheltered?

Global Financial Turmoil: Global Financial Turmoil: Is Latin America Is Latin America

Sheltered?Sheltered?



Ernesto TalviErnesto Talvi

Prepared for Presentation at the XXVI Meeting of the Latin American Prepared for Presentation at the XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries, IADB, Washington DCNetwork of Central Banks and Finance Ministries, IADB, Washington DC

October 16October 16thth, 2007, 2007

CERESCERES

MAIN POINTS OF THE PRESENTATION

In every major episode of global financial turmoil Latin America suffered In every major episode of global financial turmoil Latin America suffered a severe blow.a severe blow.

Tequila Crisis

Asian Crisis

LTCM / Russian Crisis*

Debt Crisis

Subprime Crisis

Global Financial Turmoil Episodes in Perspective*

10y Mov.Avg. + 1

10y Mov.Avg. + 2

0

50

100

150

200

250

300

350

400

Jan

-78

Jan

-80

Jan

-82

Jan

-84

Jan

-86

Jan

-88

Jan

-90

Jan

-92

Jan

-94

Jan

-96

Jan

-98

Jan

-00

Jan

-02

Jan

-04

Jan

-06

(Moody’s US Baa Spread over US Treasuries)

*A *A global financial turmoil episodeglobal financial turmoil episode is defined as an aggregate-spread window containing a spike in the US Baa spread exceeding two standard deviations is defined as an aggregate-spread window containing a spike in the US Baa spread exceeding two standard deviations from its mean (which starts when the aggregate US Baa spread exceeds one standard deviation, and ends when it is smaller than one standard deviation). from its mean (which starts when the aggregate US Baa spread exceeds one standard deviation, and ends when it is smaller than one standard deviation). If between the end of an episode and the beginning of the next there is less that one year, both are considered part of the same episode.

(Moody’s US Baa Spread over US Treasuries and Gross Capital Flows to LAC-7 in billions of 2006 US dollars)

Spread on Risky Assets

Gross Capital Flows to LAC-7

Global Financial Turmoil Episodes and Sudden Stops in LAC-7*

0

50

100

150

200

250

300

350

400LTCM / Russian Crisis

Debt Crisis

126.5 129.5

-116.6-146.9

-40-20

0

20406080

100120140

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

10y Mov.Avg. + 1

10y Mov.Avg. + 2

*LAC-7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela, which represent 93% of Latin America GDP

(LAC-7 GDP, real index)

Global Financial Turmoil Episodes and Output Performance*

*Talvi, E. (forthcoming), “Sudden Stops in the 80s and the 90s: a Fresh Look at Latin America’s Debt Crisis”

75

78

81

84

87

90

93

96

99

102

105

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

Avg. growth 1974-1980:

4.5% Avg. growth 1981-1985:

0.5%

Debt Crisis

1980s: Debt Crisis

Peak to Trough

Duration of Recession

Phase

-5.4% 2 yrs

Recovery to pre-crisis peak levels

Output Contraction

4 yrs

LTCM/ Russian Crisis


4.6%


0.8%

1990s: LTCM / Russian Crisis

Peak to Trough


Phase

-1.3% 1 yr

Output Contraction

2 yrs

75

80

85

90

95

100

105

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002


Global Financial Turmoil Episodes and Investment Performance*(LAC-7, Gross fixed capital formation, real indices)

65

70

75

80

85

90

95

100

105

19

74

19

75

19

76

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

Debt Crisis


6.8% Avg. growth 1981-1985:

-4.3%

1980s: Debt Crisis

Peak to Trough


Phase

-27.6% 2 yrs

Output Contraction

11 yrs


1990s: LTCM / Russian Crisis

LTCM/ Russian Crisis


8.5%


-4.0%

Peak to Trough


Phase

Output Contraction

60

65

70

75

80

85

90

95

100

105

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

-13.9% 1 yr 7 yrs



Global Financial Turmoil Episodes and Social Impact:An Ilustration from Argentina and Uruguay*(% of people under the poverty line)


Argentina 90s: LTCM / Russian Crisis

Recovery to pre-crisis

trough levelsTrough to peak

30% 9 yrs

24%

LTCM / Russian Crisis

54%

20

25

30

35

40

45

50

55

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

23%

Uruguay 90s: LTCM / Russian Crisis

10

15

20

25

30

35

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006


Trough to peak

16%


trough levels

7+ yrs

17%

32%

25%



If recent episodes of capital market turbulence are any indication, the If recent episodes of capital market turbulence are any indication, the unfolding of a full blown global financial turmoil episode, would be a unfolding of a full blown global financial turmoil episode, would be a ‘lethal combo’. Given past experience, it will send once again Latin ‘lethal combo’. Given past experience, it will send once again Latin America diving.America diving.

Recent Episodes of Global Financial Turbulence (US High Yield Spread, basis points)


Expectations of Fed

Tightening

Greenspan’s Conundrum Testimony US Inflation

ScareSubprime

Crisis

China’s Stock Market Sell Off

100

200

300

400

500

600

700

800

900

1000

1100

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

X-Ray of Recent Episodes of Global Financial Turbulence

Data Sources: JPMorgan, Bloomberg and MSCI

(bond price equivalent*, peak to trough variation)Bond Prices

1.0%

0.6%

0.4%

-0.5%

-1.2%

-2.6%

-2.7%

-3.1%

-3.3%

-3.5%

-4% -3% -2% -1% 0% 1% 2%

Japan T-Bonds

Europe T-Bonds

US T-Bonds

AAA Corporate

BBB Corporate

EM Asia

EM Europe

EMBI

US High Yield

Latin America

* Own calculations assuming an 11% coupon and 10-year maturity

Credit Spreads(basis points, peak to trough variation)

-10

-9

-5

10

23

50

56

64

66

72

-20 0 20 40 60 80

Japan T-Bonds

Europe T-Bonds

US T-Bonds

AAA Corporate

BBB Corporate

EM Asia

EM Europe

EMBI

US High Yield

Latin America

Flight to Quality Flight to Quality

Commodity Prices(peak to trough variation)

-1.0%

-3.1%

-4.2%

-8.1%

-10.5%

-12% -10% -8% -6% -4% -2% 0%

Oil

AgriculturalProducts

Goldman Sachs

Gold

Industrial Metals

Commodity Index

+ 480 bps

LTCM / Russian CrisisTequila

CrisisAsian

Crisis

200

300

400

500

600

700

800

900

1000

1100

Jan

-94

Jan

-95

Jan

-96

Jan

-97

Jan

-98

Jan

-99

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

Jan

-08

Jan

-09

Jan

-10

(US High Yield Spread over US Treasuries)

Simulation of a Global Financial Turmoil Episode

10y Mov.Avg. + 1

10y Mov.Avg. + 2

“Combo Shock”: Simulation of Collateral Damage of a Global Financial Turmoil Episode

250

350

450

550

650

750

850

950

1050

Ma

r-0

0

Ma

r-0

1

Ma

r-0

2

Ma

r-0

3

Ma

r-0

4

Ma

r-0

5

Ma

r-0

6

Ma

r-0

7

Ma

r-0

8

Ma

r-0

9

Shock to the US High Yield Spread (bps, High Yield Spread over US

Treasuries)

+480 bps

3.5%

10Y Treasury Yield Dynamics (10Y T-Bond Yield)

4.0%

4.5%

5.0%

5.5%

6.0%

6.5%

Ma

r-0

0

Ma

r-0

1

Ma

r-0

2

Ma

r-0

3

Ma

r-0

4

Ma

r-0

5

Ma

r-0

6

Ma

r-0

7

Ma

r-0

8

Ma

r-0

9

Ma

r-1

0

-35 bps

Terms of Trade Dynamics (LAC-7, 91.I = 100)

95

100

105

110

115

120

125

130

135

140

Ma

r-0

0

Ma

r-0

1

Ma

r-0

2

Ma

r-0

3

Ma

r-0

4

Ma

r-0

5

Ma

r-0

6

Ma

r-0

7

Ma

r-0

8

Ma

r-0

9

Ma

r-1

0

-18%

G-7 Industrial Production Dynamics (1991.I = 100)

Ma

r-0

0

Ma

r-0

1

Ma

r-0

2

Ma

r-0

3

Ma

r-0

4

Ma

r-0

5

Ma

r-0

6

Ma

r-0

7

Ma

r-0

8

Ma

r-0

9

Ma

r-1

0

120

122

124

126

128

130

132

134

136

138

140

-1.5%

Estimation Strategy: Vector Error Correction Model (VECM) Estimation Strategy: Vector Error Correction Model (VECM)

tptpttt yyycy 1111 ...'

wherewhere

yt = ( gdp_latt ip_xt tot_latt financ_xt riskt )’

gdp_lat: (log of) Simple average of GDP indices of LAC-7 countries

ip_x: (log of) G-7 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: US High-Yield Bonds Spread

Booms and Busts in Latin America: The Role of External Factors*

*A. Izquierdo, R. Romero and E.Talvi (2007), “Booms and Busts in Latin America: The Role of External Factors”.

Booms and Busts in Latin America: The Role of External Factors*(GDP LAC-7, annualized quarter on quarter growth rate)

Actual

Fitted

-10%

-5%

0%

5%

10%

15%Tequila

CrisisAsian Crisis

Dec

-91

Dec

-92

Dec

-93

Dec

-94

Dec

-95

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05


A Vector Error Correction Model

*A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.

Commodity Prices

World Growth

External Factors

International Financial Conditions

US T-Bond Interest Rate

Spread on US HY Bonds

Steady State GDP Dynamics

90

95

100

105

110

115

120

125

130

135

140

-4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

GDP Dynamics w. “Combo Shock”

Output Performance: Simulation of the Overall Impact of a Global Financial Turmoil Episode

Output Response to “Combo Shock”*

*Impulse response simulations based on the model by A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.


peak levels

Peak to Trough

Duration of Recession Phase

Output Contraction

-4.5% 1.5 yrs“Combo Shock” 3.3 yrs

-5.4% 2 yrsDebt Crisis 4 yrs


-1.3% 1 yr 2 yrs




The analysis based on past experience is faulty, since the external The analysis based on past experience is faulty, since the external environment is less risky and Latin America’s fundamentals are much environment is less risky and Latin America’s fundamentals are much stronger today. Thus, the region is less vulnerable to global financial stronger today. Thus, the region is less vulnerable to global financial turmoil episodes than in previous expansions.turmoil episodes than in previous expansions.

The ‘This Time is Different’ Hypothesis

The World is a safer place The World is a safer place (“Great Moderation” period)(“Great Moderation” period)

US UK FRANCE GERMANY ITALY CANADA JAPAN

60s 70s 80s 90s 00s0,0

1,0

2,0

3,0

4,0

5,0

Real Interest Rates

(“perfect foresight” real ex-ante rates

for long term instruments) 1.6

3.0

2.4

1.3

0.9Excluding Japan 1.2

Growth, Inflation and Interest Rates Volatility in G-7 Countries(standard deviation)

0%

1%

2%

3%

4%

5%

6%

7%

Inflation

1.5%

3.9%3.7%

1.5%

0.6%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Economic Growth

1.6%2.0% 2.1% 2.1%

1.4%

The ‘This Time is Different’ Hypothesis

The World is a safer place The World is a safer place ( “Great Moderation” period)( “Great Moderation” period)

Latin America is more resilient than in Latin America is more resilient than in previous expansionsprevious expansions

Latin America: Growth and Inflation

Source: WEO

90s Boom Current BoomLTCM / Russian Crisis

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

6,26,0 6,1

1992

1994

1996

1998

2000

2002

2004

2006

1991

1993

1995

1997

1999

2001

2003

2005

91-97

Average:

4,6%

03-06

Average:

5,4%

74-06

Average:

3,2%

Inflation(LAC-7, CPI annual variation)

*Median

0%

5%

10%

15%

20%

25%

30%

35%

40%

Mar

-91

Mar

-92

Mar

-93

Mar

-94

Mar

-95

Mar

-96

Mar

-97

Mar

-98

Mar

-99

Mar

-00

Mar

-01

Mar

-02

Mar

-03

Mar

-04

Mar

-05

Mar

-06

4.1%


Average 91.I-98.II: 20.3%

Average 98.II-02.IV: 6.2%

Growth Performance(LAC-7, real annual growth rate)

% o

f G

DP

Mill

ion

s o

f U

SD

Millions of USD

% of GDP


-85,000

-65,000

-45,000

-25,000

-5,000

15,000

35,000

55,000

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

-7%

-5%

-3%

-1%

1%

3%

5%

Dec.02-Aug.07

Variation: 147%


Jan.91-Jun.98

Variation: 271%

Jun.98-Dec.02 Variation:

-15%

15

45

75

105

135

165

195

225

255

285

315

345

375

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

External Balance(LAC-7, current account, in millions of USD and % of GDP)

International Reserves(LAC-7, billions of US dollars)

Latin America: External Balance and International Reserves

Colombia 2.2

Argentina 1.9

Peru 2.3

Mexico 2.4

Aug.07/Jun.98

LAC-7 2.1

2.3Brazil

Venezuela 1.8

Chile 1.0

-4.9%

3.5%

173

363

Latin America: Fiscal Stance and Latin America: Fiscal Stance and Debt ManagementDebt Management

-3,5%

-3,0%

-2,5%

-2,0%

-1,5%

-1,0%

-0,5%

0,0%

0,5%

1,0%

1,5%

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006


-2.7%

1.0%

*Adjusted by Argentina’s debt exchange


39%

20%

25%

30%

35%

40%

45%

50%

55%

60%

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Public Debt Level*(LAC-7, % of GDP)

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

40%

Dollarization of Publc Debt(LAC-7, foreign currency debt, % of total debt)

Source: Cowan, Levy, Panizza, Sturzenegger (2006) and own calculations based on official data.

34%

Fiscal Balance(LAC-7, % of GDP)

61%

Latin America: Credit Ratings(LAC-9** excluding Ecuador, Standard & Poor´s Credit Ratings)

7,5

8,0

8,5

9,0

9,5

10,0

10,5

11,0

Jun-

03

Oct

-03

Feb

-04

Jun-

04

Oct

-04

Feb

-05

Jun-

05

Oct

-05

Feb

-06

Jun-

06

Oct

-06

Feb

-07

Jun-

07

AAA21

AA+20

AA19

AA-18

A+17

A16

A-15

BBB+14

BBB13

BBB-12

BB+ 11

BB10

BB-9

B+8

B7

B-6

CCC+5

CCC4

CCC-3

CC2

SD1

*A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” *A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” (forthcoming)(forthcoming)

Numerical Transformation of Credit Ratings*

B+

BB+

InvestmentGradeInvestment Grade

ChileColombia

Mexico

Investment Grade

Chile

Mexico

** LAC-9 includes the Latin American countries currently covered by JPMorgan EMBI** LAC-9 includes the Latin American countries currently covered by JPMorgan EMBI





At closer look, the world is still a risky place and Latin America’s At closer look, the world is still a risky place and Latin America’s underlying vulnerabilities to a global financial turmoil episode are still underlying vulnerabilities to a global financial turmoil episode are still large, but the current bonanza is disguising a host of fundamental large, but the current bonanza is disguising a host of fundamental fragilities.fragilities.

The World is still a risky placeThe World is still a risky place

‘‘Plus Ça Change, Plus Ça Reste La Même Chose’ Plus Ça Change, Plus Ça Reste La Même Chose’ ((The more things change, the more they remain the same)The more things change, the more they remain the same)

Great Moderation?The Calm Before the Storm…

Moody’s Baa Corporate

Spread

(basis points)

Moody’s Baa Corporate Spread

Volatility

(3 year moving standard deviation,

in basis points)

0

50

100

150

200

250

300

350

400

450

0

10

20

30

40

50

60

70

80

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

Debt Crisis LTCM / Russian Crisis

116

24

375

66

169

11

379

48

165

15

1978-2007 Avg.

1978-2007 Avg.

Mean+2

The Global Financial Turmoil Histogram(Moody’s Baa Spread Histogram, 1978 – 2007)

0%

1.4%

2.8%

4.2%

5.6%

7.0%

8.4%

9.8%

11.2%

12.6%90 11

0

130

150

170

190

210

230

250

270

290

310

330

350

370

390

Global Financial Turmoil Probability: 4.5%

Mean+1

Latin America’s fundamentals are weaker Latin America’s fundamentals are weaker than meets the eyethan meets the eye

The World is still a risky placeThe World is still a risky place

‘‘Plus Ça Change, Plus Ça Reste La Même Chose’ Plus Ça Change, Plus Ça Reste La Même Chose’ ((The more things change, the more they remain the same)The more things change, the more they remain the same)

Assessing Performance in Latin America: A Counterfactual Exercise*

Forecast for GDP: 2003 – 2006(LAC-7, Values in logs)

Forecast for GDP: 1998 – 2001(LAC-7, Values in logs)

4.54

4.56

4.58

4.60

4.62

4.64

4.66

4.68

4.70

4.72

Mar

-97

Jul-9

7

Nov

-97

Mar

-98

Jul-9

8

Nov

-98

Mar

-99

Jul-9

9

Nov

-99

Mar

-00

Jul-0

0

Nov

-00

Mar

-01

Jul-0

1

Nov

-01

Observed GDP

*Simulations based on the model by A. Izquierdo, Romero, R., and Talvi, E. (2007), “Booms and Busts in Latin America: The Role of External Factors”.

Predicted GDP w. Observed

External Factors

4.58

4.63

4.68

4.73

4.78

4.83

Mar

-02

Jul-0

2

Nov

-02

Mar

-03

Jul-0

3

Nov

-03

Mar

-04

Jul-0

4

Nov

-04

Mar

-05

Jul-0

5

Nov

-05

Mar

-06

Jul-0

6

Observed GDP

90% confidence interval

Steady State GDP

90% confidence interval

Predicted GDP w. Observed

External Factors

Steady State GDP

% o

f G

DP

Mill

ion

s o

f U

SD

Millions of USD

% of GDP


Latin America External Balance: A Different Perspective* (LAC-7, current account, in millions of USD and % of

GDP)

Terms of Trade Adjusted at I.2002

prices

-85,000

-65,000

-45,000

-25,000

-5,000

15,000

35,000

55,0001

99

0

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

-7%

-5%

-3%

-1%

1%

3%

5%

* G. Calvo and Talvi, E. (2007): “Current Account Surplus in Latin America: Recipe Against Capital Market Crises?”; www.rgemonitor.com (forthcoming)

-4.9%

-4.5%

Reserves / M2

Latin America: International Reserves (billions of US dollars and % of M2)


Reserves

Source: IFS and own calculations

Bill

ions

of U

S d

olla

rs

% o

f M2

20

40

60

80

100

120

140

160

180

200

220

240

260

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

30%

35%

40%

45%

50%

55%

60%

Average 1991.I-1998.II: 45.6%Average 1991.I-1998.II: 45.6%

Average 1998.II-Average 1998.II-2002.IV: 40.3%2002.IV: 40.3%

Average 2002.IV – Average 2002.IV – 2006.III: 48.3%2006.III: 48.3%

M2 = Currency outside banks + demand deposits + time, savings and foreign currency deposits of resident sectors

Latin America: Structural Fiscal Balance*

1.0%Observed Balance

LAC-7 (% of GDP)

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

Dec

-91

Dec

-92

Dec

-93

Dec

-94

Dec

-95

Dec

-96

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Beginning of Current Boom

LTCM / Russian

Crisis

*A. Izquierdo, Ottonello, P., Talvi, E. (forthcoming), “ *A. Izquierdo, Ottonello, P., Talvi, E. (forthcoming), “ If Latin America Were Chile: A Comment on Structural Fiscal Balances and Public DebtIf Latin America Were Chile: A Comment on Structural Fiscal Balances and Public Debt” .” .

Structural Balance

Chile (% of GDP)

-5,0%

-3,0%

-1,0%

1,0%

3,0%

5,0%

7,0%

9,0%

Dic

-91

Dic

-92

Dic

-93

Dic

-94

Dic

-95

Dic

-96

Dic

-97

Dic

-98

Dic

-99

Dic

-00

Dic

-01

Dic

-02

Dic

-03

Dic

-04

Dic

-05

Dic

-06

LTCM/ Russian

Crisis


Observed Balance

Structural Balance

-4.5%

-3.1%

Structural Balance**

**Excluding Venezuela

-2.7%

-2.4%

Latin America: Fiscal Revenues and Expenditures*

Fiscal Expenditures

LAC-7 (Mar-91 = 100)

Fiscal Revenues

Adjusted Revenues

80

100

120

140

160

180

200

220

240

260

280

Mar

-91

Mar

-92

Mar

-93

Mar

-94

Mar

-95

Mar

-96

Mar

-97

Mar

-98

Mar

-99

Mar

-00

Mar

-01

Mar

-02

Mar

-03

Mar

-04

Mar

-05

Mar

-06


LTCM / Russian

Crisis


Fiscal Expenditures

Chile (Mar-91 = 100)

80

130

180

230

280

Ma

r-9

1

Ma

r-9

3

Ma

r-9

5

Ma

r-9

7

Ma

r-9

9

Ma

r-0

1

Ma

r-0

3

Ma

r-0

5

LTCM/ Russian

Crisis


Fiscal Revenues

Adjusted Revenues

Prociclicality in Public Expenditures

(in % of increase in fiscal revenues, 2002-2006)

0%

20%

40%

60%

80%

100%

Increase in Public Expenditures for LAC-7

25%

57%

73%

76%

85%

87%

92%

0% 20% 40% 60% 80% 100%

Chile

Peru

Colombia

Argentina

Mexico

Brasil

Venezuela

(in % of increase in fiscal revenues, 2002-2006)

Increase in Public Expenditures per Country

68%Primary

Expenditures

Interest Payments 2%

Increase in Total Revenues

Latin America: Structural Debt: Structural Debt(LAC-7, in % of GDP)

30%

35%

40%

45%

50%

55%1

99

0

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

Observed Debt

Current Boom90s Boom LTCM / Russian Crisis

52%

39%

49%

32%

48%

42%Structural Debt


November 1994

66.9%

November 1998

88.1%

December 1993

4.9%

August 1997

28.3%

Debt Mutation: Two Compelling Examples*

Pre-Asian Crisis Pre-Devaluation Pre-Tequila

CrisisPre-Devaluation

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Brazil(Federal Domestic Securities, exchange rate

linked + Selic linked, % of total debt)

0%

10%

20%

30%

40%

50%

60%

70%

80%

Mexico(Federal Government Domestic Securities, exchange rate

linked Tesobonos, % of total debt)

* E. Cavallo, Izquierdo, A., and Talvi, E. (in progress), “* E. Cavallo, Izquierdo, A., and Talvi, E. (in progress), “External Financial Conditions and Debt Composition: the Mutation FactorExternal Financial Conditions and Debt Composition: the Mutation Factor”.”.





At closer look, the world is still a risky place and Latin America’s At closer look, the world is still a risky place and Latin America’s underlying vulnerabilities to a global financial turmoil episode are still underlying vulnerabilities to a global financial turmoil episode are still large, but the current bonanza is disguising a host of fundamental large, but the current bonanza is disguising a host of fundamental fragilities.fragilities.

The evidence from credit ratings and the behavior of asset prices is The evidence from credit ratings and the behavior of asset prices is consistent with the view that Latin America is still vulnerable to global consistent with the view that Latin America is still vulnerable to global turmoil, but financial shocks so far have been “too small to hurt”.turmoil, but financial shocks so far have been “too small to hurt”.

Credit Ratings Agencies Verdict

*A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” (forthcoming)*A. Powell and J.F. Martinez, (2007), “On Emerging Economy Spreads and Ratings” (forthcoming)

Dic

-96

Dic

-97

Dic

-98

Dic

-99

Dic

-00

Dic

-01

Dic

-02

Dic

-03

Dic

-04

Dic

-05

Dic

-06

7,5

8,0

8,5

9,0

9,5

10,0

10,5

11,0

BB+BB+

BB

AAA21

AA+20

AA19

AA-18

A+17

A16

A-15

BBB+14

BBB13

BBB-12

BB+ 11

BB10

BB-9

B+8

B7

B-6

CCC+5

CCC4

CCC-3

CC2

SD1

Numerical Transformation of Credit Ratings*

InvestmentGrade

(LAC-9 excluding Ecuador, Standard & Poor´s Credit Ratings)

Investment Grade

ChileColombiaMexico

Investment Grade

ChileMexico

Russian Crisis

Investment Grade

ChileColombiaUruguay

Systemic Turmoil Period

(US High Yield and Latin EMBI spreads, basis points)

Relatively Tranquil Recent Period

Let Prices Talk: EMBI Spreads Reaction to Spikes in US High Yield Spreads

0

400

800

1200

1600

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Latin EMBI

US High Yield

Recent Period Average

19-Apr to 17-May-04

10-Mar to 18-May-05

10-May to 27-Jun-06

26-Feb to 7-Mar-07

23-Jul to 16-Aug-07

55

158

43

30

90

77

80

47

20

49

1.4

0.5

1.1

0.7

0.5

0.8

Dating Δ US HY Spread

Δ LA EMBI Spread

Naïve Beta

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

1.3Systemic Turmoil Period Average

(1) (2) (3) (4)

(3) / (2)

Measuring Contagion:The Forbes-Rigobon Adjustment*

11

utt

ut

2

t

Correlation Adjustment

where is the actual correlation coefficient and

is the unadjusted correlation coefficient

t t

u

*K. Forbes and Rigobon E. (1999), “No Contagion, Only Interdependence: Measuring Stock Market Co-Movements”

y

x

Beta Coefficient

where is the correlation coefficient between x and y,

and and are the variance of x and y,

respectively

x

y

1l

h

t

xx

xx

Variance Adjustment Coefficient

where is the variance of x during a period of market

turmoil and is the variance of x during a period of

relative market stability

xh

x lx

x


1.27


0.86

*Adjusted using Forbes, Rigobon (1999) methodology

0.76*

Beta Coefficient(average beta per period,

US high yield vs. Latin EMBI)

0.2

0.4

0.6

0.8

1.0

1.2

1.4


(US High Yield and Latin EMBI spreads, basis points)

0

400

800

1200

1600

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Latin EMBI

US High Yield


Let Prices Talk: EMBI Spreads Reaction to Spikes in US High Yield Spreads

IN SUMMARY

When scratching the surface, Latin America is still highly vulnerable to a global financial turmoil episode

This analysis should not be construed as a gloomy forecast, but rather as a warning against “irrational exuberance”.

Although we should enjoy the good times, policy makers in the region should be on guard and fire departments (i.e. multilaterals) in full alert mode





Ernesto TalviErnesto Talvi

Prepared for Presentation at the XXVI Meeting of the Latin American Prepared for Presentation at the XXVI Meeting of the Latin American Network of Central Banks and Finance Ministries, IADB, Washington DCNetwork of Central Banks and Finance Ministries, IADB, Washington DC

October 16October 16thth, 2007, 2007

CERESCERES

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