All of which will put a new premium on trade competitivenessâeven to preserve the same .... development policies will
LATIN‐AMERICA BEYOND THE CRISIS IMPACTS, POLICIES AND OPPORTUNITIES
AMÉRICA LATINA MÁS ALLÁ DE LA CRISIS IMPACTOS, POLÍTICAS Y OPORTUNIDADES
Table of Contents LATIN‐AMERICA BEYOND THE CRISIS—IMPACTS, POLICIES AND OPPORTUNITIES— A SYNTHESIS Marcelo M. Giugale .............................................................................................................................. 1 AMÉRICA LATINA MÁS ALLÁ DE LA CRISIS—IMPACTOS, POLÍTICAS Y OPORTUNIDADES—UNA SÍNTESIS Marcelo M. Giugale .............................................................................................................................. 7 PART I ‐ WORKING PAPERS 1. THE GLOBAL FINANCIAL AND ECONOMIC STORM: HOW BAD IS THE WEATHER IN LATIN AMERICA AND THE CARIBBEAN? Augusto de la Torre............................................................................................................................. 13 2.
REGULATORY REFORM: INTEGRATING PARADIGMS Augusto de la Torre and Alain Ize ....................................................................................................... 23
3.
HOW HAS POVERTY EVOLVED IN LATIN AMERICA AND HOW IS IT LIKELY TO BE AFFECTED BY THE ECONOMIC CRISIS? Joao Pedro Azevedo, Ezequiel Molina, John Newman, Eliana Rubiano and Jaime Saavedra............. 55
4.
LABOR MARKETS AND THE CRISIS IN LATIN AMERICA AND THE CARIBBEAN (A PRELIMINARY REVIEW FOR SELECTED COUNTRIES) Samuel Freije‐Rodríguez and Edmundo Murrugarra .......................................................................... 81
PART II ‐ TECHNICAL NOTES 5. HOW MUCH ROOM DOES LATIN AMERICA AND THE CARIBBEAN HAVE FOR IMPLEMENTING COUNTER‐CYCLICAL FISCAL POLICIES? Cesar Calderón and Pablo Fajnzylber.................................................................................................. 97 6.
CRISIS IN LAC: INFRASTRUCTURE INVESTMENT AND THE POTENTIAL FOR EMPLOYMENT GENERATION Laura Tuck, Jordan Schwartz and Luis Andres .................................................................................. 108
7.
HOW WILL LABOR MARKETS ADJUST TO THE CRISIS? A DYNAMIC VIEW William Maloney............................................................................................................................... 115
8.
WHAT IS THE LIKELY IMPACT OF THE 2009 CRISIS ON REMITTANCES AND POVERTY IN LATIN AMERICA AND THE CARIBBEAN? Gabriel Demombynes, Hector Valdés Conroy, Ezequiel Molina and Amparo Ballivián .................... 123
9.
WILL FDI BE RESILIENT IN THIS CRISIS? Cesar Calderon and Tatiana Didier ................................................................................................... 129
10. PATTERNS OF FINANCING DURING PERIODS OF HIGH RISK AVERSION: HOW HAVE LATIN FIRMS FARED IN THIS CRISIS SO FAR? Tatiana Didier ................................................................................................................................... 135
Additional References: World Bank Documents on the Current Global Crisis World Bank Reports • •
Global Development Finance 2009: Charting a Global Recovery. The World Bank, Washington DC, 2009. http://web.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTDECPROSPECTS/EXTGDF/EXTGDF2009/0,,contentMDK:222183 27~menuPK:5924239~pagePK:64168445~piPK:64168309~theSitePK:5924232,00.html Global Monitoring Report 2009: A Development Emergency. The World Bank, Washington DC, 2009. http://web.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTGLOBALMONITOR/EXTGLOMONREP2009/0,,contentMDK:2214 9019~pagePK:64168445~piPK:64168309~theSitePK:5924405,00.html
Macroeconomics and Finance • •
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“Global Financial Crisis and Implications for Developing Countries.” G20 Finance’s Ministers Meeting. Sao Paulo, Brazil. November, 2008. World Bank. http://www.worldbank.org/html/extdr/financialcrisis/pdf/G20FinBackgroundpaper.pdf “Weathering the Storm: Economic Policy Responses to the Financial Crisis.” Poverty Reduction and Economic Management Network, World Bank, Washington DC. November, 2008. http://siteresources.worldbank.org/NEWS/Resources/weatheringstorm.pdf Borchert, Ingo and Mattoo, Aaditya. “The Crisis‐Resilience of Services Trade.” Policy Research Working Paper 4910. November, 2008. World Bank, Washington DC. http://econ.worldbank.org/external/default/main?ImgPagePK=64202990&entityID=000158349_20090428090316&menu PK=64210521&pagePK=64210502&theSitePK=544849&piPK=64210520 Caprio Jr, Gerard, Demirgüç‐Kunt, Asli and Kane, Edward J. “The 2007 Meltdown in Structured Securitization: Searching for Lessons, Not Scapegoats.” Policy Research Working Paper 4756. October, 2008. Finance and Private Sector Team, World Bank, Washington DC. http://econ.worldbank.org/external/default/main?pagePK=64165259&piPK=64165421&theSitePK=469372&menuPK=642 16926&entityID=000158349_20081125132435 Development Research Group. “Lessons from World Bank Research on Financial Crises.” Policy Research Working Paper 4779. November, 2008. World Bank, Washington DC. http://econ.worldbank.org/external/default/main?pagePK=64165259&theSitePK=469372&piPK=64165421&menuPK=641 66093&entityID=000158349_20081216093241 Financial Crisis Website. The World Bank, Washington DC, 2009. http://www.worldbank.org/html/extdr/financialcrisis/ Lin, Justin Yifu. “The Impact of the Financial Crisis on Developing Countries.” Korea Development Institute. October, 2008. World Bank, Washington DC. http://siteresources.worldbank.org/DEC/Resources/Oct_31_JustinLin_KDI_remarks.pdf World Bank Financial Systems and Development Economics Department. “The Unfolding Crisis: Implications for Financial Systems and Their Oversight.” Financial Systems and Development Economics Departments, World Bank, Washington DC. October, 2008. http://www.worldbank.org/html/extdr/financialcrisis/pdf/UnfoldingCrisis.pdf
Social Impact • •
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“How Should Labor Market Policy Respond to the Financial Crisis?” Human Development and Poverty Reduction and Economic Management Networks, World Bank, Washington DC. 2009. http://siteresources.worldbank.org/INTLM/Resources/Note‐LM_Crisis_Response_26April.pdf “The Financial Crisis and Mandatory Pension Systems in Developing Countries.” Human Development Network, World Bank, Washington DC. 2008. http://siteresources.worldbank.org/INTPENSIONS/Resources/395443‐ 1121194657824/PRPNote‐Financial_Crisis_12‐10‐2008.pdf Ravallion, Martin. “Bailing out the World’s Poorest.” Policy Research Working Paper 4763. October, 2008. Development Research Group, World Bank, Washington DC. http://www-
wds.worldbank.org/external/default/WDSContentServer/IW3P/IB/2008/12/16/000158349_2 0081216092058/Rendered/PDF/WPS4763.pdf http://econ.worldbank.org/external/default/main?pagePK=64165259&piPK=64165421&theSitePK=469372&menuPK=642 16926&entityID=000158349_20081216092058
LATIN‐AMERICA BEYOND THE CRISIS—IMPACTS, POLICIES AND OPPORTUNITIES—A SYNTHESIS Marcelo M. Giugale1 Introduction and Summary Over the past five years, good policies and good luck had put Latin‐America on a path to prosperity.2 Slowly the mass of its poor was shrinking. In most countries, out went inflation, default, isolation, exclusion, uncertainty. In came budget surpluses, investment grades, free‐trade agreements, cash transfers, institutions. There was still a long way to go, but progress was real. But just when things seemed on track, the first global financial crisis in almost a century reaches the region—and will hit it hard. From fast growth, its economy will suddenly go in reverse. During this difficult period, the World Bank has sought to assist its Latin‐American clients with a package of rapid financial assistance (it tripled its lending) and a large body of crisis‐related policy advice. This paper synthesizes that body of advice.3 It is organized around three core questions: (i) (ii) (iii)
How will the crisis impact the region? Slowly and harshly, but without catastrophe; How should Latin governments respond? With focused social assistance, tailored macro stimuli, support for the unemployed, and securing debt roll‐overs; What issues will dominate the post‐crisis regional agenda? The rebalancing of the world’s economy, short‐term growth management, the middle‐class, a new contract between people and the state, the regulation of finance, and global synergies.
Impacts The global crisis has entered Latin‐America through four contractions—in external financing (notably, private trade finance), demand for exports, commodity prices and remittances. Different from previous, home‐grown episodes, there have been no massive currency devaluations, bank collapses, debt defaults, inflationary spikes or capital flights. In fact, most countries in the region had, and continue to have, liquid and solvent banking systems, primary fiscal surpluses, and manageable debt burdens. Half a dozen of them also have central banks that have successfully committed to inflation targets, and now find themselves able to allow for flexibility in their foreign exchange rates. So, given the quality of its macroeconomic framework, what will be the main consequences of the crisis in Latin‐America? There will be five. First, recession. The region’s average growth will shift from over 4 percent p.a. in 2008 to minus 2‐2.5 percent in 2009. These averages hide important differences across 1
The author is the World Bank’s Director of Poverty Reduction and Economic Management for the Latin‐American and Caribbean region. The views expressed in this note are his own, and do not necessarily represent those of the World Bank Group, its Board of Executive Directors, or its member countries. 2 This paper uses the term “Latin‐America” as a short‐hand for Latin‐American and the Caribbean region. 3 The technical notes presented in this compilation can be found in the LCR Crisis Briefs Series at: http://go.worldbank.org/2IWPN6MH20.
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countries, but very few of them will escape the downturn (Panama, Peru). Growth will return in 2010, but it is likely to be slow (1‐2 percent p.a.) and uneven. Second, poverty will increase. The World Bank estimates that the crisis will push eight million Latin‐ Americans into poverty.4 To put that in perspective, sixty million of them had left poverty during 2002‐ 2008, thanks to faster growth, smarter social policies, and larger remittances. But the crisis is expected to be unusually harsh on the region’s middle class—mostly because of the fall in the demand for non‐ traditional exports that employ formal, urban, technologically‐more‐advanced workers. Third, unemployment will also increase. All countries for which timely data is available, show short‐term rises in unemployment rates—so far between half and a full percentage point. But the reasons for the rise vary. In some cases (Brazil, Chile, Mexico), it is primarily salaried workers who either lost their jobs or saw job openings shrink; in others (Colombia), it is the self‐employed who are suffering the brunt of the recession. Wages are falling in some sectors in real terms. Informality is expected to expand, and productivity may suffer as a result. Fourth, there will be less foreign financing. By the time the global crisis broke out (last quarter of 2008), Latin‐American sovereign borrowers had by and large secured the foreign financing they needed for 2009. Corporations, on the other hand, face a much tighter financial outlook. This is not surprising as net private capital flows to emerging markets for the year are projected to dive to less than US$200 billion—a fraction of its almost one trillion dollars peak in 2007. More importantly, foreign direct investment towards Latin‐America may no longer show the resilience of previous crisis, for the flow of mergers and acquisitions that sustained it then (“fire‐sale FDI”) will not be forthcoming now. Fifth, there will be less remittances. In 2008, the 20 million Latin‐Americans living abroad managed to send home some US$60 billion (a third to Mexico). This made remittances one of the region’s largest foreign currency earners. Those flows will decline between 4 and 8 percent in 2009, and may continue to decline as long as the housing market in the G7 does not recover. And, if the global recovery does not materialize in 2010, a significant number of Latino migrants might return to their countries of origin. Policy Responses – Today’s Priorities Latin‐American governments reacted swiftly to the crisis and, on the whole, appropriately. This has defined a short‐term policy agenda that is not entirely similar to the one observed among G7 countries—and rightly so. For the region, the first priority continues to be to avoid a permanent loss of human capital. This is because its countries have a fairly advanced system of social assistance (thirteen of them make direct cash transfers to their poor) but lack a comprehensive system of social insurance (both unemployment and pensions benefits cover only a fraction of the population). The latter automatically reacts to falls in income; the former doesn’t. As a result, past crises in Latin‐America quickly translated into increases in malnutrition, high‐school drop‐outs, and interruptions in the provision of preventive and primary health care. In other words, the crises translated into losses of cognitive capacity amongst young children, a life of informal work for more teenagers, and jumps in mortality rates among adults—even in otherwise middle‐income countries. The mechanisms to avoid those impacts are in place (from school feeding programs to decentralized health budgets), and the costs involved are relatively small (possibly less than a tenth of one percent of GDP). At the same time, Latin‐American governments will need to see through the various stimulus packages that they have put in place. By necessity, those packages have had a limited scope. On the fiscal side, 4
Poverty is defined here as US$4 PPP per day.
2
room for counter‐cyclical policies is small in all but a few countries (Chile, Brazil, Colombia). This is due to a combination of traditionally low tax collection, insufficient institutional capacity to implement additional public investment quickly enough, and a dearth of lenders willing to finance enlarged fiscal deficits at a time of global crisis. Put differently, fiscal stimulus has been easier for those that saved during the years of bonanza. Things look better on the monetary side. Several countries in the region have built their inflation‐fighter credentials during the period of fast growth and now find themselves able to cut interest rates and let their currencies depreciate to stimulate domestic and external demand, without risking a rise in inflationary expectations.5 More fundamentally, Latin‐America as a whole has not resorted to state ownership as a means of stimulus: governments have not had to take over private corporations, and central banks have not had to open their balance sheets to fund either of them directly. There have been no “bail‐outs” and no “quantitative easing”. The institutional equilibrium built over the past decade has been largely preserved. However, the crisis is beginning to seriously challenge Latin‐America on two fronts—unemployment and debt. As mentioned before, job losses have so far not been massive. But, as global export demand continues to stagnate through 2010 and, perhaps, beyond, non‐extractive export industries will shed labor at accelerating speed. This will raise political pressure for government action, not least because the shedding will disproportionally affect the middle class. And few countries in the region have in place unemployment insurance systems with sufficient coverage. Some have worked on expanding that coverage (Brazil, Mexico). But, for the most part, efforts have focused on labor intermediation services, training, tax relief for small enterprises, subsidies to youth employment, state‐led temporary employment, and larger budgets for cash transfer programs. Whether these interventions work will depend on what form the recession takes. A short‐and‐sharp “V” shape downturn argues for transitory transfers to smooth the temporary fall in income, while a longer “U” or “L” shape contraction that causes changes in the productive structure calls for programs that facilitate inter‐sectoral adjustments— like retraining. Independently of the shape of the recession (as of now, an unknown), the region’s governments have turned to public investment as an employment generation tool. They have pledged some US$ 25 billion in additional public works over 2009; data on actual execution is not available yet. The World Bank estimates that, on average, implementing US$ 1 billion of additional infrastructure outlays in Latin‐ America employs 40,000 people, depending on the mix of sectors, technology, wages and leakage to imports.6 And the number of permanent jobs created in the economy as a result of those outlays can reach several times that figure. For all the difficulties involved in employment generation, they may be dwarfed by, and will be framed in, the region’s financing needs. The World Bank estimates that, in 2010, Latin‐American governments will need to borrow between US$350 and 400 billion dollars. That assumes no major fiscal deterioration. It is mostly driven by amortizations coming due. For their part, private corporations will need an estimated US$200 billion next year. Little or no funding has so far been secured by either sovereign or private borrowers—unlike what happened during 2008 with 2009 obligations. At the same time, the international supply of finance will be constrained, even for investment‐grade borrowers, by the crowding‐out effect of the borrowing done by developed nations to pay for their own stimulus packages. And many of the traditional intermediaries of Latin‐American debt (notably investment banks) are currently out of commission or out of business. All this will shift some, perhaps as much as 5
Brasil, Chile, Colombia, Guatemala, México, Perú and Uruguay have set up formal inflation‐targeting arrangements. 6 Rural road maintenance appears to be the outlay with the largest employment impact: 200,000 to 500,000 jobs per billion dollars.
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half, of the borrowing towards domestic sources—in the few countries that can count on those sources. But it still leaves a large gap. And the ability to roll‐over debt remains the largest single risk in the region’s short‐term horizon. Policy Responses – Tomorrow’s Opportunities For all the problems the crisis will cause to Latin‐America, it can also become the event that finally unleashes the region’s enormous potential. A broad agenda of reforms may now, or soon, be possible, based on an unprecedented constellation of new economic realities, political will and technical advances. The first of those realities is that world growth will no longer be driven by G7 countries consuming beyond their means. At the margin, emerging markets will need to rebalance their export‐led growth models towards domestic absorption. In Latin‐America, this will be easier for the larger countries, but will put smaller economies to the test. Many, large and small, will see their currencies uncomfortably appreciate. All of which will put a new premium on trade competitiveness—even to preserve the same slice of a smaller trade cake. Many of the long‐delayed reforms that make integration worthy, from infrastructure and logistics to tertiary education and property rights, will now become inescapable. At the same time, the crisis has brought about a new faith in the power of public investment to affect growth in the short term. This may transform that investment, for it will cease to be a de facto source of funding—cut whenever revenues fall or current expenditures rise. Much as in the early 1990s concerns about inflation forced the region’s governments to surrender money printing as a source of fiscal deficit financing, concerns about recession may now force them to formally link public investment to short‐ term growth prospects—systematically doing more in the downturn and saving during upturns. It may also lead the marginal dollar of public investment towards projects that bring bigger private contributions, as they will have the largest total impact on growth. And it may usher a much‐needed improvement in implementation capacity. Of course, the technical and institutional issues around giving public investment a growth stabilization role are not minor. But the core principle of saving in good times to spend in bad ones made its debut in Latin‐America during this crisis (in Chile), and it has proven a success that many will seek to replicate. The crisis may also transform social policy in Latin‐America, making it much more about equity than equality, that is, more about giving all the same opportunities rather than the same rewards. This will help the region progress beyond a debate that has for far too long been politically divisive and strategically paralyzing—a debate about whether the very purpose of the state is to protect private property or to pursue wealth redistribution. A combination of factors will account for the transformation. On the one hand, the crisis revealed that the region’s social assistance systems are insufficient to respond to sudden economy‐wide contractions in income, especially among the middle classes. On the other, the technology to measure inequality of opportunities has recently become available and, more critically, operational.7 Both realities will unlock a long overdue effort to focalize universal subsidies—why should the state continue to pay for, say, the heating, gasoline or college education consumed by the rich? The end result will be a pattern of social policy more focused on giving the same chances to all.
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See Barros, R. P. de; F. H. G. Ferreira, J. R. Molinas Vega, and J. Saavedra Chanduvi, 2009, Measuring Inequality of Opportunity in Latin American and the Caribbean. New York: Palgrave Macmillian and Washington, DC: The World Bank.
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More broadly, the role of the state will change worldwide, and Latin‐America will be no exception. What is different in the region is that the relationship between its states and its people has long been one of mistrust—a manifestation of which is Latin‐Americans’ idiosyncratic reluctance to pay taxes. The crisis may become an opportunity to change that relationship, to reach a new contract. At a time when less resources will be available to the state but more will be expected of it—from regulating finance to facilitating job creation—the door opened to begin to base public sector management on results. The technology is now available to connect public action, and more particularly public expenditures, to specific outcomes—in education, in health, in infrastructure, in public services. Several countries of the region were moving that way before the crisis, at both federal and sub‐national levels. That move is now likely to become the norm. Result‐based management of the state will put a framework to its interventions in many sectors where it had been less active in the past. Nowhere will that be clearer than in finance. By and large, Latin‐ America avoided many of the mistakes that led to, and triggered, the implosion of financial markets in the developed world—no subprime lending, no off‐balance‐sheet risks, no exotic instruments. Much of this is due to over a decade of laborious improvements in regulatory and supervisory institutions. Those institutions will now be challenged by the sweeping reforms that the global financial industry is about undergo. Systemic risk regulation, capital requirements, the use of credit ratings, accounting norms and consumer protection are just some of the parameters of the industry that will change worldwide. How Latin‐America adopts and adapts those parameters may prove critical for a region that will increasingly have to rely on its own savings to develop.8 Finally, the crisis has revealed the breadth of global interconnectedness—witness the viral speed at which financial and trade flows collapsed across the world. The externalities created by the actions of individual countries have become so patent that quickly triggered the appearance of new or renewed mechanisms for global coordination and support. Many of those mechanisms are critical for post‐crisis Latin‐America, from the G20 (where Argentina, Brazil and Mexico participate) to the increases in lending capacity of multilaterals to a trade regime that remains open, fair and clean. Making the most of them is the opportunity of a generation. Conclusion ‐ The Day After Tomorrow, Latin‐America May Be Better So, as thresholds go, 2009 may be remembered as the year in which Latin‐America’s latest growth run abruptly ended. Or as the year in which an unprecedented global crisis shook the region onto a faster development path. Which way it goes will depend on how its policy‐makers respond, whether they tailor their reactions to their reality, see the opportunity behind the crisis, and proactively take on the issues that were holding Latinos back well before subprime became a household term. Clearly, Latin‐ American problems are not solely economic. The institutions that underpin politics are not fully cemented. Violence and the drugs trade that fuels it have their own dynamics. And nobody knows what development policies will work best in the post‐crisis world. But it remains true, and somewhat ironic, that a region that could not quite take off when the world was booming, could now make it on its own terms when the world tumbled.
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For a comprehensive framework of ideas on the new regulation of finance see De la Torre, A. and A. Ize, 2009, Regulatory Reform: Integrating Paradigms, World Bank Policy Research Working Paper 4842, February.
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AMÉRICA LATINA MÁS ALLÁ DE LA CRISIS—IMPACTOS, POLÍTICAS Y OPORTUNIDADES— SÍNTESIS
Marcelo M. Giugale9 Introducción y Resumen Durante los últimos cinco años, buenas políticas y buena suerte pusieron a América Latina en un sendero de prosperidad.10 Lentamente la masa de pobreza se redujo. La mayoría de los países comenzaron a dejar atrás la inflación, la bancarrota, el aislamiento, la exclusión, y la incertidumbre. Aparecíeron los superávit fiscales, los grados de inversión, los tratados de libre comercio, las transferencias directas a los pobres, las instituciones. Había todavía mucho camino por recorrer, pero el progreso era real y tangible. Pero cuando las cosas finalmente parecían estar en el camino correcto, la primera crisis financiera global en casi un siglo llega a la región—y la va golpeará con fuerza. Su economía pasará del crecimiento rápido a la recesión. Durante este periodo indudablemente difícil, el Banco Mundial ha buscado apoyar a sus clientes Latino‐americanos con un paquete de asistencia financiera rápida (triplicó su volumen de préstamos) y un compendio de análisis de políticas públicas para responder a la crisis. Este ensayo sintetiza ese compendio.11 Esta organizado alrededor de tres preguntas centrales: (i) (ii)
(iii)
¿Cómo afectará la crisis a la región? Lenta y duramente, pero sin catástrofe. ¿Cómo deberían responder los gobiernos latino‐americanos? Con asistencia social focalizada, estímulos macroeconómicos a medida, apoyo a los desempleados, y asegurando el refinanciamiento de deudas. ¿Cuáles son los temas que dominarán la agenda regional después de la crisis? El rebalanceo de la economía mundial, el manejo del crecimiento de corto plazo, la clase media, un nuevo contrato entre el estado y la gente, la regulación financiera, y las sinergias globales.
Impactos La crisis global ha entrado en América Latina a través de cuatro contracciones—en financiamiento externo (en especial para el comercio internacional privado), demanda por exportaciones, precios de las materias primas, y remesas. A diferencia de episodios nacionales anteriores, no ha habido devaluaciones masivas de la moneda, colapsos bancarios, bancarrotas, picos inflacionarios o fuga de capitales. De hecho, la mayoría de los países de la región tenían, y siguen teniendo, sistemas bancarios líquidos y 9
El autor es el Director de Política Económica y Programas de Reducción de Pobreza del Banco Mundial para América Latina. Las opiniones expresadas en este documento le pertenecen, y no necesariamente reflejan las del Grupo Banco Mundial, su Directorio, o las de sus países miembros. 10 En este documento, el término «América Latina» se usa como abreviación de « América Latina y el Caribe ». . 11 La colección completa de notas técnicas contenidas en este compendio son parte del LCR Crisis Briefs Series y pueden encontrarse en: http://go.worldbank.org/2IWPN6MH20.
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solventes, superávit fiscales primarios, y deudas manejables. Media docena de ellos también tienen bancos centrales que se han comprometido exitosamente con metas de inflación, y como consecuencia pueden ahora permitirse flexibilidad en sus tasas de cambio. Dada esa calidad en el marco macroeconómico, ¿cuáles serán las consecuencias principales de la crisis para América Latina? Serán cinco. Primero, recesión. El crecimiento promedio de la región pasara de más de 4 por ciento en el 2008 a menos 2‐2.5 en el 2009. Estos promedios disimulan grandes diferencias entre países, pero muy pocos escaparan la caída en el producto (Panamá, Perú). El crecimiento volverá en el 2010, pero es probable que sea lento (1‐2 por ciento anual) y no uniforme. Segundo, la pobreza se incrementará. El Banco Mundial estima que la crisis empujará a ocho millones de latino‐americanos a la pobreza.12 Para poner ese número en perspectiva, sesenta millones de ellos habían salido de la pobreza en el periodo 2002‐2008, gracias al crecimiento más rápido, a las mejores políticas sociales, y a las mayores remesas. Pero se espera que la crisis sea inusualmente dura con la clase media—por la caída en la demanda por exportaciones no tradicionales que tienden a emplear a trabajadores formales, urbanos y tecnológicamente más avanzados. Tercero, el desempleo también se incrementará. Todos los países para los que existen datos puntuales, muestran un aumento de corto plazo en las tasas de desempleo—hasta ahora, de entre medio y un punto porcentual. Pero las razones detrás del aumento varían. En algunos casos (Brasil, Chile, México), son mayormente los trabajadores en relación de dependencia (“asalariados”) los que han perdido su empleo o encuentran menos oportunidades de empleo; en otros (Colombia), son los trabajadores independientes los que parecen estar sintiendo más el impacto de la recesión. Los salarios están cayendo en algunos sectores en términos reales. Se espera que la informalidad se expanda, y que la productividad sufra como resultado. Cuarto, habrá menos financiamiento externo. Al momento en que se detonó la crisis global (último trimestre del 2008), los deudores Latino‐americanos soberanos, en su mayoría se habían ya asegurado el financiamiento externo que necesitaban para el 2009. Las corporaciones, en cambio, enfrentan un panorama financiero mucho más difícil. Esto no es muy sorprendente, pues las proyecciones del flujo neto de capital privado hacia los países emergentes para este año muestran un verdadero derrumbe— pasarán de un pico de casi un millón de millones de dólares en el 2007, a menos de 200,000 millones. Aun mas importante, la inversión extranjera directa hacia América Latina tal vez no siga mostrando la estabilidad que tuvo durante crisis anteriores, porque el flujo de fusiones y adquisiciones que la sostenía (“compras de remate”) ya no se harán presentes. Quinto, habrá menos remesas. En el 2008, los 20 millones de latino‐americanos que viven en el exterior enviaron unos 60,000 millones de dólares (un tercio de ese dinero fue a México). Esto convirtió a las remesas en una de las más grandes fuentes de divisas de la región. Esos flujos se reducirán entre un 4 y un 8 por ciento en el 2009, y pueden continuar cayendo mientras no se recupere la industria de la vivienda en los países G7. Y, si la recuperación global no se materializa en el 2010, un número significativo de migrantes latinos podría volver a casa.
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La pobreza se define aquí como US$4 PPP por día o menos.
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Respuestas de Política Pública – Las Prioridades de Hoy. Los gobiernos latino‐americanos reaccionaron rápidamente a la crisis y, en general, lo hicieron en forma adecuada. Esto ha definido una agenda de políticas públicas de corto plazo que no es exactamente igual a la que implementaron los países G7—y es acertado que así sea. Para la región, la primera prioridad continua siendo evitar una pérdida permanente de capital humano. La razón es que sus países tienen sistemas de asistencia social bastante desarrollados (trece de ellos hacen transferencias directas en efectivo hacia sus ciudadanos pobres) pero carecen de un sistema de seguridad social comprensivo (los beneficios por desempleo y por pensión solo cubren una pequeña porción de la población). Este último reacciona automáticamente cuando el ingreso familiar cae; el anterior no lo hace. No es casualidad entonces que, en el pasado, las crisis latino‐americanas se hayan traducido en aumentos en desnutrición, deserción en escolaridad secundaria, e interrupciones en los servicios de medicina básica y preventiva. En otras palabras, las crisis se traducían en pérdida de capacidad cognitiva entre los niños, una vida de trabajo informal para mas adolescentes, y un salto en la tasa de mortalidad entre adultos— aun en países que se consideran de ingreso medio. Los mecanismos para evitar esos impactos están ya en su lugar (desde comedores escolares hasta presupuestos de salud descentralizados), y el costo es relativamente bajo (posiblemente menos de una décima de uno por ciento del PIB). Al mismo tiempo, los gobiernos latino‐americanos tendrán que implementar los paquetes de estimulo que han puesto en marcha. Por necesidad, el alcance de esos paquetes es limitado. Del lado fiscal, el espacio para hacer políticas “contra‐cíclicas” es pequeño en casi todos los países (Chile, Brasil, Colombia parecen ser la excepción). Esto se debe a una combinación de recaudación impositiva tradicionalmente baja, insuficiente capacidad institucional para ejecutar inversión pública adicional con rapidez, y ausencia de acreedores dispuestos a financiar expansiones en el déficit fiscal durante un tiempo de crisis global. Dicho de otra forma, el estimulo fiscal ha sido más fácil para aquellos que ahorraron durante los tiempos de bonanza. Las cosas lucen mejor del lado monetario. Varios países de la región han ganado credibilidad en su lucha contra la inflación durante el periodo de crecimiento rápido y son ahora capaces de bajar sus tasas de interés y devaluar sus monedas para estimular la demanda domestica y externa sin arriesgar un repunte en expectativas inflacionarias.13 Mas fundamentalmente, América Latina en su conjunto no ha recurrido a la propiedad pública como instrumento de estimulo: los gobiernos no han tomado control de empresas privadas, y los bancos centrales no han abierto sus balances a fondear directamente a ninguno de los dos. No ha habido ni rescates (“bail‐outs”) ni emisiones monetarias directas (“quantitative easing”). El equilibrio institucional laboriosamente construido durante la última década ha sido preservado. Sin embargo, la crisis comienza a presentar dos serios desafíos para América Latina—el desempleo y la deuda. Como se mencionó antes, la pérdida de puestos de trabajo aún no ha sido masiva. Pero, en la medida en que la demanda mundial por exportaciones continúe estancada durante el 2010 y, tal vez, más allá del 2010, las industrias de exportación no extractivas acelerarán su tasa de despidos. Esto incrementara la presión política para que los gobiernos actúen, especialmente porque los despidos afectaran desproporcionalmente a la clase media. Y pocos países de la región tienen sistemas de seguro de desempleo con suficiente cobertura. Algunos han estado trabajando en expandir esa cobertura (Brasil, México). Pero, en general, las intervenciones se han concentrado en los servicios de intermediación de trabajo, entrenamiento, exenciones impositivas para pequeñas empresas, subsidios al empleo de jóvenes, programas de empleo temporal, y mayores presupuestos para los programas de transferencias directas en efectivo. El éxito que tengan esas intervenciones dependerá de la forma que tome la recesión. Una recesión profunda pero corta (en “V”) apunta a transferencias transitorias para 13
Brasil, Chile, Colombia, Guatemala, México, Perú y Uruguay han establecido sistemas formales de metas de inflación.
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suavizar la caída temporaria en el ingreso como la mejor opción, mientras que una caída más prolongada en el producto (en “U” o en “L”) con cambios permanentes en la estructura productiva necesitará de políticas que faciliten el ajuste inter‐sectorial‐‐‐como los programas de re‐entrenamiento. Independientemente de la forma que tome la recesión (una variable hasta ahora desconocida), los gobiernos de la región ha buscado usar a la inversión publica como instrumento de generación de empleo. En total, han anunciado unos 25,000 millones de dólares en obras publicas adicionales para el 2009; los datos de ejecución efectiva todavía no están disponibles. El Banco Mundial estima que, en promedio, implementar 1,000 millones de dólares en gastos de infraestructura en América Latina requiere emplear 40,000 trabajadores, dependiendo de la mezcla de sectores, tecnologías, salarios y necesidades de importación. 14 Y el número de puestos de trabajo permanentes creados en la economía como resultado de esos gastos puede llegar a varias veces esa cifra. Las dificultades que significa crear empleo se comparan con, y estarán enmarcadas en, las dificultades para asegurar el financiamiento de la región. El Banco Mundial ha estimado que, en el 2010, los gobiernos de América Latina necesitaran pedir prestados entre 350,000 y 400,000 millones de dólares. Esto supone que no habrá mayores deterioros fiscales. Esta primeramente basado en los vencimientos de deuda que ocurrirán ese año. Por su parte, las corporaciones privadas necesitarán aproximadamente 200,000 millones de dólares. Pocos de esos fondos, públicos y privados, han sido asegurados hasta el momento—a diferencia de lo ocurrido en el 2008 con respecto a las obligaciones del 2009. Al mismo tiempo, la oferta internacional de fondos estará limitada, aún para deudores con grado de inversión, por el efecto de desplazo (“crowding‐out”) que causará el endeudamiento en el que incurrirán los países desarrollados para pagar por sus propios paquetes de estimulo. Y muchos de los intermediarios tradicionales de la deuda latino‐americana (en particular, bancos de inversión) están al momento fuera de actividad o en bancarrota. Todo esto conducirá parte, tal vez la mitad, del las necesidades de financiamiento hacia fuentes domésticas—en los países que cuentan con esas fuentes. Pero aún así habrá una amplia brecha. Y la capacidad de refinanciar deuda (“debt roll‐over”) se constituye como el riesgo individual más grande que existe en el horizonte de corto plazo de la región. Respuestas de Política Pública – Las Oportunidades de Mañana Por todos los problemas que la crisis causará a América Latina, puede también convertirse en el evento que finalmente libera el enorme potencial de la región. Una amplia agenda de reforma podría ahora, o muy pronto, hacerse viable en base a una constelación sin precedentes de nuevas realidades económicas, voluntad política y avances técnicos. La primera de esas realidades es que el crecimiento del mundo ya no estará motorizado por países G7 consumiendo más allá de sus recursos. Al margen, los países emergentes necesitarán balancear sus modelos de crecimiento exportador con mayor participación de la absorción doméstica. En América Latina, eso será más fácil de hacer para países grandes, pero pondrá a prueba a las economías más pequeñas. Muchas, grandes y pequeñas, verán sus monedas apreciarse incómodamente. Todo lo cual dará un valor adicional a la competitividad comercial—aún para preservar la misma porción de un pastel más chico. Muchas de las postergadas reformas que hacen que la globalización rinda frutos—desde la infraestructura y la logística hasta la educación terciaria y los derechos de propiedad—se harán ahora inevitables.
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El mantenimiento de caminos rurales parece ser el gasto en infraestructura que conlleva la mayor necesidad de empleo : entre 200,000 y 500,000 trabajadores por cada 1000 millones de dólares de gasto implementado.
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Al mismo tiempo, la crisis ha generado una nueva fe en el poder de la inversión pública para afectar el crecimiento de corto plazo. Esto puede transformar a esa inversión, pues dejará de ser, de facto, una fuente de financiamiento—que se corta cuando caen los ingresos o aumentan los gastos corrientes. Así como al principio de los 90s la preocupación por la inflación forzó a los gobiernos de la región a abandonar la impresión de moneda como fuente de financiamiento del déficit fiscal, preocupación por la recesión puede ahora forzarlos a ligar formalmente la inversión pública con el panorama de crecimiento de corto plazo—sistemáticamente invirtiendo más cuando el ciclo productivo cae y ahorrando cuando sube. Esto también llevaría el dólar marginal de inversión pública hacia proyectos que movilicen mayores contribuciones privadas, pues tendrían mayor impacto en el crecimiento. Y detonaría las mejoras necesarias en la capacidad de implementación. Por supuesto, los problemas técnicos e institucionales de dar a la inversión pública el rol de estabilizador del crecimiento no son menores. Pero el principio central de ahorrar en los tiempos buenos para gastar en los malos hizo su debut en América Latina durante esta crisis (en Chile), y ha probado ser un éxito que muchos buscarán replicar. La crisis podría también transformar la política social de América Latina, dirigiéndola más hacia la equidad que hacia la igualdad, esto es, más en dar a todos las mismas oportunidades que en dar a todos los mismos premios. Esto ayudaría a la región a dejar atrás un debate que, por décadas, ha sido políticamente divisivo y estratégicamente paralizante—un debate sobre si el propósito mismo del estado es proteger la propiedad privada o redistribuir la riqueza. Una combinación de factores dará cuenta de la transformación. Por un lado, la crisis reveló que los sistemas de asistencia social de la región no son suficientes para responder una contracción súbita del ingreso a través de la economía, especialmente en las clases medias. Por otro, la tecnología para medir la desigualdad de oportunidades ha sido recientemente desarrollada, está disponible, y es operacional.15 Ambas realidades destrabarán los esfuerzos para focalizar los subsidios universales—¿porque debe el estado continuar pagando por, digamos, la calefacción, la gasolina o la educación universitaria que consumen los ricos? El resultado final será una matriz de política social más enfocada en dar a todos las mismas chances. Más ampliamente, el rol del estado cambiara en el mundo entero, y América Latina no será la excepción. Lo que es diferente en la región es que la relación entre sus estados y sus pueblos ha por mucho tiempo sido una de desconfianza—una manifestación de lo cual es la resistencia idiosincrática de los latino‐ americanos a pagar impuestos. La crisis podría tornarse en una oportunidad para cambiar esa relación, para llegar a un nuevo contrato. En un momento en que habrá menos recursos para el estado, más se esperará de él—desde regular más las finanzas a crear más empleo—y la puerta se abrirá para comenzar a basar la gestión del estado en resultados. La tecnología ya está disponible para conectar la acción pública, y más particularmente el gasto público, con resultados específicos—en educación, en salud, en infraestructura, en servicios públicos. Varios países de la región se estaban moviendo en esa dirección antes de la crisis, tanto a nivel federal como sub‐nacional. Ese movimiento probablemente se convertirá ahora en la norma. La gestión del estado por resultados pondrá un marco a sus intervenciones en sectores donde era menos activo en el pasado. El caso más claro es el sector financiero. En general, América Latina evitó muchos de los errores que llevaron a, y detonaron, la implosión de los mercados financieros en el mundo desarrollado—no hubo endeudamiento “subprime”, ni acumulación riesgos fuera de balance, ni instrumentos exóticos. Mucho de eso se debe a más de una década de meticulosas mejoras en las instituciones regulatorias y de supervisión. Esas instituciones enfrentarán ahora el desafío de las grandes 15
Ver Barros, R. P. de; F. H. G. Ferreira, J. R. Molinas Vega, and J. Saavedra Chanduvi, 2009, Measuring Inequality of Opportunity in Latin American and the Caribbean. (Midiendo la Desigualdad de Oportunidades en América Latina y el Caribe). New York: Palgrave Macmillian and Washington, DC: The World Bank.
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reformas de las que será sujeto la industria financiera global. La regulación del riesgo sistémico, los requerimientos de capital, el uso de calificaciones de deuda, las normas contables, y la protección al consumidor son solo algunos de los parámetros de la industria que cambiaran alrededor del mundo. Como adopta y adapta América Latina esos parámetros será critico para una región que, con mayor frecuencia, deberá recurrir al ahorro domestico para desarrollarse.16 Finalmente, la crisis ha revelado el alcance de la interconexión global—basta con ver la velocidad viral a la que colapsaron los flujos financieros y comerciales alrededor del mundo. Las externalidades creadas por las acciones de países individuales han sido tan patentes que han llevaron a la aparición de nuevos o renovados mecanismos globales de coordinación y apoyo. Muchos de esos mecanismos son esenciales para la America‐Latina de post‐crisis, desde el grupo G20 (donde Argentina, Brasil y México participan) a los incrementos en la capacidad de préstamo de los organismos multilaterales a un régimen de comercio internacional abierto, justo y sustentable. Aprovecharlos al máximo es la oportunidad de esta generación. Conclusiones – Pasado Mañana, América Latina Puede Estar Mejor Como hito, el 2009 podría ser recordado como el año en el cual otro brote de crecimiento en América Latina llegó a un abrupto fin. O como el año en el cual una crisis global sin precedentes puso a la región sobre un sendero de desarrollo mucho más rápido, y más duradero. Cuál de los dos resultados se haga realidad, dependerá de cómo respondan sus líderes, si adaptan sus respuestas a las capacidades de sus economías, si ven la oportunidad detrás de la crisis, y si pro‐activamente abordan los problemas que frenaban a los latino‐americanos mucho antes que “subprime” fuera una palabra de uso común. Claramente, los problemas de América Latina no son solo económicos. Las instituciones sobre las que se basan sus sistemas políticos todavía no están completamente consolidadas. La violencia y el narco‐ tráfico que la alimenta tienen una dinámica propia. Y nadie realmente sabe que políticas de desarrollo funcionaran mejor en el mundo post‐crisis. Pero por eso no deja de ser cierto, y un tanto irónico, que la región que no había podido despegar cuando el mundo estaba en auge, podría hacerlo ahora que el mundo tambalea.
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Para acceder a un marco conceptual comprensivo de ideas sobre la nueva regulación financiera, ver De la Torre, A. and A. Ize, 2009, Regulatory Reform: Integrating Paradigms (Reforma Regulatoria: Integrando Paradigmas), World Bank Policy Research Working Paper 4842, February.
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1. THE GLOBAL FINANCIAL AND ECONOMIC STORM: How Bad is the Weather in Latin America and the Caribbean? Augusto de la Torre April 2009* Executive Summary
The current crisis, originated in the advanced financial markets of the center, has generated alarming ripple effects throughout the periphery. No emerging economy has remained immune to its destructive power, which intensified dramatically in the 4th quarter of 2008 after the failure of Lehman Brothers. The crisis is far from over and its rapid spread to the Latin America and the Caribbean (LAC) is occurring through mutually reinforcing channels (financial, remittances, terms of trade, export demand), leading to a sharp downturn in economic activity. Nevertheless, LAC is better prepared than in the past to withstand the global storm. Its traditional sources of vulnerability and magnification of external shocks—local currency, fiscal stance, financial system, external sector—are this time around, and by and large, not part of the problem. As a result, LAC may be able to avert a systemic financial crisis at home and a number of LAC countries enjoy some space for counter‐cyclical policy, particularly in the monetary field. However, the magnitude of the shock is such that LAC will inevitably endure an economic recession so long as the global crisis lasts. Moreover, LAC remains vulnerable to a recession‐induced reversal in social gains. Arguably, such a reversal would be a more difficult affair to manage in a period of electoral contests and considering that social indicators in the region, while having registered significant improvements in recent years, remain generally well below those of middle‐income countries in other regions. This puts a premium on preventing an undue contraction in vital public spending in health, education, basic infrastructure, and social programs. The recovery path for LAC depends crucially on the ability of rich countries and key emerging economies to successfully contain and recover from the current crisis. It also hinges on the availability of substantial financial support from multilateral institutions and on the prudency and effectiveness of LAC’s own policy responses.
The Big Storm that originated in the center… The current crisis affecting the world economy is of historical dimensions and is re‐shaping the international economic and financial landscape, including the traditional dividing lines between center and periphery. The eye of the storm is in the advanced economies, where the crisis has resulted in colossal failures of financial institutions, massive deleveraging, and a staggering collapse in asset values (some US$ 18 trillion in G‐7 stock market capitalization has vanished relative to the admittedly overvalued pre‐crisis peaks). The turmoil has also produced enormous job losses (total employment in the US and Euro area has shrunk by about 6.5 million jobs since the beginning of the recession) and a sharp contraction in economic activity (in the 4th quarter of 2008, GDP fell at an annualized quarterly rate of 6.3% in the U.S. and the Euro Area, and 12.1% in Japan). In an effort to restore confidence in financial markets and pull the economy out of the hole, governments in rich countries have resorted to large‐scale financial rescue and fiscal stimulus packages—raising the degree of state intervention in private markets to levels not seen since the Great Depression. *Prepared for the IMf/World Bank Spring Meeting of April 2009.
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… has reached deeply into the periphery The ripple effects of the crisis on the periphery are in full swing and acting through multiple transmission channels. These include the sharply reduced availability of international market finance (debt and equity), the deterioration of terms of trade for net commodity exporters, the decline in remittances, and the pronounced contraction of external demand for emerging economies’ goods and services. As a result, the periphery is being forced into painful adjustments and the entire world is in crisis. Global trade is declining for the first time in 25 years and world GDP is expected to fall by nearly 2 percent in 2009. The International Labor Organization predicts that global unemployment could reach 38 million workers in 2009, up from 14 million in 2008. Furthermore, the globalization of this crisis has accentuated the feedback loops between the mentioned transmission channels. For example, the world recession keeps commodity prices and exports down, causing loan quality to decay. In turn, this threatens employment, weakens profit expectations, and undermines credit flows, all of which further undercuts private investment and consumption, and so on. Timely policy responses are called for, but constraints vary across emerging countries The recessionary implications of the external shock call in principle for timely responses, including counter‐cyclical macroeconomic policies, scaling up of social protection and basic infrastructure programs, and significant real exchange realignments to dampen the output and employment sacrifices involved in the adjustment. However, the capacity of emerging economies to respond in practice along these dimensions depends not just on the availability of financial resources from multilateral institutions but also on key policy and structural factors that determine the degree of vulnerability to the shocks as well as the scope for policy maneuver. These factors include: a. The extent of pre‐existing macroeconomic and financial policy weaknesses; b. The extent of poverty and inequality, and the degree of social conflict; c. Structural features, such as the diversification of trade, the degree of trade and financial openness, the extent of integration of the local economy to the global production chain, and the allocation of labor between tradable and non‐tradable sectors. LAC is better prepared in the macro‐financial area, compared to its own past… LAC’s history has been marked by frequent and devastating financial crises. In previous episodes (such as the debt crisis in the early 80s, the Tequila crisis in 1995, and the Asian and Russian crises of the late 90s), LAC countries were usually caught with substantial, home‐grown macroeconomic and financial vulnerabilities—reflected in high inflation, overvalued currencies, ample fiscal and current account deficits, and widespread maturity and currency mismatches (Figures 1 and 2). These conditions sapped LAC’s ability to undertake counter‐cyclical policies. LAC was instead compelled to raise interest rates or deeply cut fiscal spending in the midst of the crises in order to keep investors from fleeing, but exacerbating output and employment losses. In several past episodes, such desperate measures were unable to prevent financial meltdowns. Fortunately, the pains from past crises have led to significant institutional and policy improvements in LAC’s macroeconomic and financial areas. More specifically, LAC’s vulnerability to shocks has fallen in tandem with the emergence of: (i) sounder and more flexible currencies; (ii) more resilient financial systems; (iii) better fiscal and public debt management; and (iv) stronger external positions. These
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improvements are perhaps most noticeable in countries that have been able to build credible inflation targeting regimes. Regarding local currencies, an increased number of countries in the region have moved to flexible exchange rate arrangements (Figure 3). The effectiveness of these regimes has risen in line with a reduction in the pass‐through —implying that exchange rate movements now coexist with low and stable inflation—and the deepening of local currency debt markets—implying that exchange rate movements now generate much less adverse balance sheet effects. Similarly, the resiliency of LAC’s financial systems has increased, reflecting significant reforms in financial legislation, regulation, and infrastructure that were introduced following the crises of the late‐1990s. These reforms have led, among other things, to a virtuous combination of financial deepening and a rising share of loans funded by local currency deposits (Figure 4). LAC’s fiscal and external conditions have also registered improvements. To be sure, much of the good fiscal and external outcomes were driven by good luck. That is, LAC countries benefited from the benign external environment of the recent past, characterized by abundant liquidity, booming commodity prices, and vigorous global growth. Nevertheless, better policy frameworks are part of the story too. In the area of public finances, enhanced debt management systems and greater discipline in fiscal policy contributed to reductions in government debt burdens and improvements in the currency and term structure of such debts (Figures 5 and 6). The result was greater fiscal sustainability, even if, with the notable exception of Chile, LAC governments did not save sufficiently during the good times. Finally, in the external front, there was a substantial accumulation of international reserves across LAC countries, which was due not just to terms‐of‐trade windfall gains but also to efforts to self‐insure against capital flow reversals (Figure 7). In sum, improved policy frameworks in LAC have contributed to reducing the weaknesses that used to be incubated in the monetary, financial, fiscal, and external fronts. These vulnerabilities tended to greatly magnify the adverse effects of external shocks. In the current crisis, such vulnerabilities are tamed and are, thus, not an independent source of shock amplification. As a result, many LAC countries are likely to avert a systemic financial crisis at home. However, this reduced vulnerability is insufficient to prevent bad consequences—the storm spreading from the center to the periphery is of such a formidable magnitude that its recessionary impact is already being felt. Moreover, if the global crisis becomes more acute or extends beyond 2009, fiscal and financial conditions can weaken to a point where they could well become an increasing part of the problem. Finally, while vulnerabilities have decreased for the LAC region as a whole, there is considerable heterogeneity across LAC countries. A few countries are still saddled with significant fiscal and public debt complications which limit budgetary maneuvering room. Many others, particularly among the smaller countries in Central America and the Caribbean, have heavily‐managed or pegged exchange rates and cannot therefore undertake counter‐ cyclical monetary policy. … and perhaps also, at least in some respects, compared to other emerging regions Unlike many past experiences, some evidence suggests that LAC was this time in a relative good position vis‐à‐vis other emerging regions when the crisis hit. For instance, countries in LAC had on average lower inflation rates and were equipped with more flexible exchange rate arrangements compared to Eastern Europe and East Asia (Figures 8 and 9). Furthermore, in contrast with large current account deficits in Eastern Europe and South Asia, LAC was running current account surpluses before the crisis. Also, while significantly below South Asia, LAC’s ratio of international reserves to short‐term external debt compared favorably to those of East Asia and was above that of Eastern Europe (Figure 10). Moreover,
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financial systems in LAC, although smaller on average than in other emerging regions, had a larger share of loans backed by local deposits, a factor contributing to resiliency to reversals in capital inflows. East and South Asia had a lower loan to deposit ratio while in Eastern Europe a very high share of credit was funded by foreign inflows (Figure 11). LAC will most likely endure a recession this year The 4th quarter of 2008 marked a clear point of inflexion for LAC and the world economy. Prior to that, LAC (a net commodity‐exporting region) had been enjoying a short‐lived decoupling stage underpinned by an accelerated rise in commodity prices. During that stage, even as the subprime crisis and economic slowdown spread through the economies of the center, LAC currencies strengthened, foreign direct investment continued flowing in, and growth kept apace. The key policy concern for LAC then was inflation, which was being pushed by rising international prices of foods and fuels. That situation began turning around as commodity prices fell, and came to an abrupt end with the financial devastation unleashed by the failure of Lehman Brothers in September 2008. As a result, financial flows and economic activity throughout the world took a highly synchronized nose dive, and LAC fell into a sort of global economic whirlpool. The overall deterioration of economic conditions that was registered in the 4th quarter of 2008 has been unprecedented. During that quarter, on average for LAC, the cost of international borrowing for firms doubled; corporate issues of debt and equity securities came to a virtual halt; the flow of credit by private banks stagnated; remittances began contracting sharply; exports and imports shrunk by about 30 and 25 percent, respectively, as trade surpluses vanished; and industrial production fell by about 12 percent (Figures 12 and 13). As these developments were linked to tectonic shifts in the advanced economies, LAC countries that are closely linked to the U.S. economy (including Mexico and the small open economies of Central America and the Caribbean) have felt a more direct and stronger initial impact. For other countries in the region, the repercussions are being felt with a lag. But in all cases, growth prospects for 2009 have been downgraded dramatically as news on economic performance of advanced and developing countries were revealed on the 4th quarter. For instance, as of August 2008 the Consensus Forecasts put GDP growth for LAC in 2009 at around 3.7 percent; by contrast, the most recent Consensus Forecasts (March 2009) sees LAC growth this year in the negative territory, at around ‐0.7 percent. While the range of growth forecasts is wide—reflecting the more general uncertainty about world growth—few doubt that 2009 would be, at a minimum, a year of economic stagnation for LAC as a whole and, perhaps more likely, a year of recession. LAC is especially vulnerable to a recession‐induced reversal of social gains Poverty and inequality figures, as well as other social indicators, improved markedly in LAC during the last decade. For instance, infant mortality declined to 21.4 deaths per 1000 live births in 2006 from 36.1 in 1995, which is closely related to a larger access of the population to improved water and sanitation. Similarly, during the strong growth period of 2002‐2008, almost 60 million people in LAC were lifted out of poverty (measured at PPP‐adjusted US$4 a day) and 41 million left the ranks of extreme poverty (measured at US$2 a day). However, LAC still lags considerably other emerging regions in social dimensions. For instance, infant mortality is higher, educational achievement lower, basic infrastructure much less developed, and income distribution much more unequal in LAC compared to East Asia and Eastern Europe (Figures 14‐16). Given LAC’s unique combination of vibrant electoral processes with
16
high income and wealth inequality, these deficits in social indicators suggest that a reversal in the recently achieved social gains might be a comparatively more complicated affair to handle for LAC. Hence, there is a premium on preventing an undue contraction in public spending in health, education, basic infrastructure, and other social programs. The scope for counter‐cyclical policy responses varies considerably across LAC countries Perhaps the greatest scope for counter‐cyclical policy is in the monetary arena. LAC countries with robust inflation targeting regimes (Brazil, Chile, Colombia, Mexico, and Peru) are clearly in a better position, with exchange rate flexibility and high international reserves affording them maneuvering margins. These countries have in fact entered into aggressive monetary policy easing, especially since January 2009 (Figure 17). Some of them have also used actively their public banks to offset the decline in private bank credit. Monetary easing has helped cushion the decline in economic activity through two main channels. First, by lowering policy interest rates, it dampens the fall in investment and consumption. Second, by allowing the currency to depreciate, it helps curb imports while redirecting demand towards locally produced goods and services. Unfortunately, as noted earlier, many countries in LAC—particularly the small open economies in Central America and the Caribbean—lack the ability to conduct counter‐cyclical monetary policy. The main challenge for fiscal policy in LAC is to manage the inevitable fall in tax collection (related to the economic downturn and fall in commodity prices) so as to protect expenditures in education, social security, and infrastructure. These expenditures are necessary to prevent a rise in poverty and inequality and lay the foundations for future growth. In practice, however, the maneuvering room for counter‐cyclical fiscal policy varies considerably among LAC countries (Figure 18). It is greater in countries where: (i) savings were accumulated during good times (Chile is an indisputable leader in this regard); (ii) expenditures are not unduly rigid and can thus accommodate suitable changes in composition; (iii) the debt situation is such that there is scope for prudent borrowing; and (iv) local financial markets are relatively deep. However, given that the shortfall in fiscal revenues is likely to be substantial, a major achievement for LAC would already be to maintain fiscal spending at the initially planned level while protecting vital social and infrastructure programs. Some countries in the region have already announced fiscal stimulus packages. Nevertheless, there is a great deal of heterogeneity across countries with respect the composition and size of these packages. For instance, some countries have focused predominantly on tax cuts (Brazil), while others have planned to raise infrastructure spending (Mexico, Chile, and Peru). Moreover, some countries are reinforcing their social protection networks (Argentina and Chile) whereas others are providing incentives to non‐ traditional exports (Peru). The size of these packages also varies widely, ranging from 0.3 percent of GDP for Brazil to 2.2 percent for Chile. It is difficult however to ascertain the extent to which the announced fiscal stimulus adds to already existing plans or reallocates already budgeted spending. Furthermore, the effectiveness of some the fiscal measures announced (e.g., tax cuts) will depend on the private sector’s willingness to spend. Closing thoughts The world is gripped by the broadest, deepest, and most complex crisis since the Great Depression. As the current crisis was originated in the advanced world, its resolution mainly depends on the policies implemented there, particularly on the success of the fiscal stimulus and financial rescue packages. There is still no consensus on the effectiveness of such policies or on when things will bottom out. What is clear is that the crisis is far from over, although the rate of decline seems to be slowing down in some
17
respects. In any case, the global nature of the crisis mutes two channels that have helped emerging markets rebound quickly from past crises—namely, the ability to export to the center and attract foreign direct investment from it. This time around, the real devaluations in LAC will not have those salutary effects on exports as long as the economies of the center and key emerging countries, particularly China, remain in crisis. In all, whether the large economies of the world rebound, remains stagnant, or further deteriorate will greatly determine the periphery’s prospects in the medium term. While all emerging regions are being hit hard, the impact of the crisis has been very heterogeneous. The crisis is creating havoc in the financial systems of emerging countries where pre‐existing macro‐financial weaknesses were substantial—the most notable case is that of several countries in Eastern Europe. Emerging countries, where such weaknesses were low or non‐existent, are better able to avert a systemic financial crisis at home. LAC, fortunately, appears to be, by and large, in this latter category, thanks to significant institutional and policy improvements in macroeconomic and financial arenas achieved in recent years. These are now affording a number of LAC countries some room for counter‐ cyclical policy responses. However no emerging country, regardless of how well‐prepared or managed, is escaping the recessionary effects of the global crisis. The propagation of these effects is also marked by heterogeneity. For instance, countries that are tightly linked to world trade and highly integrated to the global production chain have experienced more severely the first‐round effects of the crisis on manufacturing production and employment. In contrast, the impact is lagged in countries where growth was supported mainly by domestic demand. Unemployment effects have also tended to be initially smaller in countries with a higher share of labor in the non‐traded sector. Finally, while LAC seems well‐positioned for a fast post‐crisis growth rebound, the recessionary effects of the current crisis threaten to reverse important social gains achieved in recent years. Such a reversal can be highly problematic for democratic‐but‐unequal LAC. The availability of financial resources as well as technical and policy advice from multilateral institutions can be highly relevant in this regard. It can help LAC countries in maintaining their spending plans, or adequately recomposing them, to protect vital infrastructure and social protection programs in the face of falling revenues.
18
Figure 1
Figure 2 Current account balance in LAC as % of GDP
Inflation in LAC annual variation 4%
50%
280
45%
3%
40%
2%
35%
1%
30%
0%
25%
‐1%
20%
‐2%
15%
‐3%
10%
‐4%
5%
‐5%
0%
‐6% 1981
1994
1996
2007
1981
1994
Figure 3
1996
2006
Figure 4
LAC countries with exchange rate flexibility as % of the sample
Loan to Deposits Ratio in LAC in %
60%
125%
50%
120%
115%
40% 110%
30% 105%
20% 100%
10%
95%
0%
90%
1981
1994
1996
2007
1981
1994
Figure 5
1996
2007
Figure 6
Total Pubic Debt in LAC as % of GDP
Share of Domestic Debt in LAC as % of total public debt
39%
65%
37%
60% 35%
55% 33%
50% 31%
45%
29%
40%
27%
25% 1996
2007
35% 1996
LAC figures usually calculated using data of LAC‐7 countries. Source: WDI and IFS
19
2007
Figure 7
Figure 8
International Reserves in LAC as % of GDP
Inflation in selected regions annual variation
15%
12%
14%
11%
13%
10%
12%
9%
11%
8%
10%
7%
9%
6%
8%
5%
7%
4% 1981
1994
1996
2007
LAC
Regional aggregates are calculated as simple averages for 2007. LAC figures usually calculated using data of LAC‐7 countries. Source: WDI and IFS
ECA
South Asia
Regional aggregates are calculated as simple averages for 2007. LAC figures usually calculated using data of LAC‐7 countries. Source: WDI and IFS
Figure 9
East Asia and Pacific
Figure 10
International Reserves in selected regions as % of short‐term external debt
Countries with exchange rate flexibility in selected regions as % of the sample 1000%
60%
900% 50%
800% 700%
40% 600% 30%
500% 400%
20%
300% 200%
10%
100% 0%
0% LAC
ECA
East Asia and Pacific
LAC
South Asia
Figure 11
East Asia and Pacific
South Asia
Regional aggregates are calculated as simple averages for 2007. LAC figures usually calculated using data of LAC‐7 countries. Source: WDI and IFS
Regional aggregates are calculated as simple averages for 2007. LAC figures usually calculated using data of LAC‐7 countries. Source: WDI and IFS
ECA
Figure 12
Loan to deposit ratio in selected regions in %
Industrial Production Annual variation 20%
130%
East Asia 15% 120%
10% 110%
South Asia
5% LAC 0%
100%
‐5% 90%
‐10% 80%
‐15%
ECA
‐20%
70%
Regional aggregates are calculated as simple averages for 2007. LAC figures usually calculated using data of LAC‐7 countries. Source: WDI and IFS
Jan‐09
Nov‐08
Jul‐08
Sep‐08
May‐08
Jan‐08
Mar‐08
Nov‐07
Jul‐07
Sep‐07
May‐07
Jan‐07
Mar‐07
Nov‐06
South Asia
Jul‐06
East Asia and Pacific
Sep‐06
ECA
May‐06
Jan‐06
LAC
Mar‐06
‐25% 60%
Regional aggregates are calculated as weighted averages. Source: World Bank DECPG
20
Figure 13
Figure 14
Imports and Exports of Goods Growth in LAC Annual variation as of Feb‐09
Income inequality in selected regions Gini index
10%
55
0% 50
‐10% ‐20%
45 ‐30% ‐40% 40 ‐50% ‐60%
35
‐70% 30
‐80% ARG
BRA
CHI
COL
CRI
ECU
MEX
PER
GTM
SLV
LAC
PAN
Source: Haver Analytics and National Authorities
ECA
EAP‐7
Regional aggregates are calculated as simple averages for 2005. LAC figures usually calculated using data of LAC‐7 countries. Source: WDI.
Figure 15
Figure 16
Mortality rate in selected regions infant per 1,000 live births
Persistence to last grade of primary in selected regions total as % of cohort 100
25
98
23 21
96
19 94
17 92
15 90
88
13 11
86
9
84
7 5
82 LAC
ECA
LAC
EAP‐7
Figure 17
Monetary Policy Rates in %
Figure 18
Monetary Policy Rates in %
Index of constraints to implement counter‐cyclical fiscal police 1.0
9
8
16
EAP‐7
Regional aggregates are calculated as simple averages for 2005. LAC figures usually calculated using data of LAC‐7 countries. Source: WDI.
Regional aggregates are calculated as simple averages for 2005. LAC figures usually calculated using data of LAC‐7 countries. Source: WDI.
18
ECA
MEXICO
BRAZIL
Debt burden
Primary deficits
Commodity dependence
Expenditure rigidity
Financing constraints
Financing costs
0.8
7 CHILE
14 6
PERU
12
0.6
5
4
10
0.4
3
8 US
COLOMBIA
2
0.2
6 1
0.0 Jan‐09
Apr‐09
Jul‐08
Oct‐08
Jan‐08
Apr‐08
Jul‐07
Oct‐07
Apr‐07
Jul‐06
Jan‐07
Oct‐06
Jan‐06
Jan‐09
Apr‐09
Jul‐08
Oct‐08
Jan‐08
Apr‐08
Jul‐07
Oct‐07
Apr‐07
Jul‐06
Jan‐07
Oct‐06
Jan‐06
Apr‐06
Apr‐06
0
4
Chile
Brazil
Colombia
Peru
Mexico
Argentina
Ecuador
Venezuela
This index is the weighted average of the relative score of the six different categories. The index as well as each category take values between 0 and 1. Higher values indicate higher constraints on the scope for counter‐cyclical fiscal police. Source: LCRCE Office calculations based on National Authorities data.
Source: Bloomberg – National Authorities
21
22
2. REGULATORY REFORM: INTEGRATING PARADIGMS Augusto de la Torre and Alain Ize April 2009* Abstract The Subprime crisis resulted from the interplay of information asymmetry and control problems with failures to internalize systemic risk and recognize the implications of Knightian uncertainty. A successful reform of prudential regulation will thus need to integrate more harmoniously the three paradigms of agency, externalities, and mood swings. This is a tall order because each paradigm has different and often inconsistent regulatory implications. Moreover, efforts to address problems under one paradigm can exacerbate problems under the others. To avoid regulatory arbitrage and ensure that externalities are uniformly internalized, all prudentially regulated intermediaries should be subjected to the same capital adequacy requirements, and unregulated intermediaries should be financed only by regulated intermediaries. Reflecting the importance of uncertainty and mood swings, the new regulatory architecture will also need to rely less on market discipline and more on “holistic” supervision, and incorporate countercyclical norms that can be adjusted in light of changing circumstances. Introduction As in the case of the other two large financial crises in modern U.S. history, the Great Depression and the Savings & Loan (S&L) crisis, the Subprime crisis was triggered by the inability of financial intermediaries to withstand large macroeconomic price volatility.17 In the Great Depression, banks started failing when the stock market crash induced losses on their equity investments or the loans they had given to investors towards the purchase of stocks. In the S&L crisis, the main trigger was the rise in deposit rates that accompanied the increase in inflation of the late 1970s and the subsequent, sharp tightening of monetary policy. For the Subprime crisis, the trigger was the decline in housing prices. In all three cases, the crisis resulted from a rapidly rising wedge between the underlying value of financial intermediaries’ assets and liabilities, which prevented them from honoring the implicit insurance commitments they had made to their clients. High leverage and liquidity on demand, which limited the size of the buffers available against shocks, made these wedges lethal. While the proximate triggers of these crises are fairly clear, the most interesting question is why financial intermediaries continue to contract such huge implicit insurance commitments while failing recurrently at honoring them, in the U.S. or elsewhere. Going back to the fundamentals of financial decision making, three possible explanations spring to mind: (i) managers of financial institutions understood the risks they were taking but made the bet because they thought they could capture the upside windfalls and leave the downside risks to others (the agency paradigm); (ii) managers understood the risks they were taking, yet went ahead because they did not internalize the social risks * World Bank Policy Research Working Paper 4842 17 Throughout this paper we use the term “Subprime crisis” to denote the current, broader crisis of structured securitization and its propagation across financial markets and borders.
23
and costs of their actions (the externalities paradigm); and (iii) managers did not fully understand the risks they were running into; instead, they reacted emotionally to a constantly evolving, uncertain world of rapid financial innovation, with an excess of optimism on the way up and, once unexpected icebergs were spotted on the path, a gripping fear of the unknown on the way down (the mood swings paradigm). These three paradigms reflect human condition in a nutshell. In the agency paradigm, the better informed are constantly tempted to take advantage of the less informed and, ultimately, the state. By contrast, in the externalities paradigm, financial intermediaries are free agents whose decisions do not necessarily coincide with the public good, or in the case of group coordination failures, with their own good. In the mood swings paradigm, like all market participants, managers of financial institutions have bounded capacity to deal with the genuine uncertainty lying ahead, which is naturally associated with bouts of risk euphoria (“this time around, things are really under control…”) followed by episodes of sudden alarm and deep risk retrenchment. The next question that naturally comes to mind is why such similarly triggered crises have continued to recur notwithstanding the development over the last eighty years or so of a formidable set of prudential regulations precisely designed to prevent systemic failures. Not only has regulation failed abysmally but attempts to seek a safer regulatory path ahead seem in some cases to have made matters subsequently worse. For example, a key piece of regulatory legislation coming out of the Great Depression was the Glass‐Steagall Act that sought to shield commercial banks from stock market price fluctuations by barring them from investment banking. In turn, the S&L crisis launched the regulatory push towards securitization as a way to pass on to markets much of the risk associated with housing and other longer term finance. Yet, investment banks and securitization are precisely two ingredients at the epicenter of the Subprime crisis. This paper argues that the failure of regulation largely resulted from a piecemeal approach to reform that looked at one paradigm at a time. In trying to address the central problem under one paradigm, they made the problems under the others worse. Thus, the creation of the Federal Reserve System in 1914 and introduction of deposit insurance after the Great Depression, which set the stage for the public lender‐of‐last‐resort function and were meant to alleviate the instability resulting from recurring runs on the banking system (a problem of externalities), exacerbated the agency‐moral hazard problem. In turn, the strengthening of prudential norms after the S&L crisis, meant to address the acute moral hazard manifestations observed during that crisis, indirectly exacerbated the externalities problem—it drove much of the intermediation outside the prudentially more tightly regulated sphere of commercial banking; once there, participants had less incentives (regulatory‐induced or otherwise) to internalize the externality and hold systemic buffers (liquidity or capital). This last problem of course came back to haunt us in the Subprime crisis. Moreover, while following this game of tag and run between moral hazard and externalities, regulation missed all along another central suspect: asset bubbles growing and bursting under the impact of rapidly shifting animal spirits. In the Great Depression, the bubble and crash were driven by stock prices; in the Subprime crisis, they were driven by housing prices and the weaknesses of subprime mortgage lending suddenly emerging from the fog. To reconcile theory and facts, the third, missing (or much less developed) paradigm—which puts Knightian uncertainty and the associated mood swings (more than incentive misalignments) at center stage—needs to be recognized and dealt with. Looking ahead, regulatory reform is largely complicated by the fact that the internal logic of each of the three paradigms leads to different and often inconsistent regulatory implications. In the pure agency paradigm, the only task of the regulator is to mitigate principal‐agent problems by fostering market discipline—mainly through the disclosure of ample, reliable information and by ensuring that financial 24
intermediaries’ “skin in the game” is sufficient to maintain their incentives aligned in the right direction. A properly set regulatory framework should thus eliminate the risk of systemic crises. By contrast, in the pure externalities paradigm, as markets of their own cannot close the wedge between private and social costs and benefits, the relevant regulation cannot be “market friendly” and the supervisor’s role becomes more central. Moreover, because of the high cost associated with crisis‐ proofing, the system’s exposure to some tail risk (akin to “one hundred year floods”) is likely to remain. The ex‐ante crowd coordination and control role of the supervisor needs therefore to double up, if a crisis materializes, with an ex‐post fireman role. Finally, in the pure mood swings paradigm there are no incentive distortions but market participants cannot fully visualize the dynamic and systemic risk implications of market completion and innovation. Hence, markets are unlikely to provide efficient pricing signals. Unless effective safeguards can be put into place, this severely undermines the Basel II‐type, risk‐based regulatory architecture where every risk can presumably be assessed and translated into an efficient prudential norm. By the same token, the mood swings paradigm boosts the role (and responsibility) of the supervisor, who has to become a scout and a moderator, constantly looking for possible systemic trouble ahead and slowing down the system when uncertainty becomes too large. To be successful, any reform of prudential regulation will need to integrate the key insights and sidestep the main pitfalls of all three paradigms in a way that limits inconsistencies and maintains a proper balance between financial stability and financial development. Overcoming these tensions will require a dialogue between researchers and policy makers whose perception of the world may be colored by different paradigms. One of the aims of this paper is to contribute to this dialogue. The paper also proposes a set of basic objectives that any regulatory reform should seek to fulfill in a multi‐paradigm world. Reflecting the main current pitfall of un‐internalized externalities, the reform will need to improve the alignment of incentives by internalizing (at least partially) systemic liquidity risk, thereby lessening the likelihood of crises. However, it should do so in a way that ensures regulatory neutrality and leaves room for prudentially unregulated intermediaries to enter and innovation to thrive. At the same time, reflecting the pitfalls of uncertainty and mood swings, the reform will also need to pay more attention to the risks of financial innovation and rebalance the monitoring roles of markets and supervisors, with the latter acquiring more responsibilities but also more powers. Since in a world of externalities and uncertainty‐driven mood swings even the best regulation and supervision are unlikely to fully eliminate the risk of systemic crises, improving the systemic features of the safety net will continue to be an essential objective. Consistent with these objectives, we propose: (i) making prudential norms also a function of the maturity structure of the intermediary’s liabilities; (ii) giving prudentially unregulated intermediaries the choice between becoming regulated (with the same capital adequacy requirements as commercial banks) or remaining unregulated subject to the condition of not funding themselves in the capital markets (in other words, prudentially unregulated intermediaries could only borrow from regulated intermediaries);18 (iii) giving the regulator more powers to authorize innovations and norm instruments; (iv) enabling the supervisor (through appropriate statutory powers, accountability, and tools) to play a more “holistic” role by focusing more on the system (its risks, evolution, links, etc.), and to set and calibrate (within bounds) countercyclical prudential requirements depending on changing circumstances, much as the interest rate is calibrated by monetary authorities; and (v) revisiting the 18
The obvious complement to this approach would be to ensure that all the direct and indirect credit risk exposures (on‐ and off‐balance sheet) of the regulated intermediaries are backed by capital (“skin‐in‐the‐game”), at a level which ensures regulatory neutrality.
25
deposit insurance to incorporate systemic risk, rethinking the LOLR as a risk absorber of last resort, and examining the feasibility of pairing them with a systemic insurance subscribed by all financial intermediaries.19 The rest of the paper is organized as follows. Section 2 goes back to the foundations and pitfalls of intermediary‐based finance and briefly retraces the steps and objectives of modern regulation. Sections 3 to 5 present alternative interpretations of the Subprime crisis from the perspective of each of the three paradigms. Section 6 sums up the main failures of regulation and emphasizes the deep contrasts that exist between the three paradigms when one tries to address these failures. Section 7 concludes by laying down a minimum set of basic objectives that would need to be met in order to ensure a more harmonious integration of the three paradigms. The Foundations of the Current Prudential Framework Finance seeks to bridge three basic gaps (Chart 1). First, there is an information and control gap (a principal‐agent problem) that reflects fund suppliers’ exposure to the idiosyncratic risks and costs involved in properly screening and monitoring fund users, and enforcing contracts with them. Second, there is a price volatility‐uncertainty gap that reflects fund suppliers’ aversion to becoming exposed to aggregate risks (market‐specific or systemic) over which they have no control. Third, there is a liquidity‐ maturity gap that reflects fund suppliers’ “opportunistic” desire to maintain access to their funds and a quick exit option at all times. This third motive responds both to idiosyncratic risks (a quick exit disciplines fund users and mitigates agency problems) and aggregate risks (liquid portfolios and flights to cash mitigate exposure to uncertainty and mood shifts). Reflecting transaction costs and borrower size, the bridging of these gaps takes on different forms along a continuum that goes from direct market contracting to intermediated contracting (Table 1). At the one extreme, markets bridge the principal‐agent gap through hard public information (arms‐length lending), the liquidity gap through the ability to trade financial contracts easily in deep markets, and the volatility gap through derivative contracts. Asset managers (mutual funds, pension funds, brokers, etc.) cover the middle ground. They help fund suppliers fill the agency gap through expert screening and continuous monitoring (including through direct board room participation), the liquidity gap through pooling, and the volatility gap through diversification. At the other extreme are financial intermediaries that engage in leverage. Commercial banks—the prototypical financial intermediaries—bridge the agency gap through soft private information (relationship lending), debt contracts (a disciplining device), and capital (skin‐in‐the‐game). They absorb the volatility gap and liquidity gap by funding themselves through debt redeemable at par and on demand, respectively, and by absorbing the ensuing risks through capital and liquidity buffers.20 Remarkably, debt and capital (hence leverage) play a key role in intermediaries’ ability to deal with each of the three gaps.
19
Needless to say, to avoid exacerbating cross‐border arbitrage, any such reform would require broad international agreement on the essence of the reforms and their modalities of implementation across borders. 20 In addition, intermediaries, unlike markets, can offer “incomplete” contracts that provide more ex‐post flexibility in adjusting to unforeseen circumstances that can lead to failures in honoring the contracts. See Boot et al. (1993) and Rajan (1998).
26
Chart 1. The gaps finance seeks to bridge and the pitfalls it encounters encounters
Risk
Gap
Response
Market Failure
Information Control
Pick and monitor borrowers Contract agent
Agency problems
Liquidity Maturity
Stay liquid Grab opportunities
Externalities
Volatility Uncertainty
Adjust portfolio to risk appetite Contract insurance
Mood swings
Idiosyncratic
Aggregate
7
Table 1. Filling the finance gaps Gap
Channel of finance Information/Control
Liquidity/Maturity
Volatility/Uncertainty
Markets
Hard information and governance standards
Deep, liquid secondary markets
Derivative markets
Asset Managers
Expert screening, direct board participation and monitoring the monitors
Pooling
Diversification
Intermediaries
Pooling, demandable Relationship lending, debt debt and capital/liquidity and capital (skin in game) (buffers)
Diversification, debt and capital (buffer)
By interposing their balance sheet between borrowers (through assets whose underlying value fluctuates with economic conditions) and investors (through liabilities whose value is fixed by contract), financial intermediaries become exposed to systemic risk. They may fail to address this risk in a socially optimal way, reflecting market failures that map all three gaps and paradigms portrayed in this paper. While we will describe these failures more fully in each of the three subsequent sections, a brief preview here will help establish the historic setting and rationale for the current regulatory framework. Principal‐agent problems give rise to a variety of malfeasance manifestations, most importantly moral hazard.21 Should all depositors be well informed, banks could eliminate moral hazard to the satisfaction 21
The list of malfeasance manifestations with which bankers and other financial intermediaries have been associated over the ages also includes adverse selection, predatory lending, outright fraud and pyramid schemes (Ponzi finance). In this paper, we will broadly lump together all forms of malfeasance within the agency paradigm
27
of depositors by holding capital.22 But the mix of small uninformed depositors and larger, better informed investors can lead to inefficient equilibria in which banks and wholesale investors benefit at the expense of the retail depositors (or their deposit insurance).23 Governance issues compound the problem by superposing additional layers of moral hazard. In particular, bank managers may take decisions that benefit them in the upside but leave the downside mostly to the shareholders or investors. The opportunistic behavior of fund suppliers or intermediaries faces an externalities problem. Financial intermediaries are exposed to runs by their depositors or lenders, triggered by self‐fulfilling panics or suspicions of intermediary insolvency. Even if they could limit this risk by holding sufficient capital and liquidity, their incentive to do so is limited by the fact that they do not internalize the social costs of a run, i.e., by the existence of externalities.24 The attitude of financial intermediaries (as well as that of other agents) towards price volatility also gives rise to a market failure in that their decisions in the face of uncertainty are influenced by mood swings. They incur bouts of excessive optimism (exuberance) during the upwards phase of financial expansions and excessive pessimism (extreme uncertainty aversion) during contractions. In either case, this compounds price volatility and can lead to sharp deviations from underlying fundamentals (bubbles). Regulation has been designed to help intermediaries overcome the two first pitfalls, albeit not the third. The current regime rests on three key pillars: (i) prudential norms that seek to align incentives ex‐ante; (ii) an ex‐post safety net (deposit insurance and lender‐of‐last‐resort) aimed at enticing small depositors to join the banking system and forestalling contagious runs on otherwise solvent institutions; and (iii) a “line‐in‐the‐sand” separating the world of the prudentially regulated (mainly commercial banking) from that of the unregulated. In turn, the line‐in‐the‐sand rests on at least three key arguments. First, regulation is costly and can produce unintended distortions. It can limit innovation and competition, and it needs to be accompanied by good, hence inherently costly, supervision. Second, extending bad oversight (oversight on the cheap) beyond commercial banking can exacerbate moral hazard—it can give poorly regulated intermediaries an undeserved “quality” label (hence an edge in the market place) and an easy scapegoat (blame the regulator if there is a problem). Third, investors outside the realm of the small depositor are but focus primarily on moral hazard because it is the only one that raises “prudential” issues, i.e., issues of risk management. 22 Moral hazard is a reflection of limited liability (limited capital). There is an important literature that questions the need for (and optimality of) capital requirements imposed from the outside. See in particular Kim and Santomero (1988), Berger, Herring, and Szego (1995), Diamond and Rajan (2000), and Allen and Gale (2005). 23 The literature has mostly stressed the “bright side” of wholesale finance, where small depositors free ride on the monitoring and disciplining services of larger investors (see for example Calomiris and Khan, 1991). However, Huang and Ratnovski (2008) recently showed that there is also a “dark side” to wholesale finance. In the presence of a noisy public signal on the state of the bank, wholesale investors may relax their monitoring and rely instead on an early exit as soon as there is any adverse change in the public signal, whether warranted or not. The fact that the smaller investors will stay put (which in their model reflects the presence of deposit insurance) facilitates the exit of the large investors. In this context, it is indeed surprising that the inherent tension within the deposit insurance as currently conceived—meant to cover only small depositors in non systemic events but de facto exposed to systemic losses resulting from early runs by the large depositors—has not received more attention. 24 There is a vast and rapidly expanding literature on the underpinnings of the demand for liquidity and the drivers of liquidity crises. In all cases there is a basic externality at the core of the respective models: liquidity has public good features which liquidity providers cannot fully appropriate. See: Diamond and Dybvig (1983), Holmstrom and Tirole (1998), Diamond and Rajan (2000), and Kahn and Santos (2008).
28
well informed and fully responsible for their investments. As a result, they should monitor adequately the unregulated financial intermediaries, making sure their capital is sufficient to eliminate moral hazard. Consistent with this line‐in‐the‐sand rationale, only deposit‐taking intermediaries are prudentially fully regulated and supervised under the current regulatory architecture. In exchange, and reflecting their systemic importance, they benefit from a safety net. Other financial intermediaries (and all other capital markets players) neither enjoy the safety net nor are burdened by full‐blown prudential norms. Instead, they are mostly (if not only) subject to market discipline, enhanced by well known securities markets regulations focused on transparency, governance, investor protection, market integrity, etc. Interestingly, the early history of regulatory intervention, which was marked by the introduction of the safety net, was more closely linked to externalities than to agency problems. However, subsequent regulatory developments came to be dominated by concerns about principal‐agent frictions, particularly moral hazard, which the safety net itself exacerbated. But at this point the logic of the line‐in the‐sand completely missed the obvious facts that, even if free markets take care of principal‐agent problems, they will (nearly by definition) neither internalize externalities nor temper mood swings and price risk appropriately where genuine uncertainty exists. Thus, the regulatory architecture that is in place today became seriously unbalanced.25 In fact, the line‐in‐the‐sand became porous and was widely breached during the build‐up to the Subprime crisis, as highly‐leveraged intermediation developed outside the confines of traditional banking—in what has now become known as the world of “shadow‐banking”—and the safety net had to be eventually sharply expanded, from the regulated to the unregulated.26 The explosive growth of “shadow banking”—driven by the originate‐to‐distribute model, which relied on the securitization of credit risk, off‐balance sheet transactions and vehicles, and fast expansion highly‐leveraged intermediation by investment banks, insurance companies, and hedge funds—has been so well documented elsewhere that it is not necessary to reiterate the details here.27 It is only worth stressing that, by radically expanding the interface between markets and intermediaries, the process brought a variety of new problems and issues. However, the same underlying pitfalls of agency problems, liquidity runs, and mood‐driven cycles reappeared with a vengeance. In what follows, we interpret the story behind this shift to “shadow banking”—its roots, dynamics, and implications—from the vantage point of each of the three paradigms. As many of the observed features of the Subprime crisis can be consistent with more than one of the three paradigms, attribution is inherently problematic and conclusive proofs are virtually impossible. Hence, the strategy is to work out the internal logic of each paradigm taken by itself, so as to illustrate its potential explanatory power as well as highlight its internal limitations. We will also refer to structural factors such as financial innovation, competition, and regulatory arbitrage when useful to illustrate the inner workings of a particular paradigm, albeit such factors affect all paradigms. On the other hand, although we certainly 25
In modern terms, the prudential framework can be seen as a “line of defense” or “buffer” that partially shields public funds from bank losses by reinforcing market discipline and putting a positive price on the safety net. While focusing on capital, the existing prudential framework clearly goes beyond capital—it includes liquidity requirements, loan‐loss provisioning, fit and proper rules, loan concentration limits, prompt corrective actions, bank failure resolution procedures, etc. 26 Key players in the Subprime meltdown included commercial banks (the prototypical financial intermediaries) and other intermediaries that blossomed outside the banking system and became hyper‐leveraged (mainly investment banks but also insurance companies, hedge funds, as well as commercial banks themselves trespassing into securities markets through off‐balance sheet special investment vehicles—SIVs). 27 See for example Adrian and Shin (2008), Brunnermeier (2008), Gorton (2008), and Greenlaw et al. (2008).
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recognize the importance of macroeconomic impulses such as the savings glut (and related macroeconomic imbalances) and the “Greenspan factor” (the long period of low interest rates), we restrict our attention to prudential failures because they are the ones that matter for regulatory reform. The Agency Paradigm The moral hazard‐agency story of the Subprime crisis is arguably the most popular.28 It posits that incentive distortions arising from unchecked principal‐agent problems (the heads‐I‐win‐tails‐you‐lose syndrome) are the source of trouble, inducing market participants to either pass on risks deceptively to the less informed or take on too much risk themselves with the expectation of capturing the upside or exiting on time and leaving the downside with someone else. The perversion of incentives can happen at one or several points of the credit chain between the borrower and ultimate investor, passing through the various intermediate links. However, for moral hazard to start driving the show, it must be the case that the expected upside benefits come to dominate the expected downside costs (i.e., losing one’s capital or reputation). This can occur under two plausible scenarios: (i) an innovation (perhaps facilitated by deregulation) opens a world of new opportunities (the upside widens), or (ii) a macro systemic shock suddenly wipes out a large part of the intermediaries’ capital (the downside shrinks).29 Indeed, one can argue that in the case of the Subprime crisis it was the discovery of new instruments and intermediation schemes (securitization and shadow‐banking) which set the process in motion.30 The expansion of upside opportunities led to a moral hazard‐induced under‐pricing of risk, encouraging participants to make the bet and take the plunge.31 This process, which Basel I regulation encouraged, can be explained in part by regulatory arbitrage.32 However, poor regulation (that did not sufficiently align the incentives of principals and agents, whether the risk was acquired off or on balance sheet) can no doubt also be blamed. Indeed, the build‐up phase of the crisis provided plenty of opportunities for all sorts of principal‐agent problems to expand and deepen. The multiplication of actors (borrowers, loan originators, servicers, securitization arrangers, rating agencies, asset managers, final investors) involved in the originate‐to‐ distribute model not only reflected the increased sophistication and complexity of intermediation but also boosted the scope for accompanying frictions, including moral hazard, but also predatory lending, 28
See for example Caprio et al. (2008) and Calomiris (2008). The sudden opening of profitable new business opportunities that set the cycle’s upswing into motion is what Fisher (1933) called a “displacement”. 30 By contrast, the S&L crisis can be viewed as driven by deregulation and the rise in interest rates that effectively de‐capitalized the system (a reduction of downside risks), unleashing the subsequent rounds of “betting for survival”. The process was exacerbated by the lack of fair value accounting (which aggravated information asymmetry problems while allowing insolvent institutions to continue operating normally) and generous regulatory forbearance. 31 There is a body of literature emphasizing moral hazard‐caused deviations of asset prices from their fundamental values. See for example Allen and Gale (1998). While these deviations may be interpreted as “bubbles”, the underlying models are typically static. 32 Basel I prudential standards encouraged securitization through differential risk weights (a mortgage held on a bank’s balance sheet is charged with a 50 percent risk weight, against only 20 percent if securitized). At the same time, although Basel I did incorporate some off‐balance sheet commitments, conversion factors limited their impact on capital. Banks could also circumvent regulation through innovations such as tranching and indirect credit enhancements, the use of the trading book rather than the banking book, and other balance sheet adjustments. See Tarullo (2008). 29
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mortgage fraud, adverse selection, and other principal‐agent problems.33 The widespread preference of unregulated intermediaries to lever up on the basis of mainly short‐term funds can also be interpreted as driven by moral hazard. Managers (at least some of them and particularly, but not only, asset managers) also seemed to have danced eagerly to the moral hazard tune. While enjoying the high returns of the good times, they let their shareholders and investors deal with the losses in the bad times under the convenient excuse that everybody shared the same miseries.34 A good case can also be made that the state promoted moral hazard on the way up. Some argue, for example, that the widespread subsidies and guarantees provided to the house financing sector in an effort to boost access (exacerbated by Fannie Mae’s and Freddie Mac’s “quasi‐mandated” foray into the sub‐prime sector) can be blamed for launching the ball and boosting its moral hazard momentum once in play.35 The failure to control the build‐up phase can then be attributed to the regulator’s inability to win the cat‐and‐mouse game of regulatory arbitrage. Banks managed to stay on top by swiftly moving to the shadow‐banking world, with regulators hardly able to keep up.36 The extreme fragmentation and overlapping mandates of agencies that comprise the U.S. supervisory system was of course the final blow. Had the regulators been aware and statutorily able to do something, the necessary coordination was just too much to handle. The agency paradigm is self‐contained in that it carries the seeds of its own demise. Once participants have taken the plunge, they have little or nothing more to lose by taking on additional risk. A dynamic could be thus unleashed that pushed bets higher and higher as less risky investment opportunities became gradually exhausted. Indeed, there is good evidence that risk taking by mortgage originators mushroomed over the cycle as less and less creditworthy borrowers were gradually let in.37 Such dynamics should be naturally unstable and eventually collapse on their own weight.38 Once the crisis hit, the liberal unfolding of the safety net under the gun of systemic contagion (lender‐of‐ last‐resort by the Fed and bail outs by the Treasury) clearly validated any moral hazard incentives that might have led to the crisis. In particular, it facilitated the early exit of at least some of the well‐informed large investors, rewarding those who had lent imprudently (and allegedly knowingly). Another moral
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Ashcraft and Schuerman (2008) analyze the “seven deadly frictions of asymmetric information” that unfolded with a vengeance in the originate‐to‐distribute world. 34 The managers masquerading their excessive tail‐risk taking as clever investment moves are dubbed by Rajan (2008a) as “fake‐alphas”. The perfect excuse for the bad times is defined by Calomiris (2008) as “plausible deniability”. Reflecting their greater concern for the short‐term bottom line than for the potential longer term risks (perhaps reflecting mostly backward looking compensation schemes), operational managers seem to have paid insufficient attention to the concerns of risk managers. On issues of managerial compensation and the scope for managerial “abuse”, see also Dewatripont and Tirole (1994), Brunnermeier (2008), and Gorton and Winston (2008). 35 Fannie Mae and Freddie Mac—the giant mortgage government‐sponsored enterprises—could meet their mandated social housing goals by buying eligible subprime mortgages. For a summary of public policy actions to promote housing finance see Calomiris (2008). 36 For good narratives along these lines, see Caprio et al. (2008), and Calomiris (2008). 37 On the propensity for increased risk taking, see Dell’ Ariccia et al. (2008), and Keys et al. (2008). Leamer (2008) goes further to argue that there was a gradual shift from hedge finance to speculative finance and then to outright Ponzi finance during the recent housing cycle. 38 In the end, the trigger for the crisis under the pure agency paradigm should still be a stochastic event (moral hazard would cease to operate if there was no longer a possible upside, as unlikely as it might be). That event, however, can be so small that it ceases to be relevant.
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hazard booster in the ex‐post unfolding of the safety net was that, for the most part, large institutions were not closed and, perhaps more importantly, managers were allowed to stay in charge.39 In sum, the moral hazard tune does ring true in many respects. However, important questions remain. First, for shadow banking to be explainable by moral hazard, it must have allowed commercial banks to pile on more risk. However, whether, on balance, commercial banks ended up shedding or piling risk through securitization is not entirely clear, albeit some evidence seems to militate in favor of the latter.40 As intended by the early promoters of securitization, the sale of mortgage‐backed securities to investment banks should in and of itself, have reduced (not increased) commercial banks’ riskiness. In reality, however, much of the risk was never really divested away. Instead, commercial banks repurchased good chunks of the instruments they sold, for reputational as well as business continuity reasons, and remained committed to support investment banks through their back‐stop liquidity facilities (they were lenders of first resort to capital markets players). Moreover, they generally retained the more risky assets (or the more risky tranches) while shedding away the less risky ones.41 At the same time, they moved down the credit market to take on new and arguably higher risks associated with consumer, mortgage, and SME lending. They also accumulated more risk by engaging in widespread rating arbitrage (shopping for the most favorable ratings).42 Moreover, even if one believes that banks did accumulate more risk, it does not necessarily follow that this was induced by moral hazard. Indeed, commercial banks could have genuinely bought the risk under the presumption that it was safe for them to store it (they perceived the regulations to be too tight and their capital more than enough to cover the associated risks). Under this interpretation, to which we will come back under the externalities paradigm, commercial banks ventured into new markets and new instruments simply because they had a comparative advantage in doing so. Perhaps more importantly, the main piece of the puzzle that does not quite fit this paradigm is the blatant asymmetry between the smart ones who are alleged to have consciously caused havoc and all the rest of the financial market participants who were not paying attention. In particular, why did the markets (informed investors and shareholders) fail to discipline financial intermediaries? In the end, many investors surely got it wrong and lost tons of money; a multitude of bank shareholders got wiped out; and many managers likely have had second thoughts about having played so eagerly the alpha card. In this context, supervisors must surely also be thinking that it is unfair to treat them as if they were the only ones asleep at the wheel. The moral hazard story inherently requires a strong agency problem, caused either by high enforcement costs or deep crevices of information asymmetry. Arguably, principals (shareholders and large investors) lacked the incentives or regulatory tools that might have helped them align the actions of their agents (managers). However, it is difficult to believe that principals would not have taken early disciplinary action, if only by voting with their feet, had they really understood the risks agents were taking. Thus, setting aside the problem faced by the regulators as regards the growth of the unregulated sector, enforcement costs are not really consistent with the lengthy gestation of the build‐up to the crisis nor with the short‐term nature of the financing that supported that build‐up. A better case can perhaps be made for the intensification of information asymmetry resulting from the opacity, complexity, and 39
Curiously, while deposit insurance fully protected the small depositor, much less was done to protect the small borrower (that has been an important asymmetry as regards consumer protection). 40 Rajan (2005) presents evidence that suggests some increase in overall banking risk, as indicators of banks’ distance to default have not risen in many developed countries and bank earnings variability has not fallen in the United States. Instead, the risk premium implicit in bank stocks appears to have risen. 41 See for example Ambrose et al. (2005). 42 See Brunnermeier (2008).
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interconnectedness of the new age housing finance market.43 Arguably, this could have provided a cover under which the ones at the top of the pack could have hidden their operations. Yet, it still remains hard to fathom that this “scam” would take place for such a long period, during which the asymmetry between those who were “in” and those who were “out” would linger unabated, and that this would happen in a market place where tips, news, and information are produced by the ton every minute. The Externalities Paradigm Externalities, the mirror image of individual opportunism, clearly play a major role in the collapsing phase of any crisis. Seeking to save oneself by running for the exits puts the others at increased risk of a major meltdown with extreme social costs, thereby exacerbating the violence of the downturn. But externalities also play a key role during the build up stage, making the system inherently more fragile. The failure to internalize the costs of a systemic crisis is at the core of the insufficient demand for prudential buffers, including in particular liquidity, which has features of a public good. Externalities can also induce bubble‐type deviations of asset prices from their fundamentals.44 They can also result in under‐production of information and monitoring (free‐riding) and over‐extension of credit during upswings, over‐contraction during downswings (in both cases, the marginal lender can “sour the market”, increasing the vulnerability of other lenders to a default). Last but not least, coordination failures (a form of un‐internalized externalities) can also play an important role in lengthening and aggravating the upwards phase of the cycle. Market participants may know it is in their best interest to prevent an asset bubble yet fail to do so because doing the right thing would only be optimal if everybody else in the group did it too. Supervisors, both across agencies and across countries, are similarly vulnerable to such coordination failures. For example, tightening regulation in isolation has a high cost, as business will quickly flow to the less regulated sectors or countries. The lack of sufficient buffers was indeed at the core of the severity of the collapse. As in the case of traditional banking, shadow banking was financed mostly through short‐term obligations (and largely perceived to be redeemable at par), much of it through overnight repos. The potential for a bank‐type run was therefore there from the outset. But two additional factors made for a much more explosive situation. First, the financing came mainly from ready‐to‐run wholesale investors, thereby introducing a new, more unstable layer to the intermediation process. Second, the capital and liquidity buffers held by most shadow‐banking intermediaries to protect their short‐term liabilities from price fluctuations in the final asset (housing) were much smaller than in traditional commercial banking. This reflected the high leverage of self‐standing investment banks and (to a less extent) hedge funds, as well as the lack of capital put in by the final borrowers who benefited from high loan‐to‐value ratios and second mortgages. Thus, as documented elsewhere in detail, once a tail‐risk event materialized and pressures
43
See for example Gorton (2008). Because individual agents do not internalize the general equilibrium impact on asset prices of fire sales under financial distress, they can bid up the price of these assets in excess of their socially optimal value. Lorenzoni (2007) develops a model along these lines and shows that competitive financial contracts can result in excessive borrowing ex‐ante and excessive volatility ex‐post. As in Holmstrom and Tirole (1998), agents cannot insure themselves against aggregate liquidity shocks due to a limited ability to commit to future repayments (this in turn reflects agency frictions). Korinek (2008) develops a paper along the same lines but applied to capital flows rather than domestic intermediation (in his model, agents borrow too much because they do not internalize the potential impact of an exchange rate move on a systemically‐induced need for sudden repayment). 44
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to sell started to build up, the devastating downward spiral quickly dried up liquidity and brought markets to a standstill.45 In the shadow banking world, the externality pitfall of traditional banking operated with a vengeance, as everyone counted on everyone else’s for support but no one adequately internalized the systemic risks of such cross‐support. Investment banks counted on commercial banks (both for liquidity and for asset repurchases);46 commercial banks counted on market liquidity (why hold liquid backing against assets which you can sell at any time in the market place?); and leveraged intermediaries counted on credit default swaps and other forms of insurance issued by other leveraged institutions. In the process, a great fallacy of composition developed—leading market players (and supervisors) wrongly to believe that risk protections at the individual level would add up to systemic risk protection. Yet, markets for individual risk protection instruments could only continue functioning if some intermediary was willing to continue “making the market”.47 The extreme systemic fragility of such interconnectedness has by now become obvious.48 By unloading (selling) risk—for example through credit default swaps—to other financial institutions such as insurance companies, intermediaries further intensified the negative systemic externalities.49 Such transactions might have reduced the exposure of institutions individually but increased the exposure of the system as a whole. Yet, this move was openly encouraged by regulators (insured assets had a low or zero risk weight), who viewed it as a way to reinforce market discipline (again, an example where moral hazard and externality containment directly collided). The possible systemic costs of trading credit derivatives over the counter (without a central clearing counterparty or protocols for multilateral netting), rather than on an exchange, were not internalized either. While the fragility brought about by externalities has received much attention in the crisis literature, an equally important consequence of un‐internalized externalities that has received much less attention is their implication for regulatory arbitrage. As in the case of moral hazard, the growth of shadow banking can also be explained as externality‐induced incentives to circumvent regulation. The key difference is one of intent. From an externality viewpoint, intermediaries were “doing nothing wrong” by finding new ways to take on more risk. Instead of seeking to take one‐sided bets with someone else’s money, as in the agency paradigm, the intermediaries engaged in regulatory arbitrage under the externalities parading were just searching for ways to match more closely their risk taking with their risk appetite, and they were doing so in a way which, from their own (limited) perspective, was sufficiently safe. From their individual viewpoint, regulations were “unnecessarily binding”. In this sense, the intent of the Glass‐Steagall Act—to shift risk away from regulated intermediaries to capital markets and unregulated intermediaries—was fundamentally misguided. While it could have solved the agency problem (by shifting risks to the land of the well informed) if it had been done cleanly enough (i.e., without dragging the banking system into the mud and the safety net over the line‐in‐the‐ sand), it exacerbated the externalities problem. Well‐informed investors can monitor the intermediaries to make sure they do not “cheat them” (play the moral hazard card). However, they have no incentives
45
See Greenlaw et al. (2008), Adrian and Shin (2007 and 2008), and Brunnermeier (2008). Yet, there were no capital charges for such “reputational” credit lines (see Brunnermeier, 2008). 47 The linkages between securities market liquidity and funding liquidity, and the resulting increased scope for liquidity spirals are analyzed by Brunnermeier and Pedersen (2008). 48 The fact that most intermediaries traveled along the same path on both the way up and the way down, driven by similar incentives and risk management models, further boosted the systemic impact of these externalities. See Brunnermeier (2008). 49 Allen and Gale (2005) discuss the possible implications for systemic risk of such transfers. 46
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to “internalize” the liquidity and other externalities.50 Instead, their incentive is to play it safe by investing very short and running at the first signal of trouble and to increase leverage by as much as is privately (not socially) optimal. To be sure, reflecting regulatory shortcomings in the internalization of systemic liquidity risk (see below), incentives were not much better aligned for the regulated intermediaries. Nonetheless, capital in the regulated sector substantially exceeded that in the unregulated sector, reflecting systemic concerns of regulators for the commercial banking sector.51 Thus, the side‐by‐side existence of a regulated sector—where systemic concerns were partially factored in—and an unregulated sector— where externalities were not at all internalized—created a wedge in returns between the two worlds, giving rise to a fundamentally unstable construct. Investors left in droves the regulated intermediaries to join the world of the less regulated, highly leveraged and short funded intermediaries, rapidly raising their relative size and boosting systemic risk in the process. Moreover, because it involved sophisticated and unsophisticated investors, the exodus spread moral hazard throughout the presumably moral‐ hazard free unregulated (or less regulated) world. The resulting competitive pressures on commercial banks ultimately motivated the repeal of the Glass‐ Steagall Act.52 However, by challenging commercial banks to compete head‐on with the blown‐up investment banks and on their turf, the repeal induced the former to find creative ways to shed their regulatory burden outside their balance sheet. Thus, oddly enough, the Glass‐Steagall Act resulted in a one‐two punch on the soundness of financial intermediaries. Its introduction boosted systemic risk outside commercial banking. Once this was done, its repeal boosted systemic risk within it. As in the agency paradigm, supervisors come out severely bruised. They did not realize that their own well‐meaning regulation was setting into motion a deadly process of regulatory arbitrage that shifted intermediation to a field where inducements to internalize externalities were weaker or nonexistent, thereby contributing to asset over‐pricing and spreading liquidity risk all over the financial system. And even when supervisors caught up, they were unable to do much because in the cat‐and‐mouse game of regulatory arbitrage the mouse had trespassed over the line‐in‐the‐sand to a territory where prudential regulation was not unreasonably reluctant to enter. Investment banks, hedge funds, and the like were thus simply left out of reach.53 Moreover, even within the regulated world, the Basel‐inspired wave of prudential regulation focused little on liquidity. And when the norms addressed liquidity issues, they did so from a purely idiosyncratic perspective.54 To his defense, however, the externality‐conscious 50
A similar point was made by Bernanke (2006). For example, investment banks’ leverage of around 25—compared to commercial banks’ leverage of only about 10—gave the former an obvious advantage. Although the SEC, as lead regulator, applied to investment banks the same Basel capital rules as for commercial banks, the differences in leverages resulted from the much lower capital requirements on “trading books” than on “banking books” and the fact that limits on gross leverage ratios only applied to commercial banks. 52 Pushed by the forces of competition and deregulation, commercial and investment banks seemed to have met somewhere in the “regulatory middle”. As the repeal of the Glass‐Steagall Act allowed commercial banks to encroach more directly on investment banks’ traditional fee‐based business, the former took on more fees in order to offset losses in intermediation margins. Also, and partly as a result of the deregulation of commissions for stock trading in the 1970s (that allowed low‐cost brokers to encroach on investment banks’ brokerage activities), self‐ standing investment banks gradually shed their fee‐based business in favor of a highly‐leveraged margin‐based business. See Eichengreen (2008). 53 The move towards consolidated supervision of financial conglomerates was as far as prudential regulators were willing to extend their reach to protect the core banking system from capital market risks. 54 For example, liquidity norms generally advocate minimum ratio of liquid assets to liabilities to limit maturity mismatches. But this is simply not good enough from a systemic viewpoint where even short‐maturity assets can 51
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supervisor may argue that systemic events such as the Subprime crisis are akin to “one‐hundred year floods”. They are too rare and unpredictable to be usefully internalized in prudential regulations. The social cost of doing so (note here the italics) would simply exceed the social benefits. Hence, a better option is to have a prompt correction regime and an efficient public rescue system. The missing piece in this paradigm, which is otherwise convincing enough, relates to its dynamics. To be sure, the lack of sufficient internalization of systemic risks can lead as easily as moral hazard‐based incentives to a more fragile and vulnerable system. Yet, unlike in the agency case, the externalities paradigm in and of itself lacks inherent dynamics that gradually increase the precariousness of the equilibrium over time and eventually bring the system so close to the edge that the tiniest exogenous shock would throw it over.55 In the pure externalities paradigm, intermediaries continue to “manage” their risk, adjusting it to what is privately optimal and then just staying there. The large shock that eventually sent the financial system over the edge must have therefore come out of “left field”—an exogenous act of god, whose probability was independent of the degree of vulnerability of the system. However, as far as one can see, there was no such shock in the case of the Subprime crisis. One could argue that, instead of an exogenous shock, the engine driving the financial system to its eventual collapse was a real sector‐driven business cycle. However, prudential norms are supposedly designed to allow financial systems to navigate unscathed through the ups and downs of the regular business cycle. Hence, this could only be a satisfactory explanation if the magnitude of the downturn was unprecedented and truly unexpected. Again, however, this does not seem likely. The financial crisis was unleashed in full force much before there was a marked real sector decline, with causality going mostly in the opposite direction. Alternatively, one could tease out some endogenous dynamics within the externalities paradigm by associating the externalities driving the system to a prisoner’s dilemma. What market participants do individually (i.e., join the feast in the boom and the stampede in the bust) is clearly harmful to themselves and the group, but each participant would stop only if everyone else in the group did the same. That this type of coordination failure can generate some cyclical fluctuation stands to reason.56 That it can lead to a catastrophic and expected systemic collapse is more difficult to accept. In the absence of a non‐externalities related factor—either moral hazard (perhaps boosted by managers’ short incentive horizon) or a truly unexpected unfolding of events (a much bigger or much sooner meltdown than anyone could reasonably have expected)—one would think that at some point the downside risk to each individual participant of remaining in the game should dominate the upside risk. At that point, self‐ preservation should de facto force coordination, keeping the group some distance away from the edge of the cliff.
become illiquid. Norms have failed to focus on systemic rollover risk, which is at the core of intermediaries’ vulnerability to runs. 55 Some recent analysis of the unfolding of the Subprime crisis stresses the extreme market fragility resulting from an unexpected market realignment in a context where all the large traders have similar underlying risk models and objectives (Khandani and Lo, 2008). However, it is not obvious that traders would have continued to operate so close to the edge if they had understood the true fragility of the environment in which they were operating and the huge potential costs of a meltdown. 56 For example, Abreu and Brunnermeier (2003) develop a model in which asset bubbles persist despite the presence of rational arbitrageurs because the latter cannot temporarily coordinate their selling strategies due to a dispersion of opinions.
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The Mood Swings Paradigm The starting point of the mood swings paradigm is the endogeneity of financial innovation within a broad process of financial development. The shift from traditional banking to shadow banking can be interpreted as the natural evolution of a rapidly deepening financial system in which markets and intermediaries increasingly complemented each other.57 Banks commoditized credit risk through the originate‐to‐distribute model and retained some credit risk to overcome agency problems.58 At the same time, they used their ability to provide first resort liquidity to help markets overcome the remaining liquidity gap associated with the yet nascent and still overly heterogeneous instruments. The pressures of competition, boosted by the steady entry and rapid growth of unregulated (or less regulated) brokers and intermediaries (particularly investment banks), were clearly at the heart of such a remarkable process of financial deepening and market completion. However, the creation of new instruments and forms of intermediation went faster than the ability of market participants and supervisors to fully comprehend their implications and handle the risks and uncertainty associated with such a rapidly changing world. The opacity, complexity, and hidden interconnectedness of the Subprime world can thus be seen in the mood swings paradigm as bad side effects of an innovative process, but side effects that were either not intended or, if intended, not necessarily maliciously pursued.59 The inability to think through the potential systemic implications and fragilities of the new universe was the fundamental and critical failure. This problem was compounded by a failure to fully comprehend the links between financial sector dynamics and the underlying asset price dynamics, and to adequately understand the feedback loop between rising asset prices and expanding credit. The possibility of a large and nation‐wide synchronized decline in housing prices (and the devastating implications this would have for the risk correlation assumptions underlying the presumed safety of credit default protections) was unthinkable because it had never happened since the Great Depression.60 Moreover, when delinquency rates on mortgages started to rise during the mini‐recession of 2002, the losses on mortgages were minimal because the housing market continued to boom.61 From this perspective, falling housing prices and their implications for the housing finance market appear not as “tail risk” but as a “black swan” event, a new reality that could not be anticipated from historical series.62 Faced with the world of the new and unknown, market participants involved in the Subprime process no longer had a steady frame of reference. On the way up, they found themselves in a truly new and wonderful territory which fueled a mood of optimism and exuberance. This was reinforced by the decline in observed macro‐financial volatility, predictable pricing and deep market liquidity, which further fed risk appetites and gave rise to pro‐cyclical leveraging.63 The low volatility environment not 57
Through securitization, markets benefit from the screening done by intermediaries and the latter benefit from the more efficient parceling and tailoring of risk carried out through the markets. See Gorton and Winston (2002), and Song and Thakor (2008). 58 This was certainly not a minor achievement—it involved standardizing the credit risk screening (through scoring and rating), breaking it up (through stripping and tranching) and dispersing it (by selling it to a wider base of investors and spreading it around through a new breed of credit risk derivatives). 59 Information got lost through the “chain of complexity” and banks became exposed in the process to heavy “pipeline risk”. See Brunnermeier (2008) and Gorton (2008). 60 See Gorton (2008) and Coval, Jurek, and Stafford (2008). 61 See Calomiris (2008). 62 See Taleb (2007). 63 Unlike commercial banks that targeted a constant leverage throughout the cycle, investment banks’ leverage was heavily pro‐cyclical. See Adrian and Shin (2007 and 2008).
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only had the immediate mechanical effect of reducing values at risk but also, the more it persisted, the more it fed the feeling that “this time around, things are different and the good times are here to stay”. New forms of macro‐financial management and oversight, including the ever more sophisticated risk modeling, widespread divestment of risk through risk derivatives, and more effective and successful monetary management, were all major contributors to this optimistic picture.64 Feelings such as “everything is being taken care of”, “good men are now in charge”, and “systemic volatility is a memory of the past which has now been vanquished even by the Mexicos and Brazils of this world” became so prevalent that few really questioned them. On the way down, the brutal downward swing in the prevalent market mood also fed the collapse. A significant dissonance would be enough to initiate the mood swing. In the Subprime crisis, the swing was arguably triggered when the CBX credit swap index on sub‐prime based instruments started going south, colliding with the still rosy assessments of the rating agencies.65 As long as there was widespread market agreement on a price vector, ensuring that instruments could continue to be unloaded on short notice, markets could go on functioning unperturbed (whether prices actually matched fundamentals was not that important as long as they were uncontested). However, by questioning the uniformity of market assessments, the drop in the CBX index suddenly raised the specter of “hidden icebergs lying ahead”. From euphoria, the mood shifted into acute Knightian uncertainty, where risk aversion swelled, driven by the fear of the unknown.66 The frenzied recoiling of investors was compounded by general market opacity—including the knowledge that intermediaries were deeply interconnected coupled with utter ignorance on the nature and specific details of this interconnectedness. Opacity thus intensified the massive sell out of securities and simultaneous flight to cash, with the resulting market collapse and evaporation of price signals further accentuating the downward spiral.67 In this paradigm, well‐meaning public policy also played a central role, both on the way up and on the way down. On the way up, a key and justifiable role for policy is to promote market completion within an evolutionary financial development process.68 Indeed, the set of policies designed to promote housing finance by jump‐starting the markets for new instruments such as securitization through guarantees and subsidies can be viewed as sowing the earliest seeds of the crisis. The Subprime crisis grew, in effect, in the “shadow” of the guaranteed world of Fannie Mae and Freddie Mac. While such policies can help overcome natural impediments to market development—particularly where collective action is difficult and network and scale effects are significant—they can also help promote the illusion that risk has been reduced to a point where it ceases to be a predominant concern. Public intervention also played (and continues to do so) a critical role on the way down. In a world of uncertainty and acute swings in risk aversion, only the State has the shoulders needed to function as the risk‐absorber‐of‐last‐ resort during episodes of acute, systemic failure.69 In this view, the ex‐post unfolding of unprecedented 64
As Greenspan (1998) famously declared, the “management of systemic risk is properly the job of central banks” and “banks should not be required to hold capital against the possibility of an overall financial breakdown”. 65 See Gorton (2008). 66 Uncertainty aversion came on top of (and interacted with) increased volatility. See Brunnermeier (2008). 67 Panics end when information recomposes and becomes available. Intermediary‐based finance is in this sense much more vulnerable than market‐based finance, since prices are less likely to vanish in markets that do not rely on market‐making institutions. 68 A theoretical justification for government intervention in a context of incomplete markets can be found in Geneakoplos and Polemarchakis (1986). Gale (2004) shows that in the presence of incomplete markets there exists an implicit pecuniary externality that generally requires the imposition of capital requirements. 69 The seminal contribution as regards the role of the State as the residual absorber of risk is that of Arrow and Lind (1970). See also Caballero (2009) for a recent reinterpretation of the insurance role of the State in systemic crisis conditions. An intriguing argument can however also be made that instead of spreading risk over taxpayers
38
Fed’s lender‐of‐last‐resort activity and the U.S. Treasury’s bail out operations can be interpreted as a way to drain away from the system sufficient systemic risk so as to allow markets to spring back up to life and intermediaries to continue operating. All in all, the mood swings paradigm presents a more rounded overall story than the other two paradigms, and a story with far‐reaching implications at that. Unlike the agency paradigm, it does not require a gigantic and unyielding asymmetry of information between market participants that are in‐ the‐know and those that are out. Rather, it is a democratic paradigm where everybody was fooled. And unlike the externalities paradigm, it does not require a vengeful god to intervene exogenously with tail‐ risk events to unleash the dynamics of a downward spiral. Instead, it has its own fully endogenous dynamics, with favorable returns and optimism feeding each other on the way up, adverse returns and pessimism on the way down. The dynamics are akin to Schumpeter’s creative destruction, where cycles are a natural part of the evolutionary process. However, unlike the traditional Schumpeterian process, where some do well while others perish at every point in the cycle, the dynamics in the mood swings paradigm are more like “Schumpeter on steroids”, as financial innovation cycles can have a devastating systemic impact because everyone follows the same path, up the bubble and down the abyss. The mood swings paradigm, however, is not free of puzzles and difficulties. In particular, uncertainty‐ driven mood swings are easy to invoke but harder to model.70 To be sure, one would expect rationality (even if bounded) and path dependence to constrain feasible outcomes. However, unlike incentive distortions under the moral hazard and externalities paradigms, which are firmly grounded in traditional economic theory, modeling mood shifts may require some departure from orthodox theory.71 In any event, it is also rather surprising that market participants were seemingly oblivious to the risks underlying the process of financial innovation. Did such obliviousness simply reflect a difficulty to look outside the box and connect the dots? Did such difficulty reflect the fact that markets do not reward (current and future), risk might be more efficiently spread over existing debt holders by using debt equity swaps as an alternative to unconditional bail outs (see Veronesi and Zingales, 2008). 70 The importance of mood swings for financial bubbles and panics has been widely recognized. It finds its roots in Keynes’ animal spirits and Hyman Minsky’s writings on financial crises (see Minsky, 1975). More recently, it was popularized by Kindleberger (1996) and Shiller (2006). While many attempts have been made to model mood driven‐cycles within the traditional world of rational expectations with full information (see the seminal contribution of Azariadis, 1981), the conditions for such rational bubbles to exist have been shown to be rather limited (Santos and Woodford, 1997). However, moods play a much more important role once one assumes problems with the information (imprecision or uncertainty) or the way one deals with it, which, in turn, may (or may not) require abandoning the assumption of full rationality. Epstein and Wang (1994), and more recently Fostel and Geneakoplos (2008), showed that multiple priors can lead to models where beliefs influence asset prices in a fully rational world. In addition, Geweke (2001) and Weitzman (2007) showed that, when there is too much uncertainty, fully rational human behavior may not conform to the precepts of traditional economic theory as defined by the standard expected‐utility framework. Abandoning the assumption of full rationality opens up the scope for innate biases in the way economic agents process information and make decisions (see the recent surveys of behavioral finance in Barberis and Thaler, 2003, and Della Vigna, 2007). Attempts to explore the implications of such limitations for finance and credit cycles are making some headway. For example, Shleifer and Vishny (1997) showed that inefficient asset pricing driven by noise traders can persist despite the presence of rational arbitrageurs. Lo (2004) proposed an evolutionary approach to economic interactions. De Grauwe (2008) showed that it is possible to generate endogenous cycles when agents use simple heuristic rules to interpret the dynamics of a model they do not fully comprehend. 71 For example, they may be associated with biased perceptions under bounded rationality, or shifts in risk appetite under rational expectations, a non trivial distinction since one would expect risk pricing to be biased in the first case but not in the second. Another key modeling difficulty is the extent to which uncertainty goes beyond the underlying environment to include group behavior.
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systemic risk gazing (a theme to which we will come back in the next section)? Or was something more sinister at play, either moral hazard or non internalized externalities? In particular, absent externalities, one wonders whether uncertainty alone could pack so much punch, particularly on the way down. In sum, the overall picture one gets from systematically reviewing the three paradigms is that they all provide broadly plausible stories. Hence, they must all contain important grains of truth. Moreover, the paradigms seem to interact and feedback on each other in complex ways, one triggering the other or becoming more predominant at different stages of the cycle. Hence, a fully rounded story—one that does not leave key questions unanswered and fully accounts for the complexity of real life—requires combining the paradigms. However, multi‐dimensionality makes the challenges of policy reform that much more difficult. To these issues we now turn. Paradigms and Regulation In this section, we will briefly summarize what we perceive to have been the main failures of regulation and illustrate in broad terms how policy prescriptions to fix them will often not be independent of the paradigm of choice. The great failures of prudential regulation evidenced by the Subprime crisis can be classified into: i) failures of scope; ii) failures of focus; and iii) failures of dynamics. Take the failures of scope first. The “line‐in‐the‐sand” philosophy simply did not work. The prevailing thinking was that opening a wide room for unregulated intermediaries to thrive was of little consequence to systemic stability. Knowledgeable investors would maintain them in line. Moreover, they were too small to be systemically important. Both assumptions turned out to be deadly wrong. The failure to internalize externalities in the unregulated world created a bias in favor of unregulated intermediaries that drew in unsophisticated investors in droves and made them grow explosively. In turn, this competitive bias induced banks to elude regulation by pushing risk outside their balance sheet and turn a somewhat blind eye to the risks taken by their borrowers. Thus, not only was risk not adequately internalized ex‐ante but also prudentially unregulated (or less regulated) intermediaries quickly grew to the point where they became systemically relevant players and, hence, had to be admitted ex‐post to the safety net, no questions asked. Consider next the failures of focus. First, the prevailing regulatory framework established a neatly dividing line between the ex‐ante prudential norms and the ex‐post safety net. The ex‐ante regulatory framework focused on maintaining the soundness of assets, the ex‐post safety net on maintaining the liquidity of liabilities. The obvious loose end was the lack of ex‐ante internalization of systemic liquidity risk. Second, prudential regulation focused on the soundness of each institution under the assumption that the sum of sound institutions was equivalent to a sound system. However, as noted earlier, the Subprime crisis showed that this approach constituted a major fallacy of composition. It turned instead the approach on its head: the system is what matters most to the soundness of each institution.72 Third, traditional regulation focused on statistically observable risks and made much out of the sophisticated and complex risk modeling techniques that fed on these statistics. Yet, the Subprime crisis
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Basel‐style regulation rewarded those institutions that covered their risks with products and services offered by other institutions. Yet, the Subprime crisis showed those atomized protections to be not only irrelevant (they provided a false sense of security, unraveling when most needed) but possibly counterproductive as well (they exacerbated contagion and the risk of overall systemic failure).
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demonstrated that what you do not see is what will kill you (tail risks, black swans, and endogenous risk).73 Finally, consider the failures of dynamics. Basel‐style regulation was essentially static. Norms were time invariant (cycle independent) and the mandated capital buffers were assumed to be sufficient to carry the system through the business cycle.74 The Subprime crisis proved that approach wrong: static norms turned out to be pro‐cyclical, too loose on the way up, too tight on the way down. Last but not least, Basel‐style regulation failed to adequately incorporate the dynamic links between monetary and prudential policies. The central bank’s job adhered to ensuring macro stability and providing lender‐of‐ last‐resort services, the supervisor’s to ensure financial prudency, and the two did not need to interact much. Yet, the insufficient attention of monetary authorities to the implications of their actions on financial developments, coupled with the insufficient attention of the supervisors to macro dynamics, deeply contributed to the crisis.75 A major problem when seeking to address these regulatory failures is that the best fix will most often depend on the paradigm. How one sees reform is thus essentially a function of the lens one uses. Table 2 synthesizes this discussion. The first questions in the table (under “foundations”) refer to the objectives of regulation. Although both the aims (reducing principal‐agent frictions or internalizing social costs) and the means (see below) differ, the need to align incentives through ex‐ante prudential norms is clear and uncontroversial under either the agency paradigm or the externalities paradigm. Instead, in the mood swings paradigm, the aim is to maintain innovation under control and to temper mood swings. While there is no obvious inconsistency between the two, aligning incentives and tempering moods are nonetheless clearly of a different nature. In either case, the key question as regards the respective roles of markets and supervisors in achieving the mentioned objectives of regulation is whether risk can be priced (which in turn largely depends on whether systemic crises can be avoided). The answer is “yes” in the agency paradigm. Anyone who has enough “skin” invested in his own game will have incentives to maintain risk taking within socially acceptable bounds. Similarly, anyone with enough skin invested in somebody else’s game (and this can also be mandated by regulation) will have an incentive to look for the earliest signs of malfeasance. Markets can thus deliver efficient signals and function as early smoke detectors. Once principal‐agent problems are kept under control, systemic crises should not occur and historical statistics can become the bread‐and‐butter of day‐to‐day micro‐prudential risk management (i.e., help price risk across borrowers, institutions, and instruments). Accordingly, the main role of the agency supervisor is to put in place the necessary apparatus for markets to conduct their monitoring role effectively. Once this is done, his only residual role is one of compliance checking and crime policing (misrepresentation, fraud, looting, etc.).
73
While the regulatory framework has attempted to reduce the gap between risk and regulation (by upgrading from Basel I to Basel II), the Subprime crisis has brought into evidence severe issues of opacity, excessive complexity, and a misleading sense of control. See Tarullo (2008). 74 Spanish regulators were the only ones in the developed world that explicitly dealt with cyclical dynamics by introducing the so‐called “statistical provisions”—i.e., provisions that are built out of income during the upswing of the credit cycle and can be converted into specific provisions in the downward part of the cycle. This commendable approach was never embraced as part of the Basel creed, however. 75 Borio (2003), Goodhart et al. (2004), Rajan (2005), and White (2006) were among the few providing early forewarnings of the dangers of this approach.
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Table 2. A Synthetic Overview of Regulatory Issues and General Policy Responses Dimensions
Foundations
Scope
Paradigm Issue
Agency
Externalities
Mood Swings
What is the main problem?
Betting with someone’s else money
Opportunistic behavior that conflicts with the social good
Mood swings in an uncertain, evolving world
What should ex‐ante prudential norms do?
Align incentives through skin in the game
Align incentives through internalizing externalities
Temper moods and domesticate creativity
Yes
Probably not fully (one hundred year floods)
Probably not (unless Moses‐ like supervisor)
How effective is market discipline?
Potentially very effective
Ineffective (inability to estimate or withstand systemic risk)
Ineffective (inability to comprehend or withstand systemic risk)
What is the role of the supervisor?
Enhancer of market discipline‐ crime police
Crowd manager‐ fireman
Scout‐ moderator‐ fireman
Should the line in the sand be redefined?
No
Yes
Not necessarily
Yes, it is fundamental
No, it exacerbates externalities
No, it exacerbates mood swings
No
Perhaps Yes
Probably Yes
How important to look at the system?
Not important
Very important
Fundamental
Should prudential and monetary authorities coordinate?
Yes, but not tightly
Tightly
Very tightly
No
Yes, rule‐based
Yes, judgment‐ based
Can risk be priced?
Does fair value accounting help? Focus
Dynamics
Are systemic liquidity norms needed?
Are dynamic, macro‐ prudential norms needed?
By contrast, the scope for market help is marginal at best in the externalities paradigm, where the key dimension of risk is dynamic rather than cross sectional. It is likely to be socially too expensive to put in place fully crisis‐proof prudential buffers. If so, risks of one hundred year floods (truly extraordinary events) will persist and markets can only help internalize externalities (i.e., provide systemic insurance) if they are able to calibrate the risks and costs of such events, and to withstand their strains. Neither is likely, however. For one thing, tail risks are unlikely to be estimated with precision, even when a
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sufficiently long statistical history is available. For another, given the contrast between the huge scale of a systemic crisis and its low probability, this is an aggravated case of catastrophe insurance. In view of the difficulties that the latter has faced, it is dubious that full‐blown, market‐based systemic insurance will see the light of day any time soon.76 The scope for market assistance is limited even further in the mood swings paradigm. As in the externalities paradigm, risk is systemic and dynamic. However, rather than tail risks that can be ultimately modeled, exceptional bumps ahead are more in the nature of “black swans” (observations that cannot be inferred from previous data series) or “endogenous risk” (risk endogenously created by market participants).77 Hence, risk pricing becomes inherently difficult, not only because statistical history provides few clues as to what might be popping up ahead, but also because markets that are shaped by alternative bouts of euphoria and despair are unlikely to provide efficient, fundamentals‐ based pricing signals. Thus, absent an effective oversight to prevent such financial system drifts (which, as argued below, will need to rely on greatly expanded supervisory skills and powers), Basel II’s aspiration to make regulation rest on internal risk management models, bolstered by risk‐rating agencies and market valuations, crumbles. This aspiration presupposes that risk dominates uncertainty and markets are efficient, two premises that an unbridled mood swings paradigm debunks.78 The only scope for markets to play a role in the mood swings paradigm would be taking bets on whether the system as a whole is headed in the right direction or likely to crash. While dedicated and well trained observers may well be able to detect an incoming iceberg through the fog, grasping how the system is wired and understanding the possible cracks is likely to require hefty investments and sophisticated skills. Hence, “systemic risk gazing” is unlikely to be a profitable market activity and should be viewed instead as a public good. Upgrading the role of the supervisor to provide such “holistic supervision” should therefore become a key component of reform. However, as discussed below, this will require, in addition to sound judgment and vision, sufficient independence and accountability—a tall order indeed. Consider next some of the key implications for the nature of prudential regulation. As regards the scope of regulation (the “line in the sand”), the discrepancies between the three sides are obvious. A supervisor grounded in the agency paradigm would insist that allowing unregulated intermediaries to operate freely is the proper thing to do. Informed investors will naturally migrate to the unregulated world where innovation can thrive, risks and returns will likely be higher, and—as long as information is timely and reliable—users of funds will be appropriately disciplined. However, for the reasons already noted above, his externalities colleague would be dead set against the idea of allowing prudentially unregulated intermediaries to operate side by side with the regulated sector. The mood swings supervisor would be of a more mixed mind. Unregulated intermediaries could make his life more difficult as uncontrolled innovation, pushed along by the forces of competition and regulatory arbitrage, could set eventually the system on the wrong track. However, provided all innovation is regulated, he might find this to be manageable. As regards the focus of regulation, the discrepancies across paradigms as regards the scope for market discipline have profound implications for the way risk is both reported and managed. Consider accounting issues first. In the agency paradigm, fair value accounting is clearly the superior alternative. Ensuring that changes in market values are immediately reflected in balance sheets is essential to contain the risk of a moral hazard‐driven bubble where undercapitalized intermediaries are allowed to 76
However, as proposed by Kashyap, Rajan, and Stein (2008), it might be feasible to set up private partial insurance schemes in the form of additional capital becoming available under stressful systemic events. 77 See Danielsson and Shin (2002). 78 De Grauwe (2008) makes a similar point.
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continue operating normally. However, fair value accounting can be problematic under the other two paradigms. By enhancing the impact of one intermediary’s actions on the balance sheets of other intermediaries, it exacerbates externalities. At the same time, and perhaps more importantly, it magnifies the impact of liquidity or mood swing‐induced deviations in asset prices from their longer run fundamentals. Consider risk management issues next. Are systemic liquidity norms needed? Clearly “no” under moral hazard (this is not a relevant problem), “perhaps” under externalities (as long as the ex‐ante social benefits exceed the ex‐ante social costs), and “probably yes” under mood swings. In the latter case, because crises are endogenous events rather than acts of god, they are likely to be more recurrent. Hence, unless the supervisor is convinced that he will be able to always navigate the ship around the icebergs, taking the proper systemic precautions is a good idea (multiple layers of steel against water inroads will better protect the keel). How important is it to look at the system as a whole? In the agency case, this is not the proper way to look at the problem. Systemic events arise from individual malfeasance and this is where the emphasis should stay. Instead, in the externalities paradigm, a systemic perspective is naturally called for. Indeed, this is exactly what one does when one “internalizes the externalities”. In the mood swings paradigm, the focus on the whole is perhaps even more fundamental. Crises are manifestations of collective excesses and it is impossible to understand the dynamics of the whole by summing up the idiosyncratic risks and dynamic paths of individual institutions. In this context, the answer to the question “how tightly should the prudential and monetary authorities coordinate?” is rather self‐evident. In the agency case, not much coordination is needed. Instead, the Greenspan doctrine seems to apply: let the prudential authority make sure that incentives are properly aligned and the monetary authorities make sure that the ship is sailing at the proper speed (i.e., take care of the cycle). In the externalities paradigm, the two authorities should instead closely consult each other to make sure that intermediaries are not unduly vulnerable to tail‐risk events and that the supervisor is sufficiently aware of where the cycle might go. In the mood swings paradigm, there should be very tight coordination between the two authorities and possibly even no major differentiation between them. By contributing to mood swings, monetary policy becomes an integral part of the prudential story. And the prudential risks ahead become a key dimension of monetary policy decision making. Hence, prudential and monetary adjustments are joined at the hip. Along similar lines, are macro‐prudential, dynamically adjusted norms needed? In the stationary moral hazard world, the answer is clearly negative. Instead, in the externalities paradigm, the exposure to exogenous shocks and fluctuations provides a good basis for cycle‐adjusted norms because it allows prudential buffers to be real buffers, i.e., to be built up during the good times and used up during the bad times. In addition, these norms can help coordinate the actions of individual agents and thus overcome the prisoner’s dilemmas‐type situations. Given that the externalities are known (or knowable); this militates in favor of rules over discretion. The mood swings paradigm also makes a strong case for anti‐cyclical prudential norms but for a different reason. Rather than systematically limiting the ship’s speed under clear weather, the main motive in this case is to lift up the yellow flag when, under foggy weather, “icebergs may possibly be lying ahead”. Hence, mood swings provide a rationale for a judgment‐based anti‐cyclical framework, much as the one in effect for monetary policy— a framework where an independent body would have the discretion to calibrate the anti‐cyclical prudential instrument in light of evolving circumstances.
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Consider finally the need for (and purpose of) a safety net (Table 3). To a large extent, this question relates to the scope for learning. In a system where learning is possible, it may be preferable to let agents face the hardships of financial crises and learn from experience.79 In the agency paradigm the system is not dominated by uncertainty and mood swings and, hence, should be broadly stationary (even if subjected to innovation). Therefore, agents should eventually learn. This might take a few crises and significant bruises (which in turn require that the ex‐post safety net not systematically validate the ex‐ante expectation of bailouts) but wisdom should eventually arise from the pain.80 Correspondingly, it would be better if the lender‐of‐last‐resort (LOLR) function did not exist. Bank runs are healthy manifestations of market discipline. Stopping runs unnecessarily protects banks that should fail and aggravates the misalignment of incentives for all other banks. Similarly, deposit insurance can only be justified by consumer protection but, given its adverse moral hazard implications, a pure agency supervisor would probably conclude that, on balance, the world would be a better place without it.81 By contrast, in the externalities paradigm, the nature of the problem makes learning irrelevant. As long as externalities are not internalized, participants only see their side of the story, no matter what. Moreover, there is no possible learning from exogenous and random acts of god or from self‐fulfilling runs in a multiple equilibrium world. Thus, to the extent that it is too expensive for society to prevent runs through large ex‐ante buffer requirements, an efficient LOLR becomes a socially superior solution and the cornerstone of the regulatory edifice. Also, as his forebears after the Great Depression, an externalities supervisor would conclude that deposit insurance is needed to induce the small uninformed depositors to join the banking system while preventing them from crying wolf and causing systemic havoc without justification. Again, however, having fire safety only a 911 call away hardly promotes incentives for keeping a fire extinguisher at home, another good example of regulatory collision between the paradigms.
79
The scope for learning is crucial for determining the need for any regulation, not just the safety net. Indeed, a good case can be made that even without a regulatory reform crises should convince principals (shareholders and investors) that they need to improve their control on agents (managers). 80 The remaining question, of course, is whether such a system would be “fair” to the smaller and less educated consumers who might be scared away and remain forever on the fringes but in the end this is likely to be an issue of consumer protection more than systemic stability. 81 Indeed, from a pure moral hazard perspective, the expansion of the safety net (particularly the creation of deposit insurance) can be seen as a mistaken knee‐jerk reaction that has come back to haunt the current regulatory architecture and the goal should be to get rid of it. See for example Herring and Santomero (2000), Gale (2004), and Calomiris (2008).
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Table 3. The Need for A Safety Net
Paradigm Issue
Agency
Externalities
Mood Swings
Can players learn on their own?
Probably Yes
No
Apparently not
Is an ex‐post LOLR needed?
No, it is Counterproductive
Yes, to provide systemic liquidity
Yes, to absorb systemic risk
Is a deposit insurance needed?
Probably not
Yes, to limit risks of Yes, to limit impact “wrong” runs of mood swings
Interestingly, as regards the scope for learning, the mood swings paradigm lies somewhere in the middle. The constantly evolving environment makes some learning possible but tricky. One would think that agents should learn to be more cautious and eventually come to realize that, even if the scope for the truly new is constrained by path dependence, nasty surprises can emerge and that “not all that glitters is gold”. History has amply demonstrated that this is not the case, however. Moreover, learning in this paradigm is somewhat of an oxymoron. Believing that one has finally “learned the lesson” can boost over‐confidence in one’s ability to navigate through the obstacles, thereby setting in motion a mood swings‐induced bubble. The uncertainty conscious supervisor would thus agree with his externalities colleague as to the core importance of the LOLR. However, as already noted, he would expect the LOLR mainly to absorb systemic risk rather than provide liquidity. Similarly, he would agree that a deposit insurance is needed to “calm down” the frayed nerves of investors when moods start to turn ugly. Towards a New Regulatory Framework The discussion in the previous sections suggests that the design of a proper regulatory architecture faces two major challenges.82 The first is to build a regulatory framework that takes into account all three paradigms and avoids solving problems in one paradigm at the cost of making matters sharply worse in another. The second challenge is to find an adequate balance between financial stability and financial development. Extreme solutions—a crisis‐proof system that hardly intermediates or a thriving system that frequently collapses of its own weight—are of course to be avoided. A fully specified reform proposal that meets these challenges lies much beyond the scope of this paper (even more so since the devil is in the implementation details). There is however a minimum set of basic objectives that, in our view, any new prudential architecture should seek to fulfill, either because they 82
A number of important and detailed proposals to fix the regulatory framework have already seen the light of day. See for example Financial Stability Forum (2008), Basel Committee on Banking Supervision (2008 a, and b, and 2009), Institute for International Finance (2008), and Goldstein (2008). The November 2008 Declaration of the G‐ 20 Summit on Financial Markets and the World Economy identifies the “root causes of the crisis”, sets out “common principles for reform of financial markets” and sketches an “action plan” to implement such principles. Rather than questioning the basic architecture and foundations of the current framework, these proposals have so far and for the most part sought to maintain (and build upon) this framework. While this approach is clearly understandable from a practitioner’s perspective, its longer term success will very much depend on the extent to which the key issues and interactions underpinning all three paradigms discussed in this paper are satisfactorily addressed.
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cut across paradigms or they are absolutely central to one of the paradigms. Given the popularity of the agency paradigm, the reform agenda will likely be strong in addressing principal‐agent issues (including through governance improvements, changes in management compensation schemes, and increased skin‐in‐the‐game requirements). Hence, we focus in this section mainly on the objectives of the regulatory reform needed to address central issues under the externalities and mood swings paradigms. The first objective, which is particularly relevant to the externalities paradigm but applies to all, is full regulatory neutrality. In a world where regulation is not applied uniformly, financial flows will sooner or later find the line of least resistance, giving unregulated financial institutions a competitive advantage and making them grow to the point where they become systemic behemoths. There are two possible solutions to this quandary. One is to make all financial intermediaries fit within the universal banking mode. This solution, however, would limit entry unduly and promote the preponderance of very large, too‐big‐to‐fail, financial conglomerates with limited creativity and large non‐competitive rents. The alternative—which we find to be superior—is to maintain a distinction between commercial banks and other non‐deposit taking financial intermediaries, but make the latter choose between being prudentially regulated or being unregulated. All regulated intermediaries would need to satisfy the same prudential requirements (capital adequacy in particular) as commercial banks and in exchange benefit from LOLR services.83 However, reflecting their reduced responsibilities towards retail investors and the payment system, regulated non‐bank intermediaries would be subject to a lower entry capital (i.e., the minimum capital needed to open) and less cumbersome fit‐and‐proper tests than those applicable to commercial banks (otherwise all non‐bank intermediaries would become universal banks). The unregulated intermediaries, by contrast, would not need to satisfy capital adequacy requirements nor be subjected to an entry capital threshold. In exchange, however, they would be restricted to funding themselves only from regulated intermediaries, banks or non‐banks (i.e., they could not borrow directly from—or acquire contingent liabilities with—the market).84 This proposal has many benefits. As in the case of universal banking, it would comply with regulatory neutrality. Because unregulated intermediaries could only fund themselves from regulated intermediaries, a dollar lent to a final borrower through an unregulated intermediary would end up paying the same capital charge as a dollar lent through a regulated intermediary. Hence, systemic risk would be evenly internalized across all possible paths of financial intermediation, whether they involve regulated intermediaries or not.85
83
Following the same logic of regulatory neutrality, all asset‐backed securities issued with some form of recourse (including reputational) to the regulated intermediary, or purchased by a regulated intermediary, should carry an equity tranche retained by the issuer at least equivalent to the uniform capital adequacy requirement imposed on the intermediation system. 84 Thus, hedge funds that wish to remain unregulated would be allowed to borrow only from banks or other regulated intermediaries. In addition, they (as well as all other prudentially unregulated financial institutions) would not be permitted to engage as counterparties in credit derivatives transactions and other forms of default hedging and insurance (these give rise to contingent liabilities whose payment at the time they fall due may exert systemic stress by requiring asset fire sales). At the same time, a clear dividing line would also need to be established between financial and non‐financial corporations, with the latter not being allowed to engage in finance operations beyond basic trade credit 85 Some regulatory bias between intermediated debt and direct debt issues would persist, since systemic risk would be internalized only in the former case. However, because it would not involve leveraged intermediation or expose financial intermediaries, this residual bias should be much less problematic and more manageable. Notice also that our proposal is only meant to address the systemic risks associated with debt‐funded intermediation, but not those attached to unleveraged asset managers such as mutual funds, whose contribution to downward
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At the same time, in contrast with universal banking, the proposed scheme would favor innovation and competition. Because they would not need to meet any entry capital requirements, unregulated intermediaries could start from scratch. This would facilitate the entry of the smaller players, possibly into “niche” or “boutique” intermediation. The most innovative and successful would eventually grow to become regulated and gain direct access to the capital markets. In turn, the most successful of the regulated non‐bank intermediaries could grow further to become universal banks, thereby authorized to tap deposits and take on full payment system responsibilities.86 The cost of oversight would remain low, however, as the activities of the unregulated would be monitored on a contractual basis by the regulated intermediaries that lend to them.87 This would effectively “delegate” supervision to the regulated intermediaries, creating a two‐tiered “nursery” system in which the start‐ups could prosper and grow under the watchful eye of the better‐established (and more experienced) institutions. Most importantly, this proposal does not rely on artificial boundaries set up by the regulator between “systemically important” and “systemically unimportant” financial intermediaries, based on size, activity, or some risk‐based measure of systemic impact (such as the recently proposed CoVar).88 Such distinctions are bound to create unending distortions or be very difficult, if not impossible, to implement operationally. If the distinction is based on a simple objective criterion, such as size, unregulated intermediaries could multiply and engage in “systemic herding”. They would individually benefit from the lighter regulation by staying just below the size threshold but become just as systemically important as a whole as in the case where unregulated intermediaries of any size were allowed to operate. On the other hand, risk‐based distinctions, even if based on meaningful and uncontested models (by no means an obvious proposition), are bound to create grey zones with an uneven playing field as regards both the intensity of regulation and access to the safety net. In such a context, reclassifying institutions in and out of the systemically important list is likely to be an operational and political conundrum. Instead, by treating all intermediaries equally subject only to a simple choice by the intermediary itself, our proposal is much simpler and operationally quite easy to implement. The second objective, particularly relevant to the externalities paradigm but also consistent with all three paradigms, is to keep the system reasonably close to a stable path (hence enhancing the scope for prices to reflect fundamentals) through a better alignment of incentives. In this regard, a key missing piece in the current framework is the internalization of systemic liquidity risk. Proposals have been made to penalize maturity mismatches between assets and liabilities. However, since short assets are likely to become as illiquid as long assets under systemic events, it seems preferable to focus on the maturity of the funding structure, irrespective of that of assets.89 By inducing final investors to hold at least part of the liquidity risk instead of pushing it back on the system, this should reduce the system’s exposure to liquidity events. In any event, a liquidity‐related norm would need to be properly calibrated liquidity spirals is tempered (albeit not eliminated, particularly under conditions of structural or temporary asset market illiquidity) by the marking‐to‐market of their liabilities. 86 In this scheme, development banks could play a particularly important and relatively novel role. They could nurture innovation and promote competition and access by financing unregulated intermediaries and helping them grow. Their lower aversion to risk (supported by the State’s higher risk sharing capacity) would give them a natural edge over private regulated intermediaries. 87 Kambhu, Schuermann, and Stiroh (2007) discuss the benefits (and limitations) of such indirect monitoring of hedge funds by regulated entities and conclude that it is a preferable alternative to direct regulation. 88 See Brunnermeier et al. (2009). 89 Penalizing maturity mismatches could encourage intermediaries to lend short. This would push liquidity risk on to borrowers but would not eliminate it from the system as it would increase the risk of defaults under systemic stress. Moreover, when several banks lend to the same borrower, it could encourage run‐like loan recalls by banks that could further exacerbate systemic stress.
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to reflect social costs and benefits, could take many alternative forms (a special capital charge, a risk‐ adjusted insurance premium, or both), and would need to reconcile the inherent pro‐cyclicality of nearly any norm based on contemporaneous risk with the need for counter‐cyclical adjustments.90 None of the above is trivial.91 The third (and closely related) objective is to continue improving the safety net, reflecting its centrality to the externalities and mood swings paradigms. (Even with vigilant supervision and sufficient internalization of externalities, the high social costs of crisis‐proof systems and the uncertain turns taken by continually evolving financial systems render the full elimination of crisis a socially undesirable endeavor.) The objective of improving the safety net calls for: (i) reviewing the pricing of deposit insurance schemes to better reflect their de facto systemic exposure; (ii) examining whether access to the LOLR should be paired with a systemic insurance that all prudentially regulated intermediaries (whether deposit‐taking or not) should subscribe to; and (iii) rethinking the LOLR from a mood swings perspective, i.e., as a risk absorber of last resort. As noted, under our proposal for the scope of prudential regulation, all regulated intermediaries would have equal access to the LOLR. In contrast, unregulated intermediaries would be allowed to fail under an efficient bankruptcy code (this would allow the less successful intermediaries to exit promptly, thereby maintaining the vitality of the system). The fourth objective relates to the importance of keeping a tighter rein on the possible downstream risks of financial innovation, particularly (but not only) from a mood swings perspective. This would require giving the regulator more powers to regulate, standardize, and authorize all forms of innovation (whether in instruments, institutions, or markets) and to subject them to much more rigorous pre‐ approval and road‐testing, much as in the case of new drugs for the FDA.92 The fifth objective is realigning the respective monitoring roles of markets and supervisors to address the underlying weaknesses of market discipline under both the externalities and mood swings paradigms. Markets can no doubt continue to play an important ex‐ante role in helping align incentives with respect to principal‐agent frictions. However, it would be foolish to expect market discipline to prevent externality‐ or mood swings‐induced systemic crises. Moreover, imposing market discipline ex‐ post, once the system is deeply out of equilibrium and a crisis is unfolding, is fraught with danger.93 By contrast, in the multi‐paradigm world, the supervisor would be naturally expected to have such a tough and complex responsibility that reasonable doubts exist as to whether its implementation lies in the feasible range. Unlike in the pure agency paradigm, he can no longer relax and concentrate on relatively simpler policing tasks once he has put in place the necessary arrangements to promote market discipline (hence, self‐regulation). Instead, the “holistic” supervisor of the mood swings paradigm provides a valuable scouting, moderating, and coordination service to society that markets cannot provide. To this end, he should be able to connect the dots, understand the forest beyond the trees, and 90
The direction towards which incentives need to be aligned (and moods tempered) shifts abruptly depending on the phase of the cycle: the upward phase calls for taking less risk and accumulating capital, the downward phase for taking more risk and using up capital. 91 Additional ways to better internalize systemic liquidity risk might also include limits on gross leverage, an in‐ depth review of the differentiated capital requirements on trading books versus banking books, and some form of liquidity buffer (i.e., a prudential norm encouraging the holding of systemically safe assets). On the latter, see Morris and Shin (2008). 92 A very similar recommendation can be found in Buiter (2008). By the same token, the tight linkages between financial innovation and deregulation also call for special attention to the potentially destabilizing market implications of regulatory reform (unduly exuberance or moral hazard‐induced dynamics). 93 The failure of Lehman Brothers provides a vivid recent illustration of the risks attached to 11th hour attempts to limit moral hazard by restricting access to the safety net.
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look ahead for possible systemic trouble. He would need the means and the clout to help coordinate expectations around systemically sustainable paths. This in turn calls for a deeper informational role— i.e., to provide systemically oriented information and benchmarks to help intermediaries think systemically and fashion their risk assessments accordingly. However, deeds will need to be added to words, which will require boosting the supervisor’s capacity (and skills) to exert judgment‐based discretionary interventions to slow down credit cycles, or restrict specific forms of intermediation that may become riskier as they develop. Given evolutionary uncertainty, macro‐prudential regulation cannot be entirely rule‐based. Instead, counter‐cyclical prudential norms may have to be at least in part judgment‐based, calibrated discretionally in view of changing circumstances, much as the interest rate is calibrated by monetary authorities.94 Of course, what shape and form such an instrument could take is hardly a trivial issue. The stronger powers of the “holistic” supervisor would also be accompanied by a tougher responsibility and, with it, a risk of calamitous failure. If things go well, financial market participants will reap the benefits and the supervisor would be an unsung hero. If things go wrong, moral hazard will have a field day: “it was the regulator’s fault, hence the state’s responsibility to pay for damages.” Moreover, initial success in stirring the system may breed complacency and irrational exuberance leading to a crash down the line. Avoiding these pitfalls will require combining hard‐wired rules (that maintain the system within reasonable bounds) with an institutional reform that is commensurate with the supervisor’s new terms of reference (including his enhanced powers and responsibilities), and sufficiently strong to overcome the multiple difficulties associated with the use of discretion. Finding the right implementation modalities and regulatory mix between rules and discretion is likely to be one of the toughest yet most central challenges of prudential regulatory reform in the years ahead.95
94
Indeed, reflecting more tenuous and complex links between the instrument and the final objective, a pure rule‐ based macro‐prudential policy could be even more elusive than a pure Taylor rule‐based monetary policy. Instead, having to explain and justify decisions could help promote progress on macro‐systemic prudential analysis, much as has been the case with inflation targeting for monetary policy. 95 In this context, to avoid regulatory capture, a particularly hard look will need to be given to the political economy of regulation (see Demirguc‐Kunt and Serven, 2009). This problem can become trickier when the supervisor needs to round off his views partly based on those who are closer to the market, including financial intermediaries. At the same time, however, players should realize that systemic adjustments should affect all players equally (provided regulation is truly neutral) and are for the common good, which should ease the way for fruitful coordination, much as in the case of monetary policy.
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3. HOW HAS POVERTY EVOLVED IN LATIN AMERICA AND HOW IS IT LIKELY TO BE AFFECTED BY THE ECONOMIC CRISIS? Joao Pedro Azevedo, Ezequiel Molina, John Newman, Eliana Rubiano and Jaime Saavedra
June 2009 Abstract After establishing the recent history of what has happened to regional poverty in LAC, the note presents simulations of the potential poverty impact of the current crisis. A range of simulations are presented, drawing upon alternative specifications of the relation between per capita GDP growth and poverty and a range of estimates of how GDP per capita in different countries is expected to evolve in 2009. For almost all of the 1980s and 1990s, the number of poor and extreme poor in Latin America and the Caribbean rose. Despite the growth episodes observed in the nineties, poverty rates stagnated. The number of poor climbed from 160.5 million in 1981 to 240.6 million by 2002, and of extreme poor from 90 to 114 million. But since 2002 the number of poor has decreased at unprecedented speed – so much so that in 2008 the number of poor is estimated to have fallen to 181.3 million and the number of extreme poor to 73 million. That is, almost 60 million people moved out of poverty while 41 million left the ranks of the extreme poor. Unfortunately, the recent worldwide recession has put an end to that progress and the number of poor are now projected to increase. Based on GDP growth forecasts for May 2009, the aggregate poverty rate for LAC is estimated to rise 1.1 points. This would mean that there would be 8.3 million more poor people in 2009 than in 2008. A more pessimistic forecast will move the increase in the poverty rate to 2 points and increase in the number of poor to 13 million. The aggregate extreme poverty rate is estimated to rise 0.5 points. This would mean a further 3.6 million would fall into extreme poverty. Introduction This note examines the recent evolution of poverty in Latin America and estimates what is likely to happen to poverty as a result of the current economic crisis. It presents new estimates for the average poverty and extreme poverty rates and for the number of extreme poor and poor for LAC, based on PPP $4 and $2 international poverty lines. While the World Bank uses international poverty lines of PPP $2 a day for poverty and PPP $1.25 a day for extreme poverty when reporting world figures, applying these lines yields a level of poverty in PPP terms that is too far below the national figures to be of interest in Latin American countries. An analysis of the national poverty and extreme poverty lines used in Latin America suggest that international poverty lines of PPP$ 4 a day for poverty and PPP$ 2 a day for extreme poverty are more appropriate (See Annex 1). After establishing the recent history of what has happened to regional poverty in LAC, the note presents simulations of the potential poverty impact of the current crisis. A range of simulations
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are presented, drawing upon alternative specifications of the relation between per capita GDP growth and poverty and a range of estimates of how GDP per capita in different countries is expected to evolve in 2009. Evolution of Poverty in LAC over the recent past Evolution of poverty rates and link to movements in per capita GDP Figure 1 illustrates how extreme poverty and per capita GDP have evolved between 1981 and 2008 in Latin America, while Figure 2 shows a similar evolution of poverty and per capita GDP96. The patterns are quite striking in both cases, as there are clearly four distinct periods. In three of the periods, the evolution of poverty rates move is an almost exact mirror image of the evolutions in per capita GDP. It is only during the 1990s (a “lost decade” in LAC in terms of poverty reduction), where the link between movements in per capita GDP and movements in poverty is broken97. Over that period, per capita GDP continued to grow as it had in the 1980s, but poverty rates did not decline.
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The data for 1981 to 2005 are taken from the WB’s regional aggregation module of POVCALNET, after setting the PPP international poverty lines at $2 and $4 a day. This module weights the individual country data by their respective populations and interpolates the data (as needed) so as to produce observations for all countries for every 3 years between 1981 and 2005. The data for 2006 were calculated by the authors using 2006 and 2007 individual country data from POVCALNET from Argentina, Brazil, Chile, Paraguay, Uruguay, Bolivia, Colombia, Peru, Ecuador, Venezuela, Costa Rica, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Panama, the Dominican Republic and Jamaica. The sample is representative of 95.2% of the population in Latin America, but representative of only 40% of the population in the Caribbean. This procedure differs from the data used in the regional aggregation module (i.e. the data from 1981‐2005) in that it does not include data from Guyana, Haiti, St Lucia, Suriname and Trinidad and Tobago. These countries together make up a small fraction of the total population in LAC. Data for 2007 and 2008 are projections. 97 Even with the break in the 1990s, the simple correlation between the LAC regional aggregates of per capita GDP and both extreme and moderate poverty rates is around ‐0.88.
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The change in poverty rates and per capita GDP over the four distinct periods can be seen clearly in Table 1. Table 1. Changes in Poverty and Per Capita GDP in LAC over different episodes Episode GDP pc change 2 USD a day Poverty Change 4 USD a day Poverty change 1981‐1984 ‐2.88 1.16 1.35 1984‐1990 0.12 ‐1.03 ‐1.31 1990‐2002 1.03 ‐0.03 0.06 2002‐2006 2.88 ‐1.74 ‐2.55 2002‐2008* 3.01 ‐1.40 ‐2.16 Annex 2 presents similar graphs of the trends in poverty and growth in GDP per capita for other regions of the world. It is apparent that in no other region did one observe such a protracted period of significant growth in GDP per capita without a resulting decrease in poverty as was observed in Latin America during the 1990s. The aggregate figures are heavily affected by what happened in Brazil, Mexico and Colombia, which make up 57.3 percent of the population of LAC. Figures 3‐4 present information on the behavior of per capita GDP growth and changes in poverty for the entire distribution of countries in Latin America. The box plots show the minimum and maximum values, and the values for the 25th, 50th and 75th percentiles. The median value (50th percentile) is shown as a bar in the middle of the box.
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Fig. 3. Distribution of Changes in Per Capita GDP in LAC
Fig. 4. Distribution of Changes in Poverty in LAC (At $4 a day PPP)
During the period 1981‐1984, virtually all countries experienced declines in per capita GDP and increases in poverty. Between 1984 and 1990, the growth in per capita GDP picked up to the point where the median value was slightly above zero. Poverty stopped increasing in most countries, but the median value of changes in the poverty rate was close to zero. The decline in poverty in the aggregate figures over this time period (Fig. 1 and 2) indicates that it was the larger countries that experienced declines in poverty. Over the 1990s there was a better performance in per capita GDP growth, but a very wide dispersion in the poverty results. It was not until 2002‐2008 when both the performance in per capita GDP growth and in poverty became strong across the entire distribution.
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Evolution in the number of poor Table 2 illustrates changes in the number of poor 1981 and 2008. While there are six instances when extreme poverty and poverty rates declined (and 2 when they increased), there are fewer periods when the number of poor declined. During the eighties, a period of weak growth and high volatility, poverty rates fell slightly, but the number of poor increased. During the nineties, a period of stronger growth, the same pattern emerges, and, actually, the number of poor is substantially higher by the end of the decade. The big break in Latin America came in the period between 2002 and 2006. Extreme poverty fell 6 points and 36 million people moved out of extreme poverty. In turn, the poverty rate fell more than 10 points and 56 million people moved out of poverty. Projections for 2007 and 2008, show an additional decrease, of at least two additional points of further extreme poverty and moderate poverty rates reduction98. Hence, during the strong growth period 2002‐2008, almost 60 million people were lifted out of poverty, and 41 million left the ranks of extreme poverty. It should be noted that towards 2007 and 2008 there seems to be already a deceleration on the rate of poverty reduction. Table 2. Poverty and Extreme Poverty ‐ Rates and Number of Poor (1981‐2008) Extreme Poverty Number of Poverty Rate Number of Poor Year Rate Extreme Poor (PPP $4 a day) (millions) (PPP $2 a day) (millions) 1981 24.6 90.0 48.5 160.5 1984 28.1 109.5 52.6 205.0 1987 24.9 103.0 47.5 196.8 1990 21.9 95.8 44.7 196.0 1993 20.7 95.5 44.4 205.1 1996 22.0 106.8 46.1 223.6 1999 21.8 110.7 45.5 230.8 2002 21.5 114.0 45.4 240.6 2005 17.1 94.2 38.8 213.6 2006 14.6 78.0 35.2 188.0 2007* 13.6 75.1 33.3 183.6 2008* 13.1 73.3 32.5 181.3 * Projected The Rapidly Developing Worldwide Economic Crisis The increase in food and energy prices in 2007 and 2008 raised concerns that the continuation of the good times in Latin America might be threatened. The arrival of the worst worldwide economic crisis since the Great Depression to Latin America has made it clear that the threat is now a reality. The period of rapid per capita GDP growth that Latin America experienced between 2002 and the middle of 2008 has come to an end. The concern today is how long and how deep will the recession be and how severely will poverty be affected. The downturn during the last quarter of 2008 was particularly dramatic and each month seems to bring worse news than the month before. While the industrialized countries were the first to experience rapid downturns in projected growth, the projections of GDP growth for most developing countries 98
2007 and 2008 are still projections as not all large countries have data for 2007, and only a few have infromation for 2008.
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(including those of Latin America) are now following the industrial countries downwards. Figure 5 indicates how the predictions for 2009 GDP growth in the US, Canada, the UK, the Euro Zone and Japan have declined every month since January 2008. There is no indication that the bottom has been reached. Figure 6 presents forecasts for Latin American countries which are covered by Consensus Forecasts. A similar downward trend in the forecasts is evident. Figure 5: Trends in Consensus Forecasts for 2009 GDP growth in US$, Canada, Euro Zone, UK and Japan 4.0
GDP (% change)
2.0
0.0
-2.0
-4.0
Canada
Euro zone
Japan
Mar 09, 2009
Feb 09, 2009
Jan 12, 2009
Dec 08, 2008
Nov 10, 2008
Oct 13, 2008
Sep 08, 2008
Aug 11, 2008
Jul 14, 2008
Jun 09, 2008
May 12, 2008
Apr 14, 2008
Mar 10, 2008
Feb 11, 2008
Jan 14, 2008
-6.0
UK
Source: Consensus Forecast
USA
Figure 6: Trends in LAC Consensus Forecasts for 2009 GDP growth
Source: Consensus Forecast
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As of April 2009, Brazil, Mexico, Chile, Ecuador, Argentina and Venezuela are all forecasted to have negative GDP growth. Moreover, given the rates of population growth that prevail in LAC many more countries (15) are forecast to experience a negative rate of growth in per capita GDP. As with the industrialized countries, every month the forecasted growth rates in GDP have been revised downwards and there is no clear indication that the bottom has been reached. The dramatic reversal in growth rates is apparent in Figure 7 which plots the number of countries that have experienced negative growth in any given year between 1980 and 200799. The figures for 2009 are the projected number of countries that, as of March 2009, are expected to experience negative per capita GDP growth. It is apparent that after falling to unprecedented low levels between 2002 and 2007, the number of countries that are now projected to have negative growth in per capita GDP has shot up sharply in both LAC and the World. Figure 7: Number of countries with negative growth in per capita GDP 90 80
2009 Projected
Number of countries
70 60 50 40 30 20 10 0 1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
Year World
LAC
Note: Year 2009 projected Source: World Bank World Development Indicators
Figure 8 provides additional detail on the size of the decline in per capita GDP for all Latin American countries over all past periods when per capita GDP growth was negative. The magnitude of the decline is represented by both the size of the bar and the darkness of the color. 100 Larger declines in per capita GDP are represented by larger bars and darker colors. For example, the shock in Argentina between 2001 and 2002 is represented by a large dark bar. Included in this figure are the 2009 projected growth rates in per capita GDP for those countries which are projected to have declines. One can observe that, as of March 2009, these projected declines have not yet reached some of the past levels. However, the contrast between the period 2003‐2008 when then were virtually no countries with negative per capita GDP growth and 2009 when virtually all countries are expected to suffer negative growth in per capita GDP is dramatic. 99
The figure includes those countries that were just starting in a given year, as well as those countries that were repeaters – ones that might have been in their second or more consecutive period of negative per capita GDP growth. 100 Using both the size of the bar and color to represent the magnitude is done to create a stronger visual impact and to make the periods of greatest decline stand out from the other periods.
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Potential Impact of the Current Worldwide Recession on Poverty in LAC This note analyzes the potential impact on poverty in two ways: a) By describing what have been the changes in poverty during previous downturns; and b) By estimating elasticities of poverty reduction with respect to changes in per capita GDP and using those elasticities, together with projected growth rates to estimate likely changes in poverty rates and the number of poor. All of this analysis is subject to the very strong caveat that we may be facing a situation that represents something very different from what has been faced in the past. While there have certainly been periods of negative per capita GDP growth in many LAC countries at the same time (mainly during the first half of the 1980s), this has not ever happened after a period of universal good growth and fast poverty reduction. Whereas previous periods of negative growth in per capita GDP over the last 25 years have usually been triggered by changes in developing countries, the current period has been triggered by events in industrialized countries. While many countries had entered into previous periods of negative growth in per capita GDP with public sector deficits, macroeconomic balances in most –not all‐ LAC countries around the end of 2008 had been strong, which gives some countries room to implement countercyclical policies. Finally, some of the factors that appear to have contributed to the recent significant gains in poverty between 2002 and 2008 (expansion of conditional cash transfers, greater effectiveness of some public transfer programs, and rising remittances) were either not present or at much lower levels during periods of previous downturns. Changes in Poverty During Previous Downturns Unfortunately, it is not possible to analyze what happened to poverty during all periods of negative growth in per capita GDP because poverty data are not collected annually in many countries in the region. Moreover, there is far less poverty data available during the 1980s, when there were many periods of crises. The analysis presented in this section makes use of all available data on poverty, taken from the SEDLAC data bank of comparable LAC household surveys.101 The SEDLAC database contains data on poverty reported by national statistical agencies and calculated on the basis of national poverty lines. These data are used in this exercise instead of the POVCALNET World Bank poverty data (where poverty is measured using international poverty lines) because the SEDLAC data have more observations on poverty over consecutive years. This ensures that periods of changes in poverty can be matched to periods of negative growth in per capita GDP. Figure 9 presents information on how poverty has changed for all the periods of negative per capita GDP growth ‐ for which poverty data are available (34 in total). Note that
101
See www.depeco.econo.unlp.edu.ar/cedlas/sedlac/ SEDLAC is a joint initiative between the Centro de Estudios Distributivos , Laborales y Sociales ‐ Universidad de la Plata and the LAC region of the World Bank.
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there were no periods of negative per capita GDP growth in the countries for which poverty data are available after 2003. Figure 9 captures multiple dimensions of the poverty response. The figure shows the beginning and end year for all periods of negative per capita GDP growth. The size of the bar shows the magnitude of the decline in per capita GDP and the color shows the change in poverty that occurred during the period of negative growth. Finally, the number under the bar indicates the number of years between the time when poverty stopped falling to when the poverty level recovered to the level of poverty that prevailed before the onset of the decline in per capita GDP. If poverty did not rise over the period of decline in per capita GDP, the recovery period is denoted as zero years. Table 3 summarizes some of the information from the observations in Figure 9.102 In this table, we divided the size of the GDP declines into ones that could be characterized as large, medium or small103. For each category of decline in per capita GDP, the table presents information on the average cumulative loss in per capita GDP and the average cumulative change in poverty over the period when per capita GDP fell. The table also presents the average number of years it took to recover to the level of poverty that prevailed before the crisis. Table 3. Effects on Poverty of GDP Shocks (Using data from 19 LAC countries over period 1981‐2006) Cumulative Loss in Per Capita GDP Large Medium Small (> 3 % loss) (Between 1.5 and 3 (Less than 1.5 percent percent loss) loss) Average cumulative loss in ‐7.2 ‐1.8 ‐0.6 per capita GDP Average cumulative 4.4 0.64104 ‐0.08 change in poverty rate Average years it takes to 3 3 1 recover poverty loss Countries with projected Ecuador (‐3.34%) Guatemala (‐1.62%) Colombia (‐.37 %) losses in per capita GDP Mexico (‐3.83%) Panama (‐0.8 %) Argentina (‐1.63%) for 2009 (Consensus Paraguay (1.82%) El Salvador (‐0.93 %) forecasts as of March, Chile (‐0.97 %) 2009) Nicaragua (‐1.09%) Honduras (‐1.14%) Brazil (‐1.25%) Dom. Rep. (‐1.42) 102
The data on poverty change and GDP per capita that underpin figure 9 are reported in Annex 4. This classification is based on the size of the cumulative loss in GDP and is not based on the length of the period of negative per capita GDP growth. The exact divisions are somewhat arbitrary, but were made in such a way as to correspond to some of the projected declines in per capita GDP that are forecast for 2009. 104 This average does not include Jamaica, which appears to be an outlier. The Jamaican experience has been a puzzle and is discussed in The Road to Sustained Growth in Jamaica, World Bank (2004) and Osei, P. (2002) , “A Critical Assessment of Jamaica’s National Poverty Eradication Programme”, Journal of International Development, Vol. 14, pp. 773‐88. 103
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The average years to recover from a poverty loss are measured from the time when poverty stops increasing to the time when it recovers to the level that prevailed before the onset of the crisis. As a crisis itself lasts typically for one or two years, a country may actually suffer through a period of 4‐5 years before it is able to get back to its position before the fall. The last row presents the March 2009 projections for per capita GDP for 2009. The GDP growth forecasts are taken from the Consensus Forecasts and these were converted to GDP per capita projections using population data from the World Development Indicators. As is evident from the table, the projected losses of GDP per capita in 2009 for Mexico and Ecuador could already be considered large by historical standards. In these cases, it may take three years to recover the losses in poverty. Estimating the Impact of the Economic Crisis on Poverty The previous section simply presented the information on past relations between declines in per capita GDP and past changes in poverty. This information can help frame the expectations for the likely change in poverty. An alternative approach to considering what might be the effect of a given change in per capita GDP is to estimate the elasticity of changes in poverty to changes in per capita GDP and then use the estimated elasticities to predict the change in poverty for a specific projected growth rate for per capita GDP. Poverty elasticities were estimated using a specification similar to Ravallion (1995)105 and Adams (2004)106. It should be noted that these elasticities make use of the periods of positive increase in per capita GDP growth and declines of poverty. We did estimate the elasticities with a spline to allow the coefficient on GDP growth to take on a different value depending on whether growth was positive or negative. However, the difference was not statistically significant. These results are presented in Annex 3. We also estimated elasticities using the POVCALNET data instead of the SEDLAC data and the differences were not very great. Table 4 reports the different elasticities and the significance level of the estimated elasticities using the SEDLAC data. Table 4 Elasticities of Changes in Poverty Measure with changes in per capita GDP Poverty Line National Extreme* National Moderate*
Elasticity ‐2.63 ‐1.62
P value 0.00 0.00
Note: (*) SEDLAC data; std errors clustered at country level; population weighted point estimates; controls: Log(Gini) and time trend. The estimated elasticities presented in Table 4 can be used to simulate the impact of the economic crisis on poverty in LAC. This is done by taking forecasted rates of growth of GDP, converting them into rates of growth of GDP per capita and using the elasticities to generate an estimated effect on poverty. The forecast economic growth rates are taken from the March 16th LAC Consensus Forecasts, which compile 105
Ravallion (1995) used the private consumption component from national accounts. Since our main objective here was to use these elasticities to simulate the impact of changes on GDP per capita, we chose to follow the approach of Adams (2004) and others, who have used per capita GDP as one the regressors. 106 The specification is of first difference on the LOG, in order to take into account for country specific fixed effects, and also includes the Gini coefficient and a time trend.
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data from several sources and report the mean, minimum and maximum expected growth rate for the period.107 The baseline values for poverty rates and numbers are calculated by taking the 2006 and 2007 poverty rates in SEDLAC and projecting them forward to 2008, using the estimated elasticities and the preliminary estimates of 2008 growth rates. Table 5 reports the estimated impact of the economic crisis on moderate poverty and extreme poverty, using poverty defined by national poverty lines and reported in SEDLAC.108 Using the mean consensus forecast, aggregate poverty rates for LAC are estimated to rise 1.14 points. That would result in 8.3 million more poor people than in 2008. About half of those people that will fall into poverty are in Mexico, about a fifth in Brasil, and the rest are distributed in Argentina, Colombia, Ecuador, Guatemala and Venezuela. The aggregate extreme poverty rate for LAC is estimated to rise 0.53 points to, which would generate an increase of approximately 3.6 million in the number of extreme poor. As today’s pessimistic forecast seems to be turning rapidly into tomorrow’s mean forecast, it is worth noting the estimated poverty rates and numbers associated with the pessimistic forecast. In this case, aggregate poverty rates are estimated to rise by 2.05 points generating 13.5 million additional poor people in 2009. Aggregate extreme poverty rates, under the pessimistic forecast, are estimated to increase almost one point, generating an increase of 6 million in the number of extreme poor. In the region, the final performance both of growth and poverty will depend on the magnitude of the downturn in industrialized countries and on the speed and effectiveness of anticyclical packages that most countries are already implementing. Figures 10 illustrate that the number of poor projected for LAC in 2009 is beginning to rise to the levels that prevailed back in 2006. If one compares the projected number of poor people in 2009 to a prediction based on what was expected to be 2009 GDP growth back in January 2008, the increase in the number of people would be 13 million (Table 6). As there was a more optimistic outlook for growth in 2009 when forecasts were made back in January 2008 (see figure 6), the estimated poverty impact is greater for this counterfactual. In other words, now we expect, by the end of 2009 , 13 million more poor people than what would have been observed had past growth been maintained. In the case of extreme poverty, comparing the change to what had been expected back in January 2008 yields an increase of 6.1 million more extreme poor than what had been expected.
107
The GDP growth rates used in the analysis are provided in Annex 5. The estimated poverty impacts for the individual countries are also presented in Annex 5. If a particular country only reported data for the mean, the same number was used on the minimum and maximum scenario. Moreover, a few countries (St Lucia, Haiti and Jamaica) were not covered by the LAC Consensus Forecast, in those cases the World Bank GEP 2009 forecast was used, also on the three scenarios. 108 Similar tables of results are presented in Annex 4, using data from POVCALNET and elasticities estimated from POVCALNET data.
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Table 5: Poverty Impact of Slowdown in 2009 (changes with respect to observed levels in 2008) Consensus Forecast for Latin America and the Caribbean* Mean Pessimist Optimistic Moderate Poverty 1.14 2.05 0.58 Absolute change in incidence (pp) 12.64% 22.79% 6.39% Percentage change in incidence (%) 8,325 13,491 5,144 Absolute change in number of poor (,000) 5.37% 8.70% 3.32% Percentage change number of poor (%) Extreme Poverty Absolute change in incidence (pp) 0.53 0.94 0.28 Percentage change in incidence (%) 5.87% 10.40% 3.06% Absolute change in number of poor (,000) 3,603 5,909 2,169 Percentage change number of poor (%) 7.16% 11.75% 4.31% Note: (*) Consensus Forecast as of May/2009 for Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.; For the countries in which theres was no Consensus Forecast esimates, the World Bank Forecast as of March 2009 was used; For the countries which Consensus Forecast did not report a minimum or a maximum value, the average reported value was used for both the optimistic and the pessimistic scenario. Countries: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, El Salvador, Honduras, Mexico, Paraguay, Peru, Uruguay, and Venezuela (90% of the region population covered by Povcalnet). Elasticities estimated using Sedlac data (17/nov/2008).
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Table 6: Poverty Impact of Slowdown in 2009 (as compared to expected poverty levels had past growth rates continued) Consensus Forecast for Latin America and the Caribbean* Mean Pessimist Optimistic Moderate Poverty Absolute change in incidence (pp) 2.30 3.22 1.74 Percentage change in incidence (%) 8.66% 12.09% 6.54% Absolute change in number of poor (,000) 13,015 18,181 9,834 Percentage change number of poor (%) 8.66% 12.09% 6.54% Extreme Poverty Absolute change in incidence (pp) 1.07 1.48 0.82 Percentage change in incidence (%) 12.70% 17.52% 9.70% Absolute change in number of poor (,000) 6,075 8,381 4,641 Percentage change number of poor (%) 12.70% 17.52% 9.70% Note: (*) Consensus Forecast as of May/2009 for Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.; For the countries in which theres was no Consensus Forecast esimates, the World Bank Forecast as of March 2009 was used; For the countries which Consensus Forecast did not report a minimum or a maximum value, the average reported value was used for both the optimistic and the pessimistic scenario. Countries: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, El Salvador, Honduras, Mexico, Paraguay, Peru, Uruguay, and Venezuela (90% of the region population covered by Povcalnet). Elasticities estimated using Sedlac data (17/nov/2008).
Figure 10. Trends in the Number and Projected Number of Poor in Latin America
The aggregate data include actual and forecasted values for Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador, El Salvador, Guatemala, Honduras, Mexico, Nicaragua, Paraguay, Peru, Uruguay, and Venezuela.
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Conclusions For almost all of the 1980s and 1990s, the number of poor and extreme poor in Latin America and the Caribbean rose. Despite the growth episodes observed in the nineties poverty rates stagnated. The number of poor climbed from 160.5 million in 1981 to 240.6 million by 2002, and of extreme poor from 90 to 114 million. Since 2002 the number of poor has decreased at unprecedented speed – so much so that in 2008 the number of poor is estimated to have fallen to 181.3 million and the number of extreme poor to 73 million. Hence, during the strong growth period 2002‐2008, almost 60 million people were lifted out of poverty, and 41 million left the ranks of extreme poverty. It should be noted that towards 2007 and 2008 there seems to be already a deceleration on the rate of poverty reduction. Unfortunately, the recent worldwide recession has put an end to that progress and the number of poor are now projected to increase. However, compared to past periods of negative growth, in most cases the current projected declines in GDP have not yet approached the largenegative shocks that Latin America experienced throughout the eighties and late nineties. The large shocks of the past averaged a loss in per capita GDP of 7.2 percent and generated increases in poverty rates that were, on average, 4 percentage points. And, historically, it has proved difficult for countries to recover quickly and get back to the poverty level that prevailed before the shock. On average it has taken 3 years to get back to the poverty level prior to the shock, for all but the smallest negative shocks.As of March 2009, only in Mexico and Ecuador are the projected declines in GDP for 2009 expected to be relatively large. Given the consequente larger increases in poverty rates it might take about three years to recovre from the povrety losses. More countries could be in similar situations as the worldwide recession deepens. If the projected growth rates are not yet at the level that has prevailed in individual countries in the past, what is noteworthy in this crisis is how it has hit all countries and how rapidly the projected growth rates are trending downwards. Whereas in 2007 and 2008, no country in Latin America was experiencing negative growth in per capita GDP, today 15 countries are projected to have negative per capita GDP growth in 2009. The downward trend in projections for Latin America are following the pattern observed in industrialized countries. Using elasticity estimates and the mean LAC Consensus Forecast for GDP growth , aggregate poverty rates are estimated to rise 1.14 points. That would result in 8.3 million more poor people than in 2008 in Latin America and the Caribbean. About half of those people that will fall into poverty are in Mexico, about a fifth in Brasil, and the rest are distributed in Argentina, Colombia, Ecuador, Guatemala and Venezuela. Aggregate extreme poverty rates are estimated to rise 0.53 points, increase that would generate a rise of approximately 3.6 million in the number of extreme poor. Using a pessimistic forecast – which, if the recent trend continues will turn rapidly into tomorrow’s mean forecast‐ aggregate poverty rates are estimated to rise by two points generating 13 million additional poor people in 2009. Aggregate extreme poverty rates, under the pessimistic forecast, are estimated to increase 0.94 points, generating an increase of almost 6 million in the number of extreme poor. Annex 1. Construction of regional poverty estimates for Latin America The World Bank has created estimates of regional poverty estimates for Latin America and other regions of the world using PPP $1.25 and $2 a day international poverty lines, corresponding to extreme and moderate poverty. Based on an analysis of the PPP equivalents of national poverty lines, this note argues that using PPP $2 a day for extreme poverty and PPP $4 a day for moderate poverty would be more appropriate for Latin America.
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The following table presents information on the PPP $ a day equivalent of national extreme poverty lines across countries and over time. These values were obtained by converting the reported local currency poverty lines into PPP equivalents using the PPP Exchange Rates for household consumption from the 2005 International Comparison Program, adjusted for inflation using the national CPI.
Source: SEDLAC data base, PPP conversion factors from World Bank POVCALNET
It is worth noting that the values of the national extreme poverty lines in PPP terms are quite consistent over time for each country. The average coefficient of variation is 0.07 and there is not a great range in the coefficient of variation across countries. The range extends from 0.01 (Chile) to 0.15 (Honduras). There is more of a variation looking across countries, with the lowest value at 1.04 for Nicaragua and the highest at 2.73 for Mexico. The coefficient of variation across countries is 0.35. The following table presents equivalent values of the PPP $ a day equivalent of national poverty lines, calculated in a similar fashion.
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Source: SEDLAC data base, PPP conversion factors from World Bank POVCALNET The values are still relatively consistent across time within a country. The average coefficient of variation is 0.06 and the range extends from 0.002 (Panama) to 0.15 (Honduras). However, in terms of the variation across countries, there is considerably greater variation in the national poverty lines in PPP terms across countries in moderate poverty than in extreme poverty. This is because all countries use some variation of a food or caloric based extreme poverty line. After accounting for differences in prices with the PPP adjustment, the remaining differences are due to differences in the combination of food that would yield the minimum requirements. The moderate poverty lines are typically defined by multiplying the extreme poverty line by the inverse Engel coefficient and this varies somewhat more across countries. The observation that there is a considerable range in the national moderate poverty lines in PPP terms implies that comparisons of estimated national poverty rates are potentially misleading. All comparisons of poverty should be made using the same international PPP line. We choose to consider extreme poverty as PPP $2 a day, because that is the round figure that minimizes the distance from the observed national extreme poverty lines. Similarly, we choose to consider moderate poverty as PPP $4 a day for the dame reason. However, this does not mean that all countries should necessarily use the $2 a day or $4 a day PPP lines. Nicaragua may want to compare their poverty situation to that of other countries using a PPP $1.25 a day line that more closely approximates their
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own particular national poverty line. Mexico may choose a different one. The important point is to use the same PPP $ a day international poverty line consistently across all comparisons. The following three graphs illustrate the relation between GDP per capita in PPP terms and the PPP $ a day equivalent to the national poverty line, national extreme poverty line and the ratio of the moderate to extreme poverty line. The graphs show that there is more variation across countries in the PPP $ a day equivalent of the national poverty lines than there is of the extreme poverty lines.
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Annex 2. Trends in Regional Poverty and Growth in GDP per Capita Figure A.2: Evolution of poverty and GDP East Asia ‐ 2USD a day
East Asia ‐ 4USD a day 100.0
5000
5000
90.0
4000
60.0
2000
50.0
Headcount Poverty Rate
3000
70.0
90.0
constant 2005 international $
Headcount Poverty Rate
4000 80.0
constant 2005 international $
100.0
3000 80.0 2000
70.0 1000
1000 40.0 60.0
30.0 1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
0 1980
0 1980
1982
1984
1986
1988
4 USD a day
2 USD a day
1990
1992
1994
1996
1998
2000
2002
2004
2004
GDP per capita, PPP (constant 2005 international $)
ECA‐ 2USD a day 20.0
GDP per capita, PPP (constant 2005 international $)
ECA‐ 4USD a day
10000
50.0
10000
45.0
9000
40.0
8000
35.0
7000
30.0
6000
16.0
9000
8000
10.0
8.0
7000
Headcount Poverty Rate
12.0
constant 2005 international $
Headcount Poverty Rate
14.0
constant 2005 international $
18.0
6.0
4.0
6000
2.0 25.0
0.0
5000 1989
1991
1993
1995
1997
2 USD a day
1999
2001
2003
5000 1989
1991
1993
1995
1997
1999
2001
2003
2005
2005 4 USD a day
GDP per capita, PPP (constant 2005 international $)
Middle East and North Africa‐ 2USD a day
GDP per capita, PPP (constant 2005 international $)
Middle East and North Africa‐ 4USD a day 70.0
29.0 68.0
21.0
5000
64.0 62.0 60.0 58.0
5000
56.0
constant 2005 international $
23.0
Headcount Poverty Rate
25.0
6000
66.0
6000 constant 2005 international $
Headcount Poverty Rate
27.0
54.0
19.0
52.0
17.0 50.0
4000 1980
15.0 1982
1984
1986
1988
2 USD a day
1990
1992
1994
1996
1998
2000
2002
1984
1986
1988
4 USD a day
2004
GDP per capita, PPP (constant 2005 international $)
Sub‐Saharan Africa‐ 2USD a day
1990
1992
1994
1996
1998
2000
2002
2004
GDP per capita, PPP (constant 2005 international $)
Sub‐Saharan Africa‐ 4USD a day
80.0
100.0 1900
99.0
1900
79.0
75.0 74.0 73.0
1300
constant 2005 international $
1600
76.0
Headcount Poverty Rate
97.0
77.0
1600
96.0 95.0 94.0
1300
93.0
constant 2005 international $
98.0
78.0
Headcount Poverty Rate
1982
4000 1980
92.0
72.0 91.0
71.0
90.0
1000 1980
70.0
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
1000 1980
1982
1984
1986
1988
1990
2 USD a day
1992
1994
1996
1998
2000
2002
GDP per capita, PPP (constant 2005 international $)
4 USD a day
2004
Source: World Bank, World Development Indicators and POVCALNET
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GDP per capita, PPP (constant 2005 international $)
2004
Annex 3. Alternative Specifications of Poverty Elasticities Table A3.1 presents the coefficients of the Poverty‐GDP pc elasticity using a linear spline transformation. This exercise allows the estimation the relationship between y and x as a piecewise linear function, which is a function composed of linear segments. In this particular case, the first linear segment represents the Poverty‐per capita GDP elasticity for periods of economics crises (negative per capita GDP change), while the second linear segment represents the Poverty‐per capita GDP elasticity for periods of economic growth (positive per capita GDP change). Two models were estimated, with two different specifications. The first model looked at the extreme poverty elasticity, and the second looked at the moderate poverty elasticity. The two alternative specifications considered the full dataset and all observations but Argentina, given the very particular magnitudes of the changes in this country. All models were estimated using ordinary least squares (OLS) algorithm, with standard errors clustered at the country level. These models allow us to test the equality of the elasticities during periods of economics crisis and growth. As it can be seen in the last two lines of Table A5.1 none of the specifications allowed the rejection of the hypothesis that the coefficients are identical.
Table A3.1: Poverty Elasticities using Splines (OLS) Extreme Poverty Moderate Poverty
Full Without Argentina Full Without Argentina d_lngdppc: (.,0) ‐2.481 ‐1.494 ‐1.332 ‐0.732 (1.221) (0.822) (0.684) (0.392) d_lngdppc: (0,.) ‐3.767** ‐3.965* ‐2.423* ‐2.547* (1.178) (1.315) (0.929) (1.037) d_lngini3 ‐0.015 ‐0.011 ‐0.010 ‐0.008 (0.008) (0.008) (0.006) (0.006) Year ‐0.001 ‐0.002* ‐0.000 ‐0.001 (0.001) (0.001) (0.001) (0.001) Constant 2.534 4.426* 0.698 1.806 (1.862) (1.646) (1.148) (1.053) Adj.R‐squared 0.335 0.301 0.348 0.310 Obs. (unweighted) 107 102 96 91 Test: d_lngdppc_a1 ‐ d_lngdppc_a2 = 0 F‐stat 0.323 1.346 0.529 1.632 P‐val 0.580 0.271 0.480 0.226 Note: clustered standard errors; population weighted. Inference: * p