Policy Responses to Sudden Stops in Capital Flows: The Case of Chile in 1998

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Policy Responses to Sudden Stops in Capital
Flows The Case of Chile in 1998

• Rodrigo Valdés Central Bank of Chile

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Motivation Why Chile 1998?

• Chile confronted a large sudden stop
• Net capital inflows were equivalent to 7 of GDP
  in the year ending in 98Q1 and dropped to less
  than 1 of GDP in 99Q1.
• In comparison to other episodes, with financial
  sector meltdown and a deep recession, this case
  could be considered a successful one mild
  recession.
• In many Chileans minds, strong doubts remain on
  the efficiency of the adjustment.

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The paper

• Revisits the 1998 Chilean episode, underpinning
  the following
• The policy framework and initial conditions
• Shocks
• Immediate policy responses and macro adjustment
• Subsequent overhaul of the policy framework
• The Chilean case in perspective
• Some lessons

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Policy Framework and Initial Conditions
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Macro policy framework-key components before the
episode

• An independent CB in transition to price
  stability
• Annual inflation targets
• XR target band with PPP adjustments
• Capital account regulations.
• Orderly managed fiscal policy
• Public debt declined from 38 of GDP in 1989 to
  5 in 1997
• Most of external debt was private.
• Strong financial institutions
• Well regulated and supervised banks.

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Cyclical conditions in 1997

• Against a backdrop of very strong GDP growth
  (7.7 in 1990-1997), signs of overheating in
  1996-97 included
• Current account deficit above 4 of GDP
• Marked FX appreciation, with signs of
  misalignment, despite heavy intervention
• Increasing core inflation in 1996.
• The economys overheating was a public policy
  issue
• Special commission to design ways to foster
  savings
• Strong discussion on role of fiscal policy
  (surplus 2 in 97)
• Extra provisions for consumer credit.

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2. Shocks
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In late 1997, ToT dropped suddenly and threatened
to increase the CA deficit
Unit Price of Exports in US Dollars in Real Time
1997Q2-1999Q2 ( annual change)
9
while domestic demand remained strong and fiscal
accounts weakened.
Current Account Deficit in Real Time (cumulative
four quarters, US million)
10
External financing was expensive, but gross
outflows dominated dynamics.
Changes in Gross Assets and Liabilities
(Transactions) (cumulative four quarters US
millions)
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3. Immediate policy responses Restrictions and
effects
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Policy objectives and restrictions

• Central objective cool down the economy
• Diagnosis It would happen anyway, either through
  domestic policy or market-induced.
• Market induced more costly (fear of sudden
  stop).
• Restrictions
• Limit nominal depreciation
• Short-term inflation target and imperfect
  credibility
• Large perceived XR pass-trough
• Fear of balance sheet effects due to perceived
  mismatches.
• Political constraints to implement fiscal policy.

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Non sterilized FX intervention and tight monetary
policy
Monetary Policy and Interbank Overnight Interest
Rate in 1998 ( UF)
Fiscal Adjustment Announcements Jan. 19th Mar.
21st Jun. 25th
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Commitment technology increased rigidities and
vulnerability.
Exchange Rate Target Band 1997-1999 (pesos per US
dollar)
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CA Adjustment absorption contracted strongly
with little demand switching

• RER depreciated only in late 1999
• Share of tradable goods stable in value added
• Stable contribution of exports to GDP growth.

Domestic Demand and Exports Contributions to GDP
Growth ()
Tradable Goods Participation in Value Added ()
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Policy effects and adjustment.

• Financial market calmed down after CB policy
  actions.
• Fiscal policy announcements had no evident effect
  on financial markets. Real- time opinions were
  mixed/negative.
• Credit followed a very pro-cyclical pattern.
  Banks indicators deteriorated, but remained in
  OK zone.
• Capital outflows in early 1999 driven by pension
  system (made possible by change in foreign
  investment limits).
• Large turnaround of macro policies in 1999,
  particularly fiscal.

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4. Subsequent overhaul of the policy framework
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Results led to deep changes in the macro policy
framework in 1999-2001

• XR floating regime
• Deepening of XR hedging market
• Full fledged inflation targeting
• Fiscal policy rule based on structural target
• Capital account liberalization
• Nominalization of monetary policy
• which combined with a different cyclical
  position implied a very different policy mix
  after 2001-2002 shocks.

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5. The Chilean case in perspective
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Among Sudden Stop episodes, Chiles intensity is
around average...
Distribution of Shock Severity as of
Trade (kernel, 55 cases)
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but the policy response and outcome stand out in
a few dimensions

• Fairly good inflation performance
• Average growth outcome
• Not very intensive in FX reserve intervention
• Rather mild RER depreciation
• Rather high real interest rates.

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6. Some Lessons
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Among other things, the Chilean case shows the
following

• Financial system resilience and public finance
  (ex-ante) seem key to avoid meltdown and give
  room for aggressive macro management.
• With hindsight adjustment could have been more
  efficient (more RER less AD)
• Some priors proved unfounded low pass-through,
  low currency mismatches.
• Other priors yet untested (costly) market
  induced adjustment
• Policy framework too rigid annual inflation
  target, XR band

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Among other things, the Chilean case shows the
following

• Potentially large costs of interest rate spikes
  (liquidity crunches).
• Implementing macho credibility can be
  self-defeating (Europe 92).
• Private sector AD responds to fundamentals.
• Although the counterfactuals are unknown, fiscal
  policy announcements apparently did not buy much
  credibility.
• Outflows were a key element behind the story
  limiting applicability to other EMEs.

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Policy Responses to Sudden Stops in Capital
Flows The Case of Chile in 1998

• Rodrigo Valdés Central Bank of Chile

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but relatively stronger drop in import-intensive
demand components.
Contributions to Domestic Demand Growth ()
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Major drop in GDP growth was largely unexpected
(as was CA adjustment)
Expected and Actual GDP Growth (cumulative four
quarters, annual change)