It is thus much harder for a developing country’s financial system to cope with a fiscal shock. The monetary disturbance it will generate would be much larger, probably too large to be digested purely at home without major macro disruptions. In these circumstances, it is going to be so much more important that developing country governments develop the capacity to address the effect of shocks by borrowing abroad. If they cannot, these shocks can create enormous pressures on monetary policy and lead to inflation and exchange rate instability.
This is one example of how, in developing countries, the interaction of risks with limited financial markets can multiply volatility, while an industrial country would be in a position to cope with it relatively easily.
To begin to remedy this, we have to better understand the sources of volatility. In some countries, it may be that budget institutions don’t ensure a stable and sustainable management of government spending and borrowing. Governments end up spending whatever they can collect or borrow. In good times, they can spend a lot, but in bad times, both revenues and lending dry up, forcing them into a fiscal contraction that aggravates the already difficult situation.
In other countries, the story might be financial. Increasingly, I also believe that the nature of international finance—the inability of countries to maintain access to international capital markets in bad times—forces both governments and households to cut back spending when things are bad, hence aggravating recessions.
I am also exploring the idea that greater financial frictions may arise from weaknesses in property rights and bankruptcy procedures. To the extent that investment is riskier because of these weaknesses, volatility will cause low investment, and low investment will increase volatility. The result is a vicious circle whose underlying, amplifying cause may be weaknesses in domestic institutions.
I am exploring two more controversial areas. One is the possibility that countries may be in a “volatility trap.” High real exchange rate volatility makes investment in exportables riskier because profits in this sector are very sensitive to the level of the real exchange rate. But countries that have a smaller export sector will have more volatility in the real exchange rate. Hence, you get this vicious circle. To pull countries out of this predicament, it may be necessary to devise interventions that socialize the real exchange rate risk borne by exporters.
The second area that I am exploring relates to the inability of most countries to borrow internationally in their own currency. This makes international finance less stabilizing than the textbooks suggest. I have been thinking about how international financial institutions could help in this regard. At present, the international financial institutions are part of the problem: the World Bank lends in U.S. dollars and the IMF lends in SDRs; they do not lend in local currency. In bad times, countries’ real exchange rates depreciate, making it harder to service these loans: bad times are made even worse, and this aggravates volatility.
To a large extent, the transmission mechanisms that make volatility so hard to manage have to do with incompleteness in international financial markets, and I do believe that there is an active agenda for the international financial institutions to help develop those markets.
Now, the World Bank justifies its dollar-based lending on the grounds that the dollar is the currency in which it can borrow in capital markets. However, the International Development Association and the IMF’s Poverty Reduction and Growth Facility don’t have to go to capital markets to borrow; they are funded with grants from member countries. They could, in principle, lend that money whichever way they want and according to the principles and rules they want to adopt.
In research I have done with Roberto Rigobon, we suggest that the World Bank and the IMF are wasting a huge opportunity for risk sharing among poor countries and that the world would be better off if these entities lent in consumer price indexed (CPI) local currency terms. It would be better for each borrower and probably for the IMF and for the World Bank, because the cash flows that they expect to get would be more or less the same, but the debts would better track each country’s ability to pay.
The more volatile the economy is, the more precautionary the policy stance needs to be. More volatile countries have to target a lower average level of debt, a higher precautionary level of fiscal savings, and more liquidity in the fiscal and external accounts. They need to impose higher capital adequacy and liquidity requirements on banks in order to cope with the underlying volatility of deposit demand, interest rates, and asset values. And they need to consider very seriously their exchange rate arrangements.
The research that I and others have done suggests that the presence of foreign currency debt makes monetary and exchange rate policy more rigid and less stabilizing and makes fiscal risks larger. That is why I have concentrated so much effort on analyzing the consequences of the currency denomination of national debt and the need to change the structure of international markets. I increasingly believe that, to a large extent, the transmission mechanisms that make volatility so hard to manage have to do with incompleteness in international financial markets, and I do believe that there is an active agenda for the international financial institutions to help develop those markets. With a more complete set of market instruments, countries will be in a better position to cope with volatility.
Australia doesn’t get into trouble despite having a large foreign debt, very few international reserves, and a significant structural deficit in its current account—three things that would scare most finance ministers in developing countries. Why is that? Because, in essence, its foreign debt does not involve a net currency exposure—it is de facto in domestic currency. Fluctuations or risks in Australia’s exchange rate are shared with its creditors, and there is consequently less risk at home. Most emerging markets can’t do this, and that is why they need more reserves, less foreign debt, and much smaller current account deficits. This is probably the best they can do, but by so doing, it will make it harder for them to smooth shocks, and hence they would at best be much more volatile than Australia. But it is still an open question why successful countries are so hard to emulate. It’s not because successful countries sacrifice more, it is because they achieve more with less pain.
Most countries are unable to follow Australia’s example and share the risk with their foreign creditors, and that inability keeps too much of the risk at home. I would urge these countries to explore avenues in which risk can be better managed and shared with others.