Journal Issue

Interview with Ricardo Hausmann: Does currency denomination of debt hold key to taming volatility?

International Monetary Fund. External Relations Dept.
Published Date:
March 2004
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What is volatility? For Harvard University’s Ricardo Hausmann, it is deep uncertainty about the future course of fundamental economic variables. It is a situation in which, to borrow a maxim from baseball’s Yogi Berra, “the future is no longer what it used to be.” In economics, the textbook reaction to volatility is to insure against risk or, if you can’t do that, borrow in bad times and save in good times to smooth out the good with the bad. In reality, though, many developing countries experience dramatically higher volatility and struggle to devise adequate coping mechanisms. In an interview with the IMF’s Alicia Jimenez, Hausmann explores this phenomenon and discusses some possible strategies to reduce volatility.

Jimenez: What are the chief effects of excess volatility?

Hausmann: Empirical evidence suggests that excess volatility is bad for growth, bad for investment, and bad for the poor. Because the poor are typically less able to cope with high volatility, volatility tends to increase poverty and worsen income distribution. In terms of educational achievements, data at both macro and micro levels suggest that during shocks children leave school, lose time, and often don’t return after the shock is gone. Education is but one example. There is convincing evidence that excess volatility is bad for all the important dimensions of development we care about.

Jimenez: You suggest that there is a relationship between volatility in macroeconomic policies and volatility in macroeconomic outcomes. How does this correlation work?

Hausmann: Policies and outcomes are deeply intertwined. In a typical industrial country, the volatility of fiscal revenues and spending implies a fiscal balance that can have an unexpected deviation, or “surprise,” of about 1 percent of GDP a year. In a developing country, it is more like 3 percent of GDP a year. Now in industrial countries, the financial system is about 100 percent of GDP on average, so a typical fiscal shock is about 1 percent of a financial system. In developing countries where the financial system may be more like 20 or 30 percent of GDP, a 3 percent of GDP shock represents something like 10 to 15 percent of the financial system.

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.

Jimenez: Why do developing countries lack the mech anisms to cope with volatility? How can they create them?

Hausmann: The absence of coping mechanisms has to do with incomplete and weak insurance and finan cial markets. There is a potential vicious circle, too, because high volatility may make it harder for these markets to develop.

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.

Jimenez: What should countries do to lower volatility?

Hausmann: That is a bit of a puzzle. Some recommendations are very uncontroversial. Better institutions, property rights, and bankruptcy procedures are things you want regardless of whether they lower volatility. Better fiscal management and financial policies are uncontroversial, too.

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.

—Ricardo Hausmann

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.

Jimenez: How would industrial countries react?

Hausmann: This proposal is in everyone’s interest. It doesn’t involve changing the grant component of these loans; it would essentially involve risk sharing among poor countries. It’s easier to implement than trying to change private capital markets, which would entail decisions by millions of individual investors. In this regard, my colleague Barry Eichengreen and I have also suggested that the World Bank should attempt to develop an international market in a basket of inflation-indexed developing country currencies to allow it to lend in each country’s CPI-indexed local currency.

Jimenez: What are the main components of a macro-economic policy response to a volatile economy?

Hausmann: In a volatile economy, it’s not just policy that has to respond differently; a different institutional setup is needed. We used to think in terms of what to do if there were a positive or a negative shock. The question now is what to do if you don’t know what the shock is going to be. How do you prepare yourself structurally to cope with surprises?

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.

Jimenez: Have some countries dealt well with excess volatility, and, if so, how did they do it?

Hausmann: The principal success stories are countries like Canada and Australia—countries that have significant commodity-based exports subject to large terms of trade volatility. They have been able to cushion their domestic economies from these shocks by actively using a floating exchange rate regime with countercyclical monetary policy and by passively employing a countercyclical fiscal policy.

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.

Jimenez: How would you compare Chile, for example, with Australia?

Hausmann: Chile is well managed and has less external debt than Australia, extremely large international reserves, and very little public debt. It’s been a star pupil and a leader in reform. But when the East Asian and Russian crises came, Chile went into recession and Australia did not, even though the shocks they received were somewhat similar. The hard question is why was one of the best managed emerging markets unable to emulate Australia or Canada during this period? I believe it is related to the fact that Australia can borrow abroad in Aussie dollars and Chile cannot do so in pesos.

Jimenez: Do you see any correlation between corporate governance and volatility?

Hausmann: Obviously, bad corporate governance makes financial markets less effective and may prevent investment and amplify volatility. However, it is very important to think of two-way causality. In an environment of low volatility, it is easy to abide by contracts because the environment people have in mind when they sign a contract is more or less the environment in which they execute that contract. The greater the volatility, the more unexpected the environment, and the more reasons, for example, to have renegotiations after a contract is signed. And while a weak institutional environment seems to be related to high volatility, the direction of causality is not clear. It may very well be that higher volatility makes it harder to develop strong institutions because following the rules becomes harder when current conditions differ dramatically from those that were envisioned when the rules were adopted.

Jimenez: What would you like to see IMF economists keep in mind with regard to volatility?

Hausmann: When you go to a country, try to understand the sources and the potential amplifiers of volatility. Take a good look at the structure of financial markets, the nature and denomination of accumulated debts, and the potential access to finance in difficult times. Also take a look at the nature of domestic financial markets and the risks involved in the structure of the fiscal accounts, and try to come up with suggestions that allow a better distribution of the risks and, ideally, a better internationalization of risks.

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.

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