Chapter

V. Conclusion

Author(s):
Paolo Mauro, Torbjorn Becker, Jonathan Ostry, Romain Ranciere, and Olivier Jeanne
Published Date:
April 2007
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The stylized facts presented in this study suggest that countries are subject to a wide variety of shocks that often have major, enduring consequences for levels of aggregate output, and thus for economic well-being. Against this background, mechanisms aimed at preventing such shocks from causing excessive economic disruption have the potential to provide sizable benefits for the affected countries and the global economy as a whole. This paper has examined various types of insurance mechanisms that countries can pursue to soften the blow from adverse shocks and their relevance for different segments of the IMF’s membership (Table 5.1).

Table 5.1.Types of Insurance and Crisis-Prevention Measures
Measure/Type of InsuranceEspecially Relevant for Which Countries?Time Frame/Difficulty
Sound macroeconomic and financial policiesAll countriesImpact to be observed in short term.
Improving institutional qualityAll countries. Evidence suggests this should help increase the share of equity-like liabilities (e.g., foreign direct investment (FDI) and portfolio equity) in countries’ total external liabilities.Medium term
Appropriate debt managementEmerging market countries. Evidence suggests sound policies (macroeconomic stability and supporting institutional reforms) may facilitate an increase in the share of long-term domestic currency debt.Impact to be observed in short term.
Innovative financial instrumentsEmerging markets and developing countries. Instruments with equity-like features (e.g., growth-indexed bonds) could help improve debt sustainability and international risk sharing. Larger economies are more likely to attain the requisite critical mass to ensure sufficient liquidity of the instruments. Financial instruments aimed at hedging against commodity price fluctuations may be relevant for countries with heavily concentrated production structures. For disaster-prone developing countries, disaster insurance may be appropriate.Immediate in principle, but obstacles in practice. May require some international coordination.
Appropriate reserve holdingsEmerging markets and developing countries. Strong reserve positions are especially important for dollarized economies and financially integrated economies.Impact to be observed in short term.
Collective arrangements, including high-access contingent financing instrument proposal and IMF support for regional pooling arrangementsEmerging market countriesTo be analyzed in separate studies.

Although all countries are subject to a range of financial and real shocks, the types of shock differ considerably across country groups. For developing countries, real shocks, such as changes in the terms of trade, tend to rank among the most costly, though the debt crises of the early 1980s also inflicted considerable economic damage. For emerging market countries, in contrast, greater integration in global financial markets has been associated with higher exposure to financial shocks, which are by far the most significant for this segment of the IMF’s membership.

For all countries, the first line of defense against adverse shocks is the pursuit of sound policies. In light of the large costs experienced by emerging markets and developing countries as a result of past debt crises, fiscal policies should seek to improve sustainability, taking into account that sustainable debt levels seem to be lower in emerging and developing countries than in advanced countries. Appropriate debt management aimed at increasing the share of long-term, domestic currency debt in total debt would also be beneficial. Efforts to improve the structure of the liability side of national balance sheets more generally, by increasing the share of equity-like liabilities, such as FDI, would also be well rewarded. The evidence presented in this paper suggests that macroeconomic stability and supporting institutional reforms may facilitate the move toward safer liability structures.

A range of financial instruments may also have a role to play in providing country insurance. Relevant examples include catastrophe bonds and insurance against natural disasters for smaller, disaster-prone countries; commodity price futures or other instruments aimed at hedging against commodity price fluctuations for countries with heavily concentrated production structures; and GDP growth–indexed bonds for a broader segment of the IMF’s membership. New instruments would have a greater chance to succeed with large issuers, which are more able to provide the critical mass necessary for a deep and liquid secondary market.

Maintaining appropriate cushions of official reserves is also clearly an essential part of countries’ self-insurance toolkit. The analytical framework developed in this paper may be useful in clarifying judgments about the trade-off between the costs of holding reserves and the benefits they provide in smoothing the impact of external shocks. When applied to data for the past two and a half decades for a sample of more than thirty middle-income countries, the framework suggests that the rapid reserve accumulation observed in Asian emerging markets since the early 1990s may now have resulted in a degree of self-insurance that exceeds what can be justified on the basis of plausible changes in fundamentals. More specifically, although increased international financial integration and the related potential for financial flow reversals seem consistent with the rapid increase in reserves observed in earlier years, for the period since the late 1990s reserve accumulation seems to be excessive compared with what the model would estimate as appropriate self-insurance. For Latin America, the model suggests a substantial degree of underinsurance, at least until the early 1990s, though, on average, reserves may have reached broadly adequate levels in recent years; an open issue that might alter this judgment is that the model may not fully account for larger output losses in the presence of de facto dollarization.

Although much can be accomplished by individual countries through sound policies, risk management, and self-insurance through reserves, collective insurance arrangements are likely to continue playing a key role in cushioning countries from the impact of shocks. Collective insurance arrangements—insurance provided through regional or other pooling arrangements such as the Chiang Mai initiative, or global insurance provided through international financial institutions—hold promise because of their ability to pool risks, which makes them potentially more cost effective than self-insurance. These issues are to be taken up in separate papers.

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