Report No.

Country Insurance: Reducing Systemic Vulnerabilities in LAC November 15, 2007 Chief Economist Office (LCRCE), Latin America and the Caribbean Region, Treasury

Document of the World Bank

CURRENCY EQUIVALENTS National Currency is the US$ (June 2007)

FISCAL YEAR July 1 – June 30

MAIN ABBREVIATIONS AND ACRONYMS 2SLS ARG ATM BEEPS BOL BRA CHL CHN COL COMTRADE CRI DBR EAP ECA ECU EMU ENI ES FDI FE Fin. Dev. GCF GDP GDPPC GEP GMM GNI Gov. GTM HIE HND IC ICA ICOR ICRG ICS IFC IMF IND INE ISO IV KOR LAC / LCR

Two-Stage Least Squares Argentina Automatic Teller Machine Business Environment and Enterprise Performance Surveys Bolivia Brazil Chile People’s Republic of China Colombia United Nations Statistics Division's Commodity Trade database Costa Rica Doing Business Report East Asia and the Pacific Europe and Central Asia Ecuador European Monetary Union Encuesta Nacional Industrial, Argentina Enterprise Survey Foreign Direct Investment Fixed Effects Financial Development Gross Capital Formation Gross Domestic Product Gross Domestic Product Per Capita Global Economic Prospects Generalized Method of Moments Gross National Income Government Guatemala High Income Exporters Honduras Investment Climate Investment Climate Assessment Incremental Capital Output Ratio International Country Risk Guide Investment Climate Survey International Finance Corporation International Monetary Fund India Instituto Nacional de Estadística de Uruguay International Organization for Standardization Instrumental Variables Republic of Korea Latin America and the Caribbean

i

LCRCE LLC M MA MENA MEX MYS NBFI NIC NTB NX Obs. OECD OLS PAN PER PISA PRY R&D SA SLV SME SSA TFP THA TI TOT Trini. & Tobago UK URY USA / US / U.S. USD USPTO Venezuela, RB WDI WDR WEF X ZAF

Office of the Chief Economist, Latin America and the Caribbean Region (World Bank) Limited Liability Company Imports Moving-average Middle East and North Africa Mexico Malaysia Non Bank Financial Institution Nicaragua Non-tariff barriers Non-exporters Observations Organisation for Economic Co-operation and Development Ordinary Least Squares Panama Peru Program for International Student Assessment Paraguay Research and Development South Asia El Salvador Small and Medium Enterprises Sub-Saharan Africa Total Factor Productivity Thailand Transparency International Terms of Trade Trinidad and Tobago United Kingdom Uruguay United States of America United States Dollars United States Patent and Trademark Office República Bolivariana de Venezuela World Development Indicators World Development Report World Economic Forum Exports South Africa

Vice President: Chief Economist: Task Managers:

Pamela Cox Augusto de la Torre Issam Abousleiman and Tito Cordella

ii

TABLE OF CONTENTS: ACKNOWLEDGEMENTS _______________________________________________ vi 1.

2

Introduction: The Case for Country Insurance ___________________________ 1 1.1

Some preliminary evidence ____________________________________________ 1

1.2

Exposure to external shocks: Too many, too large? ________________________ 3

1.3

Vulnerability: From external shocks to macroeconomic effects_______________ 9

1.4

Resilience: the welfare effects of macroeconomic volatility _________________ 12

1.5

The case for country insurance ________________________________________ 15

Country Insurance _________________________________________________ 16 2.1

A simple theoretical framework _______________________________________ 16

2.2

Liquidity shocks ____________________________________________________ 18

2.2.1 2.2.2 2.2.3

2.3 2.3.1 2.3.2 2.3.3 2.3.4 2.3.5

2.4 2.4.1

2.5

3

Liquidity buffer __________________________________________________________ 19 Market insurance _________________________________________________________ 22 IFIs and the role of an international lender of last resort ___________________________ 25

Real shocks ________________________________________________________ 26 Natural Disasters _________________________________________________________ 26 Real Economic Shocks ____________________________________________________ 30 Assets, liabilities, and the relevance of the gross position__________________________ 30 The quest for efficiency: Liquidity risk versus basis risk __________________________ 31 A taxonomy of instruments _________________________________________________ 32

Insurance and incentives _____________________________________________ 34 The catalytic role of insurance_______________________________________________ 35

Country insurance: a road map________________________________________ 36

The Policy Dimension: Diagnosis and Prognosis ________________________ 37 3.1

Toward a risk-management framework _________________________________ 38

3.2

Insurance versus hedging strategies ____________________________________ 38

3.2.1 3.2.2

Insuring oil revenues ______________________________________________________ 39 Hedging oil revenues ______________________________________________________ 40

3.3

Catastrophe instruments _____________________________________________ 42

3.4

The supply side _____________________________________________________ 45

3.4.1 3.4.2

3.5 3.5.1 3.5.2

3.6

Derivatives______________________________________________________________ 46 The IFI menu ____________________________________________________________ 49

Looking forward: Market failures and the case for IFI involvement _________ 55 Contingent facilities_______________________________________________________ 57 The IFI as market developer ________________________________________________ 58

Conclusions ________________________________________________________ 61

Appendix: Real indexed sovereign instruments: a survey ______________________ 68

iii

LIST OF TABLES: Table 1.1 Average shock frequencies, 1960–2005 ______________________________ 5 Table 1.2. Output volatility, income distribution, and poverty____________________ 14 Table 2.1 Reserves _____________________________________________________ 19 Table 2.2 Estimated timing of budgetary outflow caused by a catastrophic event_____ 28 Table 2.3 Availability of financial instruments over ___________________________ 28 Table 3.1 Premium for put option strategy (June 29, 2007) ______________________ 40 Table 3.2 Commodity derivative volumes ___________________________________ 48 Table 3.3 Turnover in derivative markets____________________________________ 49 Table 3.4 Fixed spread loans (FSL), customized repayments, and use of embedded flexibility_____________________________________________________________ 50 Table 3.5 Currency swaps in U.S. dollars (August 2007) _______________________ 51 Table 3.6 Multilateral development banks (MDBs): equity-to-loan ratio ___________ 52

LIST OF FIGURES: Figure 1.1 Output and consumption volatility, 1975–2005 _______________________ 2 Figure 1.2 Exposure: Terms of trade shocks, 1975–2005 ________________________ 4 Figure 1.3 Natural disasters damages over GDP _______________________________ 5 Figure 1.4 Exposure: The credit rating channel, 1975–2006 ______________________ 7 Figure 1.5 Contribution of external shocks to output volatility: variance decomposition post–Bretton Woods, 1974–2004 __________________________________________ 11 Figure 1.6 Insurance abilities by income level ________________________________ 12 Figure 1.7 Volatility, Income Distribution and Asymmetric Effects _______________ 13 Figure 2.1 Economic size and economic volatility_____________________________ 17 Figure 2.2 Emerging reserves _____________________________________________ 20 Figure 2.3 FLAR, CAF and Member Countries Spreads ________________________ 26 Figure 2.4 Liquidity gap _________________________________________________ 29 Figure 2.5 Aid over GDP (average per year) _________________________________ 30 Figure 3.1 Ladder strategy _______________________________________________ 41 Figure 3.2 Global OTC derivative market 1998–2006 __________________________ 46 Figure 3.3 The local currency advantage: ratings in local currencies and dollars in selected countries in LAC________________________________________________ 54 Figure 3.4 The local currency advantage: sovereign spreads in local currencies and dollars in LAC_________________________________________________________ 54

LIST OF BOXES: Box 2.1 The cost of reserves______________________________________________ Box 2.2 Two experiences with private liquidity insurance: Argentina and Mexico ___ Box 2.3 Catalytic insurance ______________________________________________ Box 3.1 Mexico oil hedging ______________________________________________ Box 3.2 Catastrophe bonds _______________________________________________ iv

21 23 35 42 43

Box 3.3 The Caribbean Catastrophe Risk Insurance Facility _____________________ Box 3.4 Peru: interest-rate management_____________________________________ Box 3.5 Local currency lending ___________________________________________ Box 3.6 Why is catastrophe insurance so expensive?___________________________ Box 3.7 GEMLOC _____________________________________________________

v

44 50 52 56 59

ACKNOWLEDGEMENTS Country Insurance: Reducing Systemic Vulnerabilities in LAC Countries is the product of a collaborative effort of the Chief Economist Office of the Latin American Region and the World Bank Treasury. The report was prepared by a core team composed by Issam Abousleiman, Cesar Calderon, Tito Cordella, and Eduardo Levy Yeyati, and comprising Luis de la Plaza Bringas, Francis Ghesquiere, Eugene Gurenko, Olivier Mahul, Nirmaljit Paul, Claudio Raddatz, Rodney Ramcharan, Guido Sandleris, Filippo Taddei, Luigi Ventura, and Ivan Zelenko. Andres Huby, Gaetana Torosantucci, and Igor Zuccardi provided excellent research assistance. Excellent advice has been received from Guillermo Perry and from our peer reviewers Chris Canavan, Augusto de la Torre, Eduardo Fernandez Arias, Paolo Mauro, and Roberto Rigobon. We would also like to thank Phillip Anderson, Elizabeth Currie, Makhtar Diop, Roy Gooi, Gloria Grandolini, Gregorio Impavido, Hala Khattar, Andrei Kirilienko, Ayhan Kose, Alberto Musalem, Miguel Navarro-Martin, George Richardson, Sergio Schmukler, Artit Serngadichaivit, Costantinos Stephanou, Antonio VelandiaRubiano and all participants in the authors’ pre-conference for the very insightful comments and suggestions.

vi

Country Insurance: Reducing Systemic Vulnerabilities in LAC

vii

1. INTRODUCTION: THE CASE FOR COUNTRY INSURANCE This study starts from the premise that output and consumption are more volatile and prone to extreme contractions in developing economies than in high-income ones. This suggests that developing countries are somehow “underinsured,” and might thus need to invest more in “country insurance” policies. In order to shed some light on such important issue, in this first chapter we first provide evidence of the excessive volatility that developing countries in general (and LAC countries in particular) face and then discuss some of the welfare costs associated with such volatility. In Chapter 2, we focus on the main trade-offs and on the strategic choices that developing countries confront should they decide to increase their resilience to exogenous shocks. Finally, in Chapter 3, we look at different policy options with a particular attention on what IFIs in general and the World Bank in particular could actually provide to help developing countries’ reduce their vulnerability to external shocks. While excessive volatility in developing countries affects both the government and the private sectors, this study limits the focus on the latter. The private sector challenges would be addressed in future research. 1.1

Some preliminary evidence

Figure 1.1 offers a succinct illustration of the higher volatility of developing countries vis-à-vis high income ones both with respect to output and consumption Why is this the case? Is it that developing countries are more exposed to shocks (i.e., they experience more shocks), or that they are more vulnerable to shocks (i.e., they suffer more from any single shock)? If vulnerabilities are important, do they depend on specific structural and financial characteristics of countries? How developing countries’ excess volatility translates in individual welfare losses, particularly to less protected low income households? What are the mitigating and the exacerbating factors? These are some of the question we touch on in this introductory chapter. For a more detailed discussion of the topic, we refer the reader to the background papers of this study, Calderon and LevyYeyati (2007), Raddatz (2007) and Ventura (2007) which provide most of the material summarized here. Among developing countries, Figure 1.1 also shows that output and consumption among LAC countries are less volatile than among other developing countries —and that this is explained by the behavior of lower-income countries. Interestingly, within the LAC region, output in upper-income countries are more volatile than in lower-income countries whereas differences in consumption volatility across LAC income groups are negligible. Below we will assess whether the volatility differences mentioned above are explained by differences in the variability or size of underlying external shocks.

1

Figure 1.1 Output and consumption volatility, 1975–2005 (a) Output volatility

Standard Deviation of Output Growth

7 6 5 4 3 2 1 0 All

Lower-Income

Latin America

Other Developing

Upper-Income High-Income OECD

Standard deviation of consumption growth

(b) Consumption volatility 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 All Latin America

Lower-Income Other Developing Countries

Upper-Income High-Income OECD

Note: Output and consumption volatility are calculated as the standard deviation of growth in real GDP and real consumption over the period 1975–2005, respectively. Note that for these calculations we have eliminated small countries and islands (with populations smaller than 1 million in the year 2000) and we have restricted the sample to countries that have data availability for both output and consumption for at least 15 consecutive years Source: Authors’ calculation based on data from the World Bank’s World Development Indicators (WDI).

2

1.2

Exposure to external shocks: Too many, too large?

It is usually asserted that developing economies are excessively exposed to exogenous external shocks, that is, to those shocks that do not depend on the current or past actions of countries’ policy makers. In order to investigate whether this is indeed the case we start by classifying such shocks into two categories: (a) real shocks and (b) financial shocks. In the former group, we then distinguish between real economic shocks such as variations in terms of trade or in export demand, and natural disasters such as hurricanes and earthquakes. As for the financial shocks, we look at changes in international liquidity or risk aversion. While the focus on exogenous shock is motivated by our interest in “insurable” and thus non-self inflicted damages, it is important to notice that, in long run, the exogeneity of any measure of exposure, with perhaps the exception of certain natural disasters, is highly questionable. For example, output volatility associated with real shocks may partially explain poor economic performance that, in turn, may lead to underinvestment, low productivity, and the concentrated trade pattern that makes developing economies more exposed to commodity prices in the first place. Analogously, output volatility—coupled with higher borrowing costs—may partly account for the higher credit risk behind the greater volatility of capital flows to developing countries. 1 This being said, from a policy perspective, these aspects (trade patterns, credit records) cannot be changed in the short term, and for this reason we take them as a given (exogenous) at any point in time. With this caveat in mind, we measure a country’s exposure to external shocks estimating the frequency and magnitude of the latter. A cursory look at the evidence shows that income explain an important part of exposure to terms of trade shocks. Lower-income countries display higher terms of trade volatility and a greater propensity to experience sharp deterioration in terms of trade relative to upper-income and high-income OECD countries. The same holds true for the LAC region and other developing areas: terms of trade are more volatile and more likely to drop dramatically in lower-income LAC countries —and, generally, in lower-income developing countries (see figure 1.2). The literature argues that the higher terms of trade volatility in developing countries (relative to industrial countries) can be explained in part by the less diversified composition of export and import baskets. Specifically, Baxter and Kouparitsas (2007) the share of terms of trade volatility attributed to the specialization of countries in highly volatile economic activities is still high and there is scope for reducing this volatility through diversification of a country’s exports.

1

The spread over an index, like the US Treasury, is partly exogenous (risk appetite) and partly endogenous related to credit worthiness affected mainly by government’s policies.

3

Standard deviation of terms of trade changes

Figure 1.2 Exposure: Terms of trade shocks, 1975–2005 (a) Terms of trade volatility 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 All Latin America

Lower-Income Other Developing

Upper-Income High-Income OECD

(b) Exposure: Sharp deterioration in terms of trade 0.18 0.16

Shock Frequency

0.14 0.12 0.10 0.08 0.06 0.04 0.02 0.00 All Latin America

Lower-Income Other Developing

Upper-Income High-Income OECD

Notes: (a) Volatility per country measured as a standard deviation of the annual growth rate for the terms of trade for the period 19752005 (average per group). (b) Shock frequency per country measured as the ratio of number of observations in which the annual growth rate for terms of trade was -10 percent or less than the total number of observations in the sample (average per group). Source: Authors’ calculations on WDI data.

If we look at natural disasters, we also get a similar picture. The average damage faced by developing countries represent 2.7 percent of GDP over the period 1960–2005, while

4

size seems to matter in terms of the damage inflicted by natural disasters. Average damage in small states represents 4.9 percent while it is 0.5 percent in big developing countries (see figure 1.3). The pattern for countries in Latin America and the Caribbean (LAC) is similar to other developing regions, albeit costs are much higher. Indeed, average damages from natural disasters faced by countries in LAC represent 4.4 percent of GDP over the period 1960–2005. The exposure of LAC to natural shocks is reflected by the fact that the region has experienced almost 27 natural disasters (climatic and geological) per year over the period 1960–2005, with an average shock frequency per country of almost 0.8 percent. Across geographical regions, as shown in Table 1.1, LAC and South Asia display the greatest incidence of natural disaster. 2 Figure 1.3 Natural disasters damages over GDP 6%

Percent of GDP

5% 4% 3% 2% 1% 0% Big Developing Countries (pop.>5mln)

Small Developing Countries (pop.