RDP 2004-03: Fear of Sudden Stops: Lessons from Australia and Chile 1. Introduction

Latin American economies are exposed to substantial external vulnerability. Domestic imbalances and terms of trade shocks are often exacerbated by sudden financial distress. In this paper we explore ways of overcoming external vulnerability, drawing lessons from a detailed comparison of the response of Chile and Australia to recent external shocks and from Australia's historical experience.

Why Australia? While it is much more developed than Latin America, it has several structural features that make it similar to several countries in the region. Through its history it has been exposed to many external shocks due to large swings in its terms of trade – commodities make up a large share of its exports (over 95 per cent in 1,900 and still around 60 per cent). Moreover, Australia has had long episodes of significant external deficits, which have often been at the centre of the policy debate. For example, in May 1986 the then Treasurer (Finance Minister) Paul Keating said that Australia risked becoming a ‘Banana Republic’ if it did not address its declining international competitiveness which had led to substantial current account deficits and growing external indebtedness. Despite these similarities, external shocks have had much milder macroeconomic consequences in Australia.

Why Chile? Because on one hand Chile is arguably the most advanced economy in Latin America in terms of institutional development and macroeconomic stability, and in this sense the closest to Australia. But the responses to similar real external shocks in Australia and Chile have been dramatically different. Australia can rely on access to international capital markets to smooth these shocks. In contrast, shifts in the supply of external funds often exacerbate the effects of real shocks in Chile. By comparing two countries that are otherwise fairly similar we can isolate those factors that make a significant difference to international capital market linkages.

We start Section 2 with a comparison of the strikingly different responses of Australia and Chile to the Asian-Russian crisis. In doing so we discuss the role played by capital flows and exchange rate concerns. We conclude that fear of a capital flow reversal appears to be a more significant ingredient in Chile's poor macroeconomic performance than fear of an exchange rate crisis. But we also note that the absence of a well developed currency-derivative market exacerbated capital outflows from the domestic banking system in the face of increased exchange rate uncertainty.

Section 3 summarises our conclusions from this comparison. We highlight the importance of drawing a distinction between two dimensions of investor confidence: country-trust and currency-trust. Currency-trust describes the degree of confidence foreign investors have in holding assets denominated in the currency of the particular country. It indicates that investors believe currency movements will not be used to expropriate their investment but also that the central bank has enough control over the currency that random shocks are unlikely to lead to perverse exchange rate dynamics. In this way currency-trust is seen to be related to the concept of inflation credibility. Country-trust describes the degree of confidence foreign investors have more generally in the country, incorporating the commitment of the country to repay debts, corporate governance, the financial system and the economic stability of the country. Importantly, country-trust means that there is no need for highly specialised knowledge to invest in the country (for example about government and institutions).

We then sketch policy recommendations for a country with limited country-trust and currency-trust. We discuss the importance of developing external insurance mechanisms that are largely independent of domestic government actions and the idiosyncrasies of the local economy. In doing so, we place in a broader perspective the concerns of the ‘original sin’ literature. This literature highlights the fact that some countries are unable to insure externally by borrowing in their own currency, a narrower concept than currency-trust. The way around ‘original sin’ is to insure through a different contingency, and we suggest several examples. It is also clear that the most fundamental problem for these economies is not ‘original sin’ per se, but insufficient country-trust, the initial reason for demanding insurance. This section then discusses how the development of a domestic currency-derivative market is key to reducing the role played by domestic banks in exacerbating capital outflows during external shocks. It closes by advocating a macroeconomic policy framework that is indexed to the contingency used in the external insurance arrangement.

In Section 4 we outline the economic history of Australia over the past century in order to extract lessons on how to build country-trust and currency-trust. For currency-trust we highlight the role of a solid inflation record and a clear policy framework. The development of a deep domestic bond market with currency as its main risk, followed by the fostering of a local-currency derivatives market, were also important. For country-trust we stress the importance of a clean sovereign default history and the development of a healthy domestic banking sector. Section 5 concludes by extracting lessons for Latin America more broadly, including highly dollarised economies.