Why are we obsessed with volatility and what have we done about it?

Ugo Panizza

Research Department

Inter-American Development Bank

Volatility is costly

It leads to lower growthNegative effect on productivityLow investment in both physical and human

capital

It increases inequality and povertyIt leads to smaller financial systemsIn the absence of a well-working

financial market, it leads to high volatility of consumption

Latin America is volatile

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V o l . G D PG r o w t h

Why is Latin America volatile?

Large external shocksTerms of tradeSudden Stops in capital flows

Volatile macroeconomic policiesMonetary PolicyFiscal PolicyExchange Rate Policy

Political shocks

What can we do to reduce volatility?The 1995 Approach

DOMESTIC POLICIES CAN DO THE TRICK!!!

Policies aimed at reducing terms of trade risk Export diversificationStabilization funds

Policies aimed at reducing fiscal volatilityBudget institutionsGood debt management

Policies aimed at reducing excessive exchange rate volatility and misalignmentsManaged floating

What can we do to reduce volatility?Lessons from the crises

The Asian and Russian crises of the late 1990s spread shockwaves throughout the whole emerging world, also affecting countries characterized by good policies

It became clear that good policies and institutions are NECESSARY but not SUFFICIENT conditions for isolating EM from external shocks

What can we do to reduce volatility?Lessons from the crises

Efforts to understanding the effects of the Asian and Russian crises and developing mechanisms to reduce volatility gave rise to two new complementary areas of researchThe role of currency denomination of

external debt (ORIGINAL SIN)The role of SUDDEN STOPS in capital

flows

What can we do to reduce volatility?Lessons from the crises

Research showed that these problems are partly due to the way in which the international capital markets work

Hence, they cannot be fully addressed with domestic policies

This led to proposals aimed at addressing what Calvo (2002) called GLOBALIZATION HAZARDS

What can we do to reduce volatility?Lessons from the crises

Emerging Markets Fund aimed at limiting contagion and generalized Sudden Stops in capital flows (Calvo, 2002)

Emerging Markets Index and IFI issues in EM currencies aimed at creating new markets and achieving redemption from Original Sin (Eichengreen and Hausmann, 2004)

Why are we obsessed with volatility and what have we done about it?

Ugo Panizza

Research Department

Inter-American Development Bank