This semiannual report examines the short and medium-term challenges for Latin America and the Caribbean (LAC) as the external factors that were instrumental in the region s recent performance recede. In particular, we address the role of the exchange rate as a counter-cyclical policy tool to buffer adverse external shocks.
This paper presents a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank’s balance sheet. Minimum variance portfolio (MVP) allocations are found to provide a natural benchmark to estimate the scope for dollarization of bank deposits and loans as a function of macroeconomic uncertainty. Dollarization hysteresis is shown to occur when the expected volatility of the inflation rate is high in relation to that of the real exchange rate. The evidence shows that MVP dollarization generally approximates actual dollarization closely for a broad sample of countries, and policy implications are explored.
As usual in this series, Chapter 1 reviews the configuration of global risks and assesses the outstanding short term opportunities and challenges facing the LAC region. We document the significant slowdown in economic activity across the region, and explore the possibility of this being the ‘new normal’. In Chapter 2 we assess if the major social gains achieved during the ‘Golden Decade’, in particular the decline in inequality, will hold in this less supportive environment, and discuss alternative policy responses to preserve and further the equity gains in the region.
This paper studies the impact of competition on the determination of interest rates and banks’ risk-taking behavior under different assumptions about deposit insurance and the dissemination of financial information. It finds that lower entry costs foster competition in deposit rate sand reduce banks’ incentives to limit risk exposure. Although higher insurance coverage amplifies this effect, two alternative arrangements (risk-based contributions to the insurance fund and public disclosure of financial information) help to reduce it. Moreover, uninsured but fully informed depositors and risk-based full deposit insurance yield the same equilibrium risk level, which is independent of entry costs. The welfare implications of the different arrangements are also explored.
The removal of government guarantees in borrowing countries does not eliminate the moral hazard problem posed by the existence of deposit guarantees in lender countries. The paper shows that, after restrictions on international capital flows are lifted, banks in low-risk developed countries benefit from lending funds captured in home markets at low deposit rates to high-risk/high-yield projects in emerging economies, even though these projects command lower expected returns. This, in turn, has a negative impact on bank profitability in the borrowing country, even when foreign funds are intermediated through domestic banks. The results are consistent with the surge in international bank lending flows that led to recent banking crises in Asia.
This paper shows that a central bank, by announcing and committing ex-ante to a bailout policy that is contingent on the realization of certain states of nature (for example on the occurrence of an adverse macroeconomic shock), creates a risk-reducing “value effect” that more than outweighs the moral hazard component of such a policy.
This paper analyzes the behavior of closed-end country fund discounts, including evidence from the Mexican and East Asian crises. We find that the ratio of fund prices to their fundamental value increases dramatically during a crisis, an anomaly that we denote the “closed-end country fund puzzle.” Our results show that the puzzle relates directly to the fact that international investors are less (more) sensitive to changes in local (global) market conditions than domestic investors. This asymmetry implies that foreign participation in local markets can both help dampen a crisis in the originating country, and amplify the contagion to noncrisis countries.
The paper presents a model of irreversible investment under uncertainty, where investment takes place whenever a threshold level of marginal returns is reached. The threshold depends positively on price volatility; a change from high to low inflation induces an upward capital stock adjustment. In economies that move in and out of temporary stabilizations, the observed effect is a negative inflation-investment correlation that replicates previous empirical findings, due to purely short-term dynamics. I study how this correlation is affected by the expected duration of each regime. Empirical evidence from ten inflationary economies confirms the predictions of the model.
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