Editor’s Note: On October 25–28, 2014, Ernesto Talvi participated in the Latin America Shadow Financial Regulatory Committee (CLAAF), held in Lima, Peru. The committee is composed of a group of prestigious independent Latin American economists, former policymakers, and academics with strong expertise in the field of macroeconomics, banking and finance and whose goal is to identify and analyze challenges and risks for the region. The following document—Policy Statement Number 32—was released at a press conference held at Universidad del Pacífico in Lima, immediately following the meetings. It discusses the risks associated with a major slowdown in emerging economies and with the possibility that emerging market asset liquidity might fall significantly when the FED increases interest rates. A series of preventive policy actions for Latin American countries and the international community are recommended by the Committee.
I. Change in Growth Perspectives of the Global Economy
Towards the end of the 2008 economic crisis, the consensus was that developed economies
would recover just as quickly as they did in past recessions. It was also expected that emerging
market economies would continue acting as the world growth locomotive for a relatively long
time. Until mid-2011, this perspective appeared to be in the process of materializing. By now,
however, this scenario differs significantly from reality. For example, projections on economic
growth published by the IMF at the October 2009 World Economic Outlook (WEO) forecasted a
global economic growth rate of 4.5% for 2014, while the latest version of the estimate reduced
the forecast to 3.3%. While the adjustment is minimal in the case of the United States, forecast
revisions are important in some other regions. In Europe the projection was adjusted by -1.3%; in
Japan by -0.9%; and in the emerging world by -2.2%.
Consensus among international economic analysts has, therefore, become increasingly
pessimistic and projection adjustments reflect the fact that the observed recovery has actually
been weaker than expected. In the case of developed economies, the slow recovery has even led
some experts to suggest the possibility of getting into a secular stagnation process, increasingly
emphasizing the need to implement structural reforms in order to foster innovation and
productivity. Stagnation in Europe in particular has reached the entire continent.
Forecast revisions have been particularly strong in the case of Latin America. The WEO growth
forecast has been revised downwards from 4% to 1.3% in the period between 2009 and 2014.
The regions’ largest economies have suffered the greatest revisions for 2014. Between 2009 and
now, the revision for Argentina stands at -4.7%; in Brazil, Chile and Venezuela at -3.4%, in
Mexico at -2.5% and in Peru at -1.9%.
In Latin America, most of these revisions are mainly explained by a reversion in growth rates
towards potential rates similar to historical averages following a strong expansionary period.
This would interrupt the catch-up process of the region’s GDP –relative to the US GDP- that
started in 2003.
Indeed, as discussed in CLAAF’s Statement N° 26, the region benefitted from the aggressive
response to the 2008 crisis by advanced economies’ central banks (particularly the FED). The
strong reductions in interest rates and the massive purchases of financial assets significantly
changed the international capital market dynamics, and facilitated an increased demand for Latin
American’s assets. Between 2010 and 2013, the region increased its external funding in order to
sustain increasing public and private expenditures; this translated into larger current account
At the same time, the region benefited from the strong anti-cyclical Chinese policy in the
aftermath of the 2008 crisis. In China, economic policy was even more expansive than that in
developed countries. This policy included substantial bank and non-bank credit expansions, and
a boost for commodity demand.
Part of Latin America’s slowdown is clearly cyclical. After the boom in commodity prices, there
was a strong increase in investments related to these industries, which is now coming to an end.
This has been particularly relevant in Chile and Peru. Also, in some economies, domestic policy
difficulties and uncertainty towards reform implementation have curbed demand expansion.
The monetary stimuli in the United States and other parts of the developed world, as well as
China’s credit expansion, mitigated the effects the 2008 crisis had on expenditure and growth
rates in the region. However, as the US FED has initiated announcement of measures to
normalize its monetary policy position (suggesting a plausible increase in interest rates by mid-
2015) the region’s financial markets have been adversely affected. For example, the region’s
currencies have depreciated and country-risk premiums have risen.
II. Additional Risk Factors in the Global Scenario
Compared to the scenario described above, the Committee has identified two additional risk
factors that have not been appropriately internalized by the current consensus. First, we are
witnessing a global financial phenomenon without precedent in the post-war era. The mortgage
crisis originated in developed countries and had strong repercussions in developing countries.
These repercussions had an unexpected turn. Initially, the markets feared a severe recession in
developing countries given the experience during the 1998 Russian crisis, when a relatively
smaller shock related to the partial default of the Russian debt had a very strong generalized
impact in emerging economies. In contrast, the mortgage crisis of 2008 was associated with a
fast unexpected dynamic recovery until mid-2011, after having caused a drastic export contraction in developing countries. This is one of the most novel aspects in the crisis’ post-
The Lehman’s crisis caused a massive and significant destruction of low-risk, highly- liquid
assets, the so-called Safe Assets. These assets constitute an important source of credit collateral.
Some estimates place the destruction of low-risk, highly- liquid assets at 25 percent of global
GDP. This created an excess demand for safe assets, which in turn generated incentives to
demand other assets with similar liquidity characteristics, although not at the same low-risk
Because emerging countries’ assets suffered relatively less during the global financial crisis, they
became a good alternative to the traditional low-risk, highly-liquid assets; thus improving their
liquidity. In Latin America, during the pre-crisis period, a number of countries experienced
improvements in their credit rating and some reached investment grade. This supported the
increased demand for these countries’ assets by institutional investors, such as pension funds and
A short-term interest rate close to zero in developed countries and the fact that the Lehman crisis
led to greater banking regulations in developed countries (capital and liquidity requirements)
fostered liquidity creation in emerging countries. This gave way to a strong expansion in the
activities of institutions, such as investment and hedge funds, much less regulated and with lesser
limitations for financial intermediation and for maintaining risk assets in their portfolios. This
process, in turn, supported greater liquidity for emerging markets’ bonds.
Presidente, CLAAF; investigadora principal y directora de la Iniciativa Latinoamericana, Center for Global Development; ex economista jefe para América Latina, Deutsche Bank
Former Brookings Expert
Profesor, Universidad de Columbia; ex economista jefe, Banco Interamericano de Desarrollo
Socio mayoritario, Konfigura Capital; ex Ministro de Finanzas, Colombia
Pedro Carvalho de Mello
Profesor, Escuela de Negocios ESAGS (Sao Paulo); ex comisionado, Comisión de Valores Mobiliarios, Brasil
José De Gregorio
Professor of Economics - University of Chile
Former Governor - Central Bank of Chile
Profesor, Universidad Torcuato di Tella; ex viceministro de Finanzas, Argentina
Investigador no residente, Center for Global Development; profesor, Universidad de los Andes; ex Ministro de Finanzas, Colombia
A main problem faced by emerging markets is that asset liquidity might fall significantly when
the FED increase interest rates, a move the market has started to anticipate. The FED has already
started tightening its monetary policy through the finalization of the Quantitative Easing (QE)
program. However, the end of QE is much less dangerous for emerging markets’ assets liquidity
than increasing the policy interest rate in developed countries, given that high-liquidity assets
(such as the US Treasury bonds) directly compete with the developing countries’ liquid assets, especially those that expanded in response to the financial crisis. This factor raises deep concerns
about a potential dry-up in the flow of capital towards emerging markets following an increase in
international interest rates (that is, a Sudden Stop). These fears include risks of an important
contraction in the level of activity and employment.
An additional problem is the FED’s lack of clarity regarding its future decisions, due to the high
complexity of the situation. The normalization of financial conditions in the US should be
accompanied by an increase in interest rates to prevent inflation. However, interest rate increases
can lead to important impacts in that country and in the global economy that are difficult to
anticipate. This creates a dilemma for the FED; one that can generate uncertainty on the nature
and timing of its decisions.
A second risk factor is that there are strong reasons indicating a deeper slowdown in China’s
economic growth than the forecasts by the current international consensus. On the one hand,
investment quality has been uneven, since it gave way to excess capacity in the real estate
industry and to an increase in spending by local governments in ambitious, but not very efficient
infrastructure projects. In turn, the decreasing quality of projects, together with a significant
indebtedness by companies and local governments, might lead to lower investment rates and
growth prospects. In fact, investment in the real estate market has already started to fall and
housing prices in several cities have started to go down.
On the other hand, the rapid increase of China’s investment has been linked to an equally rapid
increase of domestic credit. Total social funding reached almost 120 percent of GDP in 2008 and
more than 200 percent of GDP in 2014. Although a great deal of credit expansion has taken
place through the regulated banking system, credit has been increasingly channeled through trust
funds and other non-regulated instruments, usually known as “shadow banking”. Assets in this
category are currently estimated at 30 percent of assets in the traditional banking system. The
combination of a credit boom with low-productivity investments has increased the fragility of the
financial system in China.
III. Regional Risk Factors
A third risk factor which is particularly relevant for the region is the possibility that commodity
prices might fall faster than what the current consensus considers. In fact, we have recently seen
a significant reduction in the price of agricultural products, oil and metals from their highest
These additional risks that the Committee has identified find Latin America in more fragile
initial conditions than in 2008. Firstly, excessive public and/or private expenditure and
insufficient savings ratios led to a deterioration of current account balances even before the
decline in commodities prices. Secondly, public sector deficits increased significantly in several
countries, including those where counter-cyclical fiscal policies adopted in 2009 were not
reverted during the subsequent recovery. Thirdly, domestic costs of production increased faster
than productivity, reducing competitiveness in non-commodity tradable industries. Fourthly,
indebtedness levels of firms and families are relatively high in several countries. Fifthly, efforts
for increasing productivity in the region have clearly been insufficient.
Under these conditions, the likelihood of reductions in credit ratings of some countries has
increased. This possibility may become generalized if, as a consequence of an increase in the US
interest rates, there were a risk revision of the asset class formed by emerging markets bonds.
Likewise, the combination of the above mentioned factors might generate sudden currency
depreciations which, in some countries that are still highly financially-dollarized, might generate
adverse effects on the balance sheets of the public sector and of non-tradable private sectors. In
other countries, where there still exists a significant pass-through, these factors might generate
IV. Policy Implications
The risks from the global scenario described above have a clearly systemic dimension. A sudden
increase in international interest rates, together with a fall in the price of a wide range of assets,
in the context of an economic slowdown, can generate a strong loss of investors’ confidence on
emerging economies. The Committee believes that if this scenario materializes, the current
financial architecture, made up by local central banks and multilateral institutions will be
inadequate to respond to the challenges entailed by such scenario. Therefore, restoring
confidence will very likely require new liquidity support by the FED, this time towards emerging
economies. However, it seems unlikely that such action will be supported by the US Congress to
the extent that US recovery continues in its consolidation process, and that injecting liquidity is
not clearly in the interest of the United States.
In this context, the Committee believes that it is desirable to strengthen the international financial
architecture to improve its capability to respond to a sudden deterioration in global financial
markets. The Committee particularly favors the creation of an Emerging Markets Fund (EMF)
with the capacity to intervene in sovereign debt markets for the purpose of reducing volatility.
Such a fund may intervene in debt markets in case of systemic financial turmoil and under
predetermined rules; such actions could include transactions based in a bond basket (for example
the EMBI basket). The fund may also establish swap lines with central banks of the same type
that took place during the global financial crisis.
A potential problem with this kind of initiative is that it is subjected to usual criticisms regarding
moral hazard. However, the Committee believes that this is not a major problem because the
EMF is focused in establishing a bond basket price index that includes bonds from many
countries and not for individual countries. Even if the moral hazard argument has some merit,
and even if the EMF can experience losses in its interventions, the 2008-2009 crisis experience
demonstrated that counting with powerful instruments, witch lender of last resort characteristics,
in systemic situations of loss confidence derives in benefits that exceed the costs.
In previous CLAAF statements (see Statement No. 27), the Committee has already clearly
expressed the need to complement the role of current multilateral organizations, particularly the
IMF through the creation of regional institutions. In this regard, the Committee favors the
creation of a Latin American Liquidity Fund mainly aiming at: 1) providing liquidity to the
public sector, and 2) providing credit that can mitigate the possible volatility in trade credit lines.
The Committee estimated that such institution should need a capitalization of US$ 50 billion and a lending capacity of US$ 100 billion, equivalent to the net liquidity needs by the region during
the 2008-2009 crisis.
Facing the current scenario, the Committee recommends the countries in the region to run new
stress tests so as to update possible financial needs for the public and private sectors that might
arise if the FED increases interest rates suddenly in the context of the current economic
slowdown and fall of commodity international prices.
In the preceding sections we have identified the growth of “shadow banking” –a response to
greater regulatory constraints on the traditional banking system- as an important source of risk.
To contain regulatory arbitrage, the Committee recommends that financial activities with similar
characteristics should be treated coherently in the regions’ regulatory frameworks; without
distinguishing whether such activities are carried out by a bank or another entity if systemic risks
-which require potential action from a lender of last resort, such as a central bank- derive from
such activities. This implies a change in the traditional regulatory approach form “regulation by
type of institution” to “regulation by function”. In addition, it is advisable to exclude public
sector liabilities from the definition of “highest-liquidity assets” recommended by Basel III in
countries whose sovereign liabilities are subject to high volatility in the contexts of financial
turmoil. This would prevent interconnectedness between sovereign risk and financial risk.
The above mentioned change of approach concerning regulatory frameworks suggests the
convenience of consolidating regulatory and banking supervision with responsibilities for capital
markets and insurance oversight. Some countries in the region, such as Colombia and Mexico,
have already moved in this direction. However, in the US and the EU there is still separation
between banking and capital market regulators.
The prospects for increasing volatility in capital markets causing the region to face sharp
downturns in capital inflows also implies challenges to domestic economic policies. Turbulences
in capital markets may generate a contraction in banking credit that may exacerbate the adverse
effects on economic growth. It was demonstrated -during the 2008 and 2009 crisis- that in such
case public banks may play a beneficial counter-cyclical role that could mitigates the contraction
of private banks’ credit. In countries where there are public banks, the Committee believes the
counter-cyclical role of credit provided by those institutions should be strengthened. To do so,
public banks should explicitly adopt said policy objective and develop specific strategies to
appropriately exercise such role.
In terms of exchange policy, the Committee reminds the region about the importance of keeping
appropriate exchange rate flexibility and avoiding “fear to float” behaviors. The countries that
are most able to reduce currency mismatches in balance sheets and dollarization will be in better
position to face the challenges of a greater financial volatility and lower economic growth.
 Social funding is defined by the Popular Bank of China as an economic barometer that adds up total funding by non-public Chinese entities, including non-financial individuals and companies.