Coping with Chile's external vulnerability
Subtitle: a financial problem
By: by Ricardo J. Caballero
Contributors: Massachusetts Institute of Technology. Dept. of Economics
Edition: Rev.
Series: Working paper series / Massachusetts Institute of Technology, Dept. of Economics -- working paper 01-23; Working paper (Massachusetts Institute of Technology. Dept. of Economics) -- no. 01-23.
Publisher: Massachusetts Institute of Technology, Dept. of Economics
Published: 2002
Place of publication: Cambridge, MA
Language: eng
Number of pages: 44
Description: With traditional domestic imbalances long under control, the Chilean business cycle is driven by external shocks. Most importantly, Chile's external vulnerability is primarily a financial problem. A decline in the Chilean terms-of-trade, for example, is associated to a decline in real GDP that is many times larger than one would predict in the presence of perfect financial markets. The financial nature of this excess-sensitivity has two central dimensions: a sharp contraction in Chile's access to international financial markets when it needs it the most; and an inefficient reallocation of this scarce access across domestic borrowers during external crises. In this paper I characterize this financial mechanism and argue that Chile's aggregate volatility can be reduced significantly by fostering the private sector's development of financial instruments that are contingent on Chile's main external shocks. As a first step, the Central Bank or IFIs could issue a benchmark instrument contingent on these shocks. I also advocate a countercyclical monetary policy but mainly for incentive - that is, as a substitute for taxes on capital inflows and equivalent measures - rather than for ex-post liquidity purposes. Keywords: Financial underdevelopment, external shocks, capital flows, segmented financial markets, hedging, illiquid markets, underinsurance, contingent bonds. JEL Classification: E0, E5, F3, F4, G1, G3.
Notes: "Revised, January 2002."; "01/11/2002"--Abstract.

Includes bibliographical references (p. 44).

Abstract in HTML and working paper of the original 2001 publication, for download in PDF available via World Wide Web at the Social Science Research Network.