Aizenman & Riera-Crichton: Liquidity and foreign asset management challenges for LATAM countries

ABSTRACT:

We analyze the degree to which the growing importance of sovereign wealth funds [SWFs], and the diffusion of inflation targeting and augmented Taylor rules have impacted the post crisis adjustment of Latin American Countries (LATAM) to the challenges associated with terms of trade and financial shocks. We confirm that the stock of reserves and active management reduce the effects of transitory Commodity Terms of Trade (CTOT) shocks to real exchange rate [REER] in LATAM economies. This “buffer effect” seems to work more against risk of real appreciation than against risks of depreciations. Fixed exchange regimes acts as a substitute policy to reserve accumulation, and this buffering policy seems to work under relatively high levels of external debt, and in economics that are less open to trade. In contrast to reserves, SWFs seem important to buffer the REER from CTOT shocks with fixed exchange rate regimes and in relatively closed economies. The buffer effect seems to show its strongest effect during the 80’s,  90’s and the end of the Great Moderation (2003-2007). While the stock of reserves fails to smooth the transmission of CTOT shocks to REER during the Global Financial Crisis (2008-2009), we observe SWF stepping up as a potential substitute to traditional reserve assets. The CTOT- REER relationship seems to resume during the post-great recession period (2010-2013) and the reserve buffering role returns but not at the levels observed prior to the crisis. There seems to be a “substitution” between reserves and SWF, where SWFs take over the buffering of the REER and the real GDP during the Great Recession and the post-Great Recession period. Inflation targeting policy seems to matter, potentially diverting resources to the preservation of domestic price stability: IT countries seems to give up the use of reserves to buffer against CTOT shocks, relegating this role to the SWFs. In LATAM countries that seem to follow augmented Taylor rule, their monetary authorities seem to place large weight of output gaps; while inflation seems to gain importance for IT countries. The nature of the regime matters – non IT countries seem to switch from REER stabilization target to an inflation target when committing to a formal IT rule. SWF seem to provide IT countries with an alternative form of liquidity management against foreign shocks when traditional reserves are committed to other macroeconomic goals. This is true for both REER and output growth stabilization.

 

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