A key policy prescription for fending off financial crises in emerging markets has been the development of local bond markets, and this strategy has been embraced by a number of policymakers and international organizations (see World Bank and IMF, 2001). From a macroeconomic perspective, local bond markets could soften the impact of lost access to international capital markets or bank credit by providing an alternative source of funding. From a microeconomic perspective, they could help create a wider menu of instruments to deal with inherent currency and maturity mismatches in emerging markets (see Eichengreen and Hausmann, 1999; and HKMA, 2001). In part as a result of the implementation of this policy prescription, emerging local bond markets have grown considerably over the past five years, and they are gradually becoming an alternative source of funding for both sovereigns and corporates. Also, as it becomes easier to invest across borders, local instruments are also attracting the interest of global fixedincome investors. In this chapter, we assess recent trends in emerging local bond markets, with particular attention to how they relate to global bond markets and international capital flows.

The fiscal policy response to the COVID-19 shock in most LAC countries was much larger than during the GFC, suggesting fiscal space was not as tight as expected. We argue that it is feasible and desirable, though not without risks, to embark in a more gradual consolidation path than currently envisaged by several countries in the region. Avoiding an early withdrawal of support in 2021 and 2022 is important given that countries are still facing high rates of contagion and deaths, vaccination will take place very slowly, the economic recovery is partial, uncertain and not strong enough to help those most affected by the twin public health and economic crisis. At the center of this discussion is our conviction that fiscal space is not set in stone and it is endogenous to the medium-term targets and commitments undertaken by governments and congresses throughout the region. Also, revisions to fiscal responsibility frameworks should help anchor fiscal sustainability, as well as improve their effectiveness and flexibility. In this context, low-for-long interest rates and easy market access is generating a situation that, in spite of higher debt levels, interest cost on public debt will remain contained in the foreseeable future. Especially if, as argued in this paper, a more gradual fiscal consolidation path is accompanied with stronger commitments and institutional frameworks that ensure debt is put on a credible downward trajectory once the pandemic is under control. Catalyzing these changes, as well as initiating the debate to design other fiscal reforms to strengthen social protection and increase the progressivity of public finances, would require a broad social consensus and political cohesion around several crucial dimensions of public finances: a fiscal pact. On the other hand, if this agenda is neglected the continuation of low growth, social discontent, and political polarization could drive Latin America towards a very dangerous path of institutional and economic decay.

Labor markets in Latin America and the Caribbean (LAC) are characterized by high levels of informality and relatively rigid regulation. This paper shows that these two features are related and together make the speed of adjustment of employment to shocks slower, especially when regulations are tightly enforced. Evidence suggests that strict labor market regulations also have an adverse effect on medium-term growth. While both regulations on prices (minimum wages) and quantities (employment protection) decrease the speed of adjustment to shocks, they appear to be binding in different phases of the cycle—the former affects mostly the (net) job creation margin and the latter the (net) job destruction margin. The results also highlight possible interactions between labor market regulations and the effectiveness of macro-stabilization tools—including exchange rate depreciation.

We study interactions between monetary and macroprudential policies in a model with nominal and financial frictions. The latter derive from a financial sector that provides credit and liquidity services that lead to a financial accelerator-cumfire-sales amplification mechanism. In response to fluctuations in world interest rates, inflation targeting neutralizes nominal distortions but leads to increased volatility in credit and asset prices. Taylor rules do better, but the use of a counter-cyclical macroprudential instrument in addition to the policy rate improves welfare and has important implications for the conduct of monetary policy. "Leaning against the wind" or augmenting a Taylor rule with an argument on credit growth is not an optimal policy response.

This paper uses a multivariate filter and a production function to project potential growth in Colombia, modeling in detail the impact of low oil prices on investment.The framework also captures the impact of current and planned policies on potential growth, including the peace agreement with the FARC, the tax reform, and 4G infrastructure projects.The analysis suggests the growth acceleration of the 2000s is unlikely to repeat itself in a world of lower oil prices.Potential growth is likely to moderate to a range of 2.8 to 4.1 percent.The 4G infrastructure projects and the tax reform will increase investment, partly offsetting the sharp decline in oil investment.Improvements in productivity are essential to lift potential growth, as the large increases in the labor force observed in the last 15 years are unlikely to continue.

We study interactions between monetary and macroprudential policies in a model with nominal and financial frictions. The latter derive from a financial sector that provides credit and liquidity services that lead to a financial accelerator-cum-fire-sales amplification mechanism. In response to fluctuations in world interest rates, inflation targeting dominates standard Taylor rules, but leads to increased volatility in credit and asset prices. The use of a countercyclical macroprudential instrument in addition to the policy rate improves welfare and has important implications for the conduct of monetary policy. “Leaning against the wind” or augmenting a standard Taylor rule with an argument on credit growth may not be an effective policy response.

This paper applies the models used to study yield curve dynamics and spillovers in the U.S. and other countries to Central and Eastern European countries (CEE countries). Using the Diebold, Rudebusch, and Aruoba (2006) dynamic version of the Nelson-Siegel representation of the yield curve, the paper finds that the two-way relationship between macroeconomic and financial variables in the CEE countries is similar to the one in mature economies. However, inflation shocks have very little persistence in the CEE countries, owing to the strong convergence trends in these countries-which tend to re-anchor expectations faster. Increased convergence in policies and market integration over time are associated with a stronger correlation between the levels of the yield curves, while the curves slopes are more driven by idiosyncratic factors. Shifts in the euro yield curve are transmitted both to interest rates and inflation expectations in the CEE countries-and transmission is stronger after 2004.

In the wake of the 1997–98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible.

In the wake of the 1997-98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as various real frictions wear off and the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible.

In the wake of the 1997-98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as various real frictions wear off and the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible. Fabio Braggion Tilburg University and CentER Finance Department Room K 917 P.O. Box 90153 5000 LE, Tilburg The Netherlands F.Braggion@uvt.nl Lawrence J. Christiano Department of Economics Northwestern University 2003 Sheridan Road Evanston, IL 60208 and NBER l-christiano@northwestern.edu Jorge Roldos International Monetary Fund 700 19th Street, N.W. Washington, D.C. 20431 jroldos@imf.org

In the wake of the 1997-98 financial crises, interest rates in Asia were raised immediately, and then reduced sharply. We describe an environment in which this is the optimal monetary policy. The optimality of the immediate rise in the interest rate is an example of the theory of the second best: although high interest rates introduce an inefficiency wedge into the labor market, they are nevertheless welfare improving because they mitigate distortions due to binding collateral constraints. Over time, as various real frictions wear off and the collateral constraint is less binding, the familiar Friedman forces dominate, and interest rates are optimally set as low as possible. Fabio Braggion Tilburg University and CentER Finance Department Room K 917 P.O. Box 90153 5000 LE, Tilburg The Netherlands F.Braggion@uvt.nl Lawrence J. Christiano Department of Economics Northwestern University 2003 Sheridan Road Evanston, IL 60208 and NBER l-christiano@northwestern.edu Jorge Roldos International Monetary Fund 700 19th Street, N.W. Washington, D.C. 20431 jroldos@imf.org

This paper reviews macroeconomic aspects of pension reforms in Latin America, focusing on financial market stability and fiscal sustainability. Concentration of pension fund portfolios in government bonds remains high, and the lack of new investment alternatives has distorted asset prices. Countries have gradually liberalized investments abroad, but remain wary of the impact on foreign currency markets. The fiscal costs of the transition to funded systems have been higher than expected, and have contributed to high debt levels. The paper highlights the importance of coordinating changes in portfolio limits with debt management policies and measures to develop securities markets.

This paper studies changes in Canada's monetary policy transmission, associated with the important changes in financial structure experienced in the 1990's, using two methodologies. First, VAR models show a clear break in monetary transmission beginning in 1988, after changes in financial regulation initiated the process of financial disintermediation. Second, estimates of the interest rate elasticity of aggregate demand in IS equations increase in the 1990's, suggesting that the systematic component of monetary policy has become more relevant. The ratio of direct to indirect finance, a measure of disintermediation, contributes to explain changes in the interest rate elasticity, suggesting an increased effectiveness of monetary policy associated with a larger use of market-based sources of finance.

This paper reviews the evolution of certain price and nonprice competitiveness indicators in Chile and concludes that the pecuniary loss of competitiveness associated with the appreciation of the peso since the late 1980s has been broadly offset by productivity gains and adjustments in factor intensity, particularly in the manufacturing sector. However, there may be limited room for further advances from that point, which gives new prominence to certain policy issues such as structural reforms to increase productivity, a reassessment of the tax treatment of the mining sector, and a rebalancing of the macroeconomic policy mix to dampen speculative capital inflows. JEL Classification Numbers: F31, F41

What are the economic effects of an interest rate cut when an economy is in the midst of a financial crisis?Under what conditions will a cut stimulate output and employment, and raise welfare?Under what conditions will a cut have the opposite e ffects?We answer these questions in a general class of open economy models, where a financial crisis is modeled as a time when collateral constraints are suddenly binding.We find that when there are frictions in adjusting the level of output in the traded good sector and in adjusting the rate at which that output can be used in other parts of the economy, then a cut in the interest rate is most likely to result in a welfare-reducing fall in output and employment.When these frictions are absent, a cut in the interest rate improves asset positions and promotes a welfareincreasing economic expansion.

he two previous issues of the Global Financial Stability Report contained chapters on local equity and fixed-income markets in emerging market economies, with particular focus on the role of local markets as a substitute for international markets for raising funds. This chapter presents original estimates of the scale of the derivatives trading activity in the major emerging markets and compares developments in these markets with global trends. In addition to providing a brief overview of the local derivatives markets, this chapter focuses on how derivatives facilitated capital flows to emerging market economies and on the role of derivatives in past emerging market crises. Financial derivatives allow investors to unbun-dle and redistribute various risks—foreign exchange, interest rate, market, and default risks—and thus, facilitate cross-border capital flows and create more opportunities for portfolio diversification. However, the same instruments allow market participants to avoid prudential safeguards, manipulate accounting rules, and take on excessive leverage by shifting exposures off balance sheets. The latter can occur due to the weaknesses in the companies' internal risk management practices and also due to inadequate financial regulation. In a world of constantly evolving derivatives markets, the establishment of prudential regulations that create incentives for market participants to use derivatives appropriately is one of the major challenges for regulators in both mature and emerging markets. Despite rapid growth over the past several years, emerging market derivatives account for only 1 percent of the total outstanding notionals in global derivatives markets. Local derivatives markets in emerging market economies differ greatly in their sizes, both in absolute terms and relative to cash markets. Compared to mature markets, the ratio of outstanding notionals in bond and equity derivatives to market capitalization of the underlying asset markets is fairly small in most emerging economies (see Table 4.1). The most common problems that constrain the development of local derivatives markets are (1) relatively underdeveloped markets for underlying instruments; (2) weak/inadequate legal and market infrastructure; and (3) restrictions on the use of derivatives by local and foreign entities. Most of the currency derivatives trading around the world takes place through the over-the-counter (OTC) markets, with foreign exchange swaps accounting for more than two-thirds of the turnover. In emerging markets, the most liquid OTC currency derivative markets are in Hong Kong SAR, Singapore, and South Africa, where average daily turnover significantly exceeds the spot market turnover. By contrast, a significant share of the foreign exchange derivative …