Coping with Chile's external vulnerability

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.