Coping with Chile’s External Vulnerability: A Financial Problem,” http://web.mit.edu/caball/www

With traditional domestic imbalances long under control, the Chilean business cycle has been, and most likely will continue to be, primarily triggered 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 excessive 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 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 should issue a benchmark instrument contingent on these shocks