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www.iadb.orgrescentralBankspublicationscbm49_4

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									  Monetary and Fiscal Policies
      in a Sudden Stop:
     Is Tighter Brighter?
                                Alberto Ortiz*
                              Pablo Ottonello**
                           Federico Sturzenegger***
                               Ernesto Talvi**

 Boston University*, CERES**, Harvard University and Universidad Torcuato di Tella***

                               October 17th, 2007


Prepared for Presentation at the Session “Responding to Sudden Stops”,
XXVI Meeting of the Latin American Network of Central Banks and Finance
                    Ministries, IADB, Washington DC
                     MOTIVATION

During the financial crises of the 1990s, there was a lively
 debate on the optimal monetary and fiscal policy response:

  •    Should a country facing a sudden stop tighten its fiscal
       and monetary policies to restore credibility and avoid
       potentially unstable dynamics ? (the IMF’s view)
                            MOTIVATION


 Stanley Fischer (1998), in the context of the Asian 1997 crisis, argued that:

  •     “(…) when they approached the IMF, the reserves of Thailand and
        Korea were perilously low, and the Indonesian rupiah was excessively
        depreciated. Thus, the first order of business was, and still is, to
        restore confidence in the currency.”

  •     “To achieve this, countries have to make it more attractive to hold
        domestic currency, which, in turn, requires increasing interest rates
        temporarily (…)”

  •     “At the outset of the crisis, countries needed to firm their fiscal positions,
        both to make room in their budgets for the future costs of financial
        restructuring, and --depending on the balance of payments situation -- to
        reduce the current account deficit.”
                      MOTIVATION

During the financial crises of the 1990s, there was a lively
 debate on the optimal monetary and fiscal policy response:

  •    Should a country facing a sudden stop tighten its fiscal
       and monetary policies to restore credibility and avoid
       potentially unstable dynamics ? (the IMF’s view)
  •    Or conversely, should it relax those policies in order to
       attenuate the output contraction that typically occurs
       during these events? (IMF’s critics views)
                            MOTIVATION

 Joseph Stiglitz (2002, 2003), one of the most vocal critics of the IMF view,
  argued that:

  •      “For more than seventy years there has been a standard recipe for a
         country facing a severe economic downturn. The government must
         stimulate aggregate demand, either by monetary or fiscal policy – cut
         taxes, increase expenditures, or loosen monetary policy.(…) The crisis
         economies of East Asia were clearly threatened with a major downturn
         and needed stimulation. The IMF pushed exactly the opposite course,
         with consequences precisely of the kind that one would have predicted.”

  •      “(…) these procyclical discretionary fiscal policies exacerbated the
         downturns still further in country after country.”

  •      “When the Fund entered East Asia, it forced countries to raise interest
         rates to what, in conventional terms, would be considered astronomical
         levels. (…) The IMF had engineered a simultaneous contraction in
         aggregate demand and supply.”
                      MOTIVATION

During the financial crises of the 1990s, there was a lively
 debate on the optimal monetary and fiscal policy response:

  •    Should a country facing a sudden stop tighten its fiscal
       and monetary policies to restore credibility and avoid
       potentially unstable dynamics ? (the IMF’s view)
  •    Or conversely, should it relax those policies in order to
       attenuate the output contraction that typically occurs
       during these events? (IMF’s critics views)

This paper attempts to contribute to this debate empirically by
 studying the fiscal and monetary policy response and their
 effects on output, for a set of external financial crisis episodes
 occurred since the 1990s.
                    Identification of Systemic
                      Sudden Stop Episodes
 Sample
  Countries that are tracked by JP Morgan to construct its global Emerging Market Bond
  Index, or global EMBI (31 countries).
 Period
  1990-2006.

 Definition of Systemic Sudden Stop (SSS)
  In similar fashion to Calvo, Izquierdo and Loo-Kung (2005), we define a SSS window as the
  union of
 • a capital-flow window containing a large fall in capital flows for a given country exceeding two
   standard deviations from its mean (that starts when the fall in capital flows exceeds one
   standard deviation, and ends when it is smaller than one standard deviation) that overlaps at
   any point in time with an
 • aggregate-spread window containing a spike in the EMBI spread exceeding two standard
   deviations from its mean (which starts when the aggregate EMBI spread exceeds one standard
   deviation, and ends when it is smaller than one standard deviation).
                     Effective Federal Funds Rate (%)




     0
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                               10
                                                                20
                                                                                25




                                                 15
ene-70

ene-72

ene-74

ene-76

ene-78

ene-80

ene-82
                                                                            Contraction
                                                                            US Monetary
                                                                                           Fed Fund Rate




ene-84

ene-86

ene-88

ene-90

ene-92

ene-94
                                                                             Crisis
                                                                            Tequila




ene-96

ene-98

ene-00
                                                                               Crises
                                                                                           EMBI Spreads
                                                                                                           Capital Market Conditions for EMs


                                                                            Asia-Russian




ene-02

ene-04
                                                                                                                                               Identification of SSS Episodes




     0
         200
               400
                         600
                                    800
                                          1000
                                                      1200
                                                             1400
                                                                     1600
                                                                                1800




         EMBI Sovereign Spread (Bps over US Treasuries)
                            Identification of Systemic
                              Sudden Stop Episodes
 Sample
  Countries that are tracked by JP Morgan to construct its global Emerging Market Bond
  Index, or global EMBI (31 countries)
 Period
  1990-2006
 Definition of Systemic Sudden Stop (SSS)
  In similar fashion to Calvo, Izquierdo and Loo-Kung (2005), we define a SSS window as the
  union of
 • a capital-flow window containing a large fall in capital flows for a given country exceeding two
   standard deviations from its mean (that starts when the fall in capital flows exceeds one
   standard deviation, and ends when it is smaller than one standard deviation) that overlaps at
   any point in time with an
 • aggregate-spread window containing a spike in the EMBI spread exceeding two standard
   deviations from its mean (which starts when the aggregate EMBI spread exceeds one standard
   deviation, and ends when it is smaller than one standard deviation).
 Output Performance during SSS
  Output performance is computed by the peak to trough variation of GDP*.


   *If either the peak or trough falls within the SSS window, the contraction is classified as belonging to the period of the SSS. If a country
    experienced a deceleration but not a contraction, the dating was determined using the HP-filtered cyclical component of output.
      SSS Episodes and Output
                        GDP Dates      GDP Variation
                                       Peak to trough
Country              Peak     Trough
                                         % change
Argentina 98         Jun-98   Mar-02       -20.9%
Indonesia            Dec-97   Dec-98       -17.3%
Thailand             Sep-96   Sep-98       -15.1%
Morocco              Dec-94   Jun-95       -13.3%
Turkey 93            Dec-93   Jun-94       -12.2%
Malaysia             Dec-97   Sep-98       -11.0%
Russia               Dec-97   Sep-98       -10.1%
Mexico               Dec-94   Jun-95        -9.7%
Korea                Sep-97   Jun-98        -8.5%
Turkey 98            Mar-98   Mar-99        -8.1%
Ecuador              Dec-98   Sep-99        -7.6%
Colombia             Jun-98   Jun-99        -7.1%
Croatia              Dec-97   Jun-99        -5.9%
Argentina 94         Dec-94   Sep-95        -5.6%
Chile                Jun-98   Mar-99        -4.6%
Lebanon              Sep-98   Jun-99        -3.3%
Brazil 95            Mar-95   Sep-95        -2.7%
Peru                 Dec-97   Dec-98        -2.4%
Philippines          Dec-97   Jun-98        -2.2%
Brazil 97            Dec-97   Mar-99        -1.7%
Poland               Dec-97   Mar-99         3.2%
Dominican Republic   Mar-94   Sep-95         6.6%

Average                                     -7.2%
              Characterizing Fiscal Policy in SSS:
                  Structural Fiscal Balance
 Objective
  •   To capture the discretional components of fiscal policy by extracting the effect of cyclical fluctuations on
      fiscal accounts.

 Methodology
  •   We estimate the Structural Fiscal Balance by adopting the Chilean Fiscal Rule. This rule defines the
      structural balance as the difference between structural fiscal revenues and observed fiscal expenditures.
      Structural fiscal revenues are defined as the level of revenues that would have been achieved if output
      were at its potential level and the copper price were at its long run level.
  •   While we cannot directly replicate this rule for other countries we can find a “statistical equivalent” to it.
      To do so we compute the Lagrange multiplier of the Hodrick-Prescott filter for current revenues in Chile
      in order to estimate by how much the Chilean authorities smooth their income.
      The Hodrick Prescott (HP) filter chooses the sequence  t of that minimizes
       T                       T

       y         t      t 1  t    t  t 1  
                        2                                           2
                                                                               if   0, t  yt
                                                               
                                                                               if   ,  t approaches a linear trend.
              t
       t 1                   t 2

  •   The Lagrange multiplier that delivers a surplus/deficit that best matches the structural balance reported
      by the authorities is the one that provides a statistical equivalent to their complex rules. Once the
      "smoothing" parameter is chosen, the filter is applied to fiscal revenues of the countries included in our
      sample to compute our measure of structural balance.

  •   For each country of our sample the Structural Fiscal Balance (sbt) is defined as:
                                     where r*t = adjusted fiscal revenues according to the Chilean Fiscal Rule and
              sbt= r*t - gt          gt = total public expenditures, both in percent of GDP.
    Characterizing Fiscal Policy in a SSS:
   Computation of Structural Fiscal Balance
 Characterization of Fiscal Policy in SSS
  • Structural Fiscal Impulse throughout the output peak to trough window: I*t= - sbt
     A positive (negative) value indicates an expansionary (contractionary) fiscal policy.

            Structural Fiscal Impulse in SSS                                               Observed Fiscal Impulse in SSS*
                           (From Output Peak to Trough)                                             (From Output Peak to Trough)

   ARG 94                         Average: -1,1%                             THA
   PHL                                                                       ARG 98
   HRV                                                                       CHL
   CHL                                                                       MYS
   ECU                                                                       HRV
   BRA 97                                                                    ARG 94
   PER                                                                       PHL
   TUR 98                                                                    PER
   POL                                                                       TUR 98
   MEX                                                                       IDN
   KOR                                                                       POL
   MYS                                                                       BRA 97
   THA                                                                       MEX
   COL                                                                       COL
   TUR 93                                                                    KOR
   IDN                                                                       ECU
   ARG 98                                                                    RUS                                     Average: 0,6%
   RUS                                                                       TUR 93

         -5.0%     -4.0%      -3.0%     -2.0%      -1.0%    0.0%      1.0%         -3.0%    -2.0%   -1.0%   0.0%     1.0%        2.0%   3.0%   4.0%

         * Observed Fiscal Balance is defined as fbt= rt – gt,, where rt = fiscal revenues and gt = total public expenditures,
         both in percent of GDP. Observed Fiscal Impulse is defined as It= - fbt
   Characterizing Monetary Policy in SSS:
Estimation of Central Bank Reaction Function

 Objective
 • To capture the discretional components of monetary policy by eliminating the noise in
   interest rates movements typically observed during SSS.*


 Methodology
  • We estimate the pre-SSS central bank reaction function by estimating a dynamic stochastic
    general equilibrium model of a small open economy using Bayesian methods, following Lubik
    and Shorfheide (2007).

     Rt   R Rt 1  1   R  1 t   2 y t   3 s t    tR
                                
    where: Rt =nominal interest rate, y =output, t =inflation, st =nominal exchange rate
                                       t
    tR =exogenous policy shock, which can be interpreted as the non-systematic component
    of monetary policy,  = partial adjustment of the interest rate to target,
                         R
     =“Anti-Inflation” coefficient,  =“Output Motive” coefficient, 3 =“Fear of Floating” coefficient.
     1                               2




  *See Calvo (2006)
   Characterizing Monetary Policy in SSS:
  Central Bank Reaction Function Estimates
                            Parameter Estimation
Country              1       2       3 (1   R )
                                                       Central Bank Reaction Function
Australia (a)        1.41     0.24    0.07    0.24
New Zeland (a)       1.69     0.25    0.04    0.37      Rt   R Rt 1  1   R  1 t   2 y t   3 s t    tR
                                                                                   
United Kingdom (a)   1.30     0.20    0.13    0.26
Canada (a)           1.30     0.23    0.14    0.31
South Africa (b)     1.11     0.27    0.11    0.27      •    The “Anti Inflation” coefficient (  1) is on
Average              1.36     0.24    0.10    0.29           average similar in our group of EM
Argentina 94         1.04     0.70    1.46
                                                             countries to the control group, but with a
                                              0.73
Argentina 98         0.13     0.18    6.99    0.64
                                                             greater dispersion in the former.
Brazil 97            0.71     0.19    0.25    0.50      •     Similarly with respect to the “Output
Chile                1.49
                     1.49
                              0.17
                              0.15
                                      0.17
                                      0.23
                                              0.22            Motive” coefficient (  2).
Colombia                                      0.49
Croatia              0.67     0.40    1.51    0.57
Ecuador              1.15     0.17    0.23    0.75      •     The “Fear of Floating” coefficient (  3)
Indonesia            0.75     0.15    0.25    0.95            is significantly larger in our group of EM
Korea                1.64     0.33    0.72    0.31            countries suggesting the exchange rate
Malaysia             3.12     0.40    0.15    0.20            is a more relevant concern.
Mexico               0.97     0.51    0.19    0.76
Peru                 1.92     0.53    0.82    0.44      •     The initial reaction of the Central Bank
Philippines          1.59     0.43    0.23    0.47            for a given value of the shock and the  i
Poland               1.18     0.64    0.80    0.16            parameters is larger in our group of EM
Russia               0.71     0.68    0.64    0.94            countries (i.e. a larger (1 - R ) )
Thailand             2.00     0.17    1.04    0.75
Turkey 93            1.19     0.17    0.29    0.56          Notes
Turkey 98            1.77     0.20    0.50    0.87          Source: (a) Lubik and Shorfheider (2007), (b) Ortiz and Sturzenegger (2007).
Average              1.31     0.34    0.92                  Data for Argentina 98 considers the period 2001:1, 2002:2. Polish data start
                                              0.57          in 1998:1.
 Characterizing Monetary Policy in SSS:
Central Bank Reaction Function Estimates
                Anti Inflation Coefficient                                                  Output Motive Coefficient
                    1 at the outset of the SSS                                                  2 at the outset of the SSS
  MYS                                                                        ARG 94
   THA                                                                         RUS
   PER                                                                          POL
 TUR 98                                                         44%            PER
   KOR                                                                         MEX
   PHL                                                                                                                                                50%
                                                                                PHL
   CHL                                                                         HRV
   COL                                                                         MYS
 TUR 93                                                                        KOR
   POL                                                                       TUR 98
   ECU                                                                       BRA 97
 ARG 94                                                                      ARG 98
   MEX                                                                          CHL
   IDN                                                                       TUR 93
   RUS                                                                         ECU
 BRA 97                          Control Group                                  THA                         Control Group
   HRV                           Avg.: 1.4                                     COL
 ARG 98                                                                                                     Avg.: 0.2
                                                                                IDN
         0.0      0.5      1.0   1.5         2.0   2.5    3.0    3.5                  0.0    0.1     0.2      0.3     0.4    0.5    0.6         0.7   0.8

               Fear of Floating Coefficient                                                    CB Reaction Coefficient
                    3 at the outset of the SSS                                                    (1    - R ) at the outset of the SSS
ARG 98                                                                          IDN
  HRV
ARG 94                                                                         RUS
   THA                                                                       TUR 98
  PER                                                                          MEX
   POL                                                                         ECU
  KOR
  RUS                                                                          THA
TUR 98                                                                100%   ARG 94
TUR 93                                                                       ARG 98                                                                         83%
   IDN                                                                         HRV
BRA 97
   PHL                                                                       TUR 93
  ECU                                                                        BRA 97
  COL                                                                          COL
  MEX                                                                          PHL
   CHL
  MYS                                                                          PER
  CAN                                                                          KOR
  GBR                                                                          CHL
   ZAF         Control Group      Control Group
  AUS                                                                          MYS
               Avg.: 0.1
   NZL                                                                         POL
         0.0            0.5            1.0          1.5         2.0                   0.0          0.2          0.4         0.6           0.8         1.0
              Monetary Policy Trade-Offs in a SSS:
                      the Typical Shock*
                    Inflation                                              Output                              Nominal Exchange Rate
               (Annualized rate, in %)                                  (GDP trough=100)                                   (GDP trough=100)

26%            Output                                 109                                   Output       100
               Peak                      25.2%                                              Trough
                                                      108
                                                                                                         95
24%
                                                      107
                                                                                                         90
                                                                                                                       +43.1%
                                                      106
22%
                                                                                                         85
                                                      105


20%                                                   104                                                80

                                                                        -7.5%
                                                      103
                                                                                                         75
18%
                                                      102
                                                                                                         70
                                                      101
16%
                                                                                                         65
                                         Output       100                                                             Output                    Output
               15.2%                     Trough                   Output Peak                                         Peak                      Trough
14%                                                   99                                                 60
        t-5   t-4      t-3   t-2    t-1           t         t-5   t-4       t-3   t-2      t-1       t         t-5   t-4       t-3    t-2     t-1        t

                       Quarter                                              Quarter                                            Quarter


      *Average of the 18 episodes of the sample
         Characterizing Fiscal Policy in a SSS:
        Computation of Monetary Policy Indices
 Characterization of Monetary Policy in SSS
I.        We construct a Monetary Policy Regime Index at the outset of the SSS, given by*:

                                                                                      T ( , S / Y ) t  [ 1 (1   R )]  [ 3 (1   R )]
                Countries with a higher (lower) value of the index will have a
                more contractionary (expansionary) monetary policy than

                                                                                                                  [ 2 (1   R )]
                countries with a lower (higher) value of the index, in a SSS
                episode.



II.       We construct two separate Monetary Policy indices, given by*:
           •      Inflation/Output Trade-Off Index at the outset of the SSS:
                                                                                                                            [ 1 (1   R )]
                    Countries with a higher (lower) value of the index will have a more                     T  / Y t 
                    contractionary (expansionary) monetary policy than countries with a                                     [ 2 (1   R )]
                    lower (higher) value of the index, in a SSS episode.


            •     Exchange Rate/Output Trade-Off Index at the outset of the SSS:
                                                                                                                            [ 3 (1   R )]
                   Countries with a higher (lower) value of the index will have a more                      T S / Y t 
                   contractionary (expansionary) monetary policy than countries with a                                      [ 2 (1   R )]
                   lower (higher) value of the index, in a SSS episode.

     These indices are used as a proxy of how monetary policy (i.e. interest rates) will react
     during a SSS episode.

        *Where  i (1   R ) are computed as deviations with respect to the sample mean  i (1   R ) .
The Impact of Monetary and Fiscal Policy on
    Output in a SSS: Empirical Strategy

 We first compute as the dependent variable the output performance during SSS, as
  described by the (output) peak to trough variations (  Yt ).


 We then relate our measures of monetary and fiscal policy to output performance by
  performing simple OLS regressions :

    • Model I
                    Yt  0.040  1.932 I t*  0.008 T ( , S / Y )t   t
                                        (2.534)   (-2.024)

                 Adjusted R 2  0.539
Monetary, Fiscal Policy and Output
Performance in SSS
                                                             Model I
                                                    (Actual vs. Fitted GDP variation)



                            0.10


                            0.05
                                                                            POL
     Actual GDP Variation




                            0.00                                   BRA 97
                                                                           PHL
                                                                       PER
                                                                      CHL
                            -0.05                                 HRV      ARG 94
                                                              COL      ECU
                                                             KOR    TUR 98
                            -0.10                        RUS            MEX
                                                                 MYS 97
                                                               TUR 93

                            -0.15                            THA
                                                                IDN

                            -0.20       ARG 98


                            -0.25
                                -0.25    -0.20   -0.15     -0.10      -0.05       0.00   0.05   0.10

                                                     Fitted GDP Variation
Fiscal Policy and Output Performance in SSS

                                               Model I: Fiscal Policy
                                            (GDP variation and Structural Fiscal Impulse
                                             controlled by the rest of policy parameters)

                      0.10
                                                                                             POL



                      0.05                                                            BRA 97        PHL
                                                                                        PER            CHL
                                                                               COL
                                                                                 ARG 98              TUR 98
    Y)




                                                                                              HRV      ARG 94
                      0.00                                                                          ECU
                                                                                      KOR
    GDP Variation (




                                                                                   MYS 97 THA
                                  RUS                                        TUR 93   MEX
                      -0.05


                                                                       IDN
                      -0.10



                      -0.15
                         -0.045    -0.035     -0.025        -0.015           -0.005         0.005     0.015

                                                                I t*
Monetary Policy and Output Performance in SSS

                                             Model I: Monetary Policy
                                             (GDP variation and Monetary Policy Index
                                             controlled by the rest of policy parameters)
                       0.12

                       0.10
                                                                  POL
                       0.08                RUS

                       0.06
     Y)




                       0.04                                            BRA 97
                                                             PHL
     GDP Variation (




                                                                       COL
                       0.02                                     PER
                                                                            CHL
                       0.00                                 KOR        HRV
                                                      TUR 93          ARG 94
                       -0.02                                                    TUR 98
                                                     MEX       MYS 97 ECU                              ARG 98
                       -0.04

                       -0.06                                                        THA
                                                               IDN

                       -0.08
                           -8.00   -6.00     -4.00     -2.00         0.00    2.00        4.00   6.00   8.00


                                                            T ( , S / y )t
The Impact of Monetary and Fiscal Policy on
    Output in a SSS: Empirical Strategy

 We first compute as the dependent variable the output performance during SSS, as
  described by the (output) peak to trough variations (  Yt ).


 We then relate our measures of monetary and fiscal policy to output performance by
  performing simple OLS regressions :

    • Model I
                    Yt  0.040  1.932 I t*  0.008 T ( , S / Y )t   t
                                         (2.534)    (-2.024)

                 Adjusted R 2  0.539

    • Model II
                   Yt  0.022  2.111 I t*  0.020 T ( / Y ) t  0.007 T ( S / Y ) t   t
                                    (2.768)        (-1.920)         (-1.850)

                  Adjusted R 2  0.554
Monetary Policy and Output Performance in SSS
                                 Model II:                                                                                        Model II:
                      Inflation/Output Trade-Off Index                                                               Exchange Rate/Output Trade-Off Index
                          (GDP variation and Inflation/Output Trade-Off                                                   (GDP variation and Exchange Rate/Output Trade-Off
                           controlled by the rest of policy parameters)                                                       controlled by the rest of policy parameters)


                  0.12                                                                                            0.10

                  0.10                                                                                            0.08
                                    POL                                                                                                                    POL

                  0.08                                                                                                                RUS
                                                                                                                  0.06
                                                                                                                                                        COL
                  0.06




                                                                                                Y)
Y)




                              RUS
                                                                                                                  0.04
                  0.04                      BRA 97




                                                                                                GDP Variation (
GDP Variation (




                                            PHL                                                                                                      PER BRA 97
                  0.02                    PER                              COL                                    0.02                               PHL    CHL
                                               ARG 98                CHL
                  0.00              HRV                                                                                                                KOR
                                                                                                                  0.00                      TUR 98
                                                    KOR                                                                                                             MYS 97
                                 ARG 94                   ECU                                                                                         TUR 93
                  -0.02                                                TUR 98
                                                                  MYS 97                                                                                         ECU
                                                                                                                  -0.02
                                    MEX                  TUR 93                                                                                                  HRV
                  -0.04                                                                                                                                             THA
                                                                                                                                                                 ARG 94
                                                                                                                  -0.04                                MEX
                  -0.06                                                            THA                                                                                                   ARG 98
                                            IDN                                                                   -0.06
                  -0.08                                                                                                                              IDN


                  -0.10                                                                                           -0.08
                      -1.50   -1.00   -0.50       0.00    0.50     1.00    1.50   2.00   2.50                         -8.00   -6.00   -4.00   -2.00     0.00      2.00    4.00   6.00   8.00   10.00

                                            T  / Y t                                                                                               T S / Y t
 Monetary and Fiscal Policies in SSS:
           An Evaluation


Is Tighter Brighter?
 It is Not.

Is Looser Mightier?
 Maybe Yes, Maybe Not.
  Monetary and Fiscal Policies
      in a Sudden Stop:
     Is Tighter Brighter?
                                Alberto Ortiz*
                              Pablo Ottonello**
                           Federico Sturzenegger***
                               Ernesto Talvi**

 Boston University*, CERES**, Harvard University and Universidad Torcuato di Tella***

                               October 17th, 2007


Prepared for Presentation at the Session “Responding to Sudden Stops”,
XXVI Meeting of the Latin American Network of Central Banks and Finance
                    Ministries, IADB, Washington DC

								
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