Exchange rate regimes and the recent progress in economic discipline in Latin America Enrique Alberola Banco de España XXI Meeting of LA Network of Central

Exchange rate regimes and the recent progress in economic discipline in Latin America

Enrique Alberola

Banco de España

XXI Meeting of LA Network of Central Banks and Finance Ministries 13.5.05 BID, Washington

2

Outline of the presentation

1. Intro. Regime dynamics and macroeconomic outcomes

2. Exchange rate regimes and fiscal discipline

A digression: Defining the actual e-r regime Empirical results

Alberola, Molina, Navia (2004) Say you fix, enjoy and relax

3. Conclusions

3

1. Introduction

The move to flexible regimes in LA

–…. rather than hollowing out

–Traumatic crisis driven•…but, ‘ex post’, successful

– Consolidation of internal anchors

•Consolidation of new macro regime?

–Comfortable situation(a) Comprises 18 countries. De iure data from Gosh et al.

0

10

20

30

40

50

60

70

80

90

100

1980 1983 1986 1989 1992 1995 1998 2001 2004

De iure pegs

LATIN AMERICA: SHARE OF FIXED REGIMES IN AREA GDP (a)

%

4

1. IntroductionPrice stability achievements

–Inflation under control No spirals + reduced pass-through

(a) Comprises 18 countries. De iure data from Gosh et al.

(b) Comprises 7 countries. Increases are depreciations.

0

10

20

30

40

50

60

70

1980 1983 1986 1989 1992 1995 1998 2001 2004

De iure pegs (% GDP)

Median of area inflation rate

INFLATION AND EXCHANGE RATE REGIME

%

-15

-10

-5

0

5

10

15

20

25

30

97 98 99 00 01 02 03 04 05

Inflation rate

Y-o-Y changes in exchange rate againstUS$

%

5

1. IntroductionVulnerabilities persist

–Sustainability concerns diminish–Moves towards more balanced debt composition–Reduction in public debt, but resilience

(a) Comprises 7 countries.

40

45

50

55

60

65

70

2001 2002 2003 2004 2005 2006 2007 2008 2009

October 2002

February 2005

DEBT DYNAMICS: BRAZIL

%

0%

20%

40%

60%

80%

100%

2002 2004

LINKED TO ER: EXTERNAL LINKED TO ER: DOMESTIC

LINKED TO INFLATION VARIABLE RATE

FIXED RATE AND OTHER

LATIN AMERICA: DEBT STRUCTURE

%

25

30

35

40

45

50

55

60

1998q1 1999q1 2000q1 2001q1 2002q1 2003q1 2004q1

With Argentina

Without Argentina

LATIN AMERICA: PUBLIC DEBT (a)

% GDP

6

1. Introduction

Vulnerabilities persist–Closely related to

•financing conditions•Exchange rate dynamics

-10

-5

0

5

10

15

20

25

2001 2002 2003 2004

Other factors contribution (pp GDP)

ER contribution (pp GDP)

Nominal depreciation (+) or apreciation (-)

Change in public debt (pp GDP)

BRAZIL: CHANGES IN PUBLIC DEBT

%

-30

-20

-10

0

10

20

30

-30 -20 -10 0 10 20 30

EXCHANGE RATE APRECIATION AND EXTERNAL DEBT (1995 - 2004)

Real depreciation (+)

Cha

nge

in e

xter

nal d

ebt (

pp

GD

P)

Data for 2004

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1. IntroductionProgress in fiscal discipline

–Limited improvement in primary balances•More remarkable when seignoriage revenues are factored in

–Not enough to turn around procyclical fiscal stance–HOW DO E-R REGIMES IMPACT ON FISCAL DISCIPLINE?

0

10

20

30

40

50

60

70

1980 1983 1986 1989 1992 1995 1998 2001 2004

-10

-8

-6

-4

-2

0

2

4

De iure pegs (% GDP) (left scale)

Primary balance (% GDP)

Primary balance adjusted by monetary seignorage (%

GDP)

EXCHANGE RATE REGIME AND PUBLIC BALANCES

%

-0,1

-0,08

-0,06

-0,04

-0,02

0

0,02

0,04

0,06

0,08

0,1

-0,12 -0,07 -0,02 0,03 0,08

Output gap

Cha

nge

in s

truc

tura

l prim

ary

surp

lus Data for 2003Data for 2002 Data for 2004

FISCAL STANCE

Source: Alberola & Montero (2005)

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2. Exchange rates and fiscal discipline

Exchange rates as disciplining devices for fiscal policy–Fiscal dominance

•Fiscal needs → Seignoriage revenues → Inflation–Shortcut through e-r pegs

• e-r pegs → ↓Inflation → ↓ seignoriage → Fiscal discipline

–Disappointing results:•Empirical evidence unsupportive

–Gavin & Perotti ’98, Ghosh and Gulde ‘03,… •…even when seignoriage revenues are factored in

–Alberola & Molina ’03

–2 hypothesis for failure:•Inadequate exchange rate classification•Indirect effects of pegs eroding incentives for fiscal discipline

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Budget constraint (-)primary balance seignioriage + debt -(r-g)debt

Alternative view on pegs

(-)primary balance ↓seignioriage + ↑[ debt -(r-g)debt]

•Loosening of financing constraints = offsetting effects

Better financing conditions

Boom and bust ERBS (Calvo & Vegh ’98)

•Positive CREDIBILITY shock. HOW LASTING?

Short run announcement

Long-run consistency of policies


‘new’ view

Financing constraints

cre

dib

ilit

y fix

float

Inconsistent

Well-behaved

10

A digression. Exchange rate classifications

RR ‘de facto pegs’

RR floating er

RR free falling

IMF ‘de iure’ pegs

IMF flexible

Type II

Type I

IMF ‘type I errors’: floating/free fall classified as pegs

Inconsistent pegsIMF ‘type II errors’: ‘de facto’ pegs classified as floating

(fear of floating)


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ANNOUNCEMENT

FLEXIBILITYAnnounced (de iure) regimes Not preannounced regimes

ObservationsSample (*)

(RR (**))

Fixed regimes 1-No separate legal tender 4.- De facto pegs2-Pre-announced peg 3-Pre-announced horizontal band

Intermediate regimes 5-Pre-announced crawling peg 7-De facto crawling peg6,9-Pre-announced crawling band 8,10-De facto crawling band11-Moving band

Observations: Sample (*) 239 569 (RR (**)) (433) (662)

Flexible regimes 12-Managed floating13-Freely floating

Free falling 14-Freely falling15-Dual market

----------------------------------------------------------------------------------------------------------------------------------------(*) Database used in the empirical tests presented in the paper,including emerging, developing and OECD economies, from 1991-2001.(**) Original Reinhart and Rogoff's database (from 1991 to 2001)

198(214)192(248)

349(550)

459(545)


Type II error

Type I

error

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How relevant is this for Latin America?


(a) Comprises 18 countries. De iure data from Gosh et al. and De facto data from Reinhart and Rogoff.

(b) Comprises 7 countries. 2005: March.

0

10

20

30

40

50

60

70

80

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

De iure pegs

De facto pegs

LATIN AMERICA: SHARE OF FIXED REGIMES IN AREA GDP (a)

%

-10

-5

0

5

10

15

20

25

1997 1998 1999 2000 2001 2002 2003 2004 2005

Annual change

LATIN AMERICA: FOREIGN EXCHANGE RESERVES (b)

%

13

Empirical analysis• Focus on EMEs, 1990-2001, panel, 25 countries• Primary balance = gauge for fiscal discipline

– Preliminary

e-r pegs → ↓ seignoriage = YES

– Pegs and fiscal discipline

e-r pegs → ↑ Primary balance


De iure/announced

(Gosh et al.)

De facto(Reinhart-Rogoff)

NO, even reduction!

YES

14

The hypothesis: offsetting channels– Announcement effect is key = relax financing constraint

• Trigger expansionary cycle• Reduce financing costs, increase access to market

– Interest payments, gauge for financing costs (focus of analysis)

Announced (de iure) pegs → ↓Interest payments = YES

– Non-binding financing constraint = relax fiscal discipline

↓Interest payments → ↓ primary balance = YES

– Controling for financing constraint modifies results, reinforces hypothesis

Announced pegs| int.payments → ↓ primary balance = Inconclusive


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3. Conclusions Traumatic but successful transition to flexible regimes

Pegs in the nineties– Catalysers of inflation reduction…

• Allows credibility building• Smooth transtion to internal monetary anchors• Achievement of price stability regime

– …perverse results on fiscal discipline?• Peg announcement = relax budget constraints

– Higher revenues (expansionary cycle)– Reduced financing costs, easier access

• Deletereous effect on fiscal discipline

– E-r crises in nineties related to fiscal problems• “E-r pegs sow seeds of their own destruction”

Current situation– Fear of floating remains = managed exchange rates

• Divergence de iure-de facto persists– Comfortable situation

• …resilient to deteriorating environment?

Documents

Exchange rate regimes and the recent progress in economic discipline in Latin America Enrique Alberola Banco de España XXI Meeting of LA Network of Central