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Latin American Macroeconomic Reforms: the Second Stage
By Center for Research on Economic Development and Policy Reform Stanford University.
University of Chicago PressCopyright © 2003 Center for Research on Economic Development and Policy Reform Stanford University.
All right reserved.
The Latin American Experience
Vittorio Corbo and Klaus Schmidt-Hebbel
Latin America was the region with the highest inflation in the world until the early 1990s. High inflation was the result of many decades of massive neglect of macroeconomic stability. Fiscal dominance, in the sense that monetary policy was primarily dictated by fiscal financing needs, was the rule rather than the exception.
However, following the industrial countries' lead in their pursuit of price stability beginning in the 1980s, the region implemented a substantial departure from past policies around 1990. By then, most countries in Latin America launched stabilization efforts aimed at reducing inflation toward one-digit annual levels. The results have been dramatic. In the 1980s, four countries recorded inflation rates above 200 percent per annum and the average annual regional inflation rate stood at 145 percent; by the end of the 1990s, only two large countries (Mexico and Venezuela) had annual inflation rates above 10 percent and the region'saverage rate was below 10 percent. Currently many countries have attained low, single-digit inflation levels similar to industrial-country levels. Many factors have been behind the decision to make a frontal attack on inflation. First, the poor inflation record of the 1980s and the high political and economic costs that it entailed raised the public's demand for price stability. Second, a large improvement in the quality of the debate and economic policies was achieved due to the critical mass of policymakers and academics trained at top U.S. and European graduate schools. Many of these students returned to their own countries upon graduation to upgrade the quality of training and public policy. They convinced policymakers and the public at large that inflation is costly, the main contribution of monetary policy lies in delivering low inflation, monetary policy does not have permanent effects on employment, and the cost of reducing inflation is much lower under rational expectations and credible policies. Third, the introduction of market-oriented reforms reflected a growing understanding that macroeconomic stability facilitates the functioning of markets and contributes to better resource allocation.
Stabilization has been achieved under different monetary and exchange regimes in Latin America, ranging from dollarization to inflation targeting (IT) under floating exchange rates. This paper focuses on the experience stabilization under inflation targeting. It does so by assessing the implementation and results of inflation targeting in Latin America from a broad perspective. The paper starts by reviewing the issues considered in the choice of exchange rate regimes and monetary frameworks in section 1.2, in the light of recent theory and policy experience. The next section documents the evolution of exchange rate and monetary regimes in Latin America during the last two decades. Section 1.4 describes the Latin American and world samples of inflation targeters and compares their performance to that of non-inflation targeters, focusing on their success in meeting inflation targets, their output sacrifice in achieving low inflation, and their output volatility.
The subject of section 1.5 is how monetary policy is carried out in five inflation-targeting countries in the region (Brazil, Chile, Colombia, Mexico, and Peru), with reference to the design of IT in the world sample of inflation targeters. Section 1.6 focuses on the longest inflation-targeting experience in the region (the 1991-2000 case of Chile), evaluating how IT has affected inflation expectations and hence the effectiveness of monetary policy, using a battery of alternative model estimations and simulations. The main conclusions in section 1.7 close the paper.
1.2 Alternative Exchange Rate and Monetary Policy Regimes
What determines the choice of currencies and exchange rate regimes? In choosing an exchange rate regime, initial conditions are important. In particular, for countries in which, due to a long history of high inflation and currency crises a substantial part of asset and liabilities are foreign-currency denominated, the advantages of flexible exchange rates would be more limited because the room for an independent monetary policy would be restricted by its exchange rate effects. In contrast, for countries that have in place a monetary and institutional framework capable of delivering low inflation, exchange rate flexibility could be advantageous.
Historically, the literature on the choice of exchange rate regime was based on other structural country features. However, after the early work on exchange rate choices and optimum currency areas (or OCAs; Mundell 1961; McKinnon 1963), this literature fell into oblivion for three decades. Motivated by the experience of the European Monetary Union (EMU) and the abandonment of intermediate regimes by emerging countries in the wake of financial turmoil in the late 1990s, a spate of new work is looking at the issue of optimal exchange regimes.
For countries that can make a choice, today's consensus view holds that the potential benefits from monetary union or dollarization (or a 100 percent credible currency board) stem from lower inflation, elimination of currency risk and its associated premium, elimination of currency transaction costs, and elimination of currency mismatch in foreign assets and liabilities. These benefits could be particularly important in countries without much room to run an independent monetary policy. At the other extreme, maintaining a domestic currency under a free float offers potential benefits derived from allowing for nominal (and hence more real) exchange rate flexibility, an independent monetary policy employed for stabilization purposes, direct access to seigniorage revenue, and direct central-bank exercise in providing lender-of-last-resort services on a temporary basis.
A host of structural and policy conditions determines the extent of the previous gains and losses associated with each regime choice. Traditional OCA factors to be considered consist of the degree of international factor mobility and correlations of factor prices; the extent of domestic price and wage flexibility; the degree of foreign trade openness and integration; the degree of symmetry of domestic and external shocks and business cycles; and the extent of domestic output, export, and portfolio diversification. Other important factors, mostly in the realm of policies and financial markets, have been added recently: completeness and depth of domestic financial markets and their integration into world markets (particularly in their ability to hedge exchange risk and to accept domestic-currency-denominated issues of foreign debt); and coordination of monetary union or dollarization with overall economic and political union, transfer payments, and adoption of similar regulatory and tax codes.
It is far easier to list the latter costs, benefits, and determining factors in choosing exchange regimes than it is to put numbers to such choices. In fact, an overall evaluation of the relation between regime choice and welfare is hampered by three serious limitations: there is no well-established encompassing framework that takes account of the various dimensions and variables that determine regime choice, there is little agreement on the empirical weight of different costs and benefits that entail such a decision, and the costs and benefits may change over time in response to regime changes. Hence, regional or country-specific evaluations of exchange regimes tend to be partial, emphasizing each factor separately.
Having this difficulty in mind, we may still discuss the possible relations between overall country welfare and its choice of exchange regime, using the schedules drawn in figure 1.1. Schedule A reflects the textbook case under which regime choice has no bearing on country welfare, as a result of instantaneous clearing in all domestic markets and their perfect integration into complete international goods and capital markets. In the absence of any market friction there is no gain from exchange rate flexibility, independent monetary policy, or provision of lender-of-last-resort services when adopting a domestic currency and choosing any degree of exchange rate flexibility--the only residual issue is a minor one, related to the international distribution of seigniorage revenue. At the same time, nothing is gained by giving up the domestic currency, because currency transaction costs are nil and perfect financial markets hedge the currency-risk premiums and currency mismatch.
A monotonic positive (negative) schedule between exchange rate flexibility and welfare arises when the net benefits (costs) of flexibility are positive and grow (decline) with flexibility. Countries that exhibit features like significant lack of factor mobility; domestic wage and price sluggishness; low trade integration; low (or negative) correlation of shocks and business cycles with the rest of the world; large concentration of output, exports, and portfolios; lack of policy and regulatory coordination with other countries; low exchange-risk premiums; high access to foreign markets for exchange rate hedges and domestic-currency-denominated debt; low inflation; a stabilizing monetary policy; and low currency transaction costs are reflected by schedule B. The opposite is true for countries reflected by schedule C.
What about intermediate regimes? In their heyday a decade ago, adjustable pegs seemed to provide a perfect compromise between credibility (due to the nominal anchor provided by the exchange rate peg or band) and flexibility (to allow for limited and gradual adjustment of the real exchange rate in response to shocks). Both academics and policymakers had in mind a nonmonotonic relation such as schedule and arguing for and adopting variants of crawling pegs, fixed bands, or crawling bands. After a decade of growing disappointment with intermediate arrangements-- caused by a spate of currency misalignment, speculative attacks, and single or twin crises in Europe, Asia, and Latin America--the current consensus for countries that are well integrated to capital markets has shifted toward schedule E, consistent with the corners hypothesis (as espoused by Obstfeld 1995; Summers 2000; Mussa et al. 2000; Edwards and Savastano 2000; and Fischer 2001). Although this view is not unanimous (see Williamson 1996; Frankel 1999, for arguments in favor of intermediate regimes), the growing country migration toward the extreme arrangements provides policy support to the corners hypothesis. Furthermore, the disappointment about intermediate regimes is becoming broader, encompassing fixed regimes and currency boards on one side and managed floats on the other. Financial turmoil and contagion in open economies that have adopted currency boards (e.g., Argentina and Hong Kong), and protracted high exchange-rate risk premiums after nine years of Argentina's currency board (reflected both directly and indirectly through large country-risk premiums; see Powell and Sturzenegger 2000), mark disillusion with currency boards and may explain Ecuador's outright dollarization and the recent shift of El Salvador toward dollarization. At the same time, a growing view that foreign exchange interventions are costly and, at best, yield only temporary effects (as illustrated recently by the coordinated intervention in support of the euro) has led Latin American countries such as Chile, Colombia, and Brazil to adopt clean floats.
With respect to monetary regimes, once a country decides to pursue a low inflation objective it needs to decide about the monetary regime to be used to anchor the evolution of the price level. Three fundamental options can be considered: an exchange rate anchor, a monetary anchor, and an inflation target.
An exchange rate anchor uses an exogenously determined trajectory of the exchange rate as a nominal anchor. A money anchor relies on a pre-committed path for the money supply to anchor inflation. In IT, the anchor for inflation is the publicly announced inflation target itself. The credibility of this policy relies both on the power given to the central bank to orient monetary policy toward achieving the target and on its willingness to use its power for this purpose.
When using an exchange rate target, a central bank knows precisely what it has to do; the public knows at every moment whether the central bank is succeeding; and the exchange rate affects import prices and the prices of other tradables directly. An exchange rate peg can quickly garner credibility, at least for the short term; in the long term, credibility can be retained only by success in maintaining the exchange rate peg. As we saw above, however, a fixed exchange rate is very costly for a government to maintain when its promises not to devalue lack credibility. In particular, credibility suffers when unemployment is high or the health of the banking system is in jeopardy.
This is not all. The use of the exchange rate as an anchor also requires that the appropriate institutional structure be developed to prevent the financial system from becoming too vulnerable to an eventual exchange rate correction. The latter could be developed through appropriate financial sector regulation. This vulnerability--which develops as exchange rate fixing, with an open capital account and weak financial regulation-- usually results in undue risk-taking and, as a consequence, in an unsustainable expansion of credit that could result in a financial bubble (increasing financial fragility in the process; Corbo and Fischer 1995; Edwards and Vegh 1997; and Mishkin 1997). This problem is illustrated by the experience of Chile in the early 1980s and Mexico in the first half of the 1990s, and in the recent experience of Asia (Thailand, Korea, Malaysia, and Indonesia). In all these cases, after the fixing of the exchange rate, the initial spread between the domestic and the foreign interest rate--adjusted for the expected rate of devaluation--rose sharply, providing substantial encouragement for capital inflows and credit expansion. The result was a combination of large capital inflows, an expenditure boom, and a sharp real appreciation. In these cases, a sudden reversal of capital flows was all it took to set the stage for a major crisis.
For countries that are not ready or willing to go the avenue of currency boards or full dollarization and that decide instead to use a flexible exchange rate system, the question about the choice of a monetary framework is still open. For a monetary framework to be successful, it must provide sufficient independence to the central bank that it can focus its monetary policy toward the ultimate objective of achieving low inflation. Leaving out the use of an exchange rate peg, the remaining options are the use of a monetary aggregate or an inflation target.
The effectiveness of the use of a monetary aggregate as a nominal anchor for inflation depends, first of all, on the authority and capacity of the central bank to carry out an independent monetary policy aimed at achieving and maintaining low inflation. At a more technical level, however, the effectiveness of a monetary anchor depends on the stability of the demand for the monetary aggregate that is used as an anchor. It is the stability of the demand for the monetary aggregate that provides a link between the monetary anchor and the inflation rate. The stability of the demand for money presents a problem when there is considerable financial innovation, or when there is a sudden change in the level of inflation.
In particular, in an economy that has experienced a period of high and variable inflation, the demand for money becomes very unstable as economic agents develop ways to economize in the use of domestic money balances. Therefore, when the rate of inflation is reduced, hysteresis effects emerge, generating a breakdown in the old demand-for-money relationship. That is, when the inflation rate returns to previously observed lower values, the quantity of money demanded is lower than it was before the outburst of inflation. In cases like these, predicting the quantity of money demanded becomes very difficult and the use of a money target could be a very ineffective way to achieve a given inflation objective. Thus, it is not surprising that as countries have moved to flexible exchange rate regimes they have searched for new monetary anchors. Here, a third type of anchor is becoming increasingly popular: inflation targeting.
Inflation targeting was initially introduced by industrial countries with the objective of keeping inflation close to a long-run low level. New Zealand introduced the system with this purpose first, in March 1990. Since then IT has been introduced in Canada (February 1991), the United Kingdom (October 1992), Sweden (January 1993), Australia (1993), and the European Central Bank (October 1998).
Under IT, the target rate of inflation provides a monetary anchor and monetary and fiscal policies are geared toward achieving the inflation target. The attractiveness of this framework is that its effectiveness does not rely on a stable relationship between a monetary aggregate and inflation, while at the same time it avoids the problems associated with fixing the exchange rate. An additional advantage for emerging countries is that the trajectory of the market exchange rate provides important information on market evaluation of present and future monetary policy, such as the information provided by nominal and real yields on long-term government papers in industrial countries (Bernanke et al. 1999).
Excerpted from Latin American Macroeconomic Reforms: the Second Stage by Center for Research on Economic Development and Policy Reform Stanford University. Copyright © 2003 by Center for Research on Economic Development and Policy Reform Stanford University.. Excerpted by permission.
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