Transcript `Holy Trinity` to the `impossible duo`

Why is monetary policy more demanding in
emerging markets?
Lessons from Latin America
José Viñals
Banco de España
Helsinki, May 2004
Outline of the presentation

Liberalization and burdens on monetary policy management

From the holy trinity to the impossible duo?

Conclusions
Helsinki, May 2004
2
Liberalization and burdens

LA approach to Capital account liberalization
–
shock therapy
•
Swift capital account liberalization, seen as catalyser for structural
changes
•
‘A priori’ ambitious reform process
– A FORTIORI: “Meant well, tried little, failed much”
•
Macroeconomic stabilization
– Through external anchors,…turn out to be problematic
Helsinki, May 2004
3
Liberalization and burdens
Rapid stabilization, capital flood, expansion
Latin American aggregates:
Exchange rate regime and real variables
External capital flows and growth
%
FIXED REGIMES, REAL INTEREST RATE AND INFLATION
100
12
PRIVATE CAPITAL FLOWS TO LATIN AMERICA AND GDP
100
8
GROWTH
90
10
REAL INTEREST
RATE (median)
80
70
7
CAPITAL
FLOWS
(billion $)
80
8
6
60
60
5
6
50
4
40
4
40
30
2
10
0
FIXED REGIMES: SHARE IN
LATIN AMERICA GDP
0
1988
1990
1992
1994
1996
Sources: IMF and own calculations
Helsinki, May 2004
20
2
GDP GROWTH
GDP
GROWTH
20
3
1998
2000
1
0
0
-2
2002
-20
-1
1988
1990
1992
1994
1996
1998
2000
2002
2004
Source: IMF
4
Liberalization and burdens

Capital flows = Accelerated external borrowing
–
Compounded with low savings
–
Overborrowing syndrome (McKinnon)
•
–
Economic expansion masks difficulties
–
Public, financial and corporate sector
•

implicit government guarantees through exch. Rate pegs
A different type of difficulties arises from each
Problems for monetary management
Helsinki, May 2004
5
Liberalization and burdens

Deadly traits
– Unbalanced opening
• Capital account wide open v. Current account closeness
• Exposure to external financial shocks
• Globalization and volatility of flows
– High debt+high costs
• Original sin and debt intolerance
– Dollarization
• Implicit and explicit currency mismatches
– Weak initial conditions and slow strengthening
• Fragile economic governance
• Underdeveloped domestic financial system
• Weak or insufficient fiscal discipline
Helsinki, May 2004
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From the ‘holy Trinity’ to the ‘impossible duo’

EARLY NINETIES HOLY TRINITY : trade-off bw
–
–
–
–

Fixed e-r rates , free capital mobility , independent monetary policy
Successful stabilization
Initial expansion BOOM + Capital flows attraction
Monetary policy
• Accommodating appreciations in real terms (endogenous monetary policy)
• High real interest rates
• Control of inflation
BUST
– Expansion peters out
– External and internal disequilibria
• current account deficits
• exchange rates disequilibria
• Uncover fragile fiscal, financial system positions
– Overborrowing
• Debt accummulation beyond tolerance
– Contingent deterioration of sustainability
• When exchange rate, costs of financing move up
Helsinki, May 2004
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From the ‘holy Trinity’ to the
‘impossible duo’

Exchange rate regimes strains
– Ex ante failure of exit strategy
• Inflation stabilization means pegs outlive their utility
• Financial crises (from mid-90s) force pegs out (traumatic)
– Exchange rate hollowing out
• But bias towards floating
• Only very open small economies dollarise
– Exception Ecuador
– Ex post successful transition to floats
• Regime shift in expectations (from high to low inflation)
• Inflation does not goes beyond control
• Reduced pass-through
Helsinki, May 2004
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From the ‘holy Trinity’ to the
‘impossible duo’


Keys for success
– Room for manouvre to strenghten CBs
• De facto autonomy
• Vanishing inflationary taxes and resource to public sector financing
• Technical competence
• Development of basis for alternative strategies
• Deepening of domestic markets
Current traits
– Move toward (more or less explicit) inflation targeting
– Fear of floating remains. Allows for reserve accumulation
Helsinki, May 2004
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From the ‘holy Trinity’ to the
‘impossible duo’

Challenges and difficulties
– Impossible duo: ‘de iure’ floats + monetary independence
• Globalization as limiting factor, in general
• High exposure to external flows and financial vulnerability heightens
difficulties for monetary management
• Dollarization = worsening factor
– Implicit mismatches materialise
– Flight from domestic currency
– Perverse debt dynamics
– Consequences
• Asymmetric ‘Exchange rate dominance’
• Maintenance of fear of floating = ‘de facto’ managed e-r regimes
• Procyclical monetary policy
– Tighten in or just after of turbulences = downturn due to adjustment
– + procyclical fiscal policy = inadequate policy mix
Helsinki, May 2004
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From the ‘Holy Trinity’ to the
‘impossible duo’

Asymmetric exchange rate dominance
– Quiet times = ‘canonical’ inflation targeting regime
• Instruments → transmission mechanism → inflation targeting
– Plus perfectioning of instrument and transmission mechanism
– Strengthening of financial system…
– Turbulent times = ‘suspension’ of inflation targeting
• Turbulence = sharp e-r depreciations + sudden stops
• Instruments ↛ inflation target
– Financial, fiscal vulnerability surfaces
– …and economic policy (including monetary) focuses on financial stability
– INFLATION TARGET, no PARAMOUNT TARGET
• Instruments
↛
transmission mechanism
– Financial systems runs for safety
– CBs and government apply ‘crises management’ measures
» Liquidity provision
» Exchange rate hedging
» Absortion of government paper
» Changes in reserve requirements
» Use of international reserves related to IMF –programs…
– SHOCKS TO TRANSMISSION MECHANISM =LOSS OF EFFICACY
Helsinki, May 2004
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From the ‘Holy Trinity’ to the
‘impossible duo’


Inflation targeting resilience related to vulnerability
– Differences among countries:
• Low vulnerability: Chile, México = capable to implement inflation targeting in
good and bad times
• High vulnerability: Brazil = suspension in turbulences
Brazil: ‘de facto’ suspension of IT in 2002
• Paramount policy target:
– crises management, return of confidence
• Policy reaction
– Inflation target mandate asks for increase in interest rates
– Currency defense, arguably, too
– However:
» NO defensive increase of interest rates during turbulence
» Measures to reduce exchange rate speculation
– Reasons
» Perceived as self-defeating, increasing banking system strains
» Transitory collapse of transmission mechanism
Helsinki, May 2004
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From the ‘Holy Trinity’ to the
‘impossible duo’
Brazil: ‘de facto’ suspension of IT in 2002
Lagged e-r effect
Lagged monetary policy reaction
Brazil: financial conditions from 2002 to 2004
Brazil: financial conditions and inflation from 2002
to 2004
SOVEREIGN SPREADS AND DOMESTIC INTEREST RATES
EXCHANGE RATE AGAINST $ AND INFLATION
18
24
4
24
3.8
16
3.6
19
19
14
3.4
EXCHANGE
RATE
12
14
SELIC RATE (%)
14
3
10
9
9
2.8
2.6
8
2.4
SOVEREIGN SPREAD (%)
4
4
2002
2003
3.2
2004
6
INFLATION
2.2
4
Source: BCB, JP Morgan
2
2002
2003
2004
Source: BCB
Helsinki, May 2004
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Conclusions
– Success history in terms of low inflation
– Still burdened by difficulties
– No way back. Globalization is here to stay
– Strategy
• Reinforce monetary management regimes + reducing vulnerability <<reciprocal
feedback
• How (see successful cases: México, Chile)
– Higher formal independence of CBs
– Pursue dedollarization
» Awareness of costs (currency flight?)
– Deepening of domestic financial markets
– Fine tuning of monetary regimes in parallel with financial advances
– Fiscal discipline and debt reduction
– Current account openess
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