1. 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. 2 Outline of the presentation  Intro. Regime dynamics and macroeconomic outcomes  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  Conclusions

3. 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

4. 4 1. Introduction  Price stability achievements –Inflation under control  No spirals + reduced pass-through

5. 5 1. Introduction  Vulnerabilities persist –Sustainability concerns diminish –Moves towards more balanced debt composition –Reduction in public debt, but resilience

6. 6 1. Introduction  Vulnerabilities persist –Closely related to financing conditions Exchange rate dynamics

7. 7 1. Introduction  Progress 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? Source: Alberola & Montero (2005)

8. 8 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

9. 9 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 2. Exchange rates and fiscal discipline ‘new’ view Financing constraints credibility fix float Inconsistent Well-behaved

10. 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 pegs IMF ‘type II errors’: ‘de facto’ pegs classified as floating (fear of floating) 2. Exchange rates and fiscal discipline

11. 11 2. Exchange rates and fiscal discipline Type II error Type I error

12. 12  How relevant is this for Latin America? 2. Exchange rates and fiscal discipline

13. 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 2. Exchange rates and fiscal discipline De iure/announced (Gosh et al.) De facto (Reinhart-Rogoff) NO, even reduction! YES

14. 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 2. Exchange rates and fiscal discipline

15. 15 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?