Exchange Rate Policies in Latin America: Discussion Roberto Chang Rutgers University and NBER

Summary of the Papers The three papers in this session discuss recent experience with inflation targeting in Colombia, Chile and Peru, with emphasis on exchange rate management issues. The three cases share several common features, but also differ in substantial ways.

Inflation Targeting Experiences Transition to a “fully fledged” inflation targeting regime has been recent (1999 in Col and Chi, 2002 in Peru). Announced explicit targets for inflation over some horizon (2.5% - 3 % +/- 1% in Chi and Pe, 5% in Col). Communication with the public has been institutionalized (i.e. Inflation Reports).

Policy Implementation All three central banks have switched to using a short term interest rate as their main (but not the only) policy instrument. And they claim to have flexible exchange rates, consistent with the inflation targeting regime.

Favorable Results By and large, the three countries have been very successful at controlling inflation (to about 2-3 percent in Chile and Peru, 5 percent in Col). Output growth in Chile and Peru rather satisfactory for the region, less so in Colombia.

Impact on Credibility Not only inflation has fallen to low levels, but policy appears to have gained substantial credibility. In Chile and Peru, surveys of inflation expectations have converged to inflation targets. In Colombia, expectations of inflation remain half a percent above target range.

Departing from the IT playbook As noted, the three central banks claim to have flexible rates. But they also note that they reserve the right to depart from flexible rates under some exceptional circumstances.

Cited reasons for deviating from flexible rates Excessive exchange rate movements not justified by fundamentals (Colombia, Chile). Large devaluations that may jeopardize financial and payments systems (Peru). Forex intervention may complement monetary policy (Colombia).

What the deviations have looked like Interest rate has been adjusted upwards to prevent an “excessive” devaluation (Peru in September 2002). Foreign Exchange intervention, with or without sterilization, announced and limited or discretionary.

Should we worry about these peccadilloes? Are there good reasons to engage in active exchange rate management within an inflation targeting regime? If so, what is an appropriate way to do so?

What conventional IT gurus would say Svensson (1998, 2000) examines the optimal choice of a central bank that chooses its instrument path maximizes expected discounted loss of a (LQ) function of inflation and real activity. A central result (in the presence of control lags) is that the instrument should be set so as to minimize deviations of inflation forecast from target (as in Chile and Peru).

A corollary is that the current instrument setting should react to any variable that provides news with respect to expected inflation. Foreign variables and exchange rates are clearly in the latter category.

“…the more open the economy, the more the reaction function [that determines the central bank’s instrument] will depend on foreign variables, for instance foreign inflation, output, and interest rates…” (Svensson 1998)

So, even from the now widely popular theory of inflation targeting it should not be surprising that implementation of that regime should make the instrument (overnight interest rates) respond to news in exchange rates. But of course this does not seem to be the main reason why our central bankers have engaged in active exchange rate management.

What conventional IT theory misses and its implications In practice, our central bankers express strong concern for two possibilities: that exchange rates movements may not be justified by fundamentals, and that large devaluations may destabilize financial and payments systems.

On non-fundamental exchange rate gyrations It is very hard to dispute the contention that exchange rate movements at times (and perhaps most of the time) are not justified by fundamentals. But it is not clear what kind of policy such a contention justifies.

Exchange Rates and Financial Stability We are now on much firmer ground to discuss the effects of exchange rate movements on financial stability. An active literature on liability dollarization, currency mismatches, and financial frictions emphasizes how a devaluation may result in a contraction in aggregate demand through net worth effects.

Therefore, countries with high degrees of liability dollarization and less developed financial systems (e.g. Peru) are well advised to pay close attention to the balance sheet effect of devaluation. And it could be argued that a (Peruvian – like) strong effort at containing dollarization, reducing mismatches, and the like, is warranted.

On the other hand, it is not obvious in this case how exactly the central bank should adjust its policy instrument to news in exchange rates. It would be desirable to derive optimal policy in the context of a Svensson-type framework, extended to allow for balance sheet effects, etc.

How to manage the exchange rate The three central banks state that they have used foreign exchange intervention, as opposed to adjusting the interest rate, to influence exchange rates. This appears much more problematic.

Sterilized or not? The existing literature on intervention fails to provide clear evidence on the effectiveness of sterilized intervention (see Disyatat and Galati 2005 for a recent survey). Most studies find a weak and short lived effect of intervention on exchange rates. The signaling effect is controversial.

A non sterilized intervention can be seen as a sterilized one plus an adjustment in the supply of money. Seen in this way, it amounts to changing the policy instrument (money instead of interest rate). This entails no gain and instead impairs transparency and causes confusion.

So it is not surprising that, in the Colombian case, it is now “harder for the public to verify and for the central bank to communicate the monetary policy stance, since the central bank is not only moving the interest rate, but also intervening in the for-ex market with substantial amounts, closing/opening repo facilities, and selling government securities in the secondary market.” (Vargas, page 10)

The conclusion is that it does not appear advisable to include foreign exchange intervention, whether sterilized or not, as part of the overall monetary policy framework. The central bank should adjust interest rates instead.

Indeed, in his review of the Central Bank of New Zealand, Svensson (2001) concludes: “I see no reason why a transparent inflation-targeter should undertake foreign exchange interventions.”

This is not to say that accumulating foreign reserves when they are “cheap” is a bad idea. But the rationale for doing so (such as enhancing the ability of the central bank to act as a lender of last resort in dollars) is about preserving the stability of the financial system and prevent crises, not about implementing inflation targeting.

Final Remarks The recent progress in monetary management in the three countries has been remarkable. Surely, it has been aided by sound fiscal policy. It is fair to claim success. Careful in tinkering with what is not broken.