1. NS4540 Winter Term 2017 Latin American Exchange Rates

2. Overview Trade creates inflows and outflows of money
These flows can affect the price of the domestic currency relative to foreign currencies – the exchange rate
Each country has to make a choice abut how these flows are allowed to affect the domestic economy and/or the exchange rate.
Through much of its history the countries of Latin America maintained fixed exchange rates exchange rates
First the gold standard until WWI and then the 1920s
After WWII Bretton Woods Gold Exchange System from
After 1971 a generally more flexible exchange rate regimes

3. Fixed Exchange Rate I
Maintaining a fixed exchange rate difficult for a country that is an exporter of commodities.
When commodity prices are low, the supply of foreign exchange shifts to the left and the exchange rate would depreciate. To maintain the fixed rate the government will need to sell foreign exchange --
When commodity prices are high, the supply of foreign exchange shifts to the right and the government will need to buy up the excess foreign exchange to keep the exchange rate form strengthening

4. Fixed Exchange Rate II
Another example of the old principle that fixed prices create either surpluses or deficits.
Since the exchange rate is not being allowed to change, the government must at times accumulate a surplus of foreign exchange
This accumulation will be necessary in order to supply foreign exchange whenever there is a shortage.
This buying and selling of foreign exchange is known as intervention in the foreign exchange market.
A country that is a commodity exporter has to be careful managing its stock of official reserve assets.
It would need to intervene in the foreign exchange markets both when there is a commodity bust and, especially during a commodity boom.

5. Fixed Exchange Rates III
General rule, for a fixed exchange rate
Accumulate reserves when the current account in surplus
Reserves used when country running a deficit
For most of the countries in Latin America this was not the norm under the Bretton Woods system.
During commodity booms or other favorable periods, sufficient reserves were not accumulated to cover the periodic deficits
Not unique to Latin America – many countries in other parts of the world unable to do this

6. Exchange Controls I
What are the alternatives during a period of falling commodity prices? And foreign exchange shortage.
With a fixed exchange rate the price is being forced below the equilibrium. And a shortage develops

7. Exchange Controls II
Without an increase in price the government may resort to rationing the available foreign exchange
Usual term for this rationing is exchange controls
Exchange controls imply discrimination in the market for foreign exchange
With floating rates, the available foreign exchange goes to anyone who is willing to pay the current exchange rate.
With the government administering, there are many forms of exchange controls
Most rigorous form of exchange control gives the government monopoly on dealing in foreign exchange

8. Exchange Controls III
In this case, any holder of foreign exchange must sell it to the government at the official exchange rate
Gives the government an effective monopoly of the supply of foreign exchange
On the other side of the market, there will be more firms and individuals demanding foreign exchange than the supply owned by the government
Exporters will have to sell their foreign exchange at an unfavorable rate while importers can buy it at a very favorable rate
With an excess demand for foreign exchange the government will have to decide who gets it and who does not

9. Exchange Controls IV
Some rationing decisions easy – oil, food, medicines.
Beyond these process becomes more difficult
One response has been the creation of a system of multiple exchange rates
In this case the official exchange rate not uniform, but would vary depending on which the government felt were essential imports and which were less important
Ex 1P/$ for essentials, and 3P/$ for those less important.
In Latin America often became part of an industrial policy.
ISI industries could obtain foreign exchange on more favorable terms than other industries
Amounted to a subsidy for ISI
Part of the unraveling of ISI that led to the Lost Decade can be trade to rapid depreciations of exchange rates common during the period.

10. Exchange Controls V
Exchange controls of this type involve current account transactions
Fortunately in most countries of Latin America such controls no longer exist.
However there are still exchange controls on financial account transactions -- FDI and movements in portfolio capital.
FDI outflows from Latin America are not an issue as they are relatively small
However inflows can be substantial
Most often, inflows of FDI are not a significant problem – they may be large but they are not very volatile

11. Exchange Controls VI
Portfolio capital – money that is being invested in financial stocks and bonds – can easily flow out of the country
As portfolio comes in, the exchange rate may appreciate, and as it flows out a devaluation may occur.
As in the Asian Financial crisis during the late 1990s, capital flight can have disastrous macroeconomic consequences – higher inflation and negative economic growth.
Capital flight is a real risk for developing countries especially in Latin America
Part of the instability embedded in the history of the region
Ensuing disappointment with these investments led to a number of cases of capital flight from the region

12. Exchange Controls VII
Contagion is the tendency of investors to withdraw portfolio capital from an entire region in response to perceived economic difficulties in a single country or a subset of countries
The Latin American region may be particularly susceptible because of its economic history
Example – series of macroeconomic policy mistakes in late led to a rapid depreciation of the Mexican peso
Known as the Tequila crisis
Crisis country specific and not an indication of generalized economic problems in the region
Nonetheless the crisis in Mexico led to a large withdrawal of portfolio capital and had adverse economic impacts on the region as a whole

13. Capital Controls I
These risks have led a number of country to adopt some form of controls over movement of portfolio capital
Such restrictions can serve to limit the inflows and outflows of foreign exchange and help stabilize the exchange rate
As always, costs and benefits involved with policy
Benefit – can limit appreciation of the currency when inflows are high
This reduces adverse effects on exports and reduces tendency for imports to rise
Controls can also offer some protection against exchange rate shocks
Portfolio capital may be prevented from leaving the country in a massive outflow and thus can reduce the severity of the depreciation of the currency

14. Capital Controls II
In a sense, controls on the flow of capital constitute a form of insurance against large changes in the exchange rate in either direction
Insurance not free – costs of capital controls
Countries of Latin America tend to be capital scarce
Limiting follows of capital may have consequence of reducing the rate of economic growth
Could diminish the growth of the K/L ratio which is an important determinant of real wages
More importantly, not completely clear whether or not such controls have the expected effect on the exchange rate
Different studies find varying effects depending on the country or time period studied
Situation in Chile examined extensively

15. Capital Controls III
From 1991 to 1998 the government of Chile imposed restrictions on capital flows as a means of limiting exchange rate volatility
Two main forms
Inflows of FDI were subjected to a minimum stay of 1 year.
Controls on flows of portfolio capital more complex
Chilean firms were limited in their ability to issue stock in foreign markets
More importantly inflows of portfolio capital were subject to a 30% reserve requirement
This amounted to a tax on inflows of portfolio capital

16. Capital Controls IV
Overall evaluation seems to be that in the case of Chile, the controls generated small benefits and relatively small costs
However some of the costs less obvious
Limiting the flows of short-run capital in a capital-scarce country should have an impact
Larger firms able to avoid the effects of these controls by borrowing in foreign markets
Also since the regulations were complex, they represented an extra but fixed cost of borrowing – again favoring larger firms over smaller

17. Capital Controls V Difficult for banks to avoid the controls
The banking system in Chile was a major source of capital for small and medium-sized firms
During this period large Chilean firms could borrow in international markets at 7-8%
Cost of capital for smaller firms was over 20%
Controls had the effect of making capital over twice as expensive for firms that naturally tend to grow faster.
While the overall costs to the Chilean economy may have between small, the costs to an important part of the economy were much larger

18. Real Exchange Rate I
So far have discussed the nominal exchange rate – the rate observed in the market
More important for economic policy and impacts is the real exchange rate – the nominal rate adjusted for inflation both domestic and foreign
Example: Last year $1 = 1,000 pesos and can purchase an item in Mexico for this amount
If inflation in Mexico had been 100% over the year, and U.S. inflation 0, this year $1 = 2,000 pesos and can buy the same item in Mexico
The nominal exchange rate has changed drastically, but the real exchange rate is the same
Common situation in Latin America to have higher inflation
With fixed normal exchange rate caused the real exchange rate to appreciate and cause trade imbalances

19. Real Exchange Rate II Long Term: Purchasing Power Parity
Clark Reynolds, Why Mexico’s Stabilizing Development Was Actually Destabilizing

20. Managed Exchange Rates I
The exchange rate regime is the system the country uses to manage the exchange rate and the foreign exchange market
Most exchange rate regimes somewhere between the extremes of a fixed rate and completely flexible rate
At one extreme Venezuela still has a conventional fixed exchange rate regime
This is workable in a country with extremely good economic management
If not the case the results can be disastrous.
On the other end Chile and Mexico have freely floating exchange rates which are the norm in high-income countries

21. Managed Exchange Rates II
Four countries have a form of floating that is influenced by monetary policy
Many central banks operate with an inflation target
Given history of inflation in the region, not surprising that the central banks of Brazil, Colombia, Paraguay and Peru have official inflation targets
This influences the exchange rate as low inflation would serve to limit the volatility of the exchange rate
Uruguay goes one step further and targets the money supply through its link to the inflation rate

22. Managed Exchange Rates III
Nicaragua uses a crawling peg
With a crawling peg, the nominal exchange rate is changed by a determined amount at preannounced points in time
Point of a crawling peg is to limit fluctuations in the real exchange rate – nominal exchange rate corrected for inflation
Argentina, Guatemala and Honduras use a crawl-like arrangement where the goal is to limit fluctuations in the real exchange rate
Bolivia and Costa Rica do something similar without officially stating exactly what factors are guiding exchange rate policy
In all these cases the result is that countries use a combination of capital controls, intervention in the foreign exchange market and interest rate changes to influence the value of the exchange rate to reduce volatility

23. Managed Exchange Rates IV
Ecuador, El Salvador and Panama do not have a domestic currency, but use the U.S. dollar
Each country is a currency union with the U.S.
Dollar regime has both costs and benefits
Primary cost is the country does not have domestic monetary policy
As a result, macroeconomic stabilization can be accomplished only through the use of fiscal policy
The benefits are twofold
First the policy limits the possibility of serious inflation in the countries – given the inflation history in the region, this is no a small consideration
Second it limits exchange rate volatility
In a small country, either capital flows or large changes in commodity prices could have very large effects on the exchange rate

24. Managed Exchange Rates V
By using a stable currency such as the dollar, the potentially adverse consequences of a domestic currency are avoided
While this choice may seem odd at first glance, it is a perfectly reasonable choice for a small and open economy

25. Exchange Rate Regimes

26. Summary
The countries of the region have learned from experience that large changes in the real exchange rate can have very adverse macroeconomic consequences
Many of these changes were the result of a pegged nominal exchange rate
This experience had led to a reasonable compromise for managing exchange rates in the region
The nominal exchange rate for most countries is now flexible
This frees the governments of the region from the need to constantly intervene in the foreign exchange market to peg the exchange rate
On the other hand the real exchange rate needs to be kept in a range to maintain the competitiveness of the country’s exports, and not allow imports to be overly inexpensive.