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Exchange rate regimes and the recent progress in economic discipline in Latin America

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. Outline of the presentation. Intro. Regime dynamics and macroeconomic outcomes

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Exchange rate regimes and the recent progress in economic discipline in Latin America

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

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

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

  7. EXCHANGE RATE REGIME AND PUBLIC BALANCES De iure pegs (% GDP) (left scale) Primary balance (% GDP) Primary balance adjusted by monetary seignorage (% GDP) % 70 4 60 2 50 0 40 -2 30 -4 20 -6 10 -8 0 -10 1980 1983 1986 1989 1992 1995 1998 2001 2004 Source: Alberola & Montero (2005) 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?

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

  10. Exchange rates and fiscal discipline Type II RR ‘de facto pegs’ RR floating er Type I RR free falling • 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) • A digression. Exchange rate classifications IMF ‘de iure’ pegs IMF flexible

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

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

  13. Exchange rates and fiscal discipline • 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 NO, even reduction! YES

  14. Exchange rates and fiscal discipline • 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

  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?

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