Exchange-Rate Policy in Brazil

1. Exchange-Rate Policy in Brazil John Williamson Senior Fellow Peterson Institute for International Economics Presentation at Casa das Garças, Rio de Janeiro 13 August 2010

2. Three Impractical Scenarios • Fixed rates • Tried by Argentina • Necessary conditions are an economy that is small and open, much trade with peg currency, willingness to subject macro policy to gold standard rules, common inflation aspiration with peg currency • “Stable but Adjustable” • C20’s term for Bretton Woods system • Destabilizing speculation • Free floating • Large misalignments virtually guaranteed.

3. Present Policy of Brasil • Floating • But not free—substantial intervention, capital controls • No published concept of where rate should be • Policy of resisting appreciation (beyond some—what?—point) and welcoming depreciation (no matter what the rate?)

4. What’s the Alternative?—I, A Band • Implicitly a government engaged in unfree floating has concepts of too strong and too weak an exchange rate • So call those the bounds of a target zone and operate a BBC regime • Band—to permit a degree of cyclical freedom, to allow the crawl to work, because there’s no point in holding e to closer limits than can be calculated, to allow e to absorb part of speculative flows • Basket—to insulate target against exo variations in EER • Crawl—to prevent target being undermined by differential inflation, facilitate adjustment, and neutralize Balassa/Samuelson effect.

5. The Disadvantages of a BBC Regime • Indonesia 1997—an exchange-rate crisis even with macroeconomic equilibrium • Caused by contagion from Thailand • Ideal might have been standing pat with support from the IMF, but second-best was a depreciation that meant breaking the rules of the system • Obstfeld’s critique applies.

6. What Alternatives exist? II—A Managed Float • Two alternatives for management • Leaning against the wind • Leaning against movement from a reference rate • Problem of selecting a reference rate is same as that of selecting a parity in a BBC regime • Can’t be done with exactness, but can be an improvement on the market.

7. Tools for a Managed Float • Intervention (even sterilized) • Other monetary tools—reserve requirements, switching savings deposits to central bank • Forbidding FX loans, increasing reserve requirements against them • Differential taxation of FX loans • Taxation of traditional exports • Fiscal tightening • Relaxing controls on outward capital movements • Capital controls • “Oral intervention”, aka jawboning.

8. A Managed Float Consistency with best available model of FX market • Not REEM (= rational expectations + efficient markets) • But De Grauwe/Grimaldi’s Behavioural Model • Assumes agents change between fundamentalist and chartist strategies depending on recent profitability • Unable to solve analytically but simulations suggest that exchange rate changes are usually disconnected from changes in the fundamentals (although the exchange rate is cointegrated with its fundamental value); that if one sticks to one rule at all times, then a chartist rule tends to be more profitable than a fundamentalist rule (though it is often better still to switch between these rules); that exchange rate changes have fat tails; and that the exchange rate is sometimes, but unpredictably, disconnected from its fundamental value and instead involved in bubble-and-crash dynamics. De Grauwe, Paul, and Marianna Grimaldi. 2006. The Exchange Rate in a Behavioral Finance Framework. Princeton: Princeton University Press.

9. Some Advantages of this Approach • One of the findings of De Grauwe/Grimaldi is that leaning-against-wind intervention “works” (by increasing weight of fundamentalists) • Like a BBC regime except that it allows authorities to let the rate go in preference to sacrificing all (“soft bands”) • Does what is possible without risking crises to enable the authorities to combat Dutch disease • Is compatible with more systematic approach to international monetary system.

10. Potential Disadvantage The policy measures are too weak to give assurance of an ability to manage the rate, therefore it would make no difference (But it would preclude intervening to defend an undervalued rate, cf China.)

11. Concluding Remarks • Commodity exports (including oil) may be too much of a good thing because they threaten Dutch disease • One wants a system that will not generate crises but will enable the authorities to combat excessive appreciation • The authorities naming a reference rate is a (or the only?) competitor to the status quo.