«Draft in Progress This Version: March 12, 2001 # Chief Economist, Central Bank of Chile. I would like to thank the efficient assistance of Matías ...»
Exchange Rate Policy in Chile: Recent Experience
Felipe G. Morandé #
Draft in Progress
This Version: March 12, 2001
Chief Economist, Central Bank of Chile. I would like to thank the efficient assistance of Matías Tapia and
Herman Bennett to this draft. The views expressed here are my own and do not necessarily represent the
position of the Central Bank of Chile. This paper was prepared for the conference “Exchange Rate Regimes:
Hard Peg or Free Folating?”, organized by the IMF Institute on March 19-20, 2001, in Washington, DC.
Exchange Rate Policy in Chile: Recent Experience I. Introduction Chile has experienced virtually all the menu of options of exchange rate policies in the last 40 years with the exemption of adopting a foreign currency. From hard pegging in the early 60s and 80s, to the current clean floating, we have been even precursors of some very “innovative” intermediate regimes that later on were adopted by a number of other countries. The crawling peg adjusted to past inflation scheme of the second half of the 60s, the “active” crawling peg arrangement of 1978 (later popularized in Argentina as the “tablita”), and the crawling band of the late 80s and most of the 90s, have been examples of policy makers “ingenuity”. Figure 1 presents the evolution of Chile’s nominal exchange rate from 1984 to present, as well as the crwaling band that was in place between August 1984 and September 1999.
The quest for a reasonable exchange rate policy has been inspired in part by the different goals that, through time, policy makers have attempted to achieve with this policy.
Goals, in turn, have varied depending on the final objectives with respect to growth and inflation, the “model” of the economy in the policy makers’ minds, or both. Many other factors, including conditions in the world economy, the domestic business cycle, imperfections in the workings of internal markets (like widespread price inflexibility), political economy aspects, and even academic fads, have also played a part.
With the adoption of an inflation targeting monetary scheme in the early 1990s, right when capital inflows vigorously resumed, it soon became apparent the conflict between the targets set for inflation and the commitment with respect to the nominal exchange rate contemplated in the exchange rate policy (a crawling band adjusted with respect to past inflation). Although the inflation target always prevailed in case of conflict, in 1999 the Board decided finally to give up the exchange rate band and replace it with a policy of clean floating.
This paper confronts three questions: (a) Why was the band abandoned and, by the same token, why it took so long to do it; (b) Is floating a better choice than quitting the national currency in the case of Chile?; and (c) How has the floating regime worked so far?
II. Why Was the Exchange Rate Band Abandoned, and Why in September 1999?
II.1 A Preview:
Although the exchange rate band evolved over time since its inception in the mid 80s, it had a few central features that remained unchanged until its abandonment (see Figure 1). The first one is that it was a crawling band whose center or reference value was periodically adjusted to reflect the difference between domestic and foreign inflation in the preceding month. The second general feature is that the band’s width was gradually increased with time, except for a temporary reversal in 1998. And the third one is that intraband interventions by the Central Bank in the foreign exchange market did take place all along, although in rather circumvent ways.
These features reveal in turn important cues as to what the role assigned to the exchange rate policy was in the last fifteen years. The fact that the band’s center followed the difference between domestic and external inflation reveals that there was a concern with misalignments of the real exchange rate with respect to a PPP concept. Although the actual mechanism applied to adjust the nominal exchange rate changed through time, the choice of a PPP criterion at least shows that the authorities had no intention to use the exchange rate policy as a blunt price stabilization tool 1. This was in total opposition to the 1979-82 experiment with a fixed exchange rate and even with the pre-announced crawling peg of 1978 (later known as “la tablita”), when the exchange rate policy was presented as the nominal anchor of the economy in order to subdue inflation in a short period of time.
As is normally the case, the role assigned to the exchange rate policy at a point in time is directly linked to the lack of success of the immediately precedent role. The fixedrate episode of 1979-82, which occurred at a time of heavy capital inflows intermediated by highly leveraged and badly supervised domestic banks, was associated to a substantial real peso appreciation and an unsustainable current account deficit. More than that, after a sudden reduction in capital inflows, the episode ended up in the biggest recession of the last 50 years (15% drop in GDP in 1982-83), a very high external debt, and an upsurge in inflation. Fair or not, the nominal anchor role of the exchange rate was in part blamed for the disaster by the general public and many economists. Thus, the reaction was a complete overhaul and switch of macro policies in 1985-90. This time around, there was less concern for reducing inflation, more concern for overcoming the problems posed by the excessive external debt and the scarcity of voluntary foreign financing after the Mexican moratorium of 1982, and more concern for stimulating the economy back to growth again. The formula was to allow the peso depreciate and try to keep it depreciated in real terms, so net exports could go up producing the resources to comply with external debt obligations and bringing dynamism to economic activity. It worked, but not only because of the exchange rate policy chosen, but also because at the same time there was an austere fiscal policy and a stimulative monetary policy on average. In the end, exports grew at a compounded rate of 10,6% annual, while GDP did so at an average rate of 6.5%, between 1985 and 1990. In spite of an inflation rate that remained high hovering 20% per year, that period went to history as a successful one and so the role of the exchange rate policy as a tool to influence the real exchange rate more permanently, right or wrong, was established.
Why then the exchange rate band’s width was somewhat increased during this period?2 Why not simply obtain the same results by resorting to a plain crawling peg? In part because of fad (exchange rate bands were the new kid in the block in the mid 80s), and in part because of the first attempts of the Central Bank of the time to implement a more Of course, there was some leeway given by the definition of the band’s parameters and width.
The band started with a 0.5% width in 1984 and had a 5% width in 1990. The changes experienced by the band during its history are summarized in Table 1. See also Figure 1.
modern monetary policy aiming to reduce inflation. This needed some degrees of freedom in the exchange rate market that a straightforward crawling peg was unable to provide.
Two facts made the commitment to a depreciated peso very difficult in the 1990s.
First, after the political change in 1990, the new government stayed committed to the promarket policies followed by the previous administration and thus, capital inflows resumed very strongly. These inflows were also prompted by low interest rates in the US and the rediscovery by foreign investors of a reform-prone Latin America3. The other fact was a newly independent Central Bank with a clear mandate to reduce inflation from rates of more than 20% annual to figures more similar to those prevailing in industrial countries.
This mandate was materialized in the adoption of annual inflation targets that aimed to gradually reduce inflation over time, and the implementation of a monetary policy subordinated to these inflation targets.
The substantial inflow of capital during most of the decade, whether exogenous or endogenous, or both, put a lot of pressure for a more appreciated peso, in real terms. This was not in principle consistent with a PPP adjusted crawling band that wanted to keep the peso depreciated. On the other hand, the attempt to reduce inflation by resorting to gradually declining annual inflation targets could potentially clash with the exchange rate band as well. In a sense, having inflation targets and an exchange rate target simultaneously is an over-determination of nominal variables (two nominal anchors). Moreover, the strong growth exhibited during the 90s was associated to important improvements in factor productivity, particularly in the tradable sector, which was an additional pressure for a more appreciated peso (the Balassa-Samuelson effect 4). At the same time, demand was growing even more than output, forcing on average a strict monetary policy and high domestic interest rates all along, this being a factor in the attraction of foreign capital and compounding the pressure for a more appreciated peso, also in real terms.
The reluctance to abandon the exchange rate band in spite of all these conflicts and pressures forced the Central Bank to try different “second-best” options between 1990 and
1997. The band itself suffered a number of amendments during the decade that aimed to accommodate a more appreciated peso (see Table 1): (a) increasing the band’s width, which went from 10% in 1990 to 25% in 1997; (b) discounting a productivity factor (for the Balassa-Samuelson effect) in addition to foreign inflation in adjusting the band’s center; (c) changing (increasing) the foreign inflation definition; and (d) moving from a dollar reference to a reference to a basket of currencies (the US dollar, the mark and the yen).
This elastic use of the exchange rate band was accompanied by two other complementary policies that attempted to reduce the peso appreciation: (i) the imposition of regulations to the inflows of capital, the most important one being an unremunerated reserve requirement of 30% for the first year of stay of foreign loans and money raised in international financial markets5. And (ii) the sterilized accumulation of foreign exchange It is no accident that a that time developing economies were re-baptized as “emerging” economies, perhaps as a symptom of the growing the appetite for risk among foreign investors.
This appreciation of the equilibrium real exchange rate associated to this effect was estimated in close to 1% per year by Valdés and Délano (1998).
Finally reduced to 0 in September of 1998.
reserves. Forex were 18 billion dollars right before the Asian crisis, up from the 3 billion they were in 1990. 6 As it could be expected, this policy mix brought costs and benefits. Among the benefits, we could cite the smoothing out of the real peso appreciation that otherwise could have been more intense and drastic, bringing higher real costs in a context of inflexible prices. The costs were essentially of a microeconomic nature, like a misallocation of financial resources and less access to cheaper foreign financing. Whether or not more autonomy of the monetary policy could be ascribed to this rather unorthodox policy mix is more debatable, however. But, in any event, as the main objectives of consistently reducing inflation while the economy was kept growing at a speedy pace, the policy mix found more defenders than detractors.
But someone could argue that while foreign exchange reserve accumulation and restrictions to capital inflows made sense in attempting to avert a rapid appreciation of the peso, an exchange rate band so frequently amended was an increasingly weak instrument.
However, the dominant view within the government well until 1999 was that a crawling exchange rate band, no matter how amended and discredited, was instrumental to signal a long term commitment to a certain value of the real exchange rate. And, this line of argument follows, this commitment was key to keep the steam in the exports sector, the “engine of growth” in a small open economy.
II.2 The 1997-98 World Turbulence and the Reform of Macroeconomic Policies: