Caroline AtkinsonCaroline Atkinson

Deputy DirectorDeputy Director

Western Hemisphere DepartmentWestern Hemisphere Department

International Monetary FundInternational Monetary Fund

Real Exchange Rate Real Exchange Rate Appreciation in Latin Appreciation in Latin America: Causes and America: Causes and

ConsequencesConsequences April 2006April 2006

Strengthening of Latin American CurrenciesStrengthening of Latin American Currencies

Not surprisingly, papers present diverse viewsNot surprisingly, papers present diverse views

But all raise some concern about persistent real But all raise some concern about persistent real appreciation:appreciation:

• Possibly weaken export competitiveness and growthPossibly weaken export competitiveness and growth

• Could make the economy more vulnerableCould make the economy more vulnerable

2

0

25

50

75

100

125

150

175

1/90 1/93 1/96 1/99 1/02 1/05

Many currencies in the region have strengthened(Real effective exchange rate, Index: 2000=100)

Source: Information Notice System.3

70

80

90

100

110

120

130

140

1/90 1/93 1/96 1/99 1/02 1/05

ArgentinaArgentina

BrazilBrazil

ChileChile

ColombiaColombia

BRA avg., BRA avg., 1980-20051980-2005

ARG avg., ARG avg., 1980-20051980-2005

COL avg., COL avg., 1980-20051980-2005

CHL avg., CHL avg., 1980-20051980-2005

50

60

70

80

90

100

110

120

130

140

1/90 1/93 1/96 1/99 1/02 1/05

Many currencies in the region have strengthened(Real effective exchange rate, Index: 2000=100)

Source: Information Notice System.4

35

50

65

80

95

110

125

140

155

1/90 1/93 1/96 1/99 1/02 1/05

GuatemalaGuatemala

MexicoMexico

PeruPeru

UruguayUruguay

GTM avg., GTM avg., 1980-20051980-2005

MEX avg., MEX avg., 1980-20051980-2005

URY avg., URY avg., 1980-20051980-2005

PER avg., PER avg., 1980-20051980-2005

70

80

90

100

110

120

130

140

150

1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 05 2006

Argentina Brazil ChileColombia Guatemala MexicoPeru Uruguay LAC

This trend reflects better fundamentals, such as a sustained improvement in the terms of trade(Terms-of-trade, Index: 2000=100)

Source: World Economic Outlook.5

Export shares have increased...(Exports as share of world exports, Index: 2001=100)

Source: Direction of Trade Statistics.6

80

85

90

95

100

105

110

115

120

125

130

1/02 10/02 7/03 4/04 1/05 10/05

70

80

90

100

110

120

130

140

150

160

170

1/02 10/02 7/03 4/04 1/05 10/05

ArgentinaArgentina

BrazilBrazil

ColombiaColombia

ChileChile

VenezuelaVenezuela

PeruPeru

UruguayUruguay

MexicoMexico

0

5

10

15

20

25

30

35

40

1995 96 97 98 99 2000 01 02 03 04 05 2006

30

35

40

45

50

55

60

65

70

75

80

Also, domestic policies are more credible

Sources: World Economic Outlook; and IMF staff estimates and projections.7

Inflation rateInflation rate(annual percent (annual percent

change, left scale)change, left scale)Public debtPublic debt(% of GDP, (% of GDP, right scale)right scale)

Net international reserves have risen(Stock of net int’l. reserves, billions of U.S. dollars)

Source: World Economic Outlook.8

0

50

100

150

200

250

300

1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 2005

0

200

400

600

800

1000

1200

1400

1600

1800

1/98 12/98 11/99 10/00 9/01 8/02 7/03 6/04 5/05 4/06

Accordingly, markets perceive less risk(Basis points)

Sources: JP Morgan; and Datastream.9

EMBI Global LatinEMBI Global Latin

Global liquidity has also played a role Global liquidity has also played a role

Investor appetite for emerging market assets:Investor appetite for emerging market assets:

• relatively low U.S. interest rates, relatively low U.S. interest rates, • plus expectations of weaker U.S. dollarplus expectations of weaker U.S. dollar• Even global bond issues in local currencyEven global bond issues in local currency• Recent depreciation of some Latin currencies may Recent depreciation of some Latin currencies may

reflect shift in expectations about these conditions reflect shift in expectations about these conditions

Less foreign financing of fiscal deficits(Percent of GDP, 2000-05)

Source: IMF staff estimates.11

-4

-3

-2

-1

0

1

2

3

4

5

6PrivatizationDomesticForeign

ColombiaColombia GuatemalaGuatemala PeruPeru UruguayUruguay

-6

-4

-2

0

2

4

6

8

10

12

14

Argentina Brazil Chile Colombia Mexico Peru

2002 2003 2004 2005

Recently, many countries have bought NIR (Change in net int’l. reserves, billions of U.S. dollars)

Source: World Economic Outlook.12

To intervene or not to intervene?To intervene or not to intervene?

Reduce currency volatility (“disorderly markets”)Reduce currency volatility (“disorderly markets”)

• Could make sense if financial markets inefficient or Could make sense if financial markets inefficient or volatility discourages tradevolatility discourages trade

• Better solution could be to adopt reforms that make Better solution could be to adopt reforms that make markets more efficient. As Rodrigo Valdes points out, markets more efficient. As Rodrigo Valdes points out, less FX intervention gives markets an incentive to less FX intervention gives markets an incentive to develop their own hedging instruments. develop their own hedging instruments.

Medium-term misalignmentMedium-term misalignment

• Hard to justify—markets persistently wrong?Hard to justify—markets persistently wrong?

• Perhaps intervention could smooth adjustment to a Perhaps intervention could smooth adjustment to a new equilibriumnew equilibrium

13

Is foreign exchange intervention effective?Is foreign exchange intervention effective?

Potential channels of transmission:Potential channels of transmission:

• Signal future stance of monetary policySignal future stance of monetary policy

• Alter supply of foreign versus domestic assetsAlter supply of foreign versus domestic assets

• Affect microeconomic structure (“order flow”)Affect microeconomic structure (“order flow”)

14

Is foreign exchange intervention effective?Is foreign exchange intervention effective?

For industrialized countries, mixed evidenceFor industrialized countries, mixed evidence• Effects negligible, short durationEffects negligible, short duration• More successful if large and coordinatedMore successful if large and coordinated• Does not reduce volatility and often increases it Does not reduce volatility and often increases it

Dominguez (1998) and Cheung and Chinn (1999)Dominguez (1998) and Cheung and Chinn (1999)

For emerging markets, study of Mexico and For emerging markets, study of Mexico and Turkey (Guimaraes and Karacadag (2004):Turkey (Guimaraes and Karacadag (2004):• Unclear impact on exchange rateUnclear impact on exchange rate• Intervention may raise volatilityIntervention may raise volatility

15

-4

-2

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005 2006

Clear signaling: Top priority to low inflation

Sources: International Financial Statistics; EMED Database; and IMF staff estimates. 1Difference between real national policy rate and real Fed funds rate. 16

Real Interest RatesReal Interest Rates(percent per annum)(percent per annum)

Real Interest Rate SpreadsReal Interest Rate Spreads11

(percent per annum)(percent per annum)

BrazilBrazil

MexicoMexicoPeruPeru

ColombiaColombia

ChileChile

-4-20246810121416

2000 2001 2002 2003 2004 2005 2006

BrazilBrazil

MexicoMexico

PeruPeru

ChileChile ColombiaColombia

-10

0

10

20

30

40

50

1/95 12/9511/9610/97 9/98 8/99 7/00 6/01 5/02 4/03 3/04 2/05 1/06

Argentina Brazil ChileColombia Mexico Peru

Clear signaling: Inflation lower in most countries(Inflation rate, percent)

Source: World Economic Outlook.17

Concluding RemarksConcluding Remarks

Some reasons for concern about recent trendsSome reasons for concern about recent trends

Recent appreciation linked to fundamentalsRecent appreciation linked to fundamentals

Benefits from less reliance on foreign financingBenefits from less reliance on foreign financing

Case for FX intervention weakerCase for FX intervention weaker• Little evidence of effectiveness and can raise volatilityLittle evidence of effectiveness and can raise volatility• Perhaps can smooth adjustment to new equilibriumPerhaps can smooth adjustment to new equilibrium

Overall best way to support growth is keep Overall best way to support growth is keep policy signals clear, especially with regard to policy signals clear, especially with regard to inflationinflation

18