Real Exchange Rate Fluctuations: Reflections on the Uruguayan Experience Umberto Della Mea *

1. Real Exchange Rate Fluctuations: Reflections on the Uruguayan Experience Umberto Della Mea* Economic Policy Division Central Bank of Uruguay Outline • Some simple facts about real exchange rate fluctuations in a dollarized, multi-rest-of-the-world economy. • What to do? • Addendum: about the effect of real exchange rate fluctuations on fiscal solvency * The views here expressed are those of the author and do not necessarily represent those of the Central Bank of Uruguay.

2. Whither rest-of-the-world? 185%

3. A winner’scurse?: the real exchange rateas a transmission mechanism… … between the capital and the current account: strong RER appreciations seem mostly explained by capital inflows. Sudden-stops and sudden-starts (not offset by similar changes in international reserves) are usually behind sharp changes in trends.

4. Who's afraid of dollarization?: the procyclical role of the banking sector Liabilities dollarization (currently 92%) introduces positive balance-sheet effects: non performing assets and banks solvency improve in periods of growth, boosting confidence in the banking system, fueling capital inflows (including repatriations) and further appreciating the real exchange rate.

5. Who's afraid of dollarization?: the procyclical role of the banking sector (cont.) Return on assets improve with the real exchange rate, further encouraging credit risk taking and more agressive credit policies which feed back real exchange rate appreciation through capital inflows and domestic expenditure.

6. The original sin in reverse… • Governments in emerging economies often need to issue foreign currency debt (original sin), even in domestic markets (original super-sin). • Real exchange rate appreciations improve fiscal solvency through Debt/GDP and Interest/Revenues reduction.

7. … and the spillover towards the private sector Sovereign credit quality is normally a ceiling for private credit quality. An improval in fiscal accounts may also trigger more investment and private capital flights.

8. Digression: monetary policy and inflation targeting under RER pressure by 21%  minimum CPI inflation consistent with 13% Likely monetary policy constraint: “achieve inflation target s.t. N0”

9. What to do? The basic approach • Productivity differentials, changes in preferences technology, changes in public sector expenditure and shocks in the terms of tradedon’t seem enough to understand massive changes in this variable. Sudden-stops and sudden-starts in capital movements seem good candidates, instead. • What to do, then? The usual candidates are: • Curbing the boom-bust cycle by modifying capital and reserve requirementsto the banks: might generate problems if they are regarded as (1) a change in the rules, in the upside or (2) a regulatory subsidy, in the downside. • Countercyclical provisions: the advantage of having contingent rules to the state of the nature. • Capital controls: ¿…? • Fiscal flexibility: always welcome. • Sterilized FX interventions? Efficiency under discussion. • Unsterilized FX interventions? Inflation risks.

10. The unlikely usefulness of nominal exchange rate policies Nominal and real FX move in opposite directions (61% of total cases)

11. Addendum: real exchange rate and fiscal solvency: stock vs flow approaches The stock approach, when public debt is foreign currency denominated The standard exercise of fiscal solvency à la Blanchard is based on the analysis of the Debt/GDP (D/Y) ratio under a set of assumptions concerning: the primary fiscal surplus (PFS), the interest rate (i*), the rate of growth (), the international tradable inflation (t*) and the evolution of the RER (q) weighted by the share of tradables in the GDP deflator ():

12. Addendum: real exchange rate and fiscal solvency: stock vs flow approaches The flow approach The fiscal deficit at constant prices depends on the real evolution of revenues and expenditures, but also on the evolution of the terms of trade of the government: where: If Tradables weigh more in the revenues basket (T) than in expenditures (G), -eg, because taxes are more based on consumption goods while expenditures are more concentrated in nontradables (e.g, wages and pensions), then a real depreciation improves the fiscal accounts.

13. Addendum: real exchange rate and fiscal solvency: stock vs flow approaches Fiscal impact of a % change in RER, Uruguay 1991-2004 (preliminary) The RER is highly correlated with the government’s terms of exchange: an increase in PT over PN increases the domestic purchasing power of tax revenues This correlation sustained a significant improvement in the fiscal flows in 2002, measured at constant prices. But during appreciations, it is countercyclical and mitigates the stock effect!

14. Addendum: real exchange rate and fiscal solvency: stock vs flow approaches Decomposition of changes in the fiscal deficit (preliminary)