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Office of the Chief Economist Latin America & the Caribbean Region The World Bank Exchange Rate Policies:leaning against the wind in good times? Guillermo Perry, Cesar Calderón Presented at the XXV Meeting of the Latin American Network of Chief Economists of Central Banks and Finance Ministers IADB, May 2007
This presentation • The Context and Stylized Facts: • LAC REER appreciation is very recent (2004 onwards). REER still more depreciated than in 1997 (not 1990). However, EA, India and China REER have depreciated more since 1990 • Recent contributions to the literature • REER and Export Performance • How much floating? • Fear of floating and financial dollarization
1. REER LAC and others 1990-2007 Note: An increase (decrease) in the real effective exchange rate implies a real appreciation (depreciation) of the domestic currency.Source: IMF – International Financial Statistics.
2. Recent literature contributions • Levy-Yeyati and Sturzenegger (2001): floaters grow better then pegs • Aghion et al (2006): ER volatility bad for growth in countries with low financial deepening (financially constrained firms) • Levy-Yeyati and Sturzenegger (2007): interventions against appreciation trends seem good for growth: • Not through exports • But through higher Investment, Savings • Rodrik (2006): Overvalued REER as a growth strategy • Levy-Yeyati and Ize (2003): ER/IR volatility reduces financial dollarization • De la Torre and Schmukler (2007): floating is good for domestic capital markets development (bonds in domestic currencies)
Stronger primary balances and intervention in foreign exchange markets tend to be associated with a real exchange rate depreciation. A one percent increase in GG primary balance would lead to a real depreciation of 1.7% A one percent increase in intervention (buying foreign currency) is associated with a 0.2% real depreciation. 3. Real Exchange Determination:Role of fiscal balances and interventions
4. Ratio of Exchange rate to Interest Rate Volatility (2-Year) Note: We compute the ratio of the nominal exchange rate volatility to the nominal interest rate volatility. Source: IMF – International Financial Statistics.
4. Ratio of Exchange rate to Interest Rate Volatility (3-Year) Note: We compute the ratio of the nominal exchange rate volatility to the nominal interest rate volatility. Source: IMF – International Financial Statistics.
5. “Fear of floating” leads to increasing degrees of dollarization
Conclusions • Leaning against the wind in booms would appear to help export volumes and diversification. • It may also help investment in credit constrained economies. • But, counter cyclical fiscal policies seem to be more potent than Central Bank interventions. • And, excessively limiting REER volatility may reinforce financial dollarization and hence weaken domestic capital markets development and leave economies more vulnerable to Sudden Stops.