Latin America and the New Misalignment Politics

On June 13, U.S. Senators Baucus, Grassley, Schumer, and Graham introduced the Currency Exchange Rate Oversight Reform Act of 2007. The Act would require the Treasury to identify twice a year those countries whose currencies are “fundamentally misaligned”, of which a few ones would be given priority status if misalignment is deemed to be “caused by clear policy actions by the relevant government”. Such “priority” countries would be potentially subject to a variety of sanctions.

 

On June 18, Rodrigo de Rato announced a “major revision” of the IMF’s framework for the surveillance of exchange rate policies. The revision is to provide “clear guidance to our members on how they should run their exchange rate policies, on what is acceptable to the international community, and what is not”. And its key provision is that surveillance will add a new principle to the existing ones regarding the acceptability of foreign exchange intervention: “A member should avoid exchange rate policies that result in external instability”. And apparently the IMF, too, would chastise the bad boys. According to Reuters, “the IMF might be prompted to summon an individual country for talks if its policies are seen overstepping the rules”.

 

These two obviously related policy moves have been widely assumed (correctly, in all likelihood) to be directed at China. But I cannot help but imagine the long line of central bankers that would have to be summoned for a mea culpa in Washington, including several Latin ones.

 

For instance, Colombia’s central bank, Banco de la Republica, bought US$ 4.9 billion between January and May this year, as a result of which its net foreign reserves increased by almost a third. As to whether this is a “clear policy action” to keep the Colombian peso at an artificially undervalued level, one could note that the Banco de la Republica’s foreign exchange purchases have occurred simultaneously with interest rate increases aimed at preventing overheating.

 

Similarly, Peru’s Banco Central de Reserva purchased US$ 8.7 billion between July 2006 and May 2007, also increasing its international reserves by about a third. According to the Banco’s latest Inflation Report, the purchases are needed in case of “eventual negative external shocks in the future “. But if so the Banco’s degree of risk aversion must be clinically high, given current world perspectives and the fact that the Banco’s international reserves are already sufficient not only to purchase the monetary base five times over but also almost the total liquidity of the banking system.

 

The cases of Colombia and Peru are particularly interesting as tests of the new Treasury and IMF measures because they are performing exceptionally well. Moreover, they are both on the verge (we hope) of signing a free trade agreement with the United States, and their credit ratings are being considered  for upgrades to investment status. So they could argue that their monetary policies have served them well, in spite of substantial foreign exchange intervention and strategic manipulation of the exchange rate. Yet they emerge as clear candidates for public embarrassment by the new surveillance policies of the Treasury and the IMF.

 

This is all to say that the devil of those new policies will be in the details, such as defining what exactly constitutes misalignment, or whose external instability exchange rate policies should be concerned with. Unfortunately, or perhaps fortunately, we economists can disagree forever about those details.

7 Responses to "Latin America and the New Misalignment Politics"

  1. Anonymous   June 22, 2007 at 2:52 pm

    How about Brazil adding at least $10 bn a month to thier reserves so far this year. At least the BCB have let the real appreciate a lot against the dollar this year.

  2. JSP   June 22, 2007 at 4:59 pm

    Very interesting post. If in Peru “…the Banco’s international reserves are already sufficient not only to purchase the monetary base five times over but also almost the total liquidity of the banking system.”, then maybe Peru should consider outright dollarization of the economy; ie letting the US dollar become the legal tender of the country. As in the case of Ecuador and of El Salvador

  3. Nouriel   June 23, 2007 at 9:19 am

    Roberto, interesting piece. You are right that the new legislation regarding misaligned currencies could be used against some Latin countries. Still, the degree of fx reserve accumulation in Latam is much smaller than in Asia and China (in the latter now reserves are up to $1.4 trillion and rising at a $40 billion a month pace). At RGE Brad Setser and Vitoria Saddi wrote recently a paper asking the question of whether the fx reserve accumulation in the Latam region means that these countries have joined the BW2 regime of fixed rates in Asia (see http://www.rgemonitor.com/redir.php?sid=1&tgid=10000&cid=138313). Their answer is no: most of the reserve accumulation in Latin was still – until recently – aimed at building a war chest of reserves to avoid liquidity runs rather than an aggressive attempt to prevent a currency appreciation from occurring. Still at some point in the future such reserve accumulation could be taken as a sign of “manipulation” by the Treasury or the IMF…

  4. Anonymous   June 23, 2007 at 9:34 am

    One Continent, One Currency? Varieties of Common Currency Experience in Europe and Latin America William Miles Abstract   Currency unions have been promoted as a means to increase trade, investment and growth. A crucial issue in giving up the domestic currency is the loss of a mechanism to absorb real external shocks. High real exchange volatility between countries considering such a policy would suggest that a currency union could be quite costly in terms of large, persistent misalignment and thus balance of payments imbalances. Von Hagen and Neumann (1994) assessed the readiness of nine European countries for Euro-zone membership by examining real exchange rate variability. In this paper we analyze their predictions, and find them to be quite accurate for Europe. All of the nations which appeared ready for the Euro have joined. Of the three which did not appear prepared, two have retained their own currency, and the third has experienced real appreciation and stagnant exports.   Given the prescience of this method, we apply it to nine Latin American nations. A number of countries in this region have begun to form a currency union by unilaterally adopting the U.S. dollar. The Von Hagen-Neumann method finds very high real exchange rate variability between the U.S. and the Latin American nations-indeed much higher than that between Germany and the countries which would later adopt the Euro-so adopting the dollar could cause very painful adjustment in Latin America.  Copyright © 2006 Blackwell Publishing Ltd.. http://www.blackwell-synergy.com/links/doi/10.1111/j.1467-6435.2006.00339.x/enhancedabs

  5. bsetser   June 23, 2007 at 10:06 am

    Nouriel — my answer to the question of has Latin america joined BW2 has changed since vitoria and i wrote that paper.   Brazil’s reserves were about 1/2 their current level then — and while Brazil didn’t then meet some core tests for reserve adequacy (10% of GDP seems to be a good rule of thumb), it now does, with room to spare. Brazil, Argentina, Colombia and Peru are now all adding to their reserves very, very rapidly — and now all have reserves that are in excess of most measures of reserve adequacy (tho they are not as over-reserved, generally speaking, as most aSian economies/ russia).   Most have allowed a bit more appreciation than say China, but I still would now say they have joined BW2 (score one for Dooley and Garber). The key question is whether or not they are likely to continue to remain a part of BW2, as most face higher sterilization costs than the typical asian emerging economy.

  6. JSP   June 23, 2007 at 11:24 am

    “The Von Hagen-Neumann method finds very high real exchange rate variability between the U.S. and the Latin American nations-indeed much higher than that between Germany and the countries which would later adopt the Euro-so adopting the dollar could cause very painful adjustment in Latin America.”  It seems to me that the framework for the operation of the Euro currency is the Euro zone Common Market: with free movement of capital, free trade, and free movement of people (labor). I think the same needs to be done for a “dollar zone” between USA and Latin America. A Common Market would need to be created: free movement of capital, free trade, and free movement of labor. The US Federal Reserve could become the Central Bank for the both USA and Western Hemisphere; much like the European Central Bank operates for the Euro zone. I think that over the next 50 years (and because of strong competition with Euro zone and ACU zone) strong movement will occur in this Common Market direction. After all, USA is already a “melting pot” of cultures, and; the illegal immigration problem reflects the “movement of labor”. Obviously, common goals; the creation of common institutions at the regional level and political will are key. I think these Common Market measures would go a long way to minimize “very painful adjustment in Latin America.” from Dollarization. If “Brazil, Argentina, Colombia and Peru are now all adding to their reserves very, very rapidly — and now all have reserves that are in excess of most measures of reserve adequacy” then Central Bank reserves should cover the monetary base of each of the mentioned countries, more than enough to proceed with Dollarization.

  7. Roberto Chang   June 25, 2007 at 9:08 am

    Thank you everyone for the thoughtful comments. Nouriel, I have to agree with Brad Setser in that the magnitude of reserves accumulation in 2007 goes, in Brazil, Colombia, Peru and others, well beyond the need for building a war chest against sudden stops. As you say, the absolute amounts involved are quite small compared with the Asian ones. Yet, depending on how exactly the IMF and Treasury initiatives are crafted, we need to worry that the Latin countries may become collateral damage to an effort primarily aimed at China’s policies.   As for dollarization in Peru and maybe other countries, at this point I do not see either the need nor the benefits to pursue that reform. Instead I can see many obstacles and costs to the schemes cited in the comments. For example, would dollarizing countries have representation, not to say voting rights, at the FOMC?