Should Latin America economies coordinate their exchange rates together?

Latin America has a long history of attempts to achieve regional integration, yet, success has been modest. The only experience that may be credited a certain success is the Mercosur (Common Market of the South Cone), but it is limited. The goal of common currency seems to many too demanding and thus far away. The exchange rate arrangements in most LA economies, after long history of divergences, the economies converged into allowing their exchange rates to float. How suitable would be the adoption of exchange rate fluctuation bands and also a step forward towards common currency in the region?

There have been a wide variety of experiences with exchange rate regimes throughout Latin America since the ‘80s. The spectrum goes from adoption of “hard pegs” (currency board, dollarization), to experiences with fixed, but adjustable, exchange rates or sliding bands, with these “soft pegs” ending up being superseded by regimes with more flexible nominal adjustments of the exchange rate.

The most common sequence begun with the adoption, at some moment, of either exchange rate “soft pegs” (fixed-but-adjustable rates, crawling bands) or “hard pegs” as a basis for inflation stabilization programs. Given residual rates of inflation – mostly from prices of non-traded goods and services – usually some overvaluation of local currencies took place. Loss of trade competitiveness and “domestic growth bubbles” (derived from consumption booms) often led to current-account deficits in the balance of payments, easily sustained by abundant capital flows to emerging markets in the first half of the ‘90s. Simultaneously, an excessive “dollarization of liabilities” tended to occur (both as unit-of-account and as means of payment), as well as a corresponding currency (and often maturity) mismatch in portfolios, given declining perceived exchange-rate risks.

After a “sudden stop” and reversal of capital flows, triggering a “twin” (private or public sector) financial and balance-of-payments crisis, “soft pegs” were replaced by exchange rate fluctuation, usually going through some intermediary period of overshooting of the local currency devaluation. Chile had the smoothest recent experience of change, with a band being replaced by a floating regime. In turn, Argentina’s currency board was maintained during Mexico´s and Brazil´s exchange-rate regime upheavals, but it turns out to be no longer sustainable and Argentina went into turmoil in the beginning of the 2000s. Since that, Argentinean Peso experiences a huge real and nominal over depreciation, meanwhile, Brazilian Real suffer from high volatility and over appreciation.

The balance of advantages and disadvantages of each exchange rate regime can be translated into Robert Mundell´s criteria for an Optimum Currency Area (OCA), as adapted by textbook discussions about the convenience of tying local currencies versus letting them float. As the degree of economic integration with the rest of the world increases, advantages of fixed exchange rates increase with it, whereas advantages of flexible exchange rates tend to fall. This happens because of: larger potential gains in terms of lower transaction costs and currency risks; higher inflationary credibility and heavier weight of nominal anchor via hard pegs; and lower losses derived from the loss of monetary policy.

The main drawback in the conventional wisdom such is the fact that the adoption of common currency in a region depends only on the benefits and costs analysis and it can be conflicting.

The only conclusion of many works about desirability and suitability of a common currency in Latin American economies is that it is remarkably undesirable. There is no sufficient degree of economic integration, neither trade or financial, even their business cycles are no coordinated intra-region. They are economies contaminated far more to international (out-of-region) financial and economic shocks. Generally, they come out with comprehensive data to show that European Zone has higher level of economic integration; although they are current data and it is well-known that Euro Zone was less integrated than now.

Yet, according to the conventional economic literature Latin American economies had only two important choices in the matter of currency arrangement. They could dollarized specially because they are small economy with weak institutional record (such and Ecuador, Panama, and El Salvador) so that small and troublemakers should be addicted to the Dollar, bringing to into the credibility of the North America monetary policies. Dollarization would work as a kind of shortcut to get good institutions sooner. Taking over the dollar as their mean of payment they also import the monetary stability provided by the US Federal Reserve. Otherwise, the bigger ones like Brazil and Argentina should combine flexible exchange rates cum inflation targeting regimes. Fluctuations would indicate the redemption to the fear of floating.

Many specialists in International Finance actually recognize that monetary union provides benefits after its adoption. Surprisingly dollarization, or similar monetary strategy, had an advantage to encourage greater economic integration with the United Stated, even to a country weakly economic integration with the America, like Argentina in the beginning of the ‘90s. We simply do not understand why this couldn’t be an advantage of exchange rate coordination in the LA region, but only with the US. According to the OCA theory countries only would think about common currency if they showed high level of economic integration; however, there is reason to believe that exchange rate coordination and a step forward with common currency could encourage economic integration inside the region.

It wouldn’t be also expected exchange rates throughout economies in the region already aligned to propose such coordination, even a common currency. European Union can testify how wide was the constellation of the parities of local currency against the US Dollar. As a benchmark, European Union was built under those conflicts. Also some economies were relatively open (for example, in Belgium in the ´80s the openness ratio was by 70%), other ones do not (for example, Germany’s ratio was about 25%). Most economies allow the free movement of capital among member states aftermath the stability of the exchange rate. Actually, the stability of the exchange rate encourages the member states to press forward.

It seems that the conventional wisdom foresees criteria to get an optimum monetary union, but the practice indicates that when stable exchange rates are reached member states are encouraged to step forward in eliminating several kinds of trade and financial restrictions.

5 Responses to "Should Latin America economies coordinate their exchange rates together?"

  1. Flavio Vieira   October 2, 2007 at 9:41 am

    Dear Marcio, congratulations on your article regarding whether or not Latin American economies should coordinate their exchange rates. It is a relevant discussion and I am please to have a chance to read it. Keep working the way you have done lately. Take care. Flavio Vieira

  2. Antonio Marcio Buainain   October 2, 2007 at 11:51 am

    Marcio, Your piece is excellent. Please let me know everytime you post something such that we can take a look and learn always something new. Tuca

  3. Vitoria Saddi   October 2, 2007 at 12:04 pm

    Marcio, Your piece is very good. Here are my questions: 1) In Europe people are still questioning if the Euro is worth (in terms of a single currency). Don’t you think that it is too soon to think in a single currency for Latin America? 2) Are the pros greater than the cons such that a single Latino currency would be adopted by all the countries? 3) Who would lead the process? Brazil? Who would benefit from the process? Bolivia? When Germany led the EMU it had a stable economy, different from Brazil. But we do have think about these issues and this is why you have a great piece. Vitoria

  4. Guilherme Lichand   October 2, 2007 at 2:58 pm

    Professor Holland,   well-made point concerning the precedence of exchange-rate alignment among countries of a prospective Currency Area. I am especially worried about the hypothesis that LA countries’ monetary efficiency gains would supersede the losses derived from losing it’s monetary policy autonomy and being blocked from exercising the position of banker of last resort.   First, monetary policy of a country in a Currency Area loses room for accommodating shocks that hit particularly its economy, what could be regarded as a severe penalty for countries with not yet solid macroeconomic foundations. Second, it is well known that countries may go through speculative attacks while adjusting to the fixed exchange rate settled by the Union, what would be costly in terms of international reserves and especially when concerning structurally fragile balance of payments equilibria.  On the other hand, the gains from having its policy pegged to the other members might not payoff as it does when one addopts a currency board or dollarizes, as moderate levels of inflation and macroeconomic imbalances are still commonplace in LA. Also, it’s institutions are definitively not among the best rated ones in World Bank surveys.  Summing up, the gains and losses from integrating into a Currency Area need further investigation, and it’s an interesting research agenda.  Guilherme Lichand

  5. Mick Rolland   October 4, 2007 at 5:18 am

    Fascinating topic, and good points made by Mr. Lichand, definitely to take into account.   I tend to agree with Professor Holland in that a currency union would bring sizeable benefits to Latin America. The loss of monetary policy can sometimes be a problem if that means not being able to adjust to an assymetric shock, but it is also the welcome loss of a temptation to finance the public sector through the central bank -all too common in Latin America. Given the poor monetary policy record of Latin American monetary authorities, the choice seems clear, unless the policy of the Latin American Currency Union follows the same patterns as past national policies.   I think that the biggest obstacle to monetary integration in the region is the frequency of policy swings and the political polarization that seeds distrust among countries. In this context, it is difficult to integrate, but the regional integration may soften policy stances, introducing checks and balances.   There are interesting examples of currency unions for countries with much poorer institutional frameworks in Africa (the CEMAC) and the Caribbean. Latin America could do it, but the real challenge would be what a central bank’s mandate should be. In the present political situation, a competition of currency unions with different mandates seems to be the only viable way. Still, it would also encounter major difficulties, as commercial integration in the region has shown.