highlevel regional seminar oon inflation targeting … · 2007-05-29 · latin american central...

LATIN AMERICAN CENTRAL BANK REFORM:

PROGRESS AND CHALLENGES

Mr. Carstens

Presented at the High-Level Regional Seminar on Inflation Targeting Hosted by the International Monetary Fund and Bank Al-Maghrib Rabat, Morocco─April 4, 2007

The views expressed in this paper are those of the author(s) only, and the presence of them, or of links to them, on the IMF website does not imply that the IMF, its Executive Board, or its management endorses or shares the views expressed in the paper.

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1

SECRETARÍA DE HACIENDA

Y CRÉDITO PÚBLICO

Latin American Central

Bank Reform: Progress and

Challenges

March 2007

2

Organization

I. Introduction

II. New Institutional Framework for Monetary Policy

III. Central Bank Independence (CBI) Index

IV. CBI and Macroeconomic Trends

V. Remaining Challenges

VI. Concluding Remarks

3

Introduction

In Latin America 1990 was characterized by

– unprecedented high inflation (500% on average)

– the end of a 10-year period of stagnation on per capita GDP (-0.1% on average).

Governments faced the need to tackle inflation and made structural changes aimed at laying the foundations for a rebound in economic growth.

Central bank reform became a key component of the new economic agenda in most Latin American countries.

The objective of the reform was to restore confidence in monetary policy to fight inflation.

4

In the 1990’s, the legislation governing Latin America’s central banks was reformed, based on four main pillars.

1. Defining a clear mandate for central banks’ to ensure price stability

2. Giving central banks political independence to design monetary policy

New Institutional Framework for Monetary Policy

Price stability plus other objectives, with no indication of priority Price stability as the sole or primary objective Operation of the payment

system Stability of the financial

system Growth or economic

development Argentina, Bolivia, Colombia, Costa Rica, Dominican Republic, Mexico, Peru, Venezuela

Chile, Honduras, Nicaragua Guatemala, Paraguay, Uruguay

Brazil

5

The reform was based on four main pillars…

3. Granting operational independence to perform monetary policy

Central banks have freedom to formulate and execute monetary policy.

They are severely restricted of financing public expenditure.

Operational independence is sometimes undermined as a result of central banks’ quasi-fiscal losses.

4. Making central banks accountable

Governors are required to appear before the legislature to report on the performance of the central bank.

Central banks publish its monetary program and inflation report.

New Institutional Framework for Monetary Policy

6

An Index of Central Bank Independence was estimated based on the provisions contained in the central bank legislation.

The index of CBI measures de jure, and not de facto,independence.

The index is built on five aspects of central bank independence, which are assigned different weights:

1. Political independence (20%).

2. Central bank’s mandate (15%).

3. Autonomy in the formulation of monetary policy (15%).

4. Restrictions in lending provisions to the government and to commercial banks, as well as financial independence (40%).

5. Accountability requirements (10%).

The resulting value of the CBI gives a score between zero and one.

Central Bank Independence Index

7

Latin American central banks are more independent today than they were in 1990. The degree of independence varies from one country to another.

After the reforms the average index of CBI increased from 0.427 to 0.774.

Countries that currently have a CBI Index of over 0.80: Peru, Chile, Colombia, Bolivia, Mexico and the Dominican Republic.

Countries that currently have a CBI Index in the range of 0.64 and 0.79: Argentina, Venezuela, Costa Rica, Nicaragua, Paraguay, Guatemala, Honduras, Uruguay and Brazil.

The difference between countries is found primarily in terms of political independence.

Central Bank Independence Index

8

Even though inflation has been reduced in most Latin American countries, there are still some macroeconomic challenges.

Legal Central Bank Independence and Macroeconomic Trends

Per capita real GDP growth(%,moving average t=10)

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

1989

1992

1995

1998

2001

2004

2007

Inflation(%,moving average t=10)

Fiscal Balance / GDP(%,moving average t=5)

0.0

100.0

200.0

300.0

400.0

500.0

600.0

1989

1992

1995

1998

2001

2004

2007

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1989

1992

1995

1998

2001

2004

2007

9

CBI is statistically significant in explaining inflation performance between 1990 and 2002 for the Latin American and Caribbean economies.

Legal Central Bank Independence and Macroeconomic Trends

CBI and Inflation in Latin America(Before and after the reform of central banks)

0

20

40

60

0.2 0.4 0.6 0.8 1

CBI

Aver

age

annu

al r

ate

of in

flatio

n

CBI and Fiscal Deficit in Latin America(Before and after the reform of central banks)

-12

-8

-4

0

40.2 0.4 0.6 0.8 1

CBI

NFP

S ba

lanc

e / G

DP

Source: Jácome and Vázquez (2005) and IMF, IFS.

Source: IMF, IFS and Western Hemisphere Department

10

The reform of central bank legislation in Latin America contributed to the change in the monetary policy regime and the operating framework observed in most countries.

Changes in the Policy Regime and Operating Framework of Monetary Policy

Most central banks increasingly migrated from exchange rate pegs towards exchange rate flexibility.

A number of central banks adopted an inflation targeting (IT) strategy as a way of anchoring inflation expectations.

Central banks modernized their operating framework for monetary policy, shifting from money base control to an alternative regime where the central bank uses a short-run interest rate as an operational variable.

11

Despite the successes in defeating inflation, central banks in Latin America still face important challenges.

Challenges facing Latin America’s Central Banks

1. Achieve price stability

2. Restore confidence in domestic currencies

3. The need to cope with capital inflows while maintaining

policy consistency

4. The perils of financial system weaknesses and the lack

of fiscal discipline

12

1. Achieve Price StabilityChallenges facing Latin America’s Central Banks

While inflation in Latin America has already declined to single digits, in most countries it has not converged yet to the world inflation.

Further reducing inflation will be increasingly difficult because of its potential adverse effects in output.

Central banks may face opposition to tight monetary policies.

012345678

<4% 4% - 8% 8% - 10% >10%Annual rate of inflation (period average)

Num

ber o

f cou

ntrie

s

BoliviaChile

El SalvadorPanamá

Perú

BrasilColombiaEcuadorMexico

GuatemalaHondurasNicaragua

ParaguayUruguay

ArgentinaCosta Rica

Dominican RepublicVenezuela

Average Inflation in Latin America(2002-2007)

13

40

60

80

100

Africa Asia andthe

Pacific

Europe MiddleEast andCentralAsia

LatinAmerica

Per

cent

age

of fu

lly +

bro

adly

obs

erve

d(F

rom

tota

l crit

eria

)


Implementing a more efficient monetary policy hinges not only oncentral banks’ ability to conduct monetary policy, but also on making central banks’ policy more transparent and predictable.

While central banks in the region have already enhanced accountability and transparency standards, there is still room for improvement.

Transparency of Monetary Policy(Latin America versus other regions)

14


The high rate of turnover of central bank governors in a number of Latin American countries suggests that monetary authorities remain vulnerable to political pressures an to periods of political instability.

Turnover rate of central bank governors

Bolivia

ChileColombia

Costa Rica

EcuadorEl Salvador

Guatemala Honduras

NicaraguaParaguay

UruguayVenezuela

ArgentinaBrazil

Mexico

Peru

Dominican R.

0.0 0.2 0.4 0.6 0.8 1.0 1.2Turnover Rate

15

2. Restore Confidence in Domestic CurrenciesChallenges facing Latin America’s Central Banks

Two groups of countries facing lack of confidence in national currencies:

a. Countries with pegged currencies to the US dollar. The use of an exchange rate anchor has helped to bring down inflation but this policy regime bears costs and vulnerabilities

o The lack of a rapid and low-cost exit strategy from the exchange rate peg.

o The limitation for conducting monetary policy, and hence developing the necessary skills and institutional credibility.

The central banks of this group need to assess whether it is wise to continue with the current monetary regime or to shift to an alternative scheme.

16


b. Countries that have not recovered their monetary independence following past episodes of high inflation and/or financial instability.

o The years of macroeconomic instability are still alive in the market participants' mind. As a result, distortions endure: a high level of financial dollarization and the “peso problem”.

BOLIVIA

0.6

0.7

0.8

0.9

1.0

1990 1993 1996 1999 2002 2005

Dol

lar d

epos

its

0

5

10

15

20

25

Infla

tion

rate

Dollar deposits / total depositsInflation

PERU

0.4

0.5

0.6

0.7

0.8

0.9

1.0

1990 1993 1996 1999 2002 2005

Dol

lar d

epos

its

0

10

20

30

40

Infla

tion

rate


Financial Dollarization and InflationURUGUAY

0.6

0.7

0.8

0.9

1.0

1990 1993 1996 1999 2002 2005

Dol

lar d

epos

its

0

20

40

60

80

100

Infla

tion

rate


17


o Correcting these distortions will take a considerable length of time and will require the support of certain government policies.

o Central banks need to persevere in consolidating their reputation.

o Strengthening prudential regulations applicable to foreign exchange transactions is crucial to reestablish an independent monetary policy.

18

3. How to Cope with Capital Inflows While Maintaining Policy Consistency


If markets are unable to anticipate and understand the decisionsof central banks, and if central banks lack a consistent policy reaction function, monetary policy will be less effective.

Following the institutional reform of central banks, policy inconsistency decreased significantly.

Inconsistencies remained in a few central banks as a result of using the exchange rate as a nominal anchor.

The recent surge of capital inflows has put additional pressure on the consistency of monetary policy.

As capital inflows soared, domestic currencies tended to appreciate, leading central banks to the dilemma of whether or not to intervene in the exchange rate market to avoid real appreciation.

19



Response to Capital InflowsSome Central Banks opted for intervention…

PERU

0

5

10

15

20

2000

M1

2001

M1

2002

M1

2003

M1

2004

M1

2005

M1

2006

M1

Nom

inal

exc

hang

e ra

te

0

5

10

15

20

Inte

rest

rate

s

NXR

Interest rates

PERU

80

90

100

110

120

2000

M1

2001

M1

2002

M1

2003

M1

2004

M1

2005

M1

2006

M1R

eal e

ffec

tive

exch

ange

ra

te

6,000

8,000

10,000

12,000

14,000

16,000

18,000

Mill

ons

of d

olla

rs

R EER

Internat io nal R eserves

COLOMBIA

1000

1500

2000

2500

3000

3500

2000

M1

2001

M1

2002

M1

2003

M1

2004

M1

2005

M1

2006

M1

Inte

rest

rate

s

0

5

10

15

20

25

Nom

inal

exc

hang

e ra

te

N XR Interest rates

COLOMBIA

80

100

120

140

160

2000

M1

2001

M1

2002

M1

2003

M1

2004

M1

2005

M1

2006

M1R

eal e

ffec

tive

exch

ange

ra

te

6,000

8,000

10,000

12,000

14,000

16,000

Mill

ons

of d

olla

rs


R EER

20



Response to Capital InflowsOthers opted for no intervention…

MEXICO

100110120130140150160

2000

M1

2001

M1

2002

M1

2003

M1

2004

M1

2005

M1

2006

M1

2007

M1R

eal e

ffec

tive

exch

ange

ra

te

30,000

50,000

70,000

90,000

110,000

Mill

ons

of d

olla

rs

R EER


MEXICO

89

1011

12131415

2000

M1

2001

M1

2002

M1

2003

M1

2004

M1

2005

M1

2006

M1

Nom

inal

exc

hang

e ra

te

0

5

10

15

20

Inte

rest

rate

s

N XRInterest rates

BRAZIL

0

1

2

3

4

2000

M1

2001

M1

2002

M1

2003

M1

2004

M1

2005

M1

2006

M1

Nom

inal

exc

hang

e ra

te

10

15

20

25

30

35

40

Inte

rest

rate

sN XR

Interest rates

BRAZIL

20

40

60

80

100

2000

M1

2001

M1

2002

M1

2003

M1

2004

M1

2005

M1

2006

M1

2007

M1Rea

l eff

ectiv

e ex

chan

ge

rate

30,000

60,000

90,000

120,000

Mill

ons

of d

olla

rsR EERInternat io nal R eserves

21



Central banks’ intervention may be damaging from an institutional standpoint.

In the long-run, central banks may not be very effective in containing the real appreciation because the real exchange rate is an endogenous variable.

The appropriate way to mitigate the effects of the real appreciation is that tradable activities increase productivity.

22

4. The perils of financial system weaknesses and the lack of fiscal discipline


Most countries have made progress in establishing appropriate framework for preventing and managing banking crisis, but more needs to be done.

The new reforms must emphasize precautionary regulations.

The role of central banks in the prevention and management of banking crisis should be clearly established in law.

After fiscal consolidation during the early 1990s, fiscal deficits have soared again in a number of countries. A tight monetary policy combined with a loose fiscal stance produces an inconsistent policy mix.

23

4. The perils of financial system weaknesses and the lack of fiscal discipline


Effects of Banking Crisis on Growth and InflationARGENTINA

-15-10

-505

1015

1990

1993

1996

1999

2002

2005

Rea

l GD

P %

gro

wth

-20.00

-10.00

0.00

10.00

20.00

Infla

tion

Rat

e %

Growth Inflation

B anking C risis

ECUADOR

-8-6-4-202468

1990

1993

1996

1999

2002

2005

Rea

l GD

P gr

owth

%

-120

-70

-20

30

80

Infla

tion

Rat

e %

Growth Inflation

B anking C r isis

DOMINICAN REPUBLIC

-4-202468

1012

1990

1993

1996

1999

2002

2005

Rea

l GD

P %

Gro

wth

-20-100102030405060

Infla

tion

rate

%

Growth Inflation

B anking C risis

MEXICO

-8-6-4-202468

1990

1993

1996

1999

2002

2005

Rea

l GD

P gr

owth

%

-50

-30

-10

10

30

50

Infla

tion

rate

%

Growth Inflation

Banking Crisis

24

Concluding Remarks…

Under the new institutional framework, monetary policy has modernized and inflation has dropped to single-digit rates in a majority of countries of the region.

Today, central banks still need to address important challenges.

Central banks will not succeed in their endeavors unless government ensure macroeconomic stability and the viability of countries.

Governments should make sure that actions speak louder than words in supporting the autonomy of central banks, demanding in exchange rigorous accountability and transparency procedures from monetary policy.

highlevel regional seminar oon inflation targeting … · 2007-05-29 · latin american central...

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