real exchange rate fluctuations: reflections on the uruguayan experience umberto della mea *

Real Exchange Rate Fluctuations:Reflections on the Uruguayan Experience

Umberto Della Mea* Economic Policy Division Central Bank of Uruguay

Outline

I. Some simple facts about real exchange rate fluctuations in a dollarized, multi-rest-of-the-world economy.

II. What to do?

III. 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.

Whither rest-of-the-world?

Real effective exchange rates and exports share

40

60

80

100

120

140

160

180

200

Ene-00

Abr-00

Jul-00O

ct-00E

ne-01A

br-01Jul-01O

ct-01E

ne-02A

br-02Jul-02O

ct-02E

ne-03A

br-03Jul-03O

ct-03E

ne-04A

br-04Jul-04O

ct-04E

ne-05A

br-05Jul-05O

ct-05E

ne-06

2000

=100

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% Argentina % Brazil % Rest of the World GlobalArgentina Brasil Rest of the World

185%

A winner’s curse?: the real exchange rate as a transmission mechanism…

90

110

130

150

170

190

210

2000

2001

2002

2003

2004

2005

RE

R B

ase

2000

=100

-21%-18%-15%-12%-9%-6%-3%0%3%6%9%12%15%

% of G

DP

Net Capital Outflows (right scale) RER (extra regional)

… between the capital and the current account: strong RER appreciations seem mostlyexplained by capital inflows. Sudden-stops and sudden-starts (not offset by similar changes in international reserves) are usually behind sharp changes in trends.

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.

Private Banking System

100

120

140

160

180

200

2000

2001

2002

2003

2004

2005

RE

R B

ase

2000

=100

15

20

25

30

35

40

45

50

55

Non P

erforming Loans (in %

)

Non Performing Loans RER (extra regional)

Private Banking System

100

120

140

160

180

200

2000

2001

2002

2003

2004

2005

RE

R B

ase

2000

=100

-30

-25

-20

-15

-10

-5

0

5

Return on A

ssets (in %)

Return on Assets RER (extra regional)

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.

Who's afraid of dollarization?: the procyclical role of the banking sector (cont.)

The original sin in reverse…

100

120

140

160

180

200

2000

2001

2002

2003

2004

2005

RER B

ase

2000

=100

30

40

50

60

70

80

90

100

110

Debt/G

DP (in %

)

Debt/GDP RER (extra regional)

• 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.

100

120

140

160

180

200

2000

2001

2002

2003

2004

2005

RER B

ase

2000

=100

5

8

11

14

17

20

Interest/Revenues (in %

)

Interest payments/Govt revenues RER (extra regional)

90

110

130

150

170

190

210

2000

2001

2002

2003

2004

2005

RE

R B

ase

2000

=100

0

500

1000

1500

2000

2500

3000B

PS

over US

T

Sovereign Spread RER (extra regional)

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.

… and the spillover towards the private sector

-5%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Ene-02

Mar-02

May-02

Jul-02

Sep-02

Nov-02

Ene-03

Mar-03

May-03

Jul-03

Sep-03

Nov-03

Ene-04

Mar-04

May-04

Jul-04

Sep-04

Nov-04

Ene-05

Mar-05

May-05

Jul-05

Sep-05

Nov-05

CPI, 12 rolling months Tradables Non tradables

Digression: monetary policy and inflation targeting under RER pressure

N

T

PP

by 21% minimum CPI inflation consistent with 13% 0N

Likely monetary policy constraint: “achieve inflation target s.t. N0”

• Productivity differentials, changes in preferences technology, changes in public sector expenditure and shocks in the terms of trade don’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:

What to do? The basic approach

Curbing the boom-bust cycle by modifying capital and reserve requirements to 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.

The unlikely usefulness of nominal exchange rate policies

Nominal and real FX move in opposite

directions (61% of total cases)

-20%

0%

20%

40%

60%

80%

100%

120%

140%

160%

1978197919801981198219831984198519861987198819891990199119921993199419951996199719981999200020012002200320042005

Avg nominal depreciation/devaluation Avg real depreciation/devaluation

Addendum: real exchange rate and fiscal solvency: stock vs flow approaches

YD

qi

YPFS

dtYDd

t

11

1

11

.

*

*

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 ():

...1

&

'

0

EFFECTEXCHANGE

OFTERMS

G

T

TGONEFFECTREALGOVT

dtIPIPd

dtTGd

dtFDd

001 GTGT

G

T

GTqdqIPIPd


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:

FD

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.

RER defined as q=PT/PN vs TE (phi=PR/PE)

5060708090

100110120

1991

1993

1995

1997

1999

2001

2003

q

80

85

90

95

100

105

phi

q phi

Fiscal impact of a % change in RER, Uruguay 1991-2004 (preliminary)

TE effect as a % of real revenues, as a function of % changes in RER (q=PT/PN)

-80%

-60%

-40%

-20%

0%

20%

40%

-30%

-20%

-10%

0% 10%

20%

30%

40%

% changes in RER

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!



-6000

-4000

-2000

0

2000

4000

6000

1999

2000

2001

2002

2003

2004

milli

ons

of U

YP

, 199

1 pr

ices

80

90

100

110

120

130

140

150

160

170

180

RE

R B

ase

2000

=100

Quantum effect Terms of Exchange EffectOther RER (extra region, right scale)

Decomposition of changes in the fiscal deficit (preliminary)

real exchange rate fluctuations: reflections on the uruguayan experience umberto della mea *

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