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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 100% 200 90% 180 80% 2000=100 160 70% 185% 140 60% 50% 120 40% 100 30% 80 20% 60 10% 40 0% Global Ene-06 Oct-05 Jul-05 Abr-05 % Rest of the World Rest of the World Ene-05 Oct-04 Jul-04 Abr-04 Ene-04 Oct-03 Jul-03 Abr-03 Ene-03 Oct-02 % Brazil Brasil Jul-02 Abr-02 Ene-02 Oct-01 Jul-01 Abr-01 Ene-01 Oct-00 Jul-00 Abr-00 Ene-00 % Argentina Argentina A winner’s curse?: the real exchange rate as a transmission mechanism… … between the capital and the current account: strong RER appreciations seem mostly explained by capital inflows. Sudden-stops and sudden-starts (not offset by similar changes in international reserves) are usually behind sharp changes in trends. -21% -18% -15% -12% -9% -6% -3% 0% 3% 6% 9% 12% 15% 190 170 150 130 110 90 2005 2004 2003 2002 2001 2000 Net Capital Outflows (right scale) RER (extra regional) % of GDP RER Base 2000=100 210 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 200 55 RER Base 2000=100 180 45 40 160 35 140 30 25 120 20 100 15 2005 2004 2003 2002 2001 2000 Non Performing Loans RER (extra regional) Non Performing Loans (in %) 50 Who's afraid of dollarization?: the procyclical role of the banking sector (cont.) 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. Private Banking System 5 0 180 -5 160 -10 140 -15 -20 120 -25 100 -30 2005 2004 2003 2002 2001 2000 Return on Assets RER (extra regional) Return on Assets (in %) RER Base 2000=100 200 The original sin in reverse… • 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. 200 110 20 180 17 160 14 140 11 120 8 100 5 90 80 160 70 140 60 50 120 RER Base 2000=100 180 Debt/GDP (in %) RER Base 2000=100 100 40 100 30 2005 Interest payments/Govt revenues 2004 2003 2002 2001 2000 RER (extra regional) 2005 2004 2003 2002 2001 2000 Debt/GDP Interest/Revenues (in %) 200 RER (extra regional) … and the spillover towards the private sector 210 3000 190 2500 170 2000 150 1500 130 1000 110 500 90 0 2005 2004 2003 2002 2001 2000 Sovereign Spread RER (extra regional) BPS over UST RER Base 2000=100 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. Digression: monetary policy and inflation targeting under RER pressure PT by 21% minimum CPI inflation consistent with N 0 13% PN 40% 35% 30% Likely monetary policy constraint: “achieve inflation target s.t. N0” 25% 20% 15% 10% 5% 0% -5% Nov-05 Non tradables Sep-05 Jul-05 May-05 Mar-05 Ene-05 Nov-04 Sep-04 Tradables Jul-04 May-04 Mar-04 Ene-04 Nov-03 Sep-03 Jul-03 May-03 Mar-03 Ene-03 Nov-02 Sep-02 Jul-02 May-02 Mar-02 Ene-02 CPI, 12 rolling months What to do? The basic approach • 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: 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 160% Nominal and real FX move in opposite directions (61% of total cases) 140% 120% 100% 80% 60% 40% 20% 0% -20% 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981 1980 1979 1978 Avg nominal depreciation/devaluation Avg real depreciation/devaluation Addendum: real exchange rate and fiscal solvency: stock vs flow approaches 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 (): D d Y dt PFS 1 i * Y 1 *t 1 q 1 D Y 1 . Addendum: real exchange rate and fiscal solvency: stock vs flow approaches The flow approach The fiscal deficit at constant prices FD depends on the real evolution of revenues and expenditures, but also on the evolution of the terms of trade of the government: IPT d IPG d FD d G T 0 ... 1 dt dt dt GOVT ' REAL EFFECT ON G & T TERMS OF EXCHANGE EFFECT d where: IPT IPG dq T G q T G 1 0 T G 0 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. Addendum: real exchange rate and fiscal solvency: stock vs flow approaches Fiscal impact of a % change in RER, Uruguay 1991-2004 (preliminary) The RER is highly correlated with government’s terms of exchange: increase in PT over PN increases domestic purchasing power of revenues 120 110 100 90 80 70 60 50 105 100 95 90 phi q RER defined as q=PT/PN vs TE (phi=PR/PE) 85 80 2003 2001 1999 1997 1995 1993 1991 q phi TE effect as a % of real revenues, as a function of % changes in RER (q=PT/PN) 40% 20% 0% -20% -40% -60% -80% 40% 30% % changes in RER 20% 10% 0% -10% -20% -30% 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! the an the tax Addendum: real exchange rate and fiscal solvency: stock vs flow approaches Decomposition of changes in the fiscal deficit (preliminary) 6000 180 4000 160 150 2000 140 0 130 120 -2000 110 100 -4000 90 -6000 80 2004 2003 2002 2001 2000 1999 Quantum effect Other Terms of Exchange Effect RER (extra region, right scale) RER Base 2000=100 millions of UYP, 1991 prices 170