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Latin America's deceleration and the exchange rate buffer, Volume 1
Author:de la Torre, Augusto; Yeyati, Eduardo Levy; Pienknagura, Samuel; Didier, Tatiana; Schmukler, Sergio; Country:Latin America; Caribbean;
Date Stored:2013/10/16Document Date:2013/10/01
Document Type:PublicationSubTopics:Currencies and Exchange Rates; Emerging Markets; Economic Theory & Research; Economic Stabilization; Debt Markets
Region:Latin America & CaribbeanReport Number:81896
Volume No:1  

Summary: Economic and financial news in the past six months confirm that the external tailwinds that propelled economic activity in Latin America and the Caribbean (LAC) over the past decade continue to recede. The softening of Chinese growth and its implications for the terms of trade of natural resource-abundant LAC, and the seemingly inevitable normalization of monetary policy in the United States (U.S.) have moved to the center of attention for policy makers in the region. The great deceleration and intensification of volatility in capital flows and asset prices including local bond yields and currencies have sparked a wave of pessimism over the region's future. In its stronger version, this pessimistic view predicts that the ongoing deterioration of the external environment will expose the region's fragile dependence on speculative foreign finance and, as a result, the downturn will end up in macroeconomic and financial havoc that the region tended to experience in the 1990s following sudden stops and reversals in capital flows. This report assesses this crucial question- is this gloomy prognosis justified?, and comes out with a relatively optimistic yet nuanced view. This report presents evidence showing that the intervention motives are justifiable. The report shows that once capital gains and losses are appropriately taken into account, sterilized intervention by LAC inflation targeters over the past decade has yielded rather small costs or, in a few cases, profits although the efficiency of intervention cannot be judged solely by financial returns. Moreover, while gauging the effectiveness of interventions remains an empirical challenge, recent research suggests that interventions can in fact influence currency movements by dampening deviations and over shootings. This report is structured as follows: chapter one provides an overview of the global economy and its implications for the short and medium-term prospects of the LAC region. It also examines the vulnerabilities of the region as tailwinds recede. Chapter two describes the new role of the exchange rate as a shock absorber in LAC amid the important transformations observed in the region in the past decade on the macro-financial front. Finally, chapter three gives a detailed look at exchange rate smoothing policy interventions.

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