Middle East and North Africa; Latin America & Caribbean
Capital Markets Development
Summary: Exchange-rate-based stabilization is designed to reduce inflation by using the exchange rate as the main nominal anchor. This does not necessarily mean a fixed exchange rate. A crawling peg with a low rate of depreciation or a pre-announced gradual reduction in the rate of devaluation are alternative ways to use the exchange rate as a nominal anchor. Exchange-rate-based stabilization (ERBS) has been widely used in the high-inflation economies of Latin America. Argentina, Chile, and Uruguay adopted a pre-announced crawling peg in the late 1970s (the famous tablitas) to bring down inflation, with mixed results. Israel and Mexico used the exchange rate as a nominal anchor, and inflation came down significantly. More recently, Argentina relied on a fixed and convertible exchange rate (the convertibility plan) to bring to an end four decades of inflation. So far, the outcomes have been good. The authors find that ERBS have generally been more effective than money-based programs in bringing down inflation in the high inflation economies. But when inflation was reduced gradually, the process resulted in continuous (sometimes significant) real appreciation. Even fixing the exchange rate in Chile in 1979 did not reduce the underlying rate of inflation. Argentina's recent convertibility plan has been more successful in bringing inflation down significantly than previous money-based programs (from monthly rates of about 10 percent to just 1.5 percent in a few months). One could argue that this is a special case, since Argentina was coming from full-blown hyperinflation, so the authors compared the fixed-exchange-rate periods in Argentina and Chile, and came up with useful insights. Argentina's greater success cannot be explained only by fiscal arguments. When Chile fixed its exchange rate in 1979, it was already enjoying a budget surplus. Argentina in 1991 was running a small deficit - smaller than in previous years, but a deficit. Perhaps a better explanation is the government's perceived strong commitment to the fixed exchange rate and the potential large costs of reneging on it. The convertibility law made devaluation far more difficult (requiring congressional approval) and reduced the chances of discretionary devaluation. And the government tied its own hands further by legalizing the use of the dollar as a unit of account and means of exchange. The costs of abandoning the fixed exchange rate were also perceived to be greater in Argentina. Devaluation was (and is) perceived as opening the door for renewed hyperinflation, a dreadful scenario. Chile did not face this threat so it was more difficult - and took longer - to convince the public that the government was determined to maintain the parity. Governments tend to stick to the fixed exchange rate longer than is prudent. It is now apparent that some flexibility at an earlier stage would have reduced the costs of the final failure of the tablitas. Why do governments find it so difficult to make exchange-rate policy more flexible? Why do they wait for a balance of payments crisis rather than anticipate it? Perhaps because they fear the public will equate flexibility with failure and a loss of credibility. The authors found, however - in the experience of Israel and Mexico - that inflation does not necessarily go up when the exchange rate is made more flexible. Countries must balance the need to maintain an exchange rate rule (for credibility) with the need to keep external balance.
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