1. Caroline Atkinson Deputy Director Western Hemisphere Department International Monetary Fund Real Exchange Rate Appreciation in Latin America: Causes and Consequences April 2006

2. Strengthening of Latin American Currencies Not surprisingly, papers present diverse views Not surprisingly, papers present diverse views But all raise some concern about persistent real appreciation: But all raise some concern about persistent real appreciation: Possibly weaken export competitiveness and growthPossibly weaken export competitiveness and growth Could make the economy more vulnerableCould make the economy more vulnerable 1

3. Many currencies in the region have strengthened (Real effective exchange rate, Index: 2000=100) Source: Information Notice System. 2 Argentina Brazil Chile Colombia BRA avg., 1980-2005 ARG avg., 1980-2005 COL avg., 1980-2005 CHL avg., 1980-2005

4. Many currencies in the region have strengthened (Real effective exchange rate, Index: 2000=100) Source: Information Notice System. 3 Guatemala Mexico Peru Uruguay GTM avg., 1980-2005 MEX avg., 1980-2005 URY avg., 1980-2005 PER avg., 1980-2005

5. This trend reflects better fundamentals, such as a sustained improvement in the terms of trade (Terms-of-trade, Index: 2000=100) Source: World Economic Outlook. 4

6. Export shares have increased... (Exports as share of world exports, Index: 2001=100) Source: Direction of Trade Statistics. 5 Argentina Brazil Colombia Chile Venezuela Peru Uruguay Mexico

7. Also, domestic policies are more credible Sources: World Economic Outlook; and IMF staff estimates and projections. 6 Inflation rate (annual percent change, left scale) Public debt (% of GDP, right scale)

8. Net international reserves have risen (Stock of net int’l. reserves, billions of U.S. dollars) Source: World Economic Outlook. 7

9. Accordingly, markets perceive less risk (Basis points) Sources: JP Morgan; and Datastream. 8 EMBI Global Latin

10. Global liquidity has also played a role Investor appetite for emerging market assets: Investor appetite for emerging market assets: relatively low U.S. interest rates,relatively low U.S. interest rates, plus expectations of weaker U.S. dollarplus expectations of weaker U.S. dollar Even global bond issues in local currencyEven global bond issues in local currency Recent depreciation of some Latin currencies may reflect shift in expectations about these conditionsRecent depreciation of some Latin currencies may reflect shift in expectations about these conditions

11. Less foreign financing of fiscal deficits (Percent of GDP, 2000-05) Source: IMF staff estimates. 10 ColombiaGuatemalaPeruUruguay

12. Recently, many countries have bought NIR (Change in net int’l. reserves, billions of U.S. dollars) Source: World Economic Outlook. 11

13. To intervene or not to intervene? Reduce currency volatility (“disorderly markets”) Reduce currency volatility (“disorderly markets”) Could make sense if financial markets inefficient or volatility discourages tradeCould make sense if financial markets inefficient or volatility discourages trade Better solution could be to adopt reforms that make markets more efficient. As Rodrigo Valdes points out, less FX intervention gives markets an incentive to develop their own hedging instruments.Better solution could be to adopt reforms that make markets more efficient. As Rodrigo Valdes points out, less FX intervention gives markets an incentive to develop their own hedging instruments. Medium-term misalignment Medium-term misalignment Hard to justify—markets persistently wrong?Hard to justify—markets persistently wrong? Perhaps intervention could smooth adjustment to a new equilibriumPerhaps intervention could smooth adjustment to a new equilibrium 12

14. Is foreign exchange intervention effective? Potential channels of transmission: Potential channels of transmission: Signal future stance of monetary policySignal future stance of monetary policy Alter supply of foreign versus domestic assetsAlter supply of foreign versus domestic assets Affect microeconomic structure (“order flow”)Affect microeconomic structure (“order flow”) 13

15. Is foreign exchange intervention effective? For industrialized countries, mixed evidence For industrialized countries, mixed evidence Effects negligible, short durationEffects negligible, short duration More successful if large and coordinatedMore successful if large and coordinated Does not reduce volatility and often increases it Dominguez (1998) and Cheung and Chinn (1999)Does not reduce volatility and often increases it Dominguez (1998) and Cheung and Chinn (1999) For emerging markets, study of Mexico and Turkey (Guimaraes and Karacadag (2004): For emerging markets, study of Mexico and Turkey (Guimaraes and Karacadag (2004): Unclear impact on exchange rateUnclear impact on exchange rate Intervention may raise volatilityIntervention may raise volatility 14

16. Clear signaling: Top priority to low inflation Sources: International Financial Statistics; EMED Database; and IMF staff estimates. 1 Difference between real national policy rate and real Fed funds rate. 15 Real Interest Rates (percent per annum) Real Interest Rate Spreads 1 (percent per annum) Brazil MexicoPeru Colombia Chile Brazil Mexico Peru ChileColombia

17. Clear signaling: Inflation lower in most countries (Inflation rate, percent) Source: World Economic Outlook. 16

18. Concluding Remarks Some reasons for concern about recent trends Some reasons for concern about recent trends Recent appreciation linked to fundamentals Recent appreciation linked to fundamentals Benefits from less reliance on foreign financing Benefits from less reliance on foreign financing Case for FX intervention weaker Case for FX intervention weaker Little evidence of effectiveness and can raise volatilityLittle evidence of effectiveness and can raise volatility Perhaps can smooth adjustment to new equilibriumPerhaps can smooth adjustment to new equilibrium Overall best way to support growth is keep policy signals clear, especially with regard to inflation Overall best way to support growth is keep policy signals clear, especially with regard to inflation 17