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Prospect For Monetary Cooperation in Latin America Carlos Massad 1 • There have been several efforts to promote monetary and economic cooperation as well as integration in Latin America. • In these efforts, several stumbling blocks such as exchange rate policies and idiosyncratic shocks became evident but were not removed or ameliorated. • This paper starts analyzing optimal exchange rate policies and their role in monetary cooperation and integration. 2 • Then it goes on to examine the experience of the European Monetary Union and the lessons that derive from it. • The prospects for monetary union in Latin America are then examined. • Ways to promote monetary cooperation and integration in Latin America an explored. • The main conclusions are then highlighted 3 1. Optimal Exchange Rate Regimes • The discussion regarding the choice of an optimal exchange rate regime (ER) is long lived. • The trade-off between flexibility and credibility is linked to the discussion between rules and discretion. 4 • Floating exchange rate regimes provide the flexibility for independent monetary management. • Moreover, the exchange rate itself serves as an adjustment mechanism. This is the choice made by Chile in recent years. • Exchange rate flexibility could also foster volatility. • Fixed ER regimes sacrifice flexibility. • But enhance credibility by adopting an anchor. This was the choice of Argentina in the mid 1990´s. 5 • Intermediate solutions like adjustable pegs, crawling pegs, exchange rate bands, and crawling bands were seen as providing some flexibility with limited uncertainty. 6 • The conventional wisdom on limited flexibility exchange regimes suffered heavy blows from different quarters during the 1990s. • First: International financial integration observed worldwide in the 1990s. provided an additional transmission chanel for external shocks. • Second: EMU brought a virtually irreversible form of ER peg that had been absent from policy choices. 7 • Third: Inflation targeting provided a credible nominal anchor, as is the case of Chile at the beginning of the 21st. century. • These developments have enhanced two corner type solution. Fig. 1 and 2 provide some indication in this direction. 8 Figure 1 Source : Rogoff et al (2003) 9 Figure 2 Source : Rogoff et al (2003) 10 • If this were the options, what are the determinants of the choice?. • The first is analyzing if domestic monetary policy is capable: (1) of providing a credible and stable nominal anchor, and (2) of being effective in short- run output stabilization. • The answer seems to be positive under some institutional conditions. 11 • The second step is evaluating the benefits of monetary independence relative to the benefits provided by monetary union. The traditional framework under which such analysis is conducted is Mundell’s (1961) Optimal Currency Area (OCA) criteria, almost 45 years old. • The are drawbacks to this framework. • The third step is to recognize that some evaluation criteria for OCA are endogeneous to the exchange rate regime and to the process of integration itself. 12 2. The Case of EMU: An Outsider’s View • The experience of the European Monetary Union can not be analyzed as an isolated event. • Monetary union between the members of the European Union was the final stage of a much wider process of political and economic integration. • The EMU resembles a textbook OCA. But many of the OCA criteria have been gradually and consciously built up over time. 13 • Which are the distinct features of the countries that are part of the EMU?. • I would divide them in two main categories. The first class comprises the structural economic conditions such as trade intensity or symmetry of shocks. • The second class involves the institutional features that have been developed ex professo. • Many of the economic or structural conditions in the first category are modified by the integration strategy – in other words, OCA criteria are endogenous to integration and monetary union. 14 • Maastricht has also provided a transparent, binding commitment that has enhanced discipline in the conduct of domestic policy. • The adoption of a common financial and banking regulation, as well as of economic accounting standards, has allowed members of the union to “speak a common language”. • The chances of success of the euro have been fostered by a strong political will. 15 3. A Monetary Union for Latin America • Review of the euro experience suggests that the likelihood of a viable monetary union in Latin America is small, at least in the short to medium term. • The differences in structural and institutional conditions between Europe and Latin America are large. • Income differences among full and associated Mercosur member countries are much higher than those observed in the European Union among the initial members of the Union. 16 Figure 3 Some Features of EMU and Mercosur 16% 14% 12% Mercosur EMU 10% 8% 6% 4% 2% 0% Exports to agreement Standard Deviation of partners ( % of GDP) Supply Shocks Source: Carrera and Sturzenegger (2000) 17 • Second : Mercosur countries are not particularly open to international trade of goods and services. • Third :Available evidence suggest that idiosyncratic shocks affecting individual Mercosur countries are significantly larger than collective shocks. • Furthermore, recent studies seem to detect wide differences in microeconomic flexibility among Latin American countries. 18 • Differences among Mercosur countries regarding their institutional frameworks and policies are deep. • Trade agreements suffer from recurring administrative breaches and violations. • Mercosur members have taken only initial steps towards financial, fiscal, monetary and exchange rate integration, through efforts to establish common definitions. 19 • Most important, a monetary union does not appear currently viable from a political perspective. • This does not preclude the possibility of successful monetary union in the region in the long term. • Conditions on which evaluation of OCA criteria are based are not static. • Integration and policy coordination reduce the probability idiosyncratic shocks. 20 • Furthermore, recent evidence for the Chilean case points to the fact that changes in the real exchange rate are not as important as changes in income to explain variations in trade. • Monetary union may be a viable and even optimal option for Latin America in the future, but a long and winding mountain road lies ahead. 21 4. Macroeconomic stability in an alternative framework: the case of Chile • Which are the options? With a history of macroeconomic instability, how can small open economies in Latin America reap the benefits of low inflation and sustained growth?. • After 15 years of Central Bank independence and explicit inflation targets, Chile has achieved for the first time in a century, low and stable inflation anchored to stationary inflation target of 2-4% per year, centered on 3%. 22 23 Figure 5 GDP Growth in Chile (In Percentages 1986 – 2005) 14% P 12% E R 10% C 8% E N 6% T 4% A G 2% E 0% -2% 86 88 90 92 94 96 98 00 02 04 05* YEARS • Projected 2 •Source: Central Bank of Chile 24 • Inflation targeting has provided a reasonable and flexible monetary framework. • Attainment of the long-term inflation goal in 1999 led the Central Bank to a change in emphasis in the credibility-flexibility trade-off faced by all central bankers, by adopting a more flexible monetary and exchange rate regime. • Chile’s fiscal policy has taken a turn towards rules. 25 • The evidence suggests that we can be reasonably confident that Chile is doing currently better by sticking to its peso than by giving it up. • Chile does not satisfy traditional OCA criteria. 26 Table 1 Summary of OCA Evaluation for Chile Mercosur United States Traditional Criteria Monetary Union Dollarization Income and devlopment (1) Similar Very differente Inflation (1) Similar Similar Labor Mobility (2) Moderate Very Low Unemployment Rate Correlation (1) Strongly Negative Positive Financial Mobility (2) Moderate/High Moderate / High Real Interest Rates Correlation (1) Zero Low Real Stock Returns Correlation (1) Positive Zero Saving/Investment Correlation (1) High High Share of Chile's Trade (1) Moderate Moderate / High Terms of Trade Correlation (1) Low Negative GDP Growth Correlation (1) Zero Zero Source : Compiled from information provided in Morandé and Schmidt-Hebbel (2000), comparing Chile with two prospective currency partners. (1): Based on quantitative evidence presented in the source.(2): Based on the qualitative discussion presented in the source. 6 Table 1 Cont. Summary of OCA Evaluation for Chile Mercosur United States Traditional Criteria Monetary Union Dollarization GDP Diversification (1) Low in Chile, higher in Mercosur Low in Chile, Higher in the US. Exports Diversification (1) Low in Chile, Higher in Mercosur Low in Chile, higher in the US. Labor Market Flexibility (2) Low in Chile, Higher in Mercosur Moderate in Chile, higher in the US. Wage and Price Indexation (2) High in Chile, Lower in Mercosur High in Chile, lower in the US. Non- Traditional Criteria Depth of Structural Reforms (1) High and Similar High and Similar Fiscal Stance (2) Strong and Different Strong and Similar Fiscal Coordination/Regional Transfers(2) Negotiation Possible Negotiation Unlikely Seigniorage (1) High, diminishing High, diminishing Lender of last resort (2) Negotiation Possible Negotiation Unlikely Source : Compiled from information provided in Morandé and Schmidt-Hebbel (2000), comparing Chile with two prospective currency partners. (1): Based on quantitative evidence presented in the source. (2): Based on the qualitative discussion presented in the source. 7 • Chile has already obtained one of the main benefits of monetary union, as it has achieved credibility and discipline in the conduct of both monetary and fiscal policies. In fact, Chile satisfies all of Maastricht criteria. • This does not imply that Chile should close the door to assessing monetary unions in the future. • Strengthening domestic policies today is the best way to prepare for monetary union tomorrow. 29 5. Approaching Monetary Cooperation • Monetary union is the end of a long process, which includes progressive convergence in policy and increasing cooperation in all areas. • In Latin America, there has been little cooperation in emergency short term financing. • Policy surveillance and conditionality among equals are sine qua non pre-conditions to create the necessary confidence about due repayment of inter-central bank loans. • Establishing institutions for meaningful surveillance is a difficult political subject. 30 • This difficulty is also faced by arrangements established in Asian countries, such as those of the Chang Mai initiative approved in 2000. • The Chang Mai initiative has a potentially important feature, as it requires consultations among countries on economic policies. • Perhaps setting up a Financial and Banking Supervision Committee (FBSC), grouping the banking and financial supervisors of, for example, Mercosur members, could help speed-up the application of international norms, already agreed upon in the Basle Committee, to banks and other financial institutions. 31 • FBSC could prepare a blue-print for actions leading to a much greater degree of uniformity in institutions and regulations. • Another area of possible cooperation resides in the field of cross-border investment. • In the field of fiscal policy, coordination may be more difficult since it affects domestic political convictions and sensibilities. • A first step could be to agree on a path to convergence on some key macroeconomic variables like fiscal deficits, state or provincial imbalances and external debt management 32 • There are many other areas of prospective cooperation in the economic field, such as stock and bond cross-border transactions, social security, migration and labor mobility. I will not enter into those areas. 33 6. Concluding comments: the Blue Print Approach. • A general, all inclusive blue print would be necessary to insure that progress in all areas is both consistent and instrumental for the more general goal of economic policy cooperation and integration. • The general blue print should make explicit the areas of parallel progress in different areas as well as collective aspirations regarding the final objective. 34 • Building up the general blue print is not an easy matter and would require the assistance of a technical secretariat. Institutions like IDB and the secretariats of Mercosur, ALADI and/or ECLAC could be called upon, with the necessary strengthening. • Or an ad-hoc secretariat could be established. 35 • An initial step in the work of the secretariat would be to prepare detailed descriptions of monetary, financial and foreign exchange regulations and systems in the countries involved. • The evidence on endogeneity of at least some of the OCA criteria, or their ex-post fulfillment, support a gradual, but persistent, approach and, at the same time, provide a light of hope. • Such evidence underlines the importance of political will to proceed, as the full benefits of cooperation and integration, particularly in open economy countries, will only appear 36 after the process is well advanced.
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