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									  Prospect For Monetary
Cooperation in Latin America

         Carlos Massad

• 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
• 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
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.

• 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.
• Intermediate solutions like adjustable pegs,
  crawling pegs, exchange rate bands, and crawling
  bands were seen as providing some flexibility
  with limited uncertainty.

• 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.

• 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

                               Figure 1

Source : Rogoff et al (2003)
                               Figure 2

Source : Rogoff et al (2003)
• 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.
• 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.
    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.
• 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.
• 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

• The chances of success of the euro have been fostered by
  a strong political will.
      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.
                       Figure 3
          Some Features of EMU and Mercosur



  12%                                Mercosur





          Exports to agreement      Standard Deviation of
          partners ( % of GDP)          Supply Shocks

Source: Carrera and Sturzenegger (2000)
• 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.
• 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

• 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.
• 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.

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
                               Figure 5
                         GDP Growth in Chile
                     (In Percentages 1986 – 2005)

P   12%
R   10%
N   6%
G   2%
          86    88      90    92       94      96   98   00   02   04       05*

      • Projected
      •Source: Central Bank of Chile

• 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.

• 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.

                                                         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
(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

• 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.
  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.
• FBSC could prepare a blue-print for actions leading to a
  much greater degree of uniformity in institutions and

• 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.

  6. Concluding comments: the Blue Print
• 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.

• 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.

• 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

• 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
  after the process is well advanced.

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