Central America: Exchange Rate Regimes, CAFTA, and the Future

1
Central America Exchange Rate Regimes, CAFTA,
and the Future
GUATEMALA
HONDURAS
NICARAGUA
EL SALVADOR
PANAMA
2
A Brief History

• September 15, 1821?Central America gained
  independence from Spain
  
• 1823? Formed United Provinces of Central America
• Guatemala
• El Salvador
• Honduras
• Nicaragua
• Costa Rica
• 1828? Honduras separated and disintegration
  began
  
• 1960s?Returned focus to integration
• Integration efforts halted in the 1980s until
  mid-90s
  
• Early 2006?CAFTA-DR implemented
• WHAT DOES THE FUTURE HOLD?

3
The Prospect of Regional Integration

• FEASIBILITIES
• Common language
• Common history
• Common characteristics
• Location and size
• Potential economic benefits
• Globalization
• Central American Monetary Council and other
  regional institutions

• INFEASIBILITIES
• Political conflicts
• Civil wars
• Nationalism
• Economic shocks
• poverty

4
CAFTA Potential

• Foster integration among the countries and with
  the United States
  
• Access to the US market
• Greater predictability for investors
• Synchronize business cycles
• Reduce macroeconomic volatility
• Accelerate diversification of export base
• REQUIRES Policy coordination in tax policy,
  financial sector, and Exchange Rate Policy

5
Exchange Rate Regime History

• Until 1980s, all were dollar pegged
• Dollar pegs slowly abandoned because of civil
  unrest and abandonment of integration plans
  
• Currently several different types of regimes
• Independent Float
• Guatemala
• Crawling Peg
• Nicaragua
• Costa Rica
• Honduras
• Full Dollarization
• El Salvador

6
Guatemala

• Abandoned peg in 1984
• Oscillated between freely falling and managed
  floating
  
• Managed float throughout the 1990s
• Introduced independent float in 2003

7
Nicaragua

• Abandoned peg in 1979 with change of political
  regime
  
• Experienced periods of hyperinflation and freely
  falling rates
  
• Re-pegged in 1991 after years of war in 1980s
• Crawling peg since 1993
• Rate of depreciation announced by central bank

8
Costa Rica

• Abandoned peg in 1981
• Experienced a freely falling period
• Determined crawl rate first by inflation
  differentials with US and then by inflation
  differentials with major trading partners
  

9
Honduras

• Abandoned dollar pegs in 1991
• Settled on a crawling band
• Rate of crawl determined by inflation
  differentials with major trading partners and
  their exchange rates with the US dollar
  
• In 1997 band was widened from 1 to 7

10
El Salvador

• Abandoned peg in 1983
• Used a managed float until 1990
• De-facto peg in 1990
• Adopted dollar as official currency in 2001

11
Long-term Integrated System

• Flexible Rates with Inflation targeting
• Common independently floating or pegged currency
• Full dollarization

12
Floating Pros and Cons

• Monetary policy can be used for macroeconomic
  stabilization

• fear of floating
• Requires sound financial system

13
Crawling Peg Pros and Cons

• Credibility
• Predictability about inflation for investors,
  producers, and consumers
  
• Promotes trade and financial flows
• Best for small, integrated countries

• Inability to use exchange rate to offset shocks
• Vulnerable when country has
• Low reserves
• Low tolerance for high interest rates
• Weak banking system

14
Dollarization Pros and Cons

• Increased trade
• Lower transaction costs
• Credibility from predictability
• Stability

• Loss of seigniorage
• Less autonomy
• Cannot use individual monetary policy

15
Factors to Consider

• Openness of economyCA highly dependent upon
  trade with US 80 of exports less
  intra-regional trade imperfect factor mobility
  
• Size of economiessmall average GDP 13.7
  billion
  
• Co-movement of business cyclesincrease with
  CAFTA significant between individual nations and
  US
  
• Terms of trade shocksCAFTA will result in
  smaller and more synchronized shocks with
  expansion of the export base
  
• Currency substitution optionsCA has high level
  of substitution 40 of banking system is
  dollarized
  
• Seigniorageonly 1-2 of GDP and falling with
  inflation not very significant loss for CA

16
Ready or Not?

• Long-run option because of aforementioned
  factors
  
• Underlying requirements present language,
  culture, size, characteristics, economic
  potential, etc.
  
• High level of integration with US
• BUT. . .according to optimum currency area
  statistics, Central America is still less ready
  than Western Europe was in the 1970s

17
(No Transcript)
18
Remember the EU and OCA

• Maastricht Treaty (1991) defined three stages. .
  .almost 10 years for full implementation
  
• Well-defined convergence criteria
• Optimum Currency Areasgroups of regions with
  economies closely linked by trade in goods and
  services and by factor mobility

19
What would be the best option?

• Peg or dollarization
• More integration with US than between individual
  nations
  
• Increasing readiness for dollarization since
  1994
  
• Already large presence of dollar in all nations
• Need common standards, enhanced stability, and
  further development to meet optimum currency area
  qualifications.
  
• What will CAFTA really do?. . .
• Time will tell!