Prospect For Monetary Cooperation in Latin America

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Prospect For Monetary Cooperation in Latin
America

• Carlos Massad

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• 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.

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• 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

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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.

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• 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
  1990s.

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

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• 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.

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• 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.

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Figure 1
Source Rogoff et al (2003)
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Figure 2
Source Rogoff et al (2003)
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• 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.

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• 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 Mundells (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.

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2. The Case of EMU An Outsiders 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.

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• 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.

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• 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.

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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.

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Figure 3 Some Features of EMU and Mercosur      
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14
Mercosur
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EMU
10
8
6
4
2
0
Exports to agreement
Standard Deviation of
partners ( of GDP)
Supply Shocks
Source Carrera and Sturzenegger (2000)
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• 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.

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• 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.

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• 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.

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• 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.

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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.

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• 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.
• Chiles fiscal policy has taken a turn towards
  rules.

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• 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.

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Table 1 Summary of OCA Evaluation for
Chile
Traditional Criteria Mercosur Monetary Union United States 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.
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Table 1 Cont. Summary of OCA Evaluation for
Chile
Traditional Criteria Mercosur Monetary Union United States 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.
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• 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.

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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.

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• 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.

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• 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

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• 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.

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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.

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• 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.

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• 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 after
  the process is well advanced.