Taming the Monster
How Latin America’s central banks survived hyperinflation to become guardians of price stability
IN 1990, average inflation in Latin America reached an unprecedented 500 percent. Argentina, Brazil, and Peru—three of the region’s largest economies—posted four-digit rates of inflation, and no country managed to achieve inflation below 10 percent. As standards of living suffered, governments undertook farreaching structural changes—including central bank reform—that eventually provided the underpinnings needed to wage a successful war on inflation.
Today, inflation has been brought down to single-digit territory in most countries in Latin America. Central banks have played a key role in achieving this turnaround, but they still need to address at least three important challenges. First, most central banks have yet to achieve price stability. Second, in a number of countries, central banks need to restore market confidence in domestic currencies. And third, central banks have to maintain policy consistency in the face of volatile capital flows. Recurrent banking crises and lax fiscal discipline may threaten their ability to meet these challenges.
Mapping central bank reform
Starting with Chile in 1989, almost all Latin American countries have approved legislation that grants central banks enhanced autonomy in return for greater accountability. These reforms pursue four goals, prioritized differently across countries:
a clear mandate to pursue price stability rather than economic growth (which used to be the primary goal);
political autonomy to formulate monetary policy, which has had the effect of untying policymaking from electoral calendars;
operational autonomy to conduct monetary policy without restrictions, including the ability to set interest rates without government interference and strict limitations—sometimes even prohibitions—on financing fiscal deficits; and
accountability for achieving inflation targets.
These institutional changes have, in most countries, been complemented by a change of monetary policy regime. Over the past 10 years, most central banks migrated from exchange rate pegs to flexible arrangements. At the beginning of the 1990s, with inflation in the region hovering around triple digits, most countries embarked on stabilization strategies based on an exchange rate anchor supported by growing capital inflows. In practice, this meant that most central banks abdicated—or at least strongly restricted—their ability to conduct monetary policy. But a string of systemic financial crises, sometimes combined with excessively expansionary fiscal policies, eventually led to the collapse of exchange rate pegs in Argentina, Brazil, Ecuador, Mexico, Uruguay, and Venezuela.
The transition to exchange rate flexibility was traumatic and was accompanied by swift and steep devaluations. To restore a nominal anchor, central banks in Brazil, Chile, Colombia, Mexico, and Peru introduced inflation targeting in the late 1990s and early 2000s. The new legislation allowed central banks to formulate monetary policy with a clear objective, based on independent and transparent decision making, and subject to strict accountability requirements. Most central banks also seized on their newfound autonomy to modernize their operating procedures in an environment of flexible exchange rates. They shifted from the traditional method of controlling the money base as an intermediate target to using a short-term interest rate as the main lever of monetary policy. Today, a number of central banks signal the direction of their policies by changing short-term interest rates.
The elusive quest for price stability
The institutional reform of monetary policy, in conjunction with other macroeconomic and structural changes, has resulted in an impressive decline in inflation in Latin America (see box). But there is no room for complacency. While average inflation has declined to the single digits, it has not yet converged to world levels in most countries. This matters because inflation tends to restrict economic growth in the long run, thereby holding back badly needed improvements in living conditions. However, further cutting inflation may be a difficult endeavor because of its potential adverse impact on output in the short run. Whereas in the 1990s, Latin America supported anti-inflation policies as a vital social objective, today governments are focusing their efforts on spurring economic growth—after three decades of very modest improvements in per capita GDP.
In this environment, central banks should seek to achieve price stability while minimizing the potentially adverse effect of their policies on output. A key ingredient of such a strategy is to make central bank policies more transparent and predictable. This may help bring interest rates down, thereby encouraging investment and production. While central banks in the region—especially those that practice inflation targeting—have increased transparency, there is still room for improvement in many countries. Measuring the transparency of monetary policies by region, Latin America ranks behind Europe, Asia, and the Middle East and Central Asia (Carstens and Jácome, 2005). Central banks should also react consistently when faced with exogenous and policyinduced shocks and improve their ability to explain their policies for fighting inflation. Such steps will help market participants anticipate central bank reactions, thereby reducing uncertainty and making markets more inclined to align their inflation expectations with central bank targets.
What independence does for you
Does greater legal (de jure) central bank independence translate into lower inflation? As Chart 1 illustrates, there is a negative correlation among these two variables when considering periods before and after central bank reforms. A recent IMF study by Jácome and Vázquez (2005) on Latin America and the Caribbean shows that legal central bank independence, together with other macroeconomic variables, contributed to reducing inflation, although no causality is identified. The analysis controls for a broad index of structural reform (excluding monetary aspects) and external inflation.
However, the same relationship is not found with respect to fiscal deficits—contrary to conventional wisdom. This means that central bank reform did not encourage greater fiscal discipline in Latin America (although one needs to keep in mind that fiscal policy during this period was influenced by the banking crises that hit the region and the fiscal costs associated with these crises). It seems governments simply replaced central bank money with public debt to finance fiscal deficits.
Chart 1.Price buster
Sources: IMF, International Financial Statistics, and IMF’s Western Hemisphere Department.
1 NFPS = nonfinancial public sector.
Note: Central bank independence is measured on a scale from 0 to 1, with 1 being most independent. The index has been adapted from one developed by Alex Cukierman.
Also, central banks’ de facto autonomy needs to be strengthened. At present, the high turnover that has marked the tenure of many central bank governors is a cause for concern. Following reforms, central bank governors in Latin America have on average stayed in office for about two and a half years—clearly less than their term of appointment, which is typically between four and six years. This turnover is also greater than in industrial countries, where central bank governors routinely complete their term and sometimes have it extended.
Pesos rather than dollars
Another challenge for most of Latin America’s central bankers is how to address widespread dollarization—the use of the dollar instead of the local currency. In many countries, dollarization was a way of coping with long periods of inflation and a lack of confidence in the local currency. But dollarization is now complicating the task of conducting monetary policy. It has also created vulnerabilities in financial systems and prevented an effective response to banking crises.
In particular, in some Latin American countries, a high level of financial dollarization (economic agents holding many of their assets and liabilities in dollars) has made central banks hesitant about floating the local currency because of the damaging effect a depreciation might inflict on unhedged market participants—known as “fear of floating” (Calvo and Reinhart, 2002). In addition, some central banks wrestle with the “peso problem”—a persistent lack of confidence in the local currency, which manifests itself by high real interest rates that reflect a premium imposed by the markets fearing the potential risk of a sudden exchange rate depreciation—even if such a risk is minimal.
Defeating dollarization will take time. While the institutional strengthening of monetary policy represents a major step in the right direction, central banks need to further boost their credibility by continuously meeting their inflation targets. But even this will not be enough. They will also need to create instruments to enhance the peso’s capacity to compete with the dollar and reinforce the prudential regulations that apply to foreign exchange operations and the exposure to exchange rate risks by financial intermediaries.
Coping with capital inflows
On top of fighting residual inflation and the implications of dollarization, Latin America’s central banks face a third challenge: the recent surge in capital inflows has put pressure on the consistency of monetary policy. This is important because if markets are unable to anticipate and understand central bank decisions, the existing inflation bias will be perpetuated. As a result, efforts to reduce inflation will demand higher interest rates than otherwise, with a negative effect on output.
As capital inflows have soared in the past two years, domestic currencies have tended to appreciate, presenting central banks with the dilemma of whether to intervene in the foreign exchange market to avoid real appreciation. The current oil supply shock has further complicated central banks’ policy response by triggering a slight rebound in inflation in many countries. To cope with inflation pressures, central banks have raised interest rates, but these have attracted additional capital inflows, thereby exacerbating the appreciation trend of domestic currencies. In this environment, intervening in the exchange market helps preserve external competitiveness, but does not favor anti-inflation efforts. It also damages the consistency of monetary policy—leading to a loss of credibility for the central bank, and making for a less effective monetary policy. Alternatively, allowing exchange rate appreciation hurts the tradable sector of the economy even though it helps curb inflation and preserves policy consistency.
So what should be done? As a matter of principle, central banks should stick to price stability as their primary objective, and exchange rate interventions should be limited to curtailing excessive volatility in the foreign exchange market. To cope with the cost on tradable activities associated with the exchange rate appreciation, domestic producers should seek to improve productivity. Meanwhile, governments should deepen structural reforms to make their economies more flexible (including the labor market) and better able to withstand exogenous shocks.
Guarding against crises
The risk of recurrent banking crises and a lack of fiscal discipline is adding to the complexity of managing monetary policy. Banking crises are an all too common event in Latin America. Since 1990, banking crises have been the main cause of inflation reversals and economic contraction in many countries (see Chart 2). They have also resulted in a number of (often simultaneous) currency crises. From a microeconomic perspective, many banking crises have left behind a legacy of weakened market discipline as a result of blanket guarantees and widespread debt restructuring. And in some cases, the confidence of bank customers suffered long-lasting damage as the maturities of their deposits were unilaterally reprogrammed.
Most countries in the region have made progress in establishing a framework for preventing and managing banking crises, but more needs to be done. The new reforms must emphasize prudential regulations and vigorous supervision. Experience shows that once a crisis erupts and escalates, the costs are inexorably high. Countries should, therefore, focus on improving early warning systems and, more important, empower bank regulators to effectively deal with incipient bank liquidity and solvency problems. In turn, the legal framework for bank restructuring and resolution should be improved to allow countries to manage and resolve banking crises in a cost-effective manner.
On the fiscal front, Latin American governments will need to keep deficits in check. After an initial period of fiscal consolidation during the early 1990s, fiscal deficits have grown again in a number of countries—in some cases in the aftermath of banking crises. Because financing public expenditure with central bank resources is already legally restricted, public debt is picking up again in various economies, thereby leading to increasing debt-to-GDP ratios. Rising debt may lead to a surge in real interest rates and “country risk” indicators, which will reduce the room for maneuver of monetary policy and exacerbate output-related costs of pursuing disinflation. If a deteriorating fiscal stance becomes unsustainable, it may result in a currency crisis, as it did in Brazil in 1999, or in a banking, currency, and sovereign debt crisis, as in Argentina in 2002.
Agustin Carstens is a Deputy Managing Director of the IMF; Luis I. Jacome H. is a Senior Economist in the IMF’s Monetary and Financial Systems Department and Adjunct Associate Professor at Georgetown University.
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CalvoGuillermo and CarmenReinhart2002“Fear of Floating,”The Quarterly Journal of EconomicsVol. 117 (May) pp. 379–08.
CarstensAgustínDanielHardy and CeylaPazarbaşioğlu2004“Avoiding Banking Crises in Latin America,”Finance & DevelopmentVol. 41 (September) pp. 30–33.
CarstensAgustín and LuisI.JacomeH. 2005“Latin American Central Bank Reform: Progress and Challenges,”IMF Working Paper 05/114 (Washington: International Monetary Fund).