IV Experience with Nominal Anchors
Author: Mr. Mauro Mecagni
Language:
English
Keywords:
OP; wage control; saving; wage; real interest rate; saving rate; high-inflation country; inflation expectation; initial inflation; broad money; inflation performance; Exchange rate anchor; Nominal anchors; Fiscal consolidation; Exchange rates; Europe; CFA franc
Download PDF (5.1 MB)

Abstract

Nominal anchors—whether an exchange rate peg or a money supply rule—are widely recognized as an important component of a program to reduce or control inflation, or reinforce discipline in financial policies and wage developments. Therefore, the fact that nominal anchors have not been adopted in every IMF-supported stabilization program, particularly in those designed to lower inflation, may lead to the conjecture that these programs have not placed enough emphasis on the reduction or the containment of inflation. Rather, according to this argument, such programs have been geared toward addressing external crises, in which devaluations may play a major role and credit ceilings designed to achieve ambitious targets for reserve accumulation are favored over money rules.

Nominal anchors—whether an exchange rate peg or a money supply rule—are widely recognized as an important component of a program to reduce or control inflation, or reinforce discipline in financial policies and wage developments. Therefore, the fact that nominal anchors have not been adopted in every IMF-supported stabilization program, particularly in those designed to lower inflation, may lead to the conjecture that these programs have not placed enough emphasis on the reduction or the containment of inflation. Rather, according to this argument, such programs have been geared toward addressing external crises, in which devaluations may play a major role and credit ceilings designed to achieve ambitious targets for reserve accumulation are favored over money rules.

In fact, in 16 of the 36 countries with arrangements approved between mid-1988 and mid-1991, nominal anchors—in all but one, the exchange rate—were used at least at some stage during IMF-supported programs. The 16 countries varied in initial conditions and principal motivations for using anchors. About a third—mainly in Central Europe and the Western Hemisphere—were aiming at a rapid disinflation from very high inflation levels; another third were using the anchor to help prevent prospective price increases from igniting an inflation spiral; and another third—principally CFA franc zone countries—had longstanding exchange rate pegs as a standard for policy discipline.

This paper reviews the experience with nominal anchors in these 16 countries. Three broad questions are addressed. First, under what conditions did programs incorporate a nominal anchor? Second, how did the record of success in reducing inflation or holding it at a low level differ between countries with and without nominal anchors? Third, what were the costs for external performance and growth of using an exchange rate anchor? The paper does not question whether low inflation should be a central goal in programs. Rather, it is premised on the position that low inflation promotes efficient allocation of resources and economic growth (De Gregorio (1992a), Fischer (1993), and Levine and Renelt (1992)).

The limitations of the sample—the relatively small number of countries that used nominal anchors, the short period under review, and the paucity of money anchors—restrict the generalization of conclusions. Nonetheless, the experience of the countries reviewed confirms that there is no substitute for tight financial policies and wage restraint in the effort to reduce inflation or hold it at a low level. When such conditions exist, however, an exchange rate anchor appears to have increased the speed and size of disinflation or helped keep inflation low. These gains tended to come with significant costs to competitiveness, export growth, and possibly even short-term output growth—although the latter should be weighed against likely longer-term benefits associated with more stable prices. These costs became untenable when financial policies and wages were not restrained. However, in almost all the countries reviewed, significant reductions in high or intermediate inflation proved elusive without a nominal anchor.

Inflation at the Outset of the Arrangements

During the three years prior to the arrangements, average annual inflation in the 36 countries under review climbed from 30 to over 200 percent (Table 4-1). Differences among the countries were large. Before the first arrangement, 15 countries had annual inflation rates below 10 percent; 11 countries had increasing or persistent inflation between 10 and 50 percent; and 10 countries had inflation exceeding 50 percent (Table 4-2).

There were regional patterns in inflation rates. In the Western Hemisphere countries, sharply accelerating prices in Argentina and Brazil followed a sequence of failed attempts to stabilize, while most other countries endured chronic inflation at intermediate to high rates. In many instances, chronic inflation reflected inertia from widespread indexation arrangements. In Central Europe, Poland and Yugoslavia were slipping toward hyperinflation, and price pressures were mounting in Bulgaria. These developments were due principally to large fiscal deficits, rapid credit growth, currency depreciation, large wage increases (Yugoslavia), and the legacy of monetary overhangs (Bulgaria and Poland). In Romania, where inflation had been repressed, and Czechoslovakia, there was a major risk of wage-price spirals as prices were liberalized. Inflation was generally low in the Middle East, Asia, and Africa. In Africa, low inflation reflected the importance of CFA franc zone countries, where excess demand pressures resulted in widening external imbalances and arrears.

Table 4-1.

Initial Inflation1

(In percent)

article image
Source: IMF staff estimates.

Annual consumer price inflation rates in the three years prior to the year of the first arrangement reviewed (denoted by t) for each country, as assessed at the time of program approval. End-of-period changes in the consumer price index, except in 11 countries—Algeria, Cameroon, Côte d’Ivoire, Egypt, Jordan, Mali, Nigeria, Pakistan, Papua New Guinea, Romania, and Tunisia—where average changes were the only data consistently available. Changes in GDP deflator for Madagascar.

On the whole, inflation targets in the arrangements were quite ambitious. Excluding the extreme cases of Argentina, Brazil, and Yugoslavia, inflation for the countries under review was targeted to decline in the first program year from 47 percent to 32 percent, reversing about two thirds of the previous year’s increase.1 Inflation was targeted to decline in 60 percent of the countries. Among high-inflation countries, a sharp disinflation was targeted in Argentina, Poland, Yugoslavia, and, to a lesser extent, in Ecuador, Guyana, Mexico, and Uruguay. Of the 14 countries where inflation was targeted to rise, 6 had initial rates below 10 percent and most of the others were planning extensive price decontrol (Algeria, Bulgaria, Czechoslovakia, Egypt, and Romania), adjustment of administered prices, and/or a large initial depreciation of the exchange rate.

Role of Nominal Anchors

For countries targeting a large disinflation, demand restraint, through a reining in of public sector finances and tight credit policies, was the centerpiece of the program. Usually this effort concentrated on reducing the central government borrowing requirement, but also, in several countries, on improving the financial position of other public sector entities. It was, however, recognized that the short-run relationship between deficit reductions and inflation is often weak and that reducing inflation through demand restraint alone could involve costly and politically untenable losses of output and employment.2 These costs were a particular concern in the presence of sources of inflation inertia: backward-looking indexation; staggered nominal contracts; or slowly adjusting inflation expectations.3 In such circumstances, some countries adopted an explicit nominal anchor and changed wage-setting arrangements to foster credibility, break inflation expectations, set a standard for policy discipline, and, depending on the type of anchor, directly stabilize tradable goods prices.4

Table 4-2.

Distribution of Countries by Initial Inflation1

article image
Source: IMF staff estimates.

Consumer price inflation in the year before the (first) program, as assessed at the time the programs were approved.

GDP deflator.

For countries facing an incipient price shock, a nominal anchor stood to bolster underlying restraint in financial policies and limit the risks of onetime shocks spreading into persistent inflation. Central European countries constituted a special group among these. Beyond the uncertain outcome of price liberalization, fiscal policy was encumbered by the erosion of the traditional tax base; tax and expenditure control systems inadequate for the transition to a market economy; and pressures to cushion the effects of the output collapse. At the same time, the initial liquidity overhang in Poland, Bulgaria, and Romania was likely to push up prices, in the absence of effective financial control instruments. In these conditions, some programs complemented fiscal adjustment with an exchange rate anchor and wage controls to contain inflation after the initial price jump. (See the paper on wage controls in Central Europe in this volume.)

In low-inflation settings, a nominal anchor provided a signal of the intent to stick to a steady course of financial policies. The purpose of this section is to examine two questions about the role of nominal anchors in IMF-supported programs. First, what is a nominal anchor? And second, what circumstances lent themselves to the use of nominal anchors?

What Is a Nominal Anchor?

A nominal anchor is a nominal variable that by policy decision is fixed or set on a predetermined and announced path to help stabilize the price level (Adams and Gros (1986), Bruno (1986), and Patinkin (1993)). In principle, either the money supply or the price of a central commodity—goods, labor, or foreign exchange—can serve as an anchor. If a price is chosen, it must be the price of an important and homogeneous commodity to exert a prominent influence on the general price level while avoiding relative price distortions.

In practice, nominal anchors differ in their efficacy and potential for distortions. Price controls induce anticipatory price increases, enlarge the scope for relative price rigidities and resource misallocation, and increase subsidies. At most, therefore, they could play a role briefly at the outset of a disinflation program. Even there, price controls may damage credibility if they are perceived as a substitute for, rather than a complement to, demand restraint. Similarly, wage controls are not an ideal anchor, as they inhibit desirable changes in wage relativities. Even when applied to large segments of the labor force in Central Europe, wage ceilings were inadequate nominal anchors because at times they were adjusted in line with inflation, governments succumbed to pressures for exemptions, or their enforcement was weak.

The anchor role of money supply targets with a flexible exchange rate is prone to difficulties that become more severe with high inflation. First, large shifts in the demand for money undermine its predictability. Second, the scope for currency substitution implies that total liquidity—including the domestic value of the foreign currency component—eludes control when exchange rate fluctuations are large: with perfectly substitutable domestic and foreign currencies, a given stock of domestic money becomes consistent with any aggregate price level, depending on the exchange rate. Third, the signaling role of money targets for expectations and pricing behavior is weak before full credibility of the monetary authorities is established. Money targets are also hard to monitor, because information on money supply is not readily available and may be difficult to interpret owing to seasonal patterns and changes in money demand (Kiguel and Liviatan (1994)).

A more contentious issue concerns the anchor role of credit ceilings. Credit ceilings are effective in reaching goals for reserve accumulation, and adherence to them is essential for the sustainability of a money or exchange rate anchor.5 On their own, however, except when external sources of money creation are absent (for example, in a purely floating exchange rate regime), they do not constitute an effective nominal anchor. They are subject to all the problems of a money anchor but are also undermined by nonbank sources of credit6 and unexpected capital inflows that may increase total liquidity even when the ceilings are respected. Capital inflows have been a particular problem in high-inflation countries where a tightening of credit pushed up interest rates and attracted inflows while inflation persisted.7

In contrast, a predetermined exchange rate level or path is a visible, easily monitored anchor that provides a strong signal of the commitment to disinflate or sustain low inflation. In an open economy, pegging the exchange rate to a low-inflation currency stabilizes the traded goods component of the general price level, directly and through greater competitive pressure on domestic wage- and price-setting behavior. This effect is greater the more open the economy. An exchange rate anchor, therefore, exerts a powerful influence on both actual and expected inflation, particularly at very high inflation rates when prices are revised frequently in line with the exchange rate. As with other price-based anchors, distortive effects—on the price of tradable relative to non-tradable goods—are not uncommon.8 For although in principle a fully credible exchange rate anchor could, in the absence of backward-looking price-setting behavior, stop inflation in its track at virtually no real cost, in practice the adjustment is rarely so quick (Calvo and Végh (1991, 1992), Dornbusch and Giovannini (1990), Végh (1992)). Often exchange rate anchors do have real effects, owing to insufficient credibility of policy announcements, continued backward-looking price and wage behavior, or fiscal adjustment inadequate to constrain prices of nontraded goods.9 As a result, inflation may not decline as rapidly as required to maintain competitiveness, and in time adverse effects for the current account and output may develop. Also, the nature of the disturbances that the economy is likely to experience is crucial for the desirability of an exchange rate anchor. For instance, long-lived asymmetric real disturbances call for exchange rate changes to help stabilize output.10

Table 4-3.

Nominal Anchors in Countries with IMF Arrangements Approved During 1988–92

article image
Source: IMF staff reports.

For Argentina, the nominal anchor considered is the short-lived attempt during July-December 1989 to fix the exchange rate. The subsequent successful establishment of a currency board occurred after the period covered by this review.

In sum, the choice of the main nominal anchor is essentially limited to the exchange rate or the setting of money targets. In general, the exchange rate is preferable to money the greater the scope for disturbances to money demand (Fischer (1986)). In conditions of uncertainty, multiple anchors—the simultaneous predetermination of several nominal variables—have helped reduce inertia in the nontradable sector (Bruno (1991), Bruno and others (1991), Edwards (1992)). Typically, this involves temporary wage and price controls as supplements to a primary exchange rate anchor. The principal difficulty with multiple anchors is that the very uncertainty they are meant to address increases the likelihood of setting inconsistent paths for the nominal variables involved. At most, therefore, they can be used for short periods during a decisive disinflation program.

Nominal Anchors in IMF-Supported Programs

As noted above, a nominal anchor—a predetermined exchange rate or a money target—was used at some stage in 16 of the 36 countries under review (Table 4-3).11 In the remaining 20 countries, credit ceilings were the main predetermined nominal variable, with varying degrees of exchange rate flexibility (Appendix Table 4-A1). These countries are considered as the sample without an explicit nominal anchor.12

Table 4-4.

Timing of Adoption of Exchange Rate Nominal Anchors

article image
Source: IMF staff reports.

Except in the Philippines, nominal anchors took the form of exchange rate rules, explicit or de facto. The 15 countries with exchange rate anchors ranged from the CFA franc zone countries, which had maintained parity with the French franc since 1948, to Egypt, which unofficially and in light of large capital inflows maintained a virtually fixed exchange rate. Most of the ten countries outside the CFA franc zone adopted exchange rate rules at the outset of their first arrangement during the period (Table 4-4).13 The exchange rate anchor took the form of a peg—bilateral or to a currency basket—except in three countries: Egypt, where there was de facto a narrowly bounded float; Honduras, where the float was officially constrained within a narrow band; and Mexico, where there was a preannounced crawl. The exchange rate was accompanied by wage policies as part of a multiple anchor strategy in four countries—Czechoslovakia, Poland, Yugoslavia, and Mexico.14 Temporary price controls were used in Yugoslavia and at an early stage in Mexico.

The sample precludes an evaluation of money anchors because only the Philippines adopted that strategy (Box 4-1). The remaining discussion will focus on exchange rate anchors only.

When Was the Exchange Rate Used as a Nominal Anchor?

Among the 15 countries that used an exchange rate anchor, several considerations loomed large for its feasibility or desirability: the initial level of inflation, the ambitiousness of disinflation and fiscal adjustment targets, the fear that price reforms would ignite inflation, and the desire for a disciplining device. Sufficient external reserves to enable the authorities to adhere to the preannounced exchange rate path and to withstand a deterioration in competitiveness were also a prominent concern.

Money as a Nominal Anchor: The Philippines

The use of money targets as nominal anchors has been less common than the use of exchange rates. Successful money-based stabilizations include the recent sharp disinflation in Latvia (1992/93), but in the sample under review, only the Philippines formally used money targets. In the Philippines, reserve money targets were introduced in 1984, when disinflation was accorded high priority after protracted financial imbalances had pushed the 12-month inflation rate to a peak of 64 percent (September–October 1984). After a slower-than-targeted initial decline, by end-1985 the 12-month inflation rate (less than 6 percent) overperformed the target in the original program (10–15 percent). Reserve money targets were maintained throughout the period under review, but were rarely met: reserve money growth exceeded the ceilings for most of 1989 and 1990 during the extended arrangement, and in most test dates during the subsequent standby arrangement. While this record did not prove inconsistent with a decline of inflation from 16 percent in 1990 to 8 percent in 1992, it illustrates the problems likely to occur when using money as a nominal anchor in an environment of high capital mobility and a managed float. The frequent breaching of targets reflected central bank intervention to purchase foreign exchange originating from unexpected capital inflows. The repeated deviations indicated the unwillingness to accept the exchange rate implications of balance of payments outcomes implied by adherence to a money anchor.

About 40 percent of all countries with high inflation or the prospect of widespread price liberalization adopted an exchange rate anchor at the outset of their arrangements. On average, these countries started with higher inflation and targeted a sharper decline than the high-inflation countries that did not adopt a nominal anchor (Tables 4-5 and 4-6; tables present countries by decreasing order of initial inflation, and exclude outlier countries and countries for which data were unavailable on a consistent basis). Among low-inflation countries, about 60 percent had exchange rate anchors. In most of these—the CFA franc zone countries and Papua New Guinea—the anchor had been in force for a long time. In contrast, 20 percent (Egypt and Honduras) of countries with intermediate inflation adopted an exchange rate anchor. Typically, countries had learned to live with inflation in this range with protection mechanisms that made it difficult to garner support for reducing inflation.

The 15 countries that used exchange rate anchors faced, in about equal proportions, the three types of situation nominal anchors address: very high inflation (Argentina, Mexico, Poland, and Yugoslavia); low or intermediate inflation, but with the threat of prospective shocks—price liberalization, increases in import prices, or indirect taxes—igniting inflation (Czechoslovakia, Egypt, Honduras, Morocco, and Trinidad and Tobago); low inflation but the perceived need for an autonomous source of policy discipline (CFA franc zone countries and Papua New Guinea). In this last group, the nominal anchor was a long-standing constraint rather than a policy decision at the time of the arrangements under review.

Not surprisingly, the ambitiousness of disinflation and fiscal adjustment targets distinguished the use of an exchange rate anchor mainly in high-inflation countries. As a group, the high-inflation countries with an anchor started with a higher average fiscal deficit (by about 1 percent of GDP) but targeted a more ambitious fiscal adjustment (by about 3.5 percent of GDP) than high-inflation countries without an anchor. At low inflation, initial imbalances and deficit reduction targets were slightly higher (by about 0.5 percent of GDP) in the countries without anchors.

The role of initial foreign exchange reserves in the decision to use an exchange rate anchor appears to have been more differentiated. In low-inflation countries, reserves may have been an important factor. In non-CFA franc zone countries with nominal anchors, the import cover was about one month higher than in countries without anchors. By comparison, intermediate-inflation countries with a nominal anchor started from lower reserves than those without. However, only two countries fall in this category, and in Egypt de facto nominal exchange rate stability was part of the policy response to a surge of capital inflows. Among countries with high inflation or undergoing major price reforms, reserves were generally slightly higher (by about ¼ month of imports) in the countries adopting exchange rate anchors. An important exception was Mexico, where reserves equivalent to 12 months of imports proved important in withstanding an initial sharp decline. The issue of reserves varied considerably for the remaining countries. In Bulgaria and Romania, low initial reserves and the uncertainty over a sustainable exchange rate level deterred the adoption of an exchange rate anchor. In contrast, in Czechoslovakia the decision to peg the exchange rate in spite of low initial reserves was decisively influenced by the early commitment of the international community. In Argentina, low reserves did not prevent the adoption of an exchange rate anchor: with highly substitutable domestic and foreign currencies and a sophisticated financial system, the stabilization program was expected to induce a rapid turnaround of capital flows.

Table 4-5.

Initial Conditions in Countries with Exchange Rate Anchors

(In percent unless noted otherwise)

article image
Source: IMF staff estimates.

Inflation in the year before the first arrangement approved between mid-1988 and mid-1991, as estimated at the time of program approval.

Inflation targeted for the first year of the arrangement of the first arrangements approved between mid-1988 and mid-1991 less initial inflation.

Fiscal position (in percent of GDP) in the year before the first arrangement approved between mid-1988 and mid-1991. Broadest definition of public sector for which data were available.

Fiscal position (in percent of GDP) targeted for the first year of the first arrangement approved between mid-1988 and mid-1991 less initial fiscal position.

Reserves (in months of imports) in the year before the first arrangement approved between mid-1988 and mid-1991.

Fiscal balance net of inflation tax.

Initial data for June 1989; targets for December 1989.

To protect the external position, most countries devalued—often by a large amount—before the initial setting of the exchange rate. These devaluations were conditioned by the great uncertainty over the exchange rate level consistent with a sustainable balance of payments—particularly in countries undergoing massive structural changes—as well as the anticipated erosion of competitiveness. Consequently, they tended to err toward the lower end of an estimated range consistent with different assumptions about the stringency of policies. This was meant to diminish the risk of the rate rapidly becoming overvalued. On the other hand, there were clear risks that excessive devaluations would impart an inflation bias.15 While the actual direction of the bias remains a difficult issue, the level at which the exchange rate was pegged appears not to have been the critical factor in the success or failure of an anchor strategy.

Table 4-6.

Initial Conditions in Countries Without Nominal Anchors

(In percent, unless noted otherwise)

article image
Source: IMF staff estimates.

Inflation in the year before the first arrangement approved between mid-1988 and mid-1991, as estimated at the time of program approval.

Inflation targeted for the first year of the arrangement of the first arrangements approved between mid-1988 and mid-1991 less initial inflation.

Fiscal position (in percent of GDP) in the year before the first arrangement approved between mid-1988 and mid-1991.

Fiscal position (in percent of GDP) targeted for the first year of the first arrangement approved between mid-1988 and mid-1991 less initial fiscal position.

Reserves (in months of imports) in the year before the first arrangement approved between mid-1988 and mid-1991.

Inflation rate measured in terms of average consumer price index (end-period consumer price index not available).

Table 4-7.

Inflation Performance in Countries with Exchange Rate Anchors1

(In percent)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

As estimated at the time programs were approved.

Inflation during half-year period (t = second half of 1989).

Inflation rate measured in terms of average consumer price index (end-period consumer price index not available).

Inflation target values for 1989 not available.

How Well Did Nominal Anchors Work?

The success of nominal anchor strategies can be judged by two basic criteria: whether countries with nominal anchors were more successful than those without in reducing inflation and/or maintaining it at a low level; and whether nominal anchors helped reduce the costs of disinflation. Against these two criteria, this section examines five questions. First, what was the record of success in reducing inflation in programs with and without anchors? Second, did anchors add to the impact of other policies, especially fiscal restraint, on inflation? Third, what were the costs of using the exchange rate as an anchor? Fourth, did the use of anchors have adverse effects on growth? And fifth, what conditions affected the sustainability of nominal anchors?

Table 4-8.

Inflation Performance in Countries Without Nominal Anchors1

(In percent)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

As estimated at the time programs were approved.

Inflation rate measured in terms of average consumer price index (end-period consumer price index not available).

Inflation Record

The difference in inflation performance of countries that used exchange rate anchors and those that did not was stark (Tables 4-7 and 4-8). In countries with anchors (excluding Argentina and Yugoslavia) inflation fell on average by 41 percentage points in the first program year under review, and by a further 22 percentage points in the subsequent year.16 In countries without anchors—excluding Argentina (1990), Brazil, and Guyana—inflation rose by about 22 percentage points in the first program year, but fell slightly in the following year.17 The sharp contrast in inflation performance is confirmed by the median rate for countries with and without anchors.18

The gap in inflation performance was greatest for the high-inflation countries. Among countries with an anchor, inflation fell by three fourths in the first year and continued to fall thereafter. This result was dominated by the sharp initial disinflation in Yugoslavia, and by the significant progress in reducing inflation in Mexico and Poland. In Czechoslovakia, prices rose more than expected in the first year of the arrangement, but inflation declined rapidly thereafter. In high-inflation countries without an anchor, inflation also declined on average, but by about one fifth of the drop in countries with an anchor. Moreover, the average decline was heavily influenced by Argentina (which returned to an exchange rate anchor in 1991); in most of the other countries there was little progress in reducing high or chronic inflation. In the intermediate inflation range, inflation increased in the first program year and then subsided in countries without an anchor, while progress in reducing inflation was faster and larger in countries with an anchor. In the low range, inflation almost doubled in countries without an anchor, while it was kept in check in countries with an anchor.

The initial progress in reducing inflation proved short-lived in some countries where the anchor had to be abandoned (Argentina) or had become clearly unsustainable (Yugoslavia). Financial policies inconsistent with a pegged exchange rate led to severe external reserve losses, a sharp rebound of inflation, and a loss of credibility. Thus, in Argentina, after declining from 200 percent a month in July 1989 to 6 percent in October, inflation rose to 40 percent in December 1989. In Yugoslavia, after virtually halting in April–June 1990, monthly inflation rose to over 7 percent in September–October 1990.

Notwithstanding the sizable drop in inflation in countries that adhered to a nominal anchor, targets at least for the first program year were significantly exceeded in some countries. This result largely reflected the underestimation of the initial price shock in Central Europe and the inflationary effects of the subsequent wage catch-up, for instance in Poland. Higher-than-targeted inflation was even more frequent in countries without anchors, affecting 17 out of 22 countries. Targets were significantly overshot in Brazil, Bulgaria, Guyana, Romania, and Uruguay.

Adherence to Fiscal Targets

Was the greater success in reducing inflation of countries with exchange rate anchors simply the result of stronger fiscal adjustment or did the nominal anchor add something to the process? The strict complementarity of nominal anchors and fiscal adjustment and the mutual reinforcement of a rapid disinflation and fiscal consolidation—mainly through a reversed Olivera-Tanzi effect (Olivera (1967), Tanzi (1977)) and lower interest payments in highly indebted economies—make this a difficult question to address.

Notwithstanding this caveat, countries that adopted exchange rate anchors not only were more ambitious in their fiscal targets but also achieved a significantly greater fiscal adjustment. In other words, exchange rate anchors were on average used when there were prospects, subsequently realized, for a decisive and front-loaded fiscal adjustment. Countries with exchange rate anchors on average reduced the deficit relative to GDP by over 3 percentage points in the first program year, reaching the targeted change (Table 4-9). By comparison, excluding outlier cases, countries without anchors reduced the deficit relative to GDP by only 1.3 percentage points, or about two thirds of their less ambitious targets (Table 4-10). In both groups, the fiscal consolidation was subsequently partly reversed (by 0.5 to 1 percentage point of GDP).

Because disinflation itself typically lowers interest payments and therefore the overall deficit, comparisons of fiscal adjustment would ideally focus also on operational or primary deficits. Although data do not exist for all countries and cover a narrower fiscal aggregate (typically the central government), what data are available confirm the pattern of adjustment noted above. Countries with exchange rate anchors on average targeted a more ambitious primary balance adjustment in the first program year (about 4 percent of GDP) than countries without anchors (2.3 percent of GDP), and excluding outliers achieved a greater primary balance improvement—3.1 percent of GDP, compared with 2.2 percent of GDP in countries without anchors (Tables 4-11 and 4-12). Once again, part of the progress made was subsequently reversed.

Table 4-9.

Fiscal Performance in Countries with Exchange Rate Anchors1

(Fiscal balance, broadest coverage available; in percent of GDP)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

As estimated at the time programs were approved.

Fiscal balance net of inflation tax.

Target and actual ratios to GDP for Argentina are not comparable because of large GDP revisions.

Differences in overall fiscal performance among countries with exchange rate anchors were also large. On the one hand, Mexico, Egypt, and Morocco achieved sizable fiscal adjustments.19 In Mexico, this adjustment and success in reducing inflation were mutually reinforcing: much of the reduction in the overall deficit came from lower debt-servicing costs as nominal interest rates fell. Egypt and Morocco mainly adjusted the primary balance. On the other hand, large fiscal imbalances persisted in most CFA franc zone countries (except in Gabon), and with the drop in output, public finances deteriorated in Poland (after an initial overperformance) and, to a lesser extent, in Czechoslovakia.

Table 4-10.

Fiscal Performance in Countries Without Nominal Anchors1

(Fiscal balance, broadest coverage available; in percent of GDP)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

As estimated at the time programs were approved.

Target and actual ratios to GDP for Argentina are not comparable because of large GDP revisions.

Notwithstanding the importance of the fiscal adjustment, exchange rate anchors appear to have added to the disinflation process and to the success in sustaining low inflation. This may be seen by comparing the inflation performance of countries with and without exchange rate anchors in program years in which overall fiscal balance targets relative to GDP were met (Chart 4-1 and Appendix Table 4-A2). For this relatively small sample of program years, inflation fell substantially in countries that achieved fiscal targets and had anchors, while in those that achieved fiscal targets and did not have an anchor the decline in inflation was modest. Of course, this pattern could reflect the greater ambitiousness of fiscal targets in countries with anchors. However, a simple comparison of disinflation and fiscal adjustment between the pre-program year (t – 1) and t + 1 suggests a much greater reduction in inflation for a given reduction in the deficit in the countries with exchange rate anchors than in the countries without: specifically, the average reduction of inflation for each percentage point of fiscal adjustment amounted to 17.6 percentage points in countries with anchors, and to 1.2 percentage points in countries without (Appendix Table 4-A3). Not surprisingly, high-inflation countries account for this result. In the intermediate inflation range, the larger inflation decline in countries with anchors was associated with a much larger actual fiscal adjustment (by 4.5 percent of GDP).

Table 4-11.

Primary Fiscal Balance in Countries with Exchange Rate Anchors1

(Broadest coverage available; in percent of GDP)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

As estimated at the time programs were approved.

Target and outcome data not available.

Target and actual ratios to GDP for Argentina are not comparable because of large GDP revisions.

Target data not available.

Monetary Conditions

With highly mobile capital, even restrictive ceilings on net domestic assets were frequently not sufficient to contain money growth and inflation. On average, both in countries with exchange rate anchors and in those without, money growth exceeded targets for the first program year.20 Nonetheless, even though deviations from the targeted growth of net domestic assets were small in countries with exchange rate anchors, money growth decelerated, while in most countries without anchors money growth kept increasing (Tables 4-13 and 4-14).

Table 4-12.

Primary Fiscal Balance in Countries Without Nominal Anchors1

(Broadest coverage availably; in percent of GDP)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

As estimated at the time programs were approved.

Target and actual ratios to GDP for Argentina are not comparable because of large GDP revisions.

Target and outcome data not available.

Target data not available.

A credible nominal anchor can have a variety of often offsetting effects on money demand. One frequently observed effect is in enhancing the role of financial restraint and structural reform in restoring confidence in the economy and thereby lowering velocity. With restrictive ceilings on net domestic assets, this tends to attract capital inflows. At the same time, however, declining inflation typically lowers the demand for nominal money balances. Money growth is influenced by the relative importance of these factors. In fact, the contribution of net foreign assets to money growth in general increased in the first year of programs with exchange rate anchors, partially offsetting the effect of credit restraint (Tables 4-15 and 4-16). Notably, however, this offset was, on average, far smaller in the countries with exchange rate anchors than in countries without. On average in the latter the increase more than offset the declining contribution of net domestic assets, and money growth increased. This suggests that the combination of fiscal restraint and an exchange rate anchor exerted a sufficiently strong effect on expected and actual inflation so that a lower money growth could be attained.

Chart 4-1.
Chart 4-1.

Inflation Performance When Fiscal Targets Were Met

(Average of program years: in percent)

Source: IMF staff estimates.1Average of 15 program years accounting for 37 percent of program years of countries without nominal anchors: Uruguay, 1991; Zaïre, 1989; Jamaica, 1991/92, 1992/93; Ecuador, 1989, 1990; Venezuela, 1989, 1990; Guyana, 1991; Nigeria, 1989; Costa Rica, 1992; El Salvador, 1990; Hungary, 1990; Tunisia, 1990, 1992.2Average of 9 program years accounting for 36 percent of program years of countries with exchange rate anchors: Poland, 1990; Mexico, 1989, 1990, 1991; Honduras, 1991; Egypt, 1991/92; Trinidad and Tobago, 1990; the Congo, 1990; Mali, 1989.3As estimated at the time the programs were approved.

The limitations of credit ceilings in restraining money expansion are even more evident in countries without anchors that met fiscal targets relative to GDP. On average, in all annual programs in which fiscal targets were met and an anchor was not used, broad money growth increased from 33 percent in the pre-program year to over 36 percent during the first program year—against a target of 22 percent—and further to 50 percent in the following year. The overshooting of money targets (by over 14 percentage points) was fully accounted for by a larger-than-expected expansion in net foreign assets (by over 16 percent of the initial money stock), while the contribution of net domestic assets to money growth remained within program targets.

Indexing Arrangements

The effectiveness of a stabilization program supported by a nominal anchor is greatly enhanced by the removal of indexing practices, particularly for wages.21 When backward-looking indexation is widespread, the role of an anchor in influencing expectations, one of the most potent channels through which anchors are likely to work, is severely limited. For countries without a nominal anchor, backward-looking indexation practices are an important source of inflation inertia.

A precise characterization of the degree of indexation in most countries outside Central Europe is not possible with the scanty data available and the complexity of existing wage-setting arrangements. It is clear, however, that the persistence of high and intermediate inflation rates in many countries without nominal anchors reflects widespread indexation, whether formal or informal. In Argentina, Brazil, Costa Rica, and Uruguay, public sector wages, at least, were formally indexed. In Algeria and Venezuela, there appears to have been a high degree of de facto indexation. In Bulgaria and Romania, there were large reductions in real wages early in the arrangements but rather close indexing of public sector wages to consumer prices thereafter.

In countries with exchange rate anchors, in general there was not much progress in removing backward-looking formal or de facto indexation. The most notable exception is Mexico, which formally replaced backward indexation with a forward-looking scheme. Argentina, however, did not implement changes to the indexing of public sector wages when the exchange rate was fixed in July 1989, and Yugoslavia’s effort to freeze wages in 1989 was unsuccessful. In other countries with nominal anchors, the extent of indexation is not clear, although there were no notable efforts to change existing practices.

Trade-Offs with External Performance

Success in reducing inflation in countries with an exchange rate anchor came at the cost of deteriorating competitiveness and weaker export volume growth relative to countries that did not have an anchor (Chart 4-2 and Appendix Table 4-A4). Nevertheless, countries with anchors on average recorded a larger improvement in their current account positions. In general, this suggests that the effects of stronger fiscal adjustment on domestic absorption more than offset the short-run effects of weakening price competitiveness. At the same time, the import cover of reserves rose by slightly less in the countries with anchors than in the countries without.

Table 4-13.

Broad Money Growth in Countries with Exchange Rate Anchors1

(In percent)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

As estimated at the time the programs were approved.

Broad money growth excluding valuation changes.

It is important to remember that many factors unrelated to the role of nominal anchors contributed to differences in external performance. For instance, in Central Europe the collapse of Council for Mutual Economic Assistance trade and unmarketable product mixes, in addition to the loss of price competitiveness, induced a sharp contraction of export volumes. Also, current account positions in Central European countries with and without nominal anchors were influenced by the response of imports to the collapse in output and, in some countries, to financing shortfalls. In Mexico, widening current account deficits reflected private saving behavior and the large capital inflows, stemming from the confidence instilled by major structural and fiscal adjustments, as well as the nominal anchor itself.

The deterioration in price competitiveness in countries with nominal anchors was large in high-inflation countries, but still noticeable in intermediate inflation countries (Tables 4-17 and 4-18). The level of inflation affected both the extent to which nominal depreciations before the adoption of a nominal anchor were sustained in the real effective exchange rate and the continuous real appreciations once the anchor was in place. In contrast, countries without an anchor typically saw little change or a drop in the real effective exchange rate irrespective of the level of inflation: gains achieved before and during the first annual program were only slightly reversed afterwards. To some extent these divergences in the evolution of real effective exchange rates may have been offset by more rapid gains in productivity in the countries that successfully disinflated or maintained low inflation. However, that any such offset was not complete is suggested by marked differences in export volume growth between countries with and without nominal anchors, although limited data prevent a clear picture. Intermediate-inflation countries—mainly without anchors—stand out for their generally brisk export performance.

Table 4-14.

Broad Money Growth in Countries Without Nominal Anchors1

(In percent)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

As estimated at the time programs were approved.

Broad money growth excluding valuation changes.

Table 4-15.

Contributions to Broad Money Growth in Countries with Exchange Rate Anchors1

(In percent)

article image
Source: IMF staff estimates.

A t denotes the first year of the first arrangement reviewed for each country, except where otherwise noted.

Excluding valuation changes.