José De Gregorio: Exchange rate and export development
Speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the Special
Session on Exchange Rate at the Chamber of Deputies and the 23rd National Meeting of
Fruit and Vegetable Producers, Santiago de Chile, 6 October 2010.
* * *
Chile has prospered during recent decades thanks to globalization. Having tried various
strategies, we can say we have reached consensus on this matter. For an economy of our
size and characteristics, opening up to the rest of the world is essential for creating the
competition and efficiency that will stimulate development. Four decades ago, this idea was a
voice in the desert in developing economies, but today it is the accepted norm.
There is also consensus that monetary and exchange policy should be conducted by an
autonomous central bank, and that fiscal policy should be governed by transparent,
predictable and sustainable rules. After much trial and error, our country adopted an
institutionality that has allowed us to walk through complex international situations with
relative stability.
Today I would like to discuss how we at the Central Bank of Chile view the challenges facing
export development, in particular with regard to monetary and exchange-rate policy.
Let me open by explaining the four principles guiding our decisions, so I can clarify some
misconceptions with respect to the Central Bank and the exchange rate.
To begin with, the Central bank is not indifferent to the movements of the exchange rate, in
the same way as we are not indifferent to the evolution of unemployment, credit or any other
variables relevant to the country's economic performance. The Bank's constitutional act
mandates that we safeguard price stability and the normal functioning of internal and external
payments, but fulfilling this mandate requires us to adopt those measures which will drive the
economy to making full use of its resources and maintaining a sustainable balance of
payments. Price stability and financial stability are cornerstones of our economy's
performance, growth potential and human well being.
I could make a lengthy discourse about how the Central Bank reconciles its mandate with
welfare objectives but I think it is enough to observe our track record over the past two years
to recognize that if output and employment are recovering so strongly today, it is largely
thanks to the flexibility of our monetary policy in facing the worst global economic downturn in
almost a century.
Our second principle is that we have to evaluate the effectiveness, costs and benefits, of our
actions. We must also explain with maximum rigor and transparency our decisions and
opinions regarding the main trends of our economy. Our reputation and credibility would
suffer if we took any actions without being soundly convinced that they would be both
convenient and effective towards achieving our objectives and at the same time inflict the
smallest possible social cost.
The third principle is that the Central Bank does not use the exchange rate to target inflation.
There are many examples of financial crises and economic disasters when the exchange
rate has been used as an anti-inflationary tool, generating serious exchange setbacks that
only brought on substantial, costly adjustments to the real sector and caused long-lasting
harm to GDP potential.
However - and I must say this not to fail on the second principle I mentioned earlier - the
exchange rate does affect inflation and, yes, it is affected by monetary policy in the short
term. This is a channel for transmitting monetary policy in open economies that mitigates the
cost in terms of increased unemployment of meeting the inflation target. Let me rephrase
this. Inflation is controlled via the interest rate: if the outlook is inflation rising, then the
interest rate is raised. In a closed economy, interest rate hikes slow down demand, which
means that they also slow down economic activity and employment, thereby controlling
inflationary pressures. This allows medium- and long-term policy to be upheld but obviously
inflicts short-term costs. That is what stability is all about. In an open economy, on the other
hand, there is an additional channel and that is the temporary exchange rate appreciation
that results from raising the interest rate and this diminishes the need to slow down economic
activity. The effects of exchange rate fluctuations on activity are an important factor in our
evaluation of the inflation outlook and in our monetary policy decisions. At the present time,
interest rate differentials with developed economies are well below historic averages and the
interest rate is still below normal levels.
The fourth principle I want to discuss is that stronger countries generally have stronger
currencies. In other words, the purchasing power of their wage packets is comparatively
greater as these economies outpace the rest of the world. We could discuss many more
factors, such as ways to mitigate appreciation, what circumstantial factors spur it, etc. At the
end of the day, what we need is to transform the cyclical strength of our economy into
greater productivity which will increase our potential for growth. But it is important to note that
this principle does not work the other way around. In the past we have been obnubilated
equating a strong currency with a strong economy, but we soon had to realize that the
strength of the currency was not due to a fundamentally sound economy but rather the
outcome of policies inducing currency misalignment.
I would like to draw your attention to the fact that I have not included a flexible exchange rate
as one of the principles, in order to avoid dogmatism. But in our country, experience
overwhelmingly shows that exchange rate flexibility, managed pragmatically, is the most
adequate system for us. This regime some times involves drastic exchange rate
adjustments, which can be costly to many firms. The alternative is a more rigid exchange
rate, where fluctuations in foreign currency supply are mirrored by fluctuations in domestic
credit cost and availability, which can be very detrimental to the financial system's soundness
and to firms. More rigid systems simply put off real-sector adjustments, but in the meantime
capital flows, credit availability for firms and inflation are all affected and eventually the value
of the currency is eroded and the higher nominal exchange rate does not lead to a higher
real exchange rate.
On the other hand, a floating exchange rate allows more rapid adjustments and the next
movements of the exchange rate are uncertain, preventing the market from betting on one
direction. Thus we avoid repeating past mistakes and returning to the days where prospects
of gradual appreciation artificially cheapened foreign borrowing and induced massive capital
inflows.
Another important factor in determining the exchange rate are pressures from fiscal policy.
For more than twenty years, Chile has benefited from a responsible fiscal policy, using it
counter- cyclically when the situation warranted. Questions of budget go beyond
macroeconomic considerations but the fact is that in the present circumstances our economy
has started to take off and does not require an additional boost from fiscal policy. The
Finance Minister's recent statement on the budget aims towards reducing the structural fiscal
deficit and is fully coherent with assumptions in our latest Monetary Policy Report.
Now, from the standpoint of export development, several aspects are worth highlighting.
Firstly, since the mid-1970s, Chile adopted an ambitious agenda of insertion into the world
economy. This drive has accelerated and deepened over the years. Some sectors of the
economy that were protected by international trade barriers had to adjust. Eliminating
protection meant that each productive activity had to focus on its own comparative
advantages and the export sector benefited from this structural change, as confirmed by the
sustained growth of exports as a percentage of GDP. In the 1970s, goods and services
exports accounted for about 10% of GDP (measured in pesos of 2003) while in the past five
years they averaged 38%. Moreover, this increase has been based mainly on the growth of
non-copper shippings which went up from only 30% of total exports in the 1970s to 70% in
the past five years. That is, more than 80% of Chile's exporting boom since the 1970s is due
to non-copper exports.
Of course, this growth has not been free of reversals or accelerations due to external
conditions and domestic circumstances. Among external factors we can point to the sharp
global downturn caused by the debt crisis and the 2009 recession and, of course, the
devastating earthquake and tsunami in February this year. Among domestic factors, we had
the necessary sharp cutback to address high levels of foreign borrowing in the second half of
the 1980s. Nevertheless, as I said, the long-term performance bears witness to Chile's
vocation as an exporting economy.
What has been the role of the exchange rate in this process? This question can be looked at
from two different angles. First, it is worth noting that Chile's export development has
continued through good times and bad times in foreign accounts and with whatever
exchange regime was in force and, over the past four decades, almost all possible regimes
have been tried. However, on average, the real exchange rate has been significantly higher
than it was in the period of economic development based on substitution of imports. This is
no accident; practical evidence and economic theory both strongly indicate that more open
economies tend to have weaker currencies in real terms.
Second, irrespective of the exchange rate regime, foreign currency supply and demand
conditions fluctuate over time so, as in many other areas, relative currency prices must also
fluctuate. Sometimes changes in supply and demand reflect speculation and thus are not
associated with long-term fundamentals. At other times, they may reflect confusion as to the
future evolution of monetary policy. In these situations, the Central Bank can intervene to
affect the value of the currency and bring it back in line with fundamentals. The Central Bank
does not consider exchange rate flotation as a dogma and constantly evaluates any possible
over-reactions that could be harmful to the economy and call for an intervention.
In any case, we must mention some costs of interventions. Apart from the cost in net worth,
intervention requires withdrawing money used to purchase foreign exchange by placing debt.
This debt has an impact on market interest rates, affecting firms' financial costs and arbitrage
conditions, which could end up undoing the direct effects. At the same time, repeated or
frequent interventions lose effectiveness: it is essential for intervention to be an exceptional
occurrence in order to transmit the relevant information to financial markets. Nevertheless, it
is a valid tool, effective in changing the exchange rate and strengthening the international
liquidity position. The board of the Central Bank of Chile constantly evaluates the timing and
the size of any intervention and in the past few weeks it has certainly been present in our
discussions, based on weighing the benefits, costs and the present context.
In the Central Bank of Chile we use a variety of methods for assessing the real exchange
rate level with regard to its long-term fundamentals and thus we have an ample range of
estimates. Our aim is not to determine which is the equilibrium - that is the task of the
market -, but rather to detect any anomalous deviation. These discussions led us to the
conclusion in our latest Monetary Policy Report that the real exchange rate is within the
adequate range of levels, albeit in the lower part of it, and this is confirmed by the most
recent appreciation.
The real exchange rate is currently slightly below its average over the past twenty years but,
with respect to said period, terms of trade, even excluding copper, are today much better.
Similarly, our economy is enjoying a much easier net external position - that is, how much
we owe and how much is owed to us by the rest of the world - than in the 1980s and 1990s
and the real exchange rate has only appreciated slightly over what it was then.
Since the floating exchange rate was adopted, there have been three occasions on which the
board considered that intervention was warranted. In general, these interventions affected
the exchange rate. Other episodes, that showed how difficult it is to apply an effective
intervention, were experienced in the 1990s, when the real exchange rate was significantly
more appreciated that it is today, despite worse terms of trade, a weaker net external
position, massive purchases of foreign currency reserves and restrictions on capital inflows.
In emerging and industrialized economies that have successfully weathered the crisis, export
activity today faces considerable challenges. The financial crisis and the Great Recession
have had profound consequences on the developed world because of their financial
excesses. In this sense, they are facing a situation similar to what we lived through in the
mid-1980s, only now the adjustments they make locally have global implications. Current
account deficits in the advanced world will no longer be what they were five years ago, and
this implies also adjustments in the economies that had strong current account surpluses. All
this is resulting in a global reorganization of world currencies. However, not all countries are
contributing to this exchange reorganization and this generates tension in the workings of
international currency markets. I do not wish to enlarge on this point but what is happening in
Chile is happening in many regions of the world irrespective of the macroeconomic policy
measures they have adopted.
Four factors allow us to be optimistic about how Chile, as an exporting country, will be able to
face these challenges successfully. In the first place, we have learned from our past and we
have substantially reduced the harmful effects of copper price swings on the rest of
productive activities. The danger of exacerbating commodity cycles is widely recognized so
stabilizing macroeconomic policies are brought to bear. Secondly, a floating exchange rate
discourages speculation and massive capital inflows; in fact, in Chile today there is no
evidence of short-term capital inflows for this motive. Thirdly, exchange rate flexibility
promotes the development of a hedging market (a mechanism practically unknown when
there was a band-based exchange rate regime) and this is now a developing market. Access
to this market is to be encouraged, especially for small firms, and any steps in this direction
on the part of authorities are welcome. Fourthly, our financial system is solvent and well
regulated, which limits the possibility of appreciation bubbles being created by the prospect
of inexpensive financing from abroad and abundant credit.
We will continue to face important adjustments in the global economy, with exchange rate
tensions in all the economies of the world because rigidity among the most important
currencies persists. Recovery of the global economy will be gradual and will vary greatly from
country to country. This situation presents a national task, which we must each take on board
from our own perspective. In the Central Bank we are paying particular attention to the
evolution of the exchange rate because we recognize that there has been rapid and
substantial appreciation and we must be watchful that this does not hinder the vigorous
growth of our economy. That growth will be long-lasting provided that we ensure stability.
Thank you.