José De Gregorio: Exchange rate, macroeconomic policies, and the
global scenario
Speech by Mr José De Gregorio, Governor of the Central Bank of Chile, before the Senate at
a special session on the exchange rate, Valparaíso, 14 December 2010.
* * *
I. Introduction
I am grateful for the Senate's invitation to analyze exchange rate issues, some of the most
complex ones facing our country, as well as Latin American and most emerging market
economies. We are thus obligated to carefully evaluate the current economic environment,
its implications on the performance of our economy, and the measures that can be taken if
deemed necessary. In addition, these instances for analysis are important opportunities to
communicate in a very transparent fashion the vision of the Central Bank of Chile.
Along the last few decades, Chile has benefited enormously from being open and globally
integrated. This has been one of the cornerstones of our economic growth. However, the
international economy is at the same time a source of volatility for our economy. The prices
of our exports, the economic activity of our trading partners, foreign interest rates and
international investors' appetite for risk fluctuate substantially. These variables affect our
national income, fiscal accounts, external demand for our products, and the availability and
cost of external financing and, indirectly, expenditure, output, the interest rate and the
exchange rate in Chile.
It is impossible to eliminate this volatility without sacrificing the benefits of our international
openness. However, macroeconomic policies can help the economy to better accommodate
this changing reality. During the last decade, Chile's policy mix has succeeded in significantly
reducing output volatility and external vulnerability. This scenario of stability makes room for
further economic growth.
I will begin my presentation by taking a look at the major changes occurred in both the world
and the domestic economy in the past couple of years and which help explain the behavior of
our currency. Then I will examine in some detail the role that macroeconomic policies play,
with special emphasis on the monetary and exchange rate policies in this new external
scenario.
II. Factors affecting the evolution of the real exchange rate
The past six months have seen the peso appreciate around 3% against the euro, and 12%
against the dollar. The dollar, measured in multilateral terms compared to the main foreign
currencies, has hit record lows for the past 40 years.
Today, the real exchange rate index estimated by the Central Bank is 5% below the average
for the period 1990-2010 (October), and 6.5% below the average for 2000-2010 (figure 1).
However, and as I will discuss in a moment, current conditions are very different from those
prevailing over the past two decades. These factors warrant a somewhat more appreciated
real exchange rate than the average for the past twenty years. Overall, we are aware of the
volatilities affecting the international markets which can magnify the fluctuations of our real
exchange rate way beyond its long-term fundamentals.
Unbalanced recovery of the world economy
We observe that the global recovery is very dissimilar between advanced and emerging
economies. The US, Europe and Japan are growing slowly and have high levels of idle
capacity and unemployment. The financial crisis has caused them lasting damage in the
balance sheets of consumers, banks and governments that will take years to heal. Most
likely, their demands will continue to grow slowly. Recent financial turbulences in Europe
confirm this scenario.
This situation contrasts with growth in Latin America and emerging Asia. In the past year,
these economies have grown above trend, thanks to still expansionary macroeconomic
policies, increased external funding available and, in our region, improved terms of trade.
Output gaps are near exhaustion and policy-makers are withdrawing their stimulus to
demand in order to avoid an inflationary resurgence and generate a sustainable growth path.
The main projections of the world economy foresee that this disparity between emerging and
advanced economies will go on for the next two years. These aspects will be addressed in
more detail next week when we present our December 2010 Monetary Policy Report.
The real issue here is that the recovery of the developed world will not hold if it happens at
the expense of repeating the current account deficits of the pre-crisis years. A recomposition
of global demand is necessary. The crisis has left an excess of savings in the world that
drives down the international real interest rate. Meanwhile, the weakness of advanced
economies leads us to believe that they will hold on to their low monetary policy rates for a
very long time. These low real interest rates help boost domestic demand in surplus
economies with sound financial systems, like ours. The consequence is a global
reaccommodation of the currencies: deficit countries depreciate their real exchange rates,
while the rest of the world appreciate theirs.
Within this context, the currencies of most emerging and/or commodity exporting economies
are facing pressures for a real appreciation. The Chilean peso is part of this process of global
parity re-accommodation. Our currency has appreciated significantly with respect to that of
deficit-ridden economies: the US, the UK and, to a lesser extent, the Eurozone. However, it
remains stable or has depreciated with respect to the currencies of other emerging or
commodity exporting economies (figure 2).
One problem is that not every country is contributing to the foreign exchange adjustment at
the same pace. Such a disparity creates tensions in the world economy. In the Eurozone, the
rigidity imposed by the single currency slows down the real exchange rate adjustment
between economies that are going through very different stages in the cycle. In China, high
savings and foreign exchange market interventions hinder the adjustment. This can amplify
the effects on other currencies in emerging and commodity exporting economies.
However, underlying pressures continue to manifest themselves in other ways. In the deficit
economies of the Eurozone, the recession and its accompanying deflationary pressures
depreciate the real exchange rate. In emerging Asia, the acceleration of spending and
increased inflationary pressures appreciate the real exchange rate. Eventually, the foreign
exchange regime affects the real exchange rate's behavior only temporarily, and the
adjustment arrives sooner or later by other ways, some times at a greater cost.
Improved terms of trade
Another factor influencing the exchange rate's behavior has been the improvement of our
terms of trade. Along the past ten years, the ratio between the price of our exports and
imports, i.e., the terms of trade, has almost doubled. As of the third quarter of 2010, the
terms of trade exceeded the average for the last two decades by more than 60%. Underlying
this increment are the higher prices of copper, iron, wood pulp and other commodities
relative to manufactured goods, partly attenuated by the oil price increases (figure 3).
Improved of trade lead to an increase in the real national income - the sum of wages, profits
and taxes - faster than the expansion of our productive capacity. To the extent that this
higher national income is perceived as permanent by policy-makers and private agents, it
stimulates expenditure and puts pressure on the installed capacity, the domestic interest rate
and, ultimately, the real exchange rate.
In the case of fiscal earnings, for over twenty years our country has implemented a
responsible, prudential fiscal policy, generating fiscal surpluses for most of the period. Such
a policy has sought to save the transitory income from copper, cushioning the impact of
terms of trade cycles on fiscal expenditure, demand, and the real exchange rate. When
confronted with the worst international recession since the Great Depression, this fiscal
prudence allowed putting in place countercyclical measures that had no precedent in our
economic history.
In the present circumstances where the economy has already gained momentum, it is
adequate to withdraw part of the fiscal stimulus. The plan of gradual reduction of the
structural fiscal deficit announced by the government will contribute to moderate demand and
remove some pressure from the real exchange rate, although its effects will become
apparent gradually over time.
Beyond the business cycle, it is also worth mentioning that the persistence of high copper
prices in the world markets has been translating into better expectations for its long-term
price. In the first five years of the fiscal rule of structural balance, the average reference price
for copper was, in real terms as of today, US$1.14 per pound; now it is more than twice, at
US$2.59 per pound. The higher earnings from copper have allowed financing an important
increase in public spending as a percentage of GDP and greater transfers over the past few
years. This situation has consequences also on the real exchange rate.
Reduced net debtor position
Throughout the years, the flip side of the structural fiscal surplus has been a significant
reduction in public debt as a percentage of GDP, accumulated resources in foreign currency
in sovereign funds, and an improvement of the net financial position of the Chilean economy
relative to the rest of the world. This improvement also contributes to a more appreciated
exchange rate via lower sovereign risk, access to external credit in more favorable conditions
and a higher permanent income from interests paid on savings abroad (figure 4).
Sectoral heterogeneity
Because of heterogeneity in global recovery and currency evolution, the average path of the
real exchange rate blurs the diversity of bilateral or regional parities. As I have pointed out
before, the peso's real appreciation centers in the US and Europe, while it is more stable with
respect to the currencies of other emerging economies or commodity exporters that compete
with Chile in various markets (figure 5).
Such a disparity means that the effects of the appreciation of the peso have been
heterogeneous across the different economic sectors. In some, the appreciation has been
more than offset by higher export prices (mining), while in others the effects have been
mitigated by appreciated currencies in some countries of destination. The agricultural
industry, where nearly 70% of its sales go the United States and Europe, has seen a greater
appreciation (figure 6).
III. Monetary policy and exchange rate intervention
Last October, when I was invited to the House of Representatives to analyze the exchange
rate, I said there are three major principles in monetary policy conduct.
The first is that the Central Bank is not indifferent to exchange rate movements. Compliance
with our constitutional mandate demands adopting measures to orient the economy toward
full use of its resources and ensuring a balance of payments that is sustainable over time.
The international price of our currency is a very important variable in the Chilean economy's
performance, as it affects growth, inflation and the external accounts, and ultimately our
monetary policy decisions. For example, in recent months the appreciation of the peso has
helped attenuate inflationary pressures stemming from narrowing output gaps. This has been
an input in our decisions so, were it not for the strengthened exchange rate, our monetary
policy interest rate would probably be higher than it actually is.
A second principle is careful assessment of our decisions' effectiveness, costs and benefits.
We make no decision without being technically convinced that it will be effective and
convenient for the economy as a whole. Acting otherwise would only erode our reputation
and credibility, indispensable elements for achieving our objectives at the lowest social cost
possible.
Finally, a third principle is that the Central Bank of Chile does not use the exchange rate to
target inflation. Our history and that of the region is paved with stabilization measures based
on the exchange rate, which generated severe setbacks, and ended in balance of payments
crisis, financial turmoil and economic disasters. For this reason, we have evolved into a
floating exchange rate regime, which permits to better reconcile the stability of the Chilean
economy with the volatility of the external scenario.
This is not the time or the place for a lengthy discussion on the subject; suffice it to recall that
every economic crisis in Chile over the past fifty years - except the recession of 2009 we are
leaving behind with unprecedented vigor - have been associated to exchange rate
misalignments and rigidities. Furthermore, a very significant element to explain why the
emerging economies were spared the worst effects of the recent global crisis was that their
currencies floated, which allowed them to absorb the shocks, eliminated the invitation to
investors to wager against currency weakening and opened room to relax monetary policy
and provide liquidity.
However, although a floating exchange rate has many advantages for economic and
financial stability, it may happen that, at times of high uncertainty or excessive optimism,
financial flows could persistently push the real exchange rate away from its medium- and
long-term fundamentals, with negative effects on the economy. In such situations, the
Central Bank may intervene in the foreign exchange market with the purpose of mitigating or
eliminating these imbalances. If the exchange rate is actually misaligned from its
fundamentals, the intervention will have a better chance to amend the situation, while it will
also bring financial benefits. Conversely, if these are fundamental trends, the intervention will
have transitory effects at best, at a substantial cost.
Since the implementation of the floating regime at the end of the last decade, we have
intervened in the foreign exchange market on three occasions. In the current circumstances
we have not ruled it out. It is an option we are permanently evaluating.
I want to go deeper into the elements that are weighed for this decision.
It is always possible to design an intervention of such magnitude that it can affect the
evolution of the nominal exchange rate. But this has other consequences on the economy
that need consideration.
One such consequence is the need to sterilize the monetary effects of the intervention. The
money that is issued to buy the dollars must be taken out; otherwise monetary policy would
be subordinated to the exchange rate objective, jeopardizing the stability of growth and
inflation. This sterilization pressures long-term interest rates upward, which has an impact on
activity, while inducing capital inflows that render the intervention ineffective. In turn, the
intervention entails high financial costs, because financing the intervention via debt costs
more than the returns on the international reserves, except, as I said before, when it is
grounded on the expectation of an important correction of the exchange rate misalignment.
We must also consider the coherence of the intervention with the rest of the economy. A
sufficiently bulky intervention could sustain a more depreciated nominal exchange rate, even
if fundamental forces point to appreciation. However, these pressures to appreciate will take
the form of higher inflation as they will drive demand for national goods to grow too fast. In
the medium term, the real exchange rate is the same, but inflation is higher when the foreign
exchange rate adjustment mechanism is locked. Some emerging economies that have tried
to avoid the nominal appreciation of their currencies are seeing a faster acceleration of
inflation because the acceleration of expenditure squeezes internal production capacity.
As I said, currencies are appreciating around the world, even in Asian and Latin American
countries that have intervened in the market and adopted other types of financial measures
to contain this appreciation (figure 7). In fact, interventions may have attenuated somewhat
the nominal exchange rate appreciation, but at the end what we are seeking is to affect the
real exchange rate, and the evidence on the matter shows that, on average, there is no
obvious connection between the level of the countries' interventions and the behavior of their
real exchange rate (figure 8).
In Chile, the latest intervention occurred in April 2008, with visible effects on the exchange
rate. At the time, the real exchange rate was more appreciated than today, and it was only a
few weeks before the financial crisis took a turn for the worse after the collapse of Bear
Stearns, which warranted strengthening our international reserves position in the face of a
very volatile global economic and financial scenario. The exchange rate depreciated in the
first weeks after we announced the intervention, but the subsequent depreciation in the
following months coincided with a widespread weakening of emerging currencies, increased
risk aversion in global financial markets, a strengthened dollar and a fall in Treasury bonds'
interest rates.
But it is also helpful to learn from other episodes, and an interesting one happened in 1997,
when the real exchange rate hit its lowest since the crisis of the peg in 1982. That
intervention amounted to around 4% of GDP, there were capital controls, net capital inflows
were at 8.1% of GDP, the copper price was at US$1.42 per pound in dollars of today, and
the net international position was more to the debt side, at 50% of GDP. Certainly, the
floating regime, a monetary policy more aligned with international interest rates, and reduced
capital inflows have been key in limiting the amplitude of exchange rate fluctuations.
I want to highlight that net capital inflows to Chile are now less than the peaks we saw in the
1990s. Currently, capital inflows to the emerging world - particularly Latin America - have
resumed pre-crisis levels but are still below those of the 1990s (figure 9). This is largely due
to improved growth prospects in the emerging markets and to the fact that while in the
advanced economies interest rates are and will continue to be low, in emerging countries
monetary policy rates have been going up, to very high levels in some of them (figure 10).
In Chile, the current account balance for this year (i.e., our expenditures in excess of our
income) will be not too different from zero, which means that there will not be a significant net
capital inflow to finance excess spending (figure 11). It is thus important to note that I have
not mentioned among the causes of the peso appreciation net capital inflows, which in some
countries may be having some significant impact. In the 1990s we did receive substantial net
capital inflows, but today they are not the main point. Certainly this calls for continual
followup because the funds will always flow to the economies with the better prospects for growth,
including Chile. As I said, sometimes these flows can trigger lasting misalignments in the real
exchange rate with respect to its trend fundamentals.
IV. Final remarks
We are well aware of the challenges facing exporters under the present circumstances. In
particular, we understand the difficulties exporters in the agricultural sector are enduring,
whose primary destinations - Europe and the US - have not fully recovered yet from the
financial crisis, and with which our currency has appreciated more. This situation is
particularly complex in some regions. At the country level, however, it must be said that
production, employment, wages and investment are growing strongly. Our economy is totally
back on its feet after the global recession and the outlook is good.
I am convinced that our country must grow in a harmonious way and the benefits of progress
must spread to all the country. Economic growth and global integration generate sectoral and
regional adjustments; some economic activities expand and some contract, with all the
associated tensions. This is what progress is all about. To mitigate the costs of sectoral
adjustments - and, above all, the social costs involved - without hurting economic growth,
public policies face a tremendous challenge, but the instruments with macroeconomic reach
such as the exchange rate are ineffective when it comes to resolving sectoral difficulties.
Next week we will be presenting our Monetary Policy Report. We hope that our economy will
continue dynamic over the next 24 months, boosting higher income and employment for our
people. Our role is to ensure that the process is sustainable in an environment of stable
prices. We will watch over it taking every measure necessary.
In this presentation I have shown all the factors that may explain parity adjustments.
However, many of the elements now pressuring the exchange rate may be reversed in the
long term. As a matter of fact, today the real exchange rate is around the minimum levels
believed to be consistent with its long-term fundamentals, hence the importance we assign to
this issue.
So far we have not intervened in the foreign exchange market or taken any exceptional
measures because we do not think they are justified considering what I have been
presenting. We do not rule out these options, but it will depend on the evolution of our
economy and its relevant external environment, in the current highly volatile scenario. The
Central Bank of Chile will continue to orient its policies to safeguard the economy's stability
and ensure propitious conditions for growth in our country.
Thank you.
Figure 1
Real exchange rate
(index, 1986=100)
120 120
110 110
100 100
90 90
80 80
70 70
88 92 96 00 04 08
RER 1990-2009 average 1995-2009 average
Source: Central Bank of Chile.
Figure 2
Real exchange rates: cross-regional diversityl (*)
25 RER with respect to 2000-2010 average 22,1 25
20 20
16,8
GDP growh in 2011-2015: 6.7%
15 15
10 Deviation. % RER Oct.'10 w/respect to 2000-2010 10
average
5 5
0 0
-0,9
-5 -2,2 -2,4 -5
-10 GDP growh in 2011-2015: 2.4% -10
-9,5
-9,9 -9,8
-15 -15
-16,5
-20 -20
U.S.
U.K.
Chile
Japan
BRICS
Latin
Asia
Adv.
comm. America
Emerging Eurozone
exporters
(*) Regional aggregates reflect simple averages.
Sources: BIS and IMF.
Figure 3
Terms of trade
(index, 2000=100)
200 200
180 180
160 160
140
140
120 120
100 100
80 80
60 60
40 40
80 85 90 95 00 05 10(f)
(f) Forecast.
Source: Central Bank of Chile.
Figure 4
Net international investment position
(percentage of GDP) (1)
100 100
75 75
50 50
25 25
0 0
-25 -25
-50 -50
-75 -75
-100 -100
97 01 05 Mar.09 Mar.10
Institutional General government
Banks Monetary authorities
Companies and households NIIP (2)
(1) GDP at constant exchange rate (index, September 2010 =100).
(2) Net international investment position.
Figure 5
Real exchange rates by region
(monthly data; index, 2001-2009=100)
RER with respect to Asia
RER with respect to Latin America
150 150 150 150
140 140 140 140
130 130 130 130
120 120 120 120
110 110
110 110
100 100
100 100
90 90
90 90
80 80
80 80
70 70
70 70
01 02 03 04 05 06 07 08 09 10
01 02 03 04 05 06 07 08 09 10
RER with respect to the euro RER with respect to the U.S.
150
150 150 150
140 140 140 140
130 130 130 130
120 120 120 120
110
110 110 110
100 100 100 100
90 90 90 90
80 80 80 80
70 70 70
70
01 02 03 04 05 06 07 08 09 10 01 02 03 04 05 06 07 08 09 10
Aggregate RER Regional RER
Source: Central Bank of Chile.
Figure 6
Real exchange rate by sector
(index, 96-07=100)
250 250
200 200
150 150
100 100
50 50
0 0
96 98 00 02 04 06 08 10
Manufacturing Agriculture, forestry & fishing
Total exports Mining
(*) RER estimated using unit-value indexes. Latest date corresponds to third quarter 2010.
Source: Central Bank of Chile.
Figure 7
Nominal exchange rates
(averaged index, 1/Jul/2007-10/Dec/2010=100)
150 150
140 140
130 130
120 120
110 110
100 100
90 90
80 80
70 70
60 60
Peru Rep.
Chile
Japan Israel
Brazil
Africa Korea
Mexico
Canada
Zealand
Malaysia
Thailand
Australia
Eurozone
Indonesia Colombia
Czech
South
South
New
Rango (1) Promedio Spot (2)
(1) Range indicates peaks and troughs of the local currency parities during the period.
(2) Spot value as of 10 December 2010.
Sources: Central Bank of Chile and Bloomberg.
Figure 8
Real exchange rates and international reserves (*)
(percent)
10
Latvia
(%)
Denmark
5 Croatia
Lithuania
Bulgaria Hong Kong
Hungary
RER
Algeria
Czech Rep.
Estonia
of
0 N. Zealand
Norway China
Saudi Arabia
Poland
Argentina
Romania
IsraelPeru
Canada Russia
Japan
-5
Sweden Korea
Singapore
Malaysia
Phillipines
S.Africa
Thailand
Mexico
Indonesia
Australia Chile
Brazil
-10
Depreciation
India Turkey
Iceland
-15
-5 0 5 10 15 20 25
Reserve acumulation as % of GDP
(*) Considers variations between September 2009 and November 2010.
Source: Central Bank of Chile based on data from the BIS and Bloomberg.
Figure 9
Net capital flows
(percentage of GDP, average for each period)
9
8
7
6
5
4
3
2
1
0
-1
Brazil Chile Colombia Mexico Peru
1996-1997 2007-2008 2009 2010 (f)
(f) Forecast. Considers actual data through second quarter 2010 and estimates for second half 2010, based on the
share in net capital flows to Latin America in 2009 and forecast for 2010 from WEO, October 2010.
Source: Central Bank of Chile based on IMF figures.
Figure 10
Monetary policy interest rate (*)
(percentage)
12
10,8
10
7,3
8
5,3
6
4,8
3,4
4 3,2
3,0
2
1,0
0,5
0,3
0,1
0
U.S.
U.K.
BRIC
Chile
Japan Brazil
Latin
Asia
exp.
Europe America
Eurozone
Emerging Emerging
Advanced
commodity
(*) Simple averages by region. Emerging Asia includes: China, the Philippines, Hong Kong, Indonesia, India, Malaysia, South
Korea, Thailand and Taiwan. Emerging Europe includes: Hungary, Poland, the Czech Rep. Romania and Russia. Advanced -
commodity exporters includes: Australia, Canada, Norway, New Zealand, and South Africa.
Source: Bloomberg.
Figure 11
Financial accounts' flows
(millions of dollars)
12.000 12.000
8.000 8.000
4.000 4.000
0 0
-4.000 -4.000
-8.000 -8.000
-12.000 -12.000
06 07 08 09 10
Liabilities Assets Net
Source: Central Bank of Chile.