Worried, Whining, and un-Willing.

A couple of weeks ago I went to Colombia, and I found several things that were “business as usual”, but some others that were very unusual.

It was not surprising that the cab driver knew the exchange rate up to the third decimal. It was surprising that he spent half an hour talking about the impact of the real exchange rate appreciation and what should be the proper monetary policy response to capital inflows. He was fairly worried. It was expected that most people in the private sector were concerned with the strengthening of the peso and the excessive boom in the real estate market; as was predictable that they were complaining constantly. It was unexpected, however, that they put all the blame on the monetary authority and excused so rapidly the fiscal side from any responsibility. Hence, they mostly whined. Finally, it was not shocking that they were absolutely insulted by my policy advice; what was astounding is that I really didn’t mean to insult them this time. I only suggested that they should increase taxes. They were noticeably unwilling.

In this new world, in which inflation targeting is taking over every single possible piece of land with a flag, it is interesting to evaluate how much a central bank can do to control a severe exchange rate appreciation. First, it depends on what type of shock hits the economy. Monetary policy would find easy to handle a demand shock that creates both an appreciation of the exchange rate and domestic inflation, but it would have a hard time dealing with a supply shock that creates deflation and an appreciation of the real exchange rate. Second, it depends on the strength of the financial sector to handle large fluctuations of interest rates and the money base to be able to stabilize the real exchange rate. And finally, it depends on how coordinated the fiscal side is with the monetary authority. It is really difficult to control a real exchange rate appreciation driven by capital inflows when the fiscal side decides to embark in an expenditure extravaganza at the same time – you know, like Venezuela every time oil prices increase.

I believe that in inflation targeting regime the fiscal side has a larger share of the responsibility in the stabilization of the economy, and transitory real exchange rate appreciations, real estate market booms, or overheating in the labor market, have to be resolved with counter-cyclical fiscal policies more forcefully.

I would like to open a discussion on how Latin American countries, that are experiencing massive capital inflows and improvements in their terms of trade, but have moved their monetary policies toward inflation targeting regimes, can cope with the real exchange rate appreciation without the help of the fiscal side.

7 Responses to "Worried, Whining, and un-Willing."

  1. Eduardo Morón   May 24, 2007 at 11:09 am

    Roberto Could you re-write your last paragraph? It seems that is missing something. Sorry for the whining….  Eduardo

  2. Nouriel   May 24, 2007 at 11:19 am

    Roberto, a most interesting contribution to the Latam blog. In the ongoing debate on how Brazil, Colombia, Argentina and other Latam countries should be managing the latest capital inflow episode you bring to the discussion the issues that few have so far addressed: the role of fiscal policy. As I understand you argue that a more conservative fiscal policy in Colombia – an increase in taxes – could reduce the capital inflows and the upward currency pressure. The traditional argument for using fiscal policy as a way to address a capital inflow episodes starts from the consideration that currency/intervention policy and monetary policy alone cannot deal with an excessive capital inflow episode. Rather, a fiscal contraction can reduce the inflow by improving the current account balance and by reducing domestic interest rates. But the effect of contractionary fiscal policy on the capital inflows may be ambiguous: if the primary fiscal surplus is very large – as in some Latin countries – it is not politically feasible to increase it further; also, even more prudent fiscal policy may attract more foreign capital – rather than reduce it – as greater fiscal discipline reduces the country risk and thus the sovereign spread.  So you are right that fiscal discipline is lacking in Colombia and fiscal tightening – via higher revenues – should be achieved. But in which way would this fiscal tightening resolve the capital inflow problem? Could it instead exacerbate it? How would fiscal contraction specifically help? By reducing the overheating of the economy? Your points are valid but it may be worth fleshing out in more detail the role that fiscal policy can and should play.

  3. Paulo Hermanny   May 24, 2007 at 1:23 pm

    Roberto,  Let’s take the example of Brazil. First of all, the strongest real BRL since the beginning of the floating regime in 1999 was caused by the intense trade flow and high rates. The exports boom where caused by increase in commodity prices and increase in competitiveness of exports. High interest rates where needed to deal with inflation in the inflation targeting regime but it has induced a strong carry trade inflow. The Central Bank has been blamed for the strong FX and people in the private sector ask for measures to put the BRL “back to where it belongs”.   Secondly, as long as the current account is fairly positive I don’t see why to worry too much about the strong currency. On one hand the strong currency tame tradable prices helping to ease inflation and on the other boost imports, especially capital goods, expanding aggregate supply. Actually the strong BRL is allowing for a faster interest convergence. Truly, it shall come at cost of lower exports and negative current account in the future. In fact, the Central Bank seems to worry and not by chance international reserves are highest level ever and Brazil is moving towards a semi-fixed exchange regime.   Now coming back to your point, the fiscal tightening as you suggested is not feasible in Brazil. The tax burden is already 35% of GDP. The tightening has to be implemented thru a reduction in government size and spending followed by taxes cuts. Indeed the fiscal side is Brazil’s Aquilles heel. But is also where major upsides lies. Given the high size of the informal sector in the country, a fiscal reform that induces formalization with simpler and lower taxes shall boost the country’s productivity and at the end of the day led to higher growth path.  But as Nouriel has mentioned, a fiscal tightening shall increase the capital inflow and appreciate even further the currency. On one hand, higher grow and higher productivity shall attract more FDI, increase the competitiveness of exports and induce a Balassa-Samuelson effect. However on the other hand, interest rates could fall even faster reducing the carry trade inflow. Higher growth should also increase the imports demand. On balance the effect should be very positive.   I don’t believe that policy recipes would work for all countries regardless their own economic environment. However sound economic policies based in the inflation targeting, fiscal responsibility and floating exchange rates led to a major improvement it Brazil’s fundamentals, it is only a matter of fine tuning now.     Paulo F. Hermanny Chief Fixed Income Strategist Itaú Corretora de Valores S.A.

  4. Jorge Sol Perez   May 26, 2007 at 6:39 pm

    The following should be considered in the discussion on capital flows and fiscal policy.  1. Basic Balance  Colombia’s Basic Balance, relative to GDP, adjusted towards equilibrium from 2005 to 2006. As per Central Bank data, the Basic Balance (Current Account of BOP PLUS Net FDI was 2.1% of GDP in 2004; increased to 3.0 % of GDP in 2005; declined to 1.8% of GDP in 2006. The surplus of 1.8% of GDP observed in 2006 suggests that the Colombian currency still needs to appreciate vis a vis the US dollar. This may result in larger and sustained FDI (net) flows to Colombia.   2. Large Scale Privatizations in 2006 and through March.2007.  Public policy formulation towards capital flows in Colombia shoul also consider that substantial portion of capital inflows is explained by the sale and privatization of State assets in 2006 and early 2007, among which: TELECOM, OLA, Superview, TV Cable, DHL, Propol Monomeros, and others. This is a one time, capital flow, privatization effect. Central Bank net purchases of foreign exchange in QI of 2007 were largely a response to these events.  3. Other Capital Flows  Short term capital, net, was negative in 2006: $ -3.8 billion USD (-2.8% of GDP). NFPS flows were $ 1.6 billion net positive for the Government and negative ($ -1.1 billion, net) for the rest of the Public Sector. Therefore, public policy should specifically focus on the type, and net direction, of capital flows occurring and not on capital flows in general.  4. Non Financial Public Sector Improvement: Overall stance  It is not only the trend, the surplus, in the Primary Balance that is important. The overall borrowing requirement of the NFPS is the key. Available Central Bank data through September 2006 shows the overall NFPS in surplus for quarters I, II, and III. In 2005, quarter I was in surplus, but quarters II and III were in deficit.

  5. Hugo Franco   May 28, 2007 at 4:27 am

    Mr. Rigobon,   These sort of analysis are always elusive with one of the central points in Economic Policy: the own policy. Uribe’s regime cannot conceive any taxes increasing because it hasn’t been risen to act in that way. Further than the dogmatic and puerile economic understanding of his government economic team, Uribe has got a weak position respect to his main campaign supporters and, of course, governability ensurers: in a place such Colombia, with its highly rate of capital concentration, horizontal monopolies are the norm, so they have the key to the stability via the information they put on the air through their mass media groups.   As evidence of that fact, it’s easy to remember the war that Caracol Radio declared to Gaviria’s economic responsible, Rudolf Hommes, when he tried to increase taxes to alcoholic beverages consumption (Bavaria -beer producer- and Caracol -mass media- were owned in that time by J. M. Santodomingo, the richest man of the country and now an active Uribe supporter). Uribe’s permissivity to that sort of trusts has reached unbelievable levels when his government allowed Santodomigo to present a company sell (Bavaria to SAB-Miller) as a fusion, granting Santodomingo a huge taxes “saving” (evasion, of course).  On the other hand, Uribe’s regime has a strong corporatist character, and, moreover, is prisoner of the fragile parliamentary equilibrium reached by promises about public transfers to regions (managed by the regional representatives), so it cannot move to a responsible austere public fiscal policy, because their congress allies will immediately stop supporting its legislative initiatives, as is happening these very weeks.  Colombian state is characterized by a voracious clientelism, nested specially in the Parliament, so it is impossible for Uribe to take the fiscal policy far from the intense requirements of the regional barons, who are the key to his permanency as president.

  6. Jesús M Martínez   May 28, 2007 at 10:27 am

    Well the comments are OK but, not a word on the role of dollars from the drug business? During the first quarter 2007 the Central Bank bought US$4,527.4 millions while the privatizations (Ecogás and Bancafé) of late 2006 were about US$2,000. millions, Colombia has not had the boom in the export sector that basically de rest of the Countries of the area have enjoyed -its trade balance has been negative for some time-, so far this year net inflows seem to be in the order of US$2,850 millions, mostly direct foreign investment for the oil and mining sectors, I assume capital goods, and yet the dollar continues its downward trend. Can a change in fiscal policy revert that trend without a more severe look at the role of the drug business? It does not surprise me “that they were absolutely insulted by my policy advice” since they know by experience who will pay if taxes are increased. Recently the Government tried that route, lower the corporation’s tax rates and increase the sales tax, called IVA en Colombia.

  7. Anonymous   December 13, 2007 at 2:18 pm

    Roberto,Adjusting tax rates to deal with capital flows?!? That is non-sense. Scary non-sense.Tax smoothing, anyone?